ECN202: Macroeconomics

1
ECN202 Macroeconomics

• 1970s Experiments with Money The Domestic
  Dimension
• "neither a state nor a bank ever has had
  unrestricted power of issuing paper money,
  without abusing that power in all States,
  therefore, the issue of paper money ought to be
  under some check and control and none seems so
  proper as that of subjecting the issuers of paper
  money to the obligation of paying their notes,
  either in gold coin or bullion."

2
1970s Domestic

• This would be a decade in which liberals would
  experiment with Keynesian monetary policies, only
  to have the experiment terminated in the late
  1970s when Paul Volcker, Fed chair, embraced
  Monetarism. He did this because the experiment
  led to the only period of sustained peacetime
  inflation in US history. At the center of this
  unit is interest rates, so you will need to
  understand the equation that breaks down interest
  rates into its separate components. These
  interest rates are managed by the Fed, so well
  also look at how the Federal Reserve manages
  those interest rates and how changes in those
  rates affect the economy. In the next few slides
  you will see headlines that pertain to the
  material in this unit headlines about interest
  rates and monetary policy.

3
In the news

• Interest rates on Italian bods pushed to new
  levels
• Italy Rates Remain Near Two-Year Record Low
• The world isnt flat, but its yield curve may
  be
• States and cities start rebelling on bond
  ratings
• International capital flows alter US interest
  rates
• Poland Finds Its Not Immune to Euro Crisis
• China Cuts Lending Rate as Economic Growth
  Slows
• As Low Rates Depress Savers, Governments Reap
  Benefits
• Low rates may do little to entice nervous
  consumers

4
In the news

1. Fed's Move Toward 'Monetarists 1972
2. Humility at the Fed Inflation Brakes Don't Work
   So Well 1973
3. Fed May Be Sharply Expanding Credit Supply,
   Analysts Assert 1973
4. Fed Tries Way Of Monetarists 1979
5. Economists Criticize Volcker Galbraith Issues
   Warning 1979
6. Miller Suggests Fed Moved Too Quickly
   Uncertainty on Third Step 1979
7. CAN VOLCKER STAND UP TO INFLATION? 1979

5
In the news

• Pain spreads as credit vice grows tighter
• The Feds monetary policy response to the
  current crisis
• How the Fed can fix the world
• Paying the price for the Feds success
• The Fed plans to inject another 1 trillion to
  aid the economy
• Fed Chiefs reassurance fails to halt stock
  market plunge
• Fed ties new aid to jobs recovery
• Dear Ben Its time for your Volcker moment
• Rising inflation limits Fed as growth lags

6
A great invention?

• "Money connected human in a more extensive and
  efficient way than any other known medium.  It
  created more social ties, but in making them
  faster and more transitory, it weakened the
  traditional ties based on kinship and political
  power."
• "the use of counting and numbers, of
  calculating and figuring, propelled a tendency
  toward rationalization in human thought that
  shows in no human culture without the use of
  money. Money did not make people smarter it made
  them think in new ways, in numbers and their
  equivalencies. It made thinking far less
  personalized and much more abstract."

7
A few things to know about interest rates

• 1.) there are many interest rates that tend to
  move together.
• A few important interest rates
• Discount rate rate that the FED charges banks
  for overnight borrowing
• Federal funds rate rate banks charge other banks
  for overnight borrowing Fed sets target for
  this rate
• Treasury-bill rate the rate on short-term (lt1
  year) on government securities
• Mortgage rate the rate on home loans, car loans

8
Robert Hall, Why does the economy fall to pieces
after a financial crisis
Can you see when the financial crisis hit from
this graph?
When corporate Baa bonds surged and Treasuries
sank sign investors moved to safe investments
9
Rate on banks overnight borrowing targeted by Fed
Rate on US government debt with 6-month maturity
Look at these graphs on next few slides and see
if you can see the similarities and differences
10
Rate on US government debt with 6-month maturity
Rate on US government debt with 10-year maturity
What about those differences? Are investors
worried about the USs ability to repay its debt?
11
Rate on US government debt with 10-year maturity
Rate on 30-year mortgages this impact housing
demand
12
You can see that the 1970s was a problem
13
Here is my 18.5 mortgage
Use a mortgage calculator to see what my monthly
payment would be on a 100,000, 30-year
mortgage, and then see what it would be if the
rate were 5.
14
monthly payment would be on a 100,000, 30-year
mortgage, 18 1,548 5 .536
What will this reduction in rates do to demand
for homes?
15
A few things to know about interest rates

