economics_of_money_banking__financial_markets

Summary

1.A nominal anchor is a key element in monetary policy strategies. It helps promote price stability by tying down inflation expectations and limiting the timeconsistency problem, in which monetary policymakers conduct monetary policy in a discretionary way that produces poor long-run outcomes.

2.Exchange-rate targeting has the following advantages:

(1)it directly keeps inflation under control by tying the inflation rate for internationally traded goods to that found in the anchor country to whom its currency is pegged; (2) it provides an automatic rule for the conduct of monetary policy that helps mitigate the time-consistency problem; and (3) it has the advantage of simplicity and clarity. Exchange-rate targeting also has serious disadvantages: (1) it results in a loss of independent monetary policy and increases the exposure of the economy to shocks from the anchor country; (2) it leaves the currency open to speculative attacks; and (3) it can weaken the accountability of policymakers because the exchange-rate signal is lost. Two strategies that make it less likely that the exchangerate regime will break down are currency boards, in which the central bank stands ready to automatically exchange domestic for foreign currency at a fixed rate, and dollarization, in which a sound currency like the U.S. dollar is adopted as the countryÕs money.

3.Monetary targeting has two main advantages: It enables a central bank to adjust its monetary policy to cope with domestic considerations, and information on whether the central bank is achieving its target is known almost immediately. On the other hand, monetary targeting suffers from the disadvantage that it works well only if there is a reliable relationship between the monetary aggregate and the goal variable, inflation, a relationship that has often not held in different countries.

4.Inflation targeting has several advantages: (1) it enables monetary policy to focus on domestic considerations;

(2)stability in the relationship between money and inflation is not critical to its success; (3) it is readily understood by the public and is highly transparent;

(4)it increases accountability of the central bank; and

(5)it appears to ameliorate the effects of inflationary shocks. It does have some disadvantages, however:

(1)inflation is not easily controlled by the monetary authorities, so that an inflation target is unable to send immediate signals to both the public and markets; (2) it might impose a rigid rule on policymakers, although this has not been the case in practice; and (3) a sole focus on inflation may lead to larger output fluctuations, although this has also not been the case in practice. The concern that a sole focus on inflation may lead to larger output fluctuations has led some economists to propose a variant of inflation targeting, nominal GDP targeting, in which central banks target the growth in nominal GDP rather than inflation.

5.The Federal Reserve has a strategy of having an implicit, not an explicit, nominal anchor. This strategy has the following advantages: (1) it enables monetary policy to focus on domestic considerations; (2) it does not rely on a stable moneyÐinflation relationship; and

(3)it has had a demonstrated success, producing low inflation with the longest business cycle expansion in U.S. history. However, it does have some disadvantages:

(1)it has a lack of transparency; (2) it is strongly dependent on the preferences, skills, and trustworthiness of individuals in the central bank and the government; and (3) it has some inconsistencies with democratic principles, because the central bank is not highly accountable.

Questions marked with an asterisk are answered at the end of the book in an appendix, ÒAnswers to Selected Questions and Problems.Ó

1.What are the benefits of using a nominal anchor for the conduct of monetary policy?

2.Give an example of the time-consistency problem that you experience in your everyday life.

3.What incentives arise for a central bank to engage in time-consistent behavior?

*4. What are the key advantages of exchange-rate targeting as a monetary policy strategy?

5.Why did the exchange-rate peg lead to difficulties for the countries in the ERM when German reunification occurred?

*6. How can exchange-rate targets lead to a speculative attack on a currency?

7.Why may the disadvantage of exchange-rate targeting of not having an independent monetary policy be less of an issue for emerging market countries than for industrialized countries?

*8. How can the long-term bond market help reduce the time-consistency problem for monetary policy? Can the foreign exchange market also perform this role?

9.When is exchange-rate targeting likely to be a sensible strategy for industrialized countries? When is exchange-rate targeting likely to be a sensible strategy for emerging market countries?

*10. What are the advantages and disadvantages of a currency board over a monetary policy that just uses an exchange-rate target?

11.What are the key advantages and disadvantages of dollarization over other forms of exchange-rate targeting?

