The Ch. 18 Short Answer Test is today; put your name on the Test and a blank sheet of paper. Use a blank sheet of paper (s) to answer the questions. If you finish early you may take out non-Economics material.
We will pick up where we left off in Chapter 22, Monetary Policy.
Chapter Overview
Having introduced the Federal Reserve System and its tools for monetary policy in Chapter 21, this chapter begins by considering how money affects the economy (both the long-run quantity theory and the short-run analysis of interest rate channels are covered). The next section discusses the lags in monetary policy (you may wish to relate this section to the corresponding section in the chapter on fiscal policy). The chapter continues with a section on implementing monetary policy that raises the questions of rules versus discretion and which (if any) targets should be used by the Federal Reserve. A final consideration of transparency and the Fed concludes the chapter.
Chapter Outline
Monetary Theories
Introduction to Monetary Policy, 2:59
The Long Run: Quantity Theory
The Equation of Exchange
The equation of exchange, 3:39
Classical Money Transmission Mechanism
The Short Run: Interest Rate Channels
Keynesian Monetary Analysis
Monetarist Model
Milton Friedman: The Purpose of the Federal Reserve, 4:55
Checkpoint: Monetary Theories
Monetary Policy Lags
Information Lags
Recognition Lags
Decision Lags
Implementation Lags
Response, Implementation, Recognition Lags, 4:23
Checkpoint: Monetary Policy Lags
Implementing Monetary Policy
Monetary Policy Targets
Long Run: Price Stability
Short Run: Price Level and Income
Rules or Discretion?
Simple Rules (Targets) to Guide Monetary Policy
Monetary Targeting
Target rates vs. money supply, 11:39
The rationale for targeting interest rates instead of directly having a money supply target.
Inflation Targeting
The Bank is injecting money directly into the economy to meet the inflation target, 3:46
Cf. http://www.youtube.com/watch?v=J9wRq6C2fgo
The Fed's Performance
Bernanke Maintains that the Fed Should Not Be Audited, 2:07
Checkpoint: Implementing Monetary Policy
Transparency and the Federal Reserve
Ben Bernanke Refuses Transparency, 2:36
Ideas for Capturing Your Classroom Audience
Why do people anticipate what action the FOMC will take? Illustrate how
changes in interest rates cause changes in bond prices using a value calculator such as the one available on the Smart Money site on the Web at http://www. smartmoney.com/onebond/index.cfm?story=bondcalculator. This allows you to change the bond parameters and instantly see the effects on price. Point out that the Fed�fs actions ultimately affect market interest rates which in turn affect the value of bonds.
Compare the Fed to other central banks. The Bank of England publishes an
express inflation rate target on its Web site at http://www.bankofengland.co.uk/.
The Bank of New Zealand specifies a range of 1.3% (see its page at http://www.
rbnz.govt.nz/monpol/pta/3027620.html). The Central Bank of Iceland specifies
2.5% rise in its CPI over 12 months (http://www.rbnz.govt.nz/monpol/pta/
3027620.html). For links to other central bank pages see the page of the Bank
for International Settlements at http://www.bis.org/cbanks.htm.
Chapter Checkpoints
Monetary Theories
Question: Of the three motives for holding money, which one is most important for
monetary policy?
The point is to check that students can: apply their understanding of the three
motives for holding money to the mechanism by which monetary policy affects the
economy.
Monetary Policy Lags
Question: Why are monetary policy lags important to the effectiveness of monetary
policy?
The point is to check that students can: integrate the material on lags in monetary policy with their prior knowledge of the business cycle and the goal of monetary policy.
Implementing Monetary Policy
Question: Explain why a negative supply shock such as rising oil prices is a difficult problem for monetary authorities to compensate for.
The point is to check that students can: relate their understanding of what monetary policy makers can do (what effect their actions can have on the economy) to
their prior knowledge of the effect of supply shocks.
