Finance Basic To Advance Level Knowledge

Mark Thoma has an interesting article on the dilemma facing the Fed: does it respond to rising inflation or the anemic economic recovery?  On the one hand, the Fed is concerned about maintaining its inflation fighting credibility and its independence from Congress.  Thus, it wants to be seen as vigilant on the inflation front. On the other hand, it does not want to undermine the economic recovery, as sluggish as it is.  What will it do?  For a number of reasons, Thoma believes the Fed will err on the side of fighting inflation.  This is unfortunate because any honest, fact-based assessment of the economy will show that long-term inflation expectations are well anchored , money demand remains elevated , and there remains much economic slack . Now no one wants to see the the return of 1970s-type inflation.  But what would be appropriate currently is some catch-up growth in nominal spending (and by implication inflation) to bring nominal income back to trend...

David Leonhardt of the New York Times says too little: It’s clear which way the Fed has erred recently. It has done too little. It stopped trying to bring down long-term interest rates early last year under the wishful assumption that a recovery had taken hold, only to be forced to reverse course by the end of year. Given this recent history, you might think Fed officials would now be doing everything possible to ensure a solid recovery. But they’re not. Once again, many of them are worried that the Fed is doing too much. And once again, the odds are rising that it’s doing too little.  Yes, the Fed fell asleep on the job last year and yes, QE2 was a weak version of what could have been a more effective monetary stimulus program where the price level or nominal GDP level  was targeted. What is not true is that a successful monetary stimulus program will be defined by sustained low long-term interest rates.  A successful monetary stimulus by definition wou...

It is hard to believe that it has been  two years since hyperinflation ended in Zimbabwe. In fact, enough time has passed that now the 100 trillion dollar Zimbabwe note shown below is gaining value with collectors. The reasons the Zimbabwe hyperinflation ended were (1) the country abandoned the production of its own currency and (2) it allowed foreign currencies to be used as legal tender. As result, foreign currencies started functioning as the medium of exchange and goods started appearing in formerly barren stores throughout Zimbabwe. The main foreign currency that is now used in Zimbabwe is the U.S. dollar. Now dollarization means your monetary policy is tied to the U.S. monetary policy, so it would be interesting to know how QE2 is affecting Zimbabwe.   Also, to earn more dollars Zimbabwe needs to run trade surpluses, but Robert Mugabe's economic policies are not very conducive to that end.   Thus, while dollarization  is tied to the ending of hyp...

Since Paul Krugman is talking about the 150th anniversary of the U.S. Civil War outbreak, it is worth recalling  the great monetary experiments created by the Civil War.   This great event resulted in the establishment of  three monetary regions in the United States: the Greenback monetary system, the Yellowback monetary system, and the Confederate monetary system. The Greenback monetary system emerged in the East when the gold standard was suspended so fiat currency could be introduced in 1862.  There was no central bank at the time, so the new fiat money   popularly known as the greenback was introduced by the U.S. Treasury.  Ironically, the Treasury Secretary who introduced the Greenbacks, Salmon Chase, would later become Chief Justice of the Supreme Court and rule that the fiat currency was unconstitutional.  The Greenbacks were highly inflationary as seen in the figure below: Between 1862 and 1865, the price level rose about 60% be...

Ryan Avent is right that we should not get worked up over the possibility that U.S. core inflation appears to have bottomed out.  A potential turn around in core inflation does not negate that fact that the demand for money remains elevated and is hampering a robust recovery in nominal spending.  In addition, forward-looking measures of inflation indicate that long-term inflation expectations remain below the Fed's implicit 2% inflation target as seen in the figure below:  Source: Cleveland Fed                                                  Between the elevated demand for money and below-target inflation expectations, it is hard to see why one should get excited about the recent activity in core inflation. These developments, if anything, indicate that monetary policy may still be too tight.

Nick Rowe recently made the case that excess money demand is the fundamental reasons behind the Keynesian and Monetarist theories of recession.  Alex Tabarrok responds that if Nick is correct there should be a rise in barter transactions and the use of alternative currencies.  He shows that there was extensive use of both during the Great Depression.  Tabarrok has a harder time finding evidence of these occurring during the recent recession. Some commentators provide anecdotal evidence that barter trade has risen.  Whether it has or hasn't, the bigger point is that barter and the use of alternative money assets is a way to mitigate the impact of money demand shocks.  Even if the data were to show these mitigaters are not being used, such a finding could simply mean that the recovery will be prolonged rather than being evidence against Nick's hypothesis.  After all, there is compelling evidence of a serious excess money demand problem in the U.S. economy....

