5Monetary Theory and Policy

John Maynard Keynes, 1883-1946 Great British Economist Father of Keynesian Theory Author & Cambridge Professor England’s Treasury Secretary Had a Seat in House of Lords Strong following at Harvard

(especially after GreatDepression, to whichKeynesian theory was a response.)

An imposing figure (6’6”) anda prominent gay figure of his day

Successful investor (built $.5M into to $13.2M in 18 years.

Milton Friedman (1912 - 2006 ) At first a disciple of Keynes. Later rejected Keynes and

became father of Monetarism A Nobel Prize winner; likely the most influential

American economist of the 20th century Known for his laissez-faire or libertarian philosophy;

promoted economic freedom around the world His principles influenced a number of countries,

including, China, HK, Chile, Iceland, and Estonia (which went from impoverished communism state to the Baltic Tiger); and the U.S. (Reagan was a disciple).

He and his wife Rose educated the public about economic freedom through successful books and a TV show entitled “Freedom to Choose.”

Awarded Presidential Medal of Freedom by President Reagan, who was a follower

Supported freedom in many areas: stood for legalization of drugs & prostitution, school vouchers, and elimination of the military draft in the U.S.

Helped create tax withholding system in 1942 and the EITC (both of which he later regretted)

Believed the Great Depression was caused by Fed’s refusal to expand money supply Here’s some classic Friedman http://www.youtube.com/watch?v=R5Gppi-O3a8&feature=related

Famous Friedman Quotes "There's no such thing as a free lunch." “I am in favor of cutting taxes under any circumstances and for any excuse, for any reason, whenever it's possible." "A major source of objection to a free economy is precisely that it [...] gives people what they want instead of what a particular

group thinks they ought to want. Underlying most arguments against the free market is a lack of belief in freedom itself." "The business of business is business“ “I am a libertarian with a small ‘l’ and a Republican with a capital “R”, but only on the grounds of expediency, not on principle "Inflation is the one form of taxation that can be imposed without legislation." "The government solution to a problem is usually as bad as the problem." "We have a system that increasingly taxes work and subsidizes non-work." "With respect to teachers' salaries[....] Poor teachers are grossly overpaid and good teachers grossly underpaid. Salary

schedules tend to be uniform and determined far more by seniority." "If an exchange between two parties is voluntary, it will not take place unless both believe they will benefit from it. Most

economic fallacies derive from the neglect of this simple insight, from the tendency to assume that there is a fixed pie, that one party can only gain at the expense of another"

"Hell hath no fury like a bureaucrat scorned." "The only social responsibility of business is to increase its profits" Friedman’s categories of spending money is classic:

Friedman’s Rule Spend Your $ Spend Other’s $

On Yourself 1. Very Accountable 3. Not Very Accountable (e.g. company expense report)

On Others 2. Quite Accountable (charity) 4. Extreme lack of accountability (e.g. government)

“The problem with socialism is that eventually you run out of other people's money.” Margaret Thatcher

Monetarist vs. Keynesian Theories

MonetaristFocus is on controlling the money supply (thus its name) and inflation.Other economic goals, such as growth and employment will sort themselves outOver time, stable growth reduces borrowing and lowers interest rates by defaultKey goal is low inflation, and the other problems will resolve themselves over timeClaims Keynesian approach is a S/T fix, a kneejerk reactionCriticism: Only works over L/T, can be accused of doing nothing in the S/T

KeynesianNeed to take immediate action to lower interest rates and stimulate growth (e.g. stimulus)Key goals are growth and employmentCriticism: Might ignite inflation, but Keynesians say it’s worth it

Suppose the economy is headed downhill:

Volcker and Greenspan were monetarists; Bernanke was a modified monetarist. Yellen is

supposedly an unabashed Keynesian.

In 1979, Mrs Thatcher was elected Prime Minister of the UK. At the time, the UK was experiencing double digit inflation, trades unions were powerful and there was a feeling British industry had become uncompetitive in the post war period.Mrs Thatcher introduced revolutionary economic policies which had a deep impact on the UK economy. In the early years of the 1980s, Mrs Thatcher embarked on a policy of Monetarism. This involved trying to target the money supply to reduce inflation by increasing interest rates sharply.

Ronald Reagan's death in June 2004 prompted numerous reviews of his legacy, especially is foreign, tax, and budget policies. But little attention was paid to the success of his monetary policy. Yet President Reagan viewed reducing inflation through slower growth of monetary aggregates as equally important to his tax, budget and regulatory policies. This made Reagan’s presidency unique because no other American president, before or after, has made monetary policy so central to his economic policy objectives. Not only did his policy end the "Great Inflation" but it provided a new direction for the successful pursuit of price stability over the past quarter century, in the United States and abroad.

