Unit 13: Monetary Policy

The major purpose of macroeconomics is to help identify what types of policies and laws will best help society achieve its major macroeconomic goals of growth, stable money, stable growth and full employment. But in the last two units we’ve moved away temporarily from this main line of inquiry to study how banks create money and how a central bank manages the money-creation process. In this unit we’re going join these two lines of inquiry.

We’re now going to look at how central banks can affect macroeconomic growth, inflation, stability, and employment. In short, we’re going to look at what economists call monetary policy. Monetary policy is a counterpart of fiscal policy. Fiscal policy, you should recall, is the use of the government budget, taxes and spending, by the government to achieve macroeconomic goals. Fiscal policy is the attempt by the government to manage the economy through the budget. Monetary policy, in contrast, is the attempt by the central bank (or whatever agency creates the money) to manage the economy and achieve macroeconomic goals. A central bank implements monetary policy changing interest rates, bank regulation, and attempting to change the money supply.

In the U.S., the central bank is, of course, The Federal Reserve system. Legally and organizationally, The Federal Reserve system is a network of 12 different regional Federal Reserve banks. The policies and actions of these twelve banks, however, are closely coordinated under the guidance of two policy-making groups. One group is called the Board of Governors. The head of the Board of Governors is called The Chairman of the Federal Reserve System, or more commonly, just The Fed Chairman. The current Fed Chairman is Ben Bernanke. He succeeded the previous Chairman, Alan Greenspan, in 2005. Bernanke was reappointed to a second five-year term by President Obama in 2010. Working closely with the Board of Governors is another group, The Fed Open Market Committee (FOMC). Membership of these two groups overlaps. Together these two groups determine policy and open market operations of The Federal Reserve Banks. These are the decision-makers that decide to raise or lower the required reserve ratio, to buy or sell securities in open market operations, whether to raise or lower the discount rate, and what targets they want the Fed Funds rate to hit. In short, these two groups determine how much money banks in the U.S. can create by making loans. They determine the money supply.

The Fed, or any other central bank, has powerful effects on real economic behavior through monetary policy changes. Monetary policy can be very powerful, but it has limitations (doesn’t everything?). One major limitation is that it just doesn’t work as well when interest rates are already very low. We’ll talk more about this below. Monetary policy can also be counter-acted by innovations in banking or global currency markets. In this unit we want to understand how monetary policy works. We want to understand how changes in money supply result in changes in GDP.  There are different views on the effects of monetary policy.  We will try to examine what had been the dominant view in recent decades, called the Monetarist theory. We will also take a brief look at a counter-view called Modern Monetary Theory (MMT).

In this unit, then, our objective is to:

  • Describe how actions of The Federal Reserve System affect money supply and interest rates.
  • Describe how actions of The Federal Reserve can be used to achieve macroeconomic goals.
  • Explain and analyze the Monetarist view of policy, macroeconomic equilibrium, and the resulting implications for the role of government.

Different Views of Monetary Policy

Many people get confused when they first encounter economists’ theories about monetary policy. It appears that, on one hand, economists are saying that monetary policy is very, very powerful and should be used to help achieve macroeconomic goals. On the other hand,economists also say that long-run money is neutral and that monetary policy alone can’t really make the economy grow faster. So which is it? Does monetary policy work, or not?

The answer, of course, is: it all depends.  It depends on both the present macroeconomic situation and the theoretical/ideological orientation of the speaker. A proper evaluation of monetary policy and the question of how and whether it works has been greatly complicated by the Great Recession/Financial Crisis of 2008-09 from which we are still attempting to recover.

The Great Recession/Financial Crisis has produced a crisis in macroeconomic and financial markets theory as well.  Basically, the dominant mainstream macroeconomic theory before the crisis completely failed to foresee the crisis and has failed to adequately explain how it could happen or why monetary policies followed during and after the crisis have failed to trigger a full recovery.  You are studying macroeconomics at an interesting time (“interesting” as in the ancient curse of “may you live in interesting times”).  There is a substantial probability that much of the present dominant theory will be discarded in ten years or so as a result of the crisis.  On the other hand, economics is famous for resuscitating “zombie” theories despite the empirical evidence against them.  It’s too early to tell.

