Quantitative Easing and Recent Monetary Policy
November 30, 2009
Nottingham University
Richard Anderson
Economist, Federal Reserve Bank of St Louis
Leverhulme Visiting Professor, Aston University
Outline
•
•
•
•
Discuss “conventional” and “unconventional” monetary policy
Discuss Quantitative easing
Discuss U.K. Asset Purchase Facility and QE
Discuss Federal Reserve implementation of quantitative
easing
• Discuss “exit strategy”
• Examine a simple putative long-run demand for the adjusted
monetary base in the United States, 1919 – 2008.
Additional background on the financial crisis and US financial markets is
available on my web page in two presentations from November 2008 at Aston
University (research.stlouisfed.org/economists/anderson) or something close to
that… try a Google search
QE and Demand for the Monetary Base
2
Conventional and Unconventional Monetary Policy
Conventional:
– “The key purpose of monetary policy is to preserve price
stability.” [A. Meier, 2009, IMF]
– Monetary policy implementation is via targeting a shortterm interest rate (almost always, the overnight cost-ofcarry on central government debt)
– Mainstay of New Keynesian macro models (and RBC
models)
Does this mix objectives and constraints?
– Inflation of the 1970s: peak 24 (26?) percent Britain, 10-13
percent U.S.
– Fiscal pressures on monetary policy
QE and Recent Monetary Policy
3
“Traditional” (Historical) Monetary Policy
• Provide means of payment that is irrevocable/final, efficient,
honest (above corruption or debasement)
• Monitor/assure financial stability (avoid and/or temper
financial panics)
• Emphasis on CB’s balance sheet
Bank of England in the 19th century, especially beginning 1825
– Specie or BOE notes as prime assets during panic: flight to quality and
liquidity (counterparty risk, opaque balance sheets)
– As country banks held fewer and fewer notes, burden on BOE
increased
– BOE policy: Halt panic at any cost, then lend only against good
collateral to avoid itself failing [modern fiat money central banks
cannot fail in that fashion]
Federal Reserve at its founding after Panic of 1907
• Gold standard was to provide price stability (nominal anchor)
4
“Unconventional” Policy
• Everything except conventional policy
• Lending to banks against collateral [nice or not], foreign and
domestic (Federal Reserve)
• Equity interests in banks (ring-fencing assets on-balance
sheet)
• Purchasing private assets (with default risk)
• Purchasing large quantities of government debt (no default
risk)
Rather conventional when compared to BOE in 19th century…
• Halt the panic
• Extend credit against good collateral [usually]
• Two years or so for things to get sorted
5
Large balance sheet changes are more “conventional” than one
might think.
• Goodfriend and King (JME, 1981) noted in a simple RE model
that large balance sheet changes could be an effective
monetary policy instrument so long as the central bank could
credibly commit to the increases being temporary (rather
than financing fiscal deficit)
• A number of central banks have embraced this lesson
6
All are normalized to 100 at first
observation
Demand for the Monetary Base
7
• In some cases, these increases were
accompanied by the policy rate nearing zero,
but not all … the next slide shows policy rates
(be careful, scales differ on some panels)
8
Demand for the Monetary Base
9
Countries with Major Increases in the Monetary Base
Country
Measure of
Monetary Base
