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Evolution of Domestic Monetary System "[t]he use of counting and numbers, of calculating and figuring, propelled a tendency toward rationalization in human thought that shows in no human culture without the use of money. Money did not make people smarter; it made them think in new ways, in numbers and their equivalencies. It made thinking far less personalized and much more abstract." Weatherford
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Money is one of the
greatest inventions of all times and its discovery truly changed the course of
history because "[t]he use of counting and numbers, of calculating and
figuring, propelled a tendency toward rationalization in human thought that
shows in no human culture without the use of money. Money did not make people
smarter; it made them think in new ways, in numbers and their equivalencies. It
made thinking far less personalized and much more abstract."1
On a more practical level,
in a very real sense we can think of money as the oil keeping the economic
engine running smoothly to produce the goods and services we consume.2
If you are going to have specialization rather than self sufficiency, and you
will want that because of variations in skills, preferences, and resource
endowments, then you will need a system to facilitate the massive number of
exchanges required to move goods and services around. The earliest system of
exchange was barter where a carpenter needing plumbing would need to find a
plumber needing carpentry. It worked, but this system was too cumbersome to
allow the specialization Adam Smith identified as the secret to economic
growth.3 Keynes,
whose theories of fiscal policy we studied in detail in the last unit, also
recognized the long history of man's experiments with money.
Money is a far more ancient institution than we were taught to
believe some few years ago. Its origins are lost in the mists when the ice was
melting, and may well stretch back into the paradisaic intervals in human
history of the inter-glacial periods, when the weather was delightful and the
mind free to be fertile of new ideas in the Islands of the Hesperides or
Atlantis or some Eden of Central Asia.4
We have come a long way since
those early days, but money is still important and the 1970s will be
remembered as a decade where the US experimented with monetary policy, and in
this section we examine the experiments in monetary policy of the 1970s in the
context of developments in the domestic monetary systems. There will be three
sections:
As you work through the
material you should sense that you are seeing yet another dimension of the
debate between liberals and conservatives - this one over the proper role of
regulation in the capital market that has taken on increasing importance in the
post Reagan era. Here we will focus attention on the role of the government in
regulating the money supply, but as we saw in the financial crisis, there are
many other potential influences the government can have on the market.
Today's monetary system
can be traced back to the early civilizations of China and the Mediterranean,
and the history of money is intricately related to the rise and fall of nations
and the emergence of the business class. As we quickly trace through the
evolution of money our focus will be on productivity - how society reduces the full cost of
"producing" money - and how there have been important "leaps
forward" in the evolution that have significantly reduced the cost of
supplying and using money. A money system will beat out a barter system since
there are fewer resources devoted to transactions in the money economy leaving
more resources devoted to producing things people desire - food, shelter,
clothing - and when two monetary systems exist, the monetary system
requiring fewer resources to produce money will come to dominate.
Money is difficult to
define even though we know it when we see it. The best way to define money is
by the functions it performs, which is good since the functions have remained
constant even though the actual "things" used as money have
changed. Above all else, money is a medium of exchange. You have certainly used money to pay for
your food at the supermarket, to pay for the movies, or to buy gas for your
car. We use money when we buy and sell commodities or services.
Money is also useful as a unit of account. All prices are denominated in terms of a
monetary unit - dollars, yen, or euros - which allows one to minimize the
information needed to make price comparisons. Rather than having to keep track
of all pair-wise values - 20 packs of cigarettes for 1 sweater that can be
traded for 4 CDs, which means that 1 CD equals 5 packs of cigarettes - you need
only know the prices of the products denominated in terms of a monetary unit. A
pack of cigarettes equals $2.50 while the sweater and CD cost $50 and $12.50.
Money also shares an
important property with other financial assets; it is a store of value. If you sell something today, you receive
money you can use to purchase something in the future. Money acts as a bridge
between the present and the future - it stores value just as a refrigerator
stores food to be used at a later date. To function as a store of value,
people must have confidence in the money, which is why you will find the word
"trust" on the bills that circulate as money in the
US.
But what is money? Anyone
who has studied history or traveled abroad realizes that both money and
language vary across time and space. The existence of separate languages and
monies is the result of historical accident, the product of a distant time
where societies developed in virtual isolation, and current developments in the
monetary system are simply corrections to the "historical accidents."
Both languages and money have evolved in all parts of the world as individual
societies developed systems to facilitate cooperation and the transactions, but
advances in transportation and communication technology have moved us toward
common monies and languages. This is clearly evident in the movement toward a
common European currency, while the explosive growth of the Internet is
speeding the movement toward English as a common language.5
What a society uses as
money posses certain properties - it must be durable, divisible,
transportable, readily accepted, and not easily
duplicated. Ice cream would be out as money because it fails the
durability test, while automobiles would fail the divisible test. As for the
problem of ease of duplication, at some point the widespread production of new
money would create a transportability problem. With more money in circulation
all prices would rise and transactions would require more money. Taken to the
extreme, you might find yourself taking a trunk full of money to the store to
buy a loaf of bread - exactly what happened in Germany's hyperinflation in
1923. Finally, since money has no intrinsic value, there is one additional
property we would like to see our money possess. We would like to have the cost
of 'producing' money as low as possible so valuable resources can be used to
produce "stuff" that has intrinsic value.6
As for what has been used
by societies as money, it has changed dramatically from those cowrie shells that
circulated as money in China in 1200 BC. Early monies included salt
slabs, bricks of tea, cacao beans, whale's teeth, animal furs, and wampum. The
common denominator is they were real commodities, things
possessing value outside of their value as money, which is why they were called
commodity money7 As other commodity monies
fell from favor because they did not satisfy one or more of the above desired
properties of money, they were replaced by metals, and after
many centuries of experimentation with different metals, one metal surfaced as
the preferred money - gold.8
Eventually the world
"stumbled upon "coins," first minted in Lydia around 640BC, and
before the millennium the Roman Empire had become the first empire organized
around money. Rome also gave us a idea of one of the downsides of a money - the
ability of those in control of the supply of money to print excessive amounts
of money that create inflation, and in some cases efforts to control it with
price controls. The next big thing in money appeared in northern Italy in the
1100s when we began to see the early forms of paper money and the rise of banks
that played a key role in the distribution of the money. This was the beginning
of fiat money, money that had no intrinsic value as a commodity. Its advantage is
that few resources are used in the production of money, while the disadvantage
is it was even easier to produce excessive amounts.
One country that got the
new system right was England that founded the Bank of England in 1688 to
control the supply of money. Its "solution" was the stipulation that
the paper money notes be convertible into gold. This was an important piece in
the monetary system circling the globe - the gold standard that England
established in 1816 after inflation during the Napoleonic Wars. Gold, as a
backing to the world's currency, provided a benefit to the people - it
restricted the abuses of a government's power to print money highlighted by
David Ricardo in the 19th century.
neither a state nor a bank ever has had unrestricted power
of issuing paper money, without abusing that power; in all States, therefore,
the issue of paper money ought to be under some check and control; and none
seems so proper as that of subjecting the issuers of paper money to the
obligation of paying their notes, either in gold coin or bullion.9
The US did its share of
experimenting with money and monetary systems, and some of those experiments
went quite badly as you see in the history of reoccurring banking and financial
crises. We'll pick
up the money story again with the Coinage Act of 1873 that specified the coins
to be minted, but the silver dollar was not on the list of coins.10
The problem was that the "missing" silver meant less money in
circulation, and we know from the earlier discussion of the Quantity Theory
that less money meant falling prices or falling output. Concern over falling
prices was widespread at that time and it became one of the defining issues of
the Populist movement in the U.S. that described the Coinage Act of 1873 as the
"Crime of 1873" and believed it was part of a
conspiracy on the part of Eastern bankers to reduce the money supply and drive
down prices.11 The most notable Populist was William Jennings
Bryan who ran unsuccessfully for president a number of times including 1896
when he gained national recognition with his Cross of Gold speech to the Democratic National
Convention. In his speech Bryan made an impassioned appeal to increase the
supply of money and get the economy off the gold standard he felt was responsible
for the falling prices wreaking havoc with indebted farmers and laborers and
created the panic of 1893 with its double-digit unemployment rates between
1893-1896. According to Bryan: "You shall not press down upon the brow of
labor this crown of thorns; you shall not crucify mankind on a cross of
gold." Bryan was not alone, and for those interested in the
interpretation of The Wizard of Oz as a Populist reaction to the same gold
policies that Bryan was fighting you should check out a few interesting sites
( Littlefield,
Rockoff, UNO).12
Bryan did not win, but the
economy picked up and prices began to rise, fueled by a growth in the money
supply. In 1900 President McKinley signed the Gold Standard Act that officially
put the US on the gold standard, but the "good times" ended in the
Panic of 1907 that revealed the weaknesses of the US financial system - lack of
regulation - and set the wheels in motion to "create" a central
bank for the US.13 With passage of the Federal Reserve Act in
1913, the Federal Reserve System (Fed) became the central bank of the United
States (Federal Reserve) - the equivalent of the Bank of Sweden,
Bank of
England, and the Bank of France that were established in 1656,
1694, and 1800. The outlines of the modern financial system were in place, and
now we'll look more closely at the system and the role played by the Fed.
How do we measure money?
Money, as we saw in the
evolution of money section, is usually defined as whatever performs three
important functions - a medium of exchange, a unit of account, and a store of
value. Given this definition, most countries have developed a set of
monetary aggregates designed to measure the supply of money. The two most
frequently cited measures are M1 and M2. The definitions for these M's can be
found in the Federal Reserve's Money
Stock and Debt site.14 The short versions are M1 consists of
coins and cash held by individuals and businesses and the value of checking
account balances. M2 equals M1 plus savings (time) deposits. The composition of
these components as of 1/1/2001 can be seen in the table below. Currency
represents nearly half of M1, while savings deposits represents nearly 40% of
M2. If we look at the changes over time, currency has become a more important
component of the money supply measures, while checking deposits have become a
substantially smaller part of the money supply
Decomposition
of M1 and M2
|
|
billion $s |
% of M1 |
% of M2 |
|
Currency |
531.5 |
48% |
11% |
|
Travelers
checks |
8.2 |
1% |
0% |
|
Demand
deposits |
319.2 |
29% |
6% |
|
Other
checkable deposits |
241.7 |
22% |
5% |
|
Savings
deposits |
1,871.8 |
|
38% |
|
Small time
deposits |
1,049.7 |
|
21% |
|
Retail money
funds |
948.2 |
|
19% |
|
M1 |
1,100.6 |
100% |
|
|
M2 |
4,970.3 |
|
100% |
To understand interest rates
you should keep three points in mind.