There are essentially four viewpoints on monetary theory.  For the sake of simplicity, I’ll call them:

  • Austrian (an extreme version of Classical theory)
  • New Classical/Monetarist (an extension of Classical theory)
  • New Keynesian/Monetarist (an attempt to merge Keynesian with Monetarist)
  • MMT (Modern Monetary Theory – an evolution of Post-Keynesian theory descended from original Keynes with updated features)

I’ll explain these in more detail below, but before we can describe the existing theories and how monetary policy works (or doesn’t), we need to cover four important concepts first.

Concept One:  Interest Rates: The “Price” of (Borrowed) Money

A lot of confusion exists in the news media and among the general public about the relationship between The Federal Reserve and interest rates. It is often stated that The Federal Reserve “sets” interest rates. Strictly speaking, this isn’t true. There are many, many different interest rates depending on the loan involved: mortgage rates for home loans, prime rates on business loans, Fed Funds rate for inter-bank loans, the discount rate for Fed-to-banks loans, and outrageous rates for credit cards. If by “set” we mean The Fed meets in a room and picks a number and that’s the interest rate, then the only interest rate The Federal Reserve is able to “set” is the discount rate.

Although The Fed doesn’t “set” the Fed Funds rate, it does have enormous influence on the Fed Funds rate. The Fed Funds rate, you should recall from previous units, is the
interest rate that banks charge each other. Every day some banks have excess reserves for which they don’t have borrowers. At the same time, other banks are finding themselves either short of reserves or have borrowers but excess reserves to lend. Letting money sit idle is expensive – it’s lost profits for a bank. So banks with excess reserves make “overnight” loans to other banks that have too many borrowers but no reserves. The interest rate banks charge each other in this “money market” is called the Fed Funds rate, even though The Federal Reserve isn’t doing the lending. The Fed Funds rate is market rate. It’s determined by supply and demand. When there are more banks with more reserves to lend (supply) than other banks want to borrow (demand) the price of the loans (the Fed Funds interest rate) goes down. When there’s a shortage of reserves to lend, the price (interest rate) goes up. The Federal Reserve doesn’t directly set the Fed Funds rate. But, The Federal Reserve has tremendous influence on the Fed Funds rate. How? Since The Fed can increase or decrease bank reserves, it is effectively able to control the amount of money (reserves) that the banks have to lend each other. The Fed can control the supply of money. By increasing or decreasing the supply of money, The Fed can push the Fed Funds rate up or down. In practice, since 1988, The Federal Reserve has set “targets” for what it wants the Fed Funds rate to be. Whenever the Fed Funds rate gets too high, The Federal Reserve conducts open market operations (buys securities) and increases bank reserves, increasing the money supply, and driving the Fed Funds rate back down. If the Fed Funds rate gets too low in The Federal Reserve’s opinion, then The Fed removes excess reserves from the banking system (sells securities or raises required reserve ratio), which reduces the supply of money and raises the Fed Funds rate.

The other interest rates are only indirectly affected by Federal Reserve actions. The Fed Funds interest rate can be thought of as the “price of the raw materials” for a bank. If the Fed Funds rate goes up, then it has raised the cost to the bank of obtaining money to lend to home-owners, businesses, car owners, etc. Banks typically raise these other interest rates whenever there is a sustained increase in the Fed Funds rate. Vice versa when Fed Funds rate falls. For example, in late 2000 the Fed Funds rate was typically close to 6%. Banks would borrow from each other at 6% and lend the money to businesses at 9%, the “prime” rate that businesses were paying on loans. The bank was making its profit on the spread (3%) between the two rates. Two years later, the Fed Funds rate had dropped to 2%. As a result, the prime rate dropped to approximately 5%. The banks’ profit spread was still there at 3%. There is no law or mechanism that forces banks to lower other interest rates when the Fed Funds rate drops. Only competition between banks causes this. Indeed, during this same two-year period mortgage interest rates dropped, but not as much as the Fed Funds rate or prime rate did.

So, we can see that The Federal Reserve doesn’t directly “set” interest rates, but it does have an enormous influence on the general level of interest rates. The Federal Reserve can “drive rates up” by reducing the supply of bank reserves available to lend or by making borrowing bank reserves (discount rate or Fed funds rate) too expensive. It can also, in theory at least, “drive rates down”by increasing the supply of money. In practical terms, the power to drive rates up is greater. Attempts to drive rates down won’t always work quite as well. For one reason, once the interest hits 1% or less, it can’t really go much lower. Another reason is that while The Federal Reserve can make sure banks have plenty of money to lend, The Federal Reserve can’t make sure that there are people wanting to borrow the money. On occasions, this has been a problem. For example 2002 The Federal Reserve flooded the banking system with extra money and reserves, but there were relatively few borrowers who wanted to take out new loans. The Federal Reserve can only control the supply of money.  In the past 3 years, this has been a particularly difficult problem.  Since the Great Recession/Financial Crisis of 2008-09, The Fed has made sure that banks have plenty of bank reserves.  Banks have been swamped with excess reserves, yet they haven’t been loaning out the money.  Instead, they have largely used the money as a safety cushion or used to speculate in derivatives markets.

