Monetary Policy Reaction Function

The recent financial turmoil and its economic consequences have led the Federal Reserve to aggressively cut the federal funds rate, a key benchmark for all interest rates. In a previous blog post, I explained how the Fed could keep the federal funds rate constant while money demand increases. Now I want to focus on how and why the Federal Reserve reduces the federal funds rate.

The "how" question is easily answered in most economics textbooks. Once the Federal Open Market Committee (FOMC) decides to cut the federal funds rate by 50 basis points, the Open Market Trading Desk purchases the quantity of government securities necessary to reach the new federal funds rate. The graph on the right shows how open-market purchases could lower the federal funds rate from 5.25% to 4.75%.

So far, I have stuck to the facts without building a model of the Fed's behavior. Economists sometimes find it convenient to model the behavior of the Fed in terms of a monetary policy reaction function (MPRF). The following is an example of an MPRF from Ben Bernanke and Robert Frank's Principles of Economics:

Of course, the MPRF above is just one example, and there are other examples (such as the Taylor Rule) that are more complex. For teaching purposes, let's just use the simple MPRF.

In addition to equations, economists often use graphs to depict models. The following graph shows the simple MPRF with the real interest rate on the Y-axis and the inflation rate on the X-axis. Assume a 3% actual and long-run target inflation rate.

The graph shows that a downward shift in the MPRF reduces the actual real interest rate from 2.25% to 1.75% when the actual inflation rate is equal to the initial target inflation rate of 3%. Assuming that the actual inflation rate remains constant in the short run, the shift in the MPRF causes a reduction in the real interest rate, and consequently stimulates investment and consumption. The ultimate goal is to stimulate aggregate demand and prevent the recent financial turmoil from drastically affecting the broader economy.

Discussion Questions

1. Refer to the simple MPRF equation. A downward shift of the MPRF could be accomplished by a reduction in the long-run target real interest rate (r*). The Fed typically sets r* in line with the equilibrium real interest rate that prevails in the market for loanable funds. Is there reason to believe that the recent financial turbulence has disrupted investment, private saving, public saving, or net capital inflows?

2. A downward shift of the MPRF could also be accomplished by an increase in the long-run target inflation rate. Is there reason to believe that the Fed has increased the long-run target inflation rate?

3. Are there other factors that the Fed should consider in its MPRF?

Too Darn Hot

It’s 85 degrees and sunny on this October day in the Bay Area, and this morning’s review of the New York Times brings a trio of stories related to heat: the tragedy of the fires raging in Southern California; a long article in the Magazine section on decreasing supplies of fresh water due to global warming; and a really interesting article on the effect of lower water levels in the Great Lakes on shipping. There are lots of good economic applications in all three of these articles.

It’s clear that there are winners and losers from warming. For example, the people who lose their homes in Southern California—and their insurance companies—are clearly losers. But others win—think of the windfall that’s about to benefit construction companies in Southern California, which were suffering recently because of the downturn in the housing market. Don’t the fires create rebuilding jobs for them? And don’t they, in turn, spend that money, benefiting others? Could we view the fires as a stimulus to the economy? Maybe there’s insufficient drought in the world after all!

If this argument rings false, that’s because it is. To see why, read one of the most brilliant three-paragraph synopses of economic theory ever written: the first application in Economics in One Lesson by Henry Hazlitt. (Clicking to the next page, “The Blessings of Destruction,” is also worthwhile. Oh, heck, just read the whole book—it will take you an hour.)

Discussion Questions

1. Suppose we assume that global warming is caused by humans, and that it is an example of the tragedy of the commons: everyone suffers because of global warming, but nobody has an individual incentive to stop the behavior that causes it. As Economics in One Lesson demonstrates, Hazlitt was skeptical of government interference in markets beyond the enforcement of property rights. Can you think of any appropriate responses to global warming that involve little to no government interference?

2. Suppose we assume instead that global warming is not caused by humans, but that humans can do things—for example, produce less carbon dioxide—to reduce its effects. How does that change your response to question 1? Does it, in fact, change your response? Why?

3. The article on the Great Lakes says that “for every inch of water that the lakes lose, the ships that ferry bulk materials across them must lighten their loads by 270 tons—or 540,000 pounds—or risk running aground, according to the Lake Carriers’ Association, a trade group for United States-flag cargo companies.” What effect is this likely to have on the structure of the shipping market in the short run and the long run?

