Monetary Policy and the Fed
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Course: | ECON102: Principles of Macroeconomics (2021.A.01) |
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Date: | Thursday, March 28, 2024, 7:35 AM |
Description
Read this chapter to understand in more detail the monetary policy tools, process, and impacts on the U.S. economy. Review specific monetary policies and their effects from our recent history.
Start Up: The Fed’s Extraordinary Challenges in 2008
"The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low
levels of the federal funds rate for some time". So went the statement issued by the Federal Open Market Committee on December 16, 2008, that went on to say that the new target range for the federal funds rate would be between 0% and 0.25%. For the
first time in its history, the Fed was targeting a rate below 1%. It was also acknowledging the difficulty of hitting a specific rate target when the target is so low. And, finally, it was experimenting with extraordinary measures based on a section
of the Federal Reserve Act that allows it to take such measures when conditions in financial markets are deemed "unusual and exigent".
The Fed was responding to the broad-based weakness of the U.S. economy, the strains in financial markets,
and the tightness of credit. Unlike some other moments in U.S. economic history, it did not have to worry about inflation, at least not in the short term. On the same day, consumer prices were reported to have fallen by 1.7% for the month of November.
Indeed, commentators were beginning to fret over the possibility of deflation and how the Fed could continue to support the economy when it had already used all of its federal funds rate ammunition.
Anticipating this concern, the Fed's statement
went on to discuss other ways it was planning to support the economy over the months to come. These included buying mortgage-backed securities to support the mortgage and housing markets, buying long-term Treasury bills, and creating other new credit
facilities to make credit more easily available to households and small businesses. These options recalled a speech that Ben Bernanke had made six years earlier, when he was a member of the Federal Reserve Board of Governors but still nearly four
years away from being named its chair, titled "Deflation: Making Sure 'It' Doesn't Happen Here". In the 2002 speech he laid out how these tools, along with tax cuts, were the equivalent of what Nobel prize winning economist Milton Friedman meant by
a "helicopter drop" of money. The speech earned Bernanke the nickname of Helicopter Ben.
The Fed's decisions of mid-December put it in uncharted territory. Japan had tried a similar strategy, though somewhat less comprehensively and more belatedly,
in the 1990s when faced with a situation similar to that of the United States in 2008 with only limited success. In his 2002 speech, Bernanke suggested that Japanese authorities had not gone far enough. Only history will tell us whether the Fed will
be more successful and how well these new strategies will work.
This chapter examines in greater detail monetary policy and the roles of central banks in carrying out that policy. Our primary focus will be on the U.S. Federal Reserve System.
The basic tools used by central banks in many countries are similar, but their institutional structure and their roles in their respective countries can differ.
This text was adapted by Saylor Academy under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 License without attribution as requested by the work's original creator or licensor.
Monetary Policy in the United States
Learning Objectives
- Discuss the Fed's primary and secondary goals and relate these goals to the legislation that created the Fed as well as to subsequent legislation that affects the Fed.
- State and show graphically how expansionary and contractionary monetary policy can be used to close gaps.
In
many respects, the Fed is the most powerful maker of economic policy in
the United States. Congress can pass laws, but the president must
execute them; the president can propose laws, but only Congress can pass
them. The Fed, however, both sets and carries out monetary policy.
Deliberations about fiscal policy can drag on for months, even years,
but the Federal Open Market Committee (FOMC) can, behind closed doors,
set monetary policy in a day - and see that policy implemented within
hours. The Board of Governors can change the discount rate or reserve
requirements at any time. The impact of the Fed's policies on the
economy can be quite dramatic. The Fed can push interest rates up or
down. It can promote a recession or an expansion. It can cause the
inflation rate to rise or fall. The Fed wields enormous power.
But
to what ends should all this power be directed? With what tools are the
Fed's policies carried out? And what problems exist in trying to
achieve the Fed's goals? This section reviews the goals of monetary
policy, the tools available to the Fed in pursuing those goals, and the
way in which monetary policy affects macroeconomic variables.
Goals of Monetary Policy
When we think of the goals of
monetary policy, we naturally think of standards of macroeconomic
performance that seem desirable - a low unemployment rate, a stable
price level, and economic growth. It thus seems reasonable to conclude
that the goals of monetary policy should include the maintenance of full
employment, the avoidance of inflation or deflation, and the promotion
of economic growth.
But these goals, each of which is desirable
in itself, may conflict with one another. A monetary policy that helps
to close a recessionary gap and thus promotes full employment may
accelerate inflation. A monetary policy that seeks to reduce inflation
may increase unemployment and weaken economic growth. You might expect
that in such cases, monetary authorities would receive guidance from
legislation spelling out goals for the Fed to pursue and specifying what
to do when achieving one goal means not achieving another. But as we
shall see, that kind of guidance does not exist.
The Federal Reserve Act
When
Congress established the Federal Reserve System in 1913, it said little
about the policy goals the Fed should seek. The closest it came to
spelling out the goals of monetary policy was in the first paragraph of
the Federal Reserve Act, the legislation that created the Fed:
"An
Act to provide for the establishment of Federal reserve banks, to
furnish an elastic currency, [to make loans to banks], to establish a
more effective supervision of banking in the United States, and for
other purposes".
In short, nothing in the legislation creating
the Fed anticipates that the institution will act to close recessionary
or inflationary gaps, that it will seek to spur economic growth, or that
it will strive to keep the price level steady. There is no guidance as
to what the Fed should do when these goals conflict with one another.
The Employment Act of 1946
The
first U.S. effort to specify macroeconomic goals came after World War
II. The Great Depression of the 1930s had instilled in people a deep
desire to prevent similar calamities in the future. That desire, coupled
with the 1936 publication of John Maynard Keynes's prescription for
avoiding such problems through government policy (The General Theory of
Employment, Interest and Money), led to the passage of the Employment
Act of 1946, which declared that the federal government should "use all
practical means . . . to promote maximum employment, production and
purchasing power". The act also created the Council of Economic Advisers
(CEA) to advise the president on economic matters.
The Fed might
be expected to be influenced by this specification of federal goals,
but because it is an independent agency, it is not required to follow
any particular path. Furthermore, the legislation does not suggest what
should be done if the goals of achieving full employment and maximum
purchasing power conflict.
The Full Employment and Balanced Growth Act of 1978
The
clearest, and most specific, statement of federal economic goals came
in the Full Employment and Balanced Growth Act of 1978. This act,
generally known as the Humphrey–Hawkins Act, specified that by 1983 the
federal government should achieve an unemployment rate among adults of
3% or less, a civilian unemployment rate of 4% or less, and an inflation
rate of 3% or less. Although these goals have the virtue of
specificity, they offer little in terms of practical policy guidance.
The last time the civilian unemployment rate in the United States fell
below 4% was 1969, and the inflation rate that year was 6.2%. In 2000,
the unemployment rate touched 4%, and the inflation rate that year was
3.4%, so the goals were close to being met. Except for 2007 when
inflation hit 4.1%, inflation has hovered between 1.6% and 3.4% in all
the other years between 1991 and 2011, so the inflation goal was met or
nearly met, but unemployment fluctuated between 4.0% and 9.6% during
those years.
The Humphrey-Hawkins Act requires that the chairman
of the Fed's Board of Governors report twice each year to Congress about
the Fed's monetary policy. These sessions provide an opportunity for
members of the House and Senate to express their views on monetary
policy.
Federal Reserve Policy and Goals
Perhaps the clearest
way to see the Fed's goals is to observe the policy choices it makes.
