Chapter 10

Financial Markets and the Economy

Financial Markets are markets in which funds accumulated by one

group are made available to another group.

The bond market is a market in which institutions and individuals borrow and lend money. They do

this through buying and selling bonds.

For example, the U.S. government wishes to borrow money. They issue a bond like

this one. It will have a date of maturity, or when you can turn it back into the

government and get your money back

It will also have the amount of money you get paid back, in this case $100. So let’s say the maturity on this bond

is one year.

You buy it now and turn give it to the government in one year to be paid $100. You are loaning them your money for one year. What is the

interest rate you are getting?

That depends on how much you paid for it.

Let’s say you pay $90 for it. In one year, you get back $100.

You have lent $90 for a year and got back $100. That is equal to an interest

rate of (Face Value – Bond Price)/Bond Price

($100-$90)/$90 = $10/$90 = .1111= 11.11%

The higher the price you pay for the $100 bond 1 year bond, the lower the interest rate you get.

Pay $90, then i = 11.1%Pay $95, then i = 5.3% Pay $99, then i = 1.0%

So now we face a choice. Do we want to think of the bond market

as one where people lend and borrow money at a certain interest

rate, or buy and sell bonds at a certain price?

Both of these are correct ways of illustrating the same thing

happening. Textbook guy uses the 2nd way. I find the 1st way much

more intuitive.

Here are both ways side-by-side. We will primarily use the diagram on the right.

You’ve seen the 2nd diagram before back in unit 2, where I called it the supply and demand diagram for the credit market.

Interest rate

Loanable Funds

Supply (savings)

Demand (borrowing)

iE

QE

Here is one way that a change in interest rates can effect the macroeconomy.

Much investment spending done by businesses is financed through

borrowing. The higher the interest rate you have to pay on a loan to get the

money to build a new factory, the less likely you are to build the factory.

Suppose for some reason there is an increase in the amount available for lending. This is an

increase in supply in the credit market.Interest rate

Loanable Funds

S1

D1

S2i1i2

Q1 Q2

Interest Rates Fall

Q

P

The extra investment spending will increase AD (GDP=C+I+G)

AD1

SRAS

P1

QN

AD2

This could help get us

out of a recession

P2

Q1 Q2

You have a demand for money. Do you always want more?

What can you do with your purchasing power? 3 things.

1) Buy Goods2) Buy bonds (or other high

interest investments)3) Hold it as money

1) Why buy goods?That’s obvious. You want them.

2) Why buy bonds?To earn interest.

3) Why hold money?Purchase future goods and services

easily. Money is very liquid.

3 Reasons to be holding money

1) Holding money to make expected purchases later is the transactions

demand for money.

2) Holding money to protect against unexpected purchases (emergencies) is the precautionary demand for money.

3) The speculative demand for money you expect to invest in

bonds or stocks but are waiting for a better price.

If we look just at the choice to hold money or bonds, we can think of the interest rate as the opportunity cost

or “price” of holding money.

If the money itself earns interest, such as an interest earning checking

out, it is the difference in the two interest rates that matters.

The higher the interest rate goes on the bonds you have to give up

to hold money, the less money you want to hold.

Or the more bonds you want to hold. The two statements are

functionally equivalent.

Demand curve for money in terms of interest for bonds.

What else affects the demand for money?

1) Expected inflation – the more you expect prices to rise, the less cash you want to hold (remember the wealth

effect?)2) Confidence in the future – if you fear losing your job or that the bond you buy may not pay off, you wish to hold more

cash.

Textbook guy lists a few more, but you do not have to memorize the

others on the list.

I fear losing my job.

What about the supply of money. Let’s assume the federal reserve

board can create as much or little money as it wishes through

open market operations.

Equilibrium in the money market is when people want to hold exactly

as much money as the fed has created. Suppose the interest rate is very high. People won’t want to

hold much money, they will want to hold bonds instead. If the Fed has created a lot of money, people will

have “too much” money.

They will get rid of the excess by saving it into the bond market.

They will do this by buying bonds. The interest rate will fall until

people no longer feel they have “too much” money.

Do people really think they have too much money? Well, imagine you

have a huge cash stash in the cookie jar and read that Ford Auto Co. is

paying 100% on Ford bonds.

Wouldn’t you say I have too much cash sitting around doing nothing when it could be earning 100%?

If they have “too little” money, they will get more by saving less into the

bond market (selling bonds) and interest rates will rise.

There will be an interest rate at which people want to hold the

exact amount of money created by the Fed.

When we get to that interest rate, there will be equilibrium in the money market.

The money market graph and the credit market graphs are two sides of

the same coin.

Interest rate

Loanable Funds

Supply (savings)

Demand (borrowing)

iE

QE

If the demand curve for money shifts, the interest rate will shift. Suppose

people fear a big rise in inflation.

More money goes into the bond market and interest rates fall.