Concept Two: A Note on Interest Rates and Bond “Prices”: How Bonds Work

Bonds, whether they are government or corporate bonds, are actually loans. When issued, someone “issues” the bond such as a government or corporation. This means they sell the bond. The person who buys the bond is typically called the bondholder. By purchasing the bond, the bondholder is loaning money to the issuer. The bond itself is a legal promise to repay this debt with interest at a particular time called maturity. For example, if the government issues a new 10-year bond, the seller loans money to the government and the government promises to repay this loan in 10 years. The amount of the loan is called the principal. So far, this works much like any other type of loan such as a home mortgage, a car loan, credit card, or even a loan between friends (except the government’s a better bet to pay back than some friends!).

What’s different about bonds is how the interest is paid and the fact that bonds can be “sold” before they are paid off. Let’s take the selling bonds portion first. Let’s suppose Fred bought a 10 year bond from the government in 2002. This means Fred loaned the government money in 2002. The government issued a written promise to repay (the bond) in 2012. In the meantime, though, suppose Fred wants his money back. The government does not have to pay Fred until 2012. What Fred can do, though, is sell the bond to another person. Let’s call him Barney. This is a “secondary market bond sale”. Once Fred sells to Barney, Fred gets his money back. Barney will now collect the money from the government in 2012.

Now let’s look at how interest is paid. On most bank loans or savings accounts, interest is calculated on the outstanding balance every month or year and added to the balance owed. Bonds are different. With a bond, the interest is “discounted” from the purchase price of the bond when it is issued. For example, suppose the government issues a $1000 bond that is due in only 1 year at an interest rate of 10%. When the bond is issued, the bondholder will actually only loan the government $909, not $1000. One year later, the government will pay back the full “face amount” of $1000 to the bondholder. So the government will actually borrow $909 now and pay back $1000 a year from now. There are no other interest payments. The interest on the loan is the $91 extra the bondholder receives when they get paid back $1000 after only having lent $909. Go ahead, check it out. Collecting an extra $91 on $909 lent is a 10% interest rate, rounded off.

Implication of this: bonds are sold at prices below their face values. The face values reflect how much $ will get paid back at maturity (the $1000). The price of the bond is actual amount paid at the beginning (the $909). The interest is the difference between the price today and the face value at maturity (the $91).

This means: When interest rates go down, prices on bonds go up. When interest rates go up, prices of bonds go down.

Concept Three: The Demand for Money or “Velocity”

At first glance, the idea of the “demand for money” seems like it should be obvious: wouldn’t the demand for money be unlimited? After all, who doesn’t want more money? But the everyday observation that “people always want more money”, is really saying is that people always want to be wealthier. They want to have more assets. But, the demand for money isn’t really about how wealthy we want to be or how many assets we have. It’s about how we choose to keep those assets.The demand for money refers to the idea that, given whatever wealth we do have, we can choose to keep that wealth in various forms. We can keep our wealth as different assets.

Let’s consider an example. A millionaire might keep part of her wealth in the form of a house, some stocks, and some bonds. None of these assets are money – they are not liquid. Of course, if she kept absolutely none of her wealth as money, then there would zero in her checking account and zero cash in her pocket. It might make a trip to the store difficult. Or, she could keep all her wealth in the form of money by putting it all in a checking account. Then all of the wealth would be money – easily spendable. It would certainly make going to the store easy. Of course, some of you might suggest that keeping all of your wealth, especially if it’s a million dollars or more, in your checking account is foolish. That’s because you see the opportunity cost of holding money. When our millionaire holds her wealth as money, it’s easy to spend but it earns no interest. If the wealth is held as invested assets, such as corporate stocks, bonds, or even government bonds, then her wealth could grow, but she would have a hard time going to the store. She faces a trade-off between the convenience of making transactions (shopping) and the possibility of making a profit.

