978-0077861667 Chapter 4 Lecture Note Part 2

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Chapter 04 – The Federal Reserve System, Monetary Policy, and Interest Rates 6th edition

1. The Federal Reserve, the Money Supply, and Interest Rates

a. Effects of Monetary Tools on Various Economic Variables

If the Fed wishes to increase the money supply it can

Buy U.S. Government Securities

Decrease the Discount Rate

Lower reserve requirements

All three result in lower interest rates which encourage additional borrowing for

consumption and investment. As household and business spending increase, the total

value of goods and services produced in the economy (nominal Gross Domestic Product

or GDP) increases. Employment should increase as a result. The converse holds for

opposite movements in the variables.

Teaching Tip: Lower interest rates normally lead to increases in nominal GDP. Nominal

GDP =  (Price  Quantity) for all goods and services produced in the economy. Either

Price (inflation) or Quantity (real output), or both, will rise, albeit with lags. If the

economy is not at full capacity, or if productivity is growing so that capacity is growing,

the increase in nominal GDP will occur primarily through an increase in the quantity of

goods and services produced, at least in the short run. If the economy is near capacity the

GDP growth is liable to occur through price increases (inflation). Moreover, if economic

participants have expectations of inflation, then prices are likely to rise.

Teaching Tip: Inflation is a fairly recent phenomenon and probably results from fiat

money. If one takes a historical perspective there is no reason to expect constant positive

inflation and no reason to fear deflation. It is entirely possible that during the 1990s the

Fed allowed overly rapid monetary growth under the mistaken belief that disinflation

would be undesirable. Central bankers tend to fear Keynes’ liquidity trap: during

deflation, high real rates can occur and the Fed may then be unable to lower nominal

interest rates enough to stimulate the economy. Something very similar to this recently

occurred in Japan. In those cases fiscal policy is needed to stimulate economic growth.1

It is quite plausible that with the recent large productivity gains in the U.S. during the

1990s, prices should actually have fallen without the stimulative monetary policy at that

time.

Teaching Tip: Until recently the U.S. had enjoyed mild real asset inflation overall for

quite some time, but financial asset inflation was prevalent throughout the 1990s in the

stock market and selected real asset markets such as real estate have experienced inflation

in certain segments of the economy. An interesting question is whether the Fed should

have responded sooner to the financial asset inflation. Historically, long inflationary

cycles tend to be followed by long periods of poor growth. We will have to see if the

U.S. real estate sector will experience a long slump in housing prices. Experience in

Japan (and historically in the U.S.) indicates that if a cycle of deflation occurs in the real

estate sector the U.S. economy may slump and that slump may well indeed be protracted.

1Fiscal policy was largely unable to stimulate growth in Japan because of huge structural problems

centered in the banking and constructions industries and a large overhang of bad debts in the economy.

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Chapter 04 – The Federal Reserve System, Monetary Policy, and Interest Rates 6th edition

Teaching Tip: Many food prices have increased at a faster rate than the CPI numbers

indicate so people believe inflation is higher than reported. With the large amount of

bank reserves and high volume of money creation the Fed may have to act very quickly

when growth and inflationary pressures return. If labor force participation and income

growth is still weak at that time, the Fed may be faced with difficult policy choices that

may be politically unpalatable. The Fed’s independence may be challenged at that point.

Even with extraordinary monetary stimulus the economy in 2014 is not exhibiting rapid

growth. GDP growth in 2012 was 2.8%, 1.9% in 2013 and actually fell 1% in the first

quarter of 2014.

b. Money Supply versus Interest Rate Targeting

The Fed can target either some monetary aggregate (M1 or M2 for example) or interest

rates, but not both simultaneously. During the 1970s, Arthur Burns and other Fed

chairmen targeted interest rates. During the 1970s the United States experienced rapid

inflation, due in part to the oil embargoes. During this time period the Fed

overstimulated the economy by trying to maintain a target fed funds rate. Recall that the

Fisher effect states that nominal rates will rise due to expected inflation. The Fed

continually increased the money supply to offset the pressure high expected inflation was

exerting on interest rates. However, inflation is caused by excess demand (too much

money available relative to the goods and services produced). By keeping interest rates

low the Fed actually fueled excess demand for borrowing. Paul Volcker became

chairman of the Fed in 1979 and he changed the Fed’s target from interest rates to

non-borrowed reserves and managed to purge inflation from the economy. Due to

increases in volatility of M1 and growing instability of velocity (the relationship between

money and economic activity), the Fed had trouble hitting money supply targets. In 1993

the Fed announced it would once again target interest rates and began publicly

announcing the desired fed funds rate for the first time.