First, an interest rate is the price of
borrowing or lending funds, and the S&D model of prices is an appropriate framework
to analyzing prices. When we talk about interest rate changes we are talking
about shifts in the supply and demand for money. For example, an increase in
interest rates is the result of either an increase in demand or a decrease in
the supply of funds. It is no more difficult that that.
Second, we talk about "interest
rates" as if there is a single rate, but the fact is there are many
interest rates. Just check out the poster at your bank listing a variety of
rates next time you are there, or check out the bank's web site where you can
find rates for a car loan, a savings account, or a credit card. A few of the
ones you should know are listed below.
- Discount rate:
rate the FED charges banks for overnight borrowing
- Federal funds rate: rate banks charge other banks for overnight borrowing
- Prime rate:
rate banks charge their 'best' customers
- T-bill rate:
rate on short-term (<1 year) government securities
- Mortgage rate:
rate on home and car loans
Third, the differences between rates can be
best viewed as the result of differences in risk. If you were to approach me to
borrow some money, there are a number of factors that I would take into
consideration when deciding how much to charge you. I would go through a
checklist of factors in assessing the risk associated with lending you money,
and then set the rate. This checklist is summarized in the equation below that
specifies the actual interest rate quoted to you (r) as being dependent on five
separate components.
r = rr +ri + rd
+ rl + rm
where
·
r = nominal rate (quoted
rate - what you see in print)
·
rr = real
risk-free rate of interest
·
rd = default effect
·
rm = maturity effect
·
ri = inflation effect
·
rl = liquidity effect
rr is the real
risk-free rate of interest that measures the relative scarcity of
funds. This is what would be charged to someone who was considered to be risk
free. If I know you would absolutely pay me back on time, and nothing would
change from now until you paid me back, then this would be the rate I would
charge you to borrow money. The fact is we will never see this since it is the
rate for perfectly riskless funds and there really is no such deal, but
the closest we'll get to it would be the rate on short-term borrowing by the US
government. It is useful to think of this as a base rate upon which all other
interest rates are based.15 Actual rates differ from the real
risk-free rate of interest (rr) because of
risk, and in the equation above there are terms that reflect four important
aspects of the transaction that affect the lender's perception of
risk.
rd The ability of the borrower to pay back
the money is one of the primary factors affecting the cost of funds, and this is
captured by the default effect. This is why we have bond-rating companies to
assess a potential borrower's fiscal health, and why you need to fill out
financial forms when borrowing money. These companies rate borrowers, which
affects the rate of interest they will need to pay. It could cost BIG money for
state and local governments or major corporations who were trying to raise
funds to have their ratings downgraded from Aaa to Baa. Between 1980 and 2007
the average rates on corporate Aaa bonds was nearly 1.1 percentage points
lower, so the riskier Baa borrowers were paying rates about 12% higher to
reflect the extra risk.
Another place you see the
default premium is in the difference between corporate Aaa bonds and federal
government bonds in the left-side graph below. The differential reflects the
market assuming a higher default risk for corporations than for the federal
government. The default effect is also influenced by the ease with which a
lender can recoup its losses in the event that the borrower cannot meet the
repayment schedule. This is why interest rates are lower when the borrower
offers more collateral, which is one of the reasons why the rate on home
mortgages are lower than car loan rates, which in turn, are lower than the rate
on personal loans. It is also why in 2001, as Argentina's economy
teetered on the brink of collapse, the differential between interest rates on
US and Argentina bonds increased sharply reflecting the bond market's higher
risk premium on Argentina's bonds.
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In the midst of the
subprime crisis in 2008 we had a further example of the importance of the
default risk. At that time there was a general loss of confidence in the
ability of the market to adequately determine risk since a number of securities
backed by home mortgages that had been given good ratings proved to be poor
investments as the homeowners defaulted on their mortgages. The result was that
the spread between rates on US government securities and corporate bonds rose
as investors sought to reduce their risk by buying the US government
securities. As more investors wanted those US securities the interest rate the
government had to pay to borrow money dropped. You can see this in the diagram
below. As the economy moved out of the post .com bust and 9/11 uncertainty, the
spread between corporate and government rates dropped until the @#$%^& hit
the fan with the subprime fallout. This is very similar to what happened in
1997-98 in the midst of the Asian financial crisis when investors around the
world poured their money into US securities.16
rm Given our inability to accurately predict the future, anyone
lending money for a long period of time will generally require a higher rate of
return to compensate for the higher perceived risk – what we call the maturity
effect (rm).
You can see this in the graph of long-term and short-term lending where
the rate on long-term 10-year bonds is generally higher than the rate on
3-month bonds. Also evident there is the greater volatility of short-term
rates because when you make a 'deal" to lend money for 30 years, no news
tonight about events of the next few months will likely alter the rate you
would charge tomorrow for a 30 year loan. On the other hand, if you were just
lending money for 2 months, then some news you hear tonight about events of the
next few months might alter the rate you would charge on a two-month loan.
A second way to demonstrate the
maturity effect is the term-structure of interest rates evident in the yield curve - a graph of the relationship between
yield (rate of return = interest rate) and maturity. The upward slope indicates
the market premium for time - the longer the length of time the higher the
interest rate. The average rate on 3-month (G-3M) borrowing was approximately
7.5 percent, while the rate on 10-year (G-10Y) borrowing was close to 9.5
percent.17
Another place you would see the
maturity effect would be with home mortgages. In April of 2009 the rate was
5.1% if you wanted a 30-year fixed rate mortgage, and 4.71% if you wanted to
borrow the money for 15 years. Because the lender incurs more risk on the
longer loan, you pay a higher rate.
ri
Interest rates are also affected by inflation rates, as you can see in
the graph below where interest rates and inflation rates tend to move together,
which should not be surprising. The positive relationship between interest
rates and the inflation rate - the inflation effect ri reflects the fact that when lenders see
higher inflation rates they demand higher returns on their loans, and borrowers
will be willing to pay the higher rates because they repay in $s that are not
worth as much today’s $.
To see the impact of inflation
on interest rates, let's look at a simple example. Assume you borrow $100 today
and promise to pay back $105 one year from today. The lender will have been
paid $5 for the use of that money for a year and the lender will use the $105
next year to buy a new pair of sneakers. It sounds like a mutually beneficial
trade, but what happens if the price level changes? The mathematics of the
example in which you are borrowing $100 for one year appears below. There are
three scenarios that reflect different inflation rates.
Real
and Nominal Interest Rates: When 5% is not 5%
|
Inflation
rate |
0.0% |
5.0% |
10.0% |
|
Nominal rate |
5.0% |
5.0% |
5.0% |
|
Real rate |
5.0% |
0.0% |
-5.0% |
|
Loan |
$100 |
$100 |
$100 |
|
Interest paid |
$5 |
$5 |
$5 |
|
Total payment |
$105 |
$105 |
$105 |
|
Cost of
living |
$100 |
$105 |
$110 |
|
Gain to
lender |
5% |
0% |
-5% |
Column 1 describes a zero inflation world: In this world you pay 5% nominal
interest rate when the inflation rate is 0% so you repay $105 in one year. The
lender can use the $105 to buy $105 worth of 'stuff,' so the lender's buying
power has been increased by 5% by waiting a year. The real rate of interest
is 5%.
Column 2 describes a 5% inflation world. In this world you pay 5% nominal
interest when the inflation rate is 5% so you repay $105 in one year. The
lender can buy $105 worth of 'stuff', but the cost of living has risen 5%,
which means it now costs $105 just to buy what could be bought last year with
$100. Waiting a year has not increased the lender’s buying power. The real
rate of return is 0%.
Column 3 describes a 10% inflation world. In this world you pay 5% nominal
interest when the inflation rate is 10% so you repay $105 in one year. The
lender can buy $105 worth of 'stuff', but the cost of living has risen 10%,
which means it now costs $110 just to buy what could be bought last year with
$100. The lender's buying power has actually decreased by waiting a year. The
real rate of return is -5%.
Are there any generalizations
we can make from our simple example? If we ignore all of the other
components/dimensions of the interest rate, we can specify the relationship
between real and nominal interest rates as follows:
rn = rr + ie
or
rr = rn - ie
1. rr = real rate
2. rn = nominal rate
3. ie = expected inflation rate
The distinction between real and
nominal rates matters a lot as you can see in the graphs below. In
the late 1970s nominal interest rates rose while real interest rates turned
negative as lenders took a beating because the interest rate increases did not
keep up with spiraling, unanticipated inflation. As a result of the recessions
in 1980-1982, inflation dropped sharply, but nominal interest rate declines
failed to fully reflect the disinflation so we saw a substantial rise in real
interest rates. In the 1980s, the real interest rate on 3-month government
securities rose nearly 5 percentage points - a pattern we saw duplicated in the
recession of 1990-1992.
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Now that we have the basic
relationships between interest rates, it is time to examine why interest rates
change, and because interest rates are prices, we start with the supply and
demand for money in the next section,
Money
demand, money supply, and interest rates
Money Demand
Money was traditionally viewed
as simply a medium of exchange with no intrinsic value so people demanded money
simply to facilitate their transactions - they used it to buy things. If they
had money they would spend it, and if the volume or price of their transactions
increased, they would need more money. This demand is described in the Transactions
Demand schematic below where more income leads to more transactions, which
leads to demand for more money.
Transactions
Demand for Money
|
Higher Income |
_ |
More Transactions |
_ |
More Money Demand |
Keynes took a somewhat
different view of money, a more general view where he accepted the transactions
demand and
specified two additional reasons for holding money - precautionary and speculative motives. The speculative demand was the
real Keynesian innovation. Keynes believed money should be viewed as an asset
similar to the other assets people own - bonds, stock, and real estate - and
people would be expected to alter their portfolio of assets to maximize the
expected return. Today, if you read the financial press, you will hear financial
gurus telling investors how much of their wealth to keep in stocks, how much in
bonds, in gold, and in cash. Keynes was anticipating this literature.
The logic behind Keynes'
speculative demand is simple: if interest rates are low people will not lose much
money in foregone interest by holding a portion of their wealth as cash. If you
happen to have $1,000 and hold it as cash, then you will be giving up the
opportunity to earn $100 when the interest rate is 10%. If the interest rate
falls to 5%, then you will only be giving up the opportunity to earn $50. You
would expect as interest rates rise people will tend to hold less of their
wealth as money and more as interest earning assets. The "demand" for
money will thus be lower at the higher rates, which is what you see in the
Speculative Demand schematic below.
