Welcome to Night 11

Principles of Macroeconomics

Chapter 10

Financial Markets and the Economy

Financial Markets are markets in which funds accumulated by one

group are made available to another group.

The bond market is a market in which institutions and individuals borrow and lend money. They do

this through buying and selling bonds.

For example, this is where the U.S. government sells their bonds, as we

discussed earlier.

You paid less than $100 for this bond, then received its face value of $100

when it matured. The difference was the interest.

The rate of interest was:(Face Value – Bond Price)/Bond Price

So if you paid $90, then the interest was:

($100-$90)/$90 = $10/$90 = .1111= 11.11%

The higher the price you pay for the $100 bond 1 year bond, the lower the interest rate you get.

Pay $90, then i = 11.1%Pay $95, then i = 5.3% Pay $99, then i = 1.0%

So now we face a choice. Do we want to think of the bond market as one where people lend and borrow money at a certain interest rate, or

buy and sell bonds at a certain price?

Textbook guy uses the 2nd way. I find the 1st more intuitive.

Here are both ways side-by-side. We will primarily use the diagram on the right.

You’ve seen the 2nd diagram before back in unit 2, where I called it the supply and demand diagram for the credit market.

Interest rate

Loanable Funds

Supply (savings)

Demand (borrowing)

iE

QE

Can changes in the interest rate that comes out of the credit market affect the

macroeconomy?

Yes.

Much investment spending done by

businesses is financed through borrowing. The higher the interest rate

you have to pay on a loan to get the money to build

a new factory, the less likely you are to build the

factory.

Suppose for some reason there is an increase in the amount available for lending. This is an increase in supply in the credit market.

Interest rate

Loanable Funds

S1

D1

S2i1

i2

Q1 Q2

Interest Rates Fall

Q

P

The extra investment spending will increase AD (GDP=C+I+G)

AD1

SRAS

P1

QN

AD2

This could help get us

out of a recession

P2

Q1 Q2

You have a demand for money. Do you always want more?

What can you do with your purchasing power? 3 things.

1) Buy Goods2) Buy bonds (or other high

interest investments)3) Hold it as money

1) Why buy goods?That’s obvious. You want them.

2) Why buy bonds?To earn interest.

3) Why hold money?Purchase future goods and services

easily. Money is very liquid.

If we look just at the choice to hold money or bonds, we can think of the interest rate as the opportunity cost

or “price” of holding money.

If the money itself earns interest, such as an interest earning checking

out, it is the difference in the two interest rates that matters.

The higher the interest rate goes on the bonds you have to give up

to hold money, the less money you want to hold.

Or the more bonds you want to hold. The two statements are

functionally equivalent.

The more you hold of one, the less you hold of the other.

Demand curve for money in terms of interest for bonds.

What else affects the demand for money?

1) Expected inflation – the more you expect prices to rise, the less cash you want to hold (remember the wealth

effect?)2) Confidence in the future – if you fear

losing your job or that the bond you buy may not pay off, you wish to hold

more cash.

Textbook guy lists a few more, but you do not have to memorize the

others on the list.

I fear losing my job.

What about the supply of money. Let’s assume the federal reserve

board can create as much or little money as it wishes through

open market operations.

Equilibrium in the money market is when people want to hold exactly

as much money as the fed has created.

+ =

Why might you be unhappy with the amount of money you have?

Suppose the interest rate is very high. People won’t want to hold

much money, they will want to hold bonds instead. If the Fed has

created a lot of money, people will have “too much” money.

They will get rid of the excess by saving it into the bond market.

They will do this by buying bonds. The interest rate will fall until

people no longer feel they have “too much” money.

Do people really think they have too much money? Well, imagine you

have a huge cash stash in the cookie jar and read that General Motors is

paying 100% on their bonds.

Wouldn’t you say I have too much cash sitting around doing nothing when it could be earning 100%?

If they have “too little” money, they will get more by saving less

into the bond market (selling bonds) and interest rates will rise.