I recently made the case that money demand remains elevated and continues to be a drag on the economy.  The  flow of funds data for 2010:Q4 supports this conclusion.  This data shows that the share of nonfinancial private sector assets in liquid form remains relatively high.  Households and firms continue to hold significantly more liquid assets than they did prior to the recession.  The good news is that it the share of liquid assets  dropped slightly in Q4. Presumably, the share of liquid assets continued to decline in early 2011 though recent global events may change that. Using the Flow of Funds data , the figure below shows for the combined balance sheets of households, non-profits, corporations, and non-corporate businesses the percent of total asset that are highly liquid ones (i.e. cash, checking accounts, saving and time deposits, and money market funds) as of 2010:Q4.  The figure also shows M3 velocity. Other than the 1995-1999...

Bennett McCallum is one of the most accomplished monetary economists of the past few decades.  He also happens to be a champion of nominal GDP targeting.  In a paper he did late last year for the Shadow Open Market Committee he discusses some of the problems with inflation targeting.  He notes that even if one takes inflation targeting to be of the Taylor Rule type--where there is both an inflation and output gap term--there are still problems with it: I would myself argue that the most prominent form of a typical IT policy rule, as described above, has a weakness stemming from its inclusion of the output gap as a second target/indicator variable to respond to. In particular, measurement of the “gap” requires measurement of the “natural rate” of output; but the latter is an unobservable and unmeasured variable that is conceptually different for every different specification of price-adjustment behavior used in the adopted macro model. And the price-adjustment relationsh...

Look at the figure below.  It shows the monetary base for the Eurozone and the data comes directly from the ECB .  The monetary base follows a striking trend that begins in 2002 and continues to the present.  Even the financial and Eurozone crises create only temporary deviations from this trend.   This trend is so straight it creates the appearance that the ECB is actually targeting the monetary base rather than following its two pillar strategy.  This upward trend not only creates the appearance of a monetary base target, but it also turns out to be very important to the trend growth of nominal GDP in the Eurozone.  To see this, note that the monetary base, B , times the money multiplier, m , equals the money supply, M (i.e.  Bm = M) .  In turn, the money supply times velocity, V , equals nominal spending or nominal GDP, PY (i.e. MV=PY). Putting this all together, we get the following identity: BmV = PY . Now let's unpack the first t...

Below is a figure of the Euro monetary base.  I find it puzzling for two reasons.  First, it shows an upward trend that starts in 2002 and continues to the present.  The monetary base has more than doubled since this trend begins.  What explains it?  It almost looks like a long, drawn out quantitative easing program.  The second thing to note is even the financial and Eurozone crisis is not enough to deter the ECB permanently from this trend.  The commitment to the trend seems to be driving the sharp fall in the monetary base from June 2010 to the present.  So what is going on here?  

Caroline Baum goes after the confused thinking on oil prices and inflation: It must be the noxious fumes or the stratospheric prices because crude oil crossing the $100 threshold makes normally thoughtful individuals funny in the head.  The early symptoms of high oil price syndrome, or HOPS, can easily be masked or confused with a more generalized form of lazy economic thinking.  For example, those afflicted with HOPS start making assertions that higher oil prices are inflationary, as if relative price changes can morph into an economy-wide rise in prices without help from the central bank.  One implication of this is that the Fed should not tighten monetary policy since the higher oil prices are just a relative price change.  The Fed should also not loosen monetary policy to ease the pain of such  relative price shocks.  As Baum notes, that is what the Fed did in the 1970s and look what it got us.  The Fed should only respond to aggregate demand ...

That is what Filipa Sá, Pascal Towbin, and Tomasz Wieladek find in their new paper . Moreover, they find that the effects of monetary policy and the saving glut were more pronounced in those economies with more developed and securitized mortgage markets.  On this latter point, Roger Ahrend similarly finds that easy monetary policy had its biggest effect on housing in periods of financial deregulation and innovation.  The Sá et al. paper also is consistent with the findings of Thierry Bracke and Michael Fidora who show that monetary policy shocks and global saving glut shocks contributed to the buildup of global economic imbalances.  These nuanced studies that take a global perspective and find both monetary policy and global savings to have mattered are far more satisfying than the "Not us!" research being pushed by former and current Fed officials lately.   It would be nice, however, if these nuanced studies did more to tease out (1) how much of the s...

Why has total current dollar spending been so anemic?  Even after accounting for the run up in  nominal spending during the housing boom, it is still below trend and continues to be a drag on the recovery.   A useful way to answer this question is to look at the three components of nominal spending: the monetary base, the money multiplier, and velocity The monetary base is simply the stock of money assets directly created by the Fed.   The money multiplier shows to what extent the monetary base is supporting expansion of  other  more commonly used money assets like checking, saving, and money market accounts.  If the monetary base is not supporting an  expansion of these other money assets it is because there is an elevated demand for the monetary base and vice versa.  The money multiplier, therefore, is an indicator of the demand for the monetary base. Velocity shows how often the more commonly used money assets like checkin...

