Download What else is at the NY Fed?

4/27/2013
What will we find at the NY Fed?
Chapter 12
Monetary Policy
and the
Phillips Curve
Part 2
By Charles I. Jones
Media Slides Created By
Dave Brown
Penn State University
Possibly the largest gold repository in the world - link
Monetary Policy
and
the Central Bank
In the movies…
Where is the NY Fed?
What else is at the NY Fed?
33 Liberty Street, 2 blocks northeast of Wall Street
•These folks (from
sometime in the 1970s) are
in line to purchase
government bonds at the
New York Federal Reserve
Bank’s open market window
•These days, people don’t
stand in line anymore; they
buy or sell bonds online or
over the phone!
•But this picture, and not
the gold repository, explains
the modern relevance of the
Federal Reserve
•The NY Fed was selling
bonds to the public in this
picture. Why? What result
would that have?
1
4/27/2013
First, what is the Federal
Reserve?
•It is a system of 12
regional banks, of
which the NY Fed is
the largest in terms of
assets, and a Board
of Governors in
Washington, DC
•U.S. banking has a
long, odd history
dating back to
Alexander Hamilton (a
proud New Yorker
buried at Trinity
Church off Wall St.)
•In 1913, Woodrow Wilson signed the Federal Reserve Act into law, which “provided
for the establishment of Federal Reserve Banks, to furnish an elastic currency, to
afford means of rediscounting commercial paper, to establish a more effective
supervision of banking in the United States, and for other purposes.”
In fact, the objectives of the Federal
Reserve System are now a little broader
How do Open Market Operations work?
1. The Fed Board of Governors decides to conduct them
2. They instruct the Open Market Window at the New York Fed either
to buy or sell government bonds
3. Market interest rates, including the federal funds rate, fall when the
New York Fed buys bonds, or rise when the NY Fed sells bonds
• Why does this happen? You can see it either of two ways:
•
By selling bonds, the Fed absorbs banks’ excess reserves, which
are then in shorter supply and hence more costly — so banks
charge each other a higher federal funds interest rate. Buying
bonds produces the reverse effect
•
The price of a bond is inversely related to its yield, a.k.a. interest
rate, so when the Fed buys bonds, the demand for bonds rises,
which increases their prices and lowers interest rates — when the
Fed sells bonds, the supply of bonds rises, lowering their prices
and raising interest rates
The Fed
• In 1978, Jimmy Carter signed the Humphrey-Hawkins Full
Employment and Balanced Growth Act
– Among other things, this law directed the Federal Reserve to conduct
monetary policy that controlled inflation and promoted full employment —
the first time the real economy was formally linked to monetary policy in law
• How can the Fed carry out these directives? So far in the course,
what have we seen associated with banks and credit markets?
• The Fed Website
• The Fed minutes
– The money supply determines inflation in the long run — that’s the quantity
theory of money — and the Fed manages the money supply
– In the long run, employment and GDP are determined by capital, labor, and
technology/productivity/ideas. Fostering efficient credit markets is something
the Fed does (and others do) through oversight ...
– In the short run? We have seen that activity responds to interest rates
In the short run, the Fed can affect interest
rates, and thus the real economy
•
How might this work?
•
Banks have to hold reserves to back up their deposits
•
Maybe they need 10% of their deposits in the form of reserves at
any one time, to meet withdrawal demand
•
Sometimes banks need to borrow to meet this reserve
requirement
•
Whom do they borrow from? Other banks, through the market for
federal funds, or from the Fed itself, through the discount window
•
The Fed can directly set the interest rate it charges at its discount
window — a.k.a. the discount rate
•
It turns out the Fed can also affect the federal funds rate also,
through open market operations, which are done by the New
York Federal Reserve, right across the East River! This is the
picture of the guys waiting in line we saw earlier
12.1 Introduction
• In this chapter, we learn:
– How the central bank effectively sets the real interest
rate in the short run, and how this rate shows up as the
MP curve in our short-run model.
– That the Phillips curve describes how firms set their
prices over time, pinning down the inflation rate.
– How the IS curve, the MP curve, and the Phillips curve
make up our short-run model.
– How to analyze the evolution of the macroeconomy in
response to changes in policy or economic shocks.
2
4/27/2013
• The federal funds rate
– The interest rate paid from one bank to
another for overnight loans
• The monetary policy (MP) curve
– Describes how the central bank sets the
nominal interest rate
• The short-run model summary:
– Through the MP curve
• the nominal interest rate determines the
real interest rate
– Through the IS curve
• the real interest rate influences GDP in the
short run
– The Phillips curve
• describes how booms and recessions
affect the evolution of inflation
12.3 The Phillips Curve (PC)
• Classical PC - link
• Recall the inflation rate is the percent
change in the overall price level.