There will be an interest rate at which people want to hold the

exact amount of money created by the Fed.

When we get to that interest rate, there will be equilibrium in the money market.

The money market graph and the credit market graphs are two sides of

the same coin.

Interest rate

Loanable Funds

Supply (savings)

Demand (borrowing)

iE

QE

What we learned tonight (BB).1. The basics of financial markets.2. What determines your demand

for money. 3. Equilibrium in the money

market and the credit market.

Night 11Class Break

Principles of Macroeconomics

What we learned so far (BB).1. The basics of financial markets.

2. What determines your demand for money.

3. Equilibrium in the money market and the credit market.

If the demand curve for money shifts, the interest rate will shift. Suppose

people fear a big rise in inflation.

More money goes into the bond market and interest rates fall.

If the Fed creates more money, people put some of that money into the bond

market and interest rates fall.

Here we see what is simultaneously happening in the credit market.

Interest rate

Loanable Funds

S1

D1

S2i1

i2

Q1 Q2

Interest Rates Fall

Q

P

Why might the Fed want to do this? AS/AD diagram showing the effect of more investment caused by

lower interest rates.

AD1

SRAS

P1

QN

AD2

This could help get us

out of a recession

P2

Q1 Q2

Chapter 11

Monetary Policy and the Fed

What are the Fed’s goals?

1) Low Inflation2) Low Unemployment

3) High Growth

The same 3 variables that we said determine if the macroeconomy is

working well back at the beginning of chapter 5.

So what should the fed do? Suppose we are in a recession. In our model,

Q is in the recessionary gap.

How can we get out of the recession? We could wait until

wages adjust, but with sticky wages, that could take years … and years.

Q

P

A quicker way out would be if the fed could get AD to move right.

AD1

SRAS

P1

QN

AD2

P2

Q1

Can they do this?

The short answer is yes. 1) Fed buys government securities.2) Banks have more funds to loan.

3) Drop in interest rates.4) People borrow the new money

from the banks and buy things.

Voila, recession over!

This is known as expansionary monetary policy. The fed creates

money and drives down the interest rate to increase buying.

AD moves to the right and increases output and lowers

unemployment.

We’ve already seen what simultaneously is happening in the

credit market.Interest rate

Loanable Funds

S1

D1

S2i1

i2

Q1 Q2

Interest Rates Fall

But what if the problem is we are in the inflationary gap part of the diagram. Can we get back to QN

without inflation?

Not if we wait for the natural long-run adjustment and the shifting

SRAS curve. But what if we move AD to the left?

Q

P

Out of the inflationary gap without inflation.

AD2

SRAS

P2

QN

AD1

P1

Q1

To do this, we use contractionary monetary policy. The fed decreases the money supply, this decreasing AD. After all, what is money used for? So less money, less buying.

1) Sell government securities.2) raise r.

3) raise the discount rate.

So to sum up:

To fight recessions, expansionary monetary policy to move AD right.

To fight inflation, contractionary monetary policy to move AD left.

Well, that sounds easy. In fact, it sounds too easy. If

macroeconomics is that simple, why do we have such a hard problem with recessions and

inflation?

There are multiple possible problems.

The first we are going to talk about is lags. Lags are the time between something happening and the end

effect of that thing happening.

The first lag we are going to talk about is called recognition lag.

Recognition lag is the delay between the time a

macroeconomic problem occurs and the time policy makers

become aware of it.

The textbook discusses 1990 recession as an example, but I will

go more recent than that. Minutes from fed meetings are released with a 5 year lag, so we can now

see what the fed was doing in 2008/2009 as the economy went

into the tank.

We see that even as the economy was entering the worst recession

since the great depression, the fed in September 2008 couldn’t decide

if recession or inflation was the biggest danger. So they decided to

do nothing. No discount rate changes, no major open market

operations.

In retrospect a big mistake. When they realized this, they lowered the discount rate and did major open

market buying, but now the recession was rolling and its harder

to stop a rolling boulder than to keep it from starting to roll in the

first place.