Reference Date
Range
Starting
quantity
Ending
quantity
Reason
Argentina
Monetary Base
Dec 2001 – Jun 2008
11,981M
102,223M
Belgium
Aug 2008 – Sep 2008
Dec 2008 – Jun 2009
90,431M 166,316M
141,216M 102,704M
Jul 1994 – Aug 1994
Dec 1998 – Jan 1999
9,658M
20,698M
21,304M
3,844M
Hong Kong
Currency and
Liability to banking
Institutions
Currency and
Reserves of
depository banks
Monetary Base
political meltdown, high inflation,
753.21% 11.88%
and expansionary policy
likely to be a quantitative easing
83.91% N/A
related to the current global
recession
related to the 1990s Finnish banking 120.58% 1.55%
crisis
Oct 2008 – Jul 2009
363.35B
771.17B
Iceland
Monetary Base
Q1 2006 – Q3 2007
35,825M
111,175M
Ireland
Currency and
Liability to banking
Institutions
Reserve Money
(M0)
Reserve Money
(M0)
Jun 2008 – Mar 2009
38,194M
125,349M
Jan 1997 – Dec 1997
28,095M
56,659M
Mar 2001 – Mar 2003 68.64T
Mar 2006 – May 2006 110.63T
106.29T
93.04T
the Japanese quantitative easing
54.85%
-0.27%
likely to be a quantitative easing
related to the current global
recession
started paying interest on reserve to
create a liquidity management
regime
Reason
90.04%
N/A
99.91%
3.24%
Finland
Israel
Japan
Currency and
May 2008 – Oct 2008
Liability to banking
Institutions
New Zealand Reserve Money
Jun 2006 – Oct 2006
(M0)
59.74B
113.53B
5,333M
10,661M
Country
Measure of
Monetary Base
Reference Date
Range
Starting
quantity
Ending
quantity
Qatar
Reserve Money
(M0)
Oct 2007 – Jul 2009
14,379M
41,107M
Russia
Monetary Base
Sweden
Reserve Money
(M0)
Netherland
likely to be a quantitative easing
related to the current global
recession
related to the Icelandic financial
crisis, and the nationalization of
failed banks
likely to be a quantitative easing
related to the current global
recession
not clear
likely to be a quantitative easing
related to the current global
recession
Apr 2006 – May 2007 2,864.8B 5,350.8B
likely to be a budget stimulus plan
(fiscal policy)
Oct 1993 – Mar 1994 95.52B
204.69B
related to the government bailout of
Demand
for the Monetary
Base
May 1996 – Feb 1997
156.68B
81.11B
early 1990s credit crunch
%
Following
Increase Inflation
N/A
210.33% 8.13%
228.19% N/A
101.67% 4.39%
%
Following
Increase Inflation
185.88% 14.4%
86.78%
10.93%
114.29% 2.07%
10
Sweden
Reserve Money (M0)
Sep 2008 – Dec 2008
105.92B
319.07B
Switzerland
Monetary Base
Nov 2008 - Apr 2009
55.63B
117.95B
UK
Reserve Money (M0)
Jan 2009 - Jun 2009
68.69B
181.44B
US
Monetary Base
Sep 2008 - Jul 2009
900.6B
1668.3B
Australia
Monetary Base
Aug 2008 – Dec 2008
47,728M
73,596M
Australia
Denmark
Denmark
Denmark
Denmark
Norway
Monetary Base
Reserve Money
Reserve Money
Reserve Money
Reserve Money
Dec 2008 – Apr 2009
Jul 1985 – Apr 1986
Jun 1986 – Sep 1986
Dec 1998 – Dec 1999
Apr 2000 – Jul 2000
2002 - 2003
73,596M
19.01B
54.80B
97B
153.44B
54,676M
59.89B
26.60B
192.86B
57.74B
likely to be a quantitative easing related
to the current global recession
likely to be a quantitative easing related
to the current global recession
a quantitative easing related to the
current global recession
a quantitative easing related to the
current global recession
likely to be a quantitative easing related
to the current global recession
201.24%
N/A
112.03%
N/A
164.14%
N/A
85.24%
N/A
Privatization??
11
Country
Measure of
Monetary Base
Reference Date Range
Starting
quantity
Ending
quantity
Venezuela
Uruguay
Uruguay
Peru
Paraguay
Panama
Panama
Ecuador
Bolivia
Brazil
U.A.E.