If the Fed creates more money, people put some of that money into the bond

market and interest rates fall.

Here we see what is simultaneously happening in the credit market.

Interest rate

Loanable Funds

S1

D1

S2i1i2

Q1 Q2

Interest Rates Fall

Q

P

Why might the Fed want to do this? AS/AD diagram showing the effect of more investment caused by

lower interest rates.

AD1

SRAS

P1

QN

AD2

This could help get us

out of a recession

P2

Q1 Q2

Chapter 11

Monetary Policy and the Fed

What are the Fed’s goals?

1) Low Inflation2) Low Unemployment

3) High Growth

The same 3 variables that we said determine if the macroeconomy is

working well back at the beginning of chapter 5.

But what weight does it assign to each goal? In the 1960’s and 70’s, it was lower unemployment. Since then, it has been lower inflation.

This comes from the feeling among many bankers and economists that

the fed paid to little attention to inflation in the 60’s/70’s.

If it did, it was probably acting on the feeling that the fed paid too little attention to unemployment in the

1930’s.

Some economists are arguing that this “don’t make the same mistake we made last time” mentality is causing the fed to pay too much attention to

inflation now.

In theory, Congress can legally set the goals for the fed whenever it wants. It has given the fed a dual mandate of low unemployment

and low inflation.

In practice, this has left the fed almost completely independent.

So what should the fed do? Suppose we are in a recession. In our model,

Q is in the recessionary gap.

How can we get out of the recession? We could wait until

wages adjust, but with sticky wages, that could take years … and years.

Q

P

A quicker way out would be if the fed could get AD to move right.

AD1

SRAS

P1

QN

AD2

P2

Q1

Can they do this?

The short answer is yes. 1) Fed buys government securities.2) Banks have more funds to loan.

3) Drop in interest rates.4) People borrow the new money

from the banks and buy things.

Voila, recession over!

This is known as expansionary monetary policy. The fed creates

money and drives down the interest rate to increase buying.

AD moves to the right and increases output and lowers

unemployment.

We’ve already seen what simultaneously is happening in the

credit market.Interest rate

Loanable Funds

S1

D1

S2i1i2

Q1 Q2

Interest Rates Fall

What about in the money market? And buy this, I don’t mean the financial market sometimes known as the money market. I mean people’s choice of how much money

to hold.

Interest rates fall, people want to hold more money and less bonds.

So as the fed increases the money supply, people will hold more in their

cash stash. The increase in money to be lent will not be as large as the amount

created by the fed, since people will respond by saving less and holding

more cash. But it is unlikely this effect will be large enough to cancel out the

effect of the fed’s action.

But what if the problem is we are in the inflationary gap part of the diagram. Can we get back to QN without inflation? Not if we wait

for the natural long-run adjustment and the shifting SRAS curve. But what if we move AD to

the left?

Q

P

Out of the inflationary gap without inflation.

AD2

SRAS

P2

QN

AD1

P1

Q1

To do this, we use contractionary monetary policy. The fed decreases the money supply, this decreasing AD. After all, what is money used for? So less money, less buying.

1) Sell government securities.2) raise r.

3) raise the discount rate.

So to sum up:

To fight recessions, expansionary monetary policy to move AD right.

To fight inflation, contractionary monetary policy to move AD left.

Well, that sounds easy. In fact, it sounds too easy. If

macroeconomics is that simple, why do we have such a hard problem with recessions and

inflation?

There are problems.

The first we are going to talk about is lags. Lags are the time between something happening and the end

effect of that thing happening.

The first lag we are going to talk about is called recognition lag.

Recognition lag is the delay between the time a

macroeconomic problem occurs and the time policy makers

become aware of it.

The textbook discusses 1990 recession as an example, but I will

go more recent than that. Minutes from fed meetings are released with a 5 year lag, so we are just

seeing what the fed was doing in 2008/2009 as the economy went

into the tank.

We see that even as the economy was entering the worst recession

since the great depression, the fed in September 2008 couldn’t decide

if recession or inflation was the biggest danger. So they decided to

do nothing. No discount rate changes, no major open market

operations.

In retrospect a big mistake. When they realized this, they lowered the discount rate and did major open

market buying, but now the recession was rolling and its harder

to stop a rolling boulder than to keep it from starting to roll in the

first place.

Then comes the implementation lag. Implementation lag is the delay between the time policy

makers become aware of a problem and the time they enact a

policy to deal with it.

For the Fed, the implementation lag is quite short. They can decide

what to do and then do it quite quickly. But remember this lag when we get to the last chapter and talk about actions congress

can take.

Finally comes the impact lag. Impact lag is the delay between the time a policy is enacted and the time it has its effect on the

macroeconomy.

So the fed decides to create a lot of new money to increase AD and buys a lot of government securities from banks. This first step accomplishes nothing by itself. We have to wait

for the banks to lend out the money. And even this first effect will be

small because …

Much of the effect happens when the banks get the money back and lend it out again … and again … and

again. It could take many months for the buying of securities to result in

people having a lot more money and buying lots more stuff.

