economics_of_money_banking__financial_markets

Economic Growth

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to look for a better job might be unemployed for a while during the job search. Workers often decide to leave work temporarily to pursue other activities (raising a family, travel, returning to school), and when they decide to reenter the job market, it may take some time for them to find the right job. The benefit of having some unemployment is similar to the benefit of having a nonzero vacancy rate in the market for rental apartments. As many of you who have looked for an apartment have discovered, when the vacancy rate in the rental market is too low, you will have a difficult time finding the right apartment.

Another reason that unemployment is not zero when the economy is at full employment is due to what is called structural unemployment, a mismatch between job requirements and the skills or availability of local workers. Clearly, this kind of unemployment is undesirable. Nonetheless, it is something that monetary policy can do little about.

The goal for high employment should therefore not seek an unemployment level of zero but rather a level above zero consistent with full employment at which the demand for labor equals the supply of labor. This level is called the natural rate of unemployment.

Although this definition sounds neat and authoritative, it leaves a troublesome question unanswered: What unemployment rate is consistent with full employment? On the one hand, in some cases, it is obvious that the unemployment rate is too high: The unemployment rate in excess of 20% during the Great Depression, for example, was clearly far too high. In the early 1960s, on the other hand, policymakers thought that a reasonable goal was 4%, a level that was probably too low, because it led to accelerating inflation. Current estimates of the natural rate of unemployment place it between 412 and 6%, but even this estimate is subject to a great deal of uncertainty and disagreement. In addition, it is possible that appropriate government policy, such as the provision of better information about job vacancies or job training programs, might decrease the natural rate of unemployment.

The goal of steady economic growth is closely related to the high-employment goal because businesses are more likely to invest in capital equipment to increase productivity and economic growth when unemployment is low. Conversely, if unemployment is high and factories are idle, it does not pay for a firm to invest in additional plants and equipment. Although the two goals are closely related, policies can be specifically aimed at promoting economic growth by directly encouraging firms to invest or by encouraging people to save, which provides more funds for firms to invest. In fact, this is the stated purpose of so-called supply-side economics policies, which are intended to spur economic growth by providing tax incentives for businesses to invest in facilities and equipment and for taxpayers to save more. There is also an active debate over what role monetary policy can play in boosting growth.

Price Stability

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Over the past few decades, policymakers in the United States have become increasingly aware of the social and economic costs of inflation and more concerned with a stable price level as a goal of economic policy. Indeed, price stability is increasingly viewed as the most important goal for monetary policy. (This view is also evident in EuropeÑsee Box 1.) Price stability is desirable because a rising price level (inflation) creates uncertainty in the economy, and that uncertainty might hamper economic growth. For example, when the overall level of prices is changing, the information conveyed by the prices of goods and services is harder to interpret, which complicates

Interest-Rate

Stability

Stability of

Financial Markets

decision making for consumers, businesses, and government. Not only do public opinion surveys indicate that the public is very hostile to inflation, but a growing body of evidence suggests that inflation leads to lower economic growth.1 The most extreme example of unstable prices is hyperinflation, such as Argentina, Brazil, and Russia have experienced in the recent past. Many economists attribute the slower growth that these countries have experienced to their problems with hyperinflation.

Inflation also makes it hard to plan for the future. For example, it is more difficult to decide how much funds should be put aside to provide for a childÕs college education in an inflationary environment. Further, inflation can strain a countryÕs social fabric: Conflict might result, because each group in the society may compete with other groups to make sure that its income keeps up with the rising level of prices.

Interest-rate stability is desirable because fluctuations in interest rates can create uncertainty in the economy and make it harder to plan for the future. Fluctuations in interest rates that affect consumersÕ willingness to buy houses, for example, make it more difficult for consumers to decide when to purchase a house and for construction firms to plan how many houses to build. A central bank may also want to reduce upward movements in interest rates for the reasons we discussed in Chapter 14: Upward movements in interest rates generate hostility toward central banks like the Fed and lead to demands that their power be curtailed.

