Chapter 10 Financial Markets and the Economy

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, the U. S. government wishes to borrow money
For example, the U.S. government wishes to borrow money. They issue a bond like this one. It will have a date of maturity, or when you can turn it back into the government and get your money back

It will also have the amount of money you get paid back, in this case $100. So let’s say the maturity on this bond is one year.

You buy it now and turn give it to the government in one year to be paid $100. You are loaning them your money for one year. What is the interest rate you are getting? That depends on how much you paid for it.

Let’s say you pay $90 for it. In one year, you get back $100
Let’s say you pay $90 for it. In one year, you get back $ You have lent $90 for a year and got back $100. That is equal to an interest rate of (Face Value – Bond Price)/Bond Price ($100-$90)/$90 = $10/$90 = = 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?

Both of these are correct ways of illustrating the same thing happening. Textbook guy uses the 2nd way. I find the 1st way much more intuitive.

Here are both ways side-by-side
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 Supply (savings) iE Demand (borrowing) QE Loanable Funds

Here is one way that a change in interest rates can effect the macroeconomy. 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 S1 i1 Interest Rates Fall S2 i2 D1 Q1 Q2 Loanable Funds

The extra investment spending will increase AD (GDP=C+I+G)
SRAS This could help get us out of a recession P2 P1 AD2 AD1 Q1 Q2 QN Q

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

What can you do with your purchasing power. 3 things
What can you do with your purchasing power? 3 things. 1) Buy Goods 2) 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
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.

3 Reasons to be holding money 1) Holding money to make expected purchases later is the transactions demand for money. 2) Holding money to protect against unexpected purchases (emergencies) is the precautionary demand for money.

3) The speculative demand for money you expect to invest in bonds or stocks but are waiting for a better price.

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.

Demand curve for money in terms of interest for bonds.

What else affects the demand for money
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
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. 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 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
Do people really think they have too much money? Well, imagine you have a huge cash stash in the cookie jar and read that Ford Auto Co. is paying 100% on Ford 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 Supply (savings) iE Demand (borrowing) QE Loanable Funds

If the demand curve for money shifts, the interest rate will shift
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 S1 i1 Interest Rates Fall S2 i2 D1 Q1 Q2 Loanable Funds

This could help get us out of a recession
Why might the Fed want to do this? AS/AD diagram showing the effect of more investment caused by lower interest rates. P SRAS This could help get us out of a recession P2 P1 AD2 AD1 Q1 Q2 QN Q

Chapter 11 Monetary Policy and the Fed

What are the Fed’s goals
What are the Fed’s goals? 1) Low Inflation 2) 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.

But what weight does it assign to each goal
But what weight does it assign to each goal? In the 1960’s and 70’s, it was lower unemployment. Since then, it has been lower inflation. This comes from the feeling among many bankers and economists that the fed paid to little attention to inflation in the 60’s/70’s.

If it did, it was probably acting on the feeling that the fed paid too little attention to unemployment in the 1930’s. Some economists are arguing that this “don’t make the same mistake we made last time” mentality is causing the fed to pay too much attention to inflation now.

In theory, Congress can legally set the goals for the fed whenever it wants. It has given the fed a dual mandate of low unemployment and low inflation. In practice, this has left the fed almost completely independent.

So what should the fed do. Suppose we are in a recession
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.

A quicker way out would be if the fed could get AD to move right.
P SRAS Can they do this? P2 P1 AD2 AD1 Q1 QN Q

The short answer is yes. 1) Fed buys government securities
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
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 S1 i1 Interest Rates Fall S2 i2 D1 Q1 Q2 Loanable Funds

What about in the money market
What about in the money market? And buy this, I don’t mean the financial market sometimes known as the money market. I mean people’s choice of how much money to hold.

Interest rates fall, people want to hold more money and less bonds.

So as the fed increases the money supply, people will hold more in their cash stash. The increase in money to be lent will not be as large as the amount created by the fed, since people will respond by saving less and holding more cash. But it is unlikely this effect will be large enough to cancel out the effect of the fed’s action.

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?

Out of the inflationary gap without inflation.
SRAS P1 P2 AD1 AD2 QN Q Q1

To do this, we use contractionary monetary policy
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
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 problems. The first we are going to talk about is lags
There are 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
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 are just seeing 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
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
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
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
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 Lag 3) 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.

