Evolution of Domestic Monetary System "[t]he use of counting and numbers, of calculating and figuring, propelled a tendency toward rationalization in human thought that shows in no human culture without the use of money. Money did not make people smarter; it made them think in new ways, in numbers and their equivalencies. It made thinking far less personalized and much more abstract." Weatherford

Introduction

Money is one of the greatest inventions of all times and its discovery truly changed the course of history because "[t]he use of counting and numbers, of calculating and figuring, propelled a tendency toward rationalization in human thought that shows in no human culture without the use of money. Money did not make people smarter; it made them think in new ways, in numbers and their equivalencies. It made thinking far less personalized and much more abstract."i

On a more practical level, in a very real sense we can think of money as the oil keeping the economic engine running smoothly to produce the goods and services we consume.ii If you are going to have specialization rather than self sufficiency, and you will want that because of variations in skills, preferences, and resource endowments, then you will need a system to facilitate the massive number of exchanges required to move goods and services around. The earliest system of exchange was barter where a carpenter needing plumbing would need to find a plumber needing carpentry - he coincidence of wants. It worked, but this system was too cumbersome to allow the specialization Adam Smith identified as the iii secret to economic growth. Keynes, whose theories of fiscal policy we studied in detail in the last unit, also recognized the long history of man's experiments with money.

Money is a far more ancient institution than we were taught to believe some few years ago. Its origins are lost in the mists when the ice was melting, and may well stretch back into the paradisaic intervals in human history of the inter-glacial periods, when the weather was delightful and the mind free to be fertile of new ideas in the Islands of the Hesperides or Atlantis or some Eden of Central Asia.iv

We have come a long way since those early days, but money is still important and the 1970s will be remembered as a decade where the US experimented with monetary policy, and in this section we examine the experiments in monetary policy of the 1970s in the context of developments in the domestic monetary systems. There will be fours sections:

As you work through the material you should sense that you are seeing yet another dimension of the debate between liberals and conservatives - this one over the proper role of regulation in the capital market that has taken on increasing importance in the post Reagan era. Here we will focus attention on the role of the government in regulating the money supply, but as we saw in the financial crisis, there are many other potential influences the government can have on the market.

Evolution of Money

“In the beginning” money emerged spontaneously because of the functions it performed - it made life better for people - rather than as the result of some government edict. Today's monetary system can be traced back to the early civilizations of China and the Mediterranean, and the history of money is intricately related to the rise and fall of nations and the emergence of the business class. As we quickly trace through the evolution of money our focus will be on productivity - how society reduces the full cost of "producing" money - and how there have been some important "leaps forward" in the evolution that have significantly

1 reduced the cost of supplying and using money. A money system will beat out a barter system since there are fewer resources devoted to transactions in the money economy leaving more resources devoted to producing things people desire - food, shelter, clothing - and when two monetary systems exist, the monetary system requiring fewer resources to produce money will come to dominate.

Money is difficult to define even though we know it when we see it. The best way to define money is by the functions it performs, which is good since the functions have remained constant even though the actual "things" used as money have changed. Above all else, money is a medium of exchange. You have certainly used money to pay for your food at the supermarket, for the movies, or to buy gas for your car. We use money when we buy and sell commodities or services.

Money is also useful as a unit of account. All prices are denominated in terms of a monetary unit - dollars, yen, or Euros - which allows one to minimize the information needed to make price comparisons. Rather than having to keep track of all pair-wise values - 20 packs of cigarettes for 1 sweater that can be traded for 4 CDs, which means that 1 CD equals 5 packs of cigarettes - you need only know the prices of the products denominated in terms of a monetary unit. A pack of cigarettes equals $2.50 while the sweater and CD cost $50 and $12.50.

Money also shares an important property with other financial assets; it is a store of value. If you sell something today, you receive money you can use to purchase something in the future. Money acts as a bridge between the present and the future - it stores value just as a refrigerator stores food to be used at a later date. To function as a store of value, people must have confidence in the money, which is why you will find the word "trust" on the bills that circulate as money in the US.

But what is money? Anyone who has studied history or traveled abroad realizes that both money and language vary across time and space. The existence of separate languages and monies is the result of historical accident, the product of a distant time where societies developed in virtual isolation, and current developments in the monetary system are simply corrections to the "historical accidents." Both languages and money have evolved in all parts of the world as individual societies developed systems to facilitate cooperation and the transactions, but advances in transportation and communication technology have moved us toward common monies and languages. This is clearly evident in the movement toward a common European currency, while the explosive growth of the Internet is speeding the movement toward English as a common language.v

What a society uses as money posses certain properties - it must be durable, divisible, transportable, readily accepted, and not easily duplicated. Ice cream would be out as money because it fails the durability test, while automobiles would fail the divisible test. As for the problem of ease of duplication, at some point the widespread production of new money would create a transportability problem. With more money in circulation all prices would rise and transactions would require more money. Taken to the extreme, you might find yourself taking a trunk full of money to the store to buy a loaf of bread - exactly what happened in Germany's hyperinflation in 1923. Finally, since money has no intrinsic value, there is one additional property we would like to see our money possess. We would like to have the cost of 'producing' money as vi low as possible so valuable resources can be used to produce "stuff" that has intrinsic value.

As for what has been used by societies as money, it has changed dramatically over time. Early monies included salt slabs, bricks of tea, tobacco leaves, cacao beans, whale's teeth, animal furs, rice, and wampum, with the preferred “money” dependent upon local availability. The common denominator is they were real commodities, things possessing value outside of their value as money, which is why they were called commodity moneyvii The earliest reported commodity money was the shekel, a specified weight of barley, that appeared in Mesopotamia before 2000 BC and in the Code of Hammurabi from 1760 BC where the “prices” in many transactions – debts, wages, and fines - were established. In China, cowrie shells that were readily available in the shallow waters of the Pacific Ocean circulated as money as early as 1200 BC. All of these early monies had some deficiency, however. Existing commodity monies fell from favor because they did not satisfy one or more of the above desired properties of money, and metals replaced them. In China the cowrie shells were replaced by metallic replicas of the shells and then by small

2 metallic replicas of tools by 1000 BC. After many centuries of experimentation with different metals, one metal surfaced as the preferred money - gold.viii

But how does one trust the bearer of a gold? How pure is the gold and how much does it weigh? You can imagine how limited its use would be if every transaction required a test for purity and a scale. Eventually the world "stumbled upon "coins," first minted in Lydia around 640 BC, and before the millennium the Roman Empire had become the first empire organized around money. Rome also gave us one of the downsides of a money - the ability of those in control of the supply of money to print excessive amounts of money that create inflation, and in some cases efforts to control it with price controls.

The next big thing in the evolution of money took place in China. Metal was an improvement over cowrie shells, but the “production” of money still required substantial resources. A much cheaper solution would be paper money, but you needed to get people to accept it as money. The strong central government of China was the first to do so – beginning in the Tang Dynasty around 800 AD. Marco Polo in The Travels of Marco Polo written in the 13th century noted the circulation of paper money.

All these pieces of paper are issued with as much solemnity and authority as if they were of pure gold or silver; and on every piece a variety of officials, whose duty it is, have to write their names, and to put their seals. And when all is prepared duly, the chief officer deputed by the Khan smears the seal entrusted to him with vermilion, and impresses it on the paper, so that the form of the seal remains imprinted upon it in red; the money is then authentic. Anyone forging it would be punished with death. And the Khan causes every year to be made such a vast quantity of this money, which costs him nothing, that it must equal in amount all the treasure of the world.

But the threat of death was not enough to discourage counterfeiting and China’s emperors could not resist the temptation to simply print new bills when they needed more money. The result was inflation and the eventual disappearance of paper money in the Ming Dynasty. This was the beginning of fiat money, money that had no intrinsic value as a commodity. Its advantage was the limited resources used in the production of this money, while the disadvantage was the ease with which one could produce excessive amounts.

In the West there was also a movement to paper that first appeared in northern Italy in the 1100s when we began to see the early forms of paper money and the rise of banks that played a key role in the distribution of the money. One country that got the new system right was England that founded the Bank of England in 1688 to control the supply of money. Its "solution" was the stipulation that the paper money notes be convertible into gold. This was an important piece in the monetary system circling the globe - the gold standard that England established in 1816 after inflation during the Napoleonic Wars. Gold, as a backing to the world's currency, provided a benefit to the people - it restricted the abuses of a government's power to print money highlighted by David Ricardo in the 19th century.

neither a state nor a bank ever has had unrestricted power of issuing paper money, without abusing that power; in all States, therefore, the issue of paper money ought to be under some check and control; and none seems so proper as that of subjecting the issuers of paper money to the obligation of paying their notes, either in gold coin or bullion.ix

The US also did its share of experimenting with money and monetary systems, and some of those experiments went quite badly as you see in the history of reoccurring banking and financial crises. In colonial America a number of commodities were used as currency – tobacco in Virginia, beaver pelts in New Amsterdam (New York), and Wampum in Massachusetts). There was a scarcity of money in the colonies and as a result colonial governments accepted many commodities as payment for taxes, and these became the de facto money. All of the colonies also experimented with paper money, which they printed too much of and this produced substantial inflation, especially during the Revolutionary War – and later the US Civil War as both sides printed new money to pay their bills.