Remittances and Global Poverty

As a recent Marketplace story points out, the largest source of aid for poor people in developing countries is family members working abroad. According to a report by the UN's International Fund for Agricultural Development, approximately 150 million migrants worldwide remitted roughly $301 billion to relatives in less developed countries during 2006. Unlike traditional aid, which typically filters through government and other institutions before reaching the poor, remittances go directly to families in developing countries. While traditional aid may end up financing bureaucracy rather than poverty alleviation, the impact of remittances is concentrated and immediate.

Increasing international labor mobility, legal or otherwise, fuels the increase in global remittances. As remittances rise, their economic importance in recipient countries rises as well. In smaller Asian economies such as the Philippines, Nepal, and Tajikistan, remittances represent between 20% and 70% of income per person. The cost of sending money home varies from region to region. In Latin America, the business of money transfer is highly developed and competition between financial institutions keeps the cost of sending remittances relatively low—about $10 to send $200 to the region. By contrast, the cost of sending remittances to Africa is much higher because of restrictions on the types of institutions that can handle money transfers. As a result, African families receive a smaller percentage of the before-transfer-fee remittance.

Discussion Questions

1. How do immigration policies in developed economies like the United States affect the size of global remittances? How will the transactions costs associated with remittances differ between legal and illegal immigrants?

2. How might global aid organizations help to reduce the transactions costs of remittances? What can governments in less developed countries do to encourage the flow of remittances?

3. Poor people in less-developed countries often have very limited credit access. How might remittances change credit conditions for poor families? How might remittances impact other important development indicators such as food security, school enrollment rates among children, or health outcomes like life expectancy and infant mortality rates?

4. How would foreign aid be different if developed countries simply gave cash vouchers to individual poor families, mimicking the flow of remittances?

The 2007 Nobel Prize: Mechanism What?

The 2007 Nobel Prize in Economics went to Leonid Hurwicz, Roger Myerson, and Eric Maskin for “having laid the foundations of mechanism design theory.”

Mechanism design isn’t covered in the typical introductory economics class. The narrative of your first econ class usually goes something like this: “The ‘invisible hand’ of the free market is the most efficient way of answering the fundamental economic questions: what to produce, how to produce it, and who consumes it. Sometimes the market doesn’t work—for example, in the case of externalities or public goods.”

In short, a single mechanism—the “market”—is usually the topic of discussion for intro courses. But there are lots of other mechanisms for answering these fundamental questions. And unlike the market, which is a decentralized mechanism (meaning it is not run by a central authority), there are plenty of man-made institutions that are centralized mechanisms. One example of such a mechanism is an auction, which allocates goods according to bids. Another is a political election, which allocates political power according to the preferences of the electorate. Both auctions and elections have rules, and these rules determine the optimal behavior of bidders and politicians.

One of the biggest challenges of designing an economic mechanism is that people have private information about their own preferences. One of the most famous examples of a mechanism design problem is the provision of public goods. Suppose a small town is considering the establishment of a public park in the town square. Should it ask the citizens how much each of them would value the park, and ask them to contribute that amount? Clearly, each of the citizens would have an incentive to “free ride” on their neighbors by understating their own value of the public good—so as a mechanism, just asking for voluntary contributions leaves a lot to be desired.

We will be creating a news analysis assignment about mechanism design for professors who use Aplia in their classrooms. In the meantime, here are some discussion questions to get the ball rolling.

Discussion Questions

1. “Market failure” often occurs when dealing with things other than purely private goods—for example, public goods, common resources, or goods with externalities. One solution to market failure can be broadly categorized as “market solutions.” An example of such a market solution is the levying of a Pigovian tax, which keeps the basic mechanism of the market but alters the incentives of participants. Another solution to market failure would be to replace the market with another institution entirely. For example, the right to use a specific frequency of the wireless spectrum is allocated by the Federal Communications Commission using an auction mechanism. Can you think of other examples of market failure that we address by using centralized mechanisms? What are the advantages and disadvantages to centralized mechanisms as opposed to market solutions?