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
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. Now, have you changed the price of hamburgers or have you changed the number you sell?

Are the sellers picking the price or the quantity?
$1.20 $1.00 D 300 320 Q

These are not separate decisions that can be analyzed separately
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.

Now money has a demand curve
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? i 5% Money Market 4% D 3 Trillion 3.6 Trillion Q

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 this 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
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.

And what has happened to the money supply?

The monetary base has gone from 800 billion dollars to 4,000
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? 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
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
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 Supply V = Velocity of Money

It is also true that GDP=(Pa)(Qa)+(Pb)(Qb)+…+(Pz)(Qz) so GDP = P x Q P = Average Price of Things Q= 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.

M x V = P x Q Why 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 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
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
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 I 2) South American countries in the 1950’s/60’s

But will Q stay fixed when the government increases M
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.

M x V = P x Q $200 x 4 = $2 x 200 P SRAS What are Q and P on the diagram? $2 AD1 200 Q

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

Now we can just read the new Q off the diagram
AD2 is a doubling of AD1 P SRAS Now we can just read the new Q off the diagram ? $2 AD1 AD2 200 250 Q

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
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?

What about the long-run?
P SRAS Assume Q = 200 is Qn. What is P3? P3 3.2 $2 AD1 AD2 200 250 Q

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 V 1) Expected Inflation
Factors That Affect V 1) Expected Inflation. 2) Interest Rates 3) 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
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
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 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.

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

One is simply to say, yes they can, through brute force if necessary
One is simply to say, yes they can, through brute force if necessary. Critics point out that at the zero bound, the creation of monetary base is not very effective at creating new money, so that creating 500% more monetary base created only 37.5% more money.

Market Monetarists say, so what
Market Monetarists say, so what? If creating $20 in new base creates only $1 in new money, that’s fine, we just figure out how much new money we want and create 20 times that in currency and bank reserves. Can the fed create that huge amount of base? Sure

Sumner’s challenge to the critics is, “ Do you really believe the fed can go out and buy an essentially unlimited amount of short term bonds, and if that doesn’t work, long-term bonds, and if that doesn’t work, stocks, and if that doesn’t work, gold and property, and refrigerators, and so, and prices and output will not be affected?

I have never seen that challenge effectively answered
I have never seen that challenge effectively answered. If you have a car with hydraulic steering and the power goes out so the wheel doesn’t work nearly as well, that doesn’t mean you can’t steer to the right, it just means you have to steer more powerfully and emphatically.

Towards the end of his life, Friedman was asked about the inability of the Japanese central bank to increase AD by buying short-term bonds because their zero bound problem. He said, “they should buy long-term bonds”. Sumner is taking that to its logical conclusion.

But there is a second part to this, which is the beauty part, and means the fed shouldn’t have to create that much more money after all.

Everyone does believe that things will get back to normal eventually, with interests back well above zero, and the fed will have the power to create inflation. With NGDP level targeting, the fed will use that power, at least a little. So people should expect inflation when things get back to normal.

But of course if you expect inflation in the future, what should you do now? So what will happen to velocity now?

And once you raise velocity now, do you even have to create much money to increase AD? The point of the fed announcing it is standing ready to create as much money as necessary to get some inflation in the future is they won’t have to, because the belief they are ready and willing to do that will increase V

So the macroeconomy will become mostly self-correcting
So the macroeconomy will become mostly self-correcting. When NDGP is rising above 5% because of inflation, people will believe the fed will decrease the money supply to stop that, so future inflation will be less and V will drop, decreasing AD and inflation.

When a recession begins and NGDP starts rising less than 5%, people will expect the fed to create more money to raise inflation to get back to the 5% NGDP growth path and so V will increase, increasing AD to get us back to the 5% nominal growth path.

This is not utopia, because when higher oil prices cause SRAS to decrease, we will get inflation at say 4% and real growth will be slow at 1%; but it will at least stop recessions or high inflations caused by changes in AD.

While the fed has not embraced market monetarism totally, and might never do so, since at the end it would lead to Friedman’s dream of a fed run by a computer to achieve a simple result, it has moved in that direction. It has recently started using “forward guidance”.

This is the fed announcing it will continue expanding the monetary base even after it “normally” would.

There is more to say about good monetary policy, but it will be easier after we have learned a thing called the Phillip’s Curve. So let’s jump ahead to chapter 16.