Since 1979, following a bout of double-digit inflation, its actions have
suggested that the Fed's primary goal is to keep inflation under
control. Provided that the inflation rate falls within acceptable
limits, however, the Fed will also use stimulative measures to attempt
to close recessionary gaps.
In 1979, the Fed, then led by Paul
Volcker, launched a deliberate program of reducing the inflation rate.
It stuck to that effort through the early 1980s, even in the face of a
major recession. That effort achieved its goal: the annual inflation
rate fell from 13.3% in 1979 to 3.8% in 1982. The cost, however, was
great. Unemployment soared past 9% during the recession. With the
inflation rate below 4%, the Fed shifted to a stimulative policy early
in 1983.
In 1990, when the economy slipped into a recession, the
Fed, with Alan Greenspan at the helm, engaged in aggressive open-market
operations to stimulate the economy, despite the fact that the inflation
rate had jumped to 6.1%. Much of that increase in the inflation rate,
however, resulted from an oil-price boost that came in the wake of
Iraq's invasion of Kuwait that year. A jump in prices that occurs at the
same time as real GDP is slumping suggests a leftward shift in
short-run aggregate supply, a shift that creates a recessionary gap. Fed
officials concluded that the upturn in inflation in 1990 was a
temporary phenomenon and that an expansionary policy was an appropriate
response to a weak economy. Once the recovery was clearly under way, the
Fed shifted to a neutral policy, seeking neither to boost nor to reduce
aggregate demand. Early in 1994, the Fed shifted to a contractionary
policy, selling bonds to reduce the money supply and raise interest
rates. Then Fed Chairman Greenspan indicated that the move was intended
to head off any possible increase in inflation from its 1993 rate of
2.7%. Although the economy was still in a recessionary gap when the Fed
acted, Greenspan indicated that any acceleration of the inflation rate
would be unacceptable.
By March 1997 the inflation rate had
fallen to 2.4%. The Fed became concerned that inflationary pressures
were increasing and tightened monetary policy, raising the goal for the
federal funds interest rate to 5.5%. Inflation remained well below 2.0%
throughout the rest of 1997 and 1998. In the fall of 1998, with
inflation low, the Fed was concerned that the economic recession in much
of Asia and slow growth in Europe would reduce growth in the United
States. In quarter-point steps it reduced the goal for the federal funds
rate to 4.75%. With real GDP growing briskly in the first half of 1999,
the Fed became concerned that inflation would increase, even though the
inflation rate at the time was about 2%, and in June 1999, it raised
its goal for the federal funds rate to 5% and continued raising the rate
until it reached 6.5% in May 2000.
With inflation under control,
it then began lowering the federal funds rate to stimulate the economy.
It continued lowering through the brief recession of 2001 and beyond.
There were 11 rate cuts in 2001, with the rate at the end of that year
at 1.75%; in late 2002 the rate was cut to 1.25%, and in mid-2003 it was
cut to 1.0%.
Then, with growth picking up and inflation again a
concern, the Fed began again in the middle of 2004 to increase rates. By
the end of 2006, the rate stood at 5.25% as a result of 17
quarter-point rate increases.
Starting in September 2007, the
Fed, since 2006 led by Ben Bernanke, shifted gears and began lowering
the federal funds rate, mostly in larger steps or 0.5 to 0.75 percentage
points. Though initially somewhat concerned with inflation, it sensed
that the economy was beginning to slow down. It moved aggressively to
lower rates over the course of the next 15 months, and by the end of
2008, the rate was targeted at between 0% and 0.25%. In late 2008
through 2011, beginning with the threat of deflation and then
progressing into a period during which inflation ran fairly low, the Fed
seemed quite willing to use all of its options to try to keep financial
markets running smoothly. The Fed attempted, in the initial period, to
moderate the recession, and then it tried to support the rather
lackluster growth that followed. In January 2012, the Fed went on record
to say that given its expectation that inflation would remain under
control and that the economy would have slack, it anticipated keeping
the federal funds rate at extremely low levels through late 2014.
What
can we infer from these episodes in the 1980s, 1990s, and the first
decade of this century? It seems clear that the Fed is determined not to
allow the high inflation rates of the 1970s to occur again. When the
inflation rate is within acceptable limits, the Fed will undertake
stimulative measures in response to a recessionary gap or even in
response to the possibility of a growth slowdown. Those limits seem to
have tightened over time. In the late 1990s and early 2000s, it appeared
that an inflation rate above 3% - or any indication that inflation
might rise above 3% - would lead the Fed to adopt a contractionary
policy. While on the Federal Reserve Board in the early 2000s, Ben
Bernanke had been an advocate of inflation targeting. Under that system,
the central bank announces its inflation target and then adjusts the
federal funds rate if the inflation rate moves above or below the
central bank's target. Mr. Bernanke indicated his preferred target to be
an expected increase in the price level, as measured by the price index
for consumer goods and services excluding food and energy, of between
1% and 2%. Thus, the inflation goal appears to have tightened even more -
to a rate of 2% or less. If inflation were expected to remain below 2%,
however, the Fed would undertake stimulative measures to close a
recessionary gap. Whether the Fed will hold to that goal will not really
be tested until further macroeconomic experiences unfold.
Monetary Policy and Macroeconomic Variables
We saw in an
earlier chapter that the Fed has three tools at its command to try to
change aggregate demand and thus to influence the level of economic
activity. It can buy or sell federal government bonds through
open-market operations, it can change the discount rate, or it can
change reserve requirements. It can also use these tools in combination.
In the next section of this chapter, where we discuss the notion of a
liquidity trap, we will also introduce more extraordinary measures that
the Fed has at its disposal.
Most economists agree that these
tools of monetary policy affect the economy, but they sometimes disagree
on the precise mechanisms through which this occurs, on the strength of
those mechanisms, and on the ways in which monetary policy should be
used. Before we address some of these issues, we shall review the ways
in which monetary policy affects the economy in the context of the model
of aggregate demand and aggregate supply. Our focus will be on
open-market operations, the purchase or sale by the Fed of federal
bonds.
Expansionary Monetary Policy
The Fed might pursue an
expansionary monetary policy in response to the initial situation shown
in Panel (a) of Figure 11.1 "Expansionary Monetary Policy to Close a
Recessionary Gap". An economy with a potential output of YP is operating
at Y1; there is a recessionary gap. One possible policy response is to
allow the economy to correct this gap on its own, waiting for reductions
in nominal wages and other prices to shift the short-run aggregate
supply curve SRAS1 to the right until it intersects the aggregate demand
curve AD1 at YP. An alternative is a stabilization policy that seeks to
increase aggregate demand to AD2 to close the gap. An expansionary
monetary policy is one way to achieve such a shift.
To carry out
an expansionary monetary policy, the Fed will buy bonds, thereby
increasing the money supply. That shifts the demand curve for bonds to
D2, as illustrated in Panel (b). Bond prices rise to Pb2. The higher
price for bonds reduces the interest rate. These changes in the bond
market are consistent with the changes in the money market, shown in
Panel (c), in which the greater money supply leads to a fall in the
interest rate to r2. The lower interest rate stimulates investment. In
addition, the lower interest rate reduces the demand for and increases
the supply of dollars in the currency market, reducing the exchange rate
to E2 in Panel (d). The lower exchange rate will stimulate net exports.
The combined impact of greater investment and net exports will shift
the aggregate demand curve to the right. The curve shifts by an amount
equal to the multiplier times the sum of the initial changes in
investment and net exports. In Panel (a), this is shown as a shift to
AD2, and the recessionary gap is closed.
