Wednesday, March 31, 2010

Monetary Musings

Here are some monetary musings:

(1) In case you still happen to believe the Fed's actions in the early-to-mid 2000s were largely inconsequential and that its monetary policy stance was appropriate then you need to read this article by Barry Ritholtz. He does a great job showing that many of the credit market distortions and misused financial innovations would not not have occurred had interest rates not been pushed so low by the Fed. Ritholtz's article complements the academic literature on the "risk-taking" channel of monetary policy.

(2) Richard Alford, a former NY Fed economist, reviews the Fed's actions leading up to and during this crisis over at Naked Capitalism. He finds much wrong with Fed policies during this time but cautions us to be careful in how we criticize the Fed:
Criticize the Fed for failing to deliver financial and economic stability. Criticize the Fed for failing to discharge its responsibilities as a regulator. Criticize the Fed for foolishly exceeding its mandate. Criticize the Fed for assuming responsibilities for which it was not designed and ill-prepared. Criticize the Fed for permitting itself to be turned into an off balance sheet Treasury Department SIV. Criticize the Fed for charging in to a political mine field. The Fed deserves it.

Limit criticism of the Fed for not being what it was never designed to be: a means to unwind/resolve financially troubled, systemically important firms. Don’t criticize the Fed for having exceeded it legal mandate in the case of AIG and then criticize it for not exceeding its legal mandate in the case of Lehman (or vice versa).

Criticize the Fed for its role in AIG, but keep it in perspective. Whatever the costs to society and the taxpayer of the mistakes the Fed may have made in the AIG fiasco, they are small change compared to the cost of the Fed’s inappropriate monetary policy, the Fed’s ignoring its regulatory responsibilities, etc. In addition, compare the cost to society of any Fed errors at AIG with the costs of Treasury and Congressional inaction and/or their hasty decisions if the Fed had not assumed control of AIG

(3) Josh Hendrickson is thinking about monetary policy using the expanded equation of exchange, an approach I have used before. Here is Josh:
[C]onsider a simple monetary equilibrium framework captured by the equation of exchange:

mBV = Py

where m is the money multiplier, B is the monetary base, V is the velocity of the monetary aggregate, P is the price level and y is real output. The monetary base, B, is the tool of monetary policy because it is under more or less direct control by the Federal Reserve. The Fed’s job is to adjust to base in order to achieve a particular policy goal.

Other important factors in the equation of exchange are the money multiplier, m, and the velocity of circulation, V. These are important because V will reflect changes in the demand for the monetary aggregate whereas m will reflect changes in the demand for the components of the monetary base.

Now suppose that the Federal Reserve’s goal is to maintain monetary equilibrium. In other words, the Fed wants to ensure that the supply of money is equal to the corresponding demand for money. In the language of the equation of exchange, this would require that mBV is constant. Or, in other words, that changes in m and V are offset by changes in B.

This goal would certainly make sense because an excess supply of money ultimately leads to higher inflation whereas an excess demand for money results in — initially — a reduction in output. Unfortunately, this is a difficult task because it is difficult to observe shifts in m and V in real time. Nonetheless, there is an alternative way to ensure that monetary equilibrium is maintained. For example, in the equation of exchange, a constant mBV implies a constant Py. Thus, if the central bank wants to maintain monetary equilibrium, they can establish the path of nominal income as their policy goal.

I wish textbooks included discussions like this.

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