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Economic Growtl1 "Williamson MacroeCOIWinics Log onto www.myeconlab.com to learn more Money, Banl{ing & Financial Markets THE ECONOMICS OF NINTH EDITION Frederic S Mishkin Col umbia University Boston London Mexico City Toronto Munich Addison-Wesley San Francisco Sydney Paris : Jew York Tokyo Cape Town Singapore Madrid Hong Kong Montreal Editor in Chief: Donna Battista Acquisitions Editor: Noel Kamm Seibert Pro] ect Manager: Kerri McQueen Managing Editor: Nancy H Fenton Senior Production Supervisor: Kathryn Dinovo Supplements Production Coordinator: Alison Eusden Director of Media: Susan Schoenberg Senior Media Producer: Melissa Honig Coment Leads,MyEconlab: Douglas A Ruby and Noel Lotz Senior Author Suppon!Iechnology Specialist: j oe Vetere Marketing Manager: Elizabeth A Averbeck Permissions Project Manager: Shannon Barbe Permissions Project Supervisor: Michael j oyce Senior Manufacturing Buyer: Carol Melville Senior Media Buyer: Ginny Michaud Cover Designer: Barbara Atkinson Production Coordination,Text Design,Illustrations,and Composition: Thompson Steele Composition: Nesbitt Graphics,Inc Cover images,clock w ise from top,right: © Corbis; Superstock; Superstock; iStock For permission to use copyrighted material, grateful acknow ledgment is made to the copyright holders on p C-1 , which are hereby part of this copyright page Cop)Tight © 20 ,20 7,20 Pearson Education,Inc Al l rights reserved No part of this publication may be reproduced,stored in a retrieval system,or transmitted,in any form or by any means,electronic,mechanical, photocopying, recording,or otherwise, without the prior w ritten permission of the publisher Printed in the U nited States of America For information on obtaining permission for use of material in this w ork,please submit a w ritten request to Pearson Education,Inc.,Rights and Contracts Department,50 Boylston Street,Suite 90 ,Boston,MA 21 ,fax y our request to 7-6 71 -3447, or e-mail at http: //w w w pearsoned.com/legaVpermissions.htm Many of the designations used by manufacturers and sellers to distinguish their products are claimed as trademarks Where those designations appear in this book, and Addison-Wesley w as aware of a trademark claim, the designations have been printed in initial caps or all caps Library of Congress Cataloging-in-Publication Data Mishkin,Frederic S The economics of money, banking,and financial markets I Frederic Mishkin 9th ed (and the 2nd ed of the business ed.) p em (The Addison-Wesley Series in economics) Includes bibliographical references and index ISBN-1 3: 978-0-321 -59979-7 (main edition· alk paper) ISBN-1 : -321 -59979-9 (main edition alk paper) ISBN-1 3: 978-0-321 -59988-9 (business edition alk paper) ISBN-1 : -321 -59988-8 (business edition : alk paper) l Finance Money Banks and banking I Title HGl73.M6 32 20 332 dc22 20 90 86 32 - CRK-1 1 0 Addison Wesley is an imprint of PEARSON ISBCl-1 0 -3 21 -5 9 79 -9 www.pearsonhighered.com ISBCl- 78 -0 -3 21 -5 9 79 -7 To Sally BRIEF CONTENTS PART Introduction Why Study Money,Banking, and Financial Marketsl An Overview of the Financial System What Is Money ? PART Financial Markets 25 53 67 U nderstanding Interest Rates 69 The Behavior of Interest Rates 91 The Risk and Term Structure of Interest Rates 23 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis PART Financial Institutions 47 167 An Economic Analysis of Financial Structure financial Crises and the Subprime Meltdown 99 10 Banking and the Management of Financial Institutions 11 Economic Analysis of Financial Regulation 225 255 281 12 Banking Industry : Structure and Competition PART Central Banking and the Conduct of Monetary Policy 313 13 Central Banks and the Federal Reserve System 31 14 The Money Supply Process 345 16 The Conduct of Monetary Policy: Strategy and Tactics 395 15 The Tools of Monetary Policy PART International Finance and Monetary Policy 373 431 17 The Foreign Exchange Market 433 18 The International Financial System PART Monetary Theory 19 The Demand for Money 46 497 20 The ISLM Model 21 Monetary and Fiscal Policy in the ISLM Model 22 Aggregate Demand and Supply Analysis 23 Transmission Mechanisms of Monetary Policy: The Evidence 499 51 543 56 587 24 Money and ln!lation 617 25 Rational Expectations: Implications for Policy 43 vii I : CONTENTS PART l l Introd uction CHAPTER I Why Study Money, Banking, and Financial Markets? W hy Study Financial Marketsl The Bond 1-larket and !merest Rates The Srock Marker W hy Study Financial Institutions and Banking' St.rucmrc of rhe Financial System Financial Crises Banks and Other Financial Institutions Financial lnnovar.ion W hy Study :v!oney and Monetary Policyl t-,,toncy and Business Cycles Money and Inflation 10 1,toncy and Imeresr Rates Conduct of Monetary Policy 10 Fiscal Policy and Monetary Policy 12 W hy Study International Finance' 13 The Foreign Exchange Marker 13 14 The International Financial System 14 How We Will Study :v!oney, Banking, and Financial Markets 15 Exploring the Wr·b CollecLing and Graphing Data 15 Web Exercises 16 Concluding Remarks Summary 18 • 17 Key Terms Web Exercises 20 • 19 • Questions and Problems 19 • Web References 20 APPENDIX TO CHAPTER I Defining Aggregate Output, Income, the Price Level, and the Inflation Rate 21 Aggregate Output and Income 21 Real Versus Nominal Magnitudes 21 Aggregate Price Level 22 Growth Rates and the Inllation Rate 23 CHAPTER An Overview of the Financial System 25 Function of Financial Nlarkets 25 Structure of Financial Nlarkets 27 ix CO NTE NTS Debt and Equity Markets 27 Primary and Secondary ivlarkers 28 Exchanges and Over-the-Counter Markets 29 29 Money and Capital Markers 30 Financial Market Instruments 30 t-.·toncy Marker Instruments Following the Financial News Money Market Rates Following the Financial News Capital Market Interest Rates 31 Capital t-.-tarkc:.·t Instruments 33 34 Internationalization of Financial Markets Global 36 Are U.S Capital Markets Losing Their Edgel 36 lntcrnar.ional Bond Market, Eurobonds, and Eurocurrencies 37 37 World Srock Markers Following the Financial News Foreign Stock Market Indexes 38 Function of Financial Intermediaries: Indirect Finance 39 Transaction Costs Global 39 The Importance of Financial Intermediaries Relative to Securities Markets: An International Comparison 40 Risk Sharing 40 Asymmclric Information: Adverse Sc1ection and T\.foral Hazard 41 Types of Financial Intermediaries Depository InsLilulions 43 Contracwal Savings Institutions 44 lnvcstmcnt lnrcrmcdiaries 45 Regulation of the Financial System 46 Increasing InformationAvailable w lnvcsr.ors 46 Ensuring the Soundness of Financial lmermcdlaries 47 Financial Regulation Abroad Summary 49 • Key Terms 50 \Veb Exercises 51 42 • 49 • Questions and Problems 51 • \Veb References 52 CHAPTER What Is Money? 