As our analysis in Chapter 8 showed, financial crises can interfere with the ability of financial markets to channel funds to people with productive investment opportunities, thereby leading to a sharp contraction in economic activity. The promotion of a more stable financial system in which financial crises are avoided is thus an important goal for a central bank. Indeed, as discussed in Chapter 14, the Federal Reserve System was created in response to the bank panic of 1907 to promote financial stability.

Stability in

Foreign Exchange

Markets

Conflict Among

Goals

The stability of financial markets is also fostered by interest-rate stability, because fluctuations in interest rates create great uncertainty for financial institutions. An increase in interest rates produces large capital losses on long-term bonds and mortgages, losses that can cause the failure of the financial institutions holding them. In recent years, more pronounced interest-rate fluctuations have been a particularly severe problem for savings and loan associations and mutual savings banks, many of which got into serious financial trouble in the 1980s and early 1990s (as we have seen in Chapter 11).

With the increasing importance of international trade to the U.S. economy, the value of the dollar relative to other currencies has become a major consideration for the Fed. A rise in the value of the dollar makes American industries less competitive with those abroad, and declines in the value of the dollar stimulate inflation in the United States. In addition, preventing large changes in the value of the dollar makes it easier for firms and individuals purchasing or selling goods abroad to plan ahead. Stabilizing extreme movements in the value of the dollar in foreign exchange markets is thus viewed as a worthy goal of monetary policy. In other countries, which are even more dependent on foreign trade, stability in foreign exchange markets takes on even greater importance.

Although many of the goals mentioned are consistent with each otherÑhigh employment with economic growth, interest-rate stability with financial market stabilityÑ this is not always the case. The goal of price stability often conflicts with the goals of interest-rate stability and high employment in the short run (but probably not in the long run). For example, when the economy is expanding and unemployment is falling, both inflation and interest rates may start to rise. If the central bank tries to prevent a rise in interest rates, this might cause the economy to overheat and stimulate inflation. But if a central bank raises interest rates to prevent inflation, in the short run unemployment could rise. The conflict among goals may thus present central banks like the Federal Reserve with some hard choices. We return to the issue of how central banks should choose conflicting goals in later chapters when we examine how monetary policy affects the economy.

F I G U R E 2 Result of Targeting on the Money Supply

Targeting on the money supply at M* will lead to fluctuations in the interest rate between i and i because of fluctuations in the money demand curve between Md and Md .

C H A P T E R 1 8 Conduct of Monetary Policy: Goals and Targets 417

M*

Quantity of Money, M

F I G U R E 3 Result of Targeting on the Interest Rate

Targeting the interest rate at M* will lead to fluctuations of the money supply between M and M because of fluctuations in the money demand curve between M d and M d .

Quantity of Money, M

Criteria for Choosing Intermediate Targets

to its former level. The central bank will make open market sales until the money supply declines to M s , at which point the equilibrium interest rate is again i*. Conversely, if the demand curve rises to M d and drives up the interest rate, the central bank would keep interest rates from rising by buying bonds to keep their prices from falling. The central bank will make open market purchases until the money supply rises to Ms and the equilibrium interest rate is i*. The central bankÕs adherence to the interest-rate target thus leads to a fluctuating money supply as well as fluctuations in reserve aggregates such as the monetary base.

The conclusion from the supply and demand analysis is that interest-rate and monetary aggregate targets are incompatible: A central bank can hit one or the other but not both. Because a choice between them has to be made, we need to examine what criteria should be used to decide on the target variable.

The rationale behind a central bankÕs strategy of using targets suggests three criteria for choosing an intermediate target: It must be measurable, it must be controllable by the central bank, and it must have a predictable effect on the goal.