Figure 11.1 Expansionary Monetary Policy to Close a Recessionary Gap
In
Panel (a), the economy has a recessionary gap YP − Y1. An expansionary
monetary policy could seek to close this gap by shifting the aggregate
demand curve to AD2. In Panel (b), the Fed buys bonds, shifting the
demand curve for bonds to D2 and increasing the price of bonds to Pb2.
By buying bonds, the Fed increases the money supply to M′ in Panel (c).
The Fed's action lowers interest rates to r2. The lower interest rate
also reduces the demand for and increases the supply of dollars,
reducing the exchange rate to E2 in Panel (d). The resulting increases
in investment and net exports shift the aggregate demand curve in Panel
(a).
Contractionary Monetary Policy
The Fed will generally
pursue a contractionary monetary policy when it considers inflation a
threat. Suppose, for example, that the economy faces an inflationary
gap; the aggregate demand and short-run aggregate supply curves
intersect to the right of the long-run aggregate supply curve, as shown
in Panel (a) of Figure 11.2 "A Contractionary Monetary Policy to Close
an Inflationary Gap".
Figure 11.2 A Contractionary Monetary Policy to Close an Inflationary Gap
In
Panel (a), the economy has an inflationary gap Y1 − YP. A
contractionary monetary policy could seek to close this gap by shifting
the aggregate demand curve to AD2. In Panel (b), the Fed sells bonds,
shifting the supply curve for bonds to S2 and lowering the price of
bonds to Pb2. The lower price of bonds means a higher interest rate, r2,
as shown in Panel (c). The higher interest rate also increases the
demand for and decreases the supply of dollars, raising the exchange
rate to E2 in Panel (d), which will increase net exports. The decreases
in investment and net exports are responsible for decreasing aggregate
demand in Panel (a).
To carry out a contractionary policy, the
Fed sells bonds. In the bond market, shown in Panel (b) of Figure 11.2
"A Contractionary Monetary Policy to Close an Inflationary Gap", the
supply curve shifts to the right, lowering the price of bonds and
increasing the interest rate. In the money market, shown in Panel (c),
the Fed's bond sales reduce the money supply and raise the interest
rate. The higher interest rate reduces investment. The higher interest
rate also induces a greater demand for dollars as foreigners seek to
take advantage of higher interest rates in the United States. The supply
of dollars falls; people in the United States are less likely to
purchase foreign interest-earning assets now that U.S. assets are paying
a higher rate. These changes boost the exchange rate, as shown in Panel
(d), which reduces exports and increases imports and thus causes net
exports to fall. The contractionary monetary policy thus shifts
aggregate demand to the left, by an amount equal to the multiplier times
the combined initial changes in investment and net exports, as shown in
Panel (a).
Key Takeaways
- The Federal Reserve Board and the Federal Open Market Committee are among the most powerful institutions in the United States.
- The Fed's primary goal appears to be the control of inflation. Providing that inflation is under control, the Fed will act to close recessionary gaps.
- Expansionary policy, such as a
purchase of government securities by the Fed, tends to push bond prices
up and interest rates down, increasing investment and aggregate demand.
Contractionary policy, such as a sale of government securities by the
Fed, pushes bond prices down, interest rates up, investment down, and
aggregate demand shifts to the left.
Case in Point: A Brief History of the Greenspan Fed
Figure 11.3
With
the passage of time and the fact that the fallout on the economy turned
out to be relatively minor, it is hard in retrospect to realize how
scary a situation Alan Greenspan and the Fed faced just two months after
his appointment as Chairman of the Federal Reserve Board. On October
12, 1987, the stock market had its worst day ever. The Dow Jones
Industrial Average plunged 508 points, wiping out more than $500 billion
in a few hours of feverish trading on Wall Street. That drop
represented a loss in value of over 22%. In comparison, the largest
daily drop in 2008 of 778 points on September 29, 2008, represented a
loss in value of about 7%.
When the Fed faced another huge plunge
in stock prices in 1929 - also in October - members of the Board of
Governors met and decided that no action was necessary. Determined not
to repeat the terrible mistake of 1929, one that helped to usher in the
Great Depression, Alan Greenspan immediately reassured the country,
saying that the Fed would provide adequate liquidity, by buying federal
securities, to assure that economic activity would not fall. As it
turned out, the damage to the economy was minor and the stock market
quickly regained value.
In the fall of 1990, the economy began to
slip into recession. The Fed responded with expansionary monetary
policy - cutting reserve requirements, lowering the discount rate, and
buying Treasury bonds.
Interest rates fell quite quickly in
response to the Fed's actions, but, as is often the case, changes to the
components of aggregate demand were slower in coming. Consumption and
investment began to rise in 1991, but their growth was weak, and
unemployment continued to rise because growth in output was too slow to
keep up with growth in the labor force. It was not until the fall of
1992 that the economy started to pick up steam. This episode
demonstrates an important difficulty with stabilization policy: attempts
to manipulate aggregate demand achieve shifts in the curve, but with a
lag.
Throughout the rest of the 1990s, with some tightening when
the economy seemed to be moving into an inflationary gap and some
loosening when the economy seemed to be possibly moving toward a
recessionary gap - especially in 1998 and 1999 when parts of Asia
experienced financial turmoil and recession and European growth had
slowed down - the Fed helped steer what is now referred to as the
Goldilocks (not too hot, not too cold, just right) economy.
The
U.S. economy again experienced a mild recession in 2001 under Greenspan.
At that time, the Fed systematically conducted expansionary policy.
Similar to its response to the 1987 stock market crash, the Fed has been
credited with maintaining liquidity following the dot-com stock market
crash in early 2001 and the attacks on the World Trade Center and the
Pentagon in September 2001.
When Greenspan retired in January
2006, many hailed him as the greatest central banker ever. As the
economy faltered in 2008 and as the financial crisis unfolded throughout
the year, however, the question of how the policies of Greenspan's Fed
played into the current difficulties took center stage. Testifying
before Congress in October 2008, he said that the country faces a
"once-in-a-century credit tsunami," and he admitted, "I made a mistake
in presuming that the self-interests of organizations, specifically
banks and others, were such as that they were best capable of protecting
their own shareholders and their equity in their firms". The criticisms
he has faced are twofold: that the very low interest rates used to
fight the 2001 recession and maintained for too long fueled the real
estate bubble and that he did not promote appropriate regulations to
deal with the new financial instruments that were created in the early
2000s. While supporting some additional regulations when he testified
before Congress, he also warned that overreacting could be dangerous:
"We have to recognize that this is almost surely a once-in-a-century
phenomenon, and, in that regard, to realize the types of regulation that
would prevent this from happening in the future are so onerous as to
basically suppress the growth rate in the economy and . . . the
standards of living of the American people".
Problems and Controversies of Monetary Policy
Learning Objectives
- Explain the three kinds of lags that can influence the effectiveness of monetary policy.
- Identify the macroeconomic targets at which the Fed can aim in managing the economy, and discuss the difficulties inherent in using each of them as a target.
- Discuss how each of the following influences a central bank's ability to achieve its desired macroeconomic outcomes: political pressures, the degree of impact on the economy (including the situation of a liquidity trap), and the rational expectations hypothesis.
The Fed has some obvious advantages in its conduct of
monetary policy. The two policy-making bodies, the Board of Governors
and the Federal Open Market Committee (FOMC), are small and largely
independent from other political institutions. These bodies can thus
reach decisions quickly and implement them immediately. Their relative
independence from the political process, together with the fact that
they meet in secret, allows them to operate outside the glare of
publicity that might otherwise be focused on bodies that wield such
enormous power.
Despite the apparent ease with which the Fed can
conduct monetary policy, it still faces difficulties in its efforts to
stabilize the economy. We examine some of the problems and uncertainties
associated with monetary policy in this section.
