Management 321: Module 2a

nReview: last topic (modules 1a – 1c)

World Economy
Business in the

qThe National Income Accounts (NIA) identity can be

manipulated to answer many questions
qIt shows how aggregate (economy wide) concepts
(savings, fiscal policy, the Current Account,
Investment, … are related)
qThe Balance of Payments (BOP) identity is derived from the
NIA identity. It quantifies the relationship between cross-
border savings and investment flows and goods and
services flows

Module 2a:
nMoney & Monetary Policy
qMoney in the economy: can there be too much?
qThe Federal Reserve
qMonetary policy & its 3 (classical) tools
qThe Fisher Equation

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 Money & Inflation
1st , What is money?
Up to this point in the class, the questions have
dealt with real income, output, GDP, trade
flows, Investment, etc.
What is money?

1. unit of account (translates ‘real’ into a common

unit: ‘nominal’) – (we can add heart surgeries, autos,
oranges, etc. using their monetary value when computing
a nation’s GDP)
2. store of value – (a ‘good’ money doesn’t lose its value
quickly, thus market participants are penalized by using
money)
3. medium of exchange. Money greatly facilitates
trade
q since money can buy goods & services, rather
than searching for mutually beneficial
transactions in goods & services,  it
improves the efficiency of the economy
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 Money and Inflation
n “Money” can be: (a) commodity based – e.g.,
gold, silver, diamonds, cigarettes, etc., or,
money can be (b) fiat money - as most
currencies in the world are today.
q Fiat money is “created” by a law that defines what a nation’s
money is. Usually countries, through their laws give the
power to create money to the national Central Bank
n Inflation occurs when the change in the
overall price index is > 0
q inflation implies the purchasing power of money is declining
q Observation: if we are concerned about the purchasing power
of money, we need to know something about what causes
inflation

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 Basics: How do we measure the amount
of money in the economy?
There are different definitions of ‘money’ depending on


how inclusive we want to be:

n C: Currency
n M1: Sum of currency, demand deposits, traveler’s
checks, and other checkable deposits
n M2: Sum of M1 and overnight repurchase
agreements, Eurodollars, money market deposit
accounts, money market mutual fund shares, and
savings and small time deposits
n M3: Sum of M2 and large time deposits and term
repurchase agreements
n L: Sum of M3 and savings bonds, short term
Treasury securities, and other liquid assets

This list is intended to illustrate various ways of defining ‘money’ and is not meant to be memorized.
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 An Important Distinction
n Monetary policy versus fiscal policy
q

n What is Fiscal Policy?

q Fiscal policy: “changes in G or T”
q NIA: Y = C + I + G + NX, ‘G’ is government spending.
q “G” is decided by Congress and the Executive braches
q

n What is Monetary Policy?

q Monetary Policy: “Changes in the Money supply and/or
interest rates”
q In the U.S., the Federal Reserve controls the Money
supply and thus has exclusive responsibility for
Monetary Policy
q The Federal Open Market Committee (FOMC)
determines Monetary Policy – not congress or the
President!
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 Can there be too much
money in an economy? 1

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 Sometimes the Central Bank prints too
much money…
(usually because the government has ‘ordered’ it to)

n If the government doesn’t collect enough taxes to pay

for its spending (T<G), it might be tempted to order
the Central Bank to print money to pay for its
spending
q Not possible if a nation’s Central Bank has independence
n This is called “Seigniorage”. Seigniorage is the inflation
tax & it is measured by the amount of real goods and
services purchased by the government by printing
money
n Can a government extract as much seignorage as it
wants if there are no limits to how fast it is willing to
make the monetary base grow?
n What are the connections between government budget
deficits, seignorage, money growth, and inflation?
To
 answer these questions we need to review a very simple theory: the Quantity Theory of Money

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 Key Concept:
The ‘Quantity Theory’ of Money
 MV = PY
 M = money V = velocity
 P = Price level Y = real output
n
n The Quantity theory predicts that
excessive money growth will
ultimately (i.e., in the Long Run)
result in inflation