Measurability. Quick and accurate measurement of an intermediate-target variable is necessary, because the intermediate target will be useful only if it signals rapidly when policy is off track. What good does it do for the central bank to plan to hit a 4% growth rate for M2 if it has no way of quickly and accurately measuring M2? Data on the monetary aggregates are obtained after a two-week delay, and interest-rate data are available almost immediately. Data on a variable like GDP that serves as a goal, by contrast, are compiled quarterly and are made available with a monthÕs delay. In addition, the GDP data are less accurate than data on the monetary aggregates or interest rates. On these grounds alone, focusing on interest rates and monetary aggregates as intermediate targets rather than on a goal like GDP can provide clearer signals about the status of the central bankÕs policy.

At first glance, interest rates seem to be more measurable than monetary aggregates and hence more useful as intermediate targets. Not only are the data on interest rates available more quickly than on monetary aggregates, but they are also measured more precisely and are rarely revised, in contrast to the monetary aggregates, which are subject to a fair amount of revision (as we saw in Chapter 3). However, as we learned in Chapter 4, the interest rate that is quickly and accurately measured, the nominal interest rate, is typically a poor measure of the real cost of borrowing, which indicates with more certainty what will happen to GDP. This real cost of borrowing is more accurately measured by the real interest rateÑthe interest rate adjusted for expected inflation (ir i e ). Unfortunately, the real interest rate is extremely hard to measure, because we have no direct way to measure expected inflation. Since both interest rate and monetary aggregates have measurability problems, it is not clear whether one should be preferred to the other as an intermediate target.

Controllability. A central bank must be able to exercise effective control over a variable if it is to function as a useful target. If the central bank cannot control an intermediate target, knowing that it is off track does little good, because the central bank has no way of getting the target back on track. Some economists have suggested that nominal GDP should be used as an intermediate target, but since the central bank has little direct control over nominal GDP, it will not provide much guidance on how the Fed should set its policy tools. A central bank does, however, have a good deal of control over the monetary aggregates and interest rates.

Criteria for Choosing Operating Targets

C H A P T E R 1 8 Conduct of Monetary Policy: Goals and Targets 419

Our discussion of the money supply process and the central bankÕs policy tools indicates that a central bank does have the ability to exercise a powerful effect on the money supply, although its control is not perfect. We have also seen that open market operations can be used to set interest rates by directly affecting the price of bonds. Because a central bank can set interest rates directly, whereas it cannot completely control the money supply, it might appear that interest rates dominate the monetary aggregates on the controllability criterion. However, a central bank cannot set real interest rates, because it does not have control over expectations of inflation. So again, a clear-cut case cannot be made that interest rates are preferable to monetary aggregates as an intermediate target or vice versa.

Predictable Effect on Goals. The most important characteristic a variable must have to be useful as an intermediate target is that it must have a predictable impact on a goal. If a central bank can accurately and quickly measure the price of tea in China and can completely control its price, what good will it do? The central bank cannot use the price of tea in China to affect unemployment or the price level in its country. Because the ability to affect goals is so critical to the usefulness of an intermediate-target variable, the linkage of the money supply and interest rates with the goalsÑoutput, employment, and the price levelÑis a matter of much debate. The evidence on whether these goals have a closer (more predictable) link with the money supply than with interest rates is discussed in Chapter 26.

The choice of an operating target can be based on the same criteria used to evaluate intermediate targets. Both the federal funds rate and reserve aggregates are measured accurately and are available daily with almost no delay; both are easily controllable using the policy tools that we discussed in Chapter 17. When we look at the third criterion, however, we can think of the intermediate target as the goal for the operating target. An operating target that has a more predictable impact on the most desirable intermediate target is preferred. If the desired intermediate target is an interest rate, the preferred operating target will be an interest-rate variable like the federal funds rate because interest rates are closely tied to each other (as we saw in Chapter 6). However, if the desired intermediate target is a monetary aggregate, our money supply model in Chapters 15 and 16 shows that a reserve aggregate operating target such as the monetary base will be preferred. Because there does not seem to be much reason to choose an interest rate over a reserve aggregate on the basis of measurability or controllability, the choice of which operating target is better rests on the choice of the intermediate target (the goal of the operating target).

