Monetary policy introduction
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This was a short presentation to introduce monetary policy to the Michigan Interactive Investments Club
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Monetary policy introduction
- 1. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES AN INTRODUCTION TO MONETARY POLICY Yichuan Wang Michigan Interactive Investments University of Michigan December 5, 2013
- 2. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES OUTLINE 1 INTRODUCTION Motivation 2 THINKING ABOUT GOLD 3 MODELING Nominal Rigidities Timing Misconceptions 4 MONETARY POLICY, QE, AND INTEREST RATES Thinking About Interest Rates QE Specifics
- 3. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES OUTLINE 1 INTRODUCTION Motivation 2 THINKING ABOUT GOLD 3 MODELING Nominal Rigidities Timing Misconceptions 4 MONETARY POLICY, QE, AND INTEREST RATES Thinking About Interest Rates QE Specifics
- 4. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES MOTIVATION OUTLINE 1 INTRODUCTION Motivation 2 THINKING ABOUT GOLD 3 MODELING Nominal Rigidities Timing Misconceptions 4 MONETARY POLICY, QE, AND INTEREST RATES Thinking About Interest Rates QE Specifics
- 5. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES MOTIVATION WHAT IS MONETARY POLICY? MY DEFINITION A set of rules for how to adjust the money supply in response to economic conditions Key ideas: Raising rates = Policy, the framework is crucial Focus on M, not r. Examples: Gold standard – adjust money supply so that price of gold is constant Inflation targeting – tighten M if inflation is high, expand if inflation is too low Lingo: Tight money – very harsh against inflation Easy money – “tolerant”
- 6. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES MOTIVATION NOMINAL AND REAL VARIABLES Real variables: How much stuff can I buy?
- 7. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES MOTIVATION NOMINAL AND REAL VARIABLES Real variables: How much stuff can I buy? RGDP, Industrial Production, Initial Claims
- 8. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES MOTIVATION NOMINAL AND REAL VARIABLES Real variables: How much stuff can I buy? RGDP, Industrial Production, Initial Claims Nominal variables: How many dollars does it cost?
- 9. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES MOTIVATION NOMINAL AND REAL VARIABLES Real variables: How much stuff can I buy? RGDP, Industrial Production, Initial Claims Nominal variables: How many dollars does it cost? Two key aggregates Nominal GDP – total dollar value of all goods and services Price Level – price index of all goods
- 10. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES MOTIVATION MONEY SUPPLY AND INFLATION Key driver of inflation AFG ALB DZA ATG ARG ABW AUSBHS BHR BGD BRB BLZ BEN BTN BOL BIH BWA BRN BGR BFA BDI KHMCMR CAN CPV CAF TCD CHL CHN COL COM COG CRI CIV HRV CYP CZE DNK DJI DMA DOM ECU EGY SLV GNQ ERI EST ETH FJI FIN GAB GMB GHA GRD GTM GIN GNB GUY HTI HND HKG HUN ISL IND IDN IRN IRQ IRL ISR ITA JAM JOR KEN KOR KSV KWT KGZ LAO LVA LBN LSO LBR LBY LTU MAC MKD MDG MWI MYS MDV MLI MLT MRT MUS MEX FSM MDA MNG MNE MAR MOZ MMR NAM NPL NLD NZL NIC NER NGA NOR OMN PAK PAN PNG PRY PER PHL POL QAT ROM RWA WSM STP SAU SEN SRB SYC SLE SGP SVK SLB ZAF LKA KNA LCA VCT SDN SUR SWZ SWE CHE SYR TZA THA TMP TGO TON TTO TUN TUR UGA ARE GBRUSA URY VUT VEN VNM WBG YEM ZMB ZWE 0 10 20 30 40 50 0 10 20 30 40 50 Average Annual Percent Growth in Broad Money AverageAnnualPercentChangeintheGDPDeflator Money Supply Growth and Inflation (1992−2012)
- 11. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES OUTLINE 1 INTRODUCTION Motivation 2 THINKING ABOUT GOLD 3 MODELING Nominal Rigidities Timing Misconceptions 4 MONETARY POLICY, QE, AND INTEREST RATES Thinking About Interest Rates QE Specifics
- 12. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES MONETARY POLICY UNDER A GOLD STANDARD If our economy were based on gold, what happens to output of goods and services if there were a gold rush?
- 13. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES MONETARY POLICY UNDER A GOLD STANDARD If our economy were based on gold, what happens to output of goods and services if there were a gold rush? It goes up! People buy goods with newfound money, firm not quick enough to raise prices Does output rise forever?
