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Transcript
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