2. The term “asymmetric information” refers to cases in which parties hold private (or hidden) information about their preferences or costs. One of the core challenges of mechanism design is to encourage people to reveal their private information in a truthful and credible way. For example, it is easy to show that the optimal strategy for a bidder in a Vickrey auction like eBay is to bid one’s true value. Think of a situation in which asymmetric information causes problems. What kind of mechanism could you design to elicit truthful information from the participants in that situation?

3. A recent Washington Post article has provoked a fair amount of discussion about the effectiveness of torture in acquiring information from prisoners. The most heavily quoted passage of the article reads:

“We got more information out of a German general with a game of chess or Ping-Pong than they do today, with their torture,” said Henry Kolm, 90, an MIT physicist who had been assigned to play chess in Germany with Hitler’s deputy, Rudolf Hess.

What do you think the economic study of mechanism design would have to say about torture? Is it an effective method for eliciting private information? How would an economist interrogate a suspected terrorist?

Speculating about the Nobel

Next week, we can expect the winner to be announced for this year's Nobel Prize in Economics. (Last year, the Aplia Econ Blog posted an article about the previous winner, Edmund S. Phelps.) This weekend will see lots of speculation over who will take the prize. Proving there's a market for everything, Intrade posted its odds on this year's prospective Nobel laureates, and allows speculators to bet on who they think will win (thanks to Greg Mankiw for finding this site). The early favorite on Intrade (though trading has been extremely light) is the University of Chicago's Eugene Fama. Truth be told, Professor Fama is my favorite for this year's Nobel (at least, my favorite non-Aplian!).

It's a challenging matter determining how to judge academics relative to each other, especially when they may publish in significantly different fields. The number of citations an academic receives is probably the gold standard for measuring performance in academia. An author receives a citation when a later author recognizes the original author's work as contributing to the later author's own research. This site seeks to objectively measure economists' citations, but applies a weighting scheme to control for individually authored papers relative to co-authored papers and for the time elapsed since papers were cited. Eugene Fama also resides at the top of this list (though a lot of us at Aplia think number 21 on the list deserves a good look too).

Professor Fama has made major contributions to the finance field with his work on market efficiency and asset pricing. He is regarded by many as the father of the efficient market hypothesis. In the early 1990s, he published a series of papers with Kenneth French in which they challenged the Capital Asset Pricing Model's assertion that a stock's market beta is the primary determinant of variations in stock returns. They argued that the market and its participants are too complex to be encapsulated by a single factor. In an article entitled "The Cross-Section of Expected Stock Returns," they developed a three-factor model that tried to explain stock returns using two observed anomalies. They incorporated the fact that small companies tend to outperform big companies, while value stocks (with higher book/market ratios) tend to outperform growth stocks (with lower book/market ratios). Since the paper's publication, Fama-French's three-factor model has become a fundamental evaluation tool in the portfolio management industry.

Discussion Questions

1. Why is an economist's number of citations a relevant measure for his or her impact on the field?

2. The citation list weights recent citations more heavily than older ones. Why might this distinction be relevant when judging an academic?

3. Are markets efficient?

4. There have been a few times in stock-market history when crashes (huge stock-price declines) occurred, such as the stock-market crashes of 1929 and 1987 and the burst of the Internet bubble. What would an analyst who believes in market efficiency say to explain these events?

Should the Government Tax Consumption or Income?

Robert Frank devoted his most recent New York Times column to the idea of shifting taxes from income to consumption. It’s not a new idea, and it’s one that many economists of various political stripes agree on.

Right now, the amount of tax you pay is based on your income. The more you earn, the more you pay in taxes on each additional dollar earned—the “marginal income tax rate.” One important argument against the income tax is that it penalizes savings. Consider an unmarried taxpayer—let’s call her Sally—who is in the 25% tax bracket. (For an individual, that means earning between about $30,000 and $70,000 per year.)

Now suppose that Sally gets a $10,000 raise. She faces a marginal tax rate of 25%, so that $10,000 raise is really a $7,500 raise at most. If she saves that money at 6% interest, the additional income will also be taxed at 25%, bringing it down to about 4.5% per year—barely more than inflation. It would take her eight years to earn enough interest to get her bank account back to the initial “raise” of $10,000.