Saudi Arabia
Oman
Libya
Lebanon
Lebanon
Kuwait
Egypt
Egypt
Bahrain
Iran
Ukraine
Tajikistan
Slovak Rep
Slovak Rep
Turkey
Serbia
Poland
Kazakhstan
Czech Rep
Croatia
Bulgaria
Bulgaria
Bosnia
Bosnia
Reserve Money
Monetary Base
Monetary Base
Monetary Base
Monetary Base
Reserve Money
Res erve Money
Reserve Money
Reserve Money
Reserve Money
Reserve Money
Reserve Money
Reserve Money
Monetary Base
Reserve Money
Reserve Money
Monetary Base
Reserve Money
Reserve Money
Reserve Money
Reserve Money
Monetary Base
Reserve Money
Reserve Money
Reserve Money
Reserve Money
Reserve Money
Reserve Money
Reserve Money
Reserve Money
Reserve Money
Reserve Money
Reserve Money
Reserve Money
Reserve Money
Jun 2006 – Dec 2008
Sep 2004 – Dec 2006
Nov 2007 – Dec 2008
May 2006 – May 2008
Nov 2008 – Jun 2009
Nov 2002 – Dec -2002
Sep 2007 – Jan 2008
Jul 2007 – Jul 2008
May 2005 – Sep 2008
May 2006– Dec 2008
Jan 2007 – Nov 2007
Jan 2008 – Sep 2008
Aug 2007 – Dec 2008
May 2007 – Aug 2008
Mar 2003 – Oct 2008
Jan 2008 – Jul 2009
Nov 2006 – Mar 2007
Nov 2001 – Nov 2002
Aug 2006 – Jul 2008
Oct 2007 – Feb 2008
Feb 2006 – Mar 2008
Feb 2007 – Dec 2008
Dec 2004 – Dec 2008
Feb 2007 – Mar 2007
Mar 2007 – Apr 2007
Oct 2002 – Dec 2002
Jan 2005 - May 2006
Sep 2007 – Oct 2008
Oct 2008 – Jul 2009
Jan 1995 – Dec 1995
Jan 1993 – Oct 1993
Nov 1996 – Jul 1997
May 2007 – Dec 2007
Sep 1999 – Dec 1999
Sep 2001 – Dec 2001
26,530M
11,970M
25,389M
10,861M
6715.8M
100.9M
276.6M
937.5M
7,023M
86,159M
89,008M
117.14B
800.8M
17495M
14680B
29435B
1631.7M
40,070M
221429M
934.7M
181,385B
92,719M
276.9M
182698M
342597M
10,252M
141538M
96,869M
1296.1B
213.78B
215.7M
193M
9,678M
383M
1,121M
83,745M
24,590M
40,788M
20,663M
9327.4M
210.9M
371.7M
1907.9M
28,727M
146,617M
261,767M
178.65B
2061.2M
36107.2M
29279B
49344B
4432.7M
102,094M
362,440M
1,809M
382,980B
186,671M
1897.2M
342,597M
161,567M
21,432M
327,006M
135,062M
2669.3B
342.77B
1494.2M
1,543M
14,301M
828M
2,543M
Reason
Increase
(ratio)
3.2
2.1
1.6
1.9
1.4
2.1
1.3
2.0
4.1
1.7
2.9
1.5
2.6
2.1
2.0
1.7
2.7
2.5
1.6
1.9
2.1
2.0
6.9
1.9
0.5
2.1
2.3
1.4
2.1
1.6
6.9
8.0
1.5
2.2
2.3
Subsequen
t Inflation
30%
12
Overview of Recent U.K. and U.S. QE
• Both the BOE and the Fed have purchased approximately onequarter of their countries’ respective privately held, interestbearing, central government debt
– US: $2-1/2 T of $1T
– UK: £180B of £600B
• Both suggest longer-term market yields are 120 to 150 bps
lower than they otherwise would be
• Neither (?) has a model to support this conclusion
U.K.: Bank of England QE
• January 2009: Chancellor of the Exchequer authorizes BOE to
create Asset Purchase Facility
– Purchase assets financed by issue of Treasury Bills.