• Firms set their prices on the basis of
– Their expectations of the economy-wide
inflation rate
– The state of demand for their product.
• Expected inflation
– The inflation rate firms think will prevail in
the economy over the coming year.
• Firms expect next year’s inflation rate to
be the same as this year’s inflation rate.
• Under adaptive expectations firms adjust
their forecasts of inflation slowly.
• Expected inflation embodies the sticky
inflation assumption.
• The Phillips curve
– Describes how inflation evolves over time as
a function of short-run output
This
year’s
inflation
Last
year’s
inflation
Short run
output
• If output is below potential
– Prices rise more slowly than usual
• If output is above potential
– Prices rise more rapidly than usual
3
4/27/2013
• Later critiques
– Stimulating the economy would raise output
temporarily
– Firms will build high inflation into their price
changes
– Output will return to potential.
• Using the equations:
Price Shocks and the Phillips Curve
Change in
inflation
• Therefore, the Phillips curve can be expressed as:
• We can add shocks to the Phillips curve
to account for temporary increases in
the price of inflation:
The parameter measures
how sensitive inflation is
to demand conditions.
Case Study: A Brief History of the
Phillips Curve
• The actual rate of inflation now depends
on three things:
• Originally
– The Phillips curve showed a relationship
between the level of inflation and economic
activity.
– Low inflation implied low output.
Expected rate
of inflation
Adjustment
factor for state
of economy
Shock to
inflation
• Rewrite again:
4
4/27/2013
• Oil price shock - link
– The price of oil rises
– Results in a temporary upward shift in the
Phillips curve
Case Study: The Phillips Curve and
the Quantity Theory of Money
MV=PY
• An increase in the growth rate of real
GDP would reduce inflation.
• The Phillips curve, however, seems to
say a booming economy causes the
rate of inflation to increase.
• Which one is correct?
• The quantity theory of money
– Long-run model
– An increase in real GDP reflects an
increase in the supply of goods, which
lowers prices.
• The Phillips curve
– Part of our short-run model
– An increase in short-run output reflects an
increase in the demand for goods.
Cost-Push and Demand-Pull
Inflation
• Price shocks to an input in production
– Cost-push inflation
– Tends to push the inflation rate up
• The effect of short-run output on
inflation in the Phillips curve
– Demand-pull inflation
– Increases in aggregate demand pull up the
inflation rate.
12.4 Using the Short-Run
Model
• Disinflation
– Sustained reduction of inflation to a stable
lower rate
• The Great Inflation of the 1970s
– Misinterpreting the productivity slowdown
contributed to rising inflation.
5
4/27/2013
The Volcker Disinflation
• Paul Volcker
• Reducing the level of inflation requires a
sharp reduction in the rate of money
growth–a tight monetary policy.
• Because of the stickiness of inflation
– The classical dichotomy is unlikely to hold
exactly in the short run.
– Just a reduction in the rate of money growth
may not slow inflation immediately.
• Thus, the real interest rate must increase
to induce a recession.
• Lowering the inflation rate
– Can create the cost of a slumping economy
– High unemployment and lost output
• Once inflation has declined sufficiently
– Real interest rate can be raised back to MPK
– Allowing output to rise back to potential
– The recession causes inflation to become
negative.
– As demand falls firms raise their prices less
aggressively to sell more.
6
4/27/2013
3. The Federal Reserve did not have
perfect information.
– Thought the productivity slowdown was a
recession
• it was actually a change in potential
output.
– The Fed lowered interest rates in response
to what they perceived was a demand
shock.
• which increased output above potential
• generated more inflation
The Great Inflation of the 1970s
• Inflation rose in the 1970s for three
reasons:
1. OPEC coordinated oil price increases.
• Oil shock as shown in the model
2. The U.S. monetary policy was too loose.
– The conventional wisdom was that reducing
inflation required permanent increases in
employment.
– In reality, disinflation requires only a
temporary recession.
The Short-Run Model in a Nutshell
7
4/27/2013
Case Study: The 2001 Recession
• The recession of 2001 had a “jobless
recovery.”
– Even after the return of strong GDP,
employment continued to fall.
– This is an exception to Okun’s law.
The Classical Dichotomy
in the Short Run
• How to make the classical dichotomy
hold at all points in time?
– All prices, including wages and rental
prices, must adjust in the same proportion
immediately.
• Reasons that the classical dichotomy fails
in the short run:
– Imperfect information
– Costs of setting prices
– Contracts also set prices and wages in
nominal rather than real terms.
12.5 Microfoundations:
Understanding Sticky Inflation
• The short run model
– Changes in the nominal interest rate affect
the real interest rate.
