INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

AN INTRODUCTION TO MONETARY POLICY

Yichuan Wang

Michigan Interactive InvestmentsUniversity of Michigan

December 5, 2013

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

OUTLINE

1 INTRODUCTIONMotivation

2 THINKING ABOUT GOLD

3 MODELINGNominal RigiditiesTimingMisconceptions

4 MONETARY POLICY, QE, AND INTEREST RATESThinking About Interest RatesQE Specifics

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

OUTLINE

1 INTRODUCTIONMotivation

2 THINKING ABOUT GOLD

3 MODELINGNominal RigiditiesTimingMisconceptions

4 MONETARY POLICY, QE, AND INTEREST RATESThinking About Interest RatesQE Specifics

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

MOTIVATION

OUTLINE

1 INTRODUCTIONMotivation

2 THINKING ABOUT GOLD

3 MODELINGNominal RigiditiesTimingMisconceptions

4 MONETARY POLICY, QE, AND INTEREST RATESThinking About Interest RatesQE Specifics

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

MOTIVATION

WHAT IS MONETARY POLICY?

MY DEFINITION

A set of rules for how to adjust the money supply in response to economicconditions

Key ideas:Raising rates 6= Policy, the framework is crucialFocus on M, not r.

Examples:Gold standard – adjust money supply so that price of gold is constantInflation targeting – tighten M if inflation is high, expand if inflation is toolow

Lingo:Tight money – very harsh against inflationEasy money – “tolerant”

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

MOTIVATION

NOMINAL AND REAL VARIABLES

Real variables:How much stuff can I buy?

RGDP, Industrial Production, Initial Claims

Nominal variables:How many dollars does it cost?Two key aggregates

Nominal GDP – total dollar value of all goods and servicesPrice Level – price index of all goods

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

MOTIVATION

NOMINAL AND REAL VARIABLES

Real variables:How much stuff can I buy?RGDP, Industrial Production, Initial Claims

Nominal variables:How many dollars does it cost?Two key aggregates

Nominal GDP – total dollar value of all goods and servicesPrice Level – price index of all goods

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

MOTIVATION

NOMINAL AND REAL VARIABLES

Real variables:How much stuff can I buy?RGDP, Industrial Production, Initial Claims

Nominal variables:How many dollars does it cost?

Two key aggregatesNominal GDP – total dollar value of all goods and servicesPrice Level – price index of all goods

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

MOTIVATION

NOMINAL AND REAL VARIABLES

Real variables:How much stuff can I buy?RGDP, Industrial Production, Initial Claims

Nominal variables:How many dollars does it cost?Two key aggregates

Nominal GDP – total dollar value of all goods and servicesPrice Level – price index of all goods

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

MOTIVATION

MONEY SUPPLY AND INFLATION

Key driver of inflation

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Money Supply Growth and Inflation (1992−2012)

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

OUTLINE

1 INTRODUCTIONMotivation

2 THINKING ABOUT GOLD

3 MODELINGNominal RigiditiesTimingMisconceptions

4 MONETARY POLICY, QE, AND INTEREST RATESThinking About Interest RatesQE Specifics

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

MONETARY POLICY UNDER A GOLD STANDARD

If our economy were based on gold, what happens to output of goodsand services if there were a gold rush?

It goes up!People buy goods with newfound money, firm not quick enough to raiseprices

Does output rise forever?No!Eventually, firms adjust

David Hume: “On Money”

Money // Quantities // Prices

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

MONETARY POLICY UNDER A GOLD STANDARD

If our economy were based on gold, what happens to output of goodsand services if there were a gold rush?

It goes up!People buy goods with newfound money, firm not quick enough to raiseprices

Does output rise forever?

No!Eventually, firms adjust

David Hume: “On Money”

Money // Quantities // Prices

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

MONETARY POLICY UNDER A GOLD STANDARD

If our economy were based on gold, what happens to output of goodsand services if there were a gold rush?

It goes up!People buy goods with newfound money, firm not quick enough to raiseprices

Does output rise forever?No!Eventually, firms adjust

David Hume: “On Money”

Money // Quantities // Prices

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

DAVID HUME - “ON MONEY” (1742)

To account, then, for this phenomenon, we must consider, thatthough the high price of commodities be a necessary consequenceof the encrease of gold and silver, yet it follows not immediatelyupon that encrease; but some time is required before the moneycirculates through the whole state, and makes its effect be felt onall ranks of people. At first, no alteration is perceived; by degreesthe price rises, first of one commodity, then of another; till thewhole at last reaches a just proportion with the new quantity ofspecie which is in the kingdom. In my opinion, it is only in thisinterval or intermediate situation, between the acquisition ofmoney and rise of prices, that the encreasing quantity of gold andsilver is favourable to industry.

