Chapter 28: Monetary Policy and the Debate about Macro Policy



CHAPTER 12: FINANCIAL CRISES, PANICS, AND UNCONVENTIONAL MACROECONOMIC POLICYQuestions and Exercises1.The Fed's role as lender of last resort is important because if credit dries up, the entire real economy can come to a halt. The Fed can meet this shortage of short-term credit with loans and monetary policy if no one else will.2. Because financial institutions could not sell their assets quickly enough at nonfire sale prices, they could not cover their short-run liabilities, leading to illiquidity. This caused the stock market to decline significantly and reduced firms' ability to borrow for their short-term needs. The inability to sell their assets was the cause of the illiquidity.3.Extrapolative expectations are expectations that a trend will accelerate. The market may experience an initial shock that causes prices to rise. In an asset price bubble, though, the initial rise in prices leads people to expect further price increases. Thus, people buy goods and assets, causing aggregate demand to shift out to the right, which leads prices to rise even further, fulfilling expectations so that people expect even more price increases. Thus, a rise in prices leads to expectations of a further rise in prices and to a rise in demand at the current price, which leads to another rise in prices and then to expectations of a further rise in prices and so on. Eventually, asset prices will no longer reflect their real value.4.Your initial personal investment is $20 and you borrowed the remaining $180 (.9 × $200). At 10 percent interest, you had to repay the original $180 plus $18 interest for a total of $198. The value of the stock rose to $240, which is an increase of $40 (.2 × 200). You will earn $22 ($40 –18) on an investment of $20, which makes your rate of return 110 percent (22/20 × 100).5. The Fed followed a much more expansionary policy because there was no sign of inflation, making policy makers estimate a much greater value for potential output than its actual value.6.In the standard AS/AD model, financial bubbles play no role in determining potential output because asset price inflation (a financial bubble), is not included in the model. In the standard model, one looks at only goods price inflation to determine whether an economy has exceeded potential output. 7.The efficient market hypothesis is that all financial decisions are made by rational people and are based on all relevant information that accurately reflects the value of assets today and in the future. The implication is that government does not need to regulate financial markets because people will recognize when the price of assets does not reflect their true value. That is, financial bubbles will not form.8.The moral hazard problem is a problem that arises when people’s actions do not reflect the full cost that will result. With deposit insurance, people can put their money into a bank that offers high interest rates, even though the bank made excessively risky loans, without a risk of losing their money. 9.Three reasons the Glass-Steagall Act became less and less effective include: (1) new financial institutions and instruments were invented to circumvent the Act (2) regulations covered fewer financial instruments, and (3) as the collective memory of the reasons for the regulations faded, political pressure to reduce regulations rose.10.Large financial institutions are considered too-big-to-fail because these institutions are essential to the workings of the economy; if they fail the entire economy fails. Too-big-to-fail creates the moral hazard problem.11.Some economists believe that the Fed needs to unwind its unconventional expansionary policies so that the private sector faces up to, and starts to deal with, the structural problems of the economy. Eventually, something has to bring about the structural adjustments necessary for the economy to return to its long-run growth rate. The risk of unwinding those unconventional policies is that the unwinding may lead to higher unemployment and lower output growth in the short run.12.The primary goal of quantitative easing is to increase credit in the economy in general with newly created money. With quantitative easing, the Fed buys a much more diverse set of assets, such as long-term government bonds and mortgage backed securities, than it does with conventional monetary policy. Because quantitative easing doesn’t work through increasing reserves, or short-term interest rates, it can be expansionary even if excess reserves are high or if the short-term interest rate is at or near zero.Credit easing differs from quantitative easing?because the primary goal of credit easing is to change the quality—or?mix—of assets the Fed buys, and not to change the total amount of assets. Credit easing always?involves buying long-term nongovernmental securities such?as mortgage-backed securities, or other private assets; quantitative easing does not always involve such purchases. They were each designed to address the problems of the 2008 financial crisis, notably the lack of short-term credit and liquidity.13. Like credit easing, operation twist changes the composition?of the Fed’s portfolio; unlike credit easing, operation twist does not entail buying private?securities. Operation twist involves the Fed selling short-term Treasury bills and buying long-term Treasury bonds to invert the yield curve. Credit easing refers to a change the?mix or quality of assets that the Fed buys, rather than a change in the total amount of assets.14.Quantitative easing is designed to shift the entire yield curve down by increasing the total amount of assets held by the Fed: this effect is demonstrated in graph (a). Operation twist is designed to twist the yield curve--raising the short-term rates and lowering the long-term rates, as the Fed sells short-term Treasury bills and buys long-term Treasury bonds: this effect is demonstrated in graph (b).