Then comes the implementation lag. Implementation lag is the delay between the time policy

makers become aware of a problem and the time they enact a

policy to deal with it.

For the Fed, the implementation lag is quite short. They can decide

what to do and then do it quite quickly. But remember this lag when we get to the last chapter and talk about actions congress

can take.

Finally comes the impact lag. Impact lag is the delay between the time a policy is enacted and the time it has its effect on the

macroeconomy.

So the fed decides to create a lot of new money to increase AD and buys a lot of government securities from banks. This first step accomplishes nothing by itself. We have to wait

for the banks to lend out the money. And even this first effect will be

small because …

Much of the effect happens when the banks get the money back and lend it out again … and again … and

again. It could take many months for the buying of securities to result in

people having a lot more money and buying lots more stuff.

The textbook says conventional wisdom is it takes from 6 months

to 2 years for open market operations or a change in the

discount/federal funds interest rate to have its full effect on the

macroeconomy

Putting these 3 lags together:1) Recognition Lag

2) Implementation Lag3) Effect lag

We can see that the fed has to either risk being too late or act on its predictions about the future,

which could be wrong.

There is a view that in the 1970’s, the fed made things more unstable instead of less because lags were making their decisions the wrong

ones.

What we learned tonight (AB).1. How changes in the credit market

affect RGDP.2. What expansionary and

contractionary monetary policy is.3. What the lag problem is.

Welcome to Night 12

Principles of Macroeconomics

What we learned last class (AB).1. How changes in the credit market

affect RGDP.2. What expansionary and

contractionary monetary policy is.3. What the lag problem is.

While the fed looks at many things in setting policy, it is accurate to say that the most important thing they have looked at in setting policy in

the 21st century has been inflation. The fed has “targeted” a goal of 2% inflation. They don’t try to hit 2%

inflation every month, but over what they call the medium term.

When inflation has gone above 2%, the fed has decreased the money supply to decrease AD

and when it has been below 2% they have increased the money supply … in general.

Now textbook guy writes “The FOMC does not decide to increase

or decrease the money supply. Rather, it engages in operations to nudge the federal funds rate up or down.” So why did I just say the fed increases or decreases the

money supply?

Suppose you are selling hamburgers. Currently the price is

$1.20 and you are selling 300 a day. You lower the price to $1.00 and

sales rise to 350 a day.

Have you changed the price of hamburgers or have you changed

the number you sell?

P

Q

$1.20$1.00

300 350

Are the sellers picking the price or the quantity?

D

These are not separate decisions that can be analyzed separately. To decide to do one means to decide

to do the other. We chose between describing the outcome as changing the price or changing the quantity merely as a matter of

convenience.

i

Q

5%4%

3 Trillion 3.6 Trillion

Now money has a demand curve. If the fed wants to lower the interest rate from 5% to 4%, what do they have to do?

D

Money Market

It doesn’t matter that the fed may describe this as a lowering of the interest rate, it is just as much a decision to increase the money

supply. That is what they have to do to support the lower interest

rate.

Another problem the fed may have in a bad recession beyond lags is

something called a liquidity trap or the zero bound problem.

The usual way monetary policy works is that the fed creates bank reserves, the banks lower interest rates and people borrow the new

money and spend it.

But what if the interest rate is already zero?

The new money would just sit in the bank vault unspent. In fact, it

is worse than that, because the fed pays interest on bank deposits at

the fed. Very little interest (0.25%), but still a positive amount.

The monetary base is currency (both inside and outside banks)

and bank deposits at the fed.

The fed has greatly expanded the monetary base as part of its

expansionary monetary policy.

https://research.stlouisfed.org/fred2/series/BASE/

And what has happened to the money supply?

https://research.stlouisfed.org/fred2/series/M2/

The monetary base has gone from 800 billion dollars to 4,000. That is an increase of 500%. The money supply (M2) has risen from 8,000 to 11,000. An increase of 37.5%

How is this possible?https://research.stlouisfed.org/

fred2/series/EXCSRESNS

Almost as fast as the fed has been shoveling money into the economy, the banks have been shoveling it out again.