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

THE FIRST “QUANTITATIVE EASING” – LEAVING THE

GOLD STANDARD

September 19, 1931: Britian leaves gold standard, high interest ratesnormalized in March of 19321

100

120

140

1930 1931 1932 1933 1934 1935Date

London Security Price Index

1http://www2.warwick.ac.uk/fac/soc/economics/research/centres/cage/

events/conferences/lessons/papers/british_monetary_and_fiscal_policy_in_

the_1930s_ver_1_13.04.10.pdf

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

THE U.S. EXPERIENCE

April 5, 1933: FDR suspends convertibility of gold, “goes off goldstandard”

100

200

300

1930 1932 1934 1936 1938 1940Date

Dow Jones Industrial Index and the Great Reflation

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

OUTLINE

1 INTRODUCTIONMotivation

2 THINKING ABOUT GOLD

3 MODELINGNominal RigiditiesTimingMisconceptions

4 MONETARY POLICY, QE, AND INTEREST RATESThinking About Interest RatesQE Specifics

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

NOMINAL RIGIDITIES

OUTLINE

1 INTRODUCTIONMotivation

2 THINKING ABOUT GOLD

3 MODELINGNominal RigiditiesTimingMisconceptions

4 MONETARY POLICY, QE, AND INTEREST RATESThinking About Interest RatesQE Specifics

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

NOMINAL RIGIDITIES

NOMINAL RIGIDITIES

KEY IDEA

If monetary policy affects the economy, it’s because “nominal shockshave real effects”

Two main explanations:1 Nominal rigidities: contracts are dollar denominated, hence money supply

(not credit supply) plays crucial role in driving the business cycleExamples: Debt, Wages

2 Say’s Law: excess supply (i.e. recession) for goods is matched by excessdemand for money (i.e. money hoarding)

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

NOMINAL RIGIDITIES

WAGE RIGIDITIES

FRBSF Economic Letter, “Why Has Wage Growth Stayed Strong”2011 Distribution of Wage Increases from CPSSudden drop in nominal variables =⇒ new distribution of real wages

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

NOMINAL RIGIDITIES

DEBT

Debt build up – written in terms of nominal ratesWhen nominal variables change, real distribution of debt changes

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

TIMING

OUTLINE

1 INTRODUCTIONMotivation

2 THINKING ABOUT GOLD

3 MODELINGNominal RigiditiesTimingMisconceptions

4 MONETARY POLICY, QE, AND INTEREST RATESThinking About Interest RatesQE Specifics

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

TIMING

TEMPORARY VERSUS PERMANENT SHOCKS

Permanent monetary shocks always result in nominal shocksHistory: going off the gold standard, Eurozone vs U.S. austerity

When perceived as temporary, then no effectExample: Y2K

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

MISCONCEPTIONS

OUTLINE

1 INTRODUCTIONMotivation

2 THINKING ABOUT GOLD

3 MODELINGNominal RigiditiesTimingMisconceptions

4 MONETARY POLICY, QE, AND INTEREST RATESThinking About Interest RatesQE Specifics

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

MISCONCEPTIONS

A LITANY OF BAD ARGUMENTS AGAINST MONETARY

POLICY

“Central Planning”

Business cycle = market failure – nominal rigiditiesMonetary policy gone wrong: what did FDR do in response to GreatDepression, what did Nixon do in response to Great Inflation?

“Malinvestment”Depth of downturn not related to previous boomNo reason why “good” investments need to be sacrificed

Zimbabwe! Weimar Germany!/

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

MISCONCEPTIONS

A LITANY OF BAD ARGUMENTS AGAINST MONETARY

POLICY

“Central Planning”Business cycle = market failure – nominal rigiditiesMonetary policy gone wrong: what did FDR do in response to GreatDepression, what did Nixon do in response to Great Inflation?

“Malinvestment”Depth of downturn not related to previous boomNo reason why “good” investments need to be sacrificed

Zimbabwe! Weimar Germany!/

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

MISCONCEPTIONS

A LITANY OF BAD ARGUMENTS AGAINST MONETARY

POLICY

“Central Planning”Business cycle = market failure – nominal rigiditiesMonetary policy gone wrong: what did FDR do in response to GreatDepression, what did Nixon do in response to Great Inflation?