We'll pick up the money story again with the Coinage Act of 1873 that specified the coins to be minted, but the silver dollar was not on the list of coins.x The problem was that the "missing" silver meant less money in circulation, and we know from the earlier discussion of the Quantity Theory that less money meant

3 falling prices and / or falling output – which is just what happened. Concern over falling prices and the overall state of the economy was widespread at that time and it became one of the defining issues of the Populist movement in the U.S. that described the Coinage Act of 1873 as the "Crime of 1873" and believed it was part of a conspiracy on the part of Eastern bankers to reduce the money supply and drive down prices.xi The most notable Populist was William Jennings Bryan who ran unsuccessfully for president a number of times including 1896 when he gained national recognition with his Cross of Gold speech to the Democratic National Convention. In his speech Bryan made an impassioned appeal to increase the supply of money and get the economy off the gold standard he felt was responsible for the falling prices wreaking havoc with indebted farmers and laborers and the panic of 1893 with its double-digit unemployment rates. According to Bryan: "You shall not press down upon the brow of labor this crown of thorns; you shall not crucify mankind on a cross of gold." Bryan was not alone. You may never have thought about it this way, but The Wizard of Oz has been interpreted as a Populist reaction to the same gold policies that Bryan was fighting and you should check it out on the web.xii

Bryan did not win, but the economy picked up and prices began to rise, fueled by a growth in the money supply. In 1900 President McKinley signed the Gold Standard Act that officially put the US on the gold standard, but the "good times" ended in the Panic of 1907 that revealed the weaknesses of the US financial system - lack of regulation - and set the wheels in motion to "create" a central bank for the US.xiii With passage of the Federal Reserve Act in 1913, the Federal Reserve System (Fed) became the central bank of the United States (Federal Reserve) - the equivalent of the Bank of Sweden, Bank of England, and the Bank of France that were established in 1656, 1694, and 1800. The outlines of the modern financial system were in place, and now we'll look more closely at the system and the role played by the Fed. We’ll start with a brief discussion of two key financial concepts - money and interest rates.

How do we measure money?

Money, as we saw in the evolution of money section, is usually defined as whatever performs three important functions - a medium of exchange, a unit of account, and a store of value. Given this definition, most countries have developed a set of monetary aggregates designed to measure the supply of money. The two most frequently cited measures are M1 and M2. The definitions for these M's can be found in the xiv Federal Reserve's Money Stock and Debt site. The short version is M1 consists of coins and cash held by individuals and businesses plus the value of checking account balances. M2 equals M1 plus savings (time) deposit balances. The composition of these components as of December 2010 can be seen in the table below. Currency represents nearly half of M1, while savings deposits represents nearly 50% of M2. If we look at the changes over time, currency has become a more important component of the money supply measures, while checking deposits have become a substantially smaller part of the money supply.

Decomposition of M1 and M2 (December 2010) Billion $s % of M1 % of M2 Currency 915 50% 10% Travelers checks 4.7 0% 0% Demand deposits 509 28% 6% Other checkable deposits 402 22% 5% Savings deposits 4,436.00 50% Small time deposits 656.00 7% Retail money funds 700 8% M1 1,832.00 21% M2 8,816.00 100%

Interest rates

Interest rates are the price of money and to understand interest rates you should keep three points in mind.

4 1. There are many interest rates. Just check out the poster at your bank listing a variety of rates next time you are there, or check out the bank's web site where you can find rates for a car loan, a savings account, or a credit card. A few of the ones you should know are listed below. • Discount rate: rate the FED charges banks for overnight borrowing • Federal funds rate: rate banks charge other banks for overnight borrowing • Prime rate: rate banks charge their 'best' customers • T-bill rate: rate on short-term (<1 year) government securities • Mortgage rate: rate on home and car loans

2. Differences between rates can be best viewed as the result of differences in risk. If you were to approach me to borrow some money, there are a number of factors that I would take into consideration when deciding how much to charge you. I would go through a checklist in assessing the risk associated with lending you money, and then set the rate. This checklist is summarized in the equation below that specifies the actual interest rate quoted to you (r) as being dependent on five separate components.

r = rr + rd + rm + ri + rl where r is the nominal rate - the actual rate you pay or receive. rr is the real risk-free rate of interest that measures the relative scarcity of funds. This is what would be charged to someone who was considered to be risk free. If I know you would absolutely pay me back on time, and nothing would change from now until you paid me back, then this would be the rate I would charge you to borrow money. The problem is we will never see this since it is the rate for perfectly riskless funds and there really is no such deal. The closest we'll get to it would be the rate on short-term borrowing by the US government. It is useful to think of this as a base rate upon which all other interest rates are set.xv Actual rates differ from the real risk-free rate of interest (rr) because of risk, and in the equation above there are terms representing four important aspects of the transaction that affect the lender's perception of risk. rd is the default risk. The ability of the borrower to pay back the money is one of the primary factors affecting the cost of funds, and this is captured by the default risk effect. The default effect reflects the ease with which a lender can recoup its losses in the event that the borrower cannot meet the repayment schedule. This is why interest rates are lower when the borrower offers more collateral, which is one of the reasons why the rate on home mortgages are lower than car loan rates, which in turn, are lower than the rate on personal loans. This is also why we have bond-rating companies to assess a potential borrower's fiscal health, and why you need to fill out financial forms when borrowing money. Bond rating companies rate borrowers on their estimate of their ability to repay the loan, and these ratings affect the rate of interest they pay. It could cost BIG money for state and local governments or major corporations who were trying to raise funds to have their ratings downgraded - from Aaa to Baa, for example. Between 1980 and 2007 the average rate on corporate Aaa bonds was nearly 1.1 percentage points lower than the rate on Baa bonds, so the riskier Baa borrowers were paying higher rates to reflect the extra risk.

5

Another place you see the default premium is in the difference between corporate Aaa bonds and federal government bonds, which is the 10-Yr line in the graph above. The corporate rates are higher because the market is assessing a higher default risk for corporations than for the federal government. In the right-side graph, meanwhile, we see how the gap between corporate and government rates changed over the business cycle. In the recession years – 2001 and 2008 – the differential increased substantially indicating that investors believed that if there were to be casualties in the tough times, it would be private companies that would collapse before the US federal government. As more investors wanted those US securities the interest rate the government had to pay to borrow money dropped, while the rate on corporate bonds rose to reflect the higher risk assessment. As the economy moved out of the post .com bust and 9/11 uncertainty of the early 2000s, the spread between corporate and government rates dropped.

This is very similar to what happened in 1997-98 in the midst of the Asian financial crisis when investors around the world poured their money into US securities,xvi and in 2001 as Argentina's economy teetered on the brink of collapse. The impact of the crises on interest rates in Hong Kong and Argentina are clearly evident in the two graphs below. Investors demanded extremely high interest rates to cover the high default-risk on bonds issued by the two countries.

The pattern repeated itself in 2009-2012 when concern over Greece’s finances quickly showed up in interest rates substantially higher than those paid by Germany. Below is the spread between the rates paid on funds raised by the government of Germany and those paid by Greece, Portugal, Ireland, Spain, and Italy. In September of 2009, the rate Greece paid was about 1.5% above the rate paid by Germany, but as the crisis deepened the default risk grew and the spread widened so that by June 2010 Greece was paying 7 % more to borrow money than Germany.

6 rm is the maturity risk. Given our inability to accurately predict the future, anyone lending money for a long period of time will generally require a higher rate of return to compensate for the higher perceived risk – what we call the maturity effect (rm). You can see this in the graph of long-term and short-term lending where the rate on long-term 10-year bonds is generally higher than the rate on 3-month bonds. Also evident is the greater volatility of short-term rates because when you make a 'deal" to lend money for 30 years, no news tonight will likely alter the rate you would charge tomorrow for a 30 year loan. On the other hand, if you were just lending money for 2 months, then some news tonight might alter the rate you would charge on a two-month loan.

A second way to demonstrate the maturity effect is the term-structure of interest rates evident in the yield curve - a graph of the relationship between yield (rate of return = interest rate) and maturity. The upward slope indicates the market premium for time - the longer the length of time, the higher the interest rate. The average rate on 3-month (G-3M) borrowing was approximately 7.5 percent, while the rate on 10-year (G- 10Y) borrowing was close to 9.5 percent.xvii

Another place you would see the maturity effect would be with home mortgages. In April of 2009 the rate was 5.1% if you wanted a 30-year fixed rate mortgage, and 4.71% if you wanted to borrow the money for 15 years. Because the lender incurs more risk on the longer loan, you pay a higher rate. ri is the inflation effect. Interest rates are also affected by inflation rates, as you can see in the graph below where interest rates and inflation rates tend to move together, which should not be surprising. The positive relationship between interest rates and the inflation rate - the inflation effect ri reflects the fact that when lenders see higher inflation rates they demand higher returns on their loans, and borrowers will be willing to pay the higher rates because they repay in $s that are not worth as much today’s $.

7

To see the impact of inflation on interest rates, let's look at a simple example. Assume you borrow $100 today and promise to pay back $105 one year from today. The lender will have been paid $5 for the use of that money for a year and the lender will use the $105 next year to buy a new pair of sneakers. It sounds like a mutually beneficial trade, but what happens if the price level changes? The mathematics of the example in which you are borrowing $100 for one year appears below. There are three scenarios that reflect different inflation rates.

Real and Nominal Interest Rates: When 5% is not 5% Scenario 1 Scenario 2 Scenario 3 Inflation rate 0.0% 5.0% 10.0% Nominal rate 5.0% 5.0% 5.0% Real rate 5.0% 0.0% -5.0% Loan $100 $100 $100 Interest paid $5 $5 $5 Total payment $105 $105 $105 Cost of living $100 $105 $110 Gain to lender 5% 0% -5%

Column 1 describes a zero inflation world: In this world you pay 5% nominal interest rate when the inflation rate is 0% so you repay $105 in one year. The lender can use the $105 to buy $105 worth of 'stuff,' so the lender's buying power has been increased by 5% by waiting a year. The real rate of interest is 5%.

Column 2 describes a 5% inflation world. In this world you pay 5% nominal interest when the inflation rate is 5% so you repay $105 in one year. The lender can buy $105 worth of 'stuff', but the cost of living has risen 5%, which means it now costs $105 just to buy what could be bought last year with $100. Waiting a year has not increased the lender’s buying power. The real rate of return is 0%.

Column 3 describes a 10% inflation world. In this world you pay 5% nominal interest when the inflation rate is 10% so you repay $105 in one year. The lender can buy $105 worth of 'stuff', but the cost of living has risen 10%, which means it now costs $110 just to buy what could be bought last year with $100. The lender's buying power has actually decreased by waiting a year. The real rate of return is -5%.