The textbook says conventional wisdom is it takes from 6 months

to 2 years for open market operations or a change in the

discount/federal funds interest rate to have its full effect on the

macroeconomy

Putting these 3 lags together:1) Recognition Lag

2) Implementation Lag3) Effect lag

We can see that the fed has to either risk being too late or act on its predictions about the future,

which could be wrong.

There is a view that in the 1970’s, the fed made things more unstable instead of less because lags were making their decisions the wrong

ones.

While the fed looks at many things in setting policy, it is accurate to say that the most important thing they have looked at in setting policy in

the 21st century has been inflation. The fed has “targeted” a goal of 2% inflation. They don’t try to hit 2%

inflation every month, but over what they call the medium term.

When inflation has gone above 2%, the fed has decreased the money

supply to decrease AD and when it has been below 2% they have

increased the money supply … in general.

Now textbook guy writes “The FOMC does not decide to increase

or decrease the money supply. Rather, it engages in operations to nudge the federal funds rate up or down.” So why did I just say the fed increases or decreases the

money supply?

Suppose you are selling hamburgers. Currently the price is

$1.20 and you are selling 300 a day. You lower the price to $1.00 and sales rise to 350 a day. Now,

have you changed the price of hamburgers or have you changed

the number you sell?

P

Q

$1.20$1.00

300 320

Are the sellers picking the price or the quantity?

D

These are not separate decisions that can be analyzed separately. To decide to do one means to decide

to do the other. We chose between describing the outcome as changing the price or changing the quantity merely as a matter of

convenience.

i

Q

5%4%

3 Trillion 3.6 Trillion

Now money has a demand curve. If the fed wants to lower the interest rate from 5% to 4%, what do they have to do?

D

Money Market

It doesn’t matter that the fed may describe this as a lowering of the interest rate, it is just as much a decision to increase the money

supply. That is what they have to do to support the lower interest

rate.

Another problem the fed may have in a bad recession beyond lags is

something called a liquidity trap or the zero bound problem.

The usual way this works is that the fed creates bank reserves, the

banks lower interest rates and people borrow the new money and

spend it.

But what if the interest rate is already zero?

The new money would just sit in the bank vault unspent. In fact, it

is worse than that, because the fed pays interest on bank deposits at

the fed. Very little interest (0.25%), but still a positive amount.

The monetary base is currency (both inside and outside banks)

and bank deposits at the fed.

The fed has greatly expanded the monetary base as part of its

expansionary monetary policy.

https://research.stlouisfed.org/fred2/series/BASE/

And what has happened to the money supply?

https://research.stlouisfed.org/fred2/series/M2/

The monetary base has gone from 800 billion dollars to 4,000. That is an increase of 500%. The money supply (M2) has risen from 8,000 to 11,000. An increase of 37.5%

How is this possible?https://research.stlouisfed.org/

fred2/series/EXCSRESNS

Almost as fast as the fed has been shoveling money into the economy, the banks have been shoveling it out again.

Normally, they would loan it out to businesses and consumers, but

remember, we are almost at 0% interest, so there is no benefit to doing so.

Better to be safe and store it at the fed

In any case, people wouldn’t want to borrow it unless the interest rate fell, but the bank won’t loan at negative interest.

If businesses had confidence in the future, they would be willing to pay

higher interest rates than the fed does to finance investment projects, but they

don’t, so they don’t.

So here we sit, stuck in a bad economy despite expansionary

monetary policy.

So what can we do? There are 2 things we could try. One is the

subject of chapters 12 and 13. Before we look at the other, we have to learn

one of the two most famous equations in macroeconomics

We are skipping over rational expectations in the textbook here

to talk about the equation of exchange. We will cover rational

expectations, but in the next chapter.

Imagine a society with no checks or credit, only cash. This economy

has $1 million cash in existence. Is it true that in the course of a year,

the people of this country must buy exactly $1 million dollars

worth of things?

A dollar can be spent more or less than 1 time during a year. How many times the average dollar is

spent on final goods and services is the velocity of money.

Now suppose $1 million dollars exists and each dollar is spent 4

times during the year. Do we know that the people bought $4 million

dollars worth of stuff?

Yes.

M x V = GDP

M = Money SupplyV = Velocity of Money

It is also true that GDP=(Pa)(Qa)+(Pb)(Qb)+…+(Pz)(Qz)

soGDP = P x Q

P = Average Price of ThingsQ= Quantity of Things Made

Put these together and you get M x V = P x Q

This is called the equation of exchange.

Textbook guy uses Y in place of Q.

M x V = P x QWhy do this? Because now we have an equation relating the

amount of money to the things we really care about, namely Q and P. But it is not helpful yet, because at

this stage, an infinite number of things could still happen. This model needs more structure.