– To improve liquidity in financial markets
• MPC reduced Bank Rate to 0.5 percent (frictionally above zero),
risk that inflation might undershoot 2 percent target
• First QE purchase: 1st week of March
• Later in March: ₤75B gilts
– ₤12.9B gilts, ₤982M commercial paper, ₤128M commercial bonds
• May: set target of ₤125B [August MPC: full ₤175B
– Owned ₤93.3B gilts, ₤2.1B c.p., and ₤0.75 commercial bonds
• November: ₤178.3B
– Purchased ₤1.7B gilts 17 Nov 2009 approx 4.3% yield
14
Demand for the Monetary Base
15
Demand for the Monetary Base
16
Demand for the Monetary Base
17
250
200
U.K. Monetary Base
150
100
50
0
Calculated by author as the sum of currency in circulation plus deposits (current
accounts) of banks at the BOE
18
Demand for the Monetary Base
19
Demand for the Monetary Base
20
Demand for the Monetary Base
21
Demand for the Monetary Base
22
Federal Reserve
• The Federal Reserve has pursued “unconventional” monetary policy since
August 2007
– Reduction in policy target rate (overnight interbank rate)
– Direct lending and discounting
• On balance sheet (TAF, TALF, central bank currency swaps)
• Off balance sheet via special purpose entities
• “Credit easing”
• Focus on composition of assets, not quantity
• “Quantitative Easing” since early 2009
– large scale asset purchase program
• “Agency” (housing GSEs) debt, MBS
• Longer-dated Treasuries
• Monetary base will be $2.4T 2010 Q1, with reserves balances > $1.4T (vs
$10B in 2007 Q1)
23
Background in US financial instruments
• Treasury securities (US Treasury)
–
–
–
–
Full faith and credit of US government
Bills (discount issues, no coupon, up to 52 weeks)
Notes (coupons, 1-10 year)
Bonds (coupons, >10 years)
• Mortgage-backed securities (MBS)
– Purchase mortgages, bundle into legal trust, sell shares in trust
– Amortized (shorter McCauley duration)
– Private issuers and federal government issuers
• Private issues (investment banks as packagers)
• First MBS issued privately 1970s
• Few private issues until 1999-2000
• Strong private issuance through 2007, few now
24
U.S. Mortgage-backed securities: Government issue
• Government National Mortgage Association
(GNMA, Ginnie Mae)
– Government agency
– Issues backed by full faith and credit of the US government
• Federal National Mortgage Association (FNMA, Fannie Mae);
Federal Home Loan Mortgage Corporation (FHMLC, Freddie
Mac)
–
–
–
–
–
Government-sponsored enterprises (GSEs)
Charter from the Congress
No explicit Congressional guarantee
Subsidies since Sept 2008
Almost equivalent to Treasury debt
25
Quantitative Easing I
• New Keynesian models (sticky prices/wages, imperfect competition in
product and labor markets, all financial assets perfect substitutes,
inflation forecast-targeting monetary policy)
• Policy rate at zero bound
• Policy effect due to promise to maintain policy rate at zero for an
“extended period”
• What is an extended period?
– When aggregate demand strengthens and forecasts suggest higher
inflation, delay increasing policy rate => future higher actual
inflation (above policy goal)
– Sustaining the nominal rate and increasing future expected inflation
=> lowering future real rates => shifting spending forward
• Balance sheet increases are a commitment mechanism to increase the
cost of policymakers reneging on the “extended period” promise
26
Quantitative Easing II
• But central bankers pledge no future higher inflation
• What channel remains?
• Credit channel (Bernanke and others)
• In Bernanke’s writing, an amplifier to the interest rate channel, not a
substitute or alternative
• Bank lending channel
• Operating in the US, loans readily available for good credit
• Off-balance sheet bank lending (ABCP conduits) (Anderson &
Gascon, FRB StL Review, 2009)
• Strong bank lending 2008 Q4
• Contraction in 2009 likely a good thing
• Balance sheet channel
• Massively alter the balance sheet of the private sector (because the
elasticities of substitution among high-quality financial assets are
large => small price impact)
27
Targeted Interest Rate and Monetary Base Growth
Percent change at an annual rate
Adjusted Monetary Base
350
280
210
140
70
0
-70
-140
2006
2007
2008
2009
Reserve Market Rates
8.00
Effective Federal Fund Rate
7.00
Intended Federal Fund Rate
Primary Credit Rate
Percent
6.00
5.00
4.00
3.00
2.00
1.00
0.00
2006
2007
2008
2009
28
Up-to-date and easier to read versions are available in US Financial Data, a
weekly web publication of the Federal Reserve Bank of St Louis
Composition of Federal Reserve Assets and Liabilities
Demand for the Monetary Base
29
The Federal Reserve Balance Sheet: Assets
Total assets: 2.164 Trillion (↑193 billion from 1 year ago / ↑1.28 trillion from 2 years
ago)
•
Securities held outright: 1.69 Trillion Dollars (↑1.2 trillion)