Are there any generalizations we can make from our simple example? If we ignore all of the other components/dimensions of the interest rate, we can specify the relationship between real and nominal interest rates as follows:

8 rn = rr + ie or rr = rn - ie 1. rr = real rate 2. rn = nominal rate 3. ie = expected inflation rate

The distinction between real and nominal rates matters a lot as you can see in the graphs below. In the late 1970s nominal interest rates rose while real interest rates turned negative as lenders took a beating because the interest rate increases did not keep up with spiraling, unanticipated inflation. As a result of the recessions in 1980-1982, inflation dropped sharply, but nominal interest rate declines failed to fully reflect the disinflation so we saw a substantial rise in real interest rates. In the 1980s, the real interest rate on 3- month government securities rose nearly 5 percentage points - a pattern we saw duplicated in the recession of 1990-1992.

3. An interest rate is the price of borrowing or lending funds and the S&D model of prices is an appropriate framework to analyzing prices. When we talk about interest rate changes we are talking about shifts in the supply and demand for money. For example, an increase in interest rates is the result of either an increase in demand or a decrease in the supply of funds. It is no more difficult than that, so now we will start with the supply and demand for money in the next section.

Money demand, money supply, and interest rates

Money Demand

Money was traditionally viewed as simply a medium of exchange with no intrinsic value so people demanded money simply to facilitate their transactions - they used it to buy things. If they had money they would spend it, and if the volume or price of their transactions increased, they would need more money. This demand is described in the Transactions Demand schematic below where more income leads to more transactions, which leads to demand for more money.

Transactions Demand for Money

Higher Income _ More Transactions _ More Money Demand Keynes took a somewhat different view of money, a more general view where he accepted the transactions demand and specified two additional reasons for holding money - precautionary and speculative motives. The speculative demand was the real Keynesian innovation. Keynes believed money should be viewed as an asset similar to the other assets people own - bonds, stock, and real estate - and people would be expected to alter their portfolio of assets to maximize their expected return. Today, if you read the financial

9 press, you will hear financial gurus telling investors how much of their wealth to keep in stocks, how much in bonds, in gold, and in cash. Keynes was anticipating this literature.

The logic behind Keynes' speculative demand is simple: if interest rates are low people will not lose much money in foregone interest by holding cash. If you happen to have $1,000 and hold it as cash, then you will be giving up the opportunity to earn $100 when the interest rate is 10%. If the interest rate falls to 5%, then you will only be giving up the opportunity to earn $50. You would expect that as interest rates rise, people tend to hold less of their wealth as money and more as interest earning assets. The "demand" for money will thus be lower at the higher rates, which is what you see in the Speculative Demand schematic below.

Speculative Demand for Money

Higher Interest Rate ¢Higher Opportunity Cost of Money¢Lower Money Demand

If we combine the two effects we will have money demand being positively related to the level of income and negatively related to interest rates. The demand for money can be demonstrated with a traditional demand curve that captures the negative relationship between interest rates (price of money) and money demand [Diagram 1]. As the interest rate rises from i* to i**, the demand for money will fall from M* to M**. Money demand for transactions purposes depends on income, and an increase in transactions resulting from an increase in income will show up as an outward shift in the money demand curve (D to D'). [Diagram 2]

Diagram 1 Diagram 2 Keynesian Money Demand Increase in Money Demand

We need to add in the supply side of the market and then put them together to discuss the price of money.

Money Supply: The Fed and the Creation and Control of Money

To understand the relationship between the Fed and the money supply you need to understand the logic of a fractional reserve system, and to do that we'll step back to the days of Robin Hood when gold was used to finance transactions. In this world many people were employed to mine the gold, refine it, and guard it during its transfer through Sherwood Forest, which offered a wonderful opportunity for Robin Hood and his merry band of men to "liberate" the gold. It was a good gig, until someone realized a way to put an end to these liberations. What if the Sheriff of Nottingham deposited the gold in a safe place - a goldsmith's vault being the most likely place – and in return the sheriff received a receipt from the goldsmith promising to provide gold to the holder of the receipt when it was returned. Before long these receipts began to circulate as money since anyone receiving it knew it could be exchanged for gold. If you sold a bow to Robin, he could pay you with a receipt for gold he had deposited at the goldsmith and you could return it to the goldsmith to convert it into gold.

10 This was a good system for cutting down on holdups in the forest, but there was a significant problem. It did not take long for the goldsmiths to recognize a way to scam this system. At the end of each day the goldsmiths’ vaults contained gold because not all of the notes issued had been returned to be exchanged for the gold. There was gold just sitting in the vaults, and soon the temptation proved too great, and the goldsmiths got into the lending business. Knowing there was extra gold in the vaults at the end of the day, the goldsmith took a chance and issued new notes promising to repay gold. If you were looking for a new crossbow you could go to the goldsmith who would issue you some new notes backed by gold. Now we had a goldsmith with 100 ounces of gold in a vault and people running around with notes promising the goldsmith would pay 200 ounces of gold.

The system just outlined is a fractional reserve system and it is a key piece of the modern money supply process. The difference is that the goldsmiths have been replaced by banks that make their profit on the difference between the interest they pay to those who deposit money in the banks and the returns they get on investing and lending the money. For example, check out the gap between the rates you pay on that car loan and the rate you receive on your savings account.xviii You should see that banks, just like the goldsmiths, have an incentive to take risks with the monies deposited with them. In the roaring 1920s stock prices were booming so banks used depositors’ money to invest in corporate stocks. It seemed like a win- win situation. You deposit your money in the bank, which then uses some of the money to buy corporate stock to participate in the booming stock market of the late 1920s. As the value of the stock goes up the bank feels “wealthier;” as the value of its assets increase so it decides to increase its liabilities and loans out more money. If you come in and ask for a $1,000 loan it says fine and gives you the $1,000 loan and credits the $1,000 into your account. And it did the same for many others and me because it made money off of the loans. Soon the value of the outstanding loans is far greater than the cash on hand, but the bank does not worry because if someone showed up for cash it could cash in some stock that had appreciated.

It works great as long as stock prices rise, but when those prices stop rising all hell can break loose. When stock prices begin to fall and people got nervous about their bank, people and businesses wanted their money in cash and we had a run on the banks. The bank needed to raise the cash to pay the people back – just like Jimmy Stewart in the movie It’s a Wonderful Life - and because the banks not kept much cash on hand because it earned nothing, the banks quickly had to sell assets. You know from S&D, however, that the banks’ liquidation of its assets increases the supply of assets, which drives down the prices of those assets. This creates more fear prompting more people to head to the banks for the cash, which further pushes down asset prices, which also reduces the wealth of people who then cut their spending. This is a traditional debt-deflation cycle: the financial system grinds to a halt as the money that “greases” the engine of business stops flowing.

It should be no surprise, therefore, that the biggest “push” behind regulation of the banks came as a response to the collapse of banks during the Great Depression. During the 1930s about 9,000 banks failed, and because there was no deposit insurance, people and businesses with money in those banks lost it all. This “forced” them to stop spending which led to the firing of workers, which led to further spending cuts, … You can see where this is going – and so could the Roosevelt administration. Banks had taken too many risks with the money that had been invested with them, and while risk-taking is a common feature of the business world and sometimes businesses go belly-up when they bet wrong, because of the importance of money in the economy and the key role banks play in its supply, the US government became involved in the regulation of the banking system. They made it the government’s responsibility to avoid the banking panics that had plagued this country since the earliest days.

The first key piece of the effort to stabilize the banking system was the Banking Act of 1933, better known as the Glass-Steagall Act, part of Roosevelt’s flurry of legislative action in the first 100 Days of his administration. In his inaugural speech Roosevelt opened with “So, first of all, let me assert my firm belief that the only thing we have to fear... is fear itself,” and the Glass-Steagall Act would eliminate some of that fear with the establishment of the Federal Deposit Insurance System to guarantee bank accounts. Deposits in banks would now be insured, and once people were no longer afraid of losing their money they returned to the banks and the money began to work its way back through the system. To reduce the risk banks assumed with other people’s money, banks were divided into two categories - investment banks that could

11 gamble with the money invested there, and commercial banks that were severely restricted in terms of what assets they could own.

Fast-forward and this should sound very much like the financial crisis of 2008-2009. In 1999 during the Clinton administration the provisions of the Glass- Steagall Act that separated out commercial and investment banks was dropped, and the rest, as they say, is history. Once again banks took on massive risks with depositors’ money – not stocks now but exotic “derivatives” tied to real estate that was in the midst of a dramatic rise in prices. But as always happens with bubbles, it popped and as foreclosures rose banks unloaded their assets leading to BIG asset deflation. As for how this happened, we’ll look more closely at that in the 2000s unit.xix For now we’ll look at THE major player in the money markets – The Federal Reserve System that from here on in will simply be called the Fed.

The Fed

Given the long-standing aversion Americans had for the concentration of financial power, the US was late in establishing a central bank, and when we did it 1913, the decision was made to establish twelve Federal Reserve Banks - one for each of the twelve Federal Reserve Districts. The thinking was that by dividing the country into twelve smaller regions, the Fed would be more accountable to the interests of the people in a particular region. If you were in Rhode Island, you were more likely to be able to influence policy by lobbying the regional Federal Reserve Bank in Boston than you could a national system located in Washington, D.C. The structure of the system is described in the diagram below. [A more extensive description of the structure of the Fed is available on-line].

Structure of the Federal Reserve

The seven members of the Board of Governors are appointed by the President and confirmed by the Senate to serve ONE 14-year term of office, although a member appointed to complete an unexpired term may be reappointed to a full term. This explains how Alan Greenspan served for over 18 years. His replacement, Ben Bernanke “got the job” by being appointed by the President and confirmed by the Senate to serve a four-year term, and the President is directed by law to select a "fair representation of the financial, agricultural, industrial, and commercial interests and geographical divisions of the country." The key here is the Fed Chair’s term does not coincide with the presidential election cycle so the Fed has some independence from the Executive & Legislative branches of government.