The Simple Quantity Theory of Money is that if V and Q are fixed, then changes in the money supply cause equal percentage changes in

prices.

Let’s assume V and Q are fixed and start moving the money supply around.M x V = P x Q

$100 x 4 = $2 x 200 $200 x 4 = $4 x 200

Ms up 100%, P up $100%$300 x 4 = $6 x 200

Ms up 50%, P up 50%$250 x 4 = $5 x 200

Ms down 16.67%, P down 16.67%

Why does this happen? Imagine you go to the store and spend $10

to buy 10 apples every month. Now the money supply is doubled

so you have twice as much money. If V is fixed, you now spend $20

trying to buy 20 apples. Are there more apples for you to buy?

No, because Q is fixed also. Now if it was just you, you would buy 20 apples; but it is not just you, it is everybody trying to buy twice as

many apples. There will be an apple shortage. What does the

price of apples have to rise to until $20 buys 10 apples again?

So double the money supply, double prices.

While the simple quantity theory is too simple for many cases, it does

answer some questions. For example, why does the

government need taxes when it can just print up the money it needs?

And, in fact, long-term inflations or hyperinflations are almost always

the result of the government increasing the money supply (a lot)

to pay for things.

1) Germany after World War I2) South American countries in the

1950’s/60’s

But will Q stay fixed when the government increases M?

Let’s investigate. To keep things simple, let’s assume V does stay

fixed fixed.

M x V = P x Q$100 x 4 = $2 x 200

Now double the money supply$200 x 4 = $? x ?

There are an infinite number of P’s and Q’s that would solve this, so

what to do? Bring in our old friend, the AS/AD diagram.

Q

P

M x V = P x Q$200 x 4 = $2 x 200

AD1

SRAS

$2

200

What are Q and P on the diagram?

M x V = AD

Assuming V stays the same, doubling the money supply means doubling buying or doubling AD.

Q

P

AD1

SRAS

$2

AD2

Now we can just read the

new Q off the diagram

?

200 250

AD2 is a doubling of AD1

M x V = P x Q

$100 x 4 = $2 x 200

$200 x 4 = ? x 250

M x V = P x Q$100 x 4 = $2 x 200$200 x 4 = P x 250

P = $3.2

Money supply rose 100%.Quantity rose 25%.

Prices rose 60%.

Why aren’t prices doubling here?

Q

P

AD1

SRAS

$2

AD2

Assume Q = 200 is Qn.

What is P3?3.2

200250

What about the long-run?

P3

P3 is $4. The assumption that Q is fixed is a better long-run assumption than

short-run.

M x V = P x Q$100 x 4 = $2 x 200

$200 x 4 = $3.2 x 250$200 x 4 = $4 x 200

What if V is not fixed? We would do the same trick of figuring the new M x V to find AD and shift to the new AD on the diagram, but it would be harder. How does the

change in M affect V?

Factors That Affect V1) Expected Inflation.

2) Interest Rates3) Confidence in the Future

More money probably means higher expected inflation, so V increases.

At least in the short-run, more money might mean lower interest rates, so V falls.

You would probably need a computer model to sort this out.

Here is what has happened to V

The rise in the money supply of 37.5% has been offset by a drop in

velocity of around 18%.

So increase the monetary base by 500%, have most of that go to

excess reserves and have velocity drop by almost 20%, and you get a

weak recovery.

Could the fed had done more? Some monetarists say yes.

Monetarists are a school of economists that believe the most important thing that determines

nominal GDP is the money supply.

The most famous and first monetarist was an economist named Milton Friedman. He

looked at the relationship between NGDP and the money supply from

1867-1960 and believed he found a close relationship, implying V was

stable.

He also found there had been a large drop in the money supply

during the Great Depression, which he posited as its largest cause. Why would there be a drop?

People grew fearful of banks and closed their checking accounts.

Out of this, he proposed a money supply growth rule.

M x V = P x Q

If you think V is relatively stable, and Q grows at an average of 3% a year, and you want stable prices,

what should M grow at?

So Friedman proposed replacing the people on the federal reserve

board with a computer programed to buy and sell government

securities to cause the money supply to grow at 3% a year.

When V dropped, you would still have a recession, but Friedman felt this was better than what the fed

was doing in the 1970’s, which was guessing wrong and causing

recessions

Such a rule might not work well for long persistent recessions, like this

one.

The new thing in macroeconomics is called market monetarism. It is

a, perhaps, logical extension of Friedman’s ideas.

Market monetarism, most closely associated with an economist named Scott Sumner at Bentley University in

Massachusetts. I mention this Bentley is not usually considered a heavy hitter in economics. Usually

important new ideas come from Yale, Princeton, University of

Chicago, M.I.T, that sort of place.

So how did Scott Sumner get influential? He used his blog –

“The Money Illusion”

It is the first case of a blog being important in macroeconomic

theory.

