Ngân hàng, tín dụng - Chapter 28: Empirical evidence of the effectiveness of monetary policy

1Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 28 Empirical Evidence of the Effectiveness of Monetary Policy Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-2 Learning Objectives • Understand the historical volatility in velocity and money demand and the implications of that volatility for Keynesianism and monetarism • Explain the fiscal and monetary policy lags and resulting difficulties in enacting these policies • Analyze the empirical evidence relating monetary and fiscal policies to GDP, investment, consumption, and interest rates Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-3 Introduction • Previous chapters dealt with theoretical concepts of monetary theory on economic activity • This chapter explores empirical evidence – How are interest rates affected – What categories of spending are most influenced – Does monetary policy alter real economic outcomes—output and unemployment—as compared to changes in prices 2Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-4 Living with Velocity • Much of Monetarist-Keynesian debate hinges on the behavior of velocity – Monetarists—relatively stable and changes are highly predictable – Keynesians—neither contention is true, velocity can vary unpredictably • While velocity is not constant, changes do not appear to be obviously random or perverse Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-5 Living with Velocity (Cont.) • If the Federal Reserve could discover the underlying determinants of these changes, it might still be able to coexist with such a moving target • Figure 28.1 plots the historical movements of measures of velocity for two definitions of the money supply—M1 and M2—over time – Velocity of M2 has been relatively stable Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-6 FIGURE 28.1 Historical movements in M1 and M2 velocities. 3Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-7 Living with Velocity (Cont.) • Figure 28.1 (Cont.) – Velocity of M1 appears highly unpredictable • Reached a peak of about 4 at the beginning of the 1920s • Fell almost continuously during the Great Depression and World War • Experienced a dramatic increase since the low in 1949 reaching almost 9 during the early 2000s Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-8 Living with Velocity (Cont.) • Figure 28.1 (Cont.) – Main reasons for the post-World War II rise in velocity of M • The relatively narrow definition of M1 • Increasing attractiveness of other categories of financial assets as prudent/desirable places to invest excess cash • Higher interest rates experienced during the 1970s and early 1980s increased opportunity cost of holding cash • This lead to an increase in velocity by inducing business firms and households to economize on money Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-9 Living with Velocity (Cont.) • Figure 28.1 (Cont.) – However, since the mid-1980s, M1 velocity has reversed the post-World War II uptrend forcing the Federal Reserve to abandon setting M1 targets and focus on the more stable behavior of M2 4Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-10 The Demand for Money • The historical movements in the velocity of M1 are a result of many factors – Movements in interest rates – Technology – Innovations in financial markets • In order to be able to focus more precisely on the relative importance of each, must be able to disentangle their separate influences Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-11 The Demand for Money (Cont.) • Formal application of statistical techniques to historical data of economic variables will permit identification of individual relationships • Statistical studies show that interest rates and the level of GDP influence money demand – Higher rates reduce demand for cash balances – Contradicts extreme forms of monetarism, which assume zero interest-sensitivity of money demand – However, none of the empirical studies isolate the Keynesian liquidity trap Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-12 The Demand for Money (Cont.) • More sophisticated approach focuses on the stability of the money demand – Recognizes that specific numbers are less important than ability to forecasting future money demand – If this relationship can be established, Federal Reserve can gauge proper amount of money to add/subtract to hit a target of economic activity – If this relationship is unpredictable, it provides no useful guidance to the Federal Reserve 5Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-13 The Demand for Money (Cont.) • Empirical evidence – Demand for money was quite stable until the mid- 1970s – Deteriorated after the middle of 1974 with people holding smaller money balances than the historical relationship suggested – The observations in the 1980s were the opposite— holding of too much money reflecting the decline in M1 velocity Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-14 Econometrics and Time Lags • The simple velocity and money demand approaches leave much to be desired as a guideline for Federal Reserve policy-making. • Ignores time lags between changes in monetary policy and impact on economy • Ignores more sophisticated computer driven statistical methodology that can simulate the impact of monetary policy via formal econometric modeling Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-15 Econometrics and Time Lags (Cont.) • Lags in monetary policy – Prompt recognition of what the economy is doing can be difficult – Available data are often inadequate and frequently mixed – The economy rarely proceeds on a perfectly smooth course 6Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-16 Econometrics and Time Lags (Cont.) • Lags in monetary policy (Cont.) – Recognition lag • Time associated with getting an accurate understanding of what is happening or is likely to happen in the future • Data suggests the Federal Reserve generally starts to tighten only a few months after a business cycle has reached its trough, while the move toward easing is somewhat more delayed • This leads to the conclusion that the Federal Reserve is typically more concerned with preventing inflation than with avoiding a recession Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-17 Econometrics and Time Lags (Cont.) • Lags in monetary policy (Cont.) – Impact lag—time span from when the central bank starts to use one of the monetary tools until an effect is evident on the ultimate objective—aggregate spending in the economy • It may take weeks before interest rates change • Changes in credit availability also take time • Delay before actual spending decisions are affected • Once monetary policy starts to influence spending, it will most likely continue to have an impact well into the future Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-18 Econometrics and Time Lags (Cont.) • Econometric Models – A mathematical-statistical representation that describes how the economy behaves – How do different economic actors (consumers and businesses) respond to economic stimuli – Once the relationships are formalized in mathematical representations, data on past experience in the real world are used to estimate the precise behavioral patterns of each sector 7Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-19 Econometrics and Time Lags (Cont.) • Econometric Models (Cont.) – The computer model simulates the economy in action and makes predictions based on the formal relationships embedded in the model – However, depending on the theoretical propositions used to construct the model, the data can produce different results – Since Monetarists and Keynesians use different theory, predictions of models based on their respective theories would be significantly different Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-20 The Impact of Monetary Policy on GDP • The Federal Reserve, working with several universities, has developed econometric models of behavior of economic aggregates in the U.S. • These econometric models are an evolutionary phenomena, constantly being revised and updated to reflect new and different perspectives about economic reality Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-21 The Impact of Monetary Policy on GDP (Cont.) • Outcomes of these models will vary with specific conditions of current economic activity • The Federal Reserve model articulates rather carefully the impact of monetary policy on various categories of spending 8Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-22 The Impact of Monetary Policy on GDP (Cont.) • Fed’s model shows that a 1% increase in the money supply raises real GDP by about ½% after one year, rising over the next two years to reflect the full 1% increase • Model demonstrates that monetary policy has a significant impact even within a year • However, because of various lags, the continued impact may cause difficulties for policymakers in subsequent years Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-23 Fiscal Policy and Crowding Out • The models test the Monetarists-Keynesian distinction of the effect of fiscal policy and crowding out – Monetarists—increased government spending will merely displace private spending, leaving little net impact of fiscal policy on GDP – Keynesians—“crowding-out” effects are incomplete, implying that fiscal policy generates much of the traditional multiplier effect on GDP Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-24 Fiscal Policy and Crowding Out (Cont.) • The Federal Reserve model – Holding the money supply constant • This results in an increase in the interest rates caused by additional government borrowing • An increase in government spending by 1 percent of GDP increases the level of real GDP by about 1 percent for at least two years • It takes more than three years for crowding out to reduce the impact on real GDP 9Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-25 Fiscal Policy and Crowding Out (Cont.) • The Federal Reserve model (Cont.) – Allowing the money supply to increase • In this case, the Federal Reserve finances the additional borrowing/spending by printing money and interest rates do not increase • In this case the multiplier effects on GDP are substantial • The effects on GDP continue even after 4 years Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-26 Fiscal Policy and Crowding Out (Cont.) • These models suggest that fiscal policy has a multiplier of about one without any help from monetary policy, but an accommodating monetary authority can make fiscal policy even more effective • Empirical evidence on fiscal policy confirms the crowding-out effect, but only if the contractionary effects on private spending are given substantial time to work themselves out Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-27 Interest Rates • Monetarists and Keynesians believe the initial liquidity impact of an expansionary monetary policy reduces the level of interest rates • Eventually both recognize inflationary expectations generated by excessive expansion of money will raise interest rates • Difference between the two rests on how long it takes for inflationary expectations to counter the initial liquidity effect 10 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-28 Interest Rates (Cont.) • Figure 28.2 – Illustrates that levels of short-term interest rates have been closely related to actual movements in the rate of inflation – However, the chart also shows substantial intervals of independent movements in the level of interest rates – Most econometric models report that interest rates decline and remain below their original levels for six months following an expansion of money Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-29 FIGURE 28.2 Interest rates move with the rate of inflation. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-30 Interest Rates (Cont.) • Figure 28.2 (Cont.) – Similarly, interest rates are above their original levels for a similar period after an contractionary monetary policy – After a year, however, the initial liquidity effect is reversed, and interest rates move in the opposite direction 11 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-31 Interest Rates (Cont.) • It should be emphasized that the response of inflationary expectations depends crucially on the initial state of the economy – Responding very quickly when the economy is very close to full employment – Also, a quick response when there is high degree of concern about possible inflation Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-32 Business Investment • Theory would suggest interest rates and all types of investment spending to move in opposite directions • However, historically the two almost always move in the same direction – This conflicting result stems from the fact that business investment is dependent upon a number of factors besides interest rates Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-33 Business Investment (Cont.) – The model, therefore, violates the assumption of holding all other influences constant and just changing the rate of interest – An increase in interest rates may inhibit investment, but an increase in investment caused by other factors may offset the interest rate effect 12 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-34 Business Investment (Cont.) • Fed’s econometric model can sort out effects of individual variables and does demonstrate the negative relationship between interest rates and business spending • Most of the effects occur during the last year of a 3 year time period • The time delay relates to the fact that current business decisions are not executed usually until several years later Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-35 Residential Construction • The impact of monetary policy is felt more promptly and powerfully on residential construction expenditures—higher interest, lower residential construction • Part of this effect occurs through credit rationing activities by financial institutions engaged in mortgage lending • Construction expenditures by state and local governments also appear sensitive to the actions of the monetary authorities Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28-36 Consumer Spending • The Federal Reserve model includes the wealth effect of modern Keynesians • Lower interest rates raise the value of financial securities which increase the level of consumer spending • According to the Fed’s model, the importance of the wealth effect in the overall impact of monetary policy is quite substantial