Economics 104B - Lecture Notes - Professor Fazzari
Topic VII: Monetary Economics
(Final, April 8, 2013)
** Note: Due to time constraints topics A and B of this section of the notes will not
be covered in the Spring, 2013 semester. I encourage students to read through these
notes (about 7.5 pages). The material is interesting and often engaging for students.
But you will not be responsible for topics A and B on the third exam. Topic C,
“Monetary Policy” will be an important part of the material covered on the exam.
This topic begins on page 8 below.
A. The Meaning and Measurement of Money
1. Definition of money
a) Meaning of “generalized purchasing power”

Generalized Purchasing Power: Money is valuable not for its intrinsic value
(aside from the case of coin collectors). Money is valuable because it has
generalized purchasing power. This means that money is the substance used to
buy “stuff.” People hold money because of what it can buy, not because of its
intrinsic value.

It’s most obvious to think of money as currency issued by the government, that is,
the fancy printed green pieces of paper. Currency certainly functions as
generalized purchasing power, but for most people it is used only for relatively
small transactions.

Other things like credit cards and checks also function as generalized purchasing
power. They are accepted as means of payment for a very wide range of goods
and services.
b) How money serves this role

Money is one side of the vast majority of exchanges in the modern economy.
That is, when an item or service is sold, it is almost always exchanged for money.
When something is bought, it is usually purchased with money.

The alternative to monetary exchange is barter: goods are exchanged directly for
other goods (my wheat is exchanged for your pot). This kind of exchange
dominates non-monetary economies, but it is of trivial importance in developed,
monetary systems.
2. Roles of money
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a) Unit of Account: money is the basic unit for measuring economic value. In the
U.S., all prices and wages are expressed in dollars, the U.S. unit of account. Having a
single, uniform measure is a useful function of money.
b) Store of Value: money is a way of storing wealth over time.
c) Medium of Exchange:
(1) Money as one side of all purchases and sales

Money is one side of every market transaction. The alternative would be a barter
economy in which there is a direct exchange of goods/services for other
goods/services. Money, as a medium of exchange, is used to make transactions easier
and more efficient.
(2) Barter and the “double coincidence of wants” problem

Double Coincidence of Wants: Imagine a barter economy with no money to use for
transactions. It would be very difficult to trade with other people. If you produce
nachos and you want to trade for chocolate, you must find a producer of chocolate
who wants nachos. This problem is called the double coincidence of wants.
o If you grow wheat and want a pot, you have to find a pot maker who wants
wheat to make a mutually beneficial exchange.
(3) How money overcomes this problem

In a monetary system, money, as the medium of exchange, is always one side of
every exchange. In this system, everybody wants money. This system eliminates the
problem of the double coincidence of wants. Money serves as generalized purchasing
power: people are willing to sell their goods for money because they are confident
that they can buy whatever they want with the money.
o In a monetary economy, the wheat farmer sells his wheat for money and buys
a pot from the pot maker with money. Even if the pot maker prefers rice to
wheat the transaction will work because the pot maker has confidence that she
can use the money to buy rice, or whatever else she would like.

Because everyone can sell their goods and services for money, it is much easier for
people to specialize in a particular production activity in a monetary economy. In a
barter economy, it would be tough to find people who would trade food, clothing, etc.
for a piece of an economics education! Thus, it’s unlikely that people would be able
to specialize in the production of economics education and research in a barter
economy plagued by the problem of the double coincidence of wants.

The possibility of specialization is a key factor in productive efficiency and economic
growth. Because specialization almost requires monetary exchange, one can say that
modern industrial economies would not be feasible without money.
3. Forms of money
a) Commodity money

Commodity money is something that is intrinsically valuable. The best example is
gold. Gold used to be used for money because it was intrinsically valuable. People
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would trade their goods for gold, but not because they necessarily wanted the gold.
Rather, it was because they knew that they could buy other goods they wanted with
the gold. Once gold is accepted not for its intrinsic value but for its ability to
purchase other things, it has become money, that is, "generalized purchasing power."
It was convenient (at first) because small quantities of gold were worth a lot, so
transactions could occur with small quantities of gold.
b) Convertible fiat money

In the first part of the 20th century, and earlier, many countries used paper money
backed by gold or another commodity (silver, for example). The paper titles to the
commodity were exchanged, not the commodity itself.
(1) The gold standard

To maintain what was called the "gold standard," the government would guarantee to
exchange paper money for a specified amount of gold. Thus, the paper money was
still a kind of "commodity money."