53 Meaning of Money Functions of Money 53 54 h,tcdium of Exchange 54 Unit of Accoum 55 Store of Value Evolution of the Papnents System Commodity Money 56 57 57 Fiat Money 57 Checks 57 650 PART Monetary Theory know the outcome of their decisions without knowing the public's expectations regard ing them Ar first you might think rhaL policymakers can still use discretionary policy Lo sta bilize the economy Once they figure out the public's expectations, they can know what effect their policies will have There are two catches to snch a conclusion First, it may be nearly impossible Lo find our what the public's expectations are , given LhaL the pub lic consists of over 300 million U.S citizens Second, even if iL were possible, policy makers would run imo funher difficulLies , because the public has rational expectations and will Lry Lo guess what policymakers plan Lo Public expectations nor remain fixed while policymakers are plotting a surprise-the public will revise its expectations , and policies will have no predictable effect on oULpuL Where does this lead us? Should the Fed and other policymaking agencies pack up , lock the doors, and go home? In a sense , the answer is yes The new classical model implies that discretionary stabilization policy cannot be effective and might have unde sirable effects on the economy Policymakers' attempts to use discretionary policy may create a fluctuating policy stance that leads to unpredictable policy surprises, which in rum cause undesirable fluctuations around the natural rare level of aggregate oULpur To eliminate these undesirable fluctuations, the Fed and other policymaking agencies should abandon discretionary policy and generate as few policy surprises as possible As we have seen in Figure 2, even rho ugh amicipared policy has no effect on aggre gate oULpuL in the new classical model, iL does have an effect on the price level The new classical macroeconomists care about anticipated policy and suggest that policy rules be designed so that the price level will remain stable N EW KEYN ES I A N M O D E L In the new classical model, all wages and prices are completely flexible with respect Lo expected changes in the price level; LhaL is, a rise in the expected price level results in an immediate and equal rise in wages and prices Many economists who accept ratio nal expectations as a working hypothesis nor accept the characterization of wage and price flexibility in the new classical model These critics of the new classical model, called new Keynesians, object to complete wage and price flexibility and identify factors in the economy that prevent some wages and prices from rising fully with a rise in the expected price level Long-term labor comracrs are one source of rigidity Lhar prevems wages and prices from responding fully to changes in the expected price level (called wage-price sticki ness) For example, workers might find themselves at the end of the first year of a three year wage contract that specifies the wage rate for the coming two years Even if new information appeared that would make them raise their expectations of the inflation rare and the future price level, they could nor anything about iL because they are locked into a wage agreement Even with a high expectation about the price level, the wage rate will not adjust In two years, when the contract is renegotiated, both workers �This result follows from one of the implications of rational expectations: The forecast error of expectations about policy (the deviation ol aCLual policy !rom expeCLauons ol policy) must be unpredictable Because output is alleCLed only by unpredictable (unanticipated) policy changes in the new classical modd, policy effects on output must be unpredictable as well CHAPTER Rational Expectations: Implications jor Policy 651 and firms may build the expected inflation rate into their agreement, but they cannot so immediately AnOLher source of rigidity is that firms may be reluctant to change wages frequently even when there are no explicit wage contracts , because such changes may affect the work effort of the labor force For example, a firm may not want to lower workers' wages when unemployment is high, because this might result in poorer worker perfor mance Price stickiness may also occur because firms engage in fixed-price contracts with their suppliers or because it is costly for firms to change prices frequently All of these rigidities (which diminish wage and price flexibility) , even if they are not present in all wage and price arrangements, suggest that an increase in the expected price level might not translate into an immediate and complete adjustment of wages and prices Although the new Keynesians not agree with the complete wage and price flex ibility of the new classical macroeconomics , they nevertheless recognize the importance of expectations to the determination of short-run aggregate supply and are willing to accept rational expectations theory as a reasonable characterization of how expectations are formed The model they have developed, the new Keynesian model, assumes that expectations are rational but does not assume complete wage and price flexibility; instead, it assumes that wages and prices are sticky Its basic conclusion is that unan ticipated policy has a larger effect on aggregate output than anticipated policy (as in the new classical model) However, in contrast to the new classical model, the policy inef fectiveness proposition does not hold in the new Keynesian model: Anticipated policy does affect aggregate output and the business cycle Effects of Unanticipated and Anticipated Policy In panel (a) of Figure 4, we look at the short-run response to an unanticipated expan sionary policy for the new Keynesian model The analysis is identical to that of the new classical model We again start at point l , where the aggregate demand curve AD1 inter sects the short-run aggregate supply curve AS1 at the natural rate level of outpUL and price level P1 When the Fed pursues its expansionary policy of purchasing bonds and raising the money supply, the aggregate demand curve shifts rightward to AD Because the expansionary policy is unanticipated, the expected price level remains unchanged , leaving the short-run aggregate supply curve unchanged Thus the economy moves to point U, where aggregate output has increased to Yu and the price level has risen to Pu In panel (b) , we see what happens when the Fed's expansionary policy that shifts the aggregate demand curve from AD1 to AD is anticipated Because the expansionary policy is anticipated and expectations are rational, the expected price level increases, causing wages to increase and the short-run aggregate supply curve to shift to the left Because of rigidities that not allow complete wage and price adjustment, the short run aggregate supply curve does not shift all the way to AS as it does in the new clas sical model Instead, it moves to AS4, and the economy seLLles at point A, the intersection of AD and AS4 Aggregate output has risen above the natural rate level to Y,1 , while the price level has increased to P,1 Unlike the new classical model, in the new Keynesian model anticipated policy does have an effect on aggregate output We can see in Figure that Yu is greater than Y,1 , meaning that the outpUL response to unanticipated policy is greater than to anticipated policy It is greater because the short-run aggregate supply curve does not shift when policy is unanticipated, causing a lower price level and hence a higher level of output We see that like the new classi cal model, the new Keynesian model distinguishes between the effects of anticipated versus unanticipated policy, with unanticipated policy having a greater effect 652 PART Monetary Theory Aggregate Price Level, P LRAS AS; A D2 Y, Yu Aggregate Output, Y (a) Response to an unanticipated expansionary policy LRAS Aggregate Price Level, P AD2 Aggregate Output, Y (b) Response to an anticipated expansionary policy FIGURE Short- Run Response to Expa nsionary Policy in the New Keynesian Model The expa nsi o n a ry p o l i cy that shifts a g g regate demand to AD, has a bigger effect on output w h e n it is u n a nticipated than when it is a nticipated When the expa nsi o n a ry p o l i cy is u n a nticipated i n panel (a), the short-ru n a g g regate supply cu rve d oes not shift, a n d the economy m oves to point U , so that a g g regate output i n c reases to Yu a n d the price l evel rises to Pu When the p o l i cy is a n ticipated in p a n e l (b), the short-run a g g regate supply cu rve shifts to ASA (but not a l l the way to AS, because r i g i d ities p reven t c o m p l ete wage and price a dj ustm ent), and the economy m oves to point A so that a g g regate output rises to YA (w h i c h is l ess than Yu) and the price l evel rises to PA (wh ich is h i g h er than Pul· CHAPTER Rational Expectations: Implications jor Policy 653 Implications for Policymakers Because the new Keynesian model indicates that anticipated policy has an effect on aggregate output, it does not rule out beneficial effects from discretionary stabilization policy, in contrast to the new classical model It does warn policy makers that designing such a policy will not be an easy task, because the effects of anticipated and unantici pated policy can be quite different As in the new classical model, to predict the out come of their aCLions , policymakers must be aware of the public's expectations aboUL those actions Policymakers face similar difficulLies in devising successful policies in both the new classical and new Keynesian models CO M PA R I S O N O F TH E TWO N EW M O D E LS WITH TH E TRAD ITI O N A L M O D E L To obtain a clearer piCLure of the impact of the rational expectations revolution on our analysis of the aggregate economy, we can compare the two rational expectations mod els (the new classical macroeconomic model and the new Keynesian model) to a model that we call, for lack of a better name , the traditional model In the traditional model, expectations are not rational That model uses adaptive expectations (mentioned in Chapter 7), expectations based solely on past experience The traditional model views expected inflation as an average of past inflation rates This average is not affected by the public's predictions of future policy; hence predictions of future policy not affect the aggregate supply curve First we will examine the short-run output and price responses in the three mod els Then we will examine the implications of these models for both stabilization and anti-inflation policies As a study aid , the comparison of the three models is summa rized in Table You may wam to refer to the table as we proceed with the comparison Short-Rnn Ontpnt and Price Responses Figure compares the response of aggregate output and the price level to an expansion ary policy in the three models Initially, the economy is at point l , the intersection of the aggregate demand curve AD and the short-run aggregate supply curve AS When the expansionary policy occurs, the aggregate demand curve shifts to AD2 If the expansion ary policy is unanticipated, all three models show the same short-run output response The traditional model views the short-run aggregate supply curve as given in the short run, while the other two view it as remaining at AS because there is no change in the expected price level when the policy is a surprise Hence, when policy is unanticipated, all three models indicate a movement to point l , where the AD2 and AS curves intersect and where aggregate omput and the price level have risen to Y1 • and P1• respectively The response to the anticipated expansionary policy is, however, qnite different in the three models In the traditional model in panel (a) , the short-run aggregate supply curve remains at AS even when the expansionary policy is anticipated, because adap tive expectations imply that anticipated policy has no effect on expectations and hence on aggregate supply It indicates that the economy moves to point l , which is where it moved when the policy was unanticipated The traditional model does not distinguish between the effects of anticipated and unanticipated policy: Both have the same effect on output and prices ' ' 654 PART Monetary Theory T h e T h ree M o d e l s Model Is Credibility Can Response to Response to Response to Response to Important to Unanticipated Anticipated Discretionary Unanticipated Anticipated Successful Anti-inflation Anti-inflation Anti-inflation Expansionary Expansionary Policy Be Policy? Policy Policy Beneficial? Policy Policy Traditional model Yi , P i Y i , P i by same amount as when policy is unanticipated Yes Y1 , 1r l Y , 7T by same amount as when policy is unanticipated No New classical macroeconomic model Yi , P i Y unchanged, P i by more than when policy is unanticipated No Y1 , 1r l Y unchanged, 7T by more than when policy is unanticipated Yes New Keynesian model Yi , P i Y i by less than when policy is unanticipated, P i by more than when policy is unanticipated Y1 , 1r l Y by less than when policy is unanticipated, 7T by more than when policy is