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 Inflation (%ΔP) is a monetary phenomenon

n MV = PY “quantity theory”
  %ΔM + %ΔV = %ΔP + %ΔY
n See “FAQ Handy approximations”

n The theory says growth in 4 things (m, v, p, y) are related

q In the long run the growth of real GDP (%ΔY) is
determined by the growth of inputs (labor force, capital,
and technological change),
q and velocity (V) can be considered a ‘technological’
constant, according to the Quantity Theory. “V” is the
number of times a dollar turns over in a year to finance
all the transactions comprising GDP.
q

n Thus,
Thus the Quantity Theory implies that inflation (%ΔP)
is determined by money growth (%ΔM) in the long
run

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 Does the quantity theory work?
U.S. Money growth and inflation

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Source: Mankiw, p.88
Business in the World Economy
 Worldwide Money growth and inflation
in the 1990s

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Source: Mankiw
Business in the World Economy
 Germany during its Hyperinflation

? How much inflation is that?

man policymaking today! Prior to the introduction of the euro (& hence the European Central Bank) the German Cent

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 Monetary Policy:
Actions taken by the Federal Reserve
The 3 tools of monetary policy


n Discount rate: It is the rate at which banks borrow

from the Federal Reserve. A higher discount rate
contracts money supply in the economy.
n Reserve requirements: All banks are required to
maintain a percentage of reserves in relation to the
deposits. Higher reserve requirements lead to
contractionary monetary policy.
n Open market operations: Buying and selling
government bonds (no new issues) on the open
market. Open market operations impact the
federal funds rate.
q Update: various auction facilities: pre-announced
fixed amount auction term funds directly to depository
institutions & discount window has been opened to
non-depository institutions.
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 Open market operations
The most important tool of monetary policy!

n When the Federal Reserve buys or sells existing

government bonds, the money supply in the hands of
the public changes
n When the Fed sells government bonds (for example), it
takes the money it receives out of the system. This
reduction in the supply of money drives interest rates
up. This is an example of contractionary monetary
policy
n The “Fed Funds” rate is the interest rate that tends to
react first. It is the rate at which the banks borrow from
each other on an overnight basis
q Banks borrow (overnight) in the fed funds market in
order to maintain their required reserves, and they
lend when they have “excess” reserves
n ExpansionaryMonetary policy is the reverse: i.e., the
Fed buys government bonds
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 Q1: How is the Fed Funds rate affected by open
market operations?
Q2: How does the Fed pay for the bonds?
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 Brief history of the Fed
n Recurring financial panics led to the
Federal Reserve Act in Dec. 1913
n Mandate to preserve financial and
economic stability through supervision
of banks and conduct of monetary
policy
n 12 regional banks
n Independence

More detail at:

http://www.federalreserveeducation.org/fed101/History/index.cfm
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 Federal Reserve Districts

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 The leadership of the Federal
Reserve System
n
n Board of governors (7 members), one appointed by
President to be Chairman for 4 years
n Current Chair is Ben Bernanke (appointed 2006)
n The FOMC: 7 governors, the president of the NY
Fed, plus 4 of the presidents of other regional Fed
banks
n The trading desk of the NY Fed makes all changes to
the Fed’s portfolio through purchases/sales of
securities that are already outstanding. Typically,
a desk purchase on a particular day may run
around 10% of that day’s market volume

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 Next topic:
Interest rates: real vs. nominal
The Fisher Equation
n The Fisher equation is very simple – but
its implications are profound
n The Fisher equation states that the
nominal interest rate (i) is comprised
of a real interest rate (r) plus a
premium (πe) for expected inflation


 Fisher equation: i = r + πe

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 The intuition
n Suppose you were lending money
q (which is what you do when you put your
money in the bank, or a money market fund
for example).
n You will demand a real return
q That is, the money you lend should retain its
purchasing power as well as earning a real
return
q Alternatively, think of the borrower. A borrower
needs money for a project with a real return.
Thus, borrowers will be willing to pay for the
use of the fund’s money
n  the nominal interest rate is the opportunity
cost (return foregone) of holding money
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 Applying the Fisher equation:
Does the nominal interest rate reflect inflation?