The money we use today is not backed by any gold standard. If you go to the Federal
Reserve today and ask for gold in exchange for your money, they will just look at you
funny.
c) True fiat money with no intrinsic value

Money that has no intrinsic value, such as modern U.S. currency, is known as fiat
money.
(1) Legal tender laws

You may have noticed that dollar bills say “legal tender” on them. This means that
the government mandates that dollars must be accepted as a way of paying off debt.
This law may help get money established. The term "fiat" means something like
command. The legal tender law is something like a government regulation
"commanding" that money be accepted in exchange.
(2) Faith in acceptability of money as generalized purchasing power, an implicit
social contract

But in a pure fiat money system, money is valuable because people believe it will
function as generalized purchasing power, not because government says that the
money is legal tender. It is this faith that really gives money value. If people did not
have faith in the value of money, legal tender laws would not really compel them to
accept money. They could always choose not to sell anything.

In cases of hyperinflation, people do not have faith in their money. This situation
causes all three functions of money to break down. If people are not willing to accept
money in transactions, then it cannot be used as a medium of exchange. If inflation is
high enough, then money is not a good store of value because it becomes worthless.
Finally, hyperinflation has caused some countries to change the unit of account role
of money (for example, knock a bunch of zeros off prices).
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4. Measuring Money

When economists talk about money, they are mostly talking about money other than
currency. Money can include checking accounts, savings deposits, money market
accounts, and other things depending on how broadly one defines money.
a) Dimensions of the concept of liquidity

Here are a variety of assets that could function as money. The term liquidity
measures the extent to which an asset functions as money. The more liquid an asset,
the more it is like money.

Two dimensions to liquidity
(1) Ease of transfer of asset into generalized purchasing power

In this sense, currency is obviously perfectly liquid because it is already generalized
purchasing power.

A check is a bit less liquid than currency. Many places will take checks. However, to
use a check at a place that does not accept checks, one must first cash it and exchange
it for currency.

Debit cards, which are like electronic checks, have made checking accounts more
liquid because more places accept debit cards than paper checks.

Treasury bonds or certificates of deposit (CD) are less liquid than checks. It is very
unlikely that a merchant would accept these assets as a form of payment. In addition,
there may be interest rate penalties for selling treasury bonds early. It also takes more
time to sell these assets for money, that is, agents must incur opportunity costs to turn
these assets into forms that can be easily used for purchases. In this sense, it is
difficult to convert treasury bonds to generalized purchasing power.
(2) Certainty of asset’s value in money terms

Liquidity is not just how easy it is to convert assets to currency, but also the extent to
which you know the exact nominal value of the asset.

A $1000 checking account is very liquid in this sense because the nominal value is
not going to change.

A share of IBM stock, however, is not very liquid in this sense. The value of the
asset changes all the time, and can potentially experience sharp fluctuations. A share
of stock is fairly easy to sell in exchange for cash. Therefore, it is liquid in the first
dimension of liquidity. In the second sense, a share of stock is not liquid.

Long-term bonds are less liquid than short-term bonds because interest-rate risk
causes the value of long-term bonds to fluctuate much more than for short-term
bonds. If you bought a 3-month Treasury Bill that yields 5 percent and interest rates
jump to 10 percent the next day, you lose the opportunity to make 5 percent interest
for just three months. But if the same thing happens the day after you buy a 10-year
Treasury Bond, the loss you face is much greater.
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b) Monetary aggregates

Economists have different definitions of money. The different aggregates are defined
by where you draw the line along the spectrum of liquidity. This line determines
whether a particular definition of money includes or excludes a given asset.

The two most common aggregates are M1 and M2.
(1) M1
(a) Definition

M1 includes those assets that can be directly used as money. M1 is currency people
hold outside banks and checkable deposits. (It also includes some other small items
such as travelers' checks.)
(b) Money used for transactions

M1 is supposed to be transaction money (but see below). In 2003, there were $694.1
billion in currency held outside banks and $649.6 billion in checkable deposits.
When we divide the sum of these two components of M1 by the current U.S.
population, the result is a surprisingly large amount of dollars ($2400) per U.S.
person. This number is inflated due to U.S. currency held outside the United States as
well as currency used in the illegal sector of the economy.
(c) Reasons for reduced usefulness of M1 in recent times of financial innovation

M2 has been more stable in recent years than M1, so M2 is the monetary aggregate
that is typically referred to as the money supply. Part of the problem with M1 is that
financial innovation has created new instruments that blur the line between accounts
used for exchange transactions and accounts used for saving.
(2) M2
(a) Definition

M2 is broader in its measurement of money that includes transaction accounts as well
as liquid savings accounts. M2 is all assets in M1 plus savings deposits + money
market mutual funds + some other assets. Money market mutual funds are assets that
invest in short-term U.S. Treasury debt to provide the holders of these funds with
some interest. Small certificates of deposit (with value less than $100,000) are
included in M2. "CDs" are assets that depositors agree to leave with the bank for a
specified period of time in return for a higher interest rate. If you sell a CD before the
term is finished, you have to pay an interest penalty.

