Seminar: Monetary Policy in the New Macroeconomic Consensus

1
Seminar Monetary Policy in the New Macroeconomic
Consensus

• Article The Phases of U.S. Monetary Policy 1987
  2001
• written by Marvin Goodfriend
• Presented by Tobias Krüger

2
Introduction

• The article describes the interaction between
  monetary policy and the economic development in
  this period
• The monetary policy in the U.S. is controlled by
  the Federal Reserve System ( short called Fed)?
• The chairman of the Fed in this period was Alan
  Greenspan (August 1987 2006)?
• main instruments
• open market operations
• federal funds rate target

3
Introduction

• The main objectives the Fed follows in monetary
  policy
• creating and maintaining credibility for low
  inflation
• gaining the benefits from trend productivity
  growth
• responding to financial markets crisis on
  occasion
• stimulating the economy with low real short term
  interest rates

4
Introduction

• the time period from 1987 to 2001 can be divided
  into 6 different phases
• every phase is characterized by different
  economic circumstances and implications for the
  monetary policy
• each phase will be described with its economical
  background, the reactions by the Fed and than the
  results on economy

5
Phase 1 1987 1990 Rising Inflation and the
stock market crash

• October 1987 to August 1990
• begins with the stock market crash in October
  1987
• the industrial Dow Jones average felt by 30
  within few days, second biggest crash in U.S.
  History
• inflation pressures were already before the
  stockmarket crash in work
• the Fed hadn't reacted quickly enough
• inflation expectations were high

6
Phase 1 1987 1990 Rising Inflation and the
stock market crash

• responses by the Fed directly after the crash
• extensive open market policy
• dropped the funds rate from 7.5 to 6.75
• inflation went up, the CPI rose from 3.8 in
  1986 to 5.3 in 1990
• to counteract the inflation the Fed raised the
  funds rate in spring 1988 to 7 and until 1990
  to nearly 10
• real GDP growth went down from 4 in 1988 to 2.5
  in 1989
• finally the funds rate was putted down to 7 in
  the late of 1990

7
Phase 1 1987 1990 Rising Inflation and the
stock market crash

• end result
• inflation in 1990 was well above the level of the
  mid 1980s
• the Fed had reacted to late with restrictive
  policy
• it had no credibility for low inflation

8
Phase 2 1990 1991 War, recession and
disinflation

• August 1990 the Gulf War started
• recession
• oil prices went up
• households and firms reduced their spending
• unemployment rate rised to 7.8
• the restrictive monetary policy before the war
  and the recession itself made inflation going
  down
• The recession is dated from July 1990 to March
  1991

9
Phase 2 1990 1991 War, recession and
disinflation

• responses by the Fed
• extensive monetary policy
• cutted down the federal funds rate from 8 to 6
  until mid of 1991
• down to 4 in the end of 1991 and in 1992 to 3
• effects
• real funds rate went down to approximately 0
• economy recovered from the war recession
• real GDP growth went up from 0.8 in 1991 to 4
  in 1992

10
Phase 3 1994 1995 Preventing rising inflation

• February 1994 to February 1995
• economy had recovered and started growing
• the real funds rate still at 0
• danger of aggregate demand rising quickly
• risk of inflation
• response by the Fed
• restrictive policy to prevent inflation
• federal funds rate was raised from 3 in 1994 to
  6 in 1995
• preventive but moderate policy

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Phase 3 1994 1995 Preventing rising inflation

• results
• CPI inflation was stable in a range at 2.5 3
• real funds rate went up to 3
• real GDP growth rised to 4 in 1994
• unemployment decreased
• economy continued growing though there was
  restrictive policy
• avoiding inflation without creating unemployment
• successful monetary policy

12
Phase 3 1994 1995 Preventing rising inflation

• Fed gained credibility for low inflation
• new in 1994 policy
• the Fed published the new funds rate target
  directly after deciding
• brought more transparency into monetary policy
• from now on atleast short run goals became
  visible
• brings the public better unterstanding of
  monetary policy