Market Monetarism says the fed should target the level of NGDP, and specifically target a growth

path of 5% a year. Why 5%? That allows for 3% real growth and 2%

inflation in a typical year.

He wants to stop things like this.

Critics say the fed can not do this, because the zero bound problem

means the fed can not raise NGDP when interest rates hit 0%.

The Market Monetarists have two answers.

One is simply to say, yes they can, through brute force if necessary.

Critics point out that at the zero bound, the creation of monetary

base is not very effective at creating new money, so that creating 500% more monetary base created only

37.5% more money.

Market Monetarists say, so what? If creating $20 in new base creates only $1 in new money, that’s fine, we just figure out how much new

money we want and create 20 times that in currency and bank

reserves. Can the fed create that huge amount of base? Sure

Sumner’s challenge to the critics is, “ Do you really believe the fed can go out and buy an essentially unlimited amount of short term bonds, and if that doesn’t work, long-term bonds,

and if that doesn’t work, stocks, and if that doesn’t work, gold and property, and refrigerators, and so, and prices

and output will not be affected?

I have never seen that challenge effectively answered.

If you have a car with hydraulic steering and the power goes out so the wheel doesn’t work nearly as well, that

doesn’t mean you can’t steer to the right, it just means you have to steer more powerfully and emphatically.

Towards the end of his life, Friedman was asked about the inability of the

Japanese central bank to increase AD by buying short-term bonds because their zero bound problem. He said, “they should buy long-term bonds”.

Sumner is taking that to its logical conclusion.

But there is a second part to this, which is the beauty part, and

means the fed shouldn’t have to create that much more money

after all.

Everyone does believe that things will get back to normal eventually, with interests

back well above zero, and the fed will have the power to create inflation.

With NGDP level targeting, the fed will use that power, at least a little. So

people should expect inflation when things get back to normal.

But of course if you expect inflation in the future, what should you do

now?

So what will happen to velocity now?

And once you raise velocity now, do you even have to create much money to increase AD?

The point of the fed announcing it is standing ready to create as much money as necessary

to get some inflation in the future is they won’t have to, because the belief they are

ready and willing to do that will increase V

So the macroeconomy will become mostly self-correcting. When

NDGP is rising above 5% because of inflation, people will believe the fed will decrease the money supply to stop that, so future inflation will be less and V will drop, decreasing

AD and inflation.

When a recession begins and NGDP starts rising less than 5%,

people will expect the fed to create more money to raise inflation to get back to the 5% NGDP growth

path and so V will increase, increasing AD to get us back to the

5% nominal growth path.

This is not utopia, because when higher oil prices cause SRAS to

decrease, we will get inflation at say 4% and real growth will be

slow at 1%; but it will at least stop recessions or high inflations caused by changes in AD.

While the fed has not embraced market monetarism totally, and

might never do so, since at the end it would lead to Friedman’s dream of a fed run by a computer to achieve a simple result, it has moved in that direction. It has recently started

using “forward guidance”.

This is the fed announcing it will continue expanding the monetary

base even after it “normally” would.

There is more to say about good monetary policy, but it will be easier after we have learned a

thing called the Phillip’s Curve. So let’s jump ahead to chapter 16.

Chapter 16

Inflation and Unemployment

The more you increase AD, the higher inflation is and the lower unemployment

Q

P

What does the shape of SRAS have to be to make the Phillip’s a U

SRAS

P1

QN

The more unused

resources, the flatter the SRAS

curve.

P2

Q1,2

An increase in AD deep in the recessionary gap will primarily increase output and decrease

unemployment with only a small increase in P. An increase in AD far

into the inflationary gap will primarily increase P with only a small

increase in Q and decrease in U

If a hardware store gets a large increase in orders for hammers and puts an ad in the paper for

more workers, does anyone show up or not? If not, what does the

store do to “accept” all the additional hammer money

In 1969, Milton Friedman gave an address to the AEA saying the

Phillip’s curve is about to go all to hell. He based this on the topic of

expectations and the question, “How stupid are people?”

Look at the Phillip’s curve this way. When the government causes 3% inflation by printing up money and

the worker’s have a fixed wage, from the viewpoint of the business

owner, workers just got cheaper relative to the sales price of the

product, so he hires more of them.

But how long will this go on? Won’t people eventually expect 3%

inflation and demand 3% cost of living raises? Now how much cheaper are workers getting compared to the price of the

product? None. And how many extra workers will be hired because

they are cheaper? None.

Un

People start expecting 3% inflation.

Q

P

At first people are caught by surprise by the inflation and Q rises, U falls.

AD1

SRAS

P1 AD2

P2

Q1 Q2

Q

P

But then they catch on and get compensating raises.

AD1

SRAS1

P1AD2

P2

Q1,2

We’ve seen this before, but this time they are happening at the same time, not one after the other.

SRAS2

Q

P

Can the government still get lower unemployment? How?