When economists discuss the demand for money, they are talking about this trade-off. The demand for money is about trading-off the convenience of making transactions vs. the opportunity to make profits. Holding assets as money is convenient. But holding other assets, like bonds or savings accounts, earns interest. The demand for money then, is the relationship between interest rates and how much money people want to own (vs. owning other assets). Since higher interest rates raise the opportunity cost of owning money and low-interest rates reduce the opportunity cost of owning money, the relationship is inverse. We can plot the relationship as an ordinary demand curve. Only this time it’s the demand for money.

The demand for money is a very controversial concept in macroeconomic theory because the question of whether or not the demand for money is stable is absolutely central to

Concept Four: Velocity: An Alternative Way to Describe the Demand for Money>

As mentioned above, the demand for money is really a way to discuss the trade-off between holding money in order to facilitate transactions and holding other assets in order to make profits. There is an alternative way that economists describe this trade-off decision that people make. It is called the velocity of money. We’re all personally familiar with the idea that money moves around. After all, we’re the ones doing the moving by spending it. I know I certainly make sure that money keeps moving around the economy because whenever I get some money I usually spend it right away. In fact, we even have everyday language to describe the phenomenon. I’m sure you’ve heard or even talked yourself about “how fast you spend your money”. That’s the concept of the velocity of money. If you’ve heard anyone described as “money burning a hole in their pocket”, then that’s likely a person with a high velocity of money.

The velocity of money refers to how fast money changes hands. In other words, how long is it between the time you receive a dollar and the time you spend it. Of course in macroeconomics we don’t care how fast you or I spend money as individuals. In macroeconomics, we want to know on average how fast everybody put together spends money, keeping in mind that some money rarely changes hands (that last $100 in my checking account that I never get below) and other money changes hands frequently. This average velocity of money is measured in terms of how many times the average dollar changes hands during a year. If you divide 365 days in a year by this average velocity, you would know how long, on average, people hold their money before spending it.

Returning to Monetary Theories: Two Theories that Say Monetary Policy Won’t Work Well

The previously mentioned “Austrian” theory and the New Classical/Monetarist view points are very similar.  They differ largely in degree.  The “Austrian” view is the more extreme and effectively holds that the central bank cannot effectively stimulate the economy beyond what would happen in laissez-faire Classical theory and that any attempts to do so will inevitably end in higher inflation.  Indeed, the Austrian view frequently advocates abolishing the central bank and returning to a gold standard as a way to keep monetary authorities from trying to manage the macroeconomy.  Politically, this Austrian view has in recent years been associated with Ron Paul and many extreme libertarians.

I won’t get into the Austrian position more here since it is effectively a more extreme version of the New Classical/Monetarist view.  So let’s look at New Classical/Monetarist view.

New Classical / Monetarist View: Background

Some units ago we discussed how Keynesian theories really displaced Classical theory as the accepted and dominant theory following the Great Depression.  This dominance of Keynesian theory lasted for approximately 40 years until a resurgence of Classical theory (now called Monetarist or Supply-side or, eventually, New Classical or Neoclassical). But not everyone was convinced nor wanted to be.  Economists led by Milton Friedman (father of Monetarism) and Friedrich Hayek (Austrian) kept trying to argue against the Keynesian analysis and theory, in part because they disagreed ideologically with the Keynesian conclusion that government has a role to play in managing macroeconomic performance.

Friedman counter attacked Keynesian theory by reviving and enhancing an old Classical theory of how money works in the economy.  This Classical idea of how money works is called the “Quantity Theory of Money” (QTM) and thing called the “equation of exchange”. Understanding the QTM and the equation of exchange are the foundation for the New Classical/Monetarist viewpoint.

This New Classical/Monetarist viewpoint holds that monetary policy (changing interest rates and money growth) can have moderate short-run effects of stimulating or slowing the economy, but that over longer periods the money supply (quantity of money in circulation) determines inflation.  Further, the New Classical/Monetarist view holds that government fiscal policy cannot work either!  Politically, the New Classical/Monetarist view is essentially what most Republican politicians (at least since 2008), some Democratic politicians, and many conservative bankers/business people have espoused.  Let’s look at the foundation of the New Classical/Monetarist view.

The Equation of Exchange:  Long-Run Limits of Monetary Policy?