Speculative Demand for Money
|
Higher Interest Rate |
_ |
Higher Opportunity Cost of Money |
_ |
Lower Money Demand |
If we combine the two effects
we will have money demand being positively related to the level of income and
negatively related to interest rates. The demand for money can be demonstrated
with a traditional demand curve that captures the negative relationship between
interest rates (price of money) and money demand [Diagram 1]. As the interest
rate rises from i* to i**, the demand for money will fall from M* to M**. Money
demand for transactions purposes depends on income, and an increase in
transactions resulting from an increase in income, possibly the result of the
economy moving out of a recession, will show up as an outward shift in the
money demand curve (D to D'). [Diagram 2]
|
Diagram 1 |
Diagram 2 |
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We need to add in the supply
side of the market and then put them together to discuss the price of money.
Money Supply: The Fed and the Creation
and Control of Money
To understand the
relationship between the Fed and the money supply you need to understand the
logic of a fractional
reserve system, and to do that we'll step back to the days of Robin Hood when gold
was used to finance transactions. In this world many people were employed to
mine the gold, refine it, and guard it during its transfer through the Sherwood
Forests, which offered a wonderful opportunity for Robin Hood and his merry
band of men to "liberate" the gold. It was a good gig, until
someone realized a way to put an end to these liberations. What if the Sheriff
of Nottingham deposited the gold in a safe place - a goldsmith's vault being
the most likely place – and the sheriff would receive a receipt from the
goldsmith who promised to provide the holder of the receipt with gold when it
was returned. Before long these receipts began to circulate as money since
anyone receiving it knew it could be exchanged for gold. If you sold a bow to
Robin, he could pay you with a receipt and you could return it to the goldsmith
for gold.
This was a good system for
cutting down on holdups in the forest, but there was one significant problem.
It did not take long for the goldsmiths to recognize a way to scam this system.
At the end of each day the goldsmiths’ vaults contained gold because all of the
notes issued had not been returned to be exchanged for the gold. Now there was
gold just sitting in the vaults, and soon the temptation proved too great, and
the goldsmiths got into the lending business. Knowing there was extra gold in
the vaults at the end of the day, the goldsmith took a chance and issued new
notes promising to repay the note's holder gold. If you were looking for a new
crossbow you could go to the goldsmith who would issue you some new notes
backed by gold. So now we had a
goldsmith with 100 ounces of gold in a vault and people running around with
notes promising the goldsmith would pay 200 ounces of gold.
The system just outlined
is a fractional
reserve system and it is a key piece of the modern money supply process. The
difference is that the goldsmiths have been replaced by banks making money on
the difference between the interest rate paid to those who deposit money in the
banks and the rates on those to whom they lend the money.18 The
banks, just like those goldsmiths, have an incentive to take risks and lend out
far more money than they have as cash because they earn no interest on cash.
Risk-taking is an important part of the business world, and sometimes
businesses go belly-up when they bet wrong, but because of the importance of
money in the economy, the US government became involved in the regulation of the
banking system.
The biggest “push” behind
regulation of the banks came as a response to the collapse of banks during the
Great Depression. During the 1930s about 9,000 banks failed, and because there
was no deposit insurance, people and businesses that had money in those banks
lost it. This “forced” them to stop spending which led to the firing of workers
which led to further spending cuts… You can see where this is going – and so
could the Roosevelt administration that made it the government’s responsibility
to avoid the banking panics that had plagued this country since the earliest
days. The key piece of the effort to stabilize the banking system was passage
of the Banking Act of 1933, better known as the Glass-Steagell Act. This was
part of the 100 Days and it addressed two fundamental problems.
First, banks had taken too
many risks with the money that had been invested with them, and there needed to
be some regulations to restrict what these banks could do with our money and
what risks they could take. For example, in the roaring 1920s stock prices were
booming so banks used stocks as capital. It seemed like a win-win situation.
You put your money in the bank and the bank then buys stock with the money –
and as the value of the stock goes up the bank decides to lend out more money
knowing that if anyone showed up at the bank to redeem cash then the bank could
sell its stock for cash and pay up.
It works great as long as
stock prices rise, but when those prices stop rising all hell can break
loose. When stock prices begin to
fall and people get nervous about the bank, people and businesses want their
money back. The bank must raise the cash, and because they have not kept much
cash on hand because it earned nothing, the banks have to quickly sell assets.
So the banks start selling their assets – those stocks – but you know from
S&D that the banks’ decision to liquidate its assets to raise cash
increases the supply of assets for sale. This drives down the prices of those
assets forcing more banks and businesses to sell, which drives asset prices
down further…To stop this debt-deflation cycle from starting the government
separated banks into two categories – investment banks that could gamble with
the money invested there, and commercial banks that were severely restricted in
terms of what assets they could own.
Second, the fear Roosevelt
mentioned in his inaugural speech that had led to runs on banks as people moved
their money out of the banks and into those mattresses at home, needed to be
eliminated. The fear drained the
financial system of funds, which prompted severe cuts in lending that families
and businesses needed to stay afloat, so something was needed to erase those
fears. The solution was establishment of the Federal Deposit Insurance System that
guarantees our bank accounts. Once people were not afraid of losing their money
they returned to the banks and the money began to work its way back through the
system.
Fast-forward and this
should sound very much like the financial crisis of 2008-2009. Once again banks
had taken massive risks with depositors’ money – not stocks now but exotic
“derivatives” tied to real estate that was in the midst of a dramatic rise in
prices. But as always happens with
bubbles, it popped and as foreclosures rose banks unloaded their assets leading
to BIG asset deflation.
So how did this happen?
Because in the 1980s the ideological pendulum had swung to the conservative
right and the deregulation of the banking system began. By the time we reached
the 2000s banks had pretty much freed themselves from the regulations of the
past and they once again were taking BIG risks with our money. This is why one
of the persistent messages coming out of Washington in 2009 was the need to re
regulate the financial industry. Another central message was the critical role
played by the Fed – the Federal Reserve - so now we will turn our attention to
that institution.19
The Fed
Given the long-standing
aversion Americans had for the concentration of financial power, the US was
late in establishing a central bank, and when we did it 1913, the decision was
made to establish twelve Federal Reserve Banks - one for each of the twelve
Federal Reserve Districts. By dividing the country into twelve smaller regions,
the Fed would be more accountable to the interests of the people in a
particular region. If you were in Rhode Island, you were more likely to be able
to influence policy by lobbying the regional Federal Reserve Bank in Boston
than you could a national system located in Washington, D.C. The structure of
the system is described in Diagram 3 below. [A more extensive description of
the structure of the Fed is available on-line].
Diagram
3
Structure of the Federal Reserve
The seven members of the Board
of Governors are appointed by the President and confirmed by the
Senate to serve ONE 14-year term of office, although a member appointed to
complete an unexpired term may be reappointed to a full term. This explains how
Alan Greenspan served for over 18 years. The Fed Chairman and Vice
Chairman are appointed by the President and confirmed by the Senate to serve
four-year terms, and the President is directed by law to select a "fair
representation of the financial, agricultural, industrial, and commercial
interests and geographical divisions of the country."
The real power, however, is
held by the Federal Open Market Committee (FOMC) that, according to the Fed,
"is the most important monetary policymaking body of the Federal Reserve
System. The FOMC consists of the seven members of the Board of Governors and
five Reserve Bank presidents. One of these is always
the president of the Federal Reserve Bank of New York and the presidents of the
other Reserve Banks serve one-year terms on a rotating basis. This is the group
most responsible for setting monetary policy in the United States. It is the
meetings of this group that grab the headlines as in 2001 when the Fed dropped
rates to stimulate the economy and in 2006 when news stories centered on the
Fed’s interest rate hikes designed to reduce inflationary pressure.
In this section we will be
focusing our attention on one aspect of the Fed’s policies - control of the
money supply.
The Fed and the money supply
process
The basic structure of the
money supply process has the following components.
1.
The
Federal Reserve (FED) supplies currency to the system and the currency is
called high-powered
money.
2.
The
high-powered money ends up in two places - the vaults of the banks as reserves, or the pockets of people and businesses
as cash
3.
Cash
(currency)
held by the public plus the balances in deposit (checking) accounts created by the banks equals the money supply (M1)
4.
The
maximum value of the checking account balances a bank can have is directly
related to the cash held by the bank - and the Fed controls that relationship
by specifying the required reserve rate.
To understand the money supply
process we need to examine the 'books' of the banking system, and here we will
keep it very simple, but for those interested in more detail you can check out
the Money
Creation section. 20 We begin with a
simple balance sheet for the banking system. The assets banks are allowed to own
are restricted by the Fed, and in our simple example we assume the Fed has
supplied $2,000,000 of cash into the economy and $1,000,000 ends up as cash in
hands of the public (people and businesses) and $1,000,000 ends up in the banks
as reserves. The banks' total assets are the cash reserves earning no interest
and the loans and government securities earning interest. In the example below,
the bank's assets total $5,500,000.
The banks' primary liabilities
are the balances on the checking and savings accounts held by their customers.
In this example, the banking system's liabilities equal $5,000,000 - there are
people and businesses who have checking accounts with balances totaling
$5,000,000 that must be paid by the bank if the checks are returned for payment.
The difference between the asset value and the value of the liabilities is the
bank's net worth, which in this case is $500,000. If all of the bank's assets
were sold and all of the liabilities were paid off, the bank would end up with
$500,000. In theory this would be a cushion the bank could fall back on in
tough times, assets it could liquidate to pay off its liabilities.
Banking
System's "Books"
|
Assets |
|
Liabilities |
|
|
Securities |
$500,000 |
|
|
|
Reserves |
|
Checking deposit |
$5,000,000 |
|
Actual |
$1,000,000 |
Saving deposit |
$0 |
|
Required |
$1,000,000
|
Net Worth |
$500,000 |
|
Excess |
$0 * |
|
|
|
Loans |
$4,000,000 |
|
|
|
Total |
$5,500,000 |
Total |
$5,500,000 |
These numbers were not just
picked randomly. There are guidelines for the banks – how the keep their books
and how they allocate their funds.
First, the balance sheet is
that the two sides of the sheet must always be equal - the result of double-entry
bookkeeping. If something changes in the "books," then something else
must change to maintain the balance between assets and liabilities, which is
the key to understanding how the Fed controls the money supply.
Second, the Fed links the
banks' assets and liabilities when it sets the required reserve rate specifying the amount of cash a bank
must keep on hand as reserves to support the demand deposits (checking
accounts). In this example, the Fed is requiring banks to hold 20 percent of
the amount of its deposit accounts as cash (reserves). For example, if you walk
into a bank and deposit $1000 in cash, then the banking system has to keep $200
as cash in its vaults and then can use the $800 to invest in assets that will
earn it money – in this case Loans
to people and businesses and loans to the government when it buys government Securities.
In this example the $1,000,000
in cash "supports" the $5,000,000 in checking account balances, so
the system is just satisfying the Fed’s required reserve rate of 20%. The bank’s
investment strategy has invested $4,000,000 in loans and $500,000 in government
securities. In this example there is only $1 million in cash in the banks so
there are no excess reserves - extra cash in the banks' vaults that does not
need to be there.
