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Economics 2 Professor Christina Romer Spring 2020 Professor David Romer
LECTURE 22
MONETARY POLICY AND FINANCIAL MARKETS
April 16, 2020
I. OVERVIEW
II. THE MONEY MARKET, THE FEDERAL RESERVE, AND INTEREST RATES A. The market for money
1. What is money? 2. Money demand 3. Money supply 4. Equilibrium
B. How does the Federal Reserve control the supply of currency? C. The effects of a change in the money supply D. The Federal Reserve’s ability to influence the real interest rate
1. The short run 2. The long run
III. MONETARY POLICY AND SHORT-RUN MACROECONOMIC FLUCTUATIONS A. Example: An increase in the real interest rate B. Reasons that the Federal Reserve might move interest rates C. Monetary policy mistakes in the Great Depression
1. The initial decline in spending and output 2. The collapse of the money supply 3. Consequences
D. A little about “unconventional” monetary policy
IV. FINANCIAL CRISES A. Financial intermediation B. How a financial crisis starts C. How a financial crisis spreads: contagion D. The effects of a financial crisis on planned aggregate expenditure E. The impact of a financial crisis on output
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LECTURE 22Monetary Policy and Financial Markets
April 16, 2020
Economics 2 Christina RomerSpring 2020 David Romer
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Announcements
• Problem Set 5, Part 1 is due now.
• We have posted Problem Set 5, Part 2.
• It is due at 2 p.m. on Thursday, April 23th.
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I. OVERVIEW
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Determination of Short-Run Output: The “Keynesian Cross”
Y
PAE
PAE Y=PAE
Y1
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Two More Things that Can Shift PAE
• Monetary Policy: Actions taken by the central bank to affect nominal and real interest rates.
• Disruptions in Financial Markets: Specifically, a financial crisis.
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Two Key Ideas Concerning Monetary Policy in the Short Run
• By changing the money supply, the central bank can change the real interest rate.
• A change in the real interest rate shifts the PAE curve in the Keynesian cross diagram, and so changes output in the short run.
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II. THE MONEY MARKET, THE FEDERAL RESERVE, ANDINTEREST RATES
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Economists’ Definition of “Money”
• Assets that can be used to make purchases.
• Concretely, you can usually think of money as meaning currency.
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The Nominal Interest Rate and Money Demand
• Because you don’t earn interest on cash, the opportunity cost of holding money is what you could earn on other assets.
• That is, the opportunity cost of holding money is the nominal interest rate.
• So: Money demand is a decreasing function of the nominal interest rate.
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The Demand for Money
M
i
MD
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Money Supply
• At any point in time, the amount of currency available is just a number.
• Determined by the central bank.
• That is, we take the quantity of money supplied as given.
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The Supply of Money
M
i MS
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Equilibrium in the Market for Money
M
i
M1
i1
MD
MS
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How Does the Federal Reserve Change the Money Supply?
• Open market operation: The buying and selling of government bonds by the central bank.
• When the Federal Reserve sells bonds, the money supply decreases.
• When the Federal Reserve buys bonds, the money supply increases.
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A Decrease in the Money Supply
M
i
M1
i1
MD
MS1MS2
M2
i2
The Fed sells bonds.
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The Fed’s Ability to Influence the Real Interest Rate—the Short Run
• By changing the money supply, the Fed can change the nominal interest rate, i.
• Recall: r = i − π (or r = i − πe), and there is nominal rigidity (inflation only changes slowly).
• So: When the Fed changes i, it changes r.
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In the Short Run, Nominal and Real Interest Rates Generally Move Together
Source: FRED.
Nominal
Real
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The Fed’s Ability to Influence the Real Interest Rate—the Short Run versus the Long Run
• As we have just seen, the Fed can affect the real interest rate in the short run.
• However, in the long run, r must be at the level that equilibrates S* and I*.
• The Fed cannot keep r away from this level indefinitely.
• We will discuss next time what prevents the Fed from doing this.
