Welcome to Day 20
Principles of
Macroeconomics
Chapter 10
Financial Markets and
the Economy
Financial Markets are markets in
which funds accumulated by one
group are made available to
another group.
The bond market is a market in
which institutions and individuals
borrow and lend money. They do
this through buying and selling
bonds.
For example, this is where the U.S.
government sells their bonds, as we
discussed earlier.
You paid less than $100 for this bond,
then received its face value of $100
when it matured. The difference was
the interest.
The rate of interest was:
(Face Value – Bond Price)/Bond Price
So if you paid $90, then the interest
was:
($100-$90)/$90 = $10/$90 = .1111
= 11.11%
The higher the price you pay for
the $100 bond 1 year bond, the
lower the interest rate you get.
Pay $90, then i = 11.1%
Pay $95, then i = 5.3%
Pay $99, then i = 1.0%
So now we face a choice. Do we
want to think of the bond market
as one where people lend and
borrow money at a certain interest
rate, or buy and sell bonds at a
certain price?
nd
2
Textbook guy uses the
way. I
st
find the 1 more intuitive.
Here are both ways side-by-side. We will
primarily use the diagram on the right.
You’ve seen the 2nd diagram before back in
unit 2, where I called it the supply and
demand diagram for the credit market.
Interest
rate
Supply
(savings)
iE
Demand
(borrowing)
QE
Loanable Funds
Can changes in the interest rate that
comes out of the credit market affect the
macroeconomy?
Yes.
Much investment spending
done by businesses is
financed through
borrowing. The higher the
interest rate you have to
pay on a loan to get the
money to build a new
factory, the less likely you
are to build the factory.
Suppose for some reason there is an
increase in the amount available for
lending. This is an increase in supply in
the credit market.
Interest
rate
S1
i1
i2
S2
D1
Q1 Q2
Interest
Rates
Fall
Loanable Funds
The extra investment spending will
increase AD (GDP=C+I+G)
P
SRAS
P2
P1
AD1
Q1 Q2 QN
AD2
Q
This could
help get us
out of a
recession
You have a demand for money.
Do you always want more?
What can you do with your
purchasing power? 3 things.
1) Buy Goods
2) Buy bonds (or other high
interest investments)
3) Hold it as money
1) Why buy goods?
That’s obvious. You want them.
2) Why buy bonds?
To earn interest.
3) Why hold money?
Purchase future goods and services
easily. Money is very liquid.
If we look just at the choice to hold
money or bonds, we can think of the
interest rate as the opportunity cost
or “price” of holding money.
If the money itself earns interest,
such as an interest earning checking
out, it is the difference in the two
interest rates that matters.
The higher the interest rate goes
on the bonds you have to give up
to hold money, the less money you
want to hold.
Or the more bonds you want to
hold. The two statements are
functionally equivalent.
The more you hold of one, the less
you hold of the other.
Demand curve for money in terms
of interest for bonds.
What else affects the demand for
money?
1) Expected inflation – the more you
expect prices to rise, the less cash you
want to hold (remember the wealth
effect?)
2) Confidence in the future – if you fear
losing your job or that the bond you buy
may not pay off, you wish to hold more
cash.
Textbook guy lists a few more, but
you do not have to memorize the
others on the list.
I fear losing my job.
What about the
supply of money.
Let’s assume the
federal reserve
board can create as
much or little money
as it wishes through
open market
operations.
Equilibrium in the money market is
when people want to hold exactly
as much money as the fed has
created.
+
=
Why might you be unhappy with the
amount of money you have?
Suppose the interest rate is very
high. People won’t want to hold
much money, they will want to hold
bonds instead. If the Fed has
created a lot of money, people will
have “too much” money.
They will get rid of the excess by
saving it into the bond market.
They will do this by buying bonds.
The interest rate will fall until
people no longer feel they have
“too much” money.
Do people really think they have too
much money? Well, imagine you
have a huge cash stash in the cookie
jar and read that General Motors is
paying 100% on their bonds.
Wouldn’t you say I have too much
cash sitting around doing nothing
when it could be earning 100%?