AD1

SRAS1

P1AD2

P2

Q1

SRAS2

Q

P

Can the government still get lower unemployment? How?

AD1

SRAS1

P1

AD2

P2

Q1 Q2

SRAS2 Move AD farther right. If people expect 3% inflation, give them 6%.

Un

Ex. Inf. = 1% Ex. Inf. = 3%

New Phillip’s at expected inflation =3%

Un

Ex. Inf.=1%

Ex. Inf.=3%

Long-run Phillip’s Curve

The Long-run Phillip’s Curve at Un

Points from 1961 to 2011

76

7778

79

8988 87

86

81

82

83

07

08

09 10

11

Rational Expectations are expectations about the future that are, on average correct. They do not contain systematic errors. They take

into account all known significant information.

Predicted ActualInflation Inflation

Y1 4% 6%Y2 5% 8%Y3 3% 5%Y4 3% 6%

What simple change would you make to this program to get better predictions?

What happens to our AS/AD model of the macroeconomy if people

have rational expectations?

Q

P

People see the increase in AD coming and get pre-arranged raises.

AD1

SRAS1

P1AD2

P2

Q1,2

Instead of first AD moving and then SRAS moving, they both move together. The government can’t increase output.

SRAS2

Friedman saw this happening, but only after a couple of years had

passed and people had caught on. Robert E. Lucas Jr. asked why can’t people catch on right away. The

information about what the fed is doing is public.

In the Rational Expectations model, the long-run becomes the short-

run. There are not 2 Phillip’s curves, there is only one.

U

π

The Rational Expectations Phillip’s Curve is a line straight up and down at Un

UN

This is the long-run Friedman curve, but

now it is the only curve.

This does not mean we are always on the line and never have a recession. People still make

mistakes in predicting the future, even with rational expectations. It

does mean the government can not correct the problem.

For example, if people think inflation is going to be 4%, but it is

actually 1%, there will be a recession. The government can

not fix this by printing money until inflation is 4%, because people will

see that and raise their inflation expectation to 7%.

The rational expectationists tend to think the best thing to do is for the

government to let them market work and let people correct their mistakes

on their own.

So how did the rational expectationists of the 1960’s explain

the almost perfect slanted “C” curve?

Trick question. There were none until Lucas wrote a couple of

articles famous articles about it in the 1970’s. It is not an accident

that rational expectations “happened” in the 70’s and not the 60’s, as people were more

concerned with it then.

This illustrates one reason that macroeconomics is hard. People can behave differently in different times, and a theory that explains

correctly in one age may not work in another.

Winners and Losers From Inflation

Losers WinnersPeople holding cash Borrowers may win Savers may lose

If you have $100 dollars in the cookie jar during the year and there is 10% inflation, the money loses 10% of its value.

$100 10% π $90

The 100 dollars on Dec. 31 will only buy what 90 dollars would have bought on Jan. 1

Saving with 5% interest rate and 10% inflation

$100 5% i $105$105 10% π $95

Why write that savers may lose rather than savers do

lose?

Because savers won’t keep their money in the bank in these conditions. Why not buy stock, land, or gold (or

even baseball cards)?

To keep their customers, the banks have to raise the interest rate to compensate depositors for the inflation, and then give them

interest on top of that.

If you have to pay people a 5% return to get their money, during

times of 10% inflation, you will have to pay them 15%.

The nominal interest rate is the written rate you pay them. The real rate of interest is the real rate their deposit is gaining value after taking

into account inflation.

i = nominal interest rater = real interest rate

π = inflation rate

r = i - π

r = i – π

First Case-5% = 5% - 10%

Second Case5% = 15% - 10%

So savers lose to an unexpected inflation, but once it becomes

expected, it should be factored into the interest rate and they

don’t lose.

By the same token, borrowers can win when there is inflation. They get to pay back with less valuable

money.

Borrowing at 5% interest rate and 10% inflation

$100 5% i $105$105 10% π $95

One of the longest running American

political battles and one of America’s

most famous political speeches (the “cross of gold” speech) is

about this.

The farmers have always owed money to the bankers … and so the farmers have always liked

inflation compared to the bankers.

This was true at the 1896 Democratic Convention.

So why was it called the cross of gold speech?

This was the time of the gold standard, so we had paper money backed by gold, which

put a limit on how much money could be created. The farmers wanted more money made, but weren’t ready for fiat money.

So they had an idea. Why should only gold back our money, why not

silver too? So the government should also print money based on

the amount of silver it owned. This is called a bimetal standard. And if this caused inflation, so much the

better.

William Jennings Bryan gave a speech supporting this idea. He ended by saying, “You shall not crucify mankind on a cross of

gold.” The Democrats liked it so well they nominated him for

President 3 times. He lost all 3 times.

In fact, there is a theory that “The Wizard of Oz” is an allegory

for this.