Lags
Perhaps the greatest obstacle facing the Fed, or any
other central bank, is the problem of lags. It is easy enough to show a
recessionary gap on a graph and then to show how monetary policy can
shift aggregate demand and close the gap. In the real world, however, it
may take several months before anyone even realizes that a particular
macroeconomic problem is occurring. When monetary authorities become
aware of a problem, they can act quickly to inject reserves into the
system or to withdraw reserves from it. Once that is done, however, it
may be a year or more before the action affects aggregate demand.
The
delay between the time a macroeconomic problem arises and the time at
which policy makers become aware of it is called a recognition lag. The
1990–1991 recession, for example, began in July 1990. It was not until
late October that members of the FOMC noticed a slowing in economic
activity, which prompted a stimulative monetary policy. In contrast, the
most recent recession began in December 2007, and Fed easing began in
September 2007.
Recognition lags stem largely from problems in
collecting economic data. First, data are available only after the
conclusion of a particular period. Preliminary estimates of real GDP,
for example, are released about a month after the end of a quarter.
Thus, a change that occurs early in a quarter will not be reflected in
the data until several months later. Second, estimates of economic
indicators are subject to revision. The first estimates of real GDP in
the third quarter of 1990, for example, showed it increasing. Not until
several months had passed did revised estimates show that a recession
had begun. And finally, different indicators can lead to different
interpretations. Data on employment and retail sales might be pointing
in one direction while data on housing starts and industrial production
might be pointing in another. It is one thing to look back after a few
years have elapsed and determine whether the economy was expanding or
contracting. It is quite another to decipher changes in real GDP when
one is right in the middle of events. Even in a world brimming with
computer-generated data on the economy, recognition lags can be
substantial.
Only after policy makers recognize there is a
problem can they take action to deal with it. The delay between the time
at which a problem is recognized and the time at which a policy to deal
with it is enacted is called the implementation lag. For monetary
policy changes, the implementation lag is quite short. The FOMC meets
eight times per year, and its members may confer between meetings
through conference calls. Once the FOMC determines that a policy change
is in order, the required open-market operations to buy or sell federal
bonds can be put into effect immediately.
Policy makers at the
Fed still have to contend with the impact lag, the delay between the
time a policy is enacted and the time that policy has its impact on the
economy.
The impact lag for monetary policy occurs for several
reasons. First, it takes some time for the deposit multiplier process to
work itself out. The Fed can inject new reserves into the economy
immediately, but the deposit expansion process of bank lending will need
time to have its full effect on the money supply. Interest rates are
affected immediately, but the money supply grows more slowly. Second,
firms need some time to respond to the monetary policy with new
investment spending - if they respond at all. Third, a monetary change
is likely to affect the exchange rate, but that translates into a change
in net exports only after some delay. Thus, the shift in the aggregate
demand curve due to initial changes in investment and in net exports
occurs after some delay. Finally, the multiplier process of an
expenditure change takes time to unfold. It is only as incomes start to
rise that consumption spending picks up.
The problem of lags
suggests that monetary policy should respond not to statistical reports
of economic conditions in the recent past but to conditions expected to
exist in the future. In justifying the imposition of a contractionary
monetary policy early in 1994, when the economy still had a recessionary
gap, Greenspan indicated that the Fed expected a one-year impact lag.
The policy initiated in 1994 was a response not to the economic
conditions thought to exist at the time but to conditions expected to
exist in 1995. When the Fed used contractionary policy in the middle of
1999, it argued that it was doing so to forestall a possible increase in
inflation. When the Fed began easing in September 2007, it argued that
it was doing so to forestall adverse effects to the economy of falling
housing prices. In these examples, the Fed appeared to be looking
forward. It must do so with information and forecasts that are far from
perfect.
Estimates of the length of time required for the impact
lag to work itself out range from six months to two years. Worse, the
length of the lag can vary - when they take action, policy makers cannot
know whether their choices will affect the economy within a few months
or within a few years. Because of the uncertain length of the impact
lag, efforts to stabilize the economy through monetary policy could be
destabilizing. Suppose, for example, that the Fed responds to a
recessionary gap with an expansionary policy but that by the time the
policy begins to affect aggregate demand, the economy has already
returned to potential GDP. The policy designed to correct a recessionary
gap could create an inflationary gap. Similarly, a shift to a
contractionary policy in response to an inflationary gap might not
affect aggregate demand until after a self-correction process had
already closed the gap. In that case, the policy could plunge the
economy into a recession.
Choosing Targets
In attempting to manage the economy, on what
macroeconomic variables should the Fed base its policies? It must have
some target, or set of targets, that it wants to achieve. The failure of
the economy to achieve one of the Fed's targets would then trigger a
shift in monetary policy. The choice of a target, or set of targets, is a
crucial one for monetary policy. Possible targets include interest
rates, money growth rates, and the price level or expected changes in
the price level.
Interest Rates
Interest rates, particularly
the federal funds rate, played a key role in recent Fed policy. 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.
Up
until August 1997, it had instructed the trading desk at the New York
Federal Reserve Bank to conduct open-market operations in a way that
would either maintain, increase, or ease the current "degree of
pressure" on the reserve positions of banks. That degree of pressure was
reflected by the federal funds rate; if existing reserves were less
than the amount banks wanted to hold, then the bidding for the available
supply would send the federal funds rate up. If reserves were
plentiful, then the federal funds rate would tend to decline. When the
Fed increased the degree of pressure on reserves, it sold bonds, thus
reducing the supply of reserves and increasing the federal funds rate.
The Fed decreased the degree of pressure on reserves by buying bonds,
thus injecting new reserves into the system and reducing the federal
funds rate.
The current operating procedures of the Fed focus
explicitly on interest rates. At each of its eight meetings during the
year, the FOMC sets a specific target or target range for the federal
funds rate. When the Fed lowers the target for the federal funds rate,
it buys bonds. When it raises the target for the federal funds rate, it
sells bonds.
Money Growth Rates
Until 2000, the Fed was
required to announce to Congress at the beginning of each year its
target for money growth that year and each report dutifully did so. At
the same time, the Fed report would mention that its money growth
targets were benchmarks based on historical relationships rather than
guides for policy. As soon as the legal requirement to report targets
for money growth ended, the Fed stopped doing so. Since in recent years
the Fed has placed more importance on the federal funds rate, it must
adjust the money supply in order to move the federal funds rate to the
level it desires. As a result, the money growth targets tended to fall
by the wayside, even over the last decade in which they were being
reported. Instead, as data on economic conditions unfolded, the Fed
made, and continues to make, adjustments in order to affect the federal
funds interest rate.
Price Level or Expected Changes in the Price Level
Some
economists argue that the Fed's primary goal should be price stability.
If so, an obvious possible target is the price level itself. The Fed
could target a particular price level or a particular rate of change in
the price level and adjust its policies accordingly. If, for example,
the Fed sought an inflation rate of 2%, then it could shift to a
contractionary policy whenever the rate rose above 2%. One difficulty
with such a policy, of course, is that the Fed would be responding to
past economic conditions with policies that are not likely to affect the
economy for a year or more. Another difficulty is that inflation could
be rising when the economy is experiencing a recessionary gap. An
example of this, mentioned earlier, occurred in 1990 when inflation
increased due to the seemingly temporary increase in oil prices
following Iraq's invasion of Kuwait. The Fed faced a similar situation
in the first half of 2008 when oil prices were again rising. If the Fed
undertakes contractionary monetary policy at such times, then its
efforts to reduce the inflation rate could worsen the recessionary gap.
The
solution proposed by Chairman Bernanke, who is an advocate of inflation
rate targeting, is to focus not on the past rate of inflation or even
the current rate of inflation, but on the expected rate of inflation, as
revealed by various indicators, over the next year.
By 2010, the
central banks of about 30 developed or developing countries had adopted
specific inflation targeting. Inflation targeters include Australia,
Brazil, Canada, Great Britain, New Zealand, South Korea, and, most
recently, Turkey and Indonesia. A study by economist Carl Walsh found
that inflationary experiences among developed countries have been
similar, regardless of whether their central banks had explicit or more
flexible inflation targets. For developing countries, however, he found
that inflation targeting enhanced macroeconomic performance, in terms of
both lower inflation and greater overall stability.
Political Pressures
The institutional relationship between the
leaders of the Fed and the executive and legislative branches of the
federal government is structured to provide for the Fed's independence.
Members of the Board of Governors are appointed by the president, with
confirmation by the Senate, but the 14-year terms of office provide a
considerable degree of insulation from political pressure. A president
exercises greater influence in the choice of the chairman of the Board
of Governors; that appointment carries a four-year term. Neither the
president nor Congress has any direct say over the selection of the
presidents of Federal Reserve district banks. They are chosen by their
individual boards of directors with the approval of the Board of
Governors.
The degree of independence that central banks around
the world have varies. A central bank is considered to be more
independent if it is insulated from the government by such factors as
longer term appointments of its governors and fewer requirements to
finance government budget deficits. Studies in the 1980s and early 1990s
showed that, in general, greater central bank independence was
associated with lower average inflation and that there was no systematic
relationship between central bank independence and other indicators of
economic performance, such as real GDP growth or unemployment.See, for
example, Alberto Alesina and Lawrence H. Summers, "Central Bank
Independence and Macroeconomic Performance: Some Comparative Evidence,". By
the rankings used in those studies, the Fed was considered quite
independent, second only to Switzerland and the German Bundesbank at the
time. Perhaps as a result of such findings, a number of countries have
granted greater independence to their central banks in the last decade.
The charter for the European Central Bank, which began operations in
1998, was modeled on that of the German Bundesbank. Its charter states
explicitly that its primary objective is to maintain price stability.
Also, since 1998, central bank independence has increased in the United
Kingdom, Canada, Japan, and New Zealand.
While the Fed is
formally insulated from the political process, the men and women who
serve on the Board of Governors and the FOMC are human beings. They are
not immune to the pressures that can be placed on them by members of
Congress and by the president. The chairman of the Board of Governors
meets regularly with the president and the executive staff and also
reports to and meets with congressional committees that deal with
economic matters.
The Fed was created by the Congress; its
charter could be altered - or even revoked - by that same body. The Fed
is in the somewhat paradoxical situation of having to cooperate with the
legislative and executive branches in order to preserve its
independence.
The Degree of Impact on the Economy
The problem of lags
suggests that the Fed does not know with certainty when its policies
will work their way through the financial system to have an impact on
macroeconomic performance. The Fed also does not know with certainty to
what extent its policy decisions will affect the macroeconomy.
For
example, investment can be particularly volatile. An effort by the Fed
to reduce aggregate demand in the face of an inflationary gap could be
partially offset by rising investment demand. But, generally,
contractionary policies do tend to slow down the economy as if the Fed
were "pulling on a rope". That may not be the case with expansionary
policies. Since investment depends crucially on expectations about the
future, business leaders must be optimistic about economic conditions in
order to expand production facilities and buy new equipment. That
optimism might not exist in a recession. Instead, the pessimism that
might prevail during an economic slump could prevent lower interest
rates from stimulating investment. An effort to stimulate the economy
through monetary policy could be like "pushing on a string". The central
bank could push with great force by buying bonds and engaging in
quantitative easing, but little might happen to the economy at the other
end of the string.
What if the Fed cannot bring about a change
in interest rates? A liquidity trap is said to exist when a change in
monetary policy has no effect on interest rates. This would be the case
if the money demand curve were horizontal at some interest rate, as
shown in Figure 11.4 "A Liquidity Trap". If a change in the money supply
from M to M′ cannot change interest rates, then, unless there is some
other change in the economy, there is no reason for investment or any
other component of aggregate demand to change. Hence, traditional
monetary policy is rendered totally ineffective; its degree of impact on
the economy is nil. At an interest rate of zero, since bonds cease to
be an attractive alternative to money, which is at least useful for
transactions purposes, there would be a liquidity trap.
Figure 11.4 A Liquidity Trap
When a change in the money supply has no effect on the interest rate, the economy is said to be in a liquidity trap.
With
the federal funds rate in the United States close to zero at the end of
2008, the possibility that the country was in or nearly in a liquidity
trap could not be dismissed. As discussed in the introduction to the
chapter, at the same time the Fed lowered the federal funds rate to
close to zero, it mentioned that it intended to pursue additional,
nontraditional measures. What the Fed seeks to do is to make firms and
consumers want to spend now by using a tool not aimed at reducing the
interest rate, since it cannot reduce the interest rate below zero. It
thus shifts its focus to the price level and to avoiding expected
deflation. For example, if the public expects the price level to fall by
2% and the interest rate is zero, by holding money, the money is
actually earning a positive real interest rate of 2% - the difference
between the nominal interest rate and the expected deflation rate. Since
the nominal rate of interest cannot fall below zero (Who would, for
example, want to lend at an interest rate below zero when lending is
risky whereas cash is not? In short, it does not make sense to lend $10
and get less than $10 back.), expected deflation makes holding cash very
attractive and discourages spending since people will put off purchases
because goods and services are expected to get cheaper.
To
combat this "wait-and-see" mentality, the Fed or another central bank,
using a strategy referred to as quantitative easing, must convince the
public that it will keep interest rates very low by providing
substantial reserves for as long as is necessary to avoid deflation. In
other words, it is aimed at creating expected inflation. For example, at
the Fed's October 2003 meeting, it announced that it would keep the
federal funds rate at 1% for "a considerable period". When the Fed
lowered the rate to between 0% and 0.25% in December 2008, it added that
"the committee anticipates that weak economic conditions are likely to
warrant exceptionally low levels of the federal funds rate for some
time". After working so hard to convince economic players that it will
not tolerate inflation above 2%, the Fed, when in such a situation, must
convince the public that it will tolerate inflation, but of course not
too much! If it is successful, this extraordinary form of expansionary
monetary policy will lead to increased purchases of goods and services,
compared to what they would have been with expected deflation. Also, by
providing banks with lots of liquidity, the Fed is hoping to encourage
them to lend.
The Japanese economy provides an interesting modern
example of a country that attempted quantitative easing. With a
recessionary gap starting in the early 1990s and deflation in most years
from 1995 on, Japan's central bank, the Bank of Japan, began to lower
the call money rate (equivalent to the federal funds rate in the United
States), reaching near zero by the late 1990s. With growth still
languishing, Japan appeared to be in a traditional liquidity trap. In
late 1999, the Bank of Japan announced that it would maintain a zero
interest rate policy for the foreseeable future, and in March 2001 it
officially began a policy of quantitative easing. In 2006, with the
price level rising modestly, Japan ended quantitative easing and began
increasing the call rate again. It should be noted that the government
simultaneously engaged in expansionary fiscal policy.
How well
did these policies work in Japan? The economy began to grow modestly in
2003, though deflation between 1% and 2% remained. Some researchers feel
that the Bank of Japan ended quantitative easing too early. Also,
delays in implementing the policy, as well as delays in restructuring
the banking sector, exacerbated Japan's problems".