If they have “too little” money,
they will get more by saving less
into the bond market (selling
bonds) and interest rates will rise.
There will be an interest rate at
which people want to hold the
exact amount of money created by
the Fed.
When we get to that interest rate, there
will be equilibrium in the money market.
The money market graph and the
credit market graphs are two sides of
the same coin.
Interest
rate
Supply
(savings)
iE
Demand
(borrowing)
QE
Loanable Funds
What we learned today.
1. The basics of financial markets.
2. What determines your demand for
money.
3. Equilibrium in the money market
and the credit market.
Welcome to Day 21
Principles of
Macroeconomics
What we learned last class.
1. The basics of financial markets.
2. What determines your demand for
money.
3. Equilibrium in the money market
and the credit market.
If the demand curve for money shifts,
the interest rate will shift. Suppose
people fear a big rise in inflation.
More
money
goes into
the bond
market
and
interest
rates fall.
If the Fed creates more money, people
put some of that money into the bond
market and interest rates fall.
Here we see what is simultaneously
happening in the credit market.
Interest
rate
S1
i1
i2
S2
D1
Q1 Q2
Interest
Rates
Fall
Loanable Funds
Why might the Fed want to do this? AS/AD
diagram showing the effect of more
investment caused by lower interest rates.
P
SRAS This could
P2
P1
AD1
Q1 Q2 QN
AD2
Q
help get us
out of a
recession
Chapter 11
Monetary Policy and the
Fed
What are the Fed’s goals?
1) Low Inflation
2) Low Unemployment
3) High Growth
The same 3 variables that we said
determine if the macroeconomy is
working well back at the beginning of
chapter 5.
So what should the fed do? Suppose
we are in a recession. In our model,
Q is in the recessionary gap.
How can we get out of the
recession? We could wait until
wages adjust, but with sticky wages,
that could take years … and years.
A quicker way out would be if the fed
could get AD to move right.
P
SRAS
P2
P1
AD2
AD1
Q1 QN
Q
Can
they
do
this?
The short answer is yes.
1) Fed buys government securities.
2) Banks have more funds to loan.
3) Drop in interest rates.
4) People borrow the new money
from the banks and buy things.
Voila, recession over!
This is known as expansionary
monetary policy. The fed creates
money and drives down the
interest rate to increase buying.
AD moves to the right and
increases output and lowers
unemployment.
We’ve already seen what
simultaneously is happening in the
credit market.
Interest
rate
S1
i1
i2
S2
D1
Q1 Q2
Interest
Rates
Fall
Loanable Funds
But what if the problem is we are
in the inflationary gap part of the
diagram. Can we get back to QN
without inflation?
Not if we wait for the natural longrun adjustment and the shifting
SRAS curve. But what if we move
AD to the left?
Out of the inflationary gap without
inflation.
P
SRAS
P1
P2
AD1
AD2
QN Q1
Q
To do this, we use contractionary
monetary policy. The fed decreases
the money supply, this decreasing
AD. After all, what is money used
for? So less money, less buying.
1) Sell government securities.
2) raise r.
3) raise the discount rate.
So to sum up:
To fight recessions, expansionary
monetary policy to move AD right.
To fight inflation, contractionary
monetary policy to move AD left.
Well, that sounds easy. In fact, it
sounds too easy. If
macroeconomics is that simple,
why do we have such a hard
problem with recessions and
inflation?
There are multiple possible
problems.
The first we are going to talk about
is lags. Lags are the time between
something happening and the end
effect of that thing happening.
The first lag we are going to talk
about is called recognition lag.
Recognition lag is the delay
between the time a
macroeconomic problem occurs
and the time policy makers
become aware of it.
The textbook discusses 1990
recession as an example, but I will
go more recent than that. Minutes
from fed meetings are released
with a 5 year lag, so we can now
see what the fed was doing in
2008/2009 as the economy went
into the tank.
We see that even as the economy
was entering the worst recession
since the great depression, the fed
in September 2008 couldn’t decide
if recession or inflation was the
biggest danger. So they decided to
do nothing. No discount rate
changes, no major open market
operations.