Chapter 16 Inflation and Unemployment

The more you increase AD, the higher inflation is and the lower unemployment

What does the shape of SRAS have to be to make the Phillip’s a U
The more unused resources, the flatter the SRAS curve. P2 P1 Q1,2 QN Q

An increase in AD deep in the recessionary gap will primarily increase output and decrease unemployment with only a small increase in P. An increase in AD far into the inflationary gap will primarily increase P with only a small increase in Q and decrease in U

If a hardware store gets a large increase in orders for hammers and puts an ad in the paper for more workers, does anyone show up or not? If not, what does the store do to “accept” all the additional hammer money

In 1969, Milton Friedman gave an address to the AEA saying the Phillip’s curve is about to go all to hell. He based this on the topic of expectations and the question, “How stupid are people?”

Look at the Phillip’s curve this way
Look at the Phillip’s curve this way. When the government causes 3% inflation by printing up money and the worker’s have a fixed wage, from the viewpoint of the business owner, workers just got cheaper relative to the sales price of the product, so he hires more of them.

But how long will this go on
But how long will this go on? Won’t people eventually expect 3% inflation and demand 3% cost of living raises? Now how much cheaper are workers getting compared to the price of the product? None. And how many extra workers will be hired because they are cheaper? None.

People start expecting 3% inflation.
Un

At first people are caught by surprise by the inflation and Q rises, U falls.
SRAS P2 P1 AD2 AD1 Q1 Q2 Q

But then they catch on and get compensating raises.
SRAS2 P We’ve seen this before, but this time they are happening at the same time, not one after the other. SRAS1 P2 P1 AD2 AD1 Q1,2 Q

Can the government still get lower unemployment? How?
SRAS2 P SRAS1 P2 P1 AD2 AD1 Q1 Q

Can the government still get lower unemployment? How?
SRAS2 Move AD farther right. If people expect 3% inflation, give them 6%. P2 SRAS1 AD2 P1 AD1 Q1 Q2 Q

New Phillip’s at expected inflation =3%
Ex. Inf. = 1% Ex. Inf. = 3% Un

Un The Long-run Phillip’s Curve at Un Long-run Phillip’s Curve
Ex. Inf.=1% Ex. Inf.=3% Un

Points from 1961 to 2011 81 79 78 77 82 76 83 89 07 88 87 11 86 08 09 10

Rational Expectations are expectations about the future that are, on average correct. They do not contain systematic errors. They take into account all known significant information.

Predicted. Actual. Inflation. Inflation Y1. 4%. 6% Y2. 5%. 8% Y3. 3%
Predicted Actual Inflation Inflation Y % % Y % % Y % % Y % % What simple change would you make to this program to get better predictions?

What happens to our AS/AD model of the macroeconomy if people have rational expectations?

People see the increase in AD coming and get pre-arranged raises.
SRAS2 Instead of first AD moving and then SRAS moving, they both move together. The government can’t increase output. P SRAS1 P2 P1 AD2 AD1 Q1,2 Q

Friedman saw this happening, but only after a couple of years had passed and people had caught on. Robert E. Lucas Jr. asked why can’t people catch on right away. The information about what the fed is doing is public.

In the Rational Expectations model, the long-run becomes the short-run
In the Rational Expectations model, the long-run becomes the short-run. There are not 2 Phillip’s curves, there is only one.

This is the long-run Friedman curve, but now it is the only curve.
The Rational Expectations Phillip’s Curve is a line straight up and down at Un π This is the long-run Friedman curve, but now it is the only curve. UN U

This does not mean we are always on the line and never have a recession. People still make mistakes in predicting the future, even with rational expectations. It does mean the government can not correct the problem.

For example, if people think inflation is going to be 4%, but it is actually 1%, there will be a recession. The government can not fix this by printing money until inflation is 4%, because people will see that and raise their inflation expectation to 7%.

The rational expectationists tend to think the best thing to do is for the government to let them market work and let people correct their mistakes on their own. So how did the rational expectationists of the 1960’s explain the almost perfect slanted “C” curve?

Trick question. There were none until Lucas wrote a couple of articles famous articles about it in the 1970’s. It is not an accident that rational expectations “happened” in the 70’s and not the 60’s, as people were more concerned with it then.

This illustrates one reason that macroeconomics is hard
This illustrates one reason that macroeconomics is hard. People can behave differently in different times, and a theory that explains correctly in one age may not work in another.