Teaching Tip:

The instructor should emphasize that an interest rate target as practiced in the 1970s will

not work in an environment with rapid inflation. If we return to an inflationary

environment, the Fed will have to be willing to significantly raise the fed funds rate to

reduce inflation.

Teaching Tip:

The difference between M1 and M2 is liquidity. Recall Keynes’ functional definition of

money as any asset that serves as a medium of exchange, a store of value and a unit of

account. Accounts in M1 are clearly mediums of exchange and the additional accounts in

M2, while less liquid than those in M1, meet the store of value function of money.

Money Supply measures

January 2014 Billions $ % of Total money supply as

measured by M2

M1 $2,650 24%

M2 (includes M1) $10,986

Money supply growth for 2013 was about 5.5%, which was greater than GDP growth.

Some economists believe that money supply growth rates faster than GDP growth are

inflationary.

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Chapter 04 – The Federal Reserve System, Monetary Policy, and Interest Rates 6th edition

Teaching Tip:

Ben Bernanke, the former Chairman of the Federal Reserve, broke with Greenspan’s

policy of only gradually changing interest rates in small increments, usually 25 basis

points. This policy gave investors time to adjust to changing interest rates.

Teaching Tip:

The instructor may wish to ask students to think about the following:

1. What are the implications of the bailouts of the financial crisis? Is the system

safer now or can we expect another crisis in the future?

2. What does it mean to be too big to fail or systemically risky? Does designating an

institution as systemically risky make the system safer?

3. What are the pros and cons of deposit insurance? Should the U.S. employ

unlimited deposit insurance as some other countries do?

Teaching Tip:

Was the financial crisis a result of excessively loose monetary policy and weak

enforcement of regulations in the 1990s when Allan Greenspan was Fed Chair?

Greenspan was fortunate to be Fed Chair during a very long period of global growth

(albeit with some significant bumps along the way). During his tenure global growth was

quite high on average and 1990s U.S. productivity growth was extremely high.

Throughout much of his tenure inflation was benign and he was able to allow long

periods of rapid U.S. monetary growth without generating inflation (annual money

supply growth rates have generally been much greater than our economic growth rates).

This strategy succeeded in large part because of foreigners’ ongoing willingness to

acquire dollars and dollar denominated assets. Earlier in his tenure, foreign private

agents were acquiring dollars, but in recent years a greater proportion of acquisitions of

dollars have been made by foreign central banks attempting to keep their currency from

appreciating. To the extent that they have succeeded, their actions have probably hurt

U.S. firms competing with foreign imports. His low rate policies also allowed U.S.

economic agents, such as the government, households and firms, to rack up record high

debt levels without generating pressure on interest rates to rise. Until the financial crisis,

the repercussions did not seem significant. Was he smart or just lucky?

The Fed can affect the exchange value of the dollar by buying and selling foreign

currencies against the dollar (foreign exchange intervention). The U.S. practices a

managed float and attempts to influence the value of the dollar in concert with other

central banks. The Fed faces a tradeoff in maintaining a stable currency value and low

U.S. inflation. If the U.S. has lower inflation than other countries, the value of the U.S.

dollar will tend to appreciate, ceteris paribus. An appreciating dollar can hurt U.S. exports

and worsen our trade deficit. Conversely, a falling dollar can generate U.S. inflation by

putting pressure on foreign firms (exporters to the U.S.) to raise U.S. prices to preserve

their local currency value of their revenues. The Fed has difficulty maintaining the value

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Chapter 04 – The Federal Reserve System, Monetary Policy, and Interest Rates 6th edition

of the dollar and managing U.S. inflation simultaneously.2 Suppose inflation is just

where the Fed wants it, but the dollar is falling against the yen because Japan is running

lower inflation than the U.S. If the U.S. wishes to stop the dollar from falling, the Fed

could theoretically sell $1 billion worth of yen denominated assets to commercial bank

currency traders for dollars. The Fed would receive payment from the commercial bank

purchasers by debiting the commercial banks’ reserves at the Fed by $1 billion. This

would decrease the U.S. money supply and should then result in a decrease in U.S.

inflation. Consequently, cooperation between central banks is needed to work out the

tradeoffs between domestic inflation and currency values around the world.