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III. MONETARY POLICY AND SHORT-RUNMACROECONOMIC FLUCTUATIONS
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The Real Interest Rate and Planned Aggregate Expenditure (PAE)
Recall: PAE = C + Ip + G + NX.
• Ip is lower when r is higher.
• Saving is higher when r is higher, so C is lower when r is higher.
• We will see two weeks from now that NX is lower when r is higher.
Conclusion: An increase in r reduces PAE at a given Y.
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An Increase in the Real Interest Rate
Y
PAE1
PAE Y=PAE
Y*
PAE2
Y2
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Monetary Policy
• Actions taken by the central bank to affect nominal and real interest rates.
• Contractionary monetary policy: Federal Reserve actions to increase nominal and real interest rates.
• Expansionary monetary policy: Federal Reserve actions to decrease nominal and real interest rates.
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Why Might the Central Bank Undertake Expansionary or Contractionary Monetary Policy?• To offset some other force that is shifting the PAE line
(countercyclical monetary policy).• We’ll discuss an example next time (monetary
policy in the Great Recession).
• To pursue some other objective.• We’ll discuss the Fed’s main other objective next
time: inflation.
• A mistake.• Example: Monetary policy in the Great
Depression.
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Industrial Production, 1927–1934
3.0
4.0
5.0
6.0
7.0
8.0
9.0
1927 1928 1929 1930 1931 1932 1933 1934
Inde
x (2
012=
100)
Source: Federal Reserve Bank of St. Louis, FRED.
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The Money Stock, 1923–1933
30
32
34
36
38
40
42
44
46
48
50
1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933
Billi
ons o
f Dol
lars
Source: Federal Reserve Bank of St. Louis, FRED.
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Real Interest Rate, 1923–1933
-2
0
2
4
6
8
10
12
14
16
1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933
Perc
ent
Source: Federal Reserve Bank of St. Louis, FRED.
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Monetary Contraction in the Great Depression
Y
PAE1
PAE Y=PAE
Y*
PAE2
Y2
PAE2 shows the effects of the fall in autonomous consumption.
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Monetary Contraction in the Great Depression
Y
PAE1
PAE Y=PAE
Y*
PAE2
Y2
PAE3
Y3
PAE3 shows the effect of monetary contraction and the rise in r.
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Industrial Production, 1927–1934
3.0
4.0
5.0
6.0
7.0
8.0
9.0
1927 1928 1929 1930 1931 1932 1933 1934
Inde
x (2
012=
100)
Source: Federal Reserve Bank of St. Louis, FRED.
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Unconventional Monetary Policy—Overview
• Definition: Refers to actions by the central bank other than buying or selling short-term government bonds for currency.
• Motivation: The main motivation for unconventional monetary policy is that nominal interest rates cannot go (much) below zero.
• The reason is that there is an asset—currency—that offers a zero nominal rate of return for sure.
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The Two Main Forms of Unconventional Monetary Policy
• Forward guidance: Statements or actions that influence expectations about future nominal interest rates.
• Quantitative easing: Buying bonds other than short-term government debt with currency.
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The Effects of Unconventional Monetary Policy
• Both forward guidance and quantitative easing lower some real interest rates.
• As a result, they increase consumption and planned investment at a given level of income, and so shift the PAE line up and increase output in the short run.
• Note: In our main analysis, we will continue to talk about “the” real interest rate, r.
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IV. FINANCIAL CRISES
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Financial Intermediation
• The process of getting saving into productive investment.
• Financial intermediaries are the markets and institutions that do this.
• Financial intermediaries include banks, investment banks, money market mutual funds, pension funds, etc.
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What Is a Financial Crisis?
• A time when:
• A number of financial institutions are in danger of failing.
• People lose confidence in many financial institutions.
• As a result, there is widespread disruption of financial intermediation.
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How Individual Financial Institutions Can Fail
• Defaults and changes in asset values can reduce the value of an institution’s loans and securities.
• If the value of the loans and securities falls to the point where they are worth less than the institution’s obligations to its depositors and lenders, the institution is insolvent.