unanticipated Yes Yes , but designing a beneficial policy is difficult Note 1t represents the inOation rate In the new classical model in panel (b) , the short-run aggregate supply curve shifts leftward to A5 when policy is anticipated, because when expectations of the higher price level are realized, aggregate output will be at the natural rate level Thus it indi cates that the economy moves to point 2; aggregate output does not rise, but prices do, to P2 This omcome is quite different from the move to point 1' when policy is unan ticipated The new classical model distinguishes between the short-run effects of antic ipated and unanticipated policies: Amicipated policy has no effect on output, but unanticipated policy does However, anticipated policy has a bigger impact than unan ticipated policy on price level movements The new Keynesian model in panel (c) is an intermediate position between the tra ditional and new classical models It recognizes that anticipated policy affects the aggre gate supply curve , but due to rigidities such as long-term contracts, wage and price adjustment is not as complete as in the new classical model Hence the short-run aggre gate supply curve shifts only to A52• in response to anticipated policy, and the economy Aggregate Price Level , P LRAS AS1 P, P, Yn (a) Traditional model y, , Aggregate Output, Y Aggregate Price Level , P AS2 AS1 P, P, P, Yn Aggregate Price Level , P (b) New classical macroeconomic model y, , Aggregate Output, Y LRAS AS,· Yn y, , y, , (c) New Keynesian model Aggregate Output, Y FIGURE Comparison of the Short-Run Response to Expa nsionary Policy in the Th ree Models I n itial ly, the economy is at point The expa nsion a ry pol icy shifts the a g g regate demand curve from AD1 to AD, In the traditional model, the expa nsionary pol icy moves the economy to point 1' whether the pol icy is a n ticipated or n ot I n the n ew classica l model, the expa nsion a ry pol icy m oves the economy to point 1' if it is u n a nticipated a n d to point if it is a n ticipated I n the new Keynesian model, the expa nsionary pol icy m oves the economy to point 1' if it is u n a ntici pated and to point 2' if it is a n ticipated 656 PART Monetary Theory moves to point ' , where output at Y2• is lower than the Y1• level reached when the expansionary policy is unanticipated But the price level at P2· is higher than the level Pr that resulted from the unanticipated policy Like the new classical model, the new Keynesian model distinguishes between the effects of anticipated and unanticipated policies: Anticipated policy has a smaller effect on output than unanticipated policy does but a larger effect on the price level However, in contrast to the new classical model, anticipated policy does affect output fluctuations Stabilization Policy The three models have different views of the effectiveness of stabilization policy, policy intended to reduce output fluctuations Because the effects of anticipated and unantic ipated policy are identical in the traditional model, policymakers not have to con cern themselves with the public's expectations This makes it easier for them to predict the outcome of their policy, an essential matter if their actions are to have the intended effect In the traditional model, it is possible for discretionary policy to stabilize output fluctuations The new classical model takes the extreme position that discretionary stabilization policy serves to aggravate output fluctuations In this model, only unanticipated policy affects output; anticipated policy does not matter Policymakers can affect output only by surprising the public Because the public is assumed to have rational expectations, it will always try to guess what policymakers plan to In the new classical model, the conduct of policy can be viewed as a game in which the public and the policymakers are always trying to outfox each other by guessing the other's intentions and expectations The sole possible outcome of this process is that discretionary stabilization policy wtll have no predictable effect on olllp lll and cannot be relied on to stabilize economic activity Instead, it may create a lot of uncertainty about policy that will increase random output fluctuations around the natural rate level of output Such an undesirable effect is exactly the opposite of what the discretionary stabilization policy is trying to achieve The outcome in the new classical view is that policy-makers should be nondiscretionary and promote as much certainty about their policy actions as possible The new Keynesian model again takes an intermediate position between the tradi tional and the new classical models Contrary to the new classical model, it indicates that anticipated policy does matter to output fluctuations Policymakers can count on some olllp ut response from their anticipated policies and can nse them to stabilize the economy In contrast to the traditional model, however, the new Keynesian model recognizes that the effects of anticipated and unanticipated policy will not be the same Policy makers will encounter more uncertainty about the outcome of their actions, because they cannot be sure to what extent the policy is anticipated Hence a discretionary pol icy is less likely to operate always in the intended direction and is less likely to achieve its goals The new Keynesian model raises the possibility that a discretionary policy could be beneficial, but uncertainty about the outcome of policies in this model may make the design of such a beneficial policy extremely difficult Anti-inflation Policies So far we have focused on the implications of these three models for policies whose intent is to eliminate fluctuations in output By the end of the 970s, the high inflation CHAPTER Rational Expectations: Implications jor Policy 657 rate (then over 10%) helped shift the primary concern of policymakers to the reduction of inflation What these models have to about anti-inflation policies designed to eliminate upward movemems in the price The aggregate demand and supply diagrams in Figure will help us answer the question Suppose that the economy has settled into a sustained 10% inflation rate caused by a high rate of money growth that shifts the aggregate demand curve so that it moves up by 10% every year If this inl1ation rate has been built imo wage and price comracts, the shon-run aggregate supply curve shifts and rises at the same rate We see this in Figure as a shift in the aggregate demand curve from AD in to AD in year 2, while the In year , the economy is at short-run aggregate supply curve moves from AS to poim (imersection of AD and AS ) ; in the second year, the