In essence what the banks are
doing here is "creating
money” because of
the fractional reserve requirements. $1 in cash held by you or me counts
as $1 to the money supply (M1), but if that $1 makes it way into the banks
where it was held as reserves, it could support $5 of checking account
balances. So, if I happened to move $1,000 from my mattress into the bank the
money supply would expand because there would be $1,000 less cash in the hands
of the public, but once that $1,000 went into the banks they could invest it
until the checking account balances increased by $5,000. The money supply would
go from $1,000 in cash to $5,000 in checking accounts. In this example, with
$1,000,000 in cash held by the public and $1,000,000 held by the banks, the money
supply equals $6,000,000 ($5,000,000 in checking account balances and
$1,000,000 in cash held by the public).
Now that you have the basics we
can see how the Fed can change the money supply. It is very simple: the money
supply (M1) can be changed if the coins and currency (cash) in circulation
change or if the checking account balances (demand deposits) change, and there
are five ways that this can happen - two that can be controlled by the Fed and
three that cannot be controlled. Let’s look at the possible ways to increase
the money supply
1. Required reserve rate:
The Fed can lower the required reserve rate, which means less cash has
to be kept as reserves in the banking system. In this example, if the Fed
lowered the required reserve rate to 10%, then the banks would need to hold
only $500,000 as cash against the deposits of $5,000,000, so the banks would be
free to lend out the remaining $500,000. Let's assume the banks decide to loan
it out, then they can make enough loans so that the $1,000,000 cash reserves
equals 10% of the outstanding checking deposits. If you do the math, which is
similar to the Keynesian multiplier, then the banks with $1,000,000 in cash can
support $10,000,000 in checking deposits. What actually happens is the banking
system adds $5,000,000 in checking accounts to new customers who are loaned
$5,000,000. Because of the double-entry bookkeeping, the banking system's books
will look like the one below. The reduction in the required reserve rate
"frees' up reserves so the money supply is increased, in this case by
$5,000,000 if we assume that there is no change in the allocation of cash
between the banks' reserves and the public's cash holdings. As a result of the
lower required reserve rate, the money supply has increased - it is now
$1,000,000 in cash held by the public and $10,000,000 in checking account
balances for a total of $11,000,000.
Banking
System's "Books" after
reduction in required reserve rate
|
Assets |
|
Liabilities |
|
|
Securities |
$500,000 |
|
|
|
Reserves |
|
Checking
deposit |
$5,000,000 |
|
Actual |
$1,000,000 |
Saving
deposit |
$0 |
|
Required |
$1,000,000
|
Net Worth |
$500,000 |
|
Excess |
$0 * |
|
|
|
Loans |
$4,000,000 +$5,000,000 |
|
|
|
Total |
$10,500,000 |
Total |
$10,500,000 |
2. Publics' holding of cash changes: In the above example, $1,000,000 held
as cash by you or me represents $1,000,000 in the money supply, while the $1,000,000
held by cash in the banks can now support $10,000,000 in checking accounts, so
any movement of money from households to the banks will increase the money
supply. In the Great Depression, one of the real problems was people
lost confidence in the banks and took their cash out of the banks, which caused
the money supply to decrease. This is why Roosevelt introduced deposit
insurance (FDIC), to help get the money back into the system. A similar pattern
emerges every Christmas season when consumers want to hold more cash to buy
those presents, and at the turn of the millennium when people hoarded cash because they were worried
about Y2K. In both cases the money supply would decrease, and to offset these
"shocks" the Fed would need to get more cash into the system. In this
example, as a result of the increase of $500,000 in cash held by the public,
the banks lose $500,000 as reserves and must call in loans (reduce them) to
lower the checking accounts to $2,500,000 to satisfy the 20% required reserve rate.
The money supply is now $1,500,000 in cash held by the public and $2,500,000 in
checking account balances for a total of $4,000,000 - lower than the original
money supply of $6,000,000.
Banking System's "Books" after public raises cash holdings by $500,000
|
Assets |
|
Liabilities |
|
|
Securities |
$500,000 |
|
|
|
Reserves |
|
Checking
deposit |
$5,000,000 |
|
Actual |
$1,000,000 |
Saving deposit |
$0 |
|
Required |
$1,000,000 |
Net Worth |
$500,000 |
|
Excess |
$0 |
|
|
|
Loans |
$4,000,000 |
|
|
|
Total |
$3,000,000 |
Total |
$3,000,000 |
3. Banks' holding of excess cash
reserves: In the above
example the $1,000,000 held as cash in the banks can support $10,000,000 in
checking accounts, but only if the bank uses its cash to support loans.
In the Great Depression, as well as in the financial crisis of 2008, an
additional real problem was that banks lost confidence in the system and
decided to "hoard" their cash, which caused the money supply to
decrease. $1,000,000 in our pockets would be $1,000,000 in the money
supply, but $1,000,000 held as excess reserves in the banking system would be
$0 in the money supply, so as banks increase their excess reserves the money
supply falls. A good example of this was the financial bailout in 2008. The Fed
and US Treasury injected $ billions into the banking system, but the banks
decided that in those uncertain times they would rather have cash - or US
Treasury securities.
In
this example, the public transfers $500,000 to the banks in prepayment of
$500,000 in loans that adds $500,000 to reserves and reduces loans by $500,000.
The public loses $500,000 in cash that simply sits in the banks so the checking
account balance remains at $5,000,000 that satisfies the 20% required reserve
rate. The money supply is now $500,000 in cash held by the public and
$5,000,000 in checking account balances for a total of $5,500,000 - lower than
the original money supply of $6,000,000.
Banking System's "Books" after excess reserves rise by $500,000
|
Assets |
|
Liabilities |
|
|
Securities |
$500,000 |
|
|
|
Reserves |
|
Checking
deposit |
$5,000,000 |
|
Actual |
$1,000,000 |
Saving deposit |
$0 |
|
Required |
$1,000,000
|
Net Worth |
$500,000 |
|
Excess |
+
$500,000 |
|
|
|
Loans |
$4,000,000 |
|
|
|
Total |
$5,500,000 |
Total |
$5,500,000 |
4. Open market operations (OMO): The Fed can buy or sell government
securities because one of the assets owned by the Fed would be government
Securities. Let's look at the situation when the Fed wants to increase the
money supply so it contacts its broker and announces it wants to buy $100,000
of government securities, and pay for it with cash. The reserves in the banking
system will increase by $100,000 if we assume the cash is deposited in the
banks. The increase of $100,000 cash into the system allows this banking
system, with the required reserve rate of 20%, to lend out an additional
$500,000 that shows up as additional loans and as additional checking balances.
The money supply is now $1,000,000 in cash held by the public and
$5,500,000 in checking account balances for a total of $6,500,000 - higher than
the original money supply of $6,000,000. If the Fed wants to increase
the money supply it will buy government securities, while if it wants to
decrease the money supply it will sell government securities.
Banking
System's "Books" after
Fed buys $100,000
|
Assets |
|
Liabilities |
|
|
Securities |
$500,000 |
|
|
|
Reserves |
|
Checking
deposit |
$5,000,000 |
|
Actual |
$1,000,000 |
Saving deposit |
$0 |
|
Required |
$1,000,000
|
Net Worth |
$500,000 |
|
Excess |
$0 |
|
|
|
Loans |
$4,000,000 |
|
|
|
Total |
$6,000,000 |
Total |
$6,000,000 |
5. Discount interest rate: One additional tool is the discount
rate, the rate the Fed charges banks for overnight lending. The banks must
balance their books and if they get caught with inadequate reserves because
they have made too many loans then they need to borrow, which they can do from
the Fed at the discount rate or from other banks at the federal funds rate. To get banks to lend out more money
the Fed could lower the discount rate and lower the costs of borrowing to
support the loans, while it could get the banks to reduce their loans by
raising the discount rate.
It should now be clear that the
Fed has three tools to affect the money supply – the discount rate, the
required reserve rate, and Open Market Operations (OMO), and in the midst of
the financial crisis of 2008-09 it used them all. Of all of the tools, however, Open Market Operations tend to
be the favored tool. Their popularity stems from the fact that the decisions
are reversible, flexible, and timely. The Fed's tools are summarized below.
Fed
Policy Tools
|
Tools |
Goal: Increase Money Supply |
Goal: Decrease Money Supply |
|
Discount rate |
lower |
raise |
|
Required reserve rate |
lower |
raise |
|
Open market operations |
buy securities |
sell securities |
Money Supply and Demand: A Model of Interest
Rates
This is the easy part since by
now you are accomplished at creating supply and demand curves. Behind the
demand for money are the individuals and firms that use money in their daily
activities, and as we saw earlier, an expanding economy will shift the demand
curve outward as demand for money increases. The supply curve is a little more
complex since it reflects the behavior of the Fed, banks, households, and
individuals. If the FED increases the supply of high-powered money, then this
would show up as an outward shift in the money supply curve in the money
market. This could be accomplished by a reduction in the discount rate, open
market purchases, or lower required reserve rates. The curve could also shift
if there was a change in bank behavior. For example, if banks become
conservative and raised their holdings of excess reserves, then banks would
loan out less money decreasing the value of demand deposits outstanding and
their would be an inward shift in the money supply curve. Households or
businesses could also want to raise their holding of cash, and any increase in
the public's holdings of cash would decrease the money supply.
Diagram
4
Money Market
Pulling the pieces together
allows us to explain / forecast interest rates. An expanding economy means
higher incomes that shows up as an outward shift in money demand. The result,
seen in the left-side graph in Diagram 5, is an increase in interest rates. If
the Fed increases the money supply, the money supply curve shifts out and
interest rates decrease (right-side graph).
Diagram
5
Money Market: Comparative Statics
The Graphs
We can now make generalizations
concerning of the impact of external shocks on these rates. Any shock that can
be translated into a shift in the supply or demand curve, the impact on price
(interest rates) and quantity (money) can be forecast using the table below.
Money
Market: Comparative Statics
A Summary
|
|
Interest Rate |
Money Supply |
|
Increase
Money Demand |
UP |
UP |
|
Decrease
Money Demand |
DOWN |
DOWN |
|
Increase
Money Supply |
DOWN |
UP |
|
Decrease
Money Supply |
UP |
DOWN |
It's now time to turn our
attention to what impact the change in the money supply and interest
rates have on the economy - what we will call the monetary transmission
mechanism. For those with some algebra skills and would like to look at the
situation one more time - this time with the help of some simple algebra, you
can check out An
algebraic perspective.