• A belief that the institution is in danger of becoming insolvent can cause depositors to withdraw their funds and lenders to stop lending—which can cause the insolvency to occur.
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House Prices, 1987–2015
Source: Federal Reserve Bank of St. Louis, FRED.
0
50
100
150
200
250
Jan-
87
Jan-
89
Jan-
91
Jan-
93
Jan-
95
Jan-
97
Jan-
99
Jan-
01
Jan-
03
Jan-
05
Jan-
07
Jan-
09
Jan-
11
Jan-
13
Jan-
15
Case
-Shi
ller H
ouse
Pric
e In
dex,
Ja
nuar
y 20
00 =
100
April 2006
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Source: http://www.housingviews.com.
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Contagion of Crises across Financial Institutions
• Confidence: Troubles at one institution create doubts about the health of other institutions, even if there are no connections between them.
• Linkage: Troubles at one institution directly harm other institutions because of loans, insurance contracts, and other direct links among them.
• Fire Sale: Troubles at one institution cause it to sell off assets, driving down the prices of assets held by other institutions.
• Macroeconomic: Troubles at one institution reduce PAE and hence Y, and so harm other institutions.
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Deposits in Failed or Suspended Banks, 1927-1933
Source: Federal Reserve.
0
50
100
150
200
250
300
350
400
450
500
1927 1928 1929 1930 1931 1932 1933
Mill
ions
of D
olla
rs
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Effects of a Financial Crisis on PAE
• It raises credit spreads.
• It may raise lending standards or otherwise reduce the availability of loans.
• It may harm consumer and firm confidence.
• All of these developments are likely to reduce PAE at a given level of Y.
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Credit Spreads during the 2008 Financial Crisis
Source: Economic Report of the President, February 2010.
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Tightening Loan Standards during the 2008 Financial Crisis
Source: Federal Reserve, Senior Loan Officer Opinion Survey, January 2018.
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Source: www.econreview.com.
Decline in the Number of Banks in the Great Depression
Number of Banks (1000s)
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Michigan Survey of Consumer Sentiment
40
50
60
70
80
90
100
110
2003 2005 2007 2009 2011 2013 2015 2017
Inde
x, 1
966
= 10
0Jan. 2007
Source: Federal Reserve Bank of St. Louis, FRED
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The Effects of a Financial Crisis on Output
Y
PAE1
PAE Y=PAE
Y*
PAE2
Y2
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Percentage Change in Real GDP
Source: Federal Reserve Bank of St. Louis, FRED
-10.0
-8.0
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
8.0
10.0
200
0-I
200
1-I
200
2-I
200
3-I
200
4-I
200
5-I
200
6-I
200
7-I
200
8-I
200
9-I
201
0-I
201
1-I
201
2-I
201
3-I
201
4-I
201
5-I
Perc
ent C
hang
e (a
t an
Annu
al R
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The Average Aftermath of a Financial Crisis
Source: Romer and Romer, “New Evidence on the Aftermath of Financial Crises.”
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But, how much output falls after a crisis is highly variable
• The ability and willingness of policymakers to use fiscal and monetary policy matters a lot.
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Possible Policies to Prevent Financial Crises
• Higher “capital” requirements for financial institutions.
• Deposit insurance.
• Regulation of risk-taking by financial institutions and linkages among financial institutions.
• Using monetary and fiscal policy to keep the economy stable.
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Midterm 2
• The scores will be released at 4 PM today.
• We were pleased with how people did!
• Summary statistics:• Median: 116• 75th percentile: 126• 25th percentile: 104
• We will send emails to students who appear to be in danger of getting an NP by early next week.
• Our advice for everyone: Work hard at staying as engaged and on top of the material as you can!
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Some Notes on Grading
• The University encourages everyone to take all their courses this semester P/NP.
• We reward improvement.
• Regrade requests must be submitted in writing to your GSI by April 23rd. We will correct clear-cut errors in grading, but we will not revisit judgment calls.