Now consider a different tax system: one in which Sally’s consumption is taxed rather than her income. That is, suppose she would owe exactly $0 in taxes on any money she saves. This means she could put away the entire $10,000 raise and let it accrue interest at the full rate of 6% per year. After eight years, she would have nearly $16,000 in the bank. Such a system would clearly encourage Americans to save more money.

The fact that a consumption tax would encourage savings by not taxing saved money has earned it the nickname of the “unlimited savings allowance.”

Discussion Questions

1. If one were choosing between a pure income tax and a pure consumption tax, the former would be more likely to encourage consumption, while the latter would be more likely to encourage savings. Which of these—consumption or savings—would be more beneficial to the economy as a whole? Why?

2. Frank suggests a highly progressive consumption tax (i.e., the marginal tax rate would rise as consumption increased). He even does a thought experiment with a 100% marginal tax rate on consumption beyond a certain level. A famous tax proposal by economists Bob Hall and Alvin Rabushka would levy a “flat tax” on consumption. How would you compare these two proposals? What are the pros and cons of each?

3. Frank is famous for his belief that because people care about “keeping up with the Joneses,” consumption actually has a negative externality associated with it. If that is true, is a consumption tax in reality a kind of Pigovian tax?

4. Two of the guiding normative principles by which many people judge tax systems are the ability to pay principle (briefly, that the rich should pay more in taxes) and the benefits received principle (briefly, that if taxes are used to fund a public good, those who benefit the most from the good should pay the taxes). Does Frank’s proposal follow these principles? Why or why not?

O.K. Consumer: Pick Your Price

I love Radiohead. Really, love. I still remember sitting in my car in the record store parking lot with one of my best friends, listening to their fourth record, Kid A, all the way through—in awe. That record took Radiohead, and rock music in general, in an unexpected direction. And true to form, Radiohead is again doing things a little differently with their latest effort, In Rainbows, releasing October 10. But this time, the surprise isn't the music itself—it's how they plan to deliver that music to the world.

Recently freed from their ties with the record label EMI, Radiohead has decided to release their latest album in two ways: as a disc-box containing the CD, vinyl, and various Radiohead goodies—available for ₤40 (about $81)—or as a download. The interesting aspect of the download option is that you can pick your own price. $0? Fine. $80? Fine. You pay whatever you want.

To find out more, check out Shane Richmond's recent column, "How Radiohead killed the record labels," and this NPR interview with Tyler Cowen of George Mason University.

Discussion Questions

1. Why would Radiohead put itself out there like this? If past releases are any indication, there are certainly millions of consumers willing to pay normal price for a new Radiohead album. But will they pay, given the choice? Like me, some fans will pay willingly, deriving some degree of benefit from knowing that they're compensating a great band for its creative efforts. You know that feeling you get after you've given a good tip? That good feeling usually comes from visible tipping—that is, the recipient knows who you are. Paying for the download, by contrast, is anonymous. How might this affect what people actually pay?

2. I certainly wouldn’t be blogging about this album if it were $9.99 on iTunes. Even as non-fans read about this, they may be curious enough to check out the Radiohead site. They may even listen to a song or two. Maybe they'll like it enough to cough up some money for the download, or maybe they'll buy the disc-box, or a concert ticket, or a T-shirt. What is Radiohead’s marginal cost of offering one more digital download for sale; what is the marginal benefit to the band of having additional listeners? Might a broader fan base generate enough revenue to more than make up for the revenue the band forgoes by not selling downloads at a standardized price?

3. A firm engages in perfect price discrimination when it charges each consumer a price equal to his or her individual willingness to pay. How is this effort similar to price discrimination? How is it different?

4. How much will you pay? You would maximize your consumer surplus by paying nothing. But can you stomach it? Does a self-selected price of $0 bring along with it an intolerably high price in guilt? Along these lines, how will the prices paid by the dedicated fan differ from those paid by the casual observer?

The Dollar Is Sinking, but What Does That Mean to Me?

Last week, the U.S. dollar continued its downward spiral against most major currencies, including an all-time low against the euro. The previous week, the U.S. dollar had begun trading at parity with the Canadian dollar—something unfathomable 10 or 20 years ago. An earlier Aplia Econ Blog post discussed the role of monetary policy and the effect of the Fed's rate cut on exchange rates.

The graph below illustrates how the U.S. dollar has performed relative to four major currencies (the euro, British pound, Canadian dollar, and Japanese yