Economics 2 Professor Christina Romer Spring 2019 Professor David - - PDF document

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Economics 2 Professor Christina Romer Spring 2019 Professor David Romer LECTURE 22 FINANCIAL MARKETS AND MONETARY POLICY April 18, 2019 I. O VERVIEW II. T HE M ONEY M ARKET , THE F EDERAL R ESERVE , AND I NTEREST R ATES A. The market for

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Economics 2 Professor Christina Romer Spring 2019 Professor David Romer LECTURE 22 FINANCIAL MARKETS AND MONETARY POLICY April 18, 2019 I. OVERVIEW

  • II. THE MONEY MARKET, THE FEDERAL RESERVE, AND INTEREST RATES
  • A. The market for money
  • 1. What is money?
  • 2. Money demand
  • 3. Money supply
  • 4. Equilibrium
  • B. How does the Federal Reserve control the supply of currency?
  • C. The effects of a change in the money supply
  • D. The Federal Reserve’s ability to influence the real interest rate
  • 1. The short run
  • 2. The long run
  • III. MONETARY POLICY AND SHORT-RUN MACROECONOMIC FLUCTUATIONS
  • A. Example: An increase in the real interest rate
  • B. Reasons that the Federal Reserve might move interest rates
  • C. Monetary policy mistakes in the Great Depression
  • 1. The initial decline in spending and output
  • 2. The collapse of the money supply
  • 3. Consequences
  • IV. FINANCIAL CRISES
  • A. Financial intermediation
  • B. How a financial crisis starts
  • C. How a financial crisis spreads: contagion
  • D. The effects of a financial crisis on planned aggregate expenditure
  • E. The impact of a financial crisis on output
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LECTURE 22

Financial Markets and Monetary Policy

April 18, 2019

Economics 2 Christina Romer Spring 2019 David Romer

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Announcement

  • Problem Set 5 is due now.
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  • I. OVERVIEW
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Determination of Short-Run Output: The “Keynesian Cross”

Y PAE PAE Y=PAE Y1

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Two More Things that Can Shift PAE

  • Monetary Policy: Actions taken by the central

bank to affect nominal and real interest rates.

  • Disruptions in Financial Markets: Specifically, a

financial crisis.

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Two Key Ideas Concerning Monetary Policy in the Short Run

  • By changing the money supply, the central bank

can change the real interest rate.

  • A change in the real interest rate shifts the PAE

curve in the Keynesian cross diagram, and so changes output in the short run.

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  • II. THE MONEY MARKET, THE FEDERAL RESERVE, AND

INTEREST RATES

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Economists’ Definition of “Money”

  • Assets that can be used to make purchases.
  • Concretely, you can usually think of money as

meaning currency.

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The Nominal Interest Rate and Money Demand

  • Because you don’t earn interest on cash, the
  • pportunity cost of holding money is what you

could earn on other assets.

  • That is, the opportunity cost of holding money is

the nominal interest rate.

  • So: Money demand is a decreasing function of the

nominal interest rate.

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The Demand for Money

M i MD

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Money Supply

  • At any point in time, the amount of currency

available is just a number.

  • Determined by the central bank.
  • That is, we take the quantity of money supplied as

given.

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The Supply of Money

M i MS

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Equilibrium in the Market for Money

M i M1 i1 MD MS

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How Does the Federal Reserve Change the Money Supply?

  • Open market operation: The buying and selling of

government bonds by the central bank.

  • When the Federal Reserve sells bonds, the money

supply decreases.

  • When the Federal Reserve buys bonds, the money

supply increases.

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A Decrease in the Money Supply

M i M1 i1 MD MS1 MS2 M2 i2

The Fed sells bonds.

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The Fed’s Ability to Influence the Real Interest Rate—the Short Run

  • By changing the money supply, the Fed can

change the nominal interest rate, i.

  • Recall: r = i − π (or r = i − πe), and there is nominal

rigidity (inflation only changes slowly).

  • So: When the Fed changes i, it changes r.
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In the Short Run, Nominal and Real Interest Rates Generally Move Together

Source: FRED.

Nominal Real

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The Fed’s Ability to Influence the Real Interest Rate—the Short Run versus the Long Run

  • As we have just seen, the Fed can affect the real

interest rate in the short run.

  • However, in the long run, r must be at the level

that equilibrates S* and I*.

  • The Fed cannot keep r away from this level

indefinitely.

  • We will discuss next week what prevents the Fed

from doing this.

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  • III. MONETARY POLICY AND SHORT-RUN

MACROECONOMIC FLUCTUATIONS

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The Real Interest Rate and Planned Aggregate Expenditure (PAE)

Recall: PAE = C + Ip + G + NX.

  • Ip is lower when r is higher.
  • Saving is higher when r is higher, so C is lower

when r is higher.

  • We will see two weeks from now that NX is lower

when r is higher. Conclusion: An increase in r reduces PAE at a given Y.

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An Increase in the Real Interest Rate

Y PAE1 PAE Y=PAE Y* PAE2 Y2

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Monetary Policy

  • Actions taken by the central bank to affect

nominal and real interest rates.

  • Contractionary monetary policy: Federal Reserve

actions to increase nominal and real interest rates.

  • Expansionary monetary policy: Federal Reserve

actions to decrease nominal and real interest rates.

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Why Might the Central Bank Undertake Expansionary or Contractionary Monetary Policy?

  • To offset some other force that is shifting the PAE line

(countercyclical monetary policy).