The Early

Years: Discount

Policy as the

Primary Tool

When the Fed was created, changing the discount rate was the primary tool of monetary policyÑthe Fed had not yet discovered that open market operations were a more powerful tool for influencing the money supply, and the Federal Reserve Act made no provisions for changes in reserve requirements. The guiding principle for the conduct of monetary policy was that as long as loans were being made for ÒproductiveÓ purposesÑthat is, to support the production of goods and servicesÑproviding reserves to the banking system to make these loans would not be inflationary.4 This theory, now thoroughly discredited, became known as the real bills doctrine. In practice, it meant that the Fed would make loans to member commercial banks when they showed up at the discount window with eligible paper, loans to facilitate the production and sale of goods and services. (Note that since the 1920s, the Fed has not conducted discount operations in this way.) The FedÕs act of making loans to member banks was initially called rediscounting, because the original bank loans to businesses were made by discounting (loaning less than) the face value of the loan, and the Fed would be discounting them again. (Over time, when the FedÕs emphasis on eligible paper diminished, the FedÕs loans to banks became known as discounts, and the interest rate on these loans the discount rate, which is the terminology we use today.)

By the end of World War I, the FedÕs policy of rediscounting eligible paper and keeping interest rates low to help the Treasury finance the war had led to a raging inflation; in 1919 and 1920, the inflation rate averaged 14%. The Fed decided that it could no longer follow the passive policy prescribed by the real bills doctrine because it was inconsistent with the goal of price stability, and for the first time the Fed accepted the responsibility of playing an active role in influencing the economy. In January 1920, the Fed raised the discount rate from 434% to 6%, the largest jump in its history, and eventually raised it further, to 7% in June 1920, where it remained for nearly a year. The result of this policy was a sharp decline in the money supply and an especially sharp recession in 1920Ð1921. Although the blame for this severe recession can clearly be laid at the FedÕs doorstep, in one sense the FedÕs policy was very successful: After an initial decline in the price level, the inflation rate went to zero, paving the way for the prosperous Roaring Twenties.

Discovery of Open

Market

Operations

In the early 1920s, a particularly important event occurred: The Fed accidentally discovered open market operations. When the Fed was created, its revenue came exclusively from the interest it received on the discount loans it made to member banks. After the 1920Ð1921 recession, the volume of discount loans shrank dramatically, and

The Great

Depression

C H A P T E R 1 8 Conduct of Monetary Policy: Goals and Targets 421

the Fed was pressed for income. It solved this problem by purchasing income-earning securities. In doing so, the Fed noticed that reserves in the banking system grew and there was a multiple expansion of bank loans and deposits. This result is obvious to us now (we studied the multiple deposit creation process in Chapter 15), but to the Fed at that time it was a revelation. A new monetary policy tool was born, and by the end of the 1920s, it was the most important weapon in the FedÕs arsenal.

The stock market boom in 1928 and 1929 created a dilemma for the Fed. It wanted to temper the boom by raising the discount rate, but it was reluctant to do so, because that would mean raising interest rates to businesses and individuals who had legitimate needs for credit. Finally, in August 1929, the Fed raised the discount rate, but by then it was too late; the speculative excesses of the market boom had already occurred, and the FedÕs action only hastened the stock market crash and pushed the economy into recession.

The weakness of the economy, particularly in the agricultural sector, led to what Milton Friedman and Anna Schwartz labeled a Òcontagion of fearÓ that triggered substantial withdrawals from banks, building to a full-fledged panic in November and December 1930. For the next two years, the Fed sat idly by while one bank panic after another occurred, culminating in the final panic in March 1933, at which point the new president, Franklin Delano Roosevelt, declared a bank holiday. (Why the Fed failed to engage in its lender-of-last-resort role during this period is discussed in Box 2.)