It is not important that you know exactly which type of assets are in M2, but just that
you understand that it is a broader aggregate than M1.
(b) More focus on this aggregate recently because most assets in M2 can be easily
translated into transactions money

M2 includes assets that are liquid, but are not typically used for daily transactions.

Banks now offer their customers accounts called "sweeps." The customer can write
checks or use debit cards on a sweep account just like a normal checking account.
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
But at the end of each day the balance in the account is "swept" into an interestbearing account, like a money market mutual fund, that pays more interest than a
normal checking account.

The Fed will count the balance in such a sweep account as part of the money market
fund, not as part of a checking account. However, the owner of this account can use
it for transactions very easily.

Measuring money is a tricky business. You may have noticed that despite their
extensive use, credit cards do not appear anywhere in the above money aggregates.
To the extent that card holders pay their balances in full each month from their
checking/savings accounts, credit card balances would be captured in M2. If card
holders use their credit cards as borrowing instruments, in principle those loans
should be included in the money measures. Counting the entire credit line could be
misleading, however. There is no easy fix to solving this problem.
B. Banking and Money Creation
1. Fractional Reserve Banking
a) Origins of banking as “safe keeping” for gold and currency

One might think of banks as a place for keeping valuables safe. Historically, you can
imagine taking your gold to the “bank” to keep it safe in the vault.
b) Reason that banks can lend part of their reserves

However, when people “deposit” their gold, they usually leave it alone for a long
time. Thus, the gold tends to just sit in the bank.

Bankers realize that they don’t have to let the gold just sit there. They can lend at last
part of it out for interest and make higher profits.

But, the bank needs to keep some of its gold in reserve just in case a depositor wants
to make a withdrawal.
c) Definition of fractional reserve banking

This is “fractional reserve banking.” Banks take deposits in the form of money. But
they don’t let all of the deposited money just sit in their vaults. They keep just a
“fraction” of the deposits as “reserve.” The rest of the money is lent to others.

Fractional reserve banking is not only a technique to increase bank profits. It is also
critical to the creation of money within the banking system.
2. Money Creation

How do banks create the majority of money in M1 and M2? They do so by lending
out the money that people put in the bank. We will illustrate how this process works
with a simple example:
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a) Deposit of currency increases bank reserves

Suppose Person A starts with $1,000 in currency (paper money). If we focus just on
person A’s contribution to M1, the value of M1 is $1,000 (that is, $1,000 held in
currency outside of the banks).

Now, Person A deposits $1,000 of currency into her checking account in Bank X.
After the deposit, M1 still equals $1000, but it is now in Person A’s checking account
(the currency in the bank is not part of M1). M1 has not changed yet, but now Bank
X can use the currency in its vault to make loans. We say that Bank X now has
“reserves” equal to $1,000.
b) Banks use excess reserves to make loans

Because of fractional reserve banking, Bank X will not hold 100% reserves against its
deposits. Suppose the bank’s management decides its adequate to hold just 20%
reserves. Then Bank X has “excess reserves” of $800.
c) Loans create more money in circulation

Bank X makes a loan of $800 in currency (80%) to Person B. Now, Person B’s
currency holding contributes $800 to M1 (currency outside the bank). But person A
still has a $1,000 checking account, which is also part of M1. Thus, the M1 money
supply is now $1,800. The loan made by Bank X to Person B has raised the money
supply. This is the key step in the money creation process.
d) Continued lending and deposits of proceeds of loans in banks lead to a multiple
expansion of deposits and money through the banking system

This process will probably continue. Person B will likely spend that $800, and the
recipient of the $800 will deposit it in another bank. This new checking account will
also be used to lend money.

Suppose this new bank also holds only 20% reserves. Then it will make a loan of
$640 after it receives the $800 deposit ($640 = 0.8 * $800). Now the M1 money
supply is $1,000 + $800 + $640 = $2,440. We could continue the example even
further, but hopefully you get the idea that the money supply will rise by a multiple of
the initial deposit of $1,000.

The two necessary conditions for money creation through the process of lending are:
(1) Fractional reserve banking
(2) The acceptance of checking accounts created by the bank as money

If the bank held 100% reserves against its deposits, the process would never get
started.

I could create “money” if my IOU were accepted as generalized purchasing power.
Suppose you loaned by $20 and I wrote you an IOU. If you could take my IOU to the
bookstore and buy something with it, I would have created money.

Of course, the bookstore would not take my IOU. However, banks create an IOU that
does function as money when they accept a checking deposit. You put your money in
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the bank, the bank then lets you write special IOUs called checks that function as
generalized purchasing power.
(1) Money Supply = Money Multiplier * Reserve Base

We mostly talk about M1 but this process applies to M2 or any other measure of
money supply.