Now that we have examined the
money supply process it is time to move on to the next important question: What
impact will a change in the supply of money have on the economy? The money supply,
and interest rates, are simply targets the Fed establishes to achieve the
ultimate goals of full employment and price stability - and here, not
surprisingly, we have substantial differences of opinion. There are very large
differences between the liberal and conservative views, and in this section we
examine the evolution of thinking on monetary policy, and how the prevailing
view on monetary policy experienced a dramatic shift in 1979. We begin with the
Keynesian view that dominated policy making in the early 1970s when the US was
"freed" from the constraints of the Bretton Woods agreement, and then
introduce the monetarists who "rose to power" in 1979 and who can
trace back their roots to the Classical theory's Quantity Theory of
Money.
Keynesian monetary theory
and monetary policy
In the Keynesian view of the world interest rates are
the price of money and monetary authorities can influence the level of interest
rates in the economy by altering the supply of money. If the Fed wanted to
decrease interest rates it would increase the supply of money (outward shift in
the S curve in Diagram 6).
Diagram
6
Impact of Increase in Money Supply
The interesting part comes next
- what happens when the interest rate changes - and to understand the chain of
events linking the money supply and GDP, employment and prices we need to look
into the transmission mechanism - traced out in Diagram 7.
Diagram
7
Monetary Policy Transmission Mechanism
The success of monetary
policy according to Keynesians depends upon 4 critical links:
(0) the ability to anticipate the appropriate policy choice
(1) the impact of policy choices on money supply
and interest rates
(2) the impact of the money supply and interest
rate changes on aggregate demand
(3) the allocation of the increased demand
between higher prices and greater output
[For a graphical
treatment of the links you should check out the graphs page]
(0) The first of these links we
discussed in the 1960s unit when we covered the problems posed by lags - the
recognition, implementation, and action lags. If action lags are long and
variable, or our ability to accurately forecast the movements in the economy is
quite limited, then monetary policy may not only prove to be ineffective, it
could even be counterproductive and destabilizing. Keynesians downplayed the
importance of these lags, while monetarists believed the lags were long and
variable which is why monetarists had an aversion to discretionary monetary (and
fiscal) policy. back
(1) Once the
policy choice has been made, attention turns to how this policy is reflected in
interest rates. The interest rate is the price of money, and based on our
earlier discussion of supply and demand, the change in the interest rate
generated by a shift in the supply curve depends on the slope of the demand
curve. As you can see in Diagram 8, if the demand curve is flat then the
increase in money supply will have a limited effect on interest rates.
Diagram
8
Potential Impacts on Interest Rates of Increase in Money Supply
The obvious question then is:
what is the slope of the demand curve? A flat demand curve indicates demand is
very responsive to interest rates, as it might be if interest rates were at
very low levels. Keynes, in his depression model, assumed interest rates were
already low enough so any expansionary monetary policy would not be able to
drive down interest rates because the demand curve was horizontal. The name
given to this extreme version of money demand elasticity where the money demand
curve is horizontal is the Liquidity Trap.21
In this case monetary policy would be completely ineffective, which is one of
the reasons Keynes favored fiscal policy as a means to get the economy out of a
depression.
(2) Once it is
known how interest rates will be affected by monetary policy choices, the
question is: how sensitive is aggregate demand to changes in interest
rates? If the Fed is successful in altering interest rates and there is no
change in aggregate demand, then monetary policy will not work. One sector of
demand generally responsive to interest rates is residential construction since
homes are paid for with mortgages, so if the Fed were interested in stimulating
the economy, as it was in 2001, it would drive interest rates down to decrease
the monthly mortgage payments. The result of the lower payment is expected to
increase demand for homes that translates into higher levels of construction activity,
while the lower rates may also prompt existing homeowners to refinance their
mortgages and use the savings in the monthly mortgage payment to buy other
"stuff."
A second sector of demand
affected by interest rates would be consumer durables - the appliances and
automobiles that households tend to purchase with loans. The rationale is the
same - lower monthly costs stimulate demand. You see this relationship in the
headlines in late 2001 such as "Auto sales ride high on no-interest loans"
and "FINANCING INCENTIVES ARE DRIVING A SPURT IN AUTO SALES" as auto
companies began offering 0 percent interest rates.
A third sector would be
business' investment demand. In theory, demand for nonresidential investment in
structures and equipment - new factories and machines - is expected to increase
with falling interest rates as the present value of the future earnings from
these machines would be increased and the cost of purchasing them
decreased.
This was the theory, but
Keynesians had doubts about the impact of a monetary policy in very depressed
situations such as the 1930s. A drop in interest rates could lower financing
costs for businesses and consumers, but consumers who did not have jobs would
be unlikely to rush out and buy new homes, and businesses, already suffering
with excess capacity, would be hard pressed to justify building new structures
or buying new machinery and equipment. In the Keynesian world of the
1930s, a decrease in the interest rate will produce only a negligible increase
in investment spending [Investment
diagram]. This was the situation in the US during the Great
Depression, in Japan throughout much of the 1990s, and in the US in the 2008-09
financial crisis as interest rates were driven down with little positive
impact. There was a general consensus that the economy would be more responsive
to changes in spending more than changes in the supply of money, and some even
went far enough to equate monetary policy to pushing on a string.22 back
(3) The final
link in the monetary policy process is the policy's impact on GDP, which
depends upon two factors. First, is the size of the original spending
multiplier. It is clear from the equation that the size of the multiplier
(DY/DG) depends critically upon the value of the marginal propensity to
consume.
DY/DG
=1/(1-MPC)
If the MPC is small, which
would be the case if consumption spending were insensitive to income, then any
initial increase in demand would have a small "multiplier" effect on
aggregate demand, which would translate into a smaller effect on income and
employment. This would likely be the situation for an open economy with high
levels of imports where leakages from the system would be high, or if
consumption spending was not much influenced by current income as suggested by
Milton Friedman with his permanent income theory.
There is also the allocation of
the increase in aggregate demand into increases in prices and increases in output,
which depends upon the slope of the AS curve. If the economy is operating close
to capacity, the AS curve is steep and we can expect the impact of the monetary
policy will be felt primarily in the price level. Similarly, if the AS slope is
relatively flat, what you would expect in a severe recession or depression, the
impact will show up in levels of output.
Diagram
9
Monetary Policy and Aggregate Supply
Before we leave, let’s
take one more look at the framework for monetary policy as seen by the
Keynesians by following the links in Diagram 10. The decision by the Fed to
increase the money supply (M) will push interest rates lower ( r) which will
increase consumption and investment spending (C & I). This will increase
aggregate demand (AD), which will result in some combination of increase in
output (GDP) and prices (CPI).
Diagram
10
Monetary Policy Transmission Mechanism
“M– r –“I&C–“AD–“GDP and/or“P
where
·
#M =
increase in money supply
·
$r =
decrease in interest rate
·
#I&C =
increase in investment and consumption spending
·
#AD =
increase in aggregate demand
·
#GDP
and/or #P = increase in GDP and / or prices
Keynesian monetary theory and fiscal policy
Once the link between the
capital market and output market is explicitly acknowledged, however, it is
important to revisit our analysis of fiscal policy and the Keynesian
multiplier. In Diagram 10 the impact of fiscal policy on the economy is once
again traced out, except this time we acknowledge the potential interdependency
between the capital and output markets. In the Keynesian world, the
expansionary fiscal policy (“G) would by definition increase aggregate demand (“AD) that would, via the multiplier,
increase aggregate output (“GDP). This increase in income would
increase demand for money (“Md), which would put upward
pressure on interest rates (“r), and this would "crowd-out"
investment and consumption spending ( C, I) which would put downward pressure on
income ( GDP), thereby lowering the value of the
spending multiplier.
Diagram
10
“G–“AD–“GDP –“Md–“r – C, I – GDP
As Keynes saw things, however, this
crowding-out effect in depressed times is minimal for two reasons. First, the
existence of surplus of funds in the capital market would mean any rise in
interest rates would be minimal. Second, if business conditions are quite bad
when the policy is undertaken, then the increase in aggregate demand and income
could raise business expectations and this could actually raise their
investment demand - a crowding-in phenomenon. If this is the case, however, we
can expect monetary policy to be ineffective as a demand management policy. If
interest rates cannot be pushed down and / or spending is insensitive to
interest rates, then monetary policy will be ineffective and fiscal policy,
because of a limited crowding out effect, will be an effective policy.
The Fed's Policy Dilemma, Volcker, and the
Monetarist Experiment
Now that you have the outlines
of monetary theory, let's look at the situation facing the Fed as a result of
the OPEC price shocks of the 1970s. Carter had hoped to use wage and price
guidelines to reduce inflation without incurring the cost of higher inflation,
but this never came to pass, so the gradualism of president Carter and his Fed
Chairman G. William Miller were grounded in the belief that lower inflation's
short term cost was higher unemployment - the Phillips Curve.
The problem faced by the Fed in
the later 1970s - what we might call a dilemma - can be seen in the following
diagram. The increase in the price level in 1970s increased demand for money,
and the increase in money demand put upward pressure on interest rates (i* to
i**) and on the money supply (M* to M**). [Diagram 11]
Diagram
11
The Initial Problem
The Fed needed to respond to the
upward shift in the money demand curve - and there were two choices. The Fed
could either manage interest rates or manage the money supply. What it could
not do was simultaneously hit a money supply (quantity) target and an interest
rate (price) target. For example, if the Fed wanted to keep interest rates from
rising as a result of the increase in money demand, it would need to increase
the supply of money - and outward shift in the Ms curve (left-side of Diagram
12) so the money supply would increase from M* to M**. By adopting a policy
that keeps interest rates constant at I* the Fed had to give up control of the
money supply that increased from M* to M**.
A second option would be Fed
polices to target the money supply. For example, if the Fed wanted to keep the
money supply from rising as a result of the increase in money demand, it would
need to decrease the supply of money - an inward shift in the Ms curve
(right-side of Diagram 12). This policy would maintain the money supply ay M*,
but interest rates would rise to I**.
Diagram
12
Alternative Fed Strategies
These policies have
substantially different effects on the economy, so what was the Fed to do? Keynesians, who dominated policy positions in
the 1970s, believed interest rates mattered most. They believed an easy money
policy (increases in money supply) was needed to keep the economy from falling
into another recession. By keeping interest rates low the Fed could
stimulate business and consumer spending and help reduce unemployment. Opposing
them were the monetarists, a group of economists whose focus on
money supply can be traced back to the work of the Classical economists of the
1920s. By allowing the money supply to grow as they tried to keep interest
rates down the Fed would be fueling inflation, so they opposed the
policies being pursued by the Fed.