Fed Chairman Bernanke and
other Fed officials have argued that the Fed is also engaged in credit
easing. Credit easing is a
strategy that involves the extension of central bank lending to
influence more broadly the proper functioning of credit markets and to
improve liquidity. The specific new credit facilities that the Fed has
created were discussed in the Case in Point in the chapter on the nature
and creation of money. In general, the Fed is hoping that these new
credit facilities will improve liquidity in a variety of credit markets,
ranging from those used by money market mutual funds to those involved
in student and car loans.
Rational Expectations
One hypothesis suggests that monetary
policy may affect the price level but not real GDP. The rational
expectations hypothesis states that people use all available information
to make forecasts about future economic activity and the price level,
and they adjust their behavior to these forecasts.
Figure 11.5
"Monetary Policy and Rational Expectations" uses the model of aggregate
demand and aggregate supply to show the implications of the rational
expectations argument for monetary policy. Suppose the economy is
operating at YP, as illustrated by point A. An increase in the money
supply boosts aggregate demand to AD2. In the analysis we have explored
thus far, the shift in aggregate demand would move the economy to a
higher level of real GDP and create an inflationary gap. That, in turn,
would put upward pressure on wages and other prices, shifting the
short-run aggregate supply curve to SRAS2 and moving the economy to
point B, closing the inflationary gap in the long run. The rational
expectations hypothesis, however, suggests a quite different
interpretation.
Figure 11.5 Monetary Policy and Rational Expectations
Suppose
the economy is operating at point A and that individuals have rational
expectations. They calculate that an expansionary monetary policy
undertaken at price level P1 will raise prices to P2. They adjust their
expectations - and wage demands - accordingly, quickly shifting the
short-run aggregate supply curve to SRAS2. The result is a movement
along the long-run aggregate supply curve LRAS to point B, with no
change in real GDP.
Suppose people observe the initial monetary
policy change undertaken when the economy is at point A and calculate
that the increase in the money supply will ultimately drive the price
level up to point B. Anticipating this change in prices, people adjust
their behavior. For example, if the increase in the price level from P1
to P2 is a 10% change, workers will anticipate that the prices they pay
will rise 10%, and they will demand 10% higher wages. Their employers,
anticipating that the prices they will receive will also rise, will
agree to pay those higher wages. As nominal wages increase, the
short-run aggregate supply curve immediately shifts to SRAS2. The result
is an upward movement along the long-run aggregate supply curve, LRAS.
There is no change in real GDP. The monetary policy has no effect, other
than its impact on the price level. This rational expectations argument
relies on wages and prices being sufficiently flexible - not sticky, as
described in an earlier chapter - so that the change in expectations
will allow the short-run aggregate supply curve to shift quickly to
SRAS2.
One important implication of the rational expectations
argument is that a contractionary monetary policy could be painless.
Suppose the economy is at point B in Figure 11.5 "Monetary Policy and
Rational Expectations", and the Fed reduces the money supply in order to
shift the aggregate demand curve back to AD1. In the model of aggregate
demand and aggregate supply, the result would be a recession. But in a
rational expectations world, people's expectations change, the short-run
aggregate supply immediately shifts to the right, and the economy moves
painlessly down its long-run aggregate supply curve LRAS to point A.
Those who support the rational expectations hypothesis, however, also
tend to argue that monetary policy should not be used as a tool of
stabilization policy.
For some, the events of the early 1980s
weakened support for the rational expectations hypothesis; for others,
those same events strengthened support for this hypothesis. As we saw in
the introduction to an earlier chapter, in 1979 President Jimmy Carter
appointed Paul Volcker as Chairman of the Federal Reserve and pledged
his full support for whatever the Fed might do to contain inflation. Mr.
Volcker made it clear that the Fed was going to slow money growth and
boost interest rates. He acknowledged that this policy would have costs
but said that the Fed would stick to it as long as necessary to control
inflation. Here was a monetary policy that was clearly announced and
carried out as advertised. But the policy brought on the most severe
recession since the Great Depression - a result that seems inconsistent
with the rational expectations argument that changing expectations would
prevent such a policy from having a substantial effect on real GDP.
Others,
however, argue that people were aware of the Fed's pronouncements but
were skeptical about whether the anti-inflation effort would persist,
since the Fed had not vigorously fought inflation in the late 1960s and
the 1970s. Against this history, people adjusted their estimates of
inflation downward slowly. In essence, the recession occurred because
people were surprised that the Fed was serious about fighting inflation.
Regardless
of where one stands on this debate, one message does seem clear: once
the Fed has proved it is serious about maintaining price stability,
doing so in the future gets easier. To put this in concrete terms,
Volcker's fight made Greenspan's work easier, and Greenspan's legacy of
low inflation should make Bernanke's easier.
Key Takeaways
- Macroeconomic policy makers must contend with recognition, implementation, and impact lags.
- Potential targets for macroeconomic policy include interest rates, money growth rates, and the price level or expected rates of change in the price level.
- Even if a central bank is structured to be independent of political pressure, its officers are likely to be affected by such pressure.
- To counteract liquidity traps or the possibility thereof, central banks have used quantitative-easing and credit-easing strategies.
- No central bank can know in advance how
its policies will affect the economy; the rational expectations
hypothesis predicts that central bank actions will affect the money
supply and the price level but not the real level of economic activity.
Case in Point: The Fed and the ECB: A Tale of Divergent Monetary Policies
In
the spring of 2011, the European Central Bank (ECB) began to raise
interest rates, while the Federal Reserve Bank held fast to its low rate
policy. With the economies of both Europe and the United States weak,
why the split in direction?
For one thing, at the time, the U.S.
economy looked weaker than did Europe's economy as a whole. Moreover,
the recession in the United States had been deeper. For example, the
unemployment rate in the United States more than doubled during the
Great Recession and its aftermath, while in the eurozone, it had risen
only 40%.
But the divergence also reflected the different legal
environments in which the two central banks operate. The ECB has a clear
mandate to fight inflation, while the Fed has more leeway in pursuing
both price stability and full employment. The ECB has a specific
inflation target, and the inflation measure it uses covers all prices.
The Fed, with its more flexible inflation target, has tended to focus on
"core" inflation, which excludes gasoline and food prices, both of
which are apt to be volatile. Using each central bank's preferred
inflation measure, European inflation was, at the time of the ECB rate
hike, running at 2.6%, while in the United States, it was at 1.6%.
Europe
also differs from the United States in its degree of unionization.
Because of Europe's higher level of unionization and collective
bargaining, there is a sense that any price increases in Europe will
translate into sustained inflation more rapidly there than they will in
the United States.
Recall, however, that the eurozone is made up
of 17 diverse countries. As made evident by the headline news from most
of 2011 and into 2012, a number of countries in the eurozone were
experiencing sovereign debt crises (meaning that there was fear that
their governments could not meet their debt obligations) as well as more
severe economic conditions. Higher interest rates make their
circumstances that much more difficult. While it is true that various
states in the United States can experience very different economic
circumstances when the Fed sets what is essentially a "national"
monetary policy, having a single monetary policy for different countries
presents additional problems. One reason for this this difference is
that labor mobility is higher in the United States than it is across the
countries of Europe. Also, the United States can use its "national"
fiscal policy to help weaker states.
In the fall of 2011, the ECB
reversed course. At its first meeting under its new president, Mario
Draghi, in November 2011, it lowered rates, citing slower growth and
growing concerns about the sovereign debt crisis. A further rate cut
followed in December. Interestingly, the inflation rate at the time of
the cuts was running at about 3%, which was above the ECB's stated goal
of 2%. The ECB argued that it was forecasting lower inflation for the
future. So even the ECB has some flexibility and room for discretion.