Normally, they would loan it out to businesses and consumers, but

remember, we are almost at 0% interest, so there is no benefit to doing so. Better

to be safe and store it at the fed

In any case, people wouldn’t want to borrow it unless the interest rate fell, but the bank won’t loan at negative

interest.

If businesses had confidence in the future, they would be willing to pay

higher interest rates than the fed does to finance investment projects, but they

don’t, so they don’t.

So here we sit, stuck in a bad economy despite expansionary

monetary policy.

So what can we do? There are 2 things we could try. One is the

subject of chapters 12 and 13. Before we look at the other, we have to learn

one of the two most famous equations in macroeconomics

We are skipping over rational expectations in the textbook here

to talk about the equation of exchange. We will cover rational

expectations, but in the next chapter.

Imagine a society with no checks or credit, only cash. This economy

has $1 million cash in existence. Is it true that in the course of a year,

the people of this country must buy exactly $1 million dollars

worth of things?

A dollar can be spent more or less than 1 time during a year. How many times the average dollar is

spent on final goods and services is the velocity of money.

Now suppose $1 million dollars exists and each dollar is spent 4

times during the year. Do we know that the people bought $4 million

dollars worth of stuff?

Yes.

M x V = GDP

M = Money SupplyV = Velocity of Money

It is also true that GDP=(Pa)(Qa)+(Pb)(Qb)+…+(Pz)(Qz)

soGDP = P x Q

P = Average Price of ThingsQ= Quantity of Things Made

Put these together and you get M x V = P x Q

This is called the equation of exchange.

Textbook guy uses Y in place of Q.

What we learned so far (BB).1. How the fed can be described as either setting interest rates or the

quantity of money.2. What the zero bound problem is.

3. The equation of exchange –M x V = P x Q

Night 12Class Break

Principles of Macroeconomics

What we learned so far (BB).1. How the fed can be described as either

setting interest rates or the quantity of money.2. What the zero bound problem is.

3. The equation of exchange –M x V = P x Q

M x V = P x QWhy do this? Because now we have an equation relating the

amount of money to the things we really care about, namely Q and P. But it is not helpful yet, because at

this stage, an infinite number of things could still happen. This model needs more structure.

The Simple Quantity Theory of Money is that if V and Q are fixed, then changes in the money supply cause equal percentage changes in

prices.

Let’s assume V and Q are fixed and start moving the money supply around.M x V = P x Q

$100 x 4 = $2 x 200 $200 x 4 = $4 x 200

Ms up 100%, P up $100%$300 x 4 = $6 x 200

Ms up 50%, P up 50%$250 x 4 = $5 x 200

Ms down 16.67%, P down 16.67%

Why does this happen? Imagine you go to the store and spend $10

to buy 10 apples every month. Now the money supply is doubled

so you have twice as much money. If V is fixed, you now spend $20

trying to buy 20 apples. Are there more apples for you to buy?

No, because Q is fixed also. Now if it was just you, you would buy 20 apples; but it is not just you, it is everybody trying to buy twice as

many apples. There will be an apple shortage. What does the

price of apples have to rise to until $20 buys 10 apples again?

So double the money supply, double prices.

While the simple quantity theory is too simple for many cases, it does

answer some questions. For example, why does the

government need taxes when it can just print up the money it needs?

And, in fact, long-term inflations or hyperinflations are almost always

the result of the government increasing the money supply (a lot)

to pay for things.

1) Germany after World War I2) South American countries in the

1950’s/60’s

But will Q stay fixed when the government increases M?

Let’s investigate. To keep things simple, let’s assume V does stay

fixed fixed.

M x V = P x Q$100 x 4 = $2 x 200

Now double the money supply$200 x 4 = $? x ?

There are an infinite number of P’s and Q’s that would solve this, so

what to do? Bring in our old friend, the AS/AD diagram.