The Federal Open Market Committee (FOMC) that the Fed describes as “the most important monetary policymaking body of the Federal Reserve System,” however, holds the real power. The FOMC consists of the seven members of the Board of Governors and five Reserve Bank presidents. One of these is always the president of the Federal Reserve Bank of New York and the presidents of the other Reserve Banks serve one-year terms on a rotating basis. This is the group most responsible for setting monetary policy in the United States. It is the meetings of this group that grab the headlines as in 2001 when the Fed dropped rates to stimulate the economy and in 2006 when news stories centered on the Fed’s interest rate hikes designed to reduce inflationary pressure.

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In this section we will be focusing our attention on one aspect of the Fed’s policies - control of the money supply.

The Fed and the money supply process

The basic structure of the money supply process has the following components that are also highlighted in the diagram that follows.xx

1. The Federal Reserve (FED) supplies currency to the system and the currency is called high-powered money. 2. The high-powered money ends up in two places – in the pockets of people and businesses as cash or in the vaults of the banks as reserves. 3. The reserves in the banks are like the gold in the goldsmiths’ vaults – and they use the cash reserves to finance loans to businesses and individuals. For example, if you want a car loan. You go to a bank and the bank creates a car loan (asset of the bank) and writes a check payable to the car company (liability of the bank). The bank creates the loan (and deposit) because it has cash in the vault. 4. The bank makes no money on the cash in its vault so it has an incentive to create many loans and checks because it makes interest on the loans. In good times the bank would like to extend many loans, but the Federal Reserve limits the amount of loans / checks the bank can issue. The Fed establishes the required reserve rate (RRR) – the percentage of outstanding liabilities (deposit accounts) that must be held as cash by the bank. For example, if the RRR is 10%, then the bank must hold 10% of the value of the checks it creates as cash (required reserves) in its vaults. So, if the bank has $100 in cash as reserves and the required reserve rate is 10%, then the bank can “create” $1,000 in checking accounts. 5. In bad times the bank may decide not to make as many loans as it could so some of the cash is not used to support loans. In this case the bank is holding excess reserves – cash banks are not required to hold is held in the bank’s vault. 6. The money supply (M1) equals the Cash (currency) held by the public plus the balances in deposit (checking) account balances created by the banks.

Money Supply Process

Now that you have the basics we can see what affects the money supply. It is very simple: the money supply (M1) can be changed if the coins and currency (cash) in circulation change or if the checking account balances (demand deposits) change, and there are five ways that this can happen - three that can be

13 controlled by the Fed and two that cannot be controlled. Let’s look at the possible ways to increase the money supply. The first two are outside of the control of the Fed, while the last three are Fed tools. In each case there will be a description of what happens and in the endnotes a numerical example.

Lower publics' holding of cash: In the original example, $1,000,000 held as cash by you or me and the $4,500,000 in checking accounts are the money supply, but if people deposited some of their cash into the banks then because of the fractional reserve system the banks could “create” additional money by extending loans and increasing heir checking account balances. In the Great Depression, one of the real problems was people lost confidence in the banks and took their cash out of the banks, which caused the money supply to decrease. This is why Roosevelt introduced deposit insurance (FDIC), to help get the money back into the system. A similar pattern emerges every Christmas season when consumers want to hold more cash to buy those presents, and at the turn of the millennium when people hoarded cash because they were worried about Y2K. In both cases the money supply would decrease, and to offset these "shocks" the Fed would need to get more cash into the system.xxi

Lower bank holding of excess cash reserves: In the original example the $100,000 held as cash in the banks was held as idle cash, possibly as a safety measure so the bank could meet any unanticipated withdrawals. In the Great Depression, as well as in the financial crisis of 2008, banks did decide to hold more excess reserves as they lost confidence in the system and decided to "hoard" their cash. In this example, banks were holding $100,000 in excess cash, but if they decided to reduce excess reserves and make the money “work,” then this cash would be the basis for new lending that would show up as an increase in the checking account balances. A good example of this was the financial bailout in 2008. The Fed and US Treasury injected $ billions into the banking system, but the banks decided that in those uncertain times they would rather have cash - or US Treasury securities. Banks holdings of excess reserves do matter, and the money supply would increase if banks reduced their holdings of excess reserves.xxii

Lower the required reserve rate: The Fed can lower the required reserve rate, which means less cash has to be kept as reserves in the banking system. In this example, if the Fed lowered the required reserve rate to 10%, then the banks would need to hold only $500,000 as cash against the checking balances of $5,000,000 rather than the $1,000,000 in reserves with a reserve requirement of 20%. In essence the banks can “create” more money from the cash they have, so this would increase the money supply.xxiii

Open market purchases (OMO): The Fed can buy or sell government securities because one of the assets owned by the Fed is government these securities. If the Fed wants to increase the money supply, then it contacts its broker and announces it wants to buy $100,000 of government securities, and pays for it with cash. The banks sell the $100,000 of securities and reserves in the banking system increase by the Fed’s payment of $100,000. The increase of $100,000 cash into the banking system allows the banks to make loans based on the new reserves and this increases the money supply. If the Fed wants to increase the money supply it will buy government securities, while if it wants to decrease the money supply it will sell government securities.xxiv

Lower discount interest rate: One additional tool is the discount rate, the rate the Fed charges banks for overnight lending. The banks must balance their books and if they get caught with inadequate reserves because they have made too many loans then they need to borrow, which they can do from the Fed at the discount rate or from other banks at the federal funds rate. To get banks to lend out more money the Fed could lower the discount rate and lower the costs of borrowing to support the loans, while it could get the banks to reduce their loans by raising the discount rate.

It should now be clear that the Fed has three tools to affect the money supply – the discount rate, the required reserve rate, and Open Market Operations (OMO), and in the midst of the financial crisis of 2008- 09 it used them all. Of all of the tools, however, Open Market Operations tend to be the favored tool. Their popularity stems from the fact that the decisions are reversible, flexible, and timely.

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The Fed's tools are summarized below.

Fed Policy Tools Goal: Increase Money Goal: Decrease Money Tools Supply Supply Discount rate lower raise Required reserve rate lower raise Open market buy securities sell securities operations

Money Supply and Demand: A Model of Interest Rates

This is the easy part since by now you are accomplished at creating supply and demand curves. Behind the demand for money are the individuals and firms that use money in their daily activities, and as we saw earlier, an expanding economy will shift the demand curve outward as demand for money increases. The supply curve is a little more complex since it reflects the behavior of the Fed, banks, households, and individuals.

Money Market

Pulling the pieces together allows us to explain / forecast interest rates. Here are a few “shocks” and their likely impact on the market and interest rates.

1. If the FED increases the supply of high-powered money by a reduction in the discount rate, open market purchases, or lower required reserve rates, this would show up as an outward shift in the money supply curve. Interest rates would fall. (Right-side diagram below) 2. If banks become less conservative and lowered their holdings of excess reserves, then banks would loan out more money and the money supply would increase and the supply curve would shift outward. Interest rates would fall. (Right-side diagram below) 3. If households want more convenience and lower their holding of cash, then this decrease in the public's holdings of cash would increase the money supply and the supply curve would shift outward. Interest rates would fall. (Right-side diagram below) 4. If the economy improved and people increased their demand for funds, then this would increase money demand and the demand curve would shift outward. Interest rates would rise. (Left-side diagram below)

15 Money Market: Comparative Statics

We can now make generalizations concerning of the impact of external shocks on these rates. Any shock that can be translated into a shift in the supply or demand curve, the impact on price (interest rates) and quantity (money) can be forecast using the table below.

Money Market: Comparative Statics A Summary Interest Rate Money Supply Increase Money Demand UP UP Decrease Money Demand DOWN DOWN Increase Money Supply DOWN UP Decrease Money Supply UP DOWN

It's now time to turn our attention to what impact the change in the money supply and interest rates have on the economy - what we will call the monetary transmission mechanism. top

Money and the economy

At this point we can see how the Fed could enact policies to alter the interest rate, but why would they do it? The answer is that Keynesians believed there is a link between interest rates and the real economy – the production of goods and services and the employment of workers – and in this unit we examine that link. The money supply, and interest rates, are simply targets the Fed establishes to achieve the ultimate goals of full employment and price stability - and here, not surprisingly, we have substantial differences of opinion. There are very large differences between the liberal and conservative views, and in this section we examine the evolution of thinking on monetary policy, and how the prevailing view on monetary policy experienced a dramatic shift in 1979. We begin with the Keynesian view that dominated policy making in the early 1970s when the US was "freed" from the constraints of the Bretton Woods agreement, and then introduce the monetarists who "rose to power" in 1979 and who can trace back their roots to the Classical theory's Quantity Theory of Money.

Keynesian monetary theory and monetary policy

In the Keynesian view of monetary policy is outlined in the transmission mechanism diagram below that traces through the sequence of events from the Fed’s policies in the financial market that affect interest rates to the output market where they affect GDP and inflation.

16 Monetary Policy Transmission Mechanism: Version 1

The success of monetary policy according to Keynesians depends upon 4 critical links that we will examine in some detail. (0) the ability to anticipate the appropriate policy choice (1) the impact of policy choices on money supply and interest rates (2) the impact of the money supply and interest rate changes on aggregate demand (3) the allocation of the increased demand between higher prices and greater output

Before we do that, however, here is another way of visualizing the way monetary policy works.

Monetary Policy Transmission Mechanism: Version 2

“M– r –“I&C–“AD–“GDP and/or“P

where • “M= increase in money supply • r = decrease in interest rate • “I&C= increase in investment and consumption spending • “AD= increase in aggregate demand • “GDP and/or“P= increase in GDP and / or prices

In this example we have the Fed employing one of its tools to increase the money supply (“M). Given what we just saw in the money market, this will decrease interest rates ( r). Now, given out analysis of consumption and investment spending we can expect to see a decrease in the interest rate increase investment and consumption spending (“I&C). But, C&I are components of AD, so this increases AD – an outward shift in the AD curve with the result being some combination of higher price level and higher output level. (–“GDP and/or“P). What the Fed wants is an increase in GDP because this would increase employment and decrease unemployment, but how successful it will be depends upon all the separate links that show up as numbers in the first diagram and – in the second diagram.