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 Applying the Fisher equation:
An implication of the Fisher equation
n Heard on the street: “last year I earned
6% on my savings. But we had 3%
inflation. I really hate inflation
because it ate into my 6% return –
leaving me with only 3%”.
q Evaluate this statement


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 The Fisher Equation around the world

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 Take Aways (part 1)

n The Federal Reserve controls the

Money supply  Monetary Policy
n Three tools of monetary policy
n Open market operations are the most
important
n The Fisher equation relates nominal
and real interest rates and expected
inflation

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 Short Run Versus the Long Run
Definitions:


n The distinction between the short run and the

long run - is the flexibility of prices
n In the long run all prices are flexible
q Hence, real resources (output, capital, labor)
can adjust accordingly - no unemployment!
q Keynes famously quipped “in the long run
we’re all dead”. Basically he was saying that
the short run is more relevant in many
instances
n The short run is that transition period before
prices have fully adjusted
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 SR vs. LR: Implications & why it matters
n In the SR, resources may not be at their LR optimum
q Output may be below ‘potential’,
q unemployment may exist, and
q government policies (e.g., monetary policy) have real
effects
q That is, in the long run, when by definition prices have
adjusted, we are at full employment of resources.
Hence government policies cannot have ‘real-
effects’
n Bottom line: the world works differently in the SR & in
the LR
n How does the short run correspond to time?
q In some markets the short run is an instant
q In some markets the short run is years
q “it depends”
q
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 Why don’t prices adjust?
(i.e., why aren’t we always in the LR?)

n It may physically cost something to change

price (menu costs), or,
q It may cost business relationships to adjust
prices
q Contracts
n At some level, it doesn’t matter why
q The fact that prices don’t adjust implies that
quantities adjust
q Market systems rely on prices to clear markets
q Whenever prices don’t adjust shortages and or
queues develop. That is, in a system with
price flexibility, there CANNOT be a
shortage, or a surplus, or even
unemployment (which is just an excess supply of
labor)!
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 Monetary Policy Review
(Key slide)

n A decrease in the money supply is achieved by the

Fed selling bonds
n

n This raises interest rates (Fed Funds rate), i.e., to sell

bonds the Fed must offer a low price (= raising the
interest rate)
q Since it is the short run, both real and nominal
interest rates rise
n

n The interest rate rise impacts the overall economy.

How?
n Short run
q money  r  Investment   Y (RGDP) 
n Long run
q  P
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(Hint: you must know the above)
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 “tradeoff between
unemployment and inflation”
n The key is the short run impact of monetary
policy on unemployment
n The short run reduction of the money supply
results in a rise in unemployment
q  monetary policy determines the amount of
unemployment
q Not: imports, exports, fiscal policy, current
account, taxes, etc.
n Thus, all the discussions in the press about
these things is simply beside the point from
a macroeconomic perspective!

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 The Role of the Central Bank
n A nation’s Central Bank, through its use of monetary
policy influences the real economy in the short run,
and inflation in the long run
q A central bank also attempts to monitor and promote
financial stability
n In some countries, the Central bank is essentially an
agent of the government (not independent) –
financing government deficits by printing money
n This is a recipe for economic mismanagement &
frequently results in hyperinflation. One solution to
the problem of non-independence – or “bad”
central bank policy, is to remove the Central
Bank’s ability to print money by adopting a
Currency Board, or dollarize, or create
institutions that will result in “good” monetary
policy
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 Take Aways (part 2)

n Thedistinction between the short run

and the long run - is the flexibility of
prices
n In the long run all prices are flexible
q Hence, real resources (output, capital,
labor) can adjust accordingly
n The short run is that transition period
before prices have fully adjusted


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 n
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n More http://www.portfolio.com/slideshows/2008/3/Worlds-Most-Worthless-Money
n back

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