Economics 374-01A Dr. John F. Olson

Monetary Theory and Policy Spring 2008

Study Guide for Third Test

The third test is scheduled for Wednesday, May 7^th from 6:00pm to 8:00pm (although you should not need the entire two hours). As the third test, it includes the adjusted/revised material from Units Four and Five: Chapters 2 (re-read/reviewed), 13, 14, & 11 from Handa; the hyper-linked documents from the FRS and SF FRB from the course web-page; and the St. Louis FRB article by Gilbert. The bulleted points below are from the end of the chapter “Summary of Critical Conclusions” in Handa. See/study the appropriate chapter sections of the text for details. I have inserted annotations (and some potential test questions in italics).

Chapter 2 – Money and Prices (reviewed as foundation for material in Chapters 13 & 14)

• The quantity theory consisted of several approaches in its evolutionary history. They asserted that, in equilibrium, a change in the money supply will cause a proportionate change in the price level, but will not affect output and unemployment. These assertions are also implied by the neoclassical and the modern classical approaches—currently the dominant approaches in macroeconomics.

This assertion is the neutrality of money. You should be able to discuss the perspectives of Fisher, the Cambridge approach, Pigou, and Wicksell to the QTM.

• The quantity theory allowed that the changes in the money supply would affect output and employment in disequilibrium. This is consistent with the neoclassical approach. It is a fundamental aspect of Keynesian ideas.

The QTM disequilibrium changes are, of course, short-run adjustment processes in moving to the new long-run equilibrium.

• Wicksell shifted the transmission mechanism (from money to aggregate demand) from the direct transmission one to the indirect one.

Explain the different concepts or views of the transmission mechanism (see the final two bulleted conclusions below).

• Keynes expanded the reasons for holding money to encompass the transactions motive, the precautionary motive and the speculative motive. Keynesians subsequently provided distinctive analyses for each of these motives.

Present and explain the economic reasoning underlying each of the three Keynesian motives for holding money.

• Friedman, although ostensibly claiming to provide a ‘restatement’ of the quantity theory, in fact provided an integrated version of the neoclassical and the Keynesian ideas on the demand for money. However, his replacement of current income by permanent income as the scale determinant of money demand belonged in neither the quantity theory nor the Keynesian traditions.
• Keynes and the Keynesians integrated the analysis of the money market and the price level into the general macroeconomic model, rather than leaving it as an appendage to the analysis of the commodity markets. They also introduced bonds as an alternative asset to money in the demand for money and made the bond market a component of the macroeconomic analysis.

Recall that the classical view assumes there is no money illusion and, thus, there is the classical dichotomy between the real (commodity markets) and nominal (money) economies. Money is primarily a transactions asset with few or no good substitutes. The Keynesian assumptions are contrasting views of the nature of money and its role in the economy.

• There are three potential transmission mechanisms through which the changes in the money supply impact on aggregate demand. These are the direct transmission mechanism, the indirect one and the lending one. The Keynesians and the modern classical macroeconomic schools, following Wicksell and Keynes, have based their IS-LM analysis on the indirect mechanism, with the direct one being ignored for the modern financially developed economies.
• The lending channel has been proposed by some economists. Whether it is distinctive from the indirect one and whether it is also significant for the modern financially developed economies is not generally accepted. Its role for financing investment in financially under-developed economies is likely to be much greater.

Chapter 13 – Neoclassical and Classical Models

In this chapter and the next (14), you are presented with the evolution of macroeconomic thinking over the past two or more centuries. I suggest using a compare/contrast approach in studying the material. What is common among the models in their assumptions about structure and behavior? What is different? And how does that yield similar or different conclusions?

There is also the development and presentation of the IS-LM and AD-AS model(s) with which you should be familiar from ECON 333 (Macroeconomic Theory). You should be able to use these tools to appropriately illustrate your macroeconomic arguments. While the graphs and/or equations are useful illustrative and/or analytical devices, what is most important are the underlying economic (conceptual) arguments.

Keynes and his subsequent followers had different assumptions about the structure and processes of the macro-economy than the classical and neo-classical approaches; thus, they reach different conclusions and results.