What the economy received was a
strong dose of Keynesian monetary policy in the 1970s. President Carter's
primary concern was unemployment, so he picked G. William Miller as Fed chair
and directed him to use monetary policy to reduce unemployment and help him
deliver on his campaign promise. By 1979 the Fed had been somewhat successful
at lowering unemployment - the unemployment rate had fallen to 5.5 percent from
a high of 9.5 percent - but inflation was on the rise again and the second
round of OPEC price increases was threatening to set off another round of
double-digit inflation. By 1979 it was beginning to look like an inflationary
spiral had been triggered by Miller's program of gradualism.
The inflationary spiral
unleashed in the 1970s is summarized in Diagram 13. High unemployment (U)
prompts the Fed to increase the money supply (Ms), which pushes down real
interest rates (i), which in turn increases investment spending (I). This
increases aggregate demand (AD) and this increase in demand pushes output (GDP)
and prices (CPI) higher. This pushes money demand (Md) higher, which prompts
the Fed to respond to higher nominal interest rates by increasing the money
supply (Ms). This will start the whole cycle again, and each loop we make the
inflation rate is higher than the previous one. The US economy was on a
treadmill that produced only rising inflation and interest rates.
Diagram
13
The Inflationary Spiral
high U
–“Ms– ir–“I–“AD–(“GDP &CPI) –“Md–“i–“Ms– i–“I–“AD–“ (GDP & CPI )– “Md“#i“#Ms– i–“I–#“AD–v(GDP & CPI )
As inflation and interest rates
spun out of control the world lost confidence in the US $ which you can
"see" in the precipitous drop in the exchange rate. In July of
1979 the exchange rate dropped sharply again and in the following month
President Carter acted to calm the capital markets. In August Miller was out as
chair of the Fed, replaced by Paul Volcker, the internationally respected
president of the New York Federal Reserve.23
The policies of the Fed during
this period could be directly tied to the aftereffects of the Great Depression,
to the political sensitivity to rising unemployment. According to De Long, it
would have taken a bold move on the part of the Fed to take up the fight
against inflation in the 1970s by raising the unemployment rate, and it may
have been that the Fed had not yet achieved the level of independence necessary
to lead the fight. "[T]he memory of the Great Depression meant that the US
was highly likely to suffer an inflationary episode like the 1970s in the
post-World war II period-maybe not as long, and maybe not exactly when it
occurred, but nevertheless a similar episode," but the opening
came in 1979 as the US economy appeared on the brink of yet another round of
stagflation.24
Monetarism
While Keynesians dominated the
economics profession and guided macro policy for most of the post WW II era,
there was a group of conservative economists called monetarists who continually
challenged the Keynesian view of the economy, and by the early 1970s the
monetarists had developed a statistical model that supported Friedman's
contention that there was no long run trade-off between inflation and
unemployment and showed monetary policy had a potentially powerful impact on
the economy.25 It was not until the mid 1970s, however, when the
inability of the Keynesian policies to control inflation created a policy void,
that policy makers began to seriously listen to the monetarists.
The biggest step toward the
conversion was Paul Volcker's appointment as Federal Reserve Chairman with a
promise to control the money supply and bring monetarism to the US. The
Keynesian policy of monitoring interest rates came to an end on October 6, 1979
when Volcker returned home early from an IMF meeting in Belgrade where he
received severe criticisms for US monetary policy. Volcker rushed home and
announced the FED would redirect its efforts toward hitting its monetary
targets and let interest rates seek their own level. Volcker was actually
not the first to move in the direction of monetarism, as the United Kingdom
under Margaret Thatcher, had already adopted monetarism to reduce
inflation.
Volcker did succeed in bringing
monetarism to the US and controlling the money supply, but the experiment was
short lived. The dramatic tightening by Volcker's Fed drove mortgage rates to
near 20 percent and helped push the US into a very serious recession. This
helped break the back of inflation, but Volcker and the Fed became a focal
point for the anger citizens.26
The monetarists' message was
simple - the Fed should focus on controlling the money supply since this was
the most important determinant of changes in GDP and it should downplay the
role of interest rates in their policy decisions.26 Monetarists,
true to their Classical roots, believed in the Quantity Theory of Money
summarized in the equation below that links the inflation rate (p) directly to
the growth rate in the money supply (m) under the assumption the growth rates
in velocity (v) and income (y) are constants.
p = m - y + v
Some economists even argued for
adoption of a monetary rule - essentially replacing the Fed's discretionary
monetary policy with a simple formula based on the above relationship. By
plugging into the equation the growth rate in potential output (y) and velocity
(v), the Fed would need to set the growth rate in the money supply at a rate
that would achieve the desired inflation rate. For example, if the Fed had a
goal of 0 inflation and expected the economy to grow at 2 percent per year and
velocity to remain constant, then it should undertake policies designed to keep
money supply growth at 2 percent [2 = 2 + 0 - 0]. In essence we would replace
the Fed with a computer programmed to meet the target levels for the money
supply growth. Furthermore, if the Fed were serious about fighting the
inflation that was beginning to accelerate in the late 1970s, then it would
need to reduce sharply the growth rate in the money supply.
The experiment with pegging
interest had come to an end - or at least it seemed so at that time - and the
Fed would now establish money supply targets. The "beauty" of this
change in approach was the Fed could now allow interest rates to rise to levels
impossible to announce as policy goals. While the Fed could not announce it had
a goal of 20 percent interest rates, it could announce a target growth rate of
the money supply of 4 percent and let interest rates achieve their own level.
The target ranges for M-1 and M-2 for 1979 were set at 3-6 and 5-8 percent, low
enough to pretty much guarantee a slowdown in the economy.
The FED was clearly successful
at lowering the growth rate of the money supply, and Volcker indicated the
Fed's policies would continue. In February 1980, Volcker testified before the
House Banking Committee:
Let there be no doubt; the Federal Reserve is determined to make
every reasonable effort to work toward reducing monetary growth from the levels
of recent years, not just in 1980, but in the years ahead.
And interest rates did respond
to the restrictive policies. The Fed raised the discount rate to 13 percent in
early 1980, and after a quick reversal in mid 1980 to avert a deep recession,
raised it again to 14 percent by late 1981.
The impact on market interest
rates was very clear from the two graphs below - one of the prime rate, the
rate banks charge their best customers, and one of rates on long-term
government bonds. In both cases in the fourth quarter of 1979, rates
reached a record-high, and by mid 1980 huge losses were being racked up in the
bond market as a result of rising interest rates and it became difficult to
find anyone willing to lend long-term money because of a fear of even higher
rates.
One definitive result of the Fed's
experiment with monetary policy was high real interest rates. As you could see
in a Ms - Md diagram, the Fed's reduction in the money supply will drive up
interest rates - and they did increase real rates. The high real interest rates
claimed a number of victims. In the US, the thrift institutions were adversely
affected since their assets were often low interest rate loans, while their
liabilities were high interest rate deposits. Internationally, the less
developed countries (LDCs) that had borrowed heavily in the 1970s were hit with
a lower demand for their products, a result of the world-wide recession, and
higher costs of borrowing, the result of a stronger US $ and higher real
interest rates. The LDC debt crisis began in earnest in August of 1982 when
Mexico suspended interest payments on its debt.
It is not an overstatement to
suggest that "Monetarism achieved its moment of apogee with both
intellectual and policy triumph in the late 1970s. Its intellectual triumph
came as the NAIRU grew very large and the multipliers grew very small in both
journals and textbooks. Its policy triumph came as both the Bank of England and
the Federal Reserve declared in the late 1970s that henceforth monetary policy
would be made not by targeting interest rates but by targeting quantitative
measures of the aggregate money stock." The influence can also be seen in
the following three quotes pertaining to the monetary policies of the UK, US,
and Japan during this period.
- "to master inflation, proper monetary discipline is
essential, with publicly stated targets for the growth of the money
supply."
- "Let there be no doubt; the XX is determined to make every
reasonable effort to work toward reducing monetary growth from the levels
of recent years, not just in YY, but in the years ahead."
- "The ZZ announced that it would henceforth focus on
monetary control instead of interest rate control instead of interest rate
control as the intermediate target of its monetary
policy."
The first statement appeared in
the Conservative manifesto of 1979 at the outset of Margaret Thatcher's tenure
as prime minister. In the second, XX is the Fed and YY is 1980, while in the
last statement, ZZ refers to the Bank of Japan's policy in the mid 1970s.
As it turned out, the
experiment with monetarism in the US was called off in 1982, but not before
interest rates rose even higher by the end of 1981. The inflation spiral
appeared to have been broken, but the cost was substantial as the US entered
its most serious slowdown since the Depression. The move toward
"rules" had been reversed and the FED was once again monitoring
interest rates.
It's now time to move into the
1980s, where will shift our attention back to fiscal policy and examine the set
of policies that became known as Reaganomics or Supply-side economics and the
theory of economic growth.
1. Glyn
Davies, History
of Money. It is therefore not surprising that money altered
the nature of relationships. "Money connected human in a
more extensive and efficient way than any other known medium. It created more
social ties, but in making them faster and more transitory, it weakened the
traditional ties based on kinship and political power." For example, you and I may know very little about
each other, but money provides a common denominator that could be the basis for
establishing a relationship. Whereas in the past we may have been likely to do
things for family and friends because we would have expected reciprocal
treatment, money allowed us to expand the "group" of those who we
might cooperate with. Money also allowed people to be more empirical.
The
decimal system, and its twin, metric measurement, not only changed the way
people handled money and numbers but also transformed the way people thought. A
new empiricism in thought, coupled with money's strict discipline in the use of
numbers and categories [emerged]. ... the new class of intellectuals no longer
sought to discover knowledge only through studying the works of ancient
scholars and religious writers. They themselves could create knowledge through
observation and the recording of events around them.
2. To
see this, consider the problem of a carpenter who needs a plumber. The
carpenter could spend the day producing woodwork for sale and use the
money to pay for a plumber's service, or spend the day looking for a plumber
who happened to need the services of a carpenter. Rather than spending time
doing what they did best, carpentry and plumbing, the two would spend their
time searching. What happens in the first system is the plumber and carpenter
are able to specialize in what they do best and minimize the time and effort
spent searching, so society has access to additional plumbing and carpentry
services and people live in better homes with better water systems.
Or, just think
back over the past 24 hours and list your financial transactions. In ECN 202
you will find students who has already bought the newspaper, breakfast, or
gasoline, and paid a tuition bill, the rent, or the monthly car payment. We
could go on but you get the point - these transactions are so numerous and
painless they slide by almost unnoticed - and on one side of each transaction
was money, either cash, a check, plastic, or e-money. Without these monies
the transactions would not have been possible, and without these transactions
we would not have our modern economy.