Teaching Tip:

Because currency intervention normally requires foreign currency reserves, the levels of

these reserves in developing countries that may experience a currency devaluation are

closely watched by currency speculators. The Economist publishes foreign currency

reserves for most developing countries.

2 The U.S. Treasury is actually responsible for the value of the dollar in the foreign exchange markets, but

the Fed implements the Treasury’s decisions on when and how much to intervene in the currency markets.

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Chapter 04 – The Federal Reserve System, Monetary Policy, and Interest Rates 6th edition

2. International Monetary Policies and Strategies

a. Systemwide Rescue Programs Employed During the Financial Crisis

September 2008 was the flash point of the financial crisis. On September 8, the

government seized Fannie Mae and Freddie Mac, the two entities that directly or

indirectly funded about ¾ of the nation’s home mortgages. On September 15, Lehman

Brothers, a 150 year old investment bank, collapsed. Merrill Lynch let itself be bought

by Bank of America rather than fail, AIG met with federal authorities to arrange a bailout

and Washington Mutual, the largest savings institution in the U.S. announced it needed a

buyer. The Dow fell more than 500 points, the biggest drop in over 20 years.

Individual country responses:

The contagion quickly spread around the globe. Germany announced a guarantee of all

deposits in October and arranged a bailout of their second largest mortgage lender Hypo

Real Estate. The UK nationalized Bradford and Bingley and increased deposit insurance.

Ireland guaranteed deposits and debt of its six major banks; a move that led to a

sovereign bailout later on. The Icelandic government bailed out its largest bank and

seized all the banks, eventually the economy of Iceland collapsed nonetheless. The list

goes on with Asian central banks forced to inject liquidity into their systems to prevent

contagion.

Common responses:

The central banks of 11 countries (Australia, Canada, France, Germany, Italy, Japan, the

Netherlands, Spain, Switzerland, the UK, and the US) acted to ease monetary conditions

in response to the crisis. These moves can be grouped into five areas:

a) Expansion of retail deposit insurance

b) Direct injections of capital to improve lender’s balance sheets

c) Debt guarantees

d) Asset purchases or asset guarantees

e) Stress tests of banks (not in text)

Many countries increased deposit insurance. The U.S. temporarily insured all deposits

without limit. Nine other countries also provided unlimited deposit insurance to prevent

any panics. The U.S. first announced they would engage in extensive asset purchases

from problem institutions although it did not. It was very difficult to price the assets

correctly in the absence of functioning markets. Paying too much was politically perilous

and paying too little would encounter bank resistance and force large losses on the debt

holders. So this plan was never extensively implemented. The FDIC announced a

temporary debt guarantee program for new issues by banks that met with some success.

Capital injections were the main method utilized. The Netherlands and the UK used debt

guarantees extensively providing commitments worth 33% and 17% of their GDP

respectively.

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Chapter 04 – The Federal Reserve System, Monetary Policy, and Interest Rates 6th edition

Europe has been undergoing a major crisis that has undermined many European’s belief

in the desirability of maintaining the Euro area as indicated by recent elections and polls

in Europe. Europe is not a ‘natural currency area,’ which means that with the current

differences in their economies, regulations and labor mobility employing a common

currency is problematic. Exchange rate changes can adjust for differences in

competitiveness. Without this, more onerous adjustments such as wages and benefits

must be reduced in less competitive countries to make their products saleable. Their

economies need more unity if the safety valve of a currency adjustment is not allowed to

offset differing competitive conditions. Otherwise large scale fiscal transfers or excessive

money creation are likely to be needed periodically. The Greek crisis that began in 2010

was thus perhaps predictable. The Greek government over-borrowed at unrealistically

low interest rates for the risk because of the common currency backed by the economic

clout of Germany. Much of the money was not invested wisely and a $480 billion +

crisis ensued with large spillover effects in other weak European economies such as

Spain, Ireland and Portugal. At one point even Italy’s financial viability was in question.

If the euro is to be maintained either Germany will have to periodically finance problem

countries or greater economic integration must be achieved. In the long run ignoring

economic forces will have consequences.