Two Great Leaders Apply Monetarist Policies

The Fed Chairs

Alan GreenspanRan the Fed successfully for 16 years and then . . . Critics claim that during his last 3 years, he kept rates too low, triggering

housing bubble. He claims now that he made the mistake of

thinking that banks would limit their lending risk out of self-

interest.

Ben BernankeAn academic who studied the

Great Depression. Took extraordinary steps during financial crisis to prevent another GD. Expanded

powers of Fed. Promoted transparency.

Three Fed chairs in a row had Monetarist leanings, but this has apparently ended.

CHAIRMEN (terms):Paul Volcker (1979-1987)Alan Greenspan (1987-2006, 19 yrs!)Ben Bernanke (2006-2014)Janet Yellen, (2/1/2014 - ??)

Janet YellenLegacy: who knows?

Will likely tend to follow the policies of Bernanke, but clearly

favors Keynesian view.

Paul VolckerTook tough steps of raising

interesting rates in early 80s to stem inflation; recently known for the Volcker Rule against

banks speculating with depositor money

Megan ClubbBoard Member of San Fran FedCEO/Chair of Baker Boyer National BankWalla Walla, Washington

Paraphrased Excerpts from Letter to Shareholders (10/30/14):

Yesterday was an important day. It marked the end of the Fed’s experiment in economic stimulus (QE), which originally was meant to be a one-time injection to a financial system in shock (Fall/08) but has, over the last six years, tried to remedy such things as labor and housing markets . . .

Despite the end of QE, the Fed plans to continue its low-interest rate policy for a considerable time. I have written to you many times about the negative impact these low interest rates are having . . . The Fed needs to do more than end QE. It must allow interest rates and economic markets to return to normal. The current Fed policy of keeping rates artificially low is driving community banks out of business . . .

Is Megan Clubb a monetarist or Keynesian?

Basic Monetary PolicyStimulative Monetary

Policy

Restrictive MonetaryPolicy

Fed

InvestorsBank Funds

IncreaseInterest Rates

Decrease

AggregateSpendingIncreases

$Buys Treasury

Securities

Fed

InvestorsBank FundsDecrease

Interest RatesIncrease

AggregateSpending

Decreases

$Sells T-

Securities

InflationDecreases

InflationIncreases

Monetary Policy Goals Goals of the Monetary Policy

Steady economic growth Low unemployment Stable prices (low inflation) Monetarists say this is most important because

the others goals cannot be achieved without this. Tradeoffs

Growth & Employment: these can be achieved simultaneously – directly related – no FOMC controversy.

Employment & Low Inflation: negatively related (teeter-totter, Phillip’s Curve) – FOMC members will seldom agree about these two conflicting goals Raising employment by growing the economy may increase inflation (e.g.

recessions during early 1990 and 2001-2004) Lowering inflation by slowing the economy may increase unemployment (e.g. 2005-

2006) “Take away the punch bowl just when the party is getting good,” (famous quip by

longest serving Fed Chair Bill Martin, 19 years, in early 1900s)

Keynesians focus more heavily on these goals

Phillips Curve

Employment/Inflation Tradeoff, Phillips Curve, 1960s

Indicators Monitored by the Fed Indicators of economic growth

Gross Domestic Product or GDP (total value of goods and services produced)

Other indicators: National income, unemployment, demand for cardboard boxes, etc.See http://research.stlouisfed.org/fred2/categories/18

Indicators of Inflation Consumer Price Index – Urban (all items at retail level).

See www.inflationdata.com

Producer price index, prices at wholesale level Also wage rates, oil and gold (tends to move with CPI)

Indicators Monitored by the Fed Leading Indicators: Used to predict future (leading index

consists of 10 indicators, 3-mo. movement indicates turning point)• The United States Department of Labor’s monthly report on the unemployment rate, average

hourly earnings and the average workweek hours from the Employment Situation report• The United States Department of Labor’s weekly report on first-time claims for state

unemployment insurance• The Census Bureau’s monthly consumer goods and materials report from the Preliminary

Report on Manufacturers' Shipments, Inventories, and Orders• The Census Bureau’s monthly non-defense capital goods report from the Preliminary Report on

Manufacturers' Shipments, Inventories, and Orders• The Census Bureau’s monthly report on building permits from the Housing Starts and Building

Permits report• The difference (spread) between the interest rates of 10-year Treasury notes and the federal

funds rate• The Federal Reserve's inflation-adjusted measure of the M2 money supply• The Institute for Supply Management’s monthly ISM Index of Manufacturing including: supplier

deliveries, imports, production, inventories, new orders, new export orders, order backlogs, prices and employment.