Monetary Policy and the Equation of Exchange
Learning Objectives
- Explain the meaning of the equation of exchange, MV = PY, and tell why it must hold true.
- Discuss the usefulness of the quantity theory of money in explaining the behavior of nominal GDP and inflation in the long run.
- Discuss why the quantity theory of money is less useful in analyzing the short run.
So
far we have focused on how monetary policy affects real GDP and the
price level in the short run. That is, we have examined how it can be
used - however imprecisely - to close recessionary or inflationary gaps
and to stabilize the price level. In this section, we will explore the
relationship between money and the economy in the context of an equation
that relates the money supply directly to nominal GDP. As we shall see,
it also identifies circumstances in which changes in the price level
are directly related to changes in the money supply.
The Equation of Exchange
We can relate the money supply to the aggregate economy by using the equation of exchange:
Equation 11.1
The
equation of exchange shows that the money supply M times its velocity V
equals nominal GDP. Velocity is the number of times the money supply is
spent to obtain the goods and services that make up GDP during a
particular time period.
To see that nominal GDP is the price
level multiplied by real GDP, recall from an earlier chapter that the
implicit price deflator P equals nominal GDP divided by real GDP:
Equation 11.2
Multiplying both sides by real GDP, we have
Equation 11.3
Letting Y equal real GDP, we can rewrite the equation of exchange as
Equation 11.4
We
shall use the equation of exchange to see how it represents spending in
a hypothetical economy that consists of 50 people, each of whom has a
car. Each person has $10 in cash and no other money. The money supply of
this economy is thus $500. Now suppose that the sole economic activity
in this economy is car washing. Each person in the economy washes one
other person's car once a month, and the price of a car wash is $10. In
one month, then, a total of 50 car washes are produced at a price of $10
each. During that month, the money supply is spent once.
Applying
the equation of exchange to this economy, we have a money supply M of
$500 and a velocity V of 1. Because the only good or service produced is
car washing, we can measure real GDP as the number of car washes. Thus Y
equals 50 car washes. The price level P is the price of a car wash:
$10. The equation of exchange for a period of 1 month is
$500 × 1 = $10 × 50
Now suppose that in the second month everyone washes someone else's car again. Over the full two-month period, the money supply has been spent twice - the velocity over a period of two months is 2. The total output in the economy is $1,000 - 100 car washes have been produced over a two-month period at a price of $10 each. Inserting these values into the equation of exchange, we have
$500 × 2 = $10 × 100
Suppose this process continues for one more month. For the three-month period, the money supply of $500 has been spent three times, for a velocity of 3. We have
$500 × 3 = $10 × 150
The essential thing to note
about the equation of exchange is that it always holds. That should come
as no surprise. The left side, MV, gives the money supply times the
number of times that money is spent on goods and services during a
period. It thus measures total spending. The right side is nominal GDP.
But that is a measure of total spending on goods and services as well.
Nominal GDP is the value of all final goods and services produced during
a particular period. Those goods and services are either sold or added
to inventory. If they are sold, then they must be part of total
spending. If they are added to inventory, then some firm must have
either purchased them or paid for their production; they thus represent a
portion of total spending. In effect, the equation of exchange says
simply that total spending on goods and services, measured as MV, equals
total spending on goods and services, measured as PY (or nominal GDP).
The equation of exchange is thus an identity, a mathematical expression
that is true by definition.
To apply the equation of exchange to a
real economy, we need measures of each of the variables in it. Three of
these variables are readily available. The Department of Commerce
reports the price level (that is, the implicit price deflator) and real
GDP. The Federal Reserve Board reports M2, a measure of the money
supply. For the second quarter of 2008, the values of these variables at
an annual rate were
M = $7,635.4 billion
P = 1.22
Y = 11,727.4 billion
To solve for the velocity of money, V, we divide both sides of Equation 11.4 by M:
Equation 11.5
Using
the data for the second quarter of 2008 to compute velocity, we find
that V then was equal to 1.87. A velocity of 1.87 means that the money
supply was spent 1.87 times in the purchase of goods and services in the
second quarter of 2008.
Money, Nominal GDP, and Price-Level Changes
Assume for the moment that velocity is constant, expressed as V¯. Our equation of exchange is now written as
Equation 11.6
A constant value for velocity would have two important implications:
- Nominal GDP could change only if there were a change in the money supply. Other kinds of changes, such as a change in government purchases or a change in investment, could have no effect on nominal GDP.
- A change in the money supply would always change nominal GDP, and by an equal percentage.
In
short, if velocity were constant, a course in macroeconomics would be
quite simple. The quantity of money would determine nominal GDP; nothing
else would matter.
Indeed, when we look at the behavior of
economies over long periods of time, the prediction that the quantity of
money determines nominal output holds rather well. Figure 11.6
"Inflation, M2 Growth, and GDP Growth" compares long-term averages in
the growth rates of M2 and nominal GNP for 11 countries (Canada,
Denmark, France, Italy, Japan, the Netherlands, Norway, Sweden,
Switzerland, the United Kingdom, and the United States) for more than a
century. These are the only countries that have consistent data for such
a long period. The lines representing inflation, M2 growth, and nominal
GDP growth do seem to move together most of the time, suggesting that
velocity is constant when viewed over the long run.
Figure 11.6 Inflation, M2 Growth, and GDP Growth
The
chart shows the behavior of price-level changes, the growth of M2, and
the growth of nominal GDP for 11 countries using the average value of
each variable. Viewed in this light, the relationship between money
growth and nominal GDP seems quite strong.
Moreover, price-level changes also follow the same pattern that changes in M2 and nominal GNP do. Why is this?
We can rewrite the equation of exchange, M = PY, in terms of percentage rates of change. When two products, such as M and PY, are equal, and the variables themselves are changing, then the sums of the percentage rates of change are approximately equal:
Equation 11.7
The
Greek letter Δ (delta) means "change in". Assume that velocity is
constant in the long run, so that %ΔV = 0. We also assume that real GDP
moves to its potential level, YP, in the long run. With these
assumptions, we can rewrite Equation 11.7 as follows:
Equation 11.8
Subtracting %ΔYP from both sides of Equation 11.8, we have the following:
Equation 11.9
Equation
11.9 has enormously important implications for monetary policy. It
tells us that, in the long run, the rate of inflation, %ΔP, equals the
difference between the rate of money growth and the rate of increase in
potential output, %ΔYP, given our assumption of constant velocity.
Because potential output is likely to rise by at most a few percentage
points per year, the rate of money growth will be close to the rate of
inflation in the long run.
Several recent studies that looked at
all the countries on which they could get data on inflation and money
growth over long periods found a very high correlation between growth
rates of the money supply and of the price level for countries with high
inflation rates, but the relationship was much weaker for countries
with inflation rates of less than 10%.For example, one study examined
data on 81 countries using inflation rates averaged for the period 1980
to 1993 (John R. Moroney, " while another examined data on 160 countries over
the period 1969–1999 (Paul De Grauwe and Magdalena Polan, "Is Inflation
Always and Everywhere a Monetary Phenomenon?" These findings support the
quantity theory of money, which holds that in the long run the price
level moves in proportion with changes in the money supply, at least for
high-inflation countries.
Why the Quantity Theory of Money Is Less Useful in Analyzing the Short Run
The
stability of velocity in the long run underlies the close relationship
we have seen between changes in the money supply and changes in the
price level. But velocity is not stable in the short run; it varies
significantly from one period to the next. Figure 11.7 "The Velocity of
M2, 1970–2011" shows annual values of the velocity of M2 from 1960 to
2011. Velocity is quite variable, so other factors must affect economic
activity. Any change in velocity implies a change in the demand for
money. For analyzing the effects of monetary policy from one period to
the next, we apply the framework that emphasizes the impact of changes
in the money market on aggregate demand.