(a)(b)15. The concern about quantitative easing was that it was increasing the money supply and therefore was inflationary.?Operation twist avoided that criticism by replacing short-term bonds with long-term bonds in the Fed’s portfolio, while keeping the money supply constant.16.Precommitments give people assurance that the policy that the Fed commits to will continue, thereby reducing uncertainty and making the policy more effective. The risk of precommitment policy is that it ties the hands of the Fed, limiting its ability to reverse its policy should the economic conditions change or inflationary pressures emerge. Questions from Alternative Perspectives1. AustrianThe gold standard can be seen as a type of precommittment policy in which the amount of money is set by the amount of gold. While the idea behind the proposal may be sound, and the experience of the past decade suggests that precommittment is needed, it also suggests that people usually find a way around any rule and use the precommittment to their advantage.2.Post-KeynesianMinsky’s theory is based on a view of the economy that involves people being collectively irrational and financial markets not working well. It suggests that regulation of those markets is necessary. Since people in financial markets were making enormous amounts of money, they did not want it regulated, and thus were not inclined to accept a theory that questioned whether the markets were serving a useful purpose. 3.Post-KeynesianIf the economy is nonergodic, the future is truly unknown to everyone, and there can be no single efficient result. There is true uncertainty that creates risk that cannot be hedged against. This undermines the efficient market hypothesis and increases the possibilities for financial bubbles, but also makes it harder to specify whether a change in asset prices is a financial bubble or a change in the structural model. Overall, it makes policy much more difficult to conduct.4.Post-KeynesianIf Greece makes its bonds legal payment for taxes, many of its taxes will be paid in those bonds rather than with cash, as long as the value of those bonds is below the face value because of default risk. This proposal would essentially monetize those bonds, which would be the equivalent of increasing the money supply. Since Greece does not have an independent money supply, but is part of the Eurozone, it is unlikely that the European Central Bank will agree to such a policy. 5.RadicalThe question whether there is what might be called regulatory capture where the people determining regulations come from the same groups that are being regulated, is legitimate. In these cases, the regulations are more likely to benefit, or be lenient on, those being regulated. The problem is that regulation requires enormous institutional knowledge and the people who have that institutional knowledge are people in the financial sector. Issues to Ponder1.The answer to such questions is normative. If considering the direct effects on the economy, paying the bondholders would probably take precedence because not doing so would raise interest rates and potentially reduce credit availability in the economy. Not paying employees their pensions would lower their consumption, since they would have to save more to ensure enough for retirement; in the end, this would lower output and raise unemployment. 2.The answer to this question depends on the specifics of the crisis as well as what view one takes regarding the state of the current economy. If one subscribes to the standard AS/AD model, the answer is to respond in the way the Fed and government are doing today and add credit to the economy (expansionary monetary policy). If one subscribes to the structural stagnation hypothesis, the answer would be to add credit to the economy to avoid a complete collapse, but once the crisis is averted, reverse that action so that structural adjustments necessary for financial health are made.3.While the fact the people cannot consistently make money in the market is consistent with the efficient market hypothesis, it is not the only explanation. In order to profit from an investment when the market is far from its “correct” value, people must have access to sufficient funds to take advantage of significant temporary deviations. Such access to sufficient funds does not exist, which means that the investor could go broke before the market returned to its more reasonable level. 4. If the bailout is needed to keep the economy alive, it is possible that economists will worry more about the short-run problems, because there will be no economy left if you don’t implement a bailout. After the bailout, regulations can then be put in place to address the moral hazard problem.5.This question has more than one right answer, but raises issues related to the moral hazard problem.6. The most recent financial crisis was in part caused by deregulation because deregulation meant that there were fewer and fewer regulations that would help to keep banks and financial institutions from making decisions that would put the financial market at risk of default. The changing institutional structure contributed to deregulation because institutional changes were undermining the goals of the existing regulation to begin with. Technological changes in the financial industry undermined the old regulatory structures, requiring the removal of some regulations, but instituting new ones that addressed potential problems of the new financial environment became necessary. The problem was that the new regulations were not up to the task. Regulation of an evolving system requires constant changes in the regulations. ................
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