The velocity of money idea is important because it is part of an idea we call the equation of exchange.  Actually, the equation of exchange is always true as an after-the-fact accounting reality.  It says:

The quantity of money (M) times velocity (V) = Price Level (P) times Real GDP (Y);

or in notation form:         M x V = P x Y.

note: some writers use Q instead of Y.  They both mean the same exact thing: realGDP.  I myself use both versions interchangeably and you should be prepared accordingly.  So, you may see it written as:   M x V = P x Y   or as   M x V = P x Q.

This equation of exchange is not a theory. It is simply an identity, a condition that is always true after the fact. Take a closer look. The right side, P x Y, is multiplying the price level times real GDP. Multiplying the Price Level times real GDP gives us back the value of nominal GDP. Nominal GDP is the value of everything we produce and purchase in a year. We can think of nominal GDP as being the total purchases in the economy in a year. Of course, these purchases must be paid for with money. That’s the left side of the equation, the M times V. M is the money supply, the actual quantity of money that exists. We use this money to make purchases. V, the velocity of money, is the number of times each year a given dollar is used to make a purchase. So, the total value of everything purchased (nominal GDP, or P x Y) is equal to the total amount of money spent (the quantity of money times how often it was spent during the year, or M x V). This equation of exchange must be true after the fact.

What does this equation of exchange have to do with monetary policy? Simple. The equation of exchange tells us that for any particular velocity, an increase in the money supply (M) must be balanced by an increase in either the price level (P) or the real GDP (Y). Let’s try a couple of examples. Let’s assume that velocity is relatively constant. In other words, let’s assume that people, on average, keep spending money at the same speed as always. Let’s suppose that the average dollar in the economy changes hands every 2 months. Remember some dollars get spend in a few days (hours for the dollars in my pocket!) and other dollars just sit in bank checking accounts for months. On average, let’s say a dollar gets spent in 2 months. That means velocity is 6. The average dollar changes hands 6 times each year. Now let’s assume that the money supply in our economy is $1000. That means that M x V = $1000 x 6 = $6000. This economy spent an aggregate of $6000 on goods this year. This total spending can also be called nominal GDP. Now we look at the other side of the equation. It too, must come to $6000. Suppose the price level is 2, meaning prices are twice as high as they were in the base year (a price index would read 200). Then real GDP must be $3000. To repeat:

M x V = P x Y

$1000 x 6 = 2 x $3000

So far, nothing special. But let’s consider what happens when the economy grows. Suppose the following year real GDP grows by 5%. That means Y is now $3150. Let’s suppose that people keep spending money as fast as before – velocity is constant. Velocity doesn’t change, so V is still 6. If the money supply doesn’t change, then M x V is unchanged: still $6000. But for this $6000 worth of spending to buy $3150 worth of real GDP, the price level must change. To keep the equation balanced, P would have to decline to 1.9, because $3150 x 1.9 = $6000. In other words, if velocity and the money supply are constant, then a 5% growth of real GDP means we will have a 5% decline in the price level. If money supply is constant, then real growth means deflation must happen! Of course, if money supply (M) increased at the same rate that real GDP did (Y), then velocity could remain constant and the price level would also be constant.

So far all we have is an accounting identity that has one equation and four variables in it.  Not much to work with policy-wise or prediction wise.  That’s where Milton Friedman comes in. Friedman argued that velocity would be and is a constant. In other words, he argued that we can assume that V never changes.  He supported his argument with both some micro-economic theory and a monumental study of the monetary history of the U.S. for 100 years (along with Ana Schwartz), a study that was part of why he was awarded a Nobel prize.  It appeared from his study that velocity in the U.S., while not strictly constant, had been increasing slightly but at a very constant and predictable rate – the closest thing to constant!

Why does it matter if velocity is constant?  Well consider the equation of exchange with the assumption that velocity is constant.  That would mean that any increase in Nominal GDP (the right side of the equation) can only happen if M, the money supply increases by the same amount. Further, if V is constant, then it means that any increase in the money supply (M) must result in an increase in Nominal GDP (PxY).  It begins to appear that the Fed has the power to manage Nominal GDP by how fast it grows the money supply.  And that is precisely what Friedman argued.  But Friedman went further and added the insight that if we assume that Q has real resource limits to how fast it can increase (basically the Classical LRAS concept), then any growth of M, the money supply, that’s faster than how fast Y can grow must result in P increasing.  Since P is the price level, that means that money supply growth (increase in M) causes inflation, a rise in P.