• The S&P 500• The University of Michigan Consumer Sentiment Index's consumer expectations

Indicators Monitored by the Fed Coincident Indicators: Simultaneous to economic cycle

• Number of employees on non-agricultural payrolls• Personal income less transfer payments• Industrial production• Manufacturing and trade sale

Lagging Indicators: Occur a few months after cycle• The average duration of unemployment (inverted)• The value of outstanding commercial and industrial loans• The change in the Consumer Price Index for services• The change in labor cost per unit of output• The ratio of manufacturing and trade inventories to sales• The ratio of consumer credit outstanding to personal income• The average prime rate charged by banks

Lags in Monetary Policy Controlling economy is very difficult for Fed because

of lags Much like driving car blindly or with 5-second delayed

vision Recognition lag

Time between when problem occurs and when it is recognized. (Stats are only measured periodically.)

Implementation lag How quickly Fed acts to implement change in monetary policy Fiscal policy via Congress takes much longer

Impact Lag Takes time for monetary changes to have full impact

Playing the Fed Chair GameGo to http://www.frbsf.org/education/activities/chairman/

Keep playing until you are reappointed!

For example of Fed Minutes analysis (go to 4 minutes or so)https://www.youtube.com/watch?v=1YzDCGrbZHU

Forecasting Money Supply Movements

Fed is most concerned with meeting L/T targets in money supply (M1, M2) rather than S/T targets

Improved communication at the Fed Prior to 1999, Fed waited several weeks to disclose its decisions

but now Fed provides immediately disclosure Speculation of Fed’s intention by financial markets caused

undesired volatility Now Fed discloses its decisions immediately after meeting Fed attempts to prime the markets by providing indications of its

“bias” on rates Starting in Dec/08, Fed gives a target range for Fed Fds Rate

rather than a specific rate. Fed recently announced more clear disclosure of its intentions

Assessing the Impact of Monetary Policy Anticipating reported money supply levels

Every Thursday, money supply data is released Because investors and financial market professionals cannot profit

on information available to everyone at the same time, they must try to forecast and anticipate changes to react before others

E.g. Bond portfolio manager knows bond prices move inversely with rates. Will try to stay one move ahead of the Fed.

Integrating Monetary and Fiscal Policies History

Executive branch usually most concerned with employment and growth. WHY?

Fed and executive branch may differ on priorities of price stability or growth needs

They will usually agree when inflation and unemployment are at relatively low levels

Monetizing the Debt Should the Fed help finance a federal budget deficit

created by fiscal policy? With a big budget deficit, the US Treasury Dept. must sell T-

securities, taking funds out of the money supply, which places an upward pressure on interest rates.

To compensate, the Fed itself could purchase T-securities (like any investor). The Treasury now owes the Fed. major bucks. (Robbing Peter to pay Paul!)

Treasury Dept. likes monetizing the debt, because it helps keeps interest rates down and the economy up.

But others might not like monetizing the debt because it could ignite inflation if the economy grows too fast.

Why are so many in the U.S. and abroad opposed to quantitative easing by the U.S. Fed?

Global Effects on Monetary Policy Impact on the U.S. dollar

Weak Dollar A weak dollar stimulates U.S. exports, discourages imports and

stimulates certain sectors of the economy May cause inflationary pressure because imports are more

expensive which allow domestic prices to rise also Foreign investors may pull money out, putting upward pressure

on interest rates Fed less likely to stimulate the economy if the dollar is weak

(allow interest rates to increase) Strong dollar

Stimulates imports, reduces inflation because of cheap imports Dampens economic growth overall Fed more likely to use stimulate policy

Global Effects on Monetary Policy Transmission of interest rates

Global capital and money markets are integrated Deficits or surpluses in the U.S. Gov’t have global implications Global Crowding Out: Barring other factors, US budget deficits

cause higher U.S. interest rates, which attract foreign investment, which causes a decrease in supply of foreign funds, which causes foreign interest rates to increase as well

Impact of Greece on European Monetary Policy1. Greece experienced a weak economy and a large budget deficit, reach a

crisis in the spring of 2010, and again in the winter of 2015.2. Creditors are less willing to lend to the Greece government because they

fear that the government may be unable to repay the loans.3. The European Central Bank (ECB) was forced to use a more stimulative

monetary policy than desired in order to ease concerns about the Greek crisis, even though this caused other concerns about potential inflation in the Eurozone.

4. Now the most important member of the EU, Germany, is balking at bailing out Greece again and appears willing to allow Greece to leave the EU, which would create turbulence.