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.