The IS curve represents goods market equilibrium, while the LM curve represents money market equilibrium. (Note: by invoking Walras’ Law, goods market equilibrium simultaneously implies credit – savings/investment – market equilibrium, and money market equilibrium simultaneously implies bond market equilibrium.) Combining IS and LM conditions creates an AD (aggregate demand) curve – a negatively-sloped relationship between the price level and level of real expenditure (income, GDP demanded) in the economy. To complete the model, an AS (aggregate supply) curve is constructed to represent the supply-side (factor market equilibrium) of the economy. Just as there are differences in views (assumptions) about how the demand-side of the economy should be modeled, there are differences about the supply-side. An essential difference (although not the only one) between the Classical (& neo-classical) view and the Keynesian view is the ability (and/or speed) of wages and prices to adjust to market-clearing levels, thus restoring equilibrium.

• In the Walrasian general equilibrium of the economy, the economy has full employment, full employment output and the natural rate of unemployment.

Why is this the case; that is, what assumptions and reasoning lead to these conclusions? What do flexible prices and wages, the extent or degree of market competition, and the absence of money illusion have to do with this?

The natural rate of unemployment exists because of normal amounts of frictional and structural unemployment – these can change over the long-run as the demographic composition of the labor force changes, the structure of the labor market and labor search changes, and as the structural composition of labor demand and supply change.

• In the Walrasian general equilibrium of the economy, the quantity of money is neutral and monetary policy cannot be used to increase or decrease the level of output or unemployment. It can only change the nominal value of aggregate demand, the price level and the rate of inflation.

Why is the quantity of money neutral; that is, what assumptions and reasoning lead to these conclusions? See immediately above as well as in Chapter 2 – pure QTM! The implication is that in the long-run, monetary policy can only affect the price level and the rate of inflation.

• The Walrasian economy can at times be in disequilibrium and take time to return to general equilibrium with full employment. In this disequilibrium phase or state, money need not be neutral so that an appropriate monetary policy could speed the recovery to full employment equilibrium.

Is this “disequilibrium” state just the adjustment phase of going from one long-run equilibrium to another? Why and/or how might monetary policy speed the recovery or adjustment to equilibrium?

• While the traditional classical economists and the neoclassical approaches, as well as the 1970s monetarism, envisaged the possibility of the economy at times being in disequilibrium, the modern classical and the new classical approaches assume continuous full employment and the Walrasian general equilibrium in the economy. While money is not always neutral in the former set of approaches, it is always neutral in the latter set. If there is uncertainty, then anticipated monetary policy is neutral.

Section 13.18 discusses the distinguishing features among the different (and evolving) views with the Classical paradigm, while section 13.19 elaborates the Monetarist view. What is it in (the assumptions of) the modern classical and new classical approaches vs. those of traditional classical, neo-classical, and monetarists that creates the difference regarding the neutrality or non-neutrality of money?

• Whether the economy, especially when in recession, is in full employment equilibrium or not, is never certain, so that the particular monetary policy being followed by the monetary authority is usually in dispute among economists.

The theory of Ricardian equivalence is addressed in section 13.17 – this is the proposition that the effects on nominal income of debt-financed vs. tax-financed increases in government expenditures are the same. The proposition largely rests on the recognition by households that debt-financing is merely postponing a subsequent increase in taxes. Thus, with an increase in current taxes, households reduce their current consumption to pay the current taxes or with debt-financing, households increase their saving (and reduce current consumption) to pay future taxes.

Chapter 14 – Keynesian and Neo-Keynesian Approaches

Keynes and his subsequent followers had different assumptions about the structure and processes of the macro-economy than the classical and neo-classical approaches; thus, they reach different conclusions and results.

• Early (1940s and 1950s) Keynesian models were based on nominal wage rigidity or price illusion by labor.
• In the 1960s and 1970s, Keynesian models were often based on the Phillips curve.

The Phillips’ curve is, of course, the inverse relationship between the inflation rate and unemployment rate. The classical and neo-classical views hold that such a relationship might exist only in the short-run; in the long-run the Phillips’ curve is vertical. Why?

• More modern versions of such (Keynesian) models rely on staggered wage contracts with price expectations and the possibility of expectational errors.

Hence, the inflation-expectations augmented short-run Phillips’ curve can be derived and applied. Explain how inflation-expectations can shift the short-run Phillips’ curve, yet still result in a vertical long-run Phillips’ curve (when expectations = actual experience).

• An abiding theme in Keynesian models, originating with Keynes’ The General Theory, is the failure of the economy to attain Walrasian general equilibrium. This is attributed to the absence in the real world of an adequate coordinating mechanism such as tatonnement, auctioneer or recontracting, and the imperfect functioning of the competitive mechanisms that do exist in the modern economy. The Keynesian approach asserts that this failure is especially symptomatic of the labor market, so that involuntary unemployment is a common occurrence in the real-world economies.