The reserve base is made up currency and Federal Funds (otherwise known as reserve
deposits). The reserve base is the money that the government creates which is why it
is known as high powered money.
(2) Money multiplier linked to the fraction of deposits banks hold as reserves

The money multiplier is the amount by which the original deposit must be multiplied
by to get the final change in the money supply. The initial deposit is called an
“injection of reserves” into the banking system. The total value of reserves is called
the “reserve base.”

The multiplier is a number greater than one.

You don’t have to know exactly what determines the size of the money multiplier.
But you should understand that the money multiplier will be larger if banks hold a
smaller fraction of their deposits as reserves.

If you go back to the example above, the expansion of M1 would have been even
greater if banks held just 10% of their deposits as reserves, rather than 20%.
e) If currency is withdrawn from banks, process works in reverse leading to money
destruction

The money creation process becomes a money destruction process if reserves are
taken from the system. If someone withdraws currency from the bank, the bank will
be short of reserves. When loans come due, the bank will not re-lend the money that
is repaid so that it can restore its desired reserve holdings. So, if reserves fall, the
money supply declines by a multiple of the amount reserves are reduced.
*** Spring 2013 class is responsible for material after this point ***
C. Monetary Policy


The Fed uses the banking system to control the money supply and interest rates.
The Fed could conduct monetary policy by simply printing paper currency, but it does
not use this method. Rather, it creates special checking accounts for banks called
reserve accounts. The banks can use the funds in their reserve accounts just like
currency to make loans. When the balances in these reserve accounts rise, the money
supply expands and interest rates fall.
1. The Federal Open Market Committee (FOMC)
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
The key policy body that decides on course of monetary policy is called the Federal
Open Market Committee (FOMC). It consists of the members of the Board of
Governors and presidents of the Federal Reserve district banks. Only a subset of the
12 regional Fed presidents are voting members of the FOMC each year. The voting
rights rotate among the presidents, with the exception of the New York Fed president
who holds permanent voting status (because the New York Fed actually undertakes
the operations to meet the targets set by the FOMC).

The Board of Governors resides in Washington D.C.. Governors are appointed by the
president and confirmed by the Senate for 14 year terms. Their long terms serve to
shield the governors from political cycles. Unlike the governors, the district bank
presidents are appointed independently of the political process.
o
Some critics of the Fed have pointed out that this feature makes the FOMC
rather “undemocratic.” Others argue, however, that political independence of
the Fed is essential to avoid pressures to stimulate the economy excessively
and create inflation.

The current chair of the Board of Governors is Ben Bernanke, who succeeded longtime chair Alan Greenspan in early 2006. Ever since Paul Volcker’s appointment as
Chairman by President Carter in 1979 there has been a lot of deference towards the
Board Chairman. There are no formal reasons for the general voting consensus
observed between the Chairman and the Board members. It is just the practical
reality.

The FOMC meets 8 times per year to analyze, and possibly adjust monetary policy.
FOMC meetings often generate a fair amount of interest in the business press.
2. Bank reserves and the federal funds interest rate

The Fed could operate monetary policy in a variety of ways. In the early 1980s, the
Fed specifically tried to target a value for the money supply. At that time, the Fed
would inject reserves (open market purchase) or drain reserves (open market sale) in
an attempt to hit its quantity of money target.

Now, rather than targeting a particular value for any measure of the money supply,
the Fed runs monetary policy by setting an interest rate called the federal funds rate.

The federal funds rate is the interest rate at which banks lend each other reserves.
Reserve accounts at the Fed do not pay interest, so if a bank has excess reserves
beyond what it needs to finance the loans it wants to make, it pays for the bank to
loan these reserves to another bank that may not have enough reserves to make all the
loans it desires.

Thus, the federal funds rate indicates the scarcity of reserves in the banking system.
If the Fed wants to stimulate the economy it will inject reserves with open market
purchases until the federal funds rate falls to a lower target. If the Fed wants to slow
down the economy, it will sell bonds on the open market and drain reserves until the
federal funds rate rises to a higher target. (See further discussion below.)

With the Fed’s current operating procedures, the federal funds rate is a direct
indicator of monetary policy.
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a) Open-market purchase

When the Fed wants to lower the federal funds interest rate, it injects bank reserves
into the system. If the Fed wants to raise interest rates it will remove ("drain")
reserves from the banking system.

Suppose the Fed wants to inject reserves into the banking system. It does so by
purchasing government bonds from banks. It pays for the bonds with reserve
deposits. The Fed literally "creates" reserve deposits it needs to buy government
bonds from banks at a price set by the money markets.