Winners and Losers From Inflation Losers
Winners and Losers From Inflation Losers Winners People holding cash Borrowers may win Savers may lose

If you have $100 dollars in the cookie jar during the year and there is 10% inflation, the money loses 10% of its value. $ % π $90 The 100 dollars on Dec. 31 will only buy what 90 dollars would have bought on Jan. 1

Saving with 5% interest rate and 10% inflation $100 5% i $105 $105 10%
π $95

Why write that savers may lose rather than savers do lose
Why write that savers may lose rather than savers do lose? Because savers won’t keep their money in the bank in these conditions. Why not buy stock, land, or gold (or even baseball cards)?

To keep their customers, the banks have to raise the interest rate to compensate depositors for the inflation, and then give them interest on top of that.

If you have to pay people a 5% return to get their money, during times of 10% inflation, you will have to pay them 15%. The nominal interest rate is the written rate you pay them. The real rate of interest is the real rate their deposit is gaining value after taking into account inflation.

i = nominal interest rate r = real interest rate π = inflation rate r = i - π

r = i – π First Case -5% = 5% - 10% Second Case 5% = 15% - 10%

So savers lose to an unexpected inflation, but once it becomes expected, it should be factored into the interest rate and they don’t lose.

By the same token, borrowers can win when there is inflation
By the same token, borrowers can win when there is inflation. They get to pay back with less valuable money.

Borrowing at 5% interest rate and 10% inflation $100 5% i $105 $105 10%
π $95

One of the longest running American political battles and one of America’s most famous political speeches (the “cross of gold” speech) is about this.

The farmers have always owed money to the bankers … and so the farmers have always liked inflation compared to the bankers. This was true at the 1896 Democratic Convention.

So why was it called the cross of gold speech
So why was it called the cross of gold speech? This was the time of the gold standard, so we had paper money backed by gold, which put a limit on how much money could be created. The farmers wanted more money made, but weren’t ready for fiat money.

So they had an idea. Why should only gold back our money, why not silver too? So the government should also print money based on the amount of silver it owned. This is called a bimetal standard. And if this caused inflation, so much the better.

William Jennings Bryan gave a speech supporting this idea
William Jennings Bryan gave a speech supporting this idea. He ended by saying, “You shall not crucify mankind on a cross of gold.” The Democrats liked it so well they nominated him for President 3 times. He lost all 3 times.

In fact, there is a theory that “The Wizard of Oz” is an allegory for this.

Dorothy = Average American Citizen/Voter Scarecrow = Farmers Tin man = Industrial Workers Cowardly Lion = Populist Party Yellow Brick Road = Gold Standard Emerald City = Money/Financial System Wizard = Bankers

Now we can see the story we have told so far about creating money and interest rates, that creating money always lowers interest rates, is too simple.

Because creating money can create inflation and/or the expectation of inflation, which raises interest rates. When the fed created money to lower interest rates in the 1970’s, it ended up creating higher rates as inflation grew.

Creating money may lower interest rates in the short-run, but if it causes inflation, it will raise them in the long-run. And if people see the inflation coming (rational expectations), it will raise them in the short-run too.

During the Great Depression, interest rates were low
During the Great Depression, interest rates were low. People argued this showed the fed was being expansionary (creating money) and so they could not do anything more.

Milton Friedman pointed out this was wrong
Milton Friedman pointed out this was wrong. If the fed had really created a lot of money, they would have reversed the deflation into inflation and the interest rates would have rose. The low interest rates in the depression were not a sign the fed was being expansionary …

They were a sign the fed was not being expansionary enough, it was not printing up enough money to cause inflation and increase AD by increasing both M and V.

Amazingly enough, the same mistaken idea has gone around during this recession. The fed has increased the monetary base, the interest rates are driven to zero, and some economists say, see, the fed is being expansionary and there is nothing else they can do.

This time it is left to Scott Sumner of market monetarism fame to play the Milton Friedman role of pointing out that low interest rates mean the fed has not created enough money to create expectations of inflation, so they are not doing everything they could do.

If they printed out enough money to cause people to expect 4% inflation, both velocity would increase and the zero bound problem would go away. AD would increase and we would get back to Qn.

Why hasn’t the fed done so
Why hasn’t the fed done so? Well, one reason is that the macroeconomics profession has seemingly forgotten what Friedman taught us about fighting the Great Depression and wants to go back to the old mistake of low interest rates mean easy money.