3. For those interested in an online source
with some good info, check out Glyn Davies' History
of Money from Ancient Times to the Present Day. While
barter was inefficient, and slowly
over time a monetary system evolved, according to Davies the primary driver
behind the appearance of monies was not efficiency.
Money
originated very largely from non-economic causes: from tribute as well as from
trade, from blood-money and bride-money as well as from barter, from ceremonial
and religious rites as well as from commerce, from ostentatious ornamentation
as well as from acting as the common drudge between economic men. ...
Many
societies had laws requiring compensation in some form for crimes of violence,
instead of the Old Testament approach of "an eye for an eye". The
author notes that the word to "pay" is derived from the Latin "pacare" meaning originally to pacify, appease, or make peace
with - through the appropriate unit of value customarily acceptable to both
sides. A similarly widespread custom was payment for brides in order to
compensate the head of the family for the loss of a daughter's services. Rulers
have since very ancient times imposed taxes on or exacted tribute from their
subjects. Religious obligations might also entail payment of tribute or
sacrifices of some kind. Thus in many societies there was a requirement for a
means of payment for blood-money, bride-money, tax or tribute and this gave a
great impetus to the spread of money.
4. J. M. Keynes,Treatise on Money
5. Not everyone agrees. Barabara Wallraff, in
"What Global Language?" writes that it is highly
unlikely that English will be a global language, and that if a global language
emerges, it will be Chinese. The Atlantic Monthly, November 2000. It is a similar
story when we look at architecture, food, clothing, or art that all possess
distinct national or regional differences, although the differences in all are
declining. If you travel across the US today you will find a sameness in
the nation's largest cities you would not have found 100 years ago. Where
once you had local banks financing local builders and restaurants serving local
cuisine reflecting the ethnic backgrounds of the city's peoples, today you find
international banks financing international construction firms and food and
clothing being sold through international franchises. You are never very far
away from a McDonalds, Gap, or Wal-Mart. Similarly, where once people
were likely to live their entire life within a five-mile radius of where they
were born and interact with only a small number of people in their lives, today
you are likely to travel thousands of miles and interact with thousands of
people scattered across the world.
6. The importance of these properties can be
seen in a letter Thomas Jefferson sent to the Continental Congress in 1776 in
which he lays out the framework for a national money. According to Jefferson,
" in fixing the unit of money the following circumstances were of
principal importance: (US Mint site)
- That
it be of a convenient size to be applied as a measure to the common money
transactions of life.
- That
its parts and multiples be in easy proportion to each other so as to
facilitate the Money Arithmetic.
- That
the Unit and its parts or divisions be so nearly of the value of some of
the known coins so that they may be of easy adoption for the people.
7. Salt mined in
large slabs in the Sahara was a popular form of money in China, North Africa, and
the Mediterranean. It was fairly durable, easily divisible and it certainly had
value as a commodity during medieval times where spices to improve the bland
food was in high demand. In the Philippines and Japan it was rice, in Mongolia
it was bricks of tea, and among the Aztecs in Mexico it was cacao
beans. You could also add to the list of monies stone disks on the island
of Yap, colored shells in India, leather in China, whale's teeth in Figi, grain
in Egypt, animal skins and furs in Canada and Siberia, Wampum (shells) in
Massachusetts, bags of corn in Guatemala, swords in England, and tobacco in
Virginia to mention just a few. And let's not forget animals, which were also a
common form of money among pastoral people. "The Siberian tribes used reindeer,
the people of Borneo used buffaloes, the ancient Hittites measured value in
sheep, and the Greeks of Homer's time used oxen."
The heritage of money can also be
seen in some of the terms that have found their way into the modern English
vocabulary. Salary can be traced back to the Latin word sal meaning salt,
while pecuniary (related to money) is derived from the Latin pecuniarius
meaning "wealth in cattle." The "buck," a slang term
for the American dollar can be traced back to the deerskins used as money in
the British colonies in North America. Finally, the words cattle and capital
are derived from the same Latin root. Weatherford..
For a brief history of money you
might want to check out A Comparative Chronology of Money from Ancient
Times to the Present Day © Roy Davies & Glyn Davies, 1996 that is
available on-line (history of money). You also may want to check
out an abbreviated outline
of some of the important dates in the evolution of money and monetary
systems. Another source was The History of Money by Jack
Weatherford. Random House 1997.
8. "The
Sudanese made iron ... Egyptians used copper, while the people of southern
Europe preferred Bronze. The people of Burma used lead, and the people of the
Malayan Peninsula used tin that abounds there." Weatherford p21
9. Ricardo was not
the only one to be concerned. The following is a description of
perspective of Alexander Hamilton, Secretary of the Treasury in 1790 from a
research paper available on-line at the San Francisco Fed. According to
the authors, "Among his first acts as Secretary was to propose
establishing a national mint, with the intent of providing a stable monetary
standard. He argued for a bimetallic standard that defined a “dollar” in terms
of a certain quantity of gold or silver. Hamilton claimed that a metallic
standard would “render the unit as little variable as possible; because on this
depends the steady value of all contracts, and, in a certain sense, of all
other property.” Gold and silver coined by the mint would engender confidence
in the emerging banking system. The potential for overissuance of bank notes
could be limited by requiring the redemption of bank notes in specie. Congress
accepted Hamilton’s arguments and passed the Mint Act of 1792. Michael Bryan,
Bruce Champ, and Jennifer Ransom, "Who Is That Guy on the $10 Bill?,"
Economic Commentary Federal Reserve Bank of Cleveland | June
2000
10. The decision to
move back towards silver took place at about the same time that much of Europe
was moving back to a gold standard. Germany, immediately after the end of
the Franco-Prussian War in the early 1870s took silver out of circulation, a
decision followed by others including France, Belgium, Italy, and Greece.
11. Pressure
began to mount for the resumption of silver backed money as a means to
"inflate" the economy, and in 1878 the Bland-Allison Act
mandated the government convert a specified amount of silver into legal tender
- silver certificates. The panic of 1893 was
quite sever and was caused in part because of passage of the Sherman Silver Act
of 1790. This act was replaced in 1890 with the Sherman Silver Purchase
Act doubling the purchases of Bland-Allison and specifying the money to be in
the form of paper bills that were redeemable in gold. Once silver was again used as a basis for money, money
became more readily available and investors around the world became worried
that the US would inflate its currency by returning to a true bimetallic system
and they began turning in their US dollars for gold. The expansion in 1890-91
was quickly reversed in 1893 and gold supplies of the US government fell below specified
targets. The result was banks needed to begin calling in loans and
spending dropped... the Keynesian multiplier kicks in.
12. The controversy over the gold
standard also may have been behind the publication in 1900 of The Wonderful
Wizard of Oz, a story with a strong money subplot. Dorothy is
uprooted from Kansas and lands in the East where she sets out on the gold road
to the land of Oz, home to the witches and wizards of banking. She is
accompanied by the scarecrow, tin man, and the lion who represent the American
farmer, the American factory worker, and Bryan. The march to Oz is a recreation
of the 1894 march led by Jacob Comet to demand issuance of $500 million
greenbacks. Marcus Hanna, the power behind the Republican party was the wizard,
and the people of the East were the munchkins. All that was needed was for the
American people to realize that the financial system was run by
frauds. Dorothy, with her silver slippers that were turned into ruby
slippers for the visual effect would help bring the people to that
realization.
13. During those good years,
banks expanded their supply of bank notes (checking accounts) much faster than
the supply of gold, so it was inevitable that at some point someone would call
a banker's bluff. It happened in 1907 as the inflow of gold from England and
Germany was reversed when the central banks in these countries raised interest
rates and investors took their gold to invest it in these countries. With less
gold in the US, bank reserves declined - and so did the money
supply. This made depositors nervous, and when a few banks closed their
doors we had a scene reminiscent of Jimmy Stewart's plight in the Christmas
movie, It's a Wonderful Life.
14.
According to the Fed, the numbers for M1, M2 and M3 are calculated as follows.
M1 "Consists of (1) currency outside the U.S. Treasury,
Federal Reserve Banks, and the vaults of depository institutions; (2) travelers
checks of nonblank issuers; (3) demand deposits at all commercial banks other
than those due to depository institutions, the U.S. government, and foreign banks and official institutions, less cash
items in the process of collection and Federal Reserve float; and (4) other
checkable deposits (OCDs), consisting of negotiable order of withdrawal (NOW)
and automatic transfer service (ATS) accounts at depository institutions,
credit union share draft accounts and demand deposits at thrift
institutions."
M2
"Consists of M1 plus savings deposits (including money market deposit
accounts), small-denomination time deposits (time deposits-including retail
RPs-in amounts of less than $100,000), and balances in retail money market
mutual funds. Excludes individual retirement account (IRA) and Keogh balances
at depository institutions and money market funds."
M3
"Consists of M2 plus large-denomination time deposits (in amounts of
$100,000 or more), balances in institutional money funds, RP liabilities
(overnight and term) issued by all depository institutions, and Eurodollars
(overnight and term) held by U.S. residents at foreign branches of U.S. banks
worldwide and at all banking offices in the United Kingdom and Canada. Excludes
amounts held by depository institutions, the U.S. government, money funds, and
foreign banks and official institutions."
15. This is the
rate we will be talking about later as the interest rate in the Ms-Md graphs.
16. You can see here that the gap between
corporate and US Treasury rates rose after the crisis hit in the end of
1997.
17. One thing you will find with yield curves
is they move around quite a bit, as you can see in the graph below. Rates in
the 1980s are clearly above rates in the earlier years, while rates in the
1960s are clearly below those in the following years. We'll return to a
discussion of the movements in the yield curves in the 1970s unit on monetary
policy and the 1990s unit on Clinton's economics policies.
18. Three
important features of the system are:
- Bank profitability: banks are in business for profit and we should
expect that their decisions are guided by the profit motive and not the
interests of the nation
- Bank discretion over money supply: bankers' decisions affect money
supply. If bankers decide to increase the value of demand deposits then
the money supply will increase, while if they increase their holdings of
excess reserves the money supply will decrease.
- Exposure to runs: potential conflict between profits and safety.
The banks will be tempted to expand the demand deposits that will mean
that if all depositors wanted their cash, the banks could not honor the
claims. This is what you saw in the movie It's a Great Life with
Jimmy Stewart struggling to pay all of the depositors.
19. The four
important aspects of bank regulation are:
- Deposit insurance: deposits are insured which lowers the fears of
customers who will not be as likely to run to the bank to withdraw their
funds when they hear a "rumor" about the bank.
- Bank examinations: banks' books are periodically reviewed so that
we are less likely to have banks adopting risky strategies that will
result in bank closures.
- Limitations on assets: banks cannot hold some assets that are
deemed risky. This is what happened in Japan in the 1990s when the value
of real estate plunged and it is what happened in the great depression in
the US when the value of banks' holding of corporate stocks dropped
sharply. As a result commercial banks were restricted from holding
corporate stock as an asset.