The price of bonds adjusts in the open market (bond prices rise and interest rates
fall—we will not explore this reverse relationship in detail here). Reserves become
less scarce, and therefore the federal funds interest rate that banks charge to lend
reserves to other banks declines

Banks ultimately use excess reserves to make more loans to businesses and
consumers. To lend out the excess reserves banks have to reduce interest rates.
Although the Fed specifically targets the rather obscure federal funds rate, the open
market purchase will eventually cause the interest rates on consumer and business
loans to decline as well.

Note that by creating excess reserves in the banking system, open market purchases
will raise the money supply. In the past (mostly in the 1980s and earlier), the Fed
measured its policy by how quickly the measures of the money supply were growing.
Now, however, monetary policy is measured by the federal funds interest rate, which
gives an index of how “scarce” monetary reserves are. (When reserves are more
“scarce” their price, that is, the fed funds rate, goes up and vice-versa.)
b) Open-market sales

If the Fed wants to decrease the money supply and raise the federal funds rate (if it is
worried about inflation for example), it will sell government bonds to the banks.
Banks will use their reserve deposits to buy the government bonds.

Reserves become more scarce, and the price of reserves (the fed funds rate) therefore
rises.

Reduction in reserves forces banks to contract their loans and interest rates on
consumer and business loans rises.

Another way to look at the effect on loan interest rates is to think of the fed funds rate
as the cost of money to the banks. If the banks want more reserves to make loans,
they can borrow reserves from other banks at the fed funds rate. When the Fed
engages in open market sales, the fed funds rate rises. This raises the cost of money
to the banks, and they therefore will charge higher interest rates to their household
and business customers. (The opposite interpretation can be used for open market
purchases discussed above.)
c) Open-market operations are the key day-to-day instrument used by the Fed to
control the money supply
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
These purchases and sales are called “open market” because the Fed does not coerce
the banks to buy or sell bonds. The Fed offers a market price at which the banks
voluntarily make the transaction with the Fed.

The New York Fed is the agent that actually undertakes the monetary operations
directed by the FOMC.
3. Money Markets and Interest Rates
a) Banks’ incentive to lower interest rates when they have excess reserves

Consumers and businesses do not borrow at the federal funds rate. But changes in the
federal funds rate usually lead to changes in the same direction in various market
interest rates.

If the Fed injects reserves into the banking system to lower the federal funds rate, the
banks’ cost of loans decline. Competition among the banks will lead them to reduce
the interest rates they charge to their customers.

Another way to look at this process is to recognize that reserves pay very little
interest (they paid no interest at all prior to 2007). If the banks agree to sell interestbearing government bonds to the Fed, they must intend to loan the reserves out.
(They don’t want to just sit on the barren reserve deposits.) To get people to borrow
the new reserves, the banks must lower interest rates.
o Think about it this way: Suppose you are one of ten people selling apples at a
stand along the street. You have priced them so that the demand for apples is
the same as the supply. You and all the other apple stands suddenly get a new
shipment of apples which you would like to sell. In order to sell these
additional apples, you will have to lower the price. In addition, you will not
be able to charge a higher price for apples than your competitors because
consumers could always go to the competition instead.
o This example is a simplified explanation of how an open market purchase
works. Of course, instead of selling apples, the banks are selling loans. And
instead of having a price for apples, the banks have an interest rate at which
they lend.
b) Banks’ incentive to increase interest rates when reserves are in short supply

If the Fed reduces reserves and raises the fed funds rate, the banks’ cost of funds will
rise. They will have to raise interest rates and cut back on their lending.

Market interest rates paid by households and businesses do not move in lock-step
with the federal funds rate. There are other influences on these interest rates that
move them around independently of monetary policy. But market rates do tend to
move in the same direction as the federal funds rate.
o It is easier for the Fed to control short-term market interest rates than it is to
control long-term rates.
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o This can create a problem for the Fed because some of the most important
interest rates for the economy, the 30-year mortgage rate for example, are long
term.
o In 2004 and 2005, the Fed increased the fed funds rate significantly, but the
30-year mortgage rate did not change much.
o The following graph provides interesting evidence. The lowest line is the
effective Fed funds rate. The changes in monetary policy are quite evident.
Notice the substantial drops in the Fed funds rate around the four recessions in
the period covered by the graph (designated by gray bars). Once the
recoveries of the mid 1990s and mid 2000s were underway, the Fed tightened
monetary policy again. Also notice how market interest rates somewhat
follow the Fed funds rate, but not at all in lock step. Indeed, when the Fed
raised the funds rate from 2004 to 2006, the long-term government bond rate
and 30-year mortgage rate rose very little. The short-term interest rate on 1year government bonds, however, moves in almost identical ways to the
policy-controlled federal funds rate.
4. Monetary Policy and Real Output: The Transmission Mechanism

Obviously, the Fed tries to stimulate the economy when it is below potential output.
It also tries to hold back aggregate demand when it fears inflation is about to rise.
The process through which the Fed controls the economy is called the “transmission
mechanism” of monetary policy.
a) Effect of money supply changes on aggregate demand
12

The Fed affects aggregate demand by changing interest rates.