(1)  Local communities such as this one in Spain resort to using old currency to stabilize spending. (2)  Ambrose Evans-Pritchard calls the ECB a flat-earth central bank for its handling of supply shocks and its attempt to kick Spain in the teeth. (3)  The ECB President says interest rates will be increased soon even though the core inflation rate declined in January and inflation expectations remain stable. (4)  An ECB Governing Council member says interest rates will rise as many as three times this year even though Eurozone nominal spending remains far below trend. (5)  Two ECB Governing Council officials say the ECB will actually tighten sooner than what is implied in (3) even though more credit downgrades are likely and credit spreads are increasing for the Eurozone periphery. Yep, that is what I call some tight monetary policy.

Scott Sumner presents his views on the Great Recession to the Warwick Economic Summit via this video: For more on Scott's views see here .

Lately, that seems to be the message coming from current and past Fed officials regarding the housing and credit boom in the early-to-mid 2000s.  First Ben Bernanke , then Vincent Reinhart , and now Janet Yellen have come out saying it was excess savings by foreigners and failings in the U.S. private sector that was the root cause of the boom.  No blame is assigned to the Fed.  They ask how could the Fed have created a liquidity glut that drove down world interest rates and sparked off a global housing boom? The answer is easy: the Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy was exported to much of the emerging world at this time. This means that the other two monetary powers, the ECB and Japan, had to be mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other curr...

Daniel Hamermesh says I should expect guns in my classroom soon:  The Texas legislature seems likely to pass a law allowing people to carry concealed weapons on campus.  Having observed enough shootings of professors by students in the U.S. over the past 45 years, I think this is a dreadful idea.  But it has interesting implications for wages.  Some people who might be willing to take jobs at Texas campuses will be hesitant to do so.  Unless there are enough others who welcome guns on campus, which I doubt, Texas universities will have to pay professors more — have to pay a compensating differential for the risk of being shot — or will be hiring lower-quality faculty members than before.  Interestingly, although there are many more undergrad than grad students, it seems like the large majority of shootings of professors have been by grad students.  Assuming that’s true, the new law will cause a change in wage differences between those who...

Inflation targeting just got a black eye in the United Kingdom.  Now its about to get another one as the  European Central Bank (ECB) President Jean-Claude Trichet signaled interest rates will probably be increased in April.  As was the case in the United Kingdom, the motivation for this move is concerns about maintaining the central bank's  inflation target.  And like the United Kingdom too, the inflation concerns are not warranted given that core inflation is low and inflation expectations remained well anchored according to the ECB.*  Morever,  aggregate spending is still well below any reasonable trend.  For example, the figure below shows Eurozone nominal GDP is below its 1995-2004 trend.  (This time period is chosen to show that nominal GDP is still below trend even after accounting for the housing boom run-up in spending .)   As Kantoos notes, all of these facts mean that tightening monetary policy in  April...

This may surprise you, but Christina Romer and John Taylor both agree on an important issue.  They both see the need for an explicit monetary policy rule that would provide more transparency and  predictability of the Fed's actions.  Here is Christina Romer in a recent article :  [The Fed] could set a price-level target, which, unlike an inflation target, calls for Fed policy to take past years’ price changes into account. That would lead the Fed to counteract some of the extremely low inflation during the recession with a more expansionary policy and lower real rates for a while. All of these alternatives would be helpful and would retain the Fed’s credibility as a defender of price stability. So Romer wants a price level rule that would keep the price level growing according to some target  rate.  This would not only commit the Fed to long-term price stability, but it would also create more certainty for the markets.  John Taylor m...

Arnold Kling does not think so: In the current setting, it appears that economic activity is expanding and inflation is higher than it had been. One may choose to interpret this as resulting from the Fed's quantitative easing. However, I am not signing onto that one. I recall reading recently that QE 2 was basically canceled out by offsetting changes in Treasury funding operations. That is, as the Fed bought more long-term bonds, the Treasury issued more long-term bonds relative to short-term securities. It is true the Treasury appears to be undermining QE2 by preventing the average duration of treasury securities from decreasing. The point of shorting the average duration is to cause a portfolio readjustment that will ultimately lead to more nominal spending. Here is how I described this process: Currently, short-term Treasury debt like T-bills are near-perfect substitutes for bank reserves because both earn close to zero percent and have similar liquidity.  In or...