– U.S. Treasury securities: 775 Billion (↑298 billion)
– Federal agency debt: 142 Billion (↑128 billion)
– Mortgage backed securities: 774 Billion (↑774 billion)
•
Term Auction Credit: 139 Billion (↓162 billion)
•
Other loans: 109 Billion (↓260 billion)
•
Commercial Paper Funding Facility: 19 Billion (↓126 Billion)
•
Central Bank Liquidity Swaps: 33 Billion (↓466 billion)
30
The Federal Reserve Balance Sheet: Liabilities
Total Liabilities: 2.112 Trillion (↑182 billion from 1 year ago / ↑1.26 trillion
from 2 years ago)
• Federal Reserve Notes: 875 Billion (↑51 billion)
• Deposits: 1.159 Trillion (↑153 billion / ↑1.133 trillion)
– Depository institutions: 1.083 Trillion (↑657 billion / ↑1.063 trillion)
– U.S. Treasury, general account: 31 Billion (↑11 billion / ↑26 billion)
– U.S. Treasury, supplementary financing account: 30 Billion (↓529
billion)
Demand for the Monetary Base
31
Bank Lending Channel
Total Loans and Leases at Commercial Banks
Strong bank lending in 2008 Q4
7600
Lehman’s collapse, Paulson plan
Fannie Mae & Freddie Mac support
7200
Billions of Dollars
Bear Stearns' rescue
6800
Credit crunch starts
6400
6000
5600
5200
2006
2007
Demand for the Monetary Base
2008
2009
32
Balance Sheet Channel
US Government Securities at All Commercial Banks
1400
1350
Lehman’s collapse, Paulson plan
Billions of Dollars
1300
Fannie Mae & Freddie Mac support
1250
1200
Bear Stearns' rescue
Credit crunch starts
1150
1100
1050
2006
2007
2008
Demand for the Monetary Base
2009
33
Household Balance Sheet (Billions of Dollars)
Real Estate
Deposits
Treasury
MBS
Corporate Equities
Mutual Fund
Pension
Other
Assests
Net Worth
Real Estate
Deposits
Treasury
MBS
Corporate Equities
Mutual Fund
Pension
Other
Assests
Net Worth
2007 Fourth Quarter
20477.39 Home Mortgage
7381.34 Consumer Credit
252.31 Bank Loan
689.82 Other Loan
9453.03 Security Credit
4575.24 Other
13375.89
21767
78228.75 Liabilities
2009 Second Quarter
18272.03 Home Mortgage
7760.17 Consumer Credit
605.86 Bank Loan
129.53 Other Loan
6266.29 Security Credit
3740.53 Other
10656.29
19777.2
67207.9 Liabilities
Demand for the Monetary Base
10485.21
2551.95
126.99
126.99
325.53
728.71
14318.12
63910.63
Perfect
Substitutes !
10401.67
2475.51
118.53
134.01
147.59
790.67
14067.98
53139.92
34
How to End Quantitative Easing?
• Many countries have done QE before (forthcoming FRBSTL Review article)
• Best way (?): Cold turkey
• How?
– Sell assets to the public [potential losses]
– RP assets to the public [losses]
– Sequester in central bank “time deposits”
– Sell central bank securities
• Raise remuneration rate (Goodfriend, Woodford, FRBNY Review, 2002)
Demand for the Monetary Base
35
Demand for the Monetary Base
• How far from a long-rate equilibrium are we?
• What does demand for base money look like along a balance growth
path?
• Does a Stable Demand Relationship Exist?
• What does “demand” mean when the quantity demanded always
equals the quantity supplied?
– Corollary: The private sector cannot change the size of the
monetary base.
– Identification is not possible.
• Instability of money demand curves, it has been argued, is an issue of
incorrect functional form.
Demand for the Monetary Base
36
Note added by author after lecture, 1
The slides after this one discuss seeking to estimate an empirical demand curve for the
monetary base. The ideas are these:
- a “demand” curve might be difficult to conceptualize because the private sector (banks,
especially, for current accounts at the BOE) must hold whatever quantity of base money
the central bank forces on them – they cannot alter the total with an action by the
central bank
- Money demand curves have a terrible reputation. They do not fit well statistically and
they tend to shift a great deal. Perhaps this is due to using a poorly chosen functional
form. We compare and contract three functional forms: in the first, the level of a longterm interest rate is on the right hand side (RHS) of the equation—the result is a
nonlinear scatter plot plus an interest elasticity of money demand that increases in the
level of the interest rate—What does this say? That the more you have already
economized on cash balances, the easier it is to economize further. We find this
backwards. In the second curve, the RHS includes the log of the interest rate—so, the
interest elasticity of money demand is constant. The third includes the inverse of the
interest rate- the scatter is more linear and, better, the interest elasticity of money
demand is a decreasing function of the interest rate level—this says: as households and
firms (including banks) have reduced the quantity of base money demanded, it
becomes increasingly difficult to economize further (and further). This seems more
sensible, to us.