Teaching Tip:

Even with the monetary stimulus (and the earlier fiscal stimulus) the economy is not

recovering as rapidly as desired and growth is projected to remain below trend through

2015. This is in part because the crisis was a debt crisis and debt overhangs typically

lead to subpar recoveries. Stimulative monetary policy is not very effective when

potential borrowers are over leveraged to begin with. Tight credit restrictions by

regulators and uncertain capital requirements have discouraged banks from aggressively

lending their excess reserves. The health care entitlement program has not helped either

as it created uncertainty about labor costs. The rules changes have also exacerbated the

problem. CFO Magazine reports that businesspeople are not necessarily opposed to the

law, but they are uncertain about its effects and costs so they are proceeding cautiously in

hiring. As of 2014, other headwinds to growth include the weak housing market, slowing

growth in China, uncertainty over the Ukraine situation, and uncertainty over future taxes

given the high government debt levels.3

Teaching Tip:

Capital is what is needed to ride out a crisis, and this is why higher capital requirements

are necessary to improve the safety of the financial system. As the time since the last

crisis increases implementing this need becomes less popular however. New rules under

Basel III, which governs international capital standards, are increasing capital

requirements for banks. The new core tier 1 ratios have been raised from 2.5% to 4.5%

and general capital requirements must be at least 7%.

3 Source: Leubsdorf, B. Economy Shrank, U.S. Now Says, Downturn, Though Likely Weather-Driven,

Reflects Pattern of Sluggishness Seen Over Past Five Years, The Wall Street Journal Online, May 29, 2014.

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Chapter 04 – The Federal Reserve System, Monetary Policy, and Interest Rates 6th edition

Although these are increases, they are unlikely to be large enough to stabilize banks in

the next crisis given the size of losses witnessed during the recent turmoil. Capital ratios

would probably have to be in the 20% range for that. Higher capital ratios lower ROE

and may increase the cost of credit. What price are we willing to pay to safeguard the

industry? Capital injections varied by country and sometimes came with restrictions on

executive compensation and dividend payments. Capital commitments ranged from 1%

to 6% of GDP.

Finally many central banks or other financial authorities conducted stress tests of their

major banks to ensure the banks could withstand varying economic conditions. These

tests helped assure the financial markets of the soundness of the financial institutions in

the various economies.

1.1.1.1 VI. Web Links

www.federalreserve.gov Website of the Board of Governors of the Federal Reserve

www.ft.com Financial Times, won two Espy awards for best new site

and best non U.S. news site. Coverage of global events and

markets

www.wsj.com Website of the Wall Street Journal Interactive edition. The

web version of the well known financial newspaper can be

personalized to meet your own needs. Instructors can also

receive via e-mail current events cases keyed to financial

market news complete with discussion questions

1.1.1.1.1.1 www.ny.frb.org Federal Reserve Bank of New York website, complete with

research, links to the Treasury Direct program and job opportunities

1.1.1.1.1.2 www.stlouis.frb.org Federal Reserve Bank of St. Louis website, contains

tremendous amount of economic data, including charts and graphs.

1.1.1.1.1.3

1.1.1.1.1.4 http://www.ecb.int/home/html/index.en.html European Central Bank

website, contains announcements of interest

policy in the euro area and discussions of the

euro system.

1.1.1.1.1.5

1.1.1.1.1.6 VII. Student Learning Activities

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Chapter 04 – The Federal Reserve System, Monetary Policy, and Interest Rates 6th edition

1. Discuss the differences in strategy followed by the Federal Reserve and the European

Central Bank with respect to monetary policy. What are the advantages and

disadvantages of each?

2. Explain how the actions of a recent FOMC meeting will affect you personally. Hint:

Think about the effect on the economy and various interest rates.

3. Can the Fed have an effect on long term interest rates as well as the fed funds rate?

Examine the Wall Street Journal on several recent days when the Fed announced

changes in the fed funds rate target. What, if anything, happened to long term interest

rates? Explain any changes.

4. Why does the stock market often respond after a FOMC meeting even when there are

no announced changes in the target Fed funds rate? Do the bond markets respond

also? Would you expect them to respond similarly? Why or why not?

5. On the web locate the Wall Street Journal Economic Forecasting Survey. According

to the survey, what are the major risks facing the U.S. economy today? In general

terms what do you believe should be the government’s response to these risks?

6. What do you think of the Fed’s dual goal of stimulating growth and limiting inflation?

Should one or the other of these be the top priority?

7. a) How has the role of the Fed changed due to the financial crisis?

b) How has the public’s perception of the Fed changed since the financial crisis?

8. a) Why is it that to the ordinary person inflation ‘feels’ higher than the CPI

indicates?

b) Why do most Americans say that the country is not heading in the right direction?

Can the Fed fix this?

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