*12. What are the advantages of monetary targeting as a strategy for the conduct of monetary policy?

13.What is the big if necessary for the success of monetary targeting? Does the experience with monetary targeting suggest that the big if is a problem?

*14. What methods have inflation-targeting central banks used to increase communication with the public and increase the transparency of monetary policymaking?

15.Why might inflation targeting increase support for the independence of the central bank to conduct monetary policy?

*16. ÒBecause the public can see whether a central bank hits its monetary targets almost immediately, whereas it takes time before the public can see whether an inflation target is achieved, monetary targeting makes central banks more accountable than inflation targeting does.Ó True, false, or uncertain? Explain.

17.ÒBecause inflation targeting focuses on achieving the inflation target, it will lead to excessive output fluctuations.Ó True, false, or uncertain? Explain.

*18. What are the most important advantages and disadvantages of nominal GDP targeting over inflation targeting?

19.What are the key advantages and disadvantages of the monetary strategy used in the United States under Alan Greenspan in which the nominal anchor is only implicit?

*20. What is the advantage that monetary targeting, inflation targeting, and a monetary strategy with an implicit, but not an explicit, nominal anchor have in common?

Web Exercises

1.Many countries have central banks that are responsible for their nationÕs monetary policy. Go to www.federalreserve.gov/centralbanks.htm and select one of the central banks (for example, Norway). Review that bankÕs web site to determine its policies regarding application of monetary policy. How does this bankÕs policies compare to those of the U.S. central bank?

2.The web provides a rich source of information about international issues. The topic of dollarization has many references. Go to www.imf.org/external/pubs /ft/fandd/2000/03/berg.htm. Summarize this report sponsored by the International Monetary Fund about the value of dollarization.

PREVIEW

In earlier chapters, we spent a lot of time and effort learning what the money supply is, how it is determined, and what role the Federal Reserve System plays in it. Now we are ready to explore the role of the money supply in determining the price level and total production of goods and services (aggregate output) in the economy. The study of the effect of money on the economy is called monetary theory, and we examine this branch of economics in the chapters of Part VI.

When economists mention supply, the word demand is sure to follow, and the discussion of money is no exception. The supply of money is an essential building block in understanding how monetary policy affects the economy, because it suggests the factors that influence the quantity of money in the economy. Not surprisingly, another essential part of monetary theory is the demand for money.

This chapter describes how the theories of the demand for money have evolved. We begin with the classical theories refined at the start of the twentieth century by economists such as Irving Fisher, Alfred Marshall, and A. C. Pigou; then we move on to the Keynesian theories of the demand for money. We end with Milton FriedmanÕs modern quantity theory.

A central question in monetary theory is whether or to what extent the quantity of money demanded is affected by changes in interest rates. Because this issue is crucial to how we view moneyÕs effects on aggregate economic activity, we focus on the role of interest rates in the demand for money.1

Velocity of Money

and Equation of

Exchange

http://cepa.newschool.edu/het /profiles/fisher.htm

A brief biography and summary of the writings of Irving Fisher.

The clearest exposition of the classical quantity theory approach is found in the work of the American economist Irving Fisher, in his influential book The Purchasing Power of Money, published in 1911. Fisher wanted to examine the link between the total quantity of money M (the money supply) and the total amount of spending on final goods and services produced in the economy P Y, where P is the price level and Y is aggregate output (income). (Total spending P Y is also thought of as aggregate nominal income for the economy or as nominal GDP.) The concept that provides the link between M and P Y is called the velocity of money (often reduced to velocity), the rate of turnover of money; that is, the average number of times per year that a dollar is spent in buying the total amount of goods and services produced in the economy. Velocity V is defined more precisely as total spending P Y divided by the quantity of money M:

Quantity Theory

Quantity Theory of

Money Demand

C H A P T E R 2 2 The Demand for Money 519

the institutional and technological features of the economy would affect velocity only slowly over time, so velocity would normally be reasonably constant in the short run.