(0) The first of these links we discussed in the 1960s unit when we covered the problems posed by lags - the recognition, implementation, and action lags. If action lags are long and variable, or our ability to accurately forecast the movements in the economy is quite limited, then monetary policy may not only prove to be ineffective, it could even be counterproductive and destabilizing. Keynesians downplayed the importance of these lags, while monetarists believed the lags were long and variable which is why monetarists had an aversion to discretionary monetary (and fiscal) policy.

(1) Once the policy choice has been made, attention turns to how this policy is reflected in interest rates. The interest rate is the price of money, and based on our earlier discussion of supply and demand, the

17 change in the interest rate generated by a shift in the supply curve depends on the slope of the demand xxv curve. The obvious question is: what is the slope of the demand curve? A flat demand curve indicates demand is very responsive to interest rates, as it might be if interest rates were at very low levels. Keynes, in his depression model, assumed interest rates were already low enough so any expansionary monetary policy would not be able to drive down interest rates because the demand curve was horizontal. The name given to this extreme version of money demand where the money demand curve is horizontal is the Liquidity Trap.xxvi In this case monetary policy would be completely ineffective, which is one of the reasons Keynes favored fiscal policy as a means to get the economy out of a depression.

(2) Once it is known how interest rates will be affected by monetary policy, the question is: how sensitive is aggregate demand to changes in interest rates? If the Fed is successful in altering interest rates and there is no change in aggregate demand, then monetary policy will not work. One sector of demand generally responsive to interest rates is residential construction because homes are paid for with mortgages, so if the Fed were interested in stimulating the economy, as it was in 2001, it would drive interest rates down to decrease the monthly mortgage payments. The lower payment is expected to increase demand for homes, which translates into higher levels of construction activity, plus the lower rates may also prompt existing homeowners to refinance their mortgages and use the savings in the monthly mortgage payment to buy other "stuff."

Interest rates may also affect demand for consumer durables - the appliances and automobiles households tend to purchase with loans. The rationale is the same - lower monthly costs stimulate demand. You see this relationship in the headlines in late 2001 such as "Auto sales ride high on no-interest loans" and "FINANCING INCENTIVES ARE DRIVING A SPURT IN AUTO SALES" as auto companies began offering 0 percent interest rates. A third sector would be business' investment demand. In theory, demand for nonresidential investment in structures and equipment - new factories and machines - is expected to increase with falling interest rates as the present value of the future earnings from these machines would be increased and the cost of purchasing them decreased.xxvii

This was the theory, but Keynesians had doubts about the impact of a monetary policy in very depressed situations such as the 1930s. A drop in interest rates could lower financing costs for businesses and consumers, but consumers who did not have jobs would be unlikely to rush out and buy new homes, and businesses, already suffering with excess capacity, would be hard pressed to justify building new structures or buying new machinery and equipment. In the Keynesian world of the 1930s, Aggregate Demand in general, or Investment Spending in particular, would not depend upon interest rates. The decrease in the interest rate will produce only a negligible increase in investment spending, which was the situation in Japan throughout much of the 1990s. Economic conditions were so bad that not even interest rates approaching 0 percent could induce businesses to invest in new equipment of structures. In the US in the 2008-09 financial crisis the situation was very much the same. Businesses had no incentive to expand capacity even with historically low interest rates as the economy fell into the recession, while households were not borrowing to buy homes while home prices were falling.

(3) The final link in the monetary policy process is the policy's impact on GDP, which depends upon two factors. First, is the size of the original spending multiplier. As you should remember from previous units, the multiplier will be smaller in an open economy with high levels of imports where leakages from the system would be high, and in the 1960s unit, and where consumption spending is not much influenced by current income, but rather by permanent income theory. This was a BIG issue in the debate over the Obama stimulus in the Great Recession of 2008-2010, with Republicans claiming small multiplier effects, while Democrats praised the positive impact of the stimulus and referred frequently to the jobs that were created by the program. And the multipliers vary depending on the policy according to the Congressional Budget Office (CBO).xxviii

18 CBO Estimates of Stimulus Multipliers Category Multiplier: High estimate Multiplier: High estimate Federal government purchases 2.5 1.0 Transfers to S&L for infrastructure 2.5 1.0 Transfers to S&L not infrastructure 1.9 .7 Two-year tax cut to low & middle income 1.7 .5 One-year tax cut to wealthy .5 .1

There is also the question of how much of the increase in aggregate demand shows up as increases in prices and how much as increases in output, and this depends upon the slope of the AS curve. If the economy is operating close to capacity where the AS curve is steep we can expect the impact of the monetary policy will be felt primarily in the price level. Similarly, if the AS slope is relatively flat, what we would expect in a severe recession or depression, the impact will show up in levels of output.xxix

Keynesian monetary theory and fiscal policy

The Keynesian version of the logical chain of events associated with fiscal policy, modified to account for the money (capital) market is specified below. In the Keynesian world, the expansionary fiscal policy (“G) would by definition increase aggregate demand (“AD) that would, via the multiplier, increase aggregate output (“GDP1). This increase in income would increase demand for money (“Md), which would put upward pressure on interest rates (“r), and this would "crowd-out" investment and consumption spending ( C, I) which would put downward pressure on income ( GDP2), thereby lowering the value of the spending multiplier.

“G–“AD–“GDP1 –“Md–“r – C, I – GDP2

As Keynes saw things, however, this crowding-out effect in depressed times is minimal for two reasons. First, the existence of surplus of funds in the capital market would mean any rise in interest rates would be minimal. Second, if business conditions are quite bad when the policy is undertaken, then the increase in aggregate demand and income could raise business expectations and this could actually raise their investment demand - a crowding-in phenomenon. If this is the case, however, we can expect monetary policy to be ineffective as a demand management policy. If interest rates cannot be pushed down and / or spending is insensitive to interest rates, then monetary policy will be ineffective and fiscal policy, because of a limited crowding out effect, will be an effective policy.

The Fed's Policy Dilemma, Volcker, and the Monetarist Experiment

Now that you have the outlines of monetary theory, let's look at the situation facing the Fed as a result of the OPEC price shocks of the 1970s. President Carter had hoped to use wage and price guidelines to reduce inflation without incurring the cost of higher inflation, but this never came to pass, so the gradualism of president Carter and his Fed Chairman G. William Miller were grounded in the belief that lower inflation's short term cost was higher unemployment - the Phillips Curve.

The problem faced by the Fed in the later 1970s - what we might call a dilemma - can be seen in the diagram below. The increase in the price level in 1970s increased demand for money, and the increase in money demand put upward pressure on interest rates (i* to i**) and on the money supply (M* to M**).

19 The Initial Problem

The Fed needed to respond to the upward shift in the money demand curve - and there were two possible choices. The Fed could either manage interest rates or manage the money supply. What it could not do was simultaneously hit a money supply (quantity) target and an interest rate (price) target. For example, if the Fed wanted to keep interest rates from rising as a result of the increase in money demand, it would need to increase the supply of money - an outward shift in the Ms curve (left-side of diagram below) so the money supply would increase from M* to M**. By adopting a policy that keeps interest rates constant at i* the Fed had to give up control of the money supply that increased from M* to M**.

A second option would be Fed polices to target the money supply. For example, if the Fed wanted to keep the money supply from rising as a result of the increase in money demand, it would need to decrease the supply of money - an inward shift in the Ms curve (right-side diagram below). This policy would maintain the money supply ay M*, but interest rates would rise to I**.

Alternative Fed Strategies

These policies have substantially different effects on the economy, so what was the Fed to do? Keynesians, who dominated policy positions in the 1970s, believed interest rates mattered most. They believed an easy money policy (increases in money supply) was needed to keep the economy from falling into another recession. By keeping interest rates low the Fed could stimulate business and consumer spending and help reduce unemployment. Opposing them were the monetarists, a group of economists whose focus on money supply can be traced back to the work of the Classical economists of the 1920s. By allowing the money supply to grow as they tried to keep interest rates down the Fed would be fueling inflation, so they opposed the policies being pursued by the Fed.

What the economy received was a strong dose of Keynesian monetary policy in the 1970s. President Carter's primary concern was unemployment, so he picked G. William Miller as Fed chair and directed him to use monetary policy to reduce unemployment and help him deliver on his campaign promise. By 1979 the Fed had been somewhat successful at lowering unemployment - the unemployment rate had fallen to 5.5 percent from a high of 9.5 percent - but inflation was on the rise again and the second round of OPEC

20 price increases was threatening to set off another round of double-digit inflation. By 1979 it was beginning to look like an inflationary spiral had been triggered by Miller's program of gradualism.

The inflationary spiral unleashed in the 1970s is summarized below. High unemployment (U) prompts the Fed to increase the money supply (“Ms), which pushes down real interest rates ( ir), which in turn increases investment spending (“I). This increases aggregate demand (“AD), which puts upward pressure on output (“GDP) and prices (“CPI). This in turn pushes money demand (“Md) higher, which increases nominal interest rates (“i). The higher rate prompts the Fed to increase the money supply (“Ms), which will start the whole cycle again, and each loop we make the inflation rate is higher than the previous one. The US economy was on a treadmill that produced only rising inflation and interest rates.