Let’s look at what would happen to our little economy if we have The Fed increase the money supply by 10% while real GDP grows by only 5% under these assumptions of constant velocity. Starting from the original values, Y increases 5% from $3000 to $3150. M increases 10% from $1000 to $1100. If we assume velocity is constant, then M x V = $1100 x 6 = $6600. So now both sides of the equation will be equal to $6600. If, as we said, real GDP grew 5% to $3150, then the price level must be 2.1, since P x Y = 2.1 x $3150 = $6600. In other words, if money supply grows faster than real GDP, then inflation happens!

Friedman Claims Inflation is a Monetary Phenomenon!

Friedman’s study of monetary history tried to also show an alternative explanation for the Great Depression.  Friedman claimed that The Great Depression happened because The  Fed shrunk the money supply, thereby forcing both deflation (lower P) and lower real GDP (Y) for 3 years when it should have done the opposite. Friedman’s theory, Monetarism, offered hope to many politicians in the late 1970’s and early 1980’s as they struggled with stagflation resulting from severe supply shocks such as increased labor participation and higher oil prices.  Of course, it helped that some politicians such as Ronald Reagan and Margaret Thatcher (U.K.) were pre-disposed ideologically to the same anti-government /Classical position as Friedman.  The theory also offered politicians the opportunity and rationale to pass the responsibility for inflation and growth over to the central bank.

Crowding Out

The equation of exchange with the added assumption of constant velocity also makes another prediction.  It suggests that fiscal policy won’t work either.  The reasoning assumes that the government would have to borrow money to finance a deficit (not neccessarily true, but most governments today voluntarily agree to). According to the crowding out hypothesis, if the government runs a deficit to stimulate the economy, then it must borrow some money. The government deficit might increase aggregate demand by increasing G, but The Fed will be forced into a dilemma. If it increases M to allow financing of the additional government borrowing (so called “printing money to finance a deficit”) then inflation will result from the higher M growth. But if The Fed limits how much M is available in an attempt to prevent P from rising (inflation), then a “shortage” of money will occur and drive up interest rates, which in turn will reduce investment spending.  Thus, it is believed that, if velocity is constant, that government borrowing will “crowd out”  private investment spending, thus offsetting and negating the stimulus.

Monetarist Policy: An Evaluation

In the late 1970’s, many central banks, including The Fed, embraced Friedman’s theories and began to target and limit the growth of M, the money supply, as a way to manage macroeconomic performance.  It didn’t work well.  By the late 1980’s all central banks had abandoned the practice of targeting M as a way to manage the growth of the real economy and limit inflation.  In the words of David Dodge, the Governor of The Bank of Canada, “We tried it. We really did give it a college try.  It just didn’t work”.

Why?  As it turns out, the assumption of constant velocity is a very bad assumption.  Velocity may have been predictable a century ago, but modern banking innovations like online banking, ATM’s, electronic financial markets, and changing firm/household behavior have made velocity highly erratic and unpredictable. For a further explanation and graphs of just how unpredictable velocity is, see my blog post: http://econproph.com/2011/11/11/the-quantity-theory-of-money-and-fears-of-inflation-are-nonsense/.

Monetarism ran into another problem. It is also based on an assumption that The Fed can manage the money supply (M1).  But in fact, The Fed cannot directly change M1.  Banks determine M1 when they decide to make loans or not make loans.  The Fed has the ability to determine how much “high-powered” money is available: currency and bank reserves. It can make bank reserves more or less expensive (through discount rate and Fed Funds rates), but the one thing it cannot do directly is create M1 in circulation.  Well, technically, it could create M1 if it were to print new currency and then just give it away for free on the street or “drop it from a helicopter”, but that’s not going to happen now is it? The Fed cannot make banks make loans.  One of the many lessons of the recent financial crisis is that banks don’t always loan out their excess reserves, no matter how much micro theory says they should.

New Keynesian/Monetarist Theory Rises

When Monetarist theory failed, an effort was made at a compromise theory now largely called New Keynesianism.   Despite its name, there’s relatively little about New Keynesianism that John Maynard Keynes would likely recognize.  It gets its name because it is an attempt to take some aspects of Keynesian theory and merge them with ideas from Monetarism. New Keynesian theory is perhaps best represented politically by the Obama, Bush (II), and Clinton administration policies.  The most noted NK economists are probably Paul Krugman and Greg Mankiw.