Q

P

M x V = P x Q$200 x 4 = $2 x 200

AD1

SRAS

$2

200

What are Q and P on the diagram?

M x V = AD

Assuming V stays the same, doubling the money supply means doubling buying or doubling AD.

Q

P

AD1

SRAS

$2

AD2

Now we can just read the

new Q off the diagram

?

200 250

AD2 is a doubling of AD1

M x V = P x Q

$100 x 4 = $2 x 200

$200 x 4 = ? x 250

M x V = P x Q$100 x 4 = $2 x 200$200 x 4 = P x 250

P = $3.2

Money supply rose 100%.Quantity rose 25%.

Prices rose 60%.

Why aren’t prices doubling here?

Q

P

AD1

SRAS

$2

AD2

Assume Q = 200 is Qn.

What is P3?3.2

200250

What about the long-run?

P3

P3 is $4. The assumption that Q is fixed is a better long-run assumption

than short-run.

M x V = P x Q$100 x 4 = $2 x 200

$200 x 4 = $3.2 x 250$200 x 4 = $4 x 200

What if V is not fixed? We would do the same trick of figuring the new M x V to find AD and shift to the new AD on the diagram, but it would be harder. How does the

change in M affect V?

Factors That Affect V1) Expected Inflation.

2) Interest Rates3) Confidence in the Future

More money probably means higher expected inflation, so V increases.

At least in the short-run, more money might mean lower interest rates, so V falls.

You would probably need a computer model to sort this out.

Here is what has happened to V

The rise in the money supply of 37.5% has been offset by a drop in

velocity of around 18%.

So increase the monetary base by 500%, have most of that go to

excess reserves and have velocity drop by almost 20%, and you get a

weak recovery.

Could the fed had done more? Some monetarists say yes.

Monetarists are a school of economists that believe the most important thing that determines

nominal GDP is the money supply.

The most famous and first monetarist was an economist

named Milton Friedman.

He looked at the relationship between NGDP and the money

supply from 1867-1960 and believed he

found a close relationship, implying

V was stable.

He also found there had been a large drop in the money supply

during the Great Depression, which he posited as its largest cause. Why would there be a drop?

People grew fearful of banks and closed their checking accounts.

M1 during the Great Depression

Out of this, he proposed a money supply growth rule.

M x V = P x Q

If you think V is relatively stable, and Q grows at an average of 3% a year, and you want stable prices,

what should M grow at?

So Friedman proposed replacing the people on the federal reserve

board with a computer programed to buy and sell government

securities to cause the money supply to grow at 3% a year.

When V dropped, you would still have a recession, but Friedman felt this was better than what the fed

was doing in the 1970’s, which was guessing wrong and causing

recessions

Such a rule might not work well for long persistent recessions, like this

one.

The new thing in macroeconomics is called market monetarism. It is

a, perhaps, logical extension of Friedman’s ideas.

Market monetarism, most closely associated with an economist named Scott Sumner at Bentley University in

Massachusetts. I mention this Bentley is not usually considered a heavy hitter in economics. Usually

important new ideas come from Yale, Princeton, University of Chicago,

M.I.T, that sort of place.

So how did Scott Sumner get influential? He used his blog –

“The Money Illusion”

It is the first case of a blog being important in macroeconomic

theory.

Market Monetarism says the fed should target the level of NGDP, and specifically target a growth path of

5% a year. Why 5%? That allows for 3% real growth and 2% inflation in a

typical year.

He wants to stop things like this.

Critics say the fed can not do this, because the zero bound problem

means the fed can not raise NGDP when interest rates hit 0%.

The Market Monetarists have two answers.

What we learned tonight (AB).1. The simple quantity theory of money.

2. How to use the equation of exchange when Q is not fixed.

3. Three factors that affect the velocity of money.

4. Who monetarists are and what market monetarists think the fed should do (target

NGDP).

Welcome to Night 13

Principles of Macroeconomics