The Inflationary Spiral

high U –“Ms– ir–“I–“AD–(“GDP &CPI) –“Md–“i–“Ms– i–“I–“AD–“ (GDP & CPI )– “Md“#i“#Ms– i–“I–#“AD–v(GDP & CPI )

As inflation and interest rates spun out of control the world lost confidence in the US $ which you can "see" in the precipitous drop in the value of the US $. In July of 1979 the exchange rate dropped sharply and in the following month President Carter acted to calm the capital markets. In August Paul Volcker, the internationally respected president of the New York Federal Reserve, replaced Miller as chair of the Fed.xxx

The policies of the Fed during the 1970s could be directly tied to the aftereffects of the Great Depression, to the political sensitivity to rising unemployment. According to De Long, it would have taken a bold move on the part of the Fed to take up the fight against inflation in the 1970s by raising the unemployment rate, and it may have been that the Fed had not yet achieved the level of independence necessary to lead the fight. "[T]he memory of the Great Depression meant that the US was highly likely to suffer an inflationary episode like the 1970s in the post-World war II period-maybe not as long, and maybe not exactly when it occurred, but nevertheless a similar episode," but the opening came in 1979 as the US economy appeared on the brink of yet another round of stagflation.xxxi

Monetarism

While Keynesians dominated the economics profession and guided macro policy for most of the post WW II era, there was a group of conservative economists called monetarists who continually challenged the Keynesian view of the economy, and by the mid 1970s when the inability of the Keynesian policies to control inflation created a policy void, these policy makers began to seriously listen to the monetarists.xxxii

The biggest step toward the conversion was Paul Volcker's appointment as Federal Reserve Chairman. Volcker had worked in the Treasury Department in the Kennedy administration and was supportive of

21 Nixon’s decision to abandon the Bretton woods agreement in 1971. Now he had the task of taming inflation that had reached double digits. At the center of Volker’s view of the Fed was the Fed’s credibility. It needed to act decisively to build up that credibility since by now an inflationary spiral had taken hold. Workers had no confidence in the Fed’s ability to do the right thing – to raise interest rates to slow the economy and reduce inflation. Nixon could not do that in the early 1970s, and Carter could not do it now.

Volcker’s solution was to abandon Keynesian theory and embrace monetarism. The Keynesian policy of monitoring interest rates came to an abrupt end on October 6, 1979 when Volcker returned home early from an IMF meeting in Belgrade where he had received severe criticisms for US monetary policy. Volcker rushed home to announce the FED would redirect its efforts toward hitting its monetary targets and let interest rates seek their own level. Volcker was actually not the first to move in the direction of monetarism, as the United Kingdom under Margaret Thatcher, had already adopted monetarism to reduce inflation. The "beauty" of this change in approach was the Fed could now allow interest rates to rise to levels impossible to announce as policy goals. While the Fed could not announce it had a goal of 20 percent interest rates, it could announce a target growth rate of the money supply of 4 percent and let interest rates achieve their own level. The target ranges for M-1 and M-2 for 1979 were set at 3-6 and 5-8 percent, low enough to pretty much guarantee a slowdown in the economy.

The FED was clearly successful at lowering the growth rate of the money supply, and Volcker indicated the Fed's policies would continue. In February 1980, Volcker testified before the House Banking Committee:

Let there be no doubt; the Federal Reserve is determined to make every reasonable effort to work toward reducing monetary growth from the levels of recent years, not just in 1980, but in the years ahead.

And interest rates did respond to the restrictive policies. The Fed raised the discount rate to 13 percent in early 1980, and after a quick reversal in mid 1980 to avert a deep recession, raised it again to 14 percent by late 1981.

The impact on market interest rates was very clear, as can be seen in the graph below. The rate on long- term government bonds in the fourth quarter of 1979 reached a record-high, and by mid 1980 huge losses were being racked up in the bond market as a result of rising interest rates and it became difficult to find anyone willing to lend long-term money because of a fear of even higher rates.

22

Volcker did succeed in bringing monetarism to the US, but the experiment was short lived. The dramatic tightening by Volcker's Fed drove mortgage rates to near 20 percent and helped push the US into a very serious recession. This helped break the back of inflation, but Volcker and the Fed became a focal point for xxxiii the anger citizens. Thrift institutions were adversely affected by the rate increases since their assets were often low interest rate loans, while their liabilities were high interest rate deposits. Internationally, the less developed countries (LDCs) that had borrowed heavily in the 1970s were hit with a lower demand for their products, a result of the world-wide recession, and higher costs of borrowing, the result of a stronger US $ and higher real interest rates. The LDC debt crisis began in earnest in August of 1982 when Mexico suspended interest payments on its debt.

It is not an overstatement to suggest that "Monetarism achieved its moment of apogee with both intellectual and policy triumph in the late 1970s. Its intellectual triumph came as the NAIRU grew very large and the multipliers grew very small in both journals and textbooks. Its policy triumph came as both the Bank of England and the Federal Reserve declared in the late 1970s that henceforth monetary policy would be made not by targeting interest rates but by targeting quantitative measures of the aggregate money stock." The influence can also be seen in the following three quotes pertaining to the monetary policies of the UK, US, and Japan during this period.

1. "to master inflation, proper monetary discipline is essential, with publicly stated targets for the growth of the money supply." 2. "Let there be no doubt; the XX is determined to make every reasonable effort to work toward reducing monetary growth from the levels of recent years, not just in YY, but in the years ahead." 3. "The ZZ announced that it would henceforth focus on monetary control instead of interest rate control instead of interest rate control as the intermediate target of its monetary policy."

The first statement appeared in the Conservative manifesto of 1979 at the outset of Margaret Thatcher's tenure as prime minister. In the second, XX is the Fed and YY is 1980, while in the last statement, ZZ refers to the Bank of Japan's policy in the mid 1970s.

23 As it turned out, the experiment with monetarism in the US was called off in 1982, but not before interest rates rose even higher by the end of 1981. The inflation spiral appeared to have been broken, but the cost was substantial as the US entered its most serious slowdown since the Depression. The move toward "rules" had been reversed and the FED was once again monitoring interest rates, which you could see in the Fed’s response to two economic crises.

The first crisis was the double shock to the US economy generated by the .com bust of 2000 and the events of 9/11/2011. In the graph of NASDAQ stock prices. You can see the magnitude of the .com bust. Within a year the market was down 60%, and this translated into a substantial loss in wealth.

The combination of fear and a loss of wealth both negatively impacted aggregate demand – firms invested less and consumers bought less – and this prompted Alan Greenspan, Chairman of the Federal Reserve, to act decisively. In fact you can see the similarity in the NASDAQ graph and the federal funds rate graph. Greenspan responded by rapidly lowering interest rates from 6.5 percent to 1 percent in little over a year.

And it worked – at least for a time. One place we can see the impact is in housing prices. Greenspan’s lowering of interest rates corresponded with the Bush administration’s push to expand home ownership – this was the ownership society he was pushing – and the securitization of mortgage debt coupled with the \unscrupulous behavior on the part of mortgage companies and banks that helped put too many people in houses that they would not be able to afford. The extent of the boom – and then the bust – can be seen in the diagram below of home prices in three cities – San Francisco with the biggest run-up in prices, Las Vegas with the smallest, and Miami. In about twenty years home prices in Vegas tripled and in San Francisco they quadrupled as buyers cashed in on the record low interest rates.

24

You can see in the interest rate graph that by mid 2004 the Fed believed the economy had rebounded enough to begin raising rates, just as it did in the late 1990s in the final stages of the .com boom. It wasn’t until late 2007 that prices began to fall, and when they did the financial crisis was underway. As people could no longer pay their mortgages bankruptcies soared and the holders of those mortgages found themselves in a BIG financial hole. This hurt the banks, among others, and it triggered aggressive action by the Fed to lower interest rates again and help with the bailout of banks.

It's now time to move into the 1980s, where will shift our attention back to fiscal policy and examine the set of policies that became known as Reaganomics or Supply-side economics and the theory of economic growth.

25 26 1970s Domestic i Glyn Davies, History of Money. It is therefore not surprising that money altered the nature of relationships. "Money connected human in a more extensive and efficient way than any other known medium. It created more social ties, but in making them faster and more transitory, it weakened the traditional ties based on kinship and political power." For example, you and I may know very little about each other, but money provides a common denominator that could be the basis for establishing a relationship. Whereas in the past we may have been likely to do things for family and friends because we would have expected reciprocal treatment, money allowed us to expand the "group" of those who we might cooperate with. Money also allowed people to be more empirical. The decimal system, and its twin, metric measurement, not only changed the way people handled money and numbers but also transformed the way people thought. A new empiricism in thought, coupled with money's strict discipline in the use of numbers and categories [emerged]. ... the new class of intellectuals no longer sought to discover knowledge only through studying the works of ancient scholars and religious writers. They themselves could create knowledge through observation and the recording of events around them. ii To see this, consider the problem of a carpenter who needs a plumber. The carpenter could spend the day producing woodwork for sale and use the money to pay for a plumber's service, or spend the day looking for a plumber who happened to need the services of a carpenter. Rather than spending time doing what they did best, carpentry and plumbing, the two would spend their time searching. What happens in the first system is the plumber and carpenter are able to specialize in what they do best and minimize the time and effort spent searching, so society has access to additional plumbing and carpentry services and people live in better homes with better water systems. Or, just think back over the past 24 hours and list your financial transactions. In ECN 202 you will find students who has already bought the newspaper, breakfast, or gasoline, and paid a tuition bill, the rent, or the monthly car payment. We could go on but you get the point - these transactions are so numerous and painless they slide by almost unnoticed - and on one side of each transaction was money, either cash, a check, plastic, or e-money. Without these monies the transactions would not have been possible, and without these transactions we would not have our modern economy. iii For those interested in an online source with some good info, check out Glyn Davies' History of Money from Ancient Times to the Present Day. While barter was inefficient, and slowly over time a monetary system evolved, according to Davies the primary driver behind the appearance of monies was not efficiency. Money originated very largely from non-economic causes: from tribute as well as from trade, from blood-money and bride-money as well as from barter, from ceremonial and religious rites as well as from commerce, from ostentatious ornamentation as well as from acting as the common drudge between economic men. ... Many societies had laws requiring compensation in some form for crimes of violence, instead of the Old Testament approach of "an eye for an eye". The author notes that the word to "pay" is derived from the Latin "pacare" meaning originally to pacify, appease, or make peace with - through the appropriate unit of value customarily acceptable to both sides. A similarly widespread custom was payment for brides in order to compensate the head of the family for the loss of a daughter's services. Rulers have since very ancient times imposed taxes on or exacted tribute from their subjects. Religious obligations might also entail payment of tribute or sacrifices of some kind. Thus in many societies there was a requirement for a means of payment for blood money, bride- money, tax or tribute and this gave a great impetus to the spread of money. iv J. M. Keynes,Treatise on Money v Not everyone agrees. Barabara Wallraff, in "What Global Language?" writes that it is highly unlikely that English will be a global language, and that if a global language emerges, it will be Chinese. The Atlantic Monthly, November 2000. It is a similar story when we look at architecture, food, clothing, or art that all possess distinct national or regional differences, although the differences in all are declining. If you travel across the US today you will find a sameness in the nation's largest cities you would not have found 100 years ago. Where once you had local banks financing local builders and restaurants serving local cuisine reflecting the ethnic backgrounds of the city's peoples, today you find international banks financing international construction firms and food and clothing being sold through international franchises. You are never very far away from a McDonalds, Gap, or Wal-Mart. Similarly, where once people were likely to live their entire life within a five-mile radius of where they were born and interact with only a small number of people in their lives, today you are likely to travel thousands of miles and interact with thousands of people scattered across the world. vi The importance of these properties can be seen in a letter Thomas Jefferson sent to the Continental Congress in 1776 in which he lays out the framework for a national money. According to Jefferson, " in fixing the unit of money the following circumstances were of principal importance: (US Mint site) 1. That it be of a convenient size to be applied as a measure to the common money transactions of life. 2. That its parts and multiples be in easy proportion to each other so as to facilitate the Money Arithmetic.