When we studied Keynesian theory in an earlier unit we emphasized fiscal policy and the management of aggregate demand (AD).  New Keynesian theory also emphasizes management of aggregate demand. NK is Keynesian in that sense.  However, New Keynesian theory recommends that fiscal policy should only be used as the stimulus engine in extremely large downturns such as 2008.  Instead, for routine management of the macroeconomy and aggregate demand, New Keynesian theory recommends that the central bank, in our case The Fed, use interest rate adjustments.  Further, it recommends that these interest rate adjustments be made via both direct targeting of the Fed Funds rate and through open market operations.

How Monetary Policy Can Stimulate/Contract the Economy Through Interest Rates

How do interest rates affect GDP, aggregate demand, and to a lesser degree, short-run aggregate supply? The mechanism of this transmission is mostly through investment spending and consumer spending on durables like cars.

Remember the AD-AS model. At any given moment in time, the economy is at a short-run equilibrium at the intersection of AD and SRAS. In other words, we are spending and trying to buy the same amount of goods (AD) that producers want to sell us (SRAS), given the current price level. For real GDP to change this point of intersection must move. But to make the short-run equilibrium (the point of intersection) change, one of the curves must shift. The focus of fiscal policy was on making the AD curve shift. The way fiscal policy makes AD shift is by increasing the amount of government spending (G). Since G is one component of AD (remember AD = C+I+G+X-M), an autonomous decision by government to increase G shifts AD to the right. Along with the shift in AD, the point of intersection shifts right and real GDP increases.

Monetary policy ultimately works the same way in that it shifts the Aggregate Demand (AD) curve. But where fiscal policy changes G, monetary policy changes I. It also changes a small part of C, but it works to just focus on changing I. Monetary policy works by changing interest rates. When interest rates go down, businesses (and consumers, too) are encouraged to spend more on investment (or houses, or new cars).

For expansionary monetary policy, the process works a little like this:

  • The Fed conducts an open market operation and buys securities from banks, creating excess reserves in the banking system.
  • Banks have a large excess reserves and need to make loans so the bank can make profits. Banks compete to get borrowers by lowering interest rates
  • The lower interest rates encourage businesses to increase their investment spending. For example, Acme Corp might have a potential expansion project that requires them to borrow $1million and the project would ultimately return a 7% return on investment. If interest rates are high (over 7%), the project isn’t profitable. But when interest rates drop below 7%, the project becomes more attractive. With the lower interest rates, firms like Acme decide to borrow and spend the money on investment projects.
  • Consumers might also be attracted by the lower interest rates and decide to buy a new car or new house.

The increased investment spending (I) and consumer spending (C), both begin the same circular-flow multiplication process we saw with fiscal policy. Acme pays the borrowed money to a contractor, who then pays the construction employees, who then increase their spending at the grocer, who then increases his spending, etc, etc.

In summary, we can say:
Fed buys bonds and announces lower interest rates >> drives interest rates down >> encourages more borrowing & spending >> increases AD (shifts right) >> increased GDP

If The Fed wanted a contractionary policy, the reverse holds true. The Fed could move to reduce bank excess reserves by selling bonds to banks who have to use their excess reserves to pay for the bonds. That makes it harder for banks to make loans and create M1. When the interest rates rise, businesses and consumers cut back some of their spending. Businesses cancel expansion projects. Consumers make their old used items last longer and don’t buy a new house or new car. Spending declines and AD shifts left, reducing GDP.

So, in the short-run, in theory The Fed (or any central bank), has very powerful tools to increase or decrease Aggregate Demand. In doing so, it can affect real GDP and the price level. How The Fed uses these tools is called monetary policy. One of the advantages of monetary policy over fiscal policy is that monetary policy can be implemented very, very quickly. Indeed, it is possible with modern electronic financial markets for The Fed to implement a major change in monetary policy literally within hours or even minutes. In October 1987 when the stock market crashed and lost 23% of it’s value in one day, people were nervous about whether it would be repeat of the 1929 crash which led us into the Great Depression. People were concerned that the drop in the stock market would cause some banks to fail. But on the same day as the market was crashing, The Fed Open Market committee was able to meet via teleconference and made a policy decision to increase bank reserves. That same afternoon, the New York Fed conducted open market operations that provided banks with the necessary reserves and liquidity to prevent any failures. Within a period of hours, The Fed responded to changes in the economy and prevented a huge stock market crash from spiralling into another recession or depression. Contrast this quick-response capability with the lag times needed to implement changes in fiscal policy. Fiscal policy requires months, even a year or more, to implement significant discretionary changes in policy. This is a major reason why most developed nations look to their central banks to manage the short-term fluctuations in the economy and to keep the economy from sliding into recessions.