FisherÕs view that velocity is fairly constant in the short run transforms the equation of exchange into the quantity theory of money, which states that nominal income is determined solely by movements in the quantity of money: When the quantity of money M doubles, M V doubles and so must P Y, the value of nominal income. To see how this works, letÕs assume that velocity is 5, nominal income (GDP) is initially $5 trillion, and the money supply is $1 trillion. If the money supply doubles to $2 trillion, the quantity theory of money tells us that nominal income will double to $10 trillion ( 5 $2 trillion).

Because the classical economists (including Fisher) thought that wages and prices were completely flexible, they believed that the level of aggregate output Y produced in the economy during normal times would remain at the full-employment level, so Y in the equation of exchange could also be treated as reasonably constant in the short run. The quantity theory of money then implies that if M doubles, P must also double in the short run, because V and Y are constant. In our example, if aggregate output is $5 trillion, the velocity of 5 and a money supply of $1 trillion indicate that the price level equals 1 because 1 times $5 trillion equals the nominal income of $5 trillion. When the money supply doubles to $2 trillion, the price level must also double to 2 because 2 times $5 trillion equals the nominal income of $10 trillion.

For the classical economists, the quantity theory of money provided an explanation of movements in the price level: Movements in the price level result solely from changes in the quantity of money.

Because the quantity theory of money tells us how much money is held for a given amount of aggregate income, it is in fact a theory of the demand for money. We can see this by dividing both sides of the equation of exchange by V, thus rewriting it as:

1

M V PY

where nominal income P Y is written as PY. When the money market is in equilibrium, the quantity of money M that people hold equals the quantity of money demanded M d, so we can replace M in the equation by M d. Using k to represent the quantity 1/V (a constant, because V is a constant), we can rewrite the equation as:

Equation 3 tells us that because k is a constant, the level of transactions generated by a fixed level of nominal income PY determines the quantity of money Md that people demand. Therefore, FisherÕs quantity theory of money suggests that the demand for money is purely a function of income, and interest rates have no effect on the demand for money.3 Fisher came to this conclusion because he believed that people hold money only to conduct transactions and have no freedom of action in terms of the amount they want to hold. The demand for money is determined (1) by the level of transactions generated

3While Fisher was developing his quantity theory approach to the demand for money, a group of classical economists in Cambridge, England, came to similar conclusions, although with slightly different reasoning. They derived Equation 3 by recognizing that two properties of money motivate people to hold it: its utility as a medium of exchange and as a store of wealth.

www.usagold.com /gildedopinion/puplava /20020614.html

A summary of how various factors affect the velocity of money.

The classical economistsÕ conclusion that nominal income is determined by movements in the money supply rested on their belief that velocity PY/M could be treated as reasonably constant.4 Is it reasonable to assume that velocity is constant? To answer this, letÕs look at Figure 1, which shows the year-to-year changes in velocity from 1915 to 2002 (nominal income is represented by nominal GDP and the money supply by M1 and M2).

What we see in Figure 1 is that even in the short run, velocity fluctuates too much to be viewed as a constant. Prior to 1950, velocity exhibited large swings up and down. This may reflect the substantial instability of the economy in this period, which included two world wars and the Great Depression. (Velocity actually falls, or at least its rate of growth declines, in years when recessions are taking place.) After 1950, velocity appears to have more moderate fluctuations, yet there are large differences in

http://www-gap.dcs

.st-and.ac.uk/~history /Mathematicians/Keynes.html

A brief history of

John Maynard Keynes.

In his famous 1936 book The General Theory of Employment, Interest, and Money, John Maynard Keynes abandoned the classical view that velocity was a constant and developed a theory of money demand that emphasized the importance of interest rates. His theory of the demand for money, which he called the liquidity preference theory, asked the question: Why do individuals hold money? He postulated that there are three motives behind the demand for money: the transactions motive, the precautionary motive, and the speculative motive.

Transactions

Motive

In the classical approach, individuals are assumed to hold money because it is a medium of exchange that can be used to carry out everyday transactions. Following the classical tradition, Keynes emphasized that this component of the demand for money is determined primarily by the level of peopleÕs transactions. Because he believed that these transactions were proportional to income, like the classical economists, he took the transactions component of the demand for money to be proportional to income.