Figure 11.7 The Velocity of M2, 1970–2011
The annual velocity of M2 varied about an average of 1.78 between 1970 and 2011.
The
factors that cause velocity to fluctuate are those that influence the
demand for money, such as the interest rate and expectations about bond
prices and future price levels. We can gain some insight about the
demand for money and its significance by rearranging terms in the
equation of exchange so that we turn the equation of exchange into an
equation for the demand for money. If we multiply both sides of Equation
11.1 by the reciprocal of velocity, 1/V, we have this equation for
money demand:
Equation 11.10
The equation of
exchange can thus be rewritten as an equation that expresses the demand
for money as a percentage, given by 1/V, of nominal GDP. With a
velocity of 1.87, for example, people wish to hold a quantity of money
equal to 53.4% (1/1.87) of nominal GDP. Other things unchanged, an
increase in money demand reduces velocity, and a decrease in money
demand increases velocity.
If people wanted to hold a quantity of
money equal to a larger percentage of nominal GDP, perhaps because
interest rates were low, velocity would be a smaller number. Suppose,
for example, that people held a quantity of money equal to 80% of
nominal GDP. That would imply a velocity of 1.25. If people held a
quantity of money equal to a smaller fraction of nominal GDP, perhaps
owing to high interest rates, velocity would be a larger number. If
people held a quantity of money equal to 25% of nominal GDP, for
example, the velocity would be 4.
As another example, in the
chapter on financial markets and the economy, we learned that money
demand falls when people expect inflation to increase. In essence, they
do not want to hold money that they believe will only lose value, so
they turn it over faster, that is, velocity rises. Expectations of
deflation lower the velocity of money, as people hold onto money because
they expect it will rise in value.
In our first look at the
equation of exchange, we noted some remarkable conclusions that would
hold if velocity were constant: a given percentage change in the money
supply M would produce an equal percentage change in nominal GDP, and no
change in nominal GDP could occur without an equal percentage change in
M. We have learned, however, that velocity varies in the short run.
Thus, the conclusions that would apply if velocity were constant must be
changed.
First, we do not expect a given percentage change in
the money supply to produce an equal percentage change in nominal GDP.
Suppose, for example, that the money supply increases by 10%. Interest
rates drop, and the quantity of money demanded goes up. Velocity is
likely to decline, though not by as large a percentage as the money
supply increases. The result will be a reduction in the degree to which a
given percentage increase in the money supply boosts nominal GDP.
Second,
nominal GDP could change even when there is no change in the money
supply. Suppose government purchases increase. Such an increase shifts
the aggregate demand curve to the right, increasing real GDP and the
price level. That effect would be impossible if velocity were constant.
The fact that velocity varies, and varies positively with the interest
rate, suggests that an increase in government purchases could boost
aggregate demand and nominal GDP. To finance increased spending, the
government borrows money by selling bonds. An increased supply of bonds
lowers their price, and that means higher interest rates. The higher
interest rates produce the increase in velocity that must occur if
increased government purchases are to boost the price level and real
GDP.
Just as we cannot assume that velocity is constant when we
look at macroeconomic behavior period to period, neither can we assume
that output is at potential. With both V and Y in the equation of
exchange variable, in the short run, the impact of a change in the money
supply on the price level depends on the degree to which velocity and
real GDP change.
In the short run, it is not reasonable to assume
that velocity and output are constants. Using the model in which
interest rates and other factors affect the quantity of money demanded
seems more fruitful for understanding the impact of monetary policy on
economic activity in that period. However, the empirical evidence on the
long-run relationship between changes in money supply and changes in
the price level that we presented earlier gives us reason to pause. As
Federal Reserve Governor from 1996 to 2002 Laurence H. Meyer put it: "I
believe monitoring money growth has value, even for central banks that
follow a disciplined strategy of adjusting their policy rate to ongoing
economic developments. The value may be particularly important at the
extremes: during periods of very high inflation, as in the late 1970s
and early 1980s in the United States … and in deflationary
episodes".
It
would be a mistake to allow short-term fluctuations in velocity and
output to lead policy makers to completely ignore the relationship
between money and price level changes in the long run.
Key Takeaways
- The equation of exchange can be written MV = PY.
- When M, V, P, and Y are changing, then %ΔM + %ΔV = %ΔP + %ΔY, where Δ means “change in.”
- In the long run, V is constant, so %ΔV = 0. Furthermore, in the long run Y tends toward YP, so %ΔM = %ΔP.
- In the short run, V is not constant, so changes in the money supply can affect the level of income.
Case in Point: Velocity and the Confederacy
The Union and the
Confederacy financed their respective efforts during the Civil War
largely through the issue of paper money. The Union roughly doubled its
money supply through this process, and the Confederacy printed enough
"Confederates" to increase the money supply in the South 20-fold from
1861 to 1865. That huge increase in the money supply boosted the price
level in the Confederacy dramatically. It rose from an index of 100 in
1861 to 9,200 in 1865.
Estimates of real GDP in the South during
the Civil War are unavailable, but it could hardly have increased very
much. Although production undoubtedly rose early in the period, the
South lost considerable capital and an appalling number of men killed in
battle. Let us suppose that real GDP over the entire period remained
constant. For the price level to rise 92-fold with a 20-fold increase in
the money supply, there must have been a 4.6-fold increase in velocity.
People in the South must have reduced their demand for Confederates.
An
account of an exchange for eggs in 1864 from the diary of Mary Chestnut
illustrates how eager people in the South were to part with their
Confederate money. It also suggests that other commodities had assumed
much greater relative value:
"She asked me 20 dollars for five
dozen eggs and then said she would take it in "Confederate". Then I
would have given her 100 dollars as easily. But if she had taken my
offer of yarn! I haggle in yarn for the millionth part of a thread! …
When they ask for Confederate money, I never stop to chafer [bargain or
argue]. I give them 20 or 50 dollars cheerfully for anything".
Summary
Part of the Fed's power stems from the fact that it has
no legislative mandate to seek particular goals. That leaves the Fed
free to set its own goals. In recent years, its primary goal has seemed
to be the maintenance of an inflation rate below 2% to 3%. Given success
in meeting that goal, the Fed has used its tools to stimulate the
economy to close recessionary gaps. Once the Fed has made a choice to
undertake an expansionary or contractionary policy, we can trace the
impact of that policy on the economy.
There are a number of
problems in the use of monetary policy. These include various types of
lags, the issue of the choice of targets in conducting monetary policy,
political pressures placed on the process of policy setting, and
uncertainty as to how great an impact the Fed's policy decisions have on
macroeconomic variables. We highlighted the difficulties for monetary
policy if the economy is in or near a liquidity trap and discussed the
use of quantitative easing and credit easing in such situations. If
people have rational expectations and respond to those expectations in
their wage and price choices, then changes in monetary policy may have
no effect on real GDP.
We saw in this chapter that the money
supply is related to the level of nominal GDP by the equation of
exchange. A crucial issue in that relationship is the stability of the
velocity of money and of real GDP. If the velocity of money were
constant, nominal GDP could change only if the money supply changed, and
a change in the money supply would produce an equal percentage change
in nominal GDP. If velocity were constant and real GDP were at its
potential level, then the price level would change by about the same
percentage as the money supply. While these predictions seem to hold up
in the long run, there is less support for them when we look at
macroeconomic behavior in the short run. Nonetheless, policy makers must
be mindful of these long-run relationships as they formulate policies
for the short run.