economy moves to poim (imersection of AD and AS ) , and the price level has risen % , from P to P2 (Note that the figure is not drawn to scale ) Now suppose that a new Federal Reserve chairman is appointed who decides that inflation must be stopped He convinces the FOMC to stop the high rate of money growth so that the aggregate demand curve wrll not rise from AD • The policy of halt ing money growth immediately could be costly if it leads to a fall in oULpuL Let's use our three models to explore the degree to which aggregate output will fall as a result of an anti-inflation policy First, look at the outcome of this policy in the traditional model's view of the world in panel (a) The movemem of the shon-run aggregate supply curve to AS2 is already set in place and is unaffected by the new policy of keeping the aggregate demand curve at AD (whether the effort is anticipated or not) The economy moves to point 2' (the intersection of the AD and AS2 curves) , and the inflation rate slows down because the price level increases only to P2• rather than P2 The reduction in inflation has not been without cost: OutpUL has declined to Y2' , which is well below the natural rate level In the traditional model, estimates of the cost in terms of lost output for each % reduction i n the inflation rate are around 4% o f a year's real GDP The high cost of reducing inflation in the traditional model is one reason why some economists are reluctam to advocate an ami-inflation policy of the son tried here They question whether the cost of high unemployment is worth the benefits of a reduced inflation rate If you adhere to the new classical philosophy, you would not be as pessimistic about the high cost of reducing the inflation rate If the public the monetary authorities to stop the inflationary process by ending the high rate money growth, it will occur without any output loss In panel (b) , the aggregate demand curve will remain at AD , bUL because this is expected, wages and prices can be adjusted so that they will not rise, and the shon-run aggregate supply curve will remain at AS instead of moving to AS The economy wrll stay put at point (the intersection of AD and AS ) , and aggregate output will remain at the natural rate level whrle inflation is stopped because the price level is unchanged An imponam elemem in the story is that the ami-inflation policy be amicipared by the public If the policy is n o t expected, the aggregate demand curve remains at AD , but the short -run aggregate supply curve continues its shift to AS The outcome of the unanticipated anti-inflation policy is a movement of the economy to point 2' Although the inflation rate slows in this case , it is not emirely eliminated as it was when the ami inflation policy was amicipated Even worse , aggregate output falls below the natural rate level to Y2' An ami-inflation policy that is unamicipated, then, is far less desirable than one that is anticipated The new Keynesian model in panel (c) also leads to the conclusion that an unan ticipated ami-inflation policy is less desirable than an amicipared one If the policy of Aggregate Price Level, P LRAS AS2 AS1 P, (a) Traditional model Aggregate Output, Y Aggregate Price Leve l , P LRAS AS2 AS1 (b) New classical macroeconomic model Aggregate Output, Y Aggregate Price Leve l , P LRAS (c) New Keynesian model Aggregate Output, Y FIGURE Anti-inflation Pol i cy in the Th ree Models With an ongoing i n fiation in which the economy is moving from point to point 2, the a g g regate d e m a n d c u rve is shifting from AD, to AD, a n d the short-run a g g regate supply cu rve from AS1 to AS, The a nti-i nflation policy, when i m p l emented, prevents the a g g regate d e m a n d curve from risi n g , h o l d i n g it at A D , ( a ) I n the tra d itional m o d e l , the economy m oves t o p o i n t ' whether the anti-infiation policy is a nticipated or n ot (b) In the new classica l model, the economy m oves to point ' if the pol icy is u n a n tici pated a n d stays at point if it is a n ticipated (c) In the n ew Keynesian model, the eco nomy m oves to point 2' if the pol icy is u n a nticipated a n d to point 2" if it is a nticipated CHAPTER Rational Expectations: Implications jor Policy 659 keeping the aggregate demand curve at AD, is not expected, the short-run aggregate supply curve will continue its shift to AS , and the economy moves to point ' at the imerseCLion of AD and AS2 The inflation rate slows , but output declines to Y2· , well below the natural rate level If, by contrast, the anti-inflation policy is expected, the short-run aggregate supply curve will not move all the way to AS Instead it will shift only to AS2, because some wages and prices (bm not all) can be adJUSted, so wages and the price level will not rise at their previous rates Instead of moving to poim 2' (as occurred when the ami-inflation policy was not expected), the economy moves to poim " , the imersection of the AD and AS2" curves The outcome is more desirable than when the policy is unanticipated the inflation rate is lower (the price level rises only to P2" and not P2·), and the omput loss is smaller as well (Y2" is higher than Y2·) Credibility in Fighting Inflation Both the new classical and new Keynesian models indicate that for an ami-inflation pol icy to be successful in reducing inflation at the lowest output cost, the public must believe (expect) that it will be implemented In the new classical view of the world , the best ami-inflation policy (when it is credible) is to go "cold turkey" The rise in the aggregate demand curve from AD should be stopped immediately Inflation would be eliminated at once with no loss of output if the policy is credible In a new Keynesian world, the cold-turkey policy, even if credible, is not as desirable , because it will produce some output loss john Taylor, a proponem of the new Keynesian model, has demonstrated that a more gradual approach to reducing inflation may be able to eliminate inflation without producing a substantial output loss l An important catch here is that this gradual pol icy must somehow be made credible , which may be harder to achieve than a cold turkey ami-inflation policy, which demonstrates immediately that the policymakers are serious about fighting inflation Taylor's comemion that inflation can be reduced with little output loss may be overly optimistic Incorporating rational expectations imo aggregate supply and demand analysis indicates that a successful ami-inflation policy must be credible Evidence that credi bility plays an important role in successful anti-inflation policies is provided by the dra matic end of the Bolivian hyperinflation in 1985 (see the Global box) But establishing credibility is easier said than done You might think that an announcemem by policy makers at the Federal Reserve that they plan to pursue an ami-inflation policy might the trick The public would expect this policy and would act accordingly However, that conclusion implies that the public will believe the policymakers' announcement Unfor tunately, that is not how the real world works Our historical review of Federal Reserve policy making in Chapter 16 suggests that the Fed has not always done what it set out to In fact, during the 970s, the chair man of the Federal Reserve Board, Arthur Burns, repeatedly announced that the Fed would pursue a vigorous anti-inflation policy The actual policy pursued, however, had quite a differem outcome : The rate of growth of the money supply increased rapidly during the period , and inflation soared Such episodes reduced the credibility of the Federal Reserve in the eyes of the public and , as predicted by the new classical and new 7John Taylor, "The Role of Expectations in the Choice of Monetary Policy," in Mandai)' Policy Issues in the 1980s (Kansas City: federal Reserw Bank, 1982), pp 47-76 660 PART Monetary Theory Global E n d i n g the Bolivian Hyperi nflati o n : A S u ccessfu l Anti - i nflation Prog m The most remarkable ami-inflation program in recent times was implemented in Bolivia In tlie first lialf of 1985, Bolivia's inflation rate was mnning at 20 ,000% and rising Indeed, the inflation rate was so high that the price of a movie ticket often rose while people waited in line to buy it In August 1985, Bolivia's new president announced his anti-inflation program, the New Economic Policy To rein in money growth and establish credibility, the new government Look drastic actions to slash the budget deficit by shutting down many state-owned enterprises, eliminating subsidies, freezing public sector salaries , and collecting a new wealth tax The finance ministry was put on a new footing; the budget was balanced on a day-by-day basis Without exceptions, the finance minister would not authorize spending in excess of the amount of tax revenue that had been collected the day before *For an excellem discussion of d1e end eJ Hoben E Hall (Chicago The rule of thumb that a reduction of 'Yo in the inflation rate requires a 4% loss of a year's aggregate output indicates that ending the Bolivian hyperin flation would have required halving Bolivian aggre gate output for ,600 years I Instead, the Bolivian inflation was stopped in its tracks within one month, and the output loss was minor (less than % of GDP) Certain hyperinflations before World War II were also ended with small losses of output using policies similar to Bolivia's ,* and a more recent anti-inflation program in Israel that also involved substantial reductions in budget deficits sharply reduced infla tion without any clear loss of output There is no doubt that credible ami-inflation policies can be highly successful in eliminating inflation 1920s, see Thomas Sargem, The [nels of four Big lnflarions," in ln�a1inn: CaLL\f_l and Con_lc1982), pp 41-98 Keynesian models, had serious consequences The reduction of inflation that occurred from to 1984 was bought at a very high cost; the 198 1-1982 recession that helped bring the inflation rate down was the most severe recession in the post-World War II period The U S government can play an important role in establishing the credibility of ami-inflation policy We have seen that large budget deficits may help stimulate infla tionary monetary policy, and when the government and the Fed announce that they will pursue a restrictive anti-inflation policy, it is less likely that they will be believed unless the federal government demonstrates fiscal responsibility Another way to say this is to use the old adage , "Actions speak louder than words." When the government takes actions that will help the Fed adhere to anti-inflation policy, the policy will be more credible Unfortunately, this lesson has sometimes been ignored by politicians in the United States and in other countries APPLI CATI O N + Cred i b i l ity a n d the Rea g a n B u d get Deficits The Reagan administration was strongly criticized for creating huge budget deficits by cutting taxes in the early 1980s In the aggregate supply and demand framework, we usually think of Lax cuts as stimulating aggregate demand and increasing aggregate out put Could the expectation of large budget deficits have helped create a more severe recession in 198 1-1982 after the Federal Reserve implemented an anti-inflation mone tary policy l CHAPTER Rational Expectations: Implications jor Policy 661 Some economists answer yes, nsing diagrams like panels (b) and (c) of Figure They claim that the prospect of large budget deficits made it harder for the public to believe that an ami-inflationary policy would actually be pursued when the Fed announced its intention to so Consequently, the short-run aggregate supply curve would continue to rise from AS to AS2 as in panels (b) and (c) When the Fed actually kept the aggregate demand curve from rising Lo AD by slowing the rare of money growth in 980-1 981 and allowing imeresr rates Lo rise, the economy moved Lo a poim like ' in panels (b) and (c) , and significam unemploymem resulted As our analysis in panels (b) and (c) of Figure predicts, the inflation rare did slow subsramially, falling below 5% by the end of 1982, but this was very costly: Unemployment reached a peak of 7% If the Reagan administration had actively tried Lo reduce deficits instead of raising them by cuLLing taxes, what might have been the omcome of the ami-inflation policy? Instead of moving to point ' , the economy might have moved to point 2" in panel (c)-or even to point in panel (b) , if the new classical macroeconomists are right Reduction of budget deficits thus could have led to an even more rapid reduction in inflation and a smaller loss of output Reagan is nor the only head of stare who ran large budget deficits while espousing an anti-inflation policy Britain's Prime Minister Margaret Thatcher preceded Reagan in this activity, and economists such as Thomas Sargent assert that the reward for her pol icy was a climb of unemploymem in Britain to unprecedemed levels -" Although many economists agree that the Fed's ami-inflation program lacked cred ibility, especially in its initial phases, not all of them agree that the Reagan budget deficits were the cause of that lack of credibility The conclusion that the Reagan bud get deficits helped create a more severe recession in 198 1-1982 is controversial a I M PACT O F TH E RAT I O N A L EXPECTAT I O N S R EVO LUTI O N The theory of rational expectations has caused a revolmion in the way most economists now think about the conduct of monetary and fiscal policies and their effects on eco nomic activity One result of this revolution is that economists are now far more aware of the importance of expectations Lo economic decision making and Lo the outcome of particular policy actions Although the rationality of expectations in all markers is still comroversial, most economists now accept the following principle suggested by ratio nal expectations: Expectations formation will change when the behavior of forecasted variables changes As a result, the Lucas critique of policy evaluation using conventional econometric models is now taken seriously by most economists The Lucas critique also demonstrates that the effect of a particular policy depends critically on the public's expectations about that policy This observation has made economists much less certain that policies will have their imended effect An imponam result of the rational expec tations revolmion is that economists are no longer as confidem in the success of dis cretionary stabilization policies as they once were 8Thomas Sargent, "Stopping Moderate lnflations: The Methods of Poincare and Thatcher," in lnflatiml, Debt, and Tndcxation, ed Rudiger Dornbusch and M H Simonsen (Cambridge, MA: MlT Press, 1983), p p 54-9 , discusses the problems that ThatcherS policies caused and contrasts them with more successful anti-inflation policies pur sued by the Poincare government in France during the l 920s 662 PART Monetary Theory Has the rational ccpectations revolution convinced economists that there is no role for discretionary stabilization policy? Those who adhere to the new classical macroeconomics ihink so Because anticipated policy does not affect aggregate output, discretionary policy can lead only to unpredictable ontpnt fluctuations Pursuing a nondiscretionary policy in which there is no uncertainty about policy actions is then the best we can Such a position is noL accepted by many economists, because the empirical evidence on the policy ineffectiveness proposition is mixed Some studies find that only unanticipated policy mauers to output fluctuations, whtle other studies find a significam impact of anticipated policy on omput movements In addition, some economists question whether the degree of wage and price flexibility required in the new classical model actually exists The result is that many economists Lake an intermediate position that recognizes the distinction between the effects of anticipated versus unanticipated policy bnt believe that anticipated policy can affect ontpnt They are still open to the possibility that dis cretionary stabilization policy can be beneficial, bnt they recognize the difficulties of designing it The rational expectations revolution has also highlighted the importance of credi bility to the success of anti-inflation policies Economists now recognize that if an anti inflation policy is not believed by the public, it may be less effective in reducing the inflation rate when iL is actually implemented and may lead Lo a larger loss of ompuL than is necessary Achieving credibility (not an easy task in that policymakers often say one thing bnt another) should then be an important goal for policymakers To achieve credibility, policymakers must be consistent in their course of action The rational expectations revolution has caused major rethinking about the way economic policy should be conducted and has forced economists Lo recognize that we may have Lo accept a more limited role for what policy can for us Rather than attempting to fine-tune the economy so that all output fluctuations are eliminated, we may have to settle for policies that create less uncertainty and thereby promote a more stable economic environment �Studies wiLh lindings that only unanticipated policy matters include Thomas Sargem, Classical Macroecono metric Modd for the Lnited States," Journal of Politi£al Ewnomy H+ (1976): 207-237: Robert _] Barro, "Lnantici pated Money Growth and Lnemployment in the Lnited States," Amoican Economic Rcvinv (1977): 10 1-1 ; a n d Robert _] Barro a n d 1\tark Rush, "Unanticipated a n d [conomic Activity," i n Rational b:patations and Economic Policy, ed Stanley Fischer (Chicago: University Chicago Press, 1980), p p 23-48 Studies that lind a significant impact of anticipated policy are fr�d�ric S l'v1ishkin, "Does Anticipated Monetary Policy Matter! An Econometric Investigation, journal ofPolitical Economy 90 (1982): 22-5 , and Robert _] Gordon, "Price Inertia and Policy Effectiveness in the United States, 1H90-19HO," )oumal of Political Economy 90 (19H2): 10H7 -1 1 S U M M A RY l The simple principle (derived from rattonal expecta metric model that has been estimated on the basis of tions theory) that expectation formation changes past data will no longer be the correct model for eval when the b ehavior or rorecasted variables changes led uating the errects or this poltcy change and may prove LO the ramous Lucas critique or econometric p o1icy to be htghly mtsleadmg The Lucas cmique also evaluation Lucas argued that when policy changes, points out that the effects of a particular p olicy expectations formation changes; hence the relation depend crittcally on the public's expectations ab out ships in an economeLric model will change An econo- the p olicy CHAPTER The nev c1assica1 macroeconomic modc1 assumes LhaL Rational Expectations: Implications jor Policy 663 Lhere is uncertainLy ab out the OULcome or a panicu1ar expectations are rational and that wages and prices are polrcy, the design of a benefrcral drscretionary p olrcy completely Jlexrble wrth respect to the expected pnce may be very difficult A tradrtronal model in whrch level II leads to the policy mellecllveness prop osruon expectallons about policy have no errect on the short that antrcipated poltcy has no ellect on output; only run aggregate supply curve does noL disLinguish unanticipated policy matters between the effects of anticipated or unanticipated pol The new Keynesran model also assumes that expeCLa tions are rational but views wages and prices as sticky Like the new classical model, the new Keynesian model distingurshes between the errects Irom anllcrpated and unanticipated policy: Anucipated p olrcy has a smaller icy This model favors discretionary policy, because the oULcome of a particular policy is less uncertain If expectations about polrcy affect the short-run aggre gate supply curve , as they in the new classical and nev Keynesian models, an anLi-innation p olicy v ill be effect on aggregate output than unanticipated policy more successlul (will produce a laster reductron m However, anticipated policy does matter to output inflation with smaller output loss) if rt is credrble, fluctuations The new classical model indicates that discretionary The raLional expccLaLions revolution has forced econo mists to be less optimistic about the effective use of dis p olicy can be only counterproductive, while the new cretionary stabilization policy and has made them more Keynesian model suggests that activrst policy mrght be aware ol the importance ol credibility to successlui pol bendrcial However because both models indrcate that icymaking KEY TE R M S econometric models, p 644 polrcy meflectrveness proposition, p, 64H wage-pnce stickiness, p , 650 QU ESTI O N S A N D P R O B LE M S All quc1tiom and problems arc available in l!lllmil1iJ!) a t wv-.