New Keynesian and New Classical Theory and the “Great Moderation”

Since the the failure of Monetarist theory in the mid 1980’s and since original Keynesian theory ran into some disfavor following the Stagflation of the 1970’s, mainstream economics theory remained split.  But instead of the clear disagreement between Classical theory and original Keynesian theory, there were many similarities between New Keynesian and New Classical theories.  Both NK and NC put the primary responsibility for managing the macroeconomy on the central bank, The Fed. Methodologically they were very similar in relying on the same sophisticated mathematical techniques that assume equilibrium in the economy.

Both NK and NC theories emphasize the ability of The Fed to manage small, short-term changes in the macroeconomy.  Both also assert that longer-run, deficits pose a problem.  The differences are largely in degree and emphasis.  New Keynesians tend to emphasize more short-term efforts to reduce unemployment while New Classicals tend to emphasize a more long-run Classical view.

Since the mid-1980’s therefore, the primary responsibility for economic policy has been on the central bank.  Central bankers have largely followed a very ad hoc approach with a greater emphasis on preventing inflation than on stimulating growth.  This period, the two decades between the mid 1980’s and 2007 have been called The Great Moderation.  Inflation has been low and controlled. Unemployment has tended to be higher than during the Keynesian golden age and income inequality has increased.


The Crisis and a New Theory Emerges


The crisis of 2007-09 was unforeseen by either New Keynesian or New Classical models. Both theories have performed very poorly in the crisis.  In response to the financial crisis, The Fed lowered interest rates to record lows.  Government bond rates (3 month Tbill) have been at virtually zero for (0.01%) for nearly 4 years. The Fed Funds rate has likewise been at rock-bottom for four years.  The banks are flooded with excess reserves, yet the economy is still struggling to recover.  Neither major theory can explain it well. Essentially the economy has gotten into a concept that Keynes first wrote about in the Great Depression, but has been largely ignored since: the liquidity trap.

A liquidity trap is basically what happens when an economy has a major financial crisis and interest rates drop to virtually zero.  Interest rates can’t (at least not easily) go lower than zero. So The Fed is essentially out of “ammunition” to stimulate the economy.  It can create new bank reserves, but out of fear or speculation, the banks just sit on the reserves. Business firms and consumers don’t want to borrow. They want to save more and pay down debt.  In conditions of a liquidity trap, Keynes pointed out that only government deficits on a large scale can stimulate the economy.  For more about our liquidity trap see my blog post: http://econproph.com/2011/09/21/what-a-liquidity-trap-looks-like-in-pictures/.

There is a new theory of monetary and fiscal policy emerging but it is still considered out of the mainstream.  It’s called MMT, or modern monetary theory.  MMT is based partly on some evolution of Keynesian theory (so called-Post Keynesian theory) and a fresh look at exactly how central banks and commercial banks work in a fiat-money, electronic markets world.  Two of the implications of MMT are that governments do not face any type of crowding out until full employment is reached, and that government deficits are necessary if private households and firms are going to be able to accumulate private financial assets.

Since MMT is not considered mainstream yet and because 4 year universities aren’t yet requiring econ transfers to know it (most schools still insist on monetarism), I’m not focusing on it much.  If you are interested in further exploring it, see my two blog posts:



Personal note from Jim:  I am very enthused by the prospects for MMT theory personally.  I used to be a strong New Classical/Monetarist until 2007 when the financial crisis drove me to do more research and update my views. The New Classical/Monetarist view makes a nice story, but the assumptions are simply untrue and the empirical record doesn’t support the NC/M theories.  MMT/Post-Keynesian theory, however, has a good record and both predicted the crisis and has tracked performance since then.


What’s Next: The Rest-of-the-World and the Open Economy

We have now studied money, monetary policy, and how the economy reacts to monetary policy. In short, we’ve studied the dynamics of the monetary side of the economy. Earlier in Part II, we had studied the dynamics of the real sector of the economy – how household, firm, and government budget decisions affect the economy. We have one remaining piece of the circular flow that we haven’t integrated into our models and theories: the rest-of-the-world. We will begin Part IV in the next unit by looking at how the rest-of-the-world, other nations, affect our domestic economy and policy.