Dorothy = Average American Citizen/VoterScarecrow = Farmers

Tin man = Industrial WorkersCowardly Lion = Populist Party

Yellow Brick Road = Gold StandardEmerald City = Money/Financial System

Wizard = Bankers

Now we can see the story we have told so far about creating money and interest rates, that creating money always lowers interest

rates, is too simple.

Because creating money can create inflation and/or the expectation of

inflation, which raises interest rates.

When the fed created money to lower interest rates in the 1970’s, it ended up creating higher rates as

inflation grew.

Creating money may lower interest rates in the short-run, but if it

causes inflation, it will raise them in the long-run. And if people see

the inflation coming (rational expectations), it will raise them in

the short-run too.

During the Great Depression, interest rates were low. People argued this showed the fed was

being expansionary (creating money) and so they could not do

anything more.

Milton Friedman pointed out this was wrong. If the fed had really created a

lot of money, they would have reversed the deflation into inflation and the interest rates would have rose. The low interest rates in the depression were not a sign the fed

was being expansionary …

They were a sign the fed was not being expansionary enough, it was not printing up enough money to cause inflation and increase AD by

increasing both M and V.

Amazingly enough, the same mistaken idea has gone around

during this recession. The fed has increased the monetary base, the interest rates are driven to zero,

and some economists say, see, the fed is being expansionary and

there is nothing else they can do.

This time it is left to Scott Sumner of market monetarism fame to play the Milton Friedman role of pointing out that low interest rates mean the fed has not created enough money to create expectations of inflation, so they are not doing everything they

could do.

If they printed out enough money to cause people to expect 4% inflation, both velocity would increase and the zero bound

problem would go away. AD would increase and we would get back to

Qn.

Why hasn’t the fed done so? Well, one reason is that the

macroeconomics profession has seemingly forgotten what

Friedman taught us about fighting the Great Depression and wants to go back to the old mistake of low interest rates mean easy money.

But another reason is the politics of it. Nobody is pushing for it in the way that William Jennings

Bryan pushed for easier money back in 1896.

Instead of pushing the fed to do more, one party has pushed for them to do less, while the other

has just been clueless.

Handout.

At least one thing you can say for the fed is that they have not been

as bad as the European Central Bank.

Unemployment in Jan 2014Greece = 26.7%

Spain = 26%Euro area = 12%Germany = 5.1%

U.S.A = 6.6%

In Jan 2013Euro area = 12%

U.S.A = 7.9%

Did any western economies avoid the Great Recession of 2009?

Chapters 12 and 13

Keynesian Economics

John Maynard Keynes is an English

economics who blamed the depression in the 1930’s not on a

lack of money, like Friedman, but on a lack of spending the money we did have.

Why would this happen?

Keynes said our income goes up and down, we spend more or less

on consumption goods. How much more we spend with each

additional dollar is our marginal propensity to consume = MPC.

If you get a $100 dollar raise, spend $70 at the store, and put

$30 in the cookie jar, your MPC = .70

Your marginal propensity to save = MPS = .30

Imagine that the President of Ford comes to work in the morning

and is feeling good about things. Maybe he had a good dream or a

great breakfast. Keynes used the term “animal

spirits”.

For whatever reason, the President of Ford thinks next year is going to be

better than this year. He orders a tool shed built behind the main factory to hold the tools of the

overtime workers he anticipates hiring next

year.

Start with an increase of $100 in investment and MPC = 0.8

I C GDPRound 1 $100 $0 $100Round 2 $0 $80 $80 Round 3 $0 $64 $64Round 4 $0 $52 $52More Rounds … … …Total $100 $400 $500

Someone is hired to build the tool shed and is paid the $100. He spends $80, and remember, what is expense for someone is income for someone else. That

person has an income of $80 and spends $64, and so on.

This process is called the Keynesian multiplier. An initial increase in spending of $100 causes GDP to go up $500.

What if the President of Ford’s animal spirits are low, so he thinks next year will be worse than this year. Last year they build a tool

shed, this year they don’t.

Everything is the same but with negative signs

I C GDPRound 1 -$100 -$0 -$100Round 2 -$0 -$80 -$80 Round 3 -$0 -$64 -$64Round 4 -$0 -$52 -$52More Rounds … … …Total -$100 -$400 -$500

Now the economy is going down as the multiplier causes a cascade of

lay-offs. Keynes was a great believer in the self-fulfilling

prophecy. When people thought things would be good, they would be good … and when they thought

things would be bad, they would go bad.

How do you now how much to multiply the initial change in spending

to get the end change in GDP?

m = 1/(1-MPC)m = 5 when mpc = 0.8

The $100 change in investment causes a $100 x 5 = $500 change in GDP.

Keynes believed the main cause of the Great Depression was the simultaneous end of a lot of

investment projects at the end of the 1920’s and drop in confidence that the 1930’s would be as good

as the roaring 20’s.

Let’s translate the table to the AD/AS diagram.

