International Financial Policy John Coleman Up to this point in the course we developed the concept of a “real” (or “supply”) shock as well as a framework to understand the effects of real shocks on the global economy. Variables we considered consisted of the real values of the wage rate, employment, GDP, the interest rate, savings, consumption, investment, the current account, and the exchange rate. We also built on this material by examining the long-run determinants of the price level and its rate of change (inflation). Once we understood what determined the price level and its rate of change we were in a position to discuss key determinants of nominal variables such as nominal GDP, nominal interest rates, and nominal exchange rates. This lecture develops the concept of a “monetary” shock as well as a framework to understand the effects of monetary shocks on the global economy. Once we have a solid understanding of the effects of monetary shocks, we will be in a position to understand how any country uses its international financial policy to manipulate its economy, and the goals it attempts to achieve be setting its international financial policy. In this sense, this lecture is perhaps the key lecture in this course. I wish to start this lecture on monetary policy and the economy with a cautionary note. In attributing real effects to shocks stemming from monetary policy, in this course we will take the perspective of the loanable-funds theory. This view of the effects of monetary policy shocks seems to closely reflect the views of both central banks and the financial press. Since one objective of this course is to teach you how to interpret articles from a variety of news sources, this perspective seems best suited to our purpose. This theory, however, draws a sharp distinction between the short-run and long-run responses of the economy to actions by central banks. This theory is thus fundamentally dynamic, which requires somewhat more effort to capture with the supply and demand diagrams that we have relied on so far. Also, in discussing the short-run response of the economy, both central banks and the financial press make some rather strong assumptions concerning the timing of various reactions to monetary policy shocks. They base these assumptions on their sense of how markets realistically react to these shocks. Once we have a clear understanding of the effects of monetary shocks, we will ask what goals the Federal Reserve and other central banks around the world attempt to attain by shocking the economy. We will think of a central bank as having two goals. The first goal is to promote steady growth in real GDP and the second is to promote a steady low rate of 1 inflation. Unfortunately, these goals often seem to conflict with each other in the sense that one goal can only be attained at the expense of the other. For example, a central bank often tries to raise the short-term interest rate to control inflation, but high interest rates tend to lower the growth rate of output. Conversely, the central bank sometimes lowers interest rates to bring the economy out of a recession, but this may lead to an acceleration of inflation. The central bank continually attempts to strike a balance between its two objectives. We will end this series of lectures by examining the international financial policy of various countries around the world, such as Mexico, Argentina, Russia, Thailand, Indonesia, Germany, and Japan. Remarkably, despite the different reputations of many of these central banks, they seem to perform in roughly the same way as the Fed. This similarity in monetary policy has important implications for things like exchange rates and international capital movements. 2 Dow Jones Interactive file:///C:/classnotes/macro/lectures/WSJ1-9-91.htm THE WALL STREET JOURNAL Wednesday, January 9, 1991 Fed Reduces Rates Again In Bid to Bolster Economy --- Action Is Expected to Trim Charge on Federal Funds To About 6 3/4% From 7% By Alan Murray Staff Reporter of The Wall Street Journal WASHINGTON -- The Federal Reserve cut short-term interest rates another notch yesterday, continuing its efforts to bolster a recessionary economy. The action is expected to bring the key federal funds interest rate down to about 6 3/4% from 7% in recent weeks. Other short-term interest rates are likely to decline accordingly. The reduction comes barely three weeks after the Fed's last easing move and illustrates the central bank's growing concern about the economy. In addition, the action follows the government's takeover Sunday of the Bank of New England, which has heightened fears that a weak economy could lead to financial crisis. "We're in a recession, and as long as we're in a recession, the Federal Reserve will be in an easing mode," says Robert Dederick, chief economist of Northern Trust Co. Many economists believe the Fed will have to cut interest rates further to get the economy growing again. ... Copyright © 2000 Dow Jones & Company, Inc. All Rights Reserved. 