In retrospect a big mistake. When
they realized this, they lowered the
discount rate and did major open
market buying, but now the
recession was rolling and its harder
to stop a rolling boulder than to
keep it from starting to roll in the
first place.
Then comes the implementation
lag. Implementation lag is the
delay between the time policy
makers become aware of a
problem and the time they enact a
policy to deal with it.
For the Fed, the implementation
lag is quite short. They can decide
what to do and then do it quite
quickly. But remember this lag
when we get to the last chapter
and talk about actions congress
can take.
Finally comes the impact lag.
Impact lag is the delay between
the time a policy is enacted and
the time it has its effect on the
macroeconomy.
So the fed decides to create a lot of
new money to increase AD and buys
a lot of government securities from
banks. This first step accomplishes
nothing by itself. We have to wait
for the banks to lend out the money.
And even this first effect will be
small because …
Much of the effect happens when
the banks get the money back and
lend it out again … and again … and
again. It could take many months for
the buying of securities to result in
people having a lot more money and
buying lots more stuff.
The textbook says conventional
wisdom is it takes from 6 months
to 2 years for open market
operations or a change in the
discount/federal funds interest rate
to have its full effect on the
macroeconomy
Putting these 3 lags together:
1) Recognition Lag
2) Implementation Lag
3) Effect lag
We can see that the fed has to
either risk being too late or act on
its predictions about the future,
which could be wrong.
There is a view that in the 1970’s,
the fed made things more unstable
instead of less because lags were
making their decisions the wrong
ones.
What we learned today.
1. How changes in the credit market
affect RGDP.
2. What expansionary and
contractionary monetary policy is.
3. What the lag problem is.
Welcome to Day 22
Principles of
Macroeconomics
What we learned last class.
1. How changes in the credit market
affect RGDP.
2. What expansionary and
contractionary monetary policy is.
3. What the lag problem is.
While the fed looks at many things in
setting policy, it is accurate to say that
the most important thing they have
looked at in setting policy in the 21st
century has been inflation. The fed
has “targeted” a goal of 2% inflation.
They don’t try to hit 2% inflation every
month, but over what they call the
medium term.
When inflation has gone above 2%, the
fed has decreased the money supply to
decrease AD and when it has been below
2% they have increased the money
supply … in general.
Now textbook guy writes “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.” So why did I just say the
fed increases or decreases the
money supply?
Suppose you are selling hamburgers.
Currently the price is $1.20 and you are
selling 300 a day. You lower the price to
$1.00 and sales rise to 350 a day.
Have you changed the price of
hamburgers or have you changed the
number you sell?
Are the sellers picking the price
or the quantity?
P
$1.20
$1.00
D
300 350
Q
These are not separate decisions
that can be analyzed separately. To
decide to do one means to decide
to do the other. We chose
between describing the outcome
as changing the price or changing
the quantity merely as a matter of
convenience.
Now money has a demand curve. If the
fed wants to lower the interest rate from
5% to 4%, what do they have to do?
i
5%
4%
D
3 Trillion 3.6 Trillion
Money
Market
Q
It doesn’t matter that the fed may
describe this as a lowering of the
interest rate, it is just as much a
decision to increase the money
supply. That is what they have to
do to support the lower interest
rate.
Another problem the fed may have
in a bad recession beyond lags is
something called a liquidity trap or
the zero bound problem.
The usual way monetary policy
works is that the fed creates bank
reserves, the banks lower interest
rates and people borrow the new
money and spend it.
But what if the interest rate is
already zero?
The new money would just sit in
the bank vault unspent. In fact, it
is worse than that, because the fed
pays interest on bank deposits at
the fed. Very little interest
(0.25%), but still a positive amount.
The monetary base is currency
(both inside and outside banks)
and bank deposits at the fed.
The fed has greatly expanded the
monetary base as part of its
expansionary monetary policy.
https://research.stlouisfed.org/fred2/
series/BASE/
And what has happened to the
money supply?
https://research.stlouisfed.org/
fred2/series/M2/
The monetary base has gone from
800 billion dollars to 4,000. That is
an increase of 500%. The money
supply (M2) has risen from 8,000
to 11,000. An increase of 37.5%
How is this possible?
https://research.stlouisfed.org/
fred2/series/EXCSRESNS
Almost as fast as the fed has been
shoveling money into the economy, the
banks have been shoveling it out again.