An increase in money supply and a reduction in the fed funds rate controlled by the
Fed tends to lower interest rates throughout the economy (although not in lock step,
as noted above).

Lower interest rates encourage consumption (the cost of consumer loans falls and the
reward for saving decreases).

Interest rates are a powerful effect on residential investment through the cost of
mortgages.

If business interest rates fall, the cost of capital declines, both through lower interest
rates on loans and a lower opportunity cost of firms’ own funds that are invested. A
lower cost of capital stimulates business investment.

Lower interest rates also tend to reduce the value of the dollar and stimulate net
exports.

Effects are reverse for tight monetary policy that increases the fed funds rate.
b) Monetary policy for macro stabilization
(1) Expansionary monetary policy to offset the effects of negative demand shocks

If output is below potential (Y*), the Fed will likely try to shift AD up through lower
interest rates. You should know how to demonstrate this policy with the Keynesian
Cross diagram.

Thus, if the economy experiences a negative demand shock, such as the decline in
business investment after the bursting of the technology bubble in 2000 or the
massive bust in residential construction that led to the Great Recession, the Fed is
likely to cut interest rates.

For example, when economic weakness became evident in late 2000 and early 2001.
The Fed lowered the federal funds rate quickly, in several separate steps, from 6.5 to
3.0 percent before the September 11, 2001 terrorist attacks. Immediately after the
attacks, the Fed lowered the rate half a percentage point to 2.5 percent. (When
talking about interest rate changes, one one-hundredth of a percentage point is often
called a “basis point.” Thus, one could say the Fed cut the federal funds rate by 50
basis points immediately after the terrorist attacks.)

Because of the disappointingly slow (“jobless”) economic recovery in 2002 and the
first half of 2003, the Fed continued to cut the federal funds rate. It reached 1.0
percent in the summer of 2003. At the time, this was the lowest the federal funds rate
since the late 1950s suggesting that the Fed pursued exceptionally loose monetary
policy in the early 2000s.

Monetary policy was also loosened substantially as problems in housing finance
became evident. In the summer of 2007 (before the beginning of the official
recession in December 2007) rising mortgage defaults caused problems in financial
markets. In response to these concerns, the Fed began to cut the Fed funds interest
rate in August of 2007. Initially these cuts were small, from 5.25 to 5.00 percent.
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But as the problems in finance and the broader economy multiplied the Fed reduced
interest rates rapidly. By the middle of 2008, the Fed funds rate was 2 percent.
Further cuts followed the dramatic failure of Lehman Brothers investment bank in the
fall of 2008.
o By late 2008, the Fed funds rate was effectively zero. (The actual target range
for this rate became zero to 25 basis points.) This low rate has been in effect
for over three years. When the Fed funds rate hits this “zero bound” it can go
no lower. The implication for monetary policy is significant. (This idea is
developed further below.)
(2) Potential output as the target for monetary policy

As we have discussed all semester, the best level of output for the economy is
potential output, Y*. At this level of output, all resources are fully utilized.
Resources are not over-utilized, which means that Y* is sustainable in the long run
and people are not working more than they desire. Potential output is a target of
monetary policy.

In this context, note the interaction of the supply side and the demand side. The Fed
affects the economy almost exclusively through the demand side by changing
(3) Flexibility of monetary policy relative to fiscal policy

Monetary policy is much more flexible than fiscal policy in meeting this goal.
Lengthy political debates about which changes in spending or taxes should occur
make fiscal policy very cumbersome. In contrast, the Fed is largely independent from
politicians. When economic weakness emerges or inflation fears rise, the Fed can
change monetary policy quickly, sometimes within a few days in an emergency
situation.
(4) Dangers of inflation from excessive monetary expansion

In addition to output, however, the Fed also wants to keep inflation low and stable. If
AD exceeds the level consistent with Y* (or the Fed fears that further increases in AD
might push it above Y*), the Fed can restrain inflation by raising interest rates and
lowering AD.

There is a trade-off between output and inflation at least over a short horizon. If the
economy starts at a recession, we do not worry too much about this trade off. As you
will remember, at high levels of unemployment the curvature of the Phillips curve is
flatter, indicating that even large reductions of unemployment as the economy gets
out of recession will only be accompanied by small increases in inflation. (Indeed, if
inflation expectations fall during the recession, there may be no increases of inflation
at all.)