1 of 1 1/6/2003 10:59 PM 10 9 8 8 P Federal Funds Rate 7 GD 6 eal 6 R n 4 th i 5 annual rates 2 annual rates y Grow 4 3 0 Real GDP Growth Monthly Federal Funds rate Quarterl 2 -2 1 Nov90 Nov93 Nov96 Nov99 Nov02 date Real GDP Growth and the Federal Funds Rate Dow Jones Interactive file:///C:/classnotes/macro/lectures/WSJ8-17-94.htm THE WALL STREET JOURNAL Wednesday, August 17, 1994 Fed Lifts Short-Term Rates By Half a Percentage Point --- Latest Move in Bid to Curb Inflation Likely to Boost Most Costs of Borrowing By Paulette Thomas Staff Reporter of The Wall Street Journal WASHINGTON -- The Federal Reserve pushed up short-term interest rates by a half percentage point, sending Wall Street and the Clinton administration a clear inflation-fighting message. The interest-rate boost, intended to keep the economy from overheating and inflation at bay, is likely to raise borrowing costs for consumers and businesses; indeed, many big banks immediately raised their prime lending rates yesterday. The half-point jump triggered rallies in the stock and bond markets, which have been unnerved for much of the year by the incremental increases in short-term rates favored by Fed Chairman Alan Greenspan, usually a quarter-point. It's also likely to bolster the flagging dollar against foreign currencies. ... In the bond markets, where inflation is feared because it reduces the value of fixed-rate instruments, the Fed's fifth interest-rate increase this year was hailed as aggressive and decisive. The 30-year bond jumped almost 1.75 points to 101 17/32, or nearly $17.50 for a bond with a $1,000 face value. "Previously it was the water-torture approach to monetary policy," said Bruce Steinberg, manager of macroeconomic analysis at Merrill Lynch & Co. "Now they're introducing a period of monetary policy stability." Although the Clinton administration publicly went along with the move, some Democrats worried that the rate increase would choke off job growth before the administration has even taken credit for the economic recovery. ... Several of the nation's largest banks -- including Citicorp, BankAmerica Corp., Chemical Banking Corp., Chase Manhattan Corp., Norwest Corp. -- raised their basic lending rates soon after the Fed's action, to 7.75% from 7.25%. ... For consumers, the results of the Fed's move will be mixed. Interest rates for adjustable-rate mortgages and home equity loans, which are tied to short-term rates, will rise. Credit-card rates may also rise, although increases will be tempered by competitive pressures in the card industry. But interest rates that consumers receive for savings accounts and bank certificates of deposit will also increase. In addition, if long-term interest rates decline as a result of the Fed's action, rates for long-term fixed mortgages will decrease. ... Copyright © 2000 Dow Jones & Company, Inc. All Rights Reserved. 1 of 1 1/6/2003 11:02 PM The Taylor Rule and the Federal Funds Rate Document file:///C:/classnotes/macro/lectures/taylor_rule2_full.html Monetary policy, made to measure The Economist; London; Aug 10, 1996 How closely does central banks' behaviour follow simple monetary-policy rules? And how closely should it? Although plenty of the world's central banks have targets for inflation, none is sure precisely how, or how rapidly, changes in monetary policy affect the economy. Therefore they cannot be certain that a sensible-looking interest-rate cut will not revive inflation - or that a cautious-looking rise will not tip the economy into recession. IT MIGHT seem that central bankers can rest easy these days. The great beast, inflation, seems tamed, having fallen to only 2.8% in America, 1.4% in Germany and nil in Japan. Have monetary policymakers got it licked? Central bankers will tell you that they have not, and not just out of modesty. Although plenty of them have targets for inflation, none is sure precisely how, or how rapidly, changes in monetary policy affect the economy. So they cannot be certain that a sensible-looking interest-rate cut will not revive inflation-or that a cautious-looking rise will not tip the economy into recession. Hence the search for the holy grail: a simple rule for choosing an optimal monetary policy that keeps inflation down without hitting the economy too hard. Several have been tried. One was the gold standard, under which national currencies could be exchanged for the metal at a fixed price. Another, in vogue in the early 1980s, was a target for the growth rate of the money supply.