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3. That the Unit and its parts or divisions be so nearly of the value of some of the known coins so that they may be of easy adoption for the people. vii Salt mined in large slabs in the Sahara was a popular form of money in China, North Africa, and the Mediterranean. It was fairly durable, easily divisible and it certainly had value as a commodity during medieval times where spices to improve the bland food was in high demand. In the Philippines and Japan it was rice, in Mongolia it was bricks of tea, and among the Aztecs in Mexico it was cacao beans. You could also add to the list of monies stone disks on the island of Yap, colored shells in India, leather in China, whale's teeth in Figi, grain in Egypt, animal skins and furs in Canada and Siberia, Wampum (shells) in Massachusetts, bags of corn in Guatemala, swords in England, and tobacco in Virginia to mention just a few. And let's not forget animals, which were also a common form of money among pastoral people. "The Siberian tribes used reindeer, the people of Borneo used buffaloes, the ancient Hittites measured value in sheep, and the Greeks of Homer's time used oxen." The heritage of money can also be seen in some of the terms that have found their way into the modern English vocabulary. Salary can be traced back to the Latin word sal meaning salt, while pecuniary (related to money) is derived from the Latin pecuniarius meaning "wealth in cattle." The "buck," a slang term for the American dollar can be traced back to the deerskins used as money in the British colonies in North America. Finally, the words cattle and capital are derived from the same Latin root. Weatherford.. For a brief history of money you might want to check out A Comparative Chronology of Money from Ancient Times to the Present Day © Roy Davies & Glyn Davies, 1996 that is available on-line (history of money). You also may want to check out an abbreviated outline of some of the important dates in the evolution of money and monetary systems. Another source was The History of Money by Jack Weatherford. Random House 1997. viii "The Sudanese made iron ... Egyptians used copper, while the people of southern Europe preferred Bronze. The people of Burma used lead, and the people of the Malayan Peninsula used tin that abounds there." Weatherford p21 ix Ricardo was not the only one to be concerned. The following is a description of perspective of Alexander Hamilton, Secretary of the Treasury in 1790 from a research paper available on-line at the San Francisco Fed. According to the authors, "Among his first acts as Secretary was to propose establishing a national mint, with the intent of providing a stable monetary standard. He argued for a bimetallic standard that defined a “dollar” in terms of a certain quantity of gold or silver. Hamilton claimed that a metallic standard would “render the unit as little variable as possible; because on this depends the steady value of all contracts, and, in a certain sense, of all other property.” Gold and silver coined by the mint would engender confidence in the emerging banking system. The potential for overissuance of bank notes could be limited by requiring the redemption of bank notes in specie. Congress accepted Hamilton’s arguments and passed the Mint Act of 1792. Michael Bryan, Bruce Champ, and Jennifer Ransom, "Who Is That Guy on the $10 Bill?," Economic Commentary Federal Reserve Bank of Cleveland | June 2000 x The decision to move back towards silver took place at about the same time that much of Europe was moving back to a gold standard. Germany, immediately after the end of the Franco-Prussian War in the early 1870s took silver out of circulation, a decision followed by others including France, Belgium, Italy, and Greece. xi Pressure began to mount for the resumption of silver backed money as a means to "inflate" the economy, and in 1878 the Bland-Allison Act mandated the government convert a specified amount of silver into legal tender - silver certificates. The panic of 1893 was quite sever and was caused in part because of passage of the Sherman Silver Act of 1790. This act was replaced in 1890 with the Sherman Silver Purchase Act doubling the purchases of Bland-Allison and specifying the money to be in the form of paper bills that were redeemable in gold. Once silver was again used as a basis for money, money became more readily available and investors around the world became worried that the US would inflate its currency by returning to a true bimetallic system and they began turning in their US dollars for gold. The expansion in 1890-91 was quickly reversed in 1893 and gold supplies of the US government fell below specified targets. The result was banks needed to begin calling in loans and spending dropped... the Keynesian multiplier kicks in. xii The controversy over the gold standard also may have been behind the publication in 1900 of The Wonderful Wizard of Oz, a story with a strong money subplot. Dorothy is uprooted from Kansas and lands in the East where she sets out on the gold road to the land of Oz, home to the witches and wizards of banking. She is accompanied by the scarecrow, tin man, and the lion who represent the American farmer, the American factory worker, and Bryan. The march to Oz is a recreation of the 1894 march led by Jacob Comet to demand issuance of $500 million greenbacks. Marcus Hanna, the power behind the Republican party was the wizard, and the people of the East were the munchkins. All that was needed was for the American people to realize that the financial system was run by frauds. Dorothy, with her silver slippers that were turned into ruby slippers for the visual effect would help bring the people to that realization. xiii During those good years, banks expanded their supply of bank notes (checking accounts) much faster than the supply of gold, so it was inevitable that at some point someone would call a banker's bluff. It happened in 1907 as the inflow of gold from England and Germany was reversed when the central banks in these countries raised interest rates and investors took their gold to invest it in these countries. With less gold in the US, bank reserves declined - and so

28 did the money supply. This made depositors nervous, and when a few banks closed their doors we had a scene reminiscent of Jimmy Stewart's plight in the Christmas movie, It's a Wonderful Life. xiv According to the Fed, the numbers for M1, M2 and M3 are calculated as follows. M1 "Consists of (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) travelers checks of nonblank issuers; (3) demand deposits at all commercial banks other than those due to depository institutions, the U.S. government, and foreign banks and official institutions, less cash items in the process of collection and Federal Reserve float; and (4) other checkable deposits (OCDs), consisting of negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository institutions, credit union share draft accounts and demand deposits at thrift institutions." M2 "Consists of M1 plus savings deposits (including money market deposit accounts), small- denomination time deposits (time deposits-including retail RPs-in amounts of less than $100,000), and balances in retail money market mutual funds. Excludes individual retirement account (IRA) and Keogh balances at depository institutions and money market funds." M3 "Consists of M2 plus large-denomination time deposits (in amounts of $100,000 or more), balances in institutional money funds, RP liabilities (overnight and term) issued by all depository institutions, and Eurodollars (overnight and term) held by U.S. residents at foreign branches of U.S. banks worldwide and at all banking offices in the United Kingdom and Canada. Excludes amounts held by depository institutions, the U.S. government, money funds, and foreign banks and official institutions." xv This is the rate we will be talking about later as the interest rate in the Ms-Md graphs. xvi You can see here that the gap between corporate Aaa (low risk) and Baa (high risk) rose after the crisis hit in the financial crisis of 2008.

xvii One thing you will find with yield curves is they move around quite a bit. Rates in the 1980s were clearly above rates in the earlier years, while rates in the 1960s are clearly below those in the following years. We'll return to a discussion of the movements in the yield curves in the 1970s unit on monetary policy and the 1990s unit on Clinton's economics policies.

xviii . Three important features of the system are:

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• Bank profitability: banks are in business for profit and we should expect that their decisions are guided by the profit motive and not the interests of the nation • Bank discretion over money supply: bankers' decisions affect money supply. If bankers decide to increase the value of demand deposits then the money supply will increase, while if they increase their holdings of excess reserves the money supply will decrease. • Exposure to runs: potential conflict between profits and safety. The banks will be tempted to expand the demand deposits that will mean that if all depositors wanted their cash, the banks could not honor the claims. This is what you saw in the movie It's a Great Life with Jimmy Stewart struggling to pay all of the depositors. xix The four important aspects of bank regulation are: • Deposit insurance: deposits are insured which lowers the fears of customers who will not be as likely to run to the bank to withdraw their funds when they hear a "rumor" about the bank. • Bank examinations: banks' books are periodically reviewed so that we are less likely to have banks adopting risky strategies that will result in bank closures. • Limitations on assets: banks cannot hold some assets that are deemed risky. This is what happened in Japan in the 1990s when the value of real estate plunged and it is what happened in the great depression in the US when the value of banks' holding of corporate stocks dropped sharply. As a result commercial banks were restricted from holding corporate stock as an asset. • Required reserves: banks required to keep cash on hand. This would limit the amount of money that could be created from a given amount of reserves and it would thus decrease the chance that the banks would have inadequate reserves to meet their obligations. xx To see how all of the pieces fit together, let's go back to examine the impact of the economy's crash in 1929 and the Fed's response. The Fed's initial reaction was to do nothing and wait for the inevitable correction. Banks, meanwhile, could not afford to pay the high discount rate in an environment where bank loans were limited because of the low levels of confidence in business profitability, so banks cut their borrowing from the Fed. The impact can be seen with a new example of the Fed's balance sheet. When business went bad in the early 1930s, bank lending to businesses declined, and with it came a decline in bank borrowing from the Fed. In this example, if bank lending to businesses dropped so the banks loans from the Fed fell by $50, then this would be offset by a reduction in Federal Reserve Notes of $50 since the Fed was required to balance its books. Fed's Newer Balance Sheet after decline in loans to banks Assets Liabilities Gold 800 Federal Reserve Notes: Currency 1,200 - 50 Loans to banks 400 - 50 Loans to government: Government Securities 600 Total 1,800 - 50 Total 1,800 - 50 After a severe recession / depression in 1920 triggered by the Fed's policy, the Fed began to experiment with a new policy, the buying and selling of government securities in 1922. In fact the widespread purchases were not the result of a coordinated Fed policy, but rather the result of individual Reserve Bank purchases to generate interest income. The result was "chaos" in the bond market, which led to the establishment in May of 1922 of the Committee of Governors on Centralized Execution of Purchases and Sales of Government Securities by Federal Reserve Banks. In the following year, as a result of growing concern over the concentration of power in the hands of the New York Reserve Bank's president, Benjamin Strong, who also happened to chair the new committee, the Committee was 'replaced" by the Open Market Investment Committee reporting directly to the Board of Governors. Internationally things were no better, and in fact by 1931 they were very bad. In May of 1931 Austria, in response to an outflow of gold, imposed controls on all gold and foreign exchange transactions and effectively moved off the gold standard. Germany, was next and on July 14th all banks in Berlin, except the Reichsbank, were shuttered and soon Germany also imposed controls. It was then England that caught the eyes of investors / speculators, and on September 21, 1931 the Bank of England suspended gold payments rather than raise interest rates. The devaluation of the £, from $4.86 to $3.75 reversed the flow of gold - from into the US to out from the US. The world's BIG money people, including its central banks, were nervous about holding any wealth denominated in any currency and US currency was being redeemed for gold. And by now you know the story, the outflow of gold drove down the money supply in the US - what would be referred to as an external drain. The situation can be seen in the final example below. The $50 outflow of gold would need to be offset by a $50 reduction in the Fed's liabilities, so Federal Reserve Notes, the nation's money supply, would fall by $50. Fed's new Balance Sheet with gold outflow of 50 Assets Liabilities

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Gold 800 -50 Federal Reserve Notes: Currency 1,200 -50 Loans to banks 400 Loans to government: Government Securities 500 Total 1,800 -50 Total 1,800 -50 Should the Fed sit back and allow these types of shocks to affect the money supply - allow the money supply to collapse as the economy fell into the Great Depression? It was a question that had to be asked again during the Asian Crisis of 1997-98 as foreign investors moved their money out of the Asian economies. What should guide the central banks in their decisions? In the case of the 1930s, the Fed had failed to establish the independence and power reflected in the Greenspan policy decisions of the late 1990s. During the 1920s and early 1930s, the Fed was wracked by power struggles between the seven member Board and the regional bank presidents, especially the president of the New York Reserve Bank. At this time the Fed allowed the decrease in loans to banks and the outflow of gold, the internal and external drains, to pull down the money supply because it was committed to the gold standard that linked the two sides of the Fed's balance sheet. When gold or loans to banks decreased, the Fed allowed the change in its assets to be reflected in a change in the money supply, and this tended to exacerbate the effects of the recession. It did not have to be this way, however, since the Fed had some policy tools that could have broken the link between the money supply and the assets of the Fed. One obvious possibility would have been a decision by the Fed to abandon the gold standard - when foreign investors arrived with dollars looking to be converted into gold, the Fed would not convert them into gold. The gold would stay in the US and the $s would continue to circulate, a policy the Fed eventually adopted, but not until after a substantial drop in the money supply. In 1997 Asian Crisis on the other hand, when the Asian stock market crashed and foreign investors wanted to take their money and run, the IMF stepped in and "encouraged" the Asian nations to raise interest rates to very high levels so that foreign investors would keep their money in Asia. For example, if Indonesia raised interest rates to 30 percent, investors could earn enough to compensate them for additional risk and the money would stay in Indonesia. Needless to say this was not good for the domestic economy as individuals and firms were "sacrificed" to the international financial system "gods," and as we will see in the 2000s unit, this brought the International Monetary Fund (IMF) into the public limelight and helped set the stage for the battle in Seattle during the World Trade Organization (WTO) meetings in early 2000. xxi Example 1 (Public holds less cash) In the earlier example, let’s assume that the public moves $500,000 from cash to deposits in the banks. The banks gain $500,000 as reserves and they can increase their loans. In this example, the $500,000 that comes in as cash (reserves) can now support $2,500,000 of new checking account balances - $500,000 for the new deposit and $2,000,000 of new loans. The change in the balance sheet appears below. The money supply (M1) is now $500,000 in cash held by the public and $7,500,000 in checking account balances for a total of $8,000,000. As a result of the lower cash holdings of individuals the money supply has increased from $5,500,000 to $8,000,000. Banking System's "Books" after public lowers cash holdings by $500,000 Assets Liabilities Securities $500,000 $5,000,000 Reserves Checking deposit + $2,500,000 $1,000,000 Actual Saving deposit $0 + $500,000 $900,000 Required Net Worth $500,000 +$500,000 Excess $100,000 $3,500,000 Loans + $2,000,000 Total $8,000,000 Total $8,000,000 xxii Example 1 (Bank hold holds less excess reserves) In the earlier example, let’s assume that the bank decides to eliminate excess reserves. The $100,000 then can be used to support loans of $500,000 that will increase the checking account balance by this amount so the $100,000 in additional reserves equals 20% of the additional checking account balances The bank accomplished this by increasing loans by $500,000.

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The money supply (M1) is now $1,000,000 in cash held by the public and $5,000,000 in checking account balances for a total of $6,000,000. As a result of the lower excess reserves the money supply has increased from $5,500,000 to $6,000,000. Banking System's "Books" after eliminates $100,000 of excess reserves Assets Liabilities Securities $500,000 $4,500,000 Reserves Checking deposit + $500,000 Actual $1,000,000 Saving deposit $0 $900,000 Required Net Worth $500,000 +$100,000 $100,000 Excess - $100,000 $3,500,000 Loans + $500,000 Total $5,500,000 Total $5,500,000 xxiii Let's assume the required reserve rate declines to 10% and the banks still want to keep $100,000 as excess reserves. This means that the banks can have $9,000,000 in checking account balances with required reserves of $900,000. The banks credit the depositors for the $1,000,000 and then extend loans totaling $8,000,000. The money supply (M1) now equals cash held by the public that remains at $1,000,000 and the checking account balance that are now $9,000,000 so the money supply is $10,000,000. The lowering of the required reserve rate has increased the money supply. Banking System's "Books" after reduction in required reserve rate Assets Liabilities Securities $500,000 Reserves Checking deposit $ 9,000,000 Actual $1,000,000 Saving deposit $0 Required $900,000 Net Worth $500,000 Excess $100,000 Loans $8,000,000 Total $9,500,000 Total $9,500,000 xxiv With the required reserve rate of 20%, the $100,000 in new reserves equals 20% (required reserve rate) of $500,000 that shows up as additional loans and as additional checking balances. The money supply (M1) is now the $1,000,000 in cash held by the public and $5,500,000 in checking account balances for a total of $6,500,000. This is higher than the original money supply of $6,000,000. Banking System's "Books" after Fed buys $100,000 Assets Liabilities $500,000 Securities -$100,000 $5,000,000 Reserves Checking deposit + $500,000 $1,000,000 Actual Saving deposit $0 + $100,000

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$900,000 Required Net Worth $500,000 + $100,000 Excess $100,000 $3,500,000 Loans + $500,000 Total $6,000,000 Total $6,000,000 xxv While some economists question the validity of the liquidity trap, others believe the situation in Japan in the late 1990s offers another example of the liquidity trap (Krugman). Interest rates were so low in Japan, reaching .5 percent on government securities, that monetary authorities were simply unable to push down rates any further. xxvii The sensitivity of investment demand to interest rates shows up in the two graphs below.

Impact of AD Interest rate Sensitivity on Monetary Policy Effectiveness

xxviii Conner Clarke, “CBO on stimulus multipliers,” The Atlantic Monthly, March 2, 2009 xxix Below are two graphs that allow us to see the impact of the slope of the AS curve on the effects of an expnsionary fiscal policy. Impact of AD Slope on Monetary Policy Effectiveness

xxx The flaw in the Keynesian theory was the inability of Fed officials to make the distinction between real and nominal interest rates. The relationship between the real interest rate (rr), what we believe affects decision makers and should be the concern for policy officials, the nominal interest rate (rn), which is the rate we actually see reported in the financial press, and the expected inflation rate (ie) is given by the following equation.

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rr = rn - ie In normal times the inflation rate (ie) remained rather stable and information on the real rate of interest (rr), what matters to the Keynesians, could be used to determine what was happening to nominal interest rates (rn). The link between the real and nominal rates collapsed in the 1970s, however, which caused troubles for policy makers. By 1974 inflation rates had risen above the rate on short-term government securities and remained there through the end of the 1970s so real rates were actually negative for the remainder of the 1970s. xxxi De Long "America's Only Peacetime Inflation: The 1970s" p1 xxxii The person most responsible for the emergence of monetarism in this era was Milton Friedman who, in his introductory essay in Studies in the Quantity Theory of Money, "established modern monetarism." De Long, "The Triumph of Monetarism?" Journal of Economic Perspectives, Winter 2000 xxxiii In Washington, D.C. demonstrators picketed the Federal Reserve Building with signs "Help American Agriculture - Eat an Economist." Volcker was unfazed by the demonstrations. He felt the Fed was responsible for breaking the inflationary spiral, so he withstood the pressure, just as he withstood pressure from the Reagan team to lower rates in 1986 to improve the macroeconomic situation prior to the midterm election. Volcker used the opportunity to step down in 1987 and into the Chairmanship stepped Alan Greenspan.

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