But if the economy is near Y*, the story changes. The KC diagram below shows the
possibility that AD may rise above AD*, the level associated with equilibrium at
point A and Y*:
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AD
AS
AD1
B
AD*
A
Y*
Y

Although Y* represents the highest level of output that is sustainable over a long
period of time, it's possible that Y could rise somewhat above Y* temporarily.
People could work overtime; some people could work more than they really want to
in the long term; firms may put off maintenance and use their productive capital more
intensively than they really want to. Thus, output could rise to a point like B when
AD is too high.

According to the Phillips Curve, however, excessive AD will lead to higher inflation,
even if it reduces employment somewhat. In the diagram below, unemployment rises
from U* to U1 and inflation rises from 0 to 1 (point A to point B).

1
B
0
A
U1

U0
This rise in inflation is undesirable. The Fed may tighten monetary policy to restrain
AD. This policy would involve draining reserves from the banking system to raise
the target for the federal funds rate.
o Question: does this action require an open market purchase or sale?
o Answer: Open market sales of government bonds lead banks to buy bonds in
return for bank reserves. So open market sales reduce reserves in the banking
system.
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
What if the Fed cannot quickly bring inflation down? The worry is that inflation
expectations will rise. This will shift the Phillips Curve upward. Even if
unemployment returns to U* (which is the unemployment rate that corresponds to
potential output Y*), inflation may be permanently higher:

C
1
B
0
Phillips Curve (High E)
A
U1
U*
Phillips Curve(Low E)

With higher inflation expectations, the economy ends up at point C. Output and
unemployment are at the desirable levels of U* and Y*, but inflation has risen and
there is no internal force to bring it back down.

In this situation, if the Fed wants to lower inflation, it may have to create
unemployment above U* to reduce actual inflation and bring down inflation
expectations. This is the kind of situation the economy experienced in the early
1980s. The unemployment during the 1980-1982 period was very painful.

As we discussed earlier, the message for the Fed and other countries' central banks is
not to let inflation expectations rise in the first place.

Consider the desirability of different monetary policies.
o The best policy, in principle, would be never to let AD rise above AD* so the
economy never leaves point A on the Keynesian Cross diagram above.
However, the Fed might not have adequate information to pull off this feat.
o The Fed might not recognize the inflationary pressure until actual inflation
begins to rise. The economy might get to point B. But if the Fed acts quickly
to restrain the inflation by tightening monetary policy, it might be able to
restore the economy to point A before inflation expectations rise.
o The worst scenario is that the Fed doesn't care about inflation or can't initially
tighten policy enough to reduce it. Inflation expectations rise. The Fed may
be able to achieve its target inflation rate by raising interest rates substantially,
most likely inducing a recession and the associated unemployment.
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o Again, this is the most common interpretation of what happened in the early
1980s when the Volcker Fed fought inflation aggressively with the highest
interest rates in modern U.S. history. Inflation came down as the result of the
deep recession, and inflation expectations eventually followed actual inflation
downward. But the cost in unemployment and decimation of the U.S.
manufacturing sector was severe.
(5) Pre-emptive strikes against inflation

The best policy described above requires the Fed to act before inflation heats up.
Thus, the Fed would have to raise interest rates before actually seeing inflation. In
academic and policy discussions this is called a "pre-emptive" strike against inflation.

To implement such a policy effectively, the Fed has to see the rise in AD above Y*
before unemployment falls and inflation rises. This may be difficult.

Furthermore, the Fed might make a costly mistake with pre-emptive strikes.
Remember that in talking about the practical challenges of fiscal policy we discussed
how it is tough for policymakers to know the level of Y*. Suppose actual output
were below Y*, but the Fed thought Y* had been reached. If the Fed forecast a rise
in AD, they might raise interest rates to strike against inflation. But the economy
might actually be able to expand further without much more inflation. The Fed might
indefinitely keep the economy below its potential.
o This issue was significant in the 1990s boom. When the unemployment rate
fell below 5%, many economist felt the Fed should take a pre-emptive strike
against inflation. But Alan Greenspan refused to do much. The expansion
continued and unemployment fell further without any significant inflation
increase.
o In mid 1999, however, with the unemployment rate close to 4%, the Fed
finally did raise interest rates pre-emptively from about 5% to 6.5%. But by
late 2000, the economy slowed significantly and it entered a recession in
2001. The economy might have slowed anyway, but the Fed's tighter
monetary policy certainly did not help matters. In retrospect, it looks like the
Fed should not have launched a pre-emptive inflation strike in 1999 and early
2000.
o In mid 2004, the fed funds rate had been at the very low level of 1% for some
time. The Fed became concerned that interest rates this low would eventually
ignite higher inflation. Once the recovery seemed more solid in mid-2004, the
Fed began to raise the Fed funds rate by 25 basis points each meeting, even
though there was no strong sign of higher inflation. The rise in energy prices
created by the continuing war in Iraq and Hurricane Katrina in August, 2005
may have exacerbated inflation concerns, but there was no significant increase
in actual inflation during this period. By the summer of 2006 it reached 5.25
percent. This rate is much higher than it was when the Fed was actively
stimulating the economy from 2001 through 2003, but it is still below the
level that prevailed through the 1990s boom.
5. Long-run monetary policy objectives
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a) “New consensus” macroeconomics