• The classical dichotomy
– Changes in nominal variables have only
nominal effects on the economy.
– If monetary policy affects real variables, the
classical dichotomy fails in the short run.
• There are bargaining costs to
negotiating prices and wages.
• Social norms and money illusions
– Cause concerns about whether the
nominal wage should decline as a matter
of fairness
• Money illusion
– The idea that people sometimes focus on
nominal rather than real magnitudes
8
4/27/2013
Case Study: The Lender
of Last Resort
• Central banks ensure a sound, stable
financial system by:
– Making sure banks abide by certain rules
– Including the maintenance of a certain
amount of reserves to be held on hand
• The nominal interest rate
– Is the opportunity cost of holding money
– Is the amount you give up by holding money
instead of keeping it in a savings account
– Is pinned down by equilibrium in the money
market
• If the nominal interest rate is higher than
its equilibrium level
– Households hold their wealth in savings rather
than currency.
– The nominal interest rate falls.
• Central banks ensure a sound, stable
financial system by:
– Acting as the lender of last resort
• lending money when banks experience
financial distress
– Having deposit insurance on small- and
medium-sized deposits
• can increase risky behavior
12.6 Microfoundations: How
Central Banks Control
Nominal Interest Rates
• The central bank controls the level of the
nominal interest rate by supplying the
money that is demanded at that rate.
• The money market clears through
changes in velocity.
– Which is driven by changes in the nominal
interest rate
• The demand for money
– Is a decreasing function of the nominal
interest rate
– Is downward sloping
– Higher interest rates reduce the demand for
money.
• The supply of money
– Is a vertical line for the level of money the
central bank provides
9
4/27/2013
Changing the Interest Rate
• To raise the interest rate
– The central bank reduces the money
supply
– Creates an excess of demand over supply
– A higher interest rate on savings accounts
reduces excess demand.
– The markets adjust to a new equilibrium.
Why it instead of Mt?
• The interest rate is crucial even when
central banks focus on the money supply.
• The money demand curve is subject to
many shocks, which shift the curve.
– Changes in price level
– Changes in output
• If the money supply is constant
– The nominal interest rate fluctuates
– Resulting in changes in output
• The money supply schedule is effectively
horizontal at a targeted interest rate.
• An expansionary (loosening) monetary policy
– Increases the money supply
– Lowers the nominal interest rate
• A contractionary (tightening) monetary policy
– Reduces the money supply
– Increases the nominal interest rate
12.7 Inside the Federal Reserve
Conventional Monetary Policy
• Reserves
– Deposits held in accounts with the central
bank
– Pay no interest
• Reserve requirements
– Banks required to hold a certain fraction of
their deposits
• Discount rate
– Interest rate charged by the Federal Reserve
on loans made to commercial banks
10
4/27/2013
Open-Market Operations: How the Fed
Controls the Money Supply
• Open-market operations
– The central bank trades interest-bearing
government bonds in exchange for currency or
non-interest bearing reserves.
• To increase the money supply, the Fed sells
government bonds in exchange for currency
or reserves.
– The price at which the bond sells determines the
nominal interest rate.
12.8 Conclusion
• Policymakers exploit the stickiness of
inflation.
• The Phillips curve
– Reflects the price-setting behavior of
individual firms
– Changes in the nominal interest rate change
the real interest rate.
• Through the Phillips curve booms and
recessions alter the evolution of inflation.
• Because inflation evolves gradually, the
only way to reduce it is to slow the
economy.
Summary
Expected rate
of inflation
Current
demand
conditions
Shocks to
inflation
• The Phillips curve can also be written as:
• The short-run model
– IS curve
– MP curve
– Phillips curve
• Central banks set the nominal interest
rate.
• The IS-MP diagram allows us to study the
consequences of monetary policy and
shocks to the economy for short-run
output.
• This equation shows that in order to
reduce inflation, actual output must be
reduced below potential temporarily.
• The Volcker disinflation of the 1980s is the
classic example illustrating this
mechanism.
11
4/27/2013
• Three important causes contributed to the
Great Inflation of the 1970s:
– The oil shocks of 1974 and 1979
– The mistaken view that reducing inflation
required a permanent reduction in output
– The fact that the productivity slowdown was
initially interpreted as a recession
• Central banks control short-term interest
rates by their willingness to supply
whatever money is demanded at a
particular rate.
• Long-term rates are an average of current
and expected future short-term rates.
– This structure allows changes in short-term
rates to affect long-term rates.
This concludes the Lecture
Slide Set for Chapter 12
Macroeconomics
Second Edition
by
Charles I. Jones
W. W. Norton & Company
Independent Publishers Since 1923
12