Normally, they would loan it out to
businesses and consumers, but
remember, we are almost at 0% interest,
so there is no benefit to doing so. Better
to be safe and store it at the fed
In any case, people wouldn’t want to
borrow it unless the interest rate fell,
but the bank won’t loan at negative
interest.
If businesses had confidence in the
future, they would be willing to pay
higher interest rates than the fed does
to finance investment projects, but they
don’t, so they don’t.
So here we sit, stuck in a bad
economy despite expansionary
monetary policy.
So what can we do? There are 2
things we could try. One is the
subject of chapters 12 and 13. Before
we look at the other, we have to learn
one of the two most famous
equations in macroeconomics
We are skipping over rational
expectations in the textbook here
to talk about the equation of
exchange. We will cover rational
expectations, but in the next
chapter.
Imagine a society with no checks or
credit, only cash. This economy
has $1 million cash in existence. Is
it true that in the course of a year,
the people of this country must
buy exactly $1 million dollars
worth of things?
A dollar can be spent more or less than
1 time during a year. How many times
the average dollar is spent on final
goods and services is the velocity of
money.
Now suppose $1 million dollars
exists and each dollar is spent 4
times during the year. Do we know
that the people bought $4 million
dollars worth of stuff?
Yes.
M x V = GDP
M = Money Supply
V = Velocity of Money
It is also true that
GDP=(Pa)(Qa)+(Pb)(Qb)+…+(Pz)(Qz)
so
GDP = P x Q
P = Average Price of Things
Q= Quantity of Things Made
Put these together and you get
MxV=PxQ
This is called the equation of
exchange.
Textbook guy uses Y in place of Q.
What we learned today.
1. How the fed can be described as
either setting interest rates or the
quantity of money.
2. What the zero bound problem is.
3. The equation of exchange –
MxV=PxQ
Welcome to Day 23
Principles of
Macroeconomics
What we learned last class.
1. How the fed can be described as
either setting interest rates or the
quantity of money.
2. What the zero bound problem is.
3. The equation of exchange –
MxV=PxQ
MxV=PxQ
Why do this? Because now we
have an equation relating the
amount of money to the things we
really care about, namely Q and P.
But it is not helpful yet, because at
this stage, an infinite number of
things could still happen. This
model needs more structure.
The Simple Quantity Theory of
Money is that if V and Q are fixed,
then changes in the money supply
cause equal percentage changes in
prices.
Let’s assume V and Q are fixed and start
moving the money supply around.
MxV=PxQ
$100 x 4 = $2 x 200
$200 x 4 = $4 x 200
Ms up 100%, P up $100%
$300 x 4 = $6 x 200
Ms up 50%, P up 50%
$250 x 4 = $5 x 200
Ms down 16.67%, P down 16.67%
Why does this happen? Imagine
you go to the store and spend $10
to buy 10 apples every month.
Now the money supply is doubled
so you have twice as much money.
If V is fixed, you now spend $20
trying to buy 20 apples. Are there
more apples for you to buy?
No, because Q is fixed also. Now if
it was just you, you would buy 20
apples; but it is not just you, it is
everybody trying to buy twice as
many apples. There will be an
apple shortage. What does the
price of apples have to rise to until
$20 buys 10 apples again?
So double the money supply,
double prices.
While the simple quantity theory is
too simple for many cases, it does
answer some questions. For
example, why does the
government need taxes when it can
just print up the money it needs?
And, in fact, long-term inflations or
hyperinflations are almost always the
result of the government increasing
the money supply (a lot) to pay for
things.
1) Germany after World War I
2) South American countries in the
1950’s/60’s
But will Q stay fixed when the
government increases M?
Let’s investigate. To keep things
simple, let’s assume V does stay
fixed fixed.
MxV=PxQ
$100 x 4 = $2 x 200
Now double the money supply
$200 x 4 = $? x ?
There are an infinite number of P’s
and Q’s that would solve this, so
what to do? Bring in our old
friend, the AS/AD diagram.