“Malinvestment”

Depth of downturn not related to previous boomNo reason why “good” investments need to be sacrificed

Zimbabwe! Weimar Germany!/

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

MISCONCEPTIONS

A LITANY OF BAD ARGUMENTS AGAINST MONETARY

POLICY

“Central Planning”Business cycle = market failure – nominal rigiditiesMonetary policy gone wrong: what did FDR do in response to GreatDepression, what did Nixon do in response to Great Inflation?

“Malinvestment”Depth of downturn not related to previous boomNo reason why “good” investments need to be sacrificed

Zimbabwe! Weimar Germany!/

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

MISCONCEPTIONS

A LITANY OF BAD ARGUMENTS AGAINST MONETARY

POLICY

“Central Planning”Business cycle = market failure – nominal rigiditiesMonetary policy gone wrong: what did FDR do in response to GreatDepression, what did Nixon do in response to Great Inflation?

“Malinvestment”Depth of downturn not related to previous boomNo reason why “good” investments need to be sacrificed

Zimbabwe! Weimar Germany!

/

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

MISCONCEPTIONS

A LITANY OF BAD ARGUMENTS AGAINST MONETARY

POLICY

“Central Planning”Business cycle = market failure – nominal rigiditiesMonetary policy gone wrong: what did FDR do in response to GreatDepression, what did Nixon do in response to Great Inflation?

“Malinvestment”Depth of downturn not related to previous boomNo reason why “good” investments need to be sacrificed

Zimbabwe! Weimar Germany!/

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

OUTLINE

1 INTRODUCTIONMotivation

2 THINKING ABOUT GOLD

3 MODELINGNominal RigiditiesTimingMisconceptions

4 MONETARY POLICY, QE, AND INTEREST RATESThinking About Interest RatesQE Specifics

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

THINKING ABOUT INTEREST RATES

OUTLINE

1 INTRODUCTIONMotivation

2 THINKING ABOUT GOLD

3 MODELINGNominal RigiditiesTimingMisconceptions

4 MONETARY POLICY, QE, AND INTEREST RATESThinking About Interest RatesQE Specifics

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

THINKING ABOUT INTEREST RATES

RELATIONSHIP WITH TRADITIONAL MODELS

Textbook models will focus on the interest rateNot completely wrong, but misleading

Interest rates: price of creditPrice level: price of money

Not necessarily related“Never reason from a price change”

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

THINKING ABOUT INTEREST RATES

THE SIX “CONTRADICTIONS”

From Scott Sumner’s “How to tell if you understand monetary economics”List of six “contradictions” – I focus on two on interest rates.

CONTRADICTIONS OF INTEREST

1 A move to a more expansionary monetary policy lowers short-terminterest rates.

2 In general, the higher the level of short-term rates, the moreexpansionary the monetary policy.

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

THINKING ABOUT INTEREST RATES

INTEREST RATES

A CONTRADICTION OF INTEREST (I)

A move to a more expansionary monetary policy lowers short-term interestrates.

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INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

THINKING ABOUT INTEREST RATES

INTEREST RATES

A CONTRADICTION OF INTEREST (II)

In general, the higher the level of short-term rates, the more expansionarythe monetary policy.

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INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

THINKING ABOUT INTEREST RATES

LONG TERM INTEREST RATES

Goes to show that “easy money” is typically in periods of high interestrates

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

QE SPECIFICS

OUTLINE

1 INTRODUCTIONMotivation

2 THINKING ABOUT GOLD

3 MODELINGNominal RigiditiesTimingMisconceptions

4 MONETARY POLICY, QE, AND INTEREST RATESThinking About Interest RatesQE Specifics

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

QE SPECIFICS

FRAMEWORK

Thinking in terms of M =⇒ QE is self evident“Zero lower bound” is red herring – permanent shocks can still havereal effect“Pushing down long term rates” is intermediate goal – monetaryexpansion will result in higher long term rates (and that’s good!)

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

QE SPECIFICS

STILL THINK MONEY DOESN’T MATTER? –COMPARISON WITH EUROPE

Similar levels of austerity:

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

QE SPECIFICS

COMPARING WITH EUROPE (II)

Drastically different nominal outcomesFor more, see my Quartz article, “Stop the taper talk—the Fed hasactually done too little”

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

QE SPECIFICS

LONG TERM RATES AND QE

Darda: Rates went up during QE periods

INTRODUCTION THINKING ABOUT GOLD MODELING MONETARY POLICY, QE, AND INTEREST RATES

QE SPECIFICS

CONCLUSIONS

Monetary policy = adjustment of M

Has real effects on economy because of nominal rigiditiesThinking in terms of M makes sure you stay consistent, clearerunderstandingPermanent shocks matterEffects of monetary policy show up in the financial markets.