Slide 1

The Federal Reserve A Critique ECO 285 Macroeconomics Dr. D. Foster The Gold Standard: the meaning of sound money

Slide 2

Is Policy the Right Choice? lags Time lags make effective policy uncertain. Discretionary policy promotes uncertainty. Rulescredible Rules and credible adherence can eliminate bias. Independence Independence is a likely key requirement.

Slide 3

Time Lags in Monetary (& Fiscal) Policy Policy time lags Recognition lag Response lag Transmission lag time Real GDP Business cycle

Slide 4

Monetary Policy may be counterproductive time Real GDP Or, if policy kicks in at the wrong time, it could worsen recessions and exacerbate inflationary periods. Ideally, policy would dampen the business cycle But, dampening the business cycle may lower ave. growth!

Slide 5

Discretion versus Rules (Milton Friedman) sourceDiscretionary policy is the source of instability. ruleA policy rule can eliminate that instability. Bank ReservesMonetary Base Money Supply Set target for Bank Reserves, Monetary Base, Money Supply to grow in LR sustainable fashion. no matter what This is a commitment to a fixed strategy no matter what happens to other economic variables. credibleTo be successful, the commitment must be credible. The public believes the Fed will act this way.

Slide 6

Has the Fed maintained stable prices?

Slide 7

Has the Fed maintained the value of the $? 4%

Slide 8

Why is Fed pursuing 2% inflation????? stable prices The Board of Governors shall maintain long run growth of the monetary and credit aggregates so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates. price stability The (FOMC) judges that inflation at the rate of 2 percent is most consistent over the longer run with the Federal Reserve's mandate for price stability and maximum employment.. Does the Fed really want to increase annual inflation to 2%, such that the price level of the country will increase by more than 700% over the next century? Is that what Congress had in mind when it tasked the Fed with achieving stable prices?

Slide 9

Central Bank Independence, Average Inflation, and Inflation Variability in Major Developed Nations SOURCE: Alberto Alesina and Lawrence Summers, Central Bank Independence and Macroeconomic Performance, Journal of Money, Credit, and Banking (May 1993): 151162.

Slide 10

Making Monetary Policy Rules Credible constitutional limitsPlace constitutional limits on monetary policy. reputationAchieve credibility by establishing a reputation. independenceMaintain central bank independence. contractsEstablish central banker contracts. conservativeAppoint a conservative central banker.

Slide 11

Making Monetary Policy Rules Credible constitutional limitsPlace constitutional limits on monetary policy. reputationAchieve credibility by establishing a reputation. independenceMaintain central bank independence. contractsEstablish central banker contracts. conservativeAppoint a conservative central banker.

Slide 12

Advantages to the Gold Standard It promotes trade by eliminating uncertainty. It keeps governments from creating money. It insures that a nations currency will maintain its value over time. The Gold Standard

Slide 13

How the Gold Standard works $20.67 = 1 oz.1 oz. = 4.25 $4.86 = 1 American firms export goods to England tractors. Value = $50 m. British firms export goods to U.S. fish & chips. Value = 10.29 m. At exchange rate of $4.86 = 1, the earned by U.S. firms will just trade for the $ earned by the British firms. Suppose that British exports fall by 23% and that there is only 8 mill available in foreign exchange market (to buy $). 10.29 mill. $50 mill. A gold standard implies that we have fixed exchange rates between currencies.

Slide 14

Now, American exporters cant exchange all of their 10.29 mill. for $. They can only exchange 8 mill. at the going exchange rate.... receiving $38,880,000. But, they arent going to lose here They would cash the rest out in gold: 2.29 mill. = 538,823 oz. They would redeem in U.S. for dollars: 538,823 oz. = $11,120,000 Total value received = $50,000,000 $20.67 = 1 oz.1 oz. = 4.25 $4.86 = 1 8 mill. $50 mill. How the Gold Standard works

Slide 15

The flow of gold from England to U.S. wont persist over time. gold = MS MS = P inflation gold = MS MS = P deflation U.S. exports fall and British exports rise until trade flows balance. $20.67 = 1 oz.1 oz. = 4.25 $4.86 = 1 8 mill. 538,823 ounces $50 mill. How the Gold Standard works

Slide 16

In England, the outflow of gold will lead to price deflation and probably a recession (or a depression). So, the Bank of England raises interest rates. This attracts foreign investment (capital inflows) which ends outflow of gold. Confounding the Gold Standard In the U.S., expanding the money supply means inflation and falling exports. The Fed can buy this gold by selling Treasury securities, so not allowing the money supply to increase. But, this will also raise U.S. interest rates which works against British policy and encourages more gold inflows!

Slide 17

WWI - Combatant countries go off gold standard to spending. After, move back to gold standard. Gold stocks insufficient for existing price levels. Worldwide deflation (i.e., depression) is required. Only U.S. and U.K. go back to gold standard. U.K. depression through 1924-25. Great Depression adds in more stress. 1933 FDR abolishes gold std. 1971 Nixon abolishes international gold payments. The Gold Standard - Stress & Collapse We now live in an era of flexible exchange rates and there is no restraint on monetary policy.

Slide 18

The Federal Reserve A Critique ECO 285 Macroeconomics Dr. D. Foster The Gold Standard: the meaning of sound money