Extended Example in the Chapter
Transparency and the Federal Reserve
When Alan Greenspan became its chairman in 1987 the transparency of the Fed
began to increase. By 1994 the Fed was releasing a policy statement each time it
changed interest rates, and by 1998 it also started to state its forecast of what would probably happen in the next month or so. By 2000, the FOMC released a statement after each of its eight meetings even if policy remained the same.
Transparency is controversial within the Fed, particularly with regard to “forwardlooking transparency.” Some believe that statements about the Fed’s views of
where the economy is headed can tie its hand by revealing likely future courses of
action. (NOTE: The key to understanding that view is believing that if the market
expects the Fed to change rates (in either direction) it will change bond purchasing
behavior and so will affect interest rates even before the Fed actually does anything,
in effect making the Fed’s action, when it comes, have no further effect on
the markets.)
This section references an article by Greg Ip, “The Fed’s Big Question: Not What to
Do, But What to Say” (The Wall Street Journal, October 27, 2003, page A1). The
debate about transparency that occurs within the Fed cites two articles by William
Poole (President of the Federal Reserve Bank of St. Louis); they are “Fed
Transparency: How, Not Whether,” from the Federal Reserve Bank of St. Louis
Review, November/December 2003 and “FOMC Transparency,” also from the
Federal Reserve Bank of St. Louis Review, January/February 2005. Past issues of
the review are available on the Bank’s Web site at http://research.stlouisfed.org/
publications/review/past/.
Also cited is a response by Ben Bernanke, Thomas Laubach, Frederic Mishkin, and
Adam S. Posen to a review of their book Missing the Mark: The Truth About
Inflation Targeting. Writing in Foreign Affairs (September/October 1999), the
authors restate their theses in response to the review that had been written by
James K. Galbraith. The response can be read on the Web at: http://www.
foreignaffairs.org/19990901faresponse1013/ben-bernanke-thomas-laubachfrederic-
mishkin-adam-s-posen/missing-the-mark-the-truth-about-inflationtargeting.
html.
Examples Used in the End-of-Chapter Questions
Question 1 cites an article by Brian Wesbury titled “Economic Rehab” from The Wall
Street Journal, June 7, 2006, p. A14. In the article Wesbury suggests that Bernanke
is being unfairly criticized for a series of missteps. To put this in the context of
transparency, look at the list of Bernanke statements compiled by Liz Rappaport of
TheStreet.com. Full text of article is available at http://www.thestreet.com/markets/
marketfeatures/10289904.html but a concise table with “translations” can be found
at: http://bigpicture.typepad.com/comments/2006/06/tracking_bernan.html.
Question 3 references the European Central Bank. For a statement on the Bank’s
policy with regard to inflation and other information about its functions and objectives,
see its Web site at http://www.ecb.int/mopo/html/index.en.html.
Question 9 could be extended to a discussion of whether or not there is such a thing
as a “liquidity trap.” If you choose to address that topic, recent experiences in Japan
provide interesting illustrations.
Question 12 discusses transparency and inflation targets. For more discussion of
this topic with regard to Federal Reserve Chairman Ben Bernanke (and Governor
Frederic Mishkin) see the article from The Economist titled “The Federal Reserve’s
Chairman Hitting his Stride” (February 1, 2007, available on the Web at http://www.
economist.com/finance/displaystory.cfm?story_id=8641615).
For Further Analysis
Using the AS/AD Model to Explore the Impacts of Expansionary Monetary
Policy
This example can be used as an in-class small group exercise or as an individual inclass exercise. It is designed to complement the text’s material by employing the
graphical analysis of the AS/AD model to illustrate the effects of expansionary monetary policy when the economy is below full employment and when it is above full
employment. It would not be difficult to adapt the handout to have students consider
contractionary policy as well.
The third question in the handout can be deleted if desired; it asks students to
explain the circumstances under which cuts in the target federal funds rate might
NOT occur. This can be useful if you want to discuss the time period during which
the Fed kept the target rate unchanged.