- 14. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES MONETARY POLICY UNDER A GOLD STANDARD If our economy were based on gold, what happens to output of goods and services if there were a gold rush? It goes up! People buy goods with newfound money, firm not quick enough to raise prices Does output rise forever? No! Eventually, firms adjust David Hume: “On Money” Money // Quantities // Prices
- 15. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES DAVID HUME - “ON MONEY” (1742) To account, then, for this phenomenon, we must consider, that though the high price of commodities be a necessary consequence of the encrease of gold and silver, yet it follows not immediately upon that encrease; but some time is required before the money circulates through the whole state, and makes its effect be felt on all ranks of people. At first, no alteration is perceived; by degrees the price rises, first of one commodity, then of another; till the whole at last reaches a just proportion with the new quantity of specie which is in the kingdom. In my opinion, it is only in this interval or intermediate situation, between the acquisition of money and rise of prices, that the encreasing quantity of gold and silver is favourable to industry.
- 16. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES THE FIRST “QUANTITATIVE EASING” – LEAVING THE GOLD STANDARD September 19, 1931: Britian leaves gold standard, high interest rates normalized in March of 19321 100 120 140 1930 1931 1932 1933 1934 1935 Date London Security Price Index 1http://www2.warwick.ac.uk/fac/soc/economics/research/centres/cage/
- 17. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES THE U.S. EXPERIENCE April 5, 1933: FDR suspends convertibility of gold, “goes off gold standard” 100 200 300 1930 1932 1934 1936 1938 1940 Date Dow Jones Industrial Index and the Great Reflation
- 18. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES OUTLINE 1 INTRODUCTION Motivation 2 THINKING ABOUT GOLD 3 MODELING Nominal Rigidities Timing Misconceptions 4 MONETARY POLICY, QE, AND INTEREST RATES Thinking About Interest Rates QE Specifics
- 19. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES NOMINAL RIGIDITIES OUTLINE 1 INTRODUCTION Motivation 2 THINKING ABOUT GOLD 3 MODELING Nominal Rigidities Timing Misconceptions 4 MONETARY POLICY, QE, AND INTEREST RATES Thinking About Interest Rates QE Specifics
- 20. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES NOMINAL RIGIDITIES NOMINAL RIGIDITIES KEY IDEA If monetary policy affects the economy, it’s because “nominal shocks have real effects” Two main explanations: 1 Nominal rigidities: contracts are dollar denominated, hence money supply (not credit supply) plays crucial role in driving the business cycle Examples: Debt, Wages 2 Say’s Law: excess supply (i.e. recession) for goods is matched by excess demand for money (i.e. money hoarding)
- 21. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES NOMINAL RIGIDITIES WAGE RIGIDITIES FRBSF Economic Letter, “Why Has Wage Growth Stayed Strong” 2011 Distribution of Wage Increases from CPS Sudden drop in nominal variables =⇒ new distribution of real wages
- 22. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES NOMINAL RIGIDITIES DEBT Debt build up – written in terms of nominal rates When nominal variables change, real distribution of debt changes
- 23. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES TIMING OUTLINE 1 INTRODUCTION Motivation 2 THINKING ABOUT GOLD 3 MODELING Nominal Rigidities Timing Misconceptions 4 MONETARY POLICY, QE, AND INTEREST RATES Thinking About Interest Rates QE Specifics
- 24. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES TIMING TEMPORARY VERSUS PERMANENT SHOCKS Permanent monetary shocks always result in nominal shocks History: going off the gold standard, Eurozone vs U.S. austerity When perceived as temporary, then no effect Example: Y2K
- 25. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES MISCONCEPTIONS OUTLINE 1 INTRODUCTION Motivation 2 THINKING ABOUT GOLD 3 MODELING Nominal Rigidities Timing Misconceptions 4 MONETARY POLICY, QE, AND INTEREST RATES Thinking About Interest Rates QE Specifics
- 26. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES MISCONCEPTIONS A LITANY OF BAD ARGUMENTS AGAINST MONETARY POLICY “Central Planning”
- 27. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES MISCONCEPTIONS A LITANY OF BAD ARGUMENTS AGAINST MONETARY POLICY “Central Planning” Business cycle = market failure – nominal rigidities Monetary policy gone wrong: what did FDR do in response to Great Depression, what did Nixon do in response to Great Inflation?
- 28. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES MISCONCEPTIONS A LITANY OF BAD ARGUMENTS AGAINST MONETARY POLICY “Central Planning” Business cycle = market failure – nominal rigidities Monetary policy gone wrong: what did FDR do in response to Great Depression, what did Nixon do in response to Great Inflation? “Malinvestment”
- 29. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES MISCONCEPTIONS A LITANY OF BAD ARGUMENTS AGAINST MONETARY POLICY “Central Planning” Business cycle = market failure – nominal rigidities Monetary policy gone wrong: what did FDR do in response to Great Depression, what did Nixon do in response to Great Inflation? “Malinvestment” Depth of downturn not related to previous boom No reason why “good” investments need to be sacrificed
- 30. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES MISCONCEPTIONS A LITANY OF BAD ARGUMENTS AGAINST MONETARY POLICY “Central Planning” Business cycle = market failure – nominal rigidities Monetary policy gone wrong: what did FDR do in response to Great Depression, what did Nixon do in response to Great Inflation? “Malinvestment” Depth of downturn not related to previous boom No reason why “good” investments need to be sacrificed Zimbabwe! Weimar Germany!
- 31. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES MISCONCEPTIONS A LITANY OF BAD ARGUMENTS AGAINST MONETARY POLICY “Central Planning” Business cycle = market failure – nominal rigidities Monetary policy gone wrong: what did FDR do in response to Great Depression, what did Nixon do in response to Great Inflation? “Malinvestment” Depth of downturn not related to previous boom No reason why “good” investments need to be sacrificed Zimbabwe! Weimar Germany!
- 32. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES OUTLINE 1 INTRODUCTION Motivation 2 THINKING ABOUT GOLD 3 MODELING Nominal Rigidities Timing Misconceptions 4 MONETARY POLICY, QE, AND INTEREST RATES Thinking About Interest Rates QE Specifics
- 33. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES THINKING ABOUT INTEREST RATES OUTLINE 1 INTRODUCTION Motivation 2 THINKING ABOUT GOLD 3 MODELING Nominal Rigidities Timing Misconceptions 4 MONETARY POLICY, QE, AND INTEREST RATES Thinking About Interest Rates QE Specifics
- 34. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES THINKING ABOUT INTEREST RATES RELATIONSHIP WITH TRADITIONAL MODELS Textbook models will focus on the interest rate Not completely wrong, but misleading Interest rates: price of credit Price level: price of money Not necessarily related “Never reason from a price change”
- 35. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES THINKING ABOUT INTEREST RATES THE SIX “CONTRADICTIONS” From Scott Sumner’s “How to tell if you understand monetary economics” List of six “contradictions” – I focus on two on interest rates. CONTRADICTIONS OF INTEREST 1 A move to a more expansionary monetary policy lowers short-term interest rates. 2 In general, the higher the level of short-term rates, the more expansionary the monetary policy.
- 36. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES THINKING ABOUT INTEREST RATES INTEREST RATES A CONTRADICTION OF INTEREST (I) A move to a more expansionary monetary policy lowers short-term interest rates. 2 3 4 5 6 0 25 50 75 100 Money (M) ShortTermInterestRate(r) Effect of a Monetary Expansion
- 37. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES THINKING ABOUT INTEREST RATES INTEREST RATES A CONTRADICTION OF INTEREST (II) In general, the higher the level of short-term rates, the more expansionary the monetary policy. 2 3 4 5 6 0 50 100 Money (M) ShortTermInterestRate(r) Effect of a Monetary Expansion
- 38. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES THINKING ABOUT INTEREST RATES LONG TERM INTEREST RATES Goes to show that “easy money” is typically in periods of high interest rates
- 39. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES QE SPECIFICS OUTLINE 1 INTRODUCTION Motivation 2 THINKING ABOUT GOLD 3 MODELING Nominal Rigidities Timing Misconceptions 4 MONETARY POLICY, QE, AND INTEREST RATES Thinking About Interest Rates QE Specifics
- 40. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES QE SPECIFICS FRAMEWORK Thinking in terms of M =⇒ QE is self evident “Zero lower bound” is red herring – permanent shocks can still have real effect “Pushing down long term rates” is intermediate goal – monetary expansion will result in higher long term rates (and that’s good!)
- 41. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES QE SPECIFICS STILL THINK MONEY DOESN’T MATTER? – COMPARISON WITH EUROPE Similar levels of austerity:
- 42. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES QE SPECIFICS COMPARING WITH EUROPE (II) Drastically different nominal outcomes For more, see my Quartz article, “Stop the taper talk—the Fed has actually done too little”
- 43. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES QE SPECIFICS LONG TERM RATES AND QE Darda: Rates went up during QE periods
- 44. INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES QE SPECIFICS CONCLUSIONS Monetary policy = adjustment of M Has real effects on economy because of nominal rigidities Thinking in terms of M makes sure you stay consistent, clearer understanding Permanent shocks matter Effects of monetary policy show up in the financial markets.