Demand for the Monetary Base
37
Note added by author after lecture, 2
The current US monetary base is so large that the points fall far off the main locus.
But there is one other episode with points far from the center: the 1930s, the
Great Depression. Our hypothesis: financial markets became scared due to the
high rate of firms defaulting on their debts and there was a “flight to quality” that
caused the Federal Reserve to increase the monetary base.
We test our flight to quality story by locating a variable that perhaps measures
concern with asset quality—here, the actual default rate on high-grade corporate
bonds. We regress the log of the inverse of monetary base velocity (that is, said
more simply, the log of the ratio of the monetary base divided by GDP) on this
default rate variable and subtract the product of the regression coefficient times
the default rate from the regression’s left-hand-side variable (that is, we filter out
the effect of default rates). After we do this and redraw the chart, the outliers
vanish—nice job!
So, is it possible that today people also are nervous regarding financial markets and
quite willing to hold large quantities of base money (that is, currency and deposits
at the central bank) at very low interest rates? Yes, it seems that way…
Demand for the Monetary Base
38
Note added by author after lecture, 3
We proceed by using a Box-Cox test to examine how well the three functional forms
match the data. The Box-Cox equation is nice because as a single parameter (λ)
moves between -1 and +1, it mimics the scatter we had on the previous slides: -1
matches the inverse rate, 0 matches the log interest rate (number 2), and +1
matches the level interest rate (example 1). The third wins because it is more
linear.
But, now, we have a different problem—in equation 3 (the inverse one) the interest
elasticity of money demand is a function of the level of the rate– the regression
coefficient estimate is a constant but the elasticity is not. So, we draw some charts
of how the interest elasticity varies with λ when the interest rate is held constant
at each of three values: the minimum in the dataset, the maximum in the dataset,
and the median. When the interest rate is at the median, the interest elasticity of
monetary base demand changes very little as λ varies between -1 and +1. But if
the interest rate is far from the median value, the interest elasticity changes
dramatically as λ moves from -1 to 0 to +1. Lesson: Functional form matters!
The final slides estimate a 3-equation structural VAR model, in which the third
equation might be a demand curve for the monetary base. Too much
econometrics to explain here… but we like the result.
Demand for the Monetary Base
39
Data Selection 1919-present
• Monetary Base: The Federal Reserve Bank of St. Louis’ adjusted monetary
Base.
• GDP: BEA’S annual GDP series (1929 -2008) is spliced with Balke and
Gordon’s GDP series (1919 - 1946) via an index number method (splice
using average of the period-by-period growth rates of the two series)
• Interest Rates: Moody’s Aaa-rated corporate bond yields
• Default rate: Moody’s series on defaults on investment grade corporate
bonds.
Demand for the Monetary Base
40
Level of Bond Rate (Lucas, 1988) – poor model
Log Monetary Base Velocity and Aaa Bond Rate
Annual 1919-2009
-3.50
log(Monetary Base Velocity)
-3.75
-4.00
2007
-4.25
1931
2008
• Nonlinear
• Interest elasticity is an increasing
function of the level of the interest rate
-4.50
1937
-4.75
2009
1941
-5.00
-5.25
0
2
4
6
8
Aaa Rate
Demand for the Monetary Base
10
12
14
16
41
Log Constant Elasticity Model (Cagan, 1956)
Log Base Velocity and Log Aaa Bond Rate
Annual 1919-2009
-3.50
• Less
Nonlinear
• Interest elasticity is constant
log(Monetary Base Velocity)
-3.75
-4.00
2007
-4.25
2008
1931
-4.50
1937
-4.75
1941
2009
-5.00