During the Great Moderation years (roughly the middle 1980s until the beginning of
the Great Recession in 2007) the mainstream of macroeconomic research converged
on a theoretical model with three key components:
o Aggregate demand drives economic fluctuations in the short run. The
interest rate is an important determinant of aggregate demand (for reasons
discussed earlier; you should know these reasons).
o Inflation is determined by two main variables: inflation expectations and
the level of aggregate demand relative to supply-determined potential
output (Y*)
o Monetary policy is an important determinant of interest rates. Monetary
policy should adjust to target a low level of inflation. It may also be
appropriate for monetary policy to respond to gaps between actual output
(Y) and potential output (Y*).

According to this model, monetary policy is the key mechanism for stabilizing the
economy.
o Note that fiscal policy does not appear prominently in the new consensus
relationships. According to the new consensus, monetary policy should be
adequate to get the economy close to Y* in a reasonable amount of time.
o In this model, fiscal policy should be set according to long-run
propositions about the appropriate size of government and taxes when the
economy is operating at Y*.
b) The Taylor Rule

Many economists argue that the Fed should adjust interest rates in response to two
main variables: the gap between actual and target inflation and the gap between
actual and potential output. In case either gap is positive, interest rate should rise. If
actual output and/or inflation are below target values, interest rates should fall.

This idea is embodied in a simple equation often called the “Taylor Rule,” after
Stanford economist John Taylor.

This behavior roughly describes how the Fed has behaved in recent years. The
Taylor Rule is one way of guiding the monetary policy piece of the new consensus
model discussed above.
c) Inflation targeting

Some economists believe the Fed should announce an explicit target for inflation.
Most proponents of this policy suggest a target of 1.5% to 2% per year.

The Fed currently tries to keep inflation low, so, in effect, it is "inflation targeting"
already. But the Fed does not explicitly announce a target number.

Why might an explicit inflation target help the economy? Consider the situation in
2003. The economy was recovering, especially in the second half of the year.
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Interest rates were very low. Some people were worried that the Fed will raise rates
soon, which could hurt the recovery. If the Fed announced a 2% inflation target,
however, people would not have to worry so much about higher interest rates.
Inflation was lower than 2%, so there would be no reason to expect higher rates. In
effect, the inflation target commits the Fed not to take a pre-emptive strike.
o This situation illustrates the concept of transparency. Many monetary
economists believe that it is important for households and businesses to
understand what the Fed is doing and what its objectives are. That is, they
argue that Fed policy should be “transparent.” This helps people form
good expectations. Policy surprises may cause uncertainty that reduces
household and business confidence, which might lower aggregate demand
(as we discussed some time ago).

Another benefit of an explicit target is that it would help to anchor inflation
expectations. Even if the inflation rate increased temporarily (due to a supply shock
for example), inflation expectation might not rise because people will trust the Fed to
bring inflation down to its target.

Note that an inflation target is similar to the Taylor Rule. The Taylor Rule explicitly
implies that interest rates should rise if inflation is above target levels. If inflation is
below target, the economy is likely weak, and interest rates should decline.

There are two possible disadvantages with the inflation target policy
o The economy is complicated and we might not be sure what the best policy
will be in future, possibly difficult, circumstances. Announcing an explicit
inflation target limits the Fed's flexibility to respond as it thinks best in each
situation. This criticism is similar to Alan Greenspan’s views. He did not
favor explicit inflation targets.
o When a big negative supply shock hits, like an increase in the cost of energy,
not only does inflation rise, but the economy might experience a recession, or
at least slower growth. (Remember the "stagflation" of the 1970s.) Strict
inflation targeting in the face of a negative supply shock would force the Fed
to tighten policy when the economy is weak. This action would be difficult to
take, and it may lead to bad political outcomes.

Ben Bernanke, the successor to Greenspan (in early 2006) as the chair of the Fed was
a strong advocate of inflation targets in his academic work. The Fed has now
explicitly stated that the target for U.S. inflation is about 2%.
6. Limitations of monetary policy (Discussed in class)
a) Problem if spending is inelastic to interest rates
b) The “zero bound” for interest rates
(1) Why nominal interest rates do not go negative
(2) Historical examples
c) Quantitative Easing
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