• 2.) there are many components of risk in each
  interest rate.
• On the next slide is an equation that specifies
  the actual interest rate as dependent on a number
  of risk components plus the riskless cost of
  money that the Fed tries to manage. Later you
  will see this as the equilibrium interest rate in
  the money market. You could think of this as the
  federal funds rate. The actual rate this Plus
  premiums for the risk.

16
Decomposition of interest rates

• r rr rd rm ri rl
• where
• r nominal rate (actual rate you pay)
• rr   real risk-free rate of interest  (Ms - Md)
• rd default risk you will not bay back
• rm maturity risk longer time more things go
  wrong
• ri inflation effect more inflation less
  return
• rl liquidity effect ability to turn it into
  cash

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Default Risk
Corporate debt is riskier higher interest rate
Corporate Aaa
US 10-yr Treasury
Municipal rate lower because of tax benefits
Municipal
18
International examples of default risk

1. Argentina Crisis of 1997-1998
2. Asian Crisis (Hong Kong) of 1997
3. Subprime Crisis of 2008
4. Greece Crisis of 2009-2010

19

1. Argentina Crisis of 1997-98

Argentina Interest Rates
20
2. Hong Kong Crisis of 1997
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3. Subprime Crisis of 2008
The default premium on corporate bonds increases
in recession as investors worry about
corporations ability to pay bills
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3. Subprime Crisis of 2008
Another view of same phenomenon the gap between
the two rates increases in uncertain/bad times
23
4. Greece Crisis of 2009-2010
Investors get very worried about Greece
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Maturity Risk
3-month is less risky than 10-year
10-yr 3-mth
25
Maturity Risk Another view
Another view on maturity risk longer the
maturity the higher the rate. This changes over
time and in the aftermath of the financial crisis
the Fed tried to reduce the slope of the curve.
Any ideas on how it could do that?
26
Inflation Risk
You can see that interest rates are closely
correlated with inflation rates. What happened
in the late 1970s and early 1980s?
Inflation
3-yr Treasury
27
Real and Nominal Rates
You saw this before the relationship between
real and nominal interest rates

• rn rr ie
• or
• rr rn - ie
• where
• rr real rate
• rn nominal rate
• ie expected inflation rate

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Real Interest Rates
Now look at those late 1970s and early 1980s. Who
got burned in the late 1970s and who got burned
in the early 1980s?
Lenders got burned in the late 1970s, and
borrowers got burned in the early 1980s. This was
when Latin Americas debt crisis happened when
they could not repay their debt.
29
A few things to know about interest rates (the
price of money)

• 3.) interest rates are prices
• Keynesian theory of money demand
• Fed and the money supply process

And if they are prices, behind them is a SD
graph, so all we need to do is understand who /
what is behind those curves
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Interest rates are prices

• r interest rates
• ms money supply (M1)

Ms
Ms
Md
Md
31
Keynesian theory of money demand

• Transactions Demand
• Higher Income ? More Transactions ? More Money
  Demand
• Precautionary Speculative Demand
• Higher Interest Rate ? Higher Opportunity Cost of
  Money ? Lower Money Demand

32
Money demand the graph

• Speculative demand
• _at_ initial interest rate (r) you hold some of
  your wealth as bonds and some as money (m )
• As interest rate falls to r the opportunity
  cost of holding money declines so you hold more
  money (m) also as rates fall you might expect
  rates to rise and you would lose money holding
  bonds

r

r
Md
m
m
33
Money demand the graph

• Transactions demand
• Income rises transactions rise
• demand rises _at_ (r) you will increase your
  holdings of so you hold more money (m ) - new Md
  curve

r
Md
Md
m
m
34
Money supply
Interest rate

• When we talk about the money supply we are
  talking about the amount of cash (coins
  currency) the value of checking accounts
  (demand deposits). The idea behind this measure
  is that this is the amount available for
  transactions. Given this definition, there are
  three major players that the money supply that
  you can see in the following diagram
• Federal Reserve control the S of cash
  (high-powered-money)

Money

1. Commercial Banks control the amount of checking
   accounts issued
2. Businesses Households they are the users of
   the money and decide what form of money they want
   to hold.

35
Money Supply Process
Fed
s
s
Banks Reserves
s
Individuals Businesses (Ms) Checking Account s
Cash s
36
Money supply

• Players
• 1. Federal Reserve (FED)
• This institution controls the supply of
  high-powered money (cash)
• The most powerful unelected official responsible
  for US monetary policy is Fed Chair Ben
  Bernanke
• The banks structure is outlined in following
  diagram. The real power rests in the hands of the
  Federal Open Market Committee (FOMC). They
  ultimately decide on what to do with the money
  supply/interest rates. Actually you will hear
  about their interest rate targets,but they
  achieve those targetsby altering the money
  supply.
• 2.

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Federal Reserve structure
38
Money supply

• Players
• 2. Commercial Banks
• These institutions are financial intermediaries
  they take in our deposits and pay a certain
  interest rate and then invest the money at higher
  interest rates. They can loan money to the US
  government when they buy Treasuries (US bonds)
  and they can lend to businesses and households by
  creating checking accounts balances. The key
  feature of the banking system is it is a
  fractional reserve system, which means that banks
  can loan out more money than it has in its
  vaults. This makes banks vulnerable to runs banks
  since there is not enough cash in the banks if
  all of thecustomers with deposits want
  theirmoney back. Because banks wantto make as
  much profit as possiblethey will loan out as
  much money asthey can, which is why the Fed
  regulates how much the banks musthold as cash.

39
What happens in a fractional reserve system

• Think of goldsmiths in the Robin Hood days who
  robbed those with gold traveling through Sherwood
  Forest. Eventually someone figured out how to
  beat the system deposit the gold in a safe
  place (goldsmiths) who gave paper receipts
  proving ownership of the gold for a small fee.
  Now Robin Hood would only get pieces of paper.
  The goldsmiths soon realized they would end the
  day with gold in the vaults, so they issued more
  paper specifying ownership of gold. This worked
  as long as everyone with the paper did not show
  up and demand gold since there would not be
  enough. The good news was a small amount of gold
  could create a larger money supply needed to
  support more transactions. The bad news was it
  was risky and prone to runs on the goldsmiths. To
  understand banks, just replace gold with
  high-powered-money (currency) supplied by the Fed
  and the paper receipts with checking accounts and
  you have the modern fractional reserve system.

40
Banks fractional reserve system

• Regulations of commercial banks
• Because of the central role money plays in our
  economy without it the system would grind to a
  halt banks are highly regulated. The big push
  to regulate banks came in the Great Depression
  was made worse by the closing of banks that had
  made risky investments with depositors funds. To
  stabilize the banking system, the following
  regulations were put in place.
• Deposit insurance deposits were guaranteed by
  the federal government, which eliminated bank
  runs
• Bank examinations the books of banks were
  regularly reviewed
• Limitations on assets banks were restricted in
  terms of what they could do with the deposits
  (after the Great Depression they could not buy
  corporate stock)
• Required reserves banks must hold a percent of
  their outstanding deposits as cash the required
  reserve rate

41
Money supply

• Players
• 3. Individuals and businesses
• Businesses and households are the ones that hold
  the money and what matters is the form in which
  they hold it. Because of the fractional reserve
  system, if you put 100 in cash in a commercial
  bank the bank can loan out some multiple of that
  amount. If the required reserve rate is 10, then
  that 100 would represent 10 of 1000, so the
  banks could loan out money until the total of
  checking accounts drawn on the bank totaled
  1,000. In this case the 100 of cash generated
  1,000 in the money supply. If you chose to hold
  the 100 as cash, then the money supply would be
  100. So, when you decide to hold more of your
  money as cash and less as checking accounts,
  the money supply decreases.
• Approach
• T-accounts

42
Its a Wonderful Life
Here is what can happen in a fractional reserve
system. When all of the depositors come to get
their cash the banks do not have the cash so they
simply close their doors. This is why Roosevelt
established the Federal Deposit Insurance
Corporation(FDIC) to convince depositors they
could
always get their money. The banks investments
were also regulated to reduce the chance of bank
bankruptcies. One of the problems with the
financial crisis that led to the Great Recession
is the Fed eliminated restrictions on investments
banks could make and they increased risky
investments for gt return. Banks can also decide
to hold excess cash above what they are
required and this will affect the money supply.
43

• What affects the Money Supply?
• The factors affecting the money supply fall into
  two categories depending on the Feds control.
• Uncontrolled influences
• Controlled influences
• Now we will look at what would be included in
  these two

44
Uncontrolled influences on Money Supply

1. Banks holding of excess reserves (banks hold
   excess reserves (extra cash) which is not counted
   in Ms and there is less to lend so deposit
   accounts go down so Ms decreases.
2. Publics holding of cash (1m in hand of public
   1m to money supply, but a decline in bank
   reserves of 1 means a loss in deposits of a
   multiple of the 1. With a required reserve rate
   (rrr) of 20, the multiple 5 1/rrr and
   the money supply would fall by 5m for every 1m
   held as cash.

45
Controlled influences on Money Supply

1. OMO If Fed buys 1m of Treasuries from banks
   then bank reserves rise by 1m and they can loan
   out a multiple of that 1m.
2. Required reserve rate If the Fed lowers the
   required reserve rate then the bank can lend out
   more which means an increase in Ms.
3. Discount rate If the Fed raises the discount
   rate then it is discouraging banks from lending
   money, which reduces the Ms.

46
Fed policies to increase Money Supply
If the Fed would like to increase the money
supply then it would

• OMO it would buy Treasuries and pay for them
  with new s that would expand the Ms.
• Required reserve rate the Fed would lower the
  rrr so banks could lend out more for any amount
  of reserves.
• Discount rate fed could lower the discount rate
  that encourages banks to borrow s from the Fed
  to lend out and increase Ms.

47
Money Market

• If we put the Md and Ms together we get the money
  market where the price rr from the interest
  rate equation the riskless rate of interest.
  Changes in the interest rate happen with changes
  in either the S or D and now we will look at
  some sample questions.

Interest rate
money
48
Questions

• What would be the impact on interest rates of the
  following, and how would you show it with the
  Ms-Md diagram?
• a. An economic expansion
• b. The Feds decision to raise the discount rate
• c. The Feds Open Market purchase of securities
• d. People decision to convert their checking
  accounts into cash
• e. The economy falls into recession and the Fed
  buys securities (OMO purchases)

Get that piece of paper out and draw the
appropriate diagrams
49
Questions

• a. How do you show the impact on the money market
  of an economic expansion?

Interest rate
money
50
Questions

• b. How do you show the impact on the money market
  of the Feds decision to raise the discount rate?

51
Questions

• c. How do you show the impact on the money market
  of the Feds Open Market purchase of securities?

Interest rate
Money
52
Questions

• d. How do you show the impact on the money market
  of people decision to convert their checking
  accounts into cash?

53
Questions

• e. How do you show the impact on the money market
  if the economy falls into recession and the Fed
  buys securities (OMO purchases)?

54
Questions

• What would be the impact on interest rates of the
  following, and how would you show it with the
  Ms-Md diagram?
• a. An economic expansion - this increases demand
  for money right shift in Md ?interest rate
  ?Ms
• b. The Feds decision to raise the discount rate
  this decreases supply of money left shift in
  Ms
• ?interest rate ?Ms
• c. The Feds Open Market purchase of securities
  this increases supply of money right shift in
  Ms
• ?interest rate ?Ms

55
Questions

• What would be the impact on interest rates of the
  following, and how would you show it with the
  Ms-Md diagram?
• d. People decision to convert their checking
  accounts into cash this decreases supply of
  money left shift in Ms ?interest rate ?Ms
• e. The economy falls into recession and the Fed
  buys securities (OMO purchases) this is a
  double shift - decreases demand for money
  (recession) left shift in Md increases supply
  of money (Fed) right shift in Ms. Combined
  effect is ?interest rate cant predict DMs

56
8f. What is Fed doing in 1991 and why?
Questions
Get that piece of paper out and draw the SD
graphs of the money market
(rr)
57
Questions

• The fed was driving down interest rates, which it
  did by increasing the money supply. It probably
  bought Treasuries using OMO to increase the Ms.

58
Monetary Policy

• What can monetary authorities do to manage the
  economy?

59
Question

• Here are two time-series graphs one of the
  discount rate in the US and one of the equivalent
  (bank discount rate) in Japan. Please look at the
  graphs and do a little reverse engineering to
  determine what was going on in the two economies
  during this 20 year period and what the
  monetary authorities in the two countries were
  doing to manage the economy?

60
Why the difference in the 1990s and why the drop
after 2001?
What is happening here?
61

• The short answer is you can see Japans lost
  decade in the graphs. Japans central bank had
  raised the interest rate in the early 1990s to
  stop a speculative boom, and once the bubble
  burst it lowered interest rates dramatically and
  had to keep them near zero trying to stimulate
  the economy. In the US the economy fell into a
  recession in the early 1990s so the Fed also
  lowered rates, but then began to raise them as
  the economy heated up in the Clinton years. In
  the US after 9/11 and the stock market bust the
  Fed flooded the economy with cash and kept them
  low. This fueled the housing boom in the US that
  eventually led to the financial crisis and the
  Great Recession.

62
Monetary Policy and the Economy

• Now that we see how the money market works, you
  should see what comes next. In the 1970s Nixon
  set the Fed free so the US could print money,
  and when the two recessions induced by OPEC price
  increases happened, the Fed responded as Keynes
  would have suggested. We will now look at the
  Keynesian theory of monetary policy and its
  influence on the economy. Well also look at The
  Wizard of Oz in a way that you never did as an
  allegory about monetary policy. First, however,
  we recap the Classical Quantity Theory of
  Money.

63
Classical vision of monetary policy

• Quantity theory of money
• ? M ? ? P

You have to love the simplicity if you print
more money people will try to spend it and
because we are at full employment this will
result in asn increase in prices.
64
Keynesian vision of monetary fiscal policy

• Monetary Policy
• M ? ? rr ? ? I ? ? Y

Keynes view was a little more involved. An
increase in the money supply (M) would push the
interest rate (rr) down and this would stimulate
investment(I) spending and this increase in
Investment spending would have a multiplier
effect on GDP (Y).
Now lets look at what this does to fiscal policy
65
Keynesian vision of monetary fiscal policy

• Fiscal Policy
• G??Y
• ??Md??rr??I??Y
• (crowding out effect)

Keynes view of fiscal policy changes a bit. Now
as the economy expands (Y) as a result of the
increase in government spending (G) there is a
secondary effect. The increase in income
increases money demand that increases the
interest rate ( r ) and this reduces Investment
spending (I) that reduces overall national output
(Y). This secondary effect is crowding out and it
reduces the full multiplier efect.
66
Keynesian Monetary Policy Transmission Mechanism
Now lets look at that transmission process

• 0 Recognition and Discussion lags
• Sensitivity on Md to interest rate
• Sensitivity of spending to interest rates
• 3 Spendings impact on price output

67
Question

• What happens if it is discovered that consumption
  of automobiles is more sensitive to changes in
  the interest rate than previously thought, what
  impact will this have on the relative
  effectiveness of monetary and fiscal policy?

Try to work your way through the logical chain of
events in the diagram in the following slide.
Find the link between interest rate and
Investment in the diagram and then see how a
change in money supply (M) can have an impact on
GDP (Y)
68
Answer

• Monetary Keynesian version
• ? M ?? rr ?? I? ? AD ??Y
• Fiscal Keynesian
• ?G ? ?AD ? ?Y1 ? ?Md ?
• ?r ? ?I ? ?AD ? ?Y2

Here are the two places the link between the
interest aret and investment show up. Now what
happens to the links?
69
Answer

• Monetary Keynesian version
• ? M ?? rr ?? I? ? AD ??Y
• Fiscal Keynesian
• ?G ? ?AD ? ?Y1 ? ?Md ?
• ?r ? ?I ? ?AD ? ?Y2

Bigger more effective
Bigger less effective
The first effect dominates so it is more effective
70
The Feds dilemma

• In the next side you see the Feds dilemma by
  altering the supply of high-powered money it can
  control either the price (interest rate) or
  quantity (Ms). It has to decide what to control,
  and that is where the ideological divide happens.
• Keynesian/ liberals believe the interest rate
  is the key variable to control
• Classical/ conservatives believe it is
  important to control the money supply

So, when the economy is hit by the OPEC oil
price shock and falls into a recession, what will
the liberals propose and what would the
conservatives propose?
71
Feds dilemma respond to Md
Control interest rate
Control money supply
Increase Ms
Decrease Ms
Ms
Ms
Md
Md
Lose control of M
Lose control of r
72
The 1970s

• Now lets look at what happened in the 1970s.
  OPEC raised prices and this increased Md and this
  put pressure on interest rates to rise. This
  would have pushed investment and consumption
  spending lower and caused a recession. To avoid
  this the Fed increased the money supply and this
  pushed won interest rates but also increased
  inflation which pushed interest rates up. The fed
  pumper more money in and for the decade this
  pattern continued as you can see in the following
  diagram

73
Story of the 1970s
Fed responds again? Ms ?? P ?? Md
? P ?? Md
? Ms ?? P ?? Md ? ? r
Fed responds to ?? r by? Ms
Interest rate
Q Money
74
The Shift

• The end result of the process was the US
  experienced persistent and increasing inflation
  the only time in peacetime in the countrys
  history. What happened was that Carter eventually
  responded with the appointment of the
  conservative Paul Volker as Fed Chair who changed
  strategies abruptly. He adopted Monetarism, an
  idea pushed by conservatives who believed in the
  need to shift focus to the money supply.
  Inflation was the result of too much money, so
  now it was time to control the money supply. We
  can see what happened in the following diagram.

75
A shift to Monetarism

• The Fed under Volcker reduced the money supply
• This increased the interest rate, which would be
  hard o claim as a target
• The Fed ignored interest rates and announced M
  targets that seemed better politically

Ms
Md
76
The results

• The Feds policies sent the US into its deepest
  post WW II recession and soon after the recession
  the monetarism policy was abandoned. It created
  much human misery, but it did break the
  inflationary spiral and set the stage for the
  second part of the ideological revolution the
  arrival of Ronald Reagan with his supply-side
  policies.

And now lets revisit those early questions
77
Those questions

• As we go through the analysis keep the following
  two question in mind.
• 1. Please explain. "the memory of the Great
  Depression meant that the US was highly likely to
  suffer an inflationary episode like the 1970s in
  the post-World war II period-maybe not as long,
  and maybe not exactly when it occurred, but
  nevertheless a similar episode.
• The reasoning behind the quote is that Keynes had
  provided the basis for using monetary policy to
  stimulate the economy, and eventually the Fed
  would use it. Because Keynes was writing in the
  1930s when inflation was not a problem,
  Keynesians ignored it and the result was Fed
  policies that would produce the policies of the
  1970s that created persistent and increasing
  inflation

78
Those questions

• As we go through the analysis keep the following
  two question in mind.
• 2. "Long after the Pope is gone, you'll remember
  this?"  What is the change in policy that is
  being referred to here, who was responsible for
  the change, and why was the policy change quickly
  called off?
• This was a simple one it was the shift to
  monetarism that created those double-digit
  interest rates (my 18. mortgage) and this was
  truly a shock to the system that would have a
  bigger impact that the Popes visit.

And one final question on the story the Wizard of
Oz.
79
The Wizard of Oz as Political Allegory
What is the economic story behind The Wizard of
Oz and who do the characters represent? Who is
William Jennings Bryan in the story and in real
life - and what was his Cross of Gold speech and
how was it related to the story?