13
Phase 4 1996 1999 The long boom

• In the second half of the 1990s the Fed had to
  deal with new circumstances
• full credibility for low inflation,
• which it gained throw the successful restrictive
  policy in 1994
• rise in trend productivity growth
• These both facts made new implications for
  monetary policy

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Phase 4 1996 1999 The long boom

• full credibility for low inflation
• even with a tight labor market there is no
  pressure on nominal wages
• confidence in price stability makes workers
  demanding less rising in nominal wages
• Firms don't tend to raise prices
• public sees excess demand as only temporary,
  because they expect the Fed to make a restrictive
  policy
• economy can top the potential output level
  without creating inflation

15
Phase 4 1996 1999 The long boom

• rising trend productivity growth
• 1990 1995 at 1.7 each year
• 1995 2000 at 2.4 each year
• optimism about future income
• higher motivation to borrow money for present
  consumption and investment
• but in aggregate goods and capacities can't be
  brought from future to present
• danger of faster overshooting
• requires higher real interest rates in long run
  to lower the motivation to borrow money

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Phase 4 1996 1999 The long boom

• 1996 1999 there was a long boom
• real GDP grew by 4.4 each year
• unemployment rate fell to 4
• Inflation stayed moderate, with CPI ranging at
  2-3
• In fact, price level remained stable even with
  growing economy, because of full credibility for
  low inflation

17
Phase 4 1996 1999 The long boom

• monetary policy by the Fed
• funds rate changed only a bit
• raised in march 1997 from 5.25 up to 5.5 ,
  when economic growth reached full push
• it signaled to counteract inflationary tendencies
  if needed
• the finacial crises in East Asia in 1997 and
  Russia in 1998 prevented the Fed doing further
  restrictive policies
• after the Russian crisis the Fed cutted the funds
  rate from 5.5 to 4.75

18
Phase 5 1999 2000 Preventing the growth of
demand

• In the second half of 1999 the boom was still
  going on
• unemployment was at a minimum level
• aggregate demand level was above potential output
  level
• risk of inflation
• remaining low interest rate level 2 possible
  outcomes
• inflation with risk of loosing credibility
• or credibility remains,
• but higher labor demand brings higher real wages
  accompanied with higher unit labor costs
• profity goes down, collapse in investment

19
Phase 5 1999 2000 Preventing the growth of
demand

• policy by the Fed
• to slower down the rising aggregate demand the
  Fed raised the funds rate from November 1999 to
  May 2000 to 6.5
• concerning the inflation pressure not especially
  high because it had still full credibility
• results
• the CPI was running at 2.5 ,
• real interest rate was about 4
• the real GDP growth slowed down during 2000 to 2
  
• tendencies that the boom was over

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Phase 6 2001 Collapse of investment and the 2001
recession

• falling GDP growth continued
• In the late 1990s investment in business
  inventories and equipments had grown much more
  than GDP
• In 2000 the investments in these went rapidly
  down
• a part of the repression on economic growth in
  2001 was the liquidation of fixed business
  investments and equipments
• reflects that the economy had overshot its
  sustainable output level in the late 1990s

21
Phase 6 2001 Collapse of investment and the 2001
recession

• responses by the fed
• to counteract the recession it made an extensive
  policy
• it cutted down the funds rate from 6.5 down to
  1.75
• big cut in this short period
• CPI inflation remained at 2.5
• so real short term funds rate went down by 4.75
  , so it was negative
• no inflation scare, because of the full
  credibility
• this period ends with the happenings at 11.
  September and a recession conncted with that

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Conclusion

• the economical circumstances and challenges
  varied a lot in the period from 1987 to 2001
• it dealt well with 3 major financial crises
• 1987 stock market crash
• 1997 East Asia crisis
• 1998 Russian crisis
• inflation was only partly a problem compared to
  earlier decades
• in the late 1980s and early 1990s inflation
  trends could be reversed by restrictive monetary
  policy

23
Conclusion

• by preventive actions the Fed could cause nearly
  full credibility for low inflation
• since the late 1990s inflation was not a big
  threat anymore
• since 1994 it brought more transparency into
  monetary policy