But another reason is the politics of it
But another reason is the politics of it. Nobody is pushing for it in the way that William Jennings Bryan pushed for easier money back in 1896.

Instead of pushing the fed to do more, one party has pushed for them to do less, while the other has just been clueless. Handout.

At least one thing you can say for the fed is that they have not been as bad as the European Central Bank.

Unemployment in Jan 2014 Greece = 26
Unemployment in Jan 2014 Greece = 26.7% Spain = 26% Euro area = 12% Germany = 5.1% U.S.A = 6.6% In Jan 2013 Euro area = 12% U.S.A = 7.9%

Did any western economies avoid the Great Recession of 2009?

Chapters 12 and 13 Keynesian Economics

John Maynard Keynes is an English economics who blamed the depression in the 1930’s not on a lack of money, like Friedman, but on a lack of spending the money we did have.

Why would this happen? Keynes said our income goes up and down, we spend more or less on consumption goods. How much more we spend with each additional dollar is our marginal propensity to consume = MPC.

If you get a $100 dollar raise, spend $70 at the store, and put $30 in the cookie jar, your MPC = Your marginal propensity to save = MPS = .30

Imagine that the President of Ford comes to work in the morning and is feeling good about things. Maybe he had a good dream or a great breakfast. Keynes used the term “animal spirits”.

For whatever reason, the President of Ford thinks next year is going to be better than this year. He orders a tool shed built behind the main factory to hold the tools of the overtime workers he anticipates hiring next year.

Start with an increase of $100 in investment and MPC = 0. 8
Start with an increase of $100 in investment and MPC =  I  C  GDP Round $ $0 $100 Round $0 $ $80 Round $0 $ $64 Round $0 $ $52 More Rounds … … … Total $100 $ $500

Someone is hired to build the tool shed and is paid the $100
Someone is hired to build the tool shed and is paid the $100. He spends $80, and remember, what is expense for someone is income for someone else. That person has an income of $80 and spends $64, and so on.

This process is called the Keynesian multiplier
This process is called the Keynesian multiplier. An initial increase in spending of $100 causes GDP to go up $500.

What if the President of Ford’s animal spirits are low, so he thinks next year will be worse than this year. Last year they build a tool shed, this year they don’t.

Everything is the same but with negative signs.  I  C  GDP Round 1
Everything is the same but with negative signs  I  C  GDP Round $ $0 -$100 Round $ $ $80 Round $ $ $64 Round $ $ $52 More Rounds … … … Total $100 -$ $500

Now the economy is going down as the multiplier causes a cascade of lay-offs. Keynes was a great believer in the self-fulfilling prophecy. When people thought things would be good, they would be good … and when they thought things would be bad, they would go bad.

How do you now how much to multiply the initial change in spending to get the end change in GDP? m = 1/(1-MPC) m = 5 when mpc = 0.8 The $100 change in investment causes a $100 x 5 = $500 change in GDP.

Keynes believed the main cause of the Great Depression was the simultaneous end of a lot of investment projects at the end of the 1920’s and drop in confidence that the 1930’s would be as good as the roaring 20’s.

Let’s translate the table to the AD/AS diagram.
$500 SRAS AD0 ADF AD1 AD2 QF Q2 Q1 Q0 $80 $100

And viola, we are into the recessionary gap
And viola, we are into the recessionary gap. In terms of M x V = P x Q We have a drop in V.

Friedman’s story of the depression. 1) A few banks fail
Friedman’s story of the depression. 1) A few banks fail. 2) People pull their money from the banks. 3) Money supply falls. 4) Less money = less buying and AD decreases. 5) As the economy tanks, V falls which further lowers AD.

His solution is for the fed to not let the money supply fall, or at least pump it up again as ASAP when it does.

Keynes’ story of the depression
Keynes’ story of the depression. 1) Business’s lose confidence in the future (their animal spirits droop). 2) They cut investment. 3) Laid off workers cut their buying. 4) The multiplier plays out. 5) Velocity drops, taking M with it.

Increasing M won’t help because it is an effect, not the cause
Increasing M won’t help because it is an effect, not the cause. Also the zero bound. The phrase Keynesians use is “the fed is pushing on a string.” So what is Keynes solution to the Great Depression? I’m glad you asked.