SRASAD0

AD1AD2ADF

QF Q2 Q1 Q0

$80 $100

$500

And viola, we are into the recessionary gap.

In terms of M x V = P x Q We have a drop in V.

Friedman’s story of the depression.1) A few banks fail.

2) People pull their money from the banks.

3) Money supply falls.4) Less money = less buying and AD

decreases.5) As the economy tanks, V falls

which further lowers AD.

His solution is for the fed to not let the money supply fall, or at least pump it up again as ASAP when it

does.

Keynes’ story of the depression.1) Business’s lose confidence in the future (their animal spirits droop).

2) They cut investment.3) Laid off workers cut their buying.

4) The multiplier plays out.5) Velocity drops, taking M with it.

Increasing M won’t help because it is an effect, not the cause. Also the zero bound. The phrase Keynesians

use is “the fed is pushing on a string.”

So what is Keynes solution to the Great Depression? I’m glad you

asked.

Let’s do the Keynesian table again, but with a change in G.

G C GDPRound 1 $100 $0 $100Round 2 $0 $80 $80 Round 3 $0 $64 $64Round 4 $0 $52 $52More Rounds … … …Total $100 $400 $500

And thus AD moves to the right. The recessionary effect of a drop in investment can be undone by the

inflationary effect of a rise in government spending.

If the government cuts spending, then the table has negative signs

and AD moves left.

What if there is a $100 tax cut?

G C GDPRound 1 $100 $0 $100Round 2 $0 $80 $80 Round 3 $0 $64 $64Round 4 $0 $52 $52More Rounds … … …Total $0 $400 $400

Expansionary Fiscal PolicyMove AD right to fight recessions.

1) Increase G2) Cut Taxes

So the government is running a deficit.

Contractionary Fiscal PolicyMove AD left to fight inflation.

1) Decrease G2) Increase Taxes

So the government is running a surplus.

The Obama stimulus program of 2009.

Spending - $550 BillionTax Cuts - $290 Billion

Problems with Fiscal Policy.1) The Lag Problem – the same lags

as monetary policy, but with the time it takes congress to do things thrown in. Also it can take awhile for spending voted by congress to

actually be spent by the government.

2) Political ProblemsKeynes says to run deficits when

recession is the problem and surpluses when inflation is the

problem. From 1969 to 2014, the federal

government has run deficits every year.

Politicians love to spend on their

favored programs and cut taxes. Some times

the only hope for good government is politicians who are

good liars.

But if the practical problems of lags and politics are solved, is fiscal

policy guaranteed to work?

No, there is an other problem called crowding out.

Here is a graph of the credit market where saving does not depend on the

interest rate.

Interest rate

Loanable Funds

Supply (savings)

Demand (borrowing)

5%

$10 Billion

Now the government borrows $5 billion. Demand moves $5 billion to the right. Has overall borrowing increased by $5 billion?

Interest rate

Loanable Funds

Supply (savings)

D1

5%

$10 Billion

D2

Equilibrium borrowing remains at $10 billion. How is this possible?

i

Loanable Funds

Supply (savings)

D1

5%

$10 Billion

D2

7%

The government borrowing has “crowded out” private borrowing

and spending through a higher interest rate. The government borrows $5 billion more. Ford,

IBM, etc. borrow $5 billion.

Private companies and individuals are dropping spending as fast as

the government increases it.

GDP = C + I + G

Keynesian table with crowding out.

G I C GDPRound 1 $100 -$100 $0 $0Round 2 $0 $0 $0 $0 Round 3 $0 $0 $0 $0Round 4 $0 $0 $0 $0And so on … … … …Total $100 -$100 $0 $0

Let’s translate the table to the AD/AS diagram.

SRAS

AD0,1,2,…,F

Q0,1,2,…F

P

Q

When does does crowding out occur? When the money the

government borrows and spends would have been spent by

someone else if the government had not borrowed it.

This happens when:1) The government borrows money someone else was going to borrow

and spend, and now they don’t.2) The person who lends the

money to the government was going to spend it but lent it to the

government instead.

Crowding out does not occur when people lend the government

“cookie jar” money, or money they were not going to spend on either

goods or bonds.

So if you think of the Great Depression as being caused by low

AD because of people sitting on large cash stashes they are afraid

to spend or lend to private companies, the government can

borrow it from them and spend it for them, increasing AD

People (usually conservatives) opposed to the Obama stimulus package point out “the money

must have come from somewhere”. Shouldn’t spending

drop wherever it came from?

Keynesians point out that even if it came from somewhere, as long as

it wasn’t being spent in that somewhere, spending will rise.

M x V = P x Q

Pure Keynesianism can be done without an increase in M. By

borrowing V=0 money and spending it, V is increased and AD

goes up.

If crowding out is true, then V will not increase. Monetarists, in

general, believe in crowding out. That is why they say there must be

an increase in M to increase AD.

Republican’s Favorite Graph