Recall how the Walrasian view (classical and neo-classical) assumes the dominance of competition, flexible wages and prices, and the absence of money illusion. How does the Keynesian view differ? What about the modern or new classical approaches?

• The Keynesian model based on this deficiency in the macroeconomic environment is the demand-deficient model. This approach posits that the rational dynamic responses by firms and households to conditions of inadequate demand and involuntary unemployment do not always take the economy to full employment or do so within the acceptable period.

Why not – that is, why don’t these rational dynamic responses take the economy to full employment (or within an acceptable period)? What prevents full-employment equilibrium from being restored?

• The demand-deficient models imply that the responses of output and unemployment with respect to changes in the money supply during periods of demand deficiency are not properly captured in the Phillips curve or the Lucas supply curve relationships.
• The neo-Keynesian theories rely on rational long-run behavior resulting in implicit contracts, staggered wage contracts, sticky prices and menu costs, etc.

Notice here that Handa is presenting and discussing a long-run view – how does this neo-Keynesian view differ from a neo-classical view in not only the assumptions, but also the conclusions?

• There is no logical inconsistency between the Keynesian approach and rational expectations. Further, Keynes’ The General Theory argued strongly for the adequate consideration of both short-run and long-run expectations in the macroeconomic analysis. The Keynesian models can quite legitimately incorporate rational expectations, provided they are defined in a manner consistent with the economy’s effective state – which need not necessarily be the general equilibrium one.
• There is no logical inconsistency between the Keynesian approach and Ricardian equivalence. While incorporation of Ricardian equivalence into the Keynesian models renders fiscal policy ineffective, it enhances the role of monetary policy in stabilizing the economy.

What is Ricardian equivalence? (See Handa 13.17 and above.)

• However, the spirit both of Keynes’ The General Theory and of Keynesian analyses, as well as their policy conclusions, runs counter to Ricardian equivalence. Therefore, while the Keynesian models can be modified to incorporate Ricardian equivalence, doing so is not consistent with the spirit of the Keynesian tradition.

What is the spirit of Keynes’ General Theory, Keynesian analyses, and their policy conclusions? How do these compare with the “spirit” of classical, neo-classical, monetarist, modern classical, and/or new classical views? What specifically accounts for the difference(s) or similarity?

Chapter 11 – The Central Bank: Goals, Tools and Guides for Monetary Policy

Because the FED has only the ability to influence (and not directly control) the money supply through the use of its policy tools, the policy process is a bit more complex than heretofore presented. The FED uses its policy tools to directly affect operating target variables which, in turn, affect intermediate target variables which are then related to the ultimate policy goal variables. This requires setting policy goals, understanding and applying the theoretical and empirical relationships among the goal, intermediate, and operating variables, and appropriately using the policy tools.

As well, one should see that the macroeconomic processes are affected by many things outside of the FED’s control – which can make policy-making very difficult. And there is, of course, the problem of “politics” in a democratic society where priorities in goal-setting can be quite contentious.

· Historically, most central banks have had the mandate to pursue a number of macroeconomic goals, including price stability, low unemployment, high growth, etc. Achievement of multiple goals is only possible if the economy allows such a possibility and the policy maker has enough policy tools.

That is, to achieve multiple goals either the goals need to be consistent with each other and/or you need to have a sufficient number of policy tools to achieve the multiple goals (at least one tool per goal). The FED really has only one tool – an ability to affect the supply of reserves through either open market operations or the discount rate. Other concerns or requirements are that the variables subject to the policy goals need to be measurable in a timely manner, as well as have a theoretical and empirical relationship to the FED’s tools or instruments. Further, because the goal variables are likely to be influenced by other macroeconomic phenomena, the FED has to know (predict?) and account for effects these other forces will have.

· In the 1960s and early 1970s, economic theory implied, and most central banks attempted to achieve, a tradeoff based on the Phillips curve between unemployment and inflation. This tradeoff proved to be unstable for policy and was abandoned by the 1980s.

There were multiple problems with this strategy. It presumed the Phillips’ curve trade-off (inverse relationship between unemployment and inflation) was a long-run relationship. More recent theory and evidence establishes that the long-run Phillips’ curve is vertical; that is, there is no trade-off. Further, attempts to push the unemployment rate below the natural rate create an accelerating rate of inflation; thus, as the natural rate of unemployment began to rise during the 1970s, the policies to reduce the actual unemployment rate had a bias to create additional inflation. As well, the underlying macroeconomic model of the period assumed the business cycle phenomena were the result of AD curve shifts – the primary exogenous macroeconomic disturbances of the 1970s are perhaps best understood and modeled as AS curve (or price) shocks.