Let’s do the Keynesian table again, but with a change in G
Let’s do the Keynesian table again, but with a change in G  G  C  GDP Round $ $0 $100 Round $0 $ $80 Round $0 $ $64 Round $0 $ $52 More Rounds … … … Total $100 $ $500

And thus AD moves to the right
And thus AD moves to the right. The recessionary effect of a drop in investment can be undone by the inflationary effect of a rise in government spending. If the government cuts spending, then the table has negative signs and AD moves left.

What if there is a $100 tax cut.  G  C  GDP Round 1. $100 $0
What if there is a $100 tax cut?  G  C  GDP Round $ $0 $100 Round $0 $ $80 Round $0 $ $64 Round $0 $ $52 More Rounds … … … Total $0 $ $400

Expansionary Fiscal Policy Move AD right to fight recessions
Expansionary Fiscal Policy Move AD right to fight recessions. 1) Increase G 2) Cut Taxes So the government is running a deficit.

Contractionary Fiscal Policy Move AD left to fight inflation
Contractionary Fiscal Policy Move AD left to fight inflation. 1) Decrease G 2) Increase Taxes So the government is running a surplus.

The Obama stimulus program of 2009
The Obama stimulus program of Spending - $550 Billion Tax Cuts - $290 Billion

Problems with Fiscal Policy
Problems with Fiscal Policy. 1) The Lag Problem – the same lags as monetary policy, but with the time it takes congress to do things thrown in. Also it can take awhile for spending voted by congress to actually be spent by the government.

2) Political Problems Keynes says to run deficits when recession is the problem and surpluses when inflation is the problem. From 1969 to 2014, the federal government has run deficits every year.

Politicians love to spend on their favored programs and cut taxes
Politicians love to spend on their favored programs and cut taxes. Some times the only hope for good government is politicians who are good liars.

But if the practical problems of lags and politics are solved, is fiscal policy guaranteed to work? No, there is an other problem called crowding out.

Here is a graph of the credit market where saving does not depend on the interest rate.
Supply (savings) 5% Demand (borrowing) $10 Billion Loanable Funds

Now the government borrows $5 billion
Now the government borrows $5 billion. Demand moves $5 billion to the right. Has overall borrowing increased by $5 billion? Interest rate Supply (savings) 5% D2 D1 $10 Billion Loanable Funds

Equilibrium borrowing remains at $10 billion. How is this possible?
Supply (savings) 7% 5% D2 D1 $10 Billion Loanable Funds

The government borrowing has “crowded out” private borrowing and spending through a higher interest rate. The government borrows $5 billion more. Ford, IBM, etc. borrow $5 billion.

Private companies and individuals are dropping spending as fast as the government increases it. GDP = C + I + G

Keynesian table with crowding out.  G  I  C  GDP Round 1
Keynesian table with crowding out  G  I  C  GDP Round 1 $100 -$100 $ $0 Round $ $ $ $0 Round $ $ $ $0 Round $ $ $ $0 And so on … … … … Total $100 -$100 $ $0

Let’s translate the table to the AD/AS diagram.
P SRAS AD0,1,2,…,F Q0,1,2,…F Q

When does does crowding out occur
When does does crowding out occur? When the money the government borrows and spends would have been spent by someone else if the government had not borrowed it.

This happens when: 1) The government borrows money someone else was going to borrow and spend, and now they don’t. 2) The person who lends the money to the government was going to spend it but lent it to the government instead.

Crowding out does not occur when people lend the government “cookie jar” money, or money they were not going to spend on either goods or bonds.

So if you think of the Great Depression as being caused by low AD because of people sitting on large cash stashes they are afraid to spend or lend to private companies, the government can borrow it from them and spend it for them, increasing AD

People (usually conservatives) opposed to the Obama stimulus package point out “the money must have come from somewhere”. Shouldn’t spending drop wherever it came from?

Keynesians point out that even if it came from somewhere, as long as it wasn’t being spent in that somewhere, spending will rise.

M x V = P x Q Pure Keynesianism can be done without an increase in M
M x V = P x Q Pure Keynesianism can be done without an increase in M. By borrowing V=0 money and spending it, V is increased and AD goes up.

If crowding out is true, then V will not increase
If crowding out is true, then V will not increase. Monetarists, in general, believe in crowding out. That is why they say there must be an increase in M to increase AD.

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Chapter 10 Financial Markets and the Economy

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