-5.25
0
0.5
1
1.5
2
2.5
3
Log(Inverse Aaa Rate)
Demand for the Monetary Base
42
Log price model (inverse interest rate)
Log Base Velocity and Inverse Aaa Bond Rate
Annual 1919-2008
-3.50
log(Monetary Base Velocity)
-3.75
-4.00
2007
-4.25
2008
1921
1931
-4.50
1937
-4.75
• Almost linear
-5.00
• Interest elasticity is decreasing
function of level of interest rate
1941
-5.25
0
5
10
15
20
25
30
35
40
45
100*(Inverse Aaa Rate)
Demand for the Monetary Base
43
Log Base Velocity and Inverse Aaa Bond Rate
Annual 1919-2009
log(Monetary Base Velocity)
-3.50
-3.75
-4.00
2007
-4.25
2008
1931
1921
-4.50
1937
-4.75
1941
2009
-5.00
-5.25
0
5
10
15
20
25
30
35
40
45
100*(Inverse Aaa Rate)
Demand for the Monetary Base
44
Default on Investment-Grade Corporate Bonds
New Defaults
Millions of Dollars
2000
1500
1000
500
0
1919
1924
1929
1934
1939
1944
1949
1954
1959
1964
1969
1974
1979
1984
1989
1994
1999
2004
1979
1984
1989
1994
1999
2004
New default as percentage of bonds
outstanding
Default Rate
8%
7%
6%
5%
4%
3%
2%
1%
0%
1919
1924
1929
1934
1939
1944
1949
1954
1959
1964
1969
Demand for the Monetary Base
1974
45
A Forecast of Monetary Base Velocity
Log Base Velocity and Inverse Aaa Bond Rate
Annual 1919-2008 (Adjusted for New Defaults)
-3.50
log(Nominal GDP/Base)
-3.75
-4.00
2007
1931
-4.25
1921
2008
1937
-4.50
-4.75
Quantitative Easing!
1941
2009
-5.00
2010
-5.25
0
5
10
15
20
25
30
35
40
45
100*(Inverse Aaa Rate)
Demand for the Monetary Base
46
A Forecast of Quarterly Monetary Base Velocity
Log Base Velocity and Inverse Aaa Bond Rate
Quarterly 1947Q1-2010Q2
log(Monetary Base Velocity)
-3.50
-3.75
-4.00
-4.25
-4.50
Quantitative Easing!
2008Q4
2009Q1
-4.75
2009Q2
2009Q3
2009Q4
-5.00
2010Q2
2010Q1
-5.25
0
5
10
15
20
25
30
35
40
45
100*(Inverse Aaa Rate)
Demand for the Monetary Base
47
Functional Form and Velocity Restriction
• We applied Box-Cox transformation to the base money demand
function, and the general functional form is:
• We also imposed a restriction on monetary base velocity (γ = 1),
and set λ0 = λ2 = 0; then the general functional form becomes:
Demand for the Monetary Base
48
Box – Cox Transformation on Aaa Rate Variable
Demand for the Monetary Base
49
Interest Rate Elasticity Estimates
Demand for the Monetary Base
50
Forward and Backward Recursive Estimations
Demand for the Monetary Base
51
Forward and Backward Recursive Estimations
Demand for the Monetary Base
52
Residual Diagnostics for Log-Inverse Model with Velocity Restriction
Demand for the Monetary Base
53
SVAR Empirical Model
• Three variable VAR: nominal GDP, Aaa bond rate, monetary base (plus
default rate as exogenous)
• One cointegrating vector (unitary income elasticity, ‘price’ of monetary
base)
• Order the equations such that the two equations with permanent shocks
are at the top and the equation with the transitory shock is at the bottom.
• Write the first two equations as a KPSW common-trends model.
Identification as a Wold recursive system.
• Estimate the coefficients of the third equation via instrument variables,
using the residuals from the first two equations (consistent estimates of
the permanent shocks) as instruments.
Demand for the Monetary Base
54
VECM Model
 The Reduced-form VECM is:
[ I p  ( L )]X t   LX t  
 After Imposing the restrictions, the VECM becomes:
utP 
 H1 
 H  {I p  ( L)}X t   LX t   T 
 2
ut 


1
 T11
 H1 
H   
1
 2
 B21T11
W1C (1)
0 



1
T22  W2 (  )  
where
defines the contemporaneous (simultaneous) relationships.
Demand for the Monetary Base
55
Impulse response functions, Inverse Interest Rate Shock
Model with Velocity Restriction
Demand for the Monetary Base
56
Impulse Response Functions, Real Output Shock
Model with Velocity Restriction
Demand for the Monetary Base
57
Impulse Response Functions, Real Monetary-Base Shock
Model with Velocity Restriction
Demand for the Monetary Base
58