�v-.� myeconlab com/mishkin l If the publrc expects the Fed to pursue a polrcy that is likely LO raise shan- term interest raLes permanently Lo the FOMC to keep the rate of money growth at % , If the new classical view of the world is correct, can his plan achieve the goals of lowering inflation and unem ploymenr' How' Do you think hrs plan wrll work' li the % but the Fed does not go through wrth this policy traditional model's view or the world is correct, will the change , what will happen to long- term interest rates? Fed chairman's surefire plan work? Explain your answer If consumer expenditure is related to consumers' expectations of their average income in the future, will an income tax cut have a larger effect on consumer expenditure rf the publrc expects the tax cut to last lor one year or for Len years? Usc an aggregate demand and supply diagram to illustrate your answer in all the following questions, Having studied the new classrcal model, the new charr man of the Federal Reserve Board has thought up a surefire plan for reducing intlation and lowering unem ployment, He announces that the Fed will lower the rate ol money growth Irom % to 5% and then persuades "The costs of lighting mnation in the new classical and new Keynesian mo dels arc lower than in the traditional model " Is this statement true, false, or uncertain? Explain your answer The new classical model rs an offshoot of the mone tarist hamework because it has a similar view of aggre gate supply What are the differences and srmilamres beL ween the moneLarisL and new classical views of aggregate supply' "The new classrcal model does not eltmmate policy makers' ability to reduce unemployment because they can always pursue policies that are more expansionary than the public expects " Is this statement true, false, or uncertain? Explain your answer 664 PART Monetary Theory Whtch pnnciple or rauonal expectations theory is used to prove the proposition that stabilization policy can have no predictable effect on aggregate output in the new classtcal model' "The Lucas cnllque by itself casts doubt on the ability or dtscrellonary siabtltzallon policy LObe benertcial." Is Lhis sLaLemenL Lrue, ra1se, or uncenain? Explain your answer "The more credtble the poltcymakers who pursue an anti-inflation policy, the more successful that policy will be." Is this statement true, false, or uncertain? Explain your answer 10 Many economtsts are worried that a high level of budgeL deficits may lead Lo innaLionary monetary policies in the rmure Could these budget deftciLS have an errw on the current rate of inflation? Using Economic Analysis to Predict the Future ll Suppose that a treaty is signed limiting annies throughout the world The result of the treaty is that the public expecLs mi1iLary and hence government spending LObe reduced U the nev classical view or Lhe economy is correct and government spending does affect the aggregate demand curve, predict what will happen to aggregate ampul and the pnce level when government spending ts reduced in line with the public's expectations 12 How would your predtction differ in Problem lltf the new Keynesian model provides a more realistic descripLion or Lhe economy? "V/haL ir the traditional model provides Lhe most realisLic description or the economy? 13 The chatrman or the Federal Reserve Board announces LhaL over Lhe next year, the raLe or money growLh will be reduced rrom liS current rate or 10% IO a rate or 2% H the chairman ts be!teved by the pub!tc but the Fed actually reduces the rate of money growth to 5%, predict what will happen to the inflation rate and aggregate outpUL ir the nev classical view or the economy is correcL 14 How would your predtcLion differ in Problem 13 tr the nev Keynesian model provides a more accurate description of the economy? ¥/hat if the traditional model provides the most realistic description of the economy? 15 H, in a surprise vicLOry, a new administration is eleCLed to office that the pub!tc be!teves wt!l pursue inflationary po!tcy, predtct what might happen to the level of ampuL and innaLion even bdore Lhe nev adminisLraLion comes inLo power "V/ould your predicLion dirrer dependmg on whtch of the three models-tradittonal, new classical, and new Keynesian-you believed in? WEB EXERCISES l Raben Lucas won the Nobel Prize in economics Go 10 nobelpnze org/nobel_pnzes/economics/ and locale the press release on Roben Lucas What was his Nobel Prize awarded ror? "V/hen was iL awarded? WEB REFERENCES http :lice pa newschoo ed u!het/pro ft l es~ ucas h 1m A brief biography of Raben Lucas including a ltsL or hts publications www federalreserve.gov/pubs/reds/200 1/200113/ 200113pap.pdf The Federal Reserve recently pub!tshed a paper discussing the new Keynesian model and price stickiness MyEconlab CAN HELP YOU GET A BEITER GRADE If your exam were tomorrow, would you be ready? For each chapter, MyEconlab Practice Test and Study Plans pinpoint which sections you have mastered and which ones you need to study That way, you are more efficient with your study time, and you are better prepared for your exams To see how it works, turn to page 20 and then go to: www.myeconlab.com/mishkin ... at the Fed? 32 Why the Chairman of the Board of Governors Really Runs the Show 330 How Independent is the Fedl Inside the Fed 32 325 Board of Governors of the Federal Reserve System Inside the. .. career of over 30 years Reordering of Part , Financial Institutions, and Rewrite of Chapter 1 , The Economic Analysis of Financial Regulation In past editions, the chapter on the structure of the banking. .. 320 32 The Political Genius of the Founders of the Federal Reserve System Structure of the Federal Reserve System 322 Federal Reserve Banks Inside the Fed 323 The Special Role of the Federal