- Required reserves: banks required to keep cash on hand. This would
limit the amount of money that could be created from a given amount of
reserves and it would thus decrease the chance that the banks would have
inadequate reserves to meet their obligations.
20. To see how all of the pieces fit
together, let's go back to examine the impact of the economy's crash in 1929
and the Fed's response. The Fed's initial reaction was to do nothing and wait
for the inevitable correction. Banks, meanwhile, could not afford to pay the
high discount rate in an environment where bank loans were limited because of
the low levels of confidence in business profitability, so banks cut their
borrowing from the Fed. The impact can be seen with a new example of the Fed's
balance sheet. When business went bad in the early 1930s, bank lending to
businesses declined, and with it came a decline in bank borrowing from the Fed.
In this example, if bank lending to businesses dropped so the banks loans from
the Fed fell by $50, then this would be offset by a reduction in Federal
Reserve Notes of $50 since the Fed was required to balance its
books.
Fed's
Newer Balance Sheet after decline in loans to banks
|
Assets |
|
Liabilities |
|
|
Gold |
800 |
Federal Reserve Notes: Currency |
1,200 - 50 |
|
Loans to banks |
400 - 50 |
|
|
|
Loans to government: Government
Securities |
600 |
|
|
|
Total |
1,800 - 50 |
Total |
1,800 - 50 |
After a severe recession / depression in 1920
triggered by the Fed's policy, the Fed began to experiment with a new policy,
the buying and selling of government securities in 1922. In fact the widespread
purchases were not the result of a coordinated Fed policy, but rather the
result of individual Reserve Bank purchases to generate interest income. The
result was "chaos" in the bond market, which led to the establishment
in May of 1922 of the Committee of Governors on Centralized Execution of
Purchases and Sales of Government Securities by Federal Reserve Banks. In the
following year, as a result of growing concern over the concentration of power
in the hands of the New York Reserve Bank's president, Benjamin Strong, who
also happened to chair the new committee, the Committee was 'replaced" by
the Open Market Investment Committee reporting directly to the Board of
Governors.
Internationally things were no better, and in
fact by 1931 they were very bad. In May of 1931 Austria, in response to an
outflow of gold, imposed controls on all gold and foreign exchange transactions
and effectively moved off the gold standard. Germany, was next and on July 14th
all banks in Berlin, except the Reichsbank, were shuttered and soon Germany
also imposed controls. It was then England that caught the eyes of investors /
speculators, and on September 21, 1931 the Bank of England suspended gold
payments rather than raise interest rates. The devaluation of the £, from $4.86
to $3.75 reversed the flow of gold - from into the US to out from the US. The
world's BIG money people, including its central banks, were nervous about
holding any wealth denominated in any currency and US currency was being
redeemed for gold. And by now you know the story, the outflow of gold drove
down the money supply in the US - what would be referred to as an external
drain. The situation can
be seen in the final example below. The $50 outflow of gold would need to be
offset by a $50 reduction in the Fed's liabilities, so Federal Reserve Notes,
the nation's money supply, would fall by $50.
Fed's
new Balance Sheet with gold outflow of 50
|
Assets |
|
Liabilities |
|
|
Gold |
800 -50 |
Federal Reserve Notes: Currency |
1,200 -50 |
|
Loans to banks |
400 |
|
|
|
Loans to government: Government
Securities |
500 |
|
|
|
Total |
1,800 -50 |
Total |
1,800 -50 |
Should the Fed sit back and allow these types
of shocks to affect the money supply - allow the money supply to collapse as the
economy fell into the Great Depression? It was a question that had to be asked
again during the Asian Crisis of 1997-98 as foreign investors moved their money
out of the Asian economies. What should guide the central banks in their
decisions?
In the case of the 1930s, the Fed had failed
to establish the independence and power reflected in the Greenspan policy
decisions of the late 1990s. During the 1920s and early 1930s, the Fed was
wracked by power struggles between the seven member Board and the regional bank
presidents, especially the president of the New York Reserve Bank. At this time
the Fed allowed the decrease in loans to banks and the outflow of gold, the
internal and external drains, to pull down the money supply because it was
committed to the gold standard that linked the two sides of the Fed's balance
sheet. When gold or loans to banks decreased, the Fed allowed the change in its
assets to be reflected in a change in the money supply, and this tended to
exacerbate the effects of the recession.
It did not have to be this way, however,
since the Fed had some policy tools that could have broken the link between the
money supply and the assets of the Fed. One obvious possibility would have been
a decision by the Fed to abandon the gold standard - when foreign investors
arrived with dollars looking to be converted into gold, the Fed would not
convert them into gold. The gold would stay in the US and the $s would continue
to circulate, a policy the Fed eventually adopted, but not until after a substantial
drop in the money supply. In 1997 Asian Crisis on the other hand,
when the Asian stock market crashed and foreign investors wanted to take their
money and run, the IMF stepped in and "encouraged" the Asian nations
to raise interest rates to very high levels so that foreign investors would
keep their money in Asia. For example, if Indonesia raised interest rates to 30
percent, investors could earn enough to compensate them for additional risk and
the money would stay in Indonesia. Needless to say this was not good for the
domestic economy as individuals and firms were "sacrificed" to the
international financial system "gods," and as we will see in the 2000s
unit, this brought the International Monetary Fund (IMF) into
the public limelight and helped set the stage for the battle in Seattle during
the World Trade Organization (WTO) meetings in early 2000.
21. While some economists question the
validity of the liquidity trap, others believe the situation in Japan in the
late 1990s offers another example of the liquidity trap (Krugman). Interest rates were so low in
Japan, reaching .5 percent on government securities, that monetary authorities
were simply unable to push down rates any further.
22.In the Keynesian world, while both of
the situations described in Diagram 2 would be possible, we were likely to
encounter the situation depicted in the right side diagram where a decrease in
the interest rate (i* to i**) will produce only a negligible increase in
investment spending (I* to I**). Discretionary monetary policy, while a
theoretical possibility, is unlikely to work in practice in this environment.
Some would come to describe the implementation of expansionary monetary policy
as equivalent to pushing on a string.
Diagram 2
Interest Rate Responsiveness of Investment Spending
23. The flaw in the Keynesian theory was the
inability of Fed officials to make the distinction between real and nominal
interest rates. The relationship between the real interest rate (rr),
what we believe affects decision makers and should be the concern for policy
officials, the nominal interest rate (rn), which is the rate we
actually see reported in the financial press, and the expected inflation rate
(ie) is given by the following equation.
rr
= rn - ie
In normal times the inflation rate (ie)
remained rather stable and information on the real rate of interest (rr),
what matters to the Keynesians, could be used to determine what was happening
to nominal interest rates (rn). The link between the real and
nominal rates collapsed in the 1970s, however, which caused troubles for policy
makers. By 1974 inflation rates had risen above the rate on short-term
government securities and remained there through the end of the 1970s so real
rates were actually negative for the remainder of the 1970s.
24. De Long
"America's Only Peacetime Inflation: The 1970s" p1
25. The person most responsible for the
emergence of monetarism in this era was Milton Friedman who, in his
introductory essay in Studies in the Quantity Theory of Money, "established modern monetarism." De Long, "The Triumph of Monetarism?" Journal
of Economic Perspectives, Winter 2000
26. In Washington, D.C. demonstrators
picketed the Federal Reserve Building with signs "Help American
Agriculture - Eat an Economist." Volcker was unfazed by the
demonstrations. He felt the Fed was responsible for breaking the inflationary
spiral, so he withstood the pressure, just as he withstood pressure from the Reagan
team to lower rates in 1986 to improve the macroeconomic situation prior to the
midterm election. Volcker used the opportunity to step down in 1987 and into
the Chairmanship stepped Alan Greenspan.
27. In their search for funds, firms were
increasingly avoiding the bond market and relying on bank loans. In response to
the "explosion" of bank lending, on March 14, 1980, President Carter
sent a directive to the Fed to control credit under the Credit Control Act of
1969, which the Fed did. The impact of the credit controls can be seen in the
table below, with the growth rate in loan moving from +16% to -14% in a
two-month period.
Commercial
and Industrial Loans at all Commercial Banks
|
Year |
Month |
Loans |
Growth Rate |
|
1980 |
1 |
287.8 |
10% |
|
1980 |
2 |
291.1 |
15% |
|
1980 |
3 |
294.7 |
16% |
|
1980 |
4 |
294.5 |
-1% |
|
1980 |
5 |
290.7 |
-14% |
|
1980 |
6 |
289.6 |
-4% |
To add further complexity to the situation,
Congress was simultaneously working on the Depository Institutions Deregulation
and Monetary Control Act of 1980 that had three provisions:
- Uniform
reserve requirements would be imposed on all depository institutions.
- Interest
rate ceilings on deposits would be phased out to solve the problem of disintermediation - the outflow of funds from banks as depositors
sought rates higher than those banks could offer.
- All
depository institutions could offer interest-paying "checking"
accounts such as negotiable orders of withdrawal (NOW accounts) which
meant that the measures of M1 and M2 were changed so that all of the
historical relationships between the Ms and the economy that were the
basis for the monetarist policies were useless. Another effect of the
legislation was greater variability in the money supply measures. For the
monetarists who supported the approach of setting targets for the monetary
aggregates, the greater variability in growth rates after the policy moves
seriously weakened the value of the monetary aggregates as policy
instruments.
28. Two reviews of
monetarism published by the Fed are: R.W. Hafer, What remains of monetarism? Economic Review Atlanta 2001:4 and The Rise and Fall of a Policy Rule: Monetarism at the St.
Louis Fed: 1968-1986, Economic Review St. Louis J/F 2001. You can also visit Allan H.
Meltzer's Monetarism section in the Concise
Encyclopedia of Economics
R.W. Hafer, What remains of monetarism? Economic Review Atlanta 2001:4 p16. What Friedman did was link money supply to nominal GDP, a relationship that was at the center of his book coauthored with Anna Scwartz, A Monetary History of the United States: 1867-1960.23 By the early 1960s Friedman was making the case that the demand for money was a very stable function - that velocity did not vary greatly - and that any significant changes in the amount of money in the economy were due to decisions made by the Fed. By doing this Friedman attempted to link the cyclical movements in money to Fed decisions, which set the stage for his proposals to set rules for the Fed - to replace the Fed by a computer that continuously monitored the money supply. By 1970 the monetarists had their own econometric model - known as the St. Louis model - that became a competitor with the large scale econometric models favored by Keynesians. This model supported the Friedman contention that there was no long run trade-off between inflation and unemployment and showed that monetary policy was a potentially powerful impact on the economy.