· In the 1990s, many economists have recommended, and the central banks have generally followed, the goal of price stability – translated as a low rate of inflation – for monetary policy. There is a corresponding abandonment, or relegation to a subsidiary role, of the objective of maintaining a low unemployment rate.

It may be fair to say that while monetary policy is recognized as having non-neutral effects in the short-run, the long-run neutrality of money largely requires monetary policy to give priority to achieving the long-run goal of price stability.

· While the interest rate was historically the operating target of monetary policy, a diversion to monetary targeting occurred during the late 1970s under the impact of St. Louis monetarism. This experiment was not considered to be a success in most countries, and the most common operational target again became interest rates.

See the Gilbert article on FED operating procedures in the 1970s and 1980s. Also, consider the origin of the macroeconomic disturbances prior to the 1970s and 1980s, during those two decades, and subsequent to them – were they AD or AS shocks, and what are the appropriate operating targets and strategies under those different circumstances?

· Most Western countries have reduced percentage reserve requirements on commercial banks to levels that are close to zero. Changes in these requirements have ceased to be a tool of monetary policy.

Not only for this reason are they not a normal tool of policy, but in the past when reserve requirements were higher or in force, they had potential to be an exceptionally powerful tool – far too powerful for the typical magnitudes of necessary monetary policy adjustment. (My “sledgehammer-to-drive-thumbtacks” analogy.)

· In the 1990s, the most common tools of monetary policy in developed economies are change in interest rates and open market operations.

The following three items are in reference to selection of intermediate targets for monetary policy:

While adoption of the goal of price stability lowers the inflation rate and its variability, it also increases the fluctuations in output and unemployment under supply shocks.

If the FED is trying to keep the price level stable (a non-accommodative policy) as the economy is subject to supply (or price) shocks, that policy creates greater fluctuations in output and employment. They could stabilize output with an accommodative policy, but then the inflation rate would become volatile.

Successful interest rate targeting, in comparison with monetary targeting, increases the impact on aggregate demand of investment, net exports, fiscal deficits and other disturbances in the commodity markets while eliminating the impact of shocks emanating from the financial sectors.

If the FED is targeting interest rates, then they are in effect creating a flat/horizontal LM curve. As the goods (commodity) market disturbances arise from consumption, investment, net exports, or fiscal sources and the IS curve fluctuates, you will get bigger changes in AD – that is, targeting interest rates provide pro-cyclical reinforcement to goods market disturbances. On the other hand, targeting interest rates isolates monetary and financial shocks from the real economy – an example of counter-cyclical stabilization (if the LM curve would shift one way, use monetary policy to counter or offset that shift and keep it at the same interest rate intersection with the IS curve).

Monetary targeting eliminates the impact of fluctuations in the money supply induced by the private sector and moderates the impact of fluctuations emanating from the commodity market.

If the FED is targeting the money stock, then goods market disturbances are mitigated (limited) – it’s a counter-cyclical policy. In effect, such a money stock targeting policy makes the LM curve steeper. But the down-side is that if the disturbances are coming from the money or financial markets, this targeting policy is pro-cyclical.

The 1985 Gilbert article from the St. Louis FRB

You should be able to articulate the first two of the three (ignore the borrowed reserves targeting procedure) different operating procedures presented in the article. That is, explain how each operating procedure fit into the process of achieving the appropriate intermediate target (interest rates or money stock), how each procedure was implemented to achieve the operating target, and the consequences for interest rate and/or money stock fluctuations.

Here is a revised form of a test question I have used in the past (stochastic means unpredictable, random):

Gilbert's article (StLFRB's Economic Review) presents and explains monetary policy operating procedures under two different regimes:

1) targeting the federal funds rate, such as was done during the 1970s (and since the mid-/late-1980s to the present); and

2) targeting non-borrowed reserves, as was done between October 1979 and October 1982.

Select ONE of these two procedures and explain how it is used to achieve control of the intermediate target of money stock growth. Clearly identify the theoretical framework for the procedure, the steps in the operating procedure in responding to a stochastic increase in money (reserve) demand, and the advantages and disadvantages in the procedure.