MxV=PxQ
$200 x 4 = $2 x 200
P
SRAS
What are
Q and P
on the
diagram?
$2
AD1
200
Q
M x V = AD
Assuming V stays the same,
doubling the money supply means
doubling buying or doubling AD.
AD2 is a doubling of AD1
P
SRAS
?
$2
Now we can
just read the
new Q off
the diagram
AD1
200 250
Q
AD2
MxV=PxQ
$100 x 4 = $2 x 200
$200 x 4 = ? x 250
MxV=PxQ
$100 x 4 = $2 x 200
$200 x 4 = P x 250
P = $3.2
Money supply rose 100%.
Quantity rose 25%.
Prices rose 60%.
Why aren’t prices doubling here?
What about the long-run?
P
SRAS
P3
3.2
$2
Assume Q =
200 is Qn.
What is P3?
AD1
200 250
Q
AD2
P3 is $4. The assumption that Q is
fixed is a better long-run assumption
than short-run.
MxV=PxQ
$100 x 4 = $2 x 200
$200 x 4 = $3.2 x 250
$200 x 4 = $4 x 200
What if V is not fixed? We would
do the same trick of figuring the
new M x V to find AD and shift to
the new AD on the diagram, but it
would be harder. How does the
change in M affect V?
Factors That Affect V
1) Expected Inflation.
2) Interest Rates
3) Confidence in the Future
More money probably means higher
expected inflation, so V increases.
At least in the short-run, more money
might mean lower interest rates, so V falls.
You would probably need a
computer model to sort this out.
Here is what has happened to V
The rise in the money supply of
37.5% has been offset by a drop in
velocity of around 18%.
So increase the monetary base by
500%, have most of that go to
excess reserves and have velocity
drop by almost 20%, and you get a
weak recovery.
Could the fed had done more?
Some monetarists say yes.
Monetarists are a school of
economists that believe the most
important thing that determines
nominal GDP is the money supply.
The most famous and first
monetarist was an economist
named Milton Friedman.
He looked at the
relationship between
NGDP and the money
supply from 18671960 and believed he
found a close
relationship, implying
V was stable.
He also found there had been a
large drop in the money supply
during the Great Depression, which
he posited as its largest cause.
Why would there be a drop?
People grew fearful of banks and
closed their checking accounts.
M1 during the Great Depression
Out of this, he proposed a money
supply growth rule.
MxV=PxQ
If you think V is relatively stable,
and Q grows at an average of 3% a
year, and you want stable prices,
what should M grow at?
So Friedman proposed replacing
the people on the federal reserve
board with a computer programed
to buy and sell government
securities to cause the money
supply to grow at 3% a year.
When V dropped, you would still
have a recession, but Friedman felt
this was better than what the fed
was doing in the 1970’s, which was
guessing wrong and causing
recessions
Such a rule might not work well for
long persistent recessions, like this
one.
The new thing in macroeconomics
is called market monetarism. It is
a, perhaps, logical extension of
Friedman’s ideas.
Market monetarism, most closely
associated with an economist named
Scott Sumner at Bentley University in
Massachusetts. I mention this
Bentley is not usually considered a
heavy hitter in economics. Usually
important new ideas come from Yale,
Princeton, University of Chicago,
M.I.T, that sort of place.
So how did Scott Sumner get
influential? He used his blog –
“The Money Illusion”
It is the first case of a blog being
important in macroeconomic
theory.
Market Monetarism says the fed
should target the level of NGDP, and
specifically target a growth path of
5% a year. Why 5%? That allows for
3% real growth and 2% inflation in a
typical year.
He wants to stop things like this.
Critics say the fed can not do this,
because the zero bound problem
means the fed can not raise NGDP
when interest rates hit 0%.
The Market Monetarists have two
answers.
What we learned today.
1. The simple quantity theory of
money.
2. How to use the equation of
exchange when Q is not fixed.
3. Three factors that affect the
velocity of money.
4. Who monetarists are and what
market monetarists think the fed
should do (target NGDP).
Welcome to Day 24
Principles of
Macroeconomics