  • We’ll disucss an example next time (monetary

policy in the Great Recession).

  • To pursue some other objective.
  • We’ll discuss this extensively next week (the

Fed’s concern with inflation).

  • A mistake.
  • Example: Monetary policy in the Great

Depression.

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Industrial Production, 1927–1934

3.0 4.0 5.0 6.0 7.0 8.0 9.0

1927 1928 1929 1930 1931 1932 1933 1934

Index (2012=100)

Source: Federal Reserve Bank of St. Louis, FRED.

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The Money Stock, 1923–1933

30 32 34 36 38 40 42 44 46 48 50

1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933

Billions of Dollars

Source: Federal Reserve Bank of St. Louis, FRED.

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Real Interest Rate, 1923–1933

  • 2

2 4 6 8 10 12 14 16

1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933

Percent

Source: Federal Reserve Bank of St. Louis, FRED.

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Monetary Contraction in the Great Depression

Y PAE1 PAE Y=PAE Y* PAE2 Y2

PAE2 shows the effects of the fall in autonomous consumption.

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Monetary Contraction in the Great Depression

Y PAE1 PAE Y=PAE Y* PAE2 Y2 PAE3 Y3

PAE3 shows the effect of monetary contraction and the rise in r.

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Industrial Production, 1927–1934

3.0 4.0 5.0 6.0 7.0 8.0 9.0

1927 1928 1929 1930 1931 1932 1933 1934

Index (2012=100)

Source: Federal Reserve Bank of St. Louis, FRED.

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  • IV. FINANCIAL CRISES
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Financial Intermediation

  • The process of getting saving into productive

investment.

  • Financial intermediaries are the markets and

institutions that do this.

  • Financial intermediaries include banks, investment

banks, money market mutual funds, pension funds, etc.

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What Is a Financial Crisis?

  • A time when:
  • A number of financial institutions are in

danger of failing.

  • People lose confidence in many financial

institutions.

  • As a result, there is widespread disruption of

financial intermediation.

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How Individual Financial Institutions Can Fail

  • Defaults and changes in asset values can reduce

the value of an institution’s loans and securities.

  • If the value of the loans and securities falls to the

point where they are worth less than the institution’s obligations to its depositors and lenders, the institution is insolvent.

  • A belief that the institution is in danger of

becoming insolvent can cause depositors to withdraw their funds and lenders to stop lending—which can cause the insolvency to occur.

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House Prices, 1987–2015

Source: Federal Reserve Bank of St. Louis, FRED.

50 100 150 200 250

Jan-87 Jan-89 Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Jan-15

Case-Shiller House Price Index, January 2000 = 100

April 2006

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Source: http://www.housingviews.com.

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Contagion of Crises across Financial Institutions

  • Confidence: Troubles at one institution create

doubts about the health of other institutions, even if there are no connections between them.

  • Linkage: Troubles at one institution directly harm
  • ther institutions because of loans, insurance

contracts, and other direct links among them.

  • Fire Sale: Troubles at one institution cause it to sell
  • ff assets, driving down the prices of assets held by
  • ther institutions.
  • Macroeconomic: Troubles at one institution reduce

PAE and hence Y, and so harm other institutions.

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Deposits in Failed or Suspended Banks, 1927-1933

Source: Federal Reserve.

50 100 150 200 250 300 350 400 450 500

1927 1928 1929 1930 1931 1932 1933

Millions of Dollars

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Effects of a Financial Crisis on PAE

  • It raises credit spreads.
  • It may raise lending standards or otherwise reduce

the availability of loans.

  • It may harm consumer and firm confidence.
  • All of these developments are likely to reduce PAE

at a given level of Y.

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Credit Spreads during the 2008 Financial Crisis

Source: Economic Report of the President, February 2010.

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Tightening Loan Standards during the 2008 Financial Crisis

Source: Federal Reserve, Senior Loan Officer Opinion Survey, January 2018.

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Source: www.econreview.com.

Decline in the Number of Banks in the Great Depression

Number of Banks (1000s)

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Michigan Survey of Consumer Sentiment

40 50 60 70 80 90 100 110

2003 2005 2007 2009 2011 2013 2015 2017

Index, 1966 = 100

  • Jan. 2007

Source: Federal Reserve Bank of St. Louis, FRED

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The Effects of a Financial Crisis on Output

Y PAE1 PAE Y=PAE Y* PAE2 Y2

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Percentage Change in Real GDP

Source: Federal Reserve Bank of St. Louis, FRED

  • 10.0
  • 8.0
  • 6.0
  • 4.0
  • 2.0

0.0 2.0 4.0 6.0 8.0 10.0

2000-I 2001-I 2002-I 2003-I 2004-I 2005-I 2006-I 2007-I 2008-I 2009-I 2010-I 2011-I 2012-I 2013-I 2014-I 2015-I

Percent Change (at an Annual Rate)

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The Average Aftermath of a Financial Crisis

Source: Romer and Romer, “New Evidence on the Impact of Financial Crises.”

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But, how much output falls after a crisis is highly variable.

  • The ability and willingness of policymakers to use

fiscal and monetary policy matters a lot.

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Some Statistics on the Midterm

  • Median: 120
  • 75th percentile: 134
  • 25th percentile: 104
  • Median corresponds roughly to a B.
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Some Notes on Grading

  • We reward improvement.
  • Regrade requests must be submitted in writing to

your GSI by April 25th.

  • We will correct clear-cut errors in grading, but we

will not revisit judgment calls.