Note that #13 of the end-of-chapter Questions and Problems uses only short-run
analysis and asks students to compare monetary policy actions in the context of
demand shocks versus supply shocks. The purpose of this exercise is to show how
monetary policy can make things worse if the current position of the economy versus
long-run aggregate supply is unclear.
Web-Based Exercise
This example can be used as a small group exercise or as an individual exercise.
The exercise provides an opportunity for students to apply the material in the chapter about the FOMC and how it communicates with the public by having students
read the latest press release. It is advisable to review how the process works before giving this assignment (for example, what is the target federal funds rate?). You may also wish to assign more than one press release to have students “track” the FOMC’s views over time.
Links to all the FOMC statements can be found at: http://www.federalreserve.
gov/FOMC/#calendars.
Reading the Tea Leaves: The Latest from the FOMC
Read the latest press release from the FOMC. Visit its Web site at: http://www.
federalreserve.gov/FOMC/#calendars and click on the “Statement” link for the most
recent date on the calendar.
After reading the statement, answer the following:
1) What did the FOMC decide to do?
2) What is the “tilt” statement embedded in the statement?
3) Was the vote on the statement unanimous? What do you conclude from the
voting result?
Tips from a Colleague
This material can be of great interest to students when they realize how critical the Fed’s conduct of monetary policy is to the action in financial markets. You may wish to create a compilation of articles in the business/financial press in advance of an FOMC meeting and then those following it to emphasize how expectations were formed about the Fed’s actions and whether those expectation were met or not.
Using the AS/AD Model to Explore the Impacts of Expansionary Monetary Policy
The job of the FOMC is to assess the current (and future) path of the economy and decide whether or not monetary policy action is indicated at any point in time. One of the many challenges they face is trying to evaluate where the economy is relative to its full employment level.
References
Milton Friedman - Socialized Medicine, 9:37
Nobel Laureate Economist Milton Friedman explores the unsettling dynamics set into motion when government imposes itself into the health care system. (1978)
Hayek on Milton Friedman and Monetary Policy, 4:56
Friedrich Hayek discusses Milton Friedman's Monetarism and monetary policy.
For more on Hayek's ideas on monetary policy see
Choice in Currency: A way to stop inflation
(for a concise summary) at
http://www.iea.org.uk/files/upld-book...
or see The Denationalisation
of Money for a more a more detailed proposal at
http://www.iea.org.uk/files/upld-book...
This is an excerpt from a longer interview which can be found here http://www.vimeo.com/4063439
Milton Friedman on Slavery and Colonization, 8:43
Modern monetary theory - Mitchell and Wray
This is a series of Modern monetary theory interviews - Professors Bill Mitchell and Randy Wray. See billy blog (http://bilbo.economicoutlook.net/blog) for more information on this approach to macroeconomics. You can also get more information from Centre of Full Employment and Equity (http://e1.newcastle.edu.au/coffee).
Questions asked:
A fundamental or central part of the research of both of you is centred on the nature of money. Could you perhaps talk a little bit about the nature of money and particularly explain to non-economists what fiat money is and what the implications it has on policy formation?
1. Be sure to review Chapters 19-21 (we will have Quizzes and Tests on this material as well, TBA). Some students have asked to be tested as close as possible after covering the material.
2. Read Ch. 22, review the Checkpoint sections, and check your responses with the Answers on p. 595.
3. As review for HW, typical questions that you may encounter on the actual AP Economics Macro Test are included daily:
Financial Sector, Review Questions
a) increase the money supply
b) decrease the money supply
c) increase the demand for money
d) make the supply of money more inelastic
e) decrease the demand for money
8. As the interest rate increase
a) investment decreases, but aggregate demand remains constant
b) investment decreases and aggregate demand decreases
c) investment increases, but aggregate demand remains constant
d) investment increases and aggregate demand increases
e) both investment and aggregate demand remain constant
9. When people hold money in the anticipation of future cash0based exchanges, they are acting from the
a) speculative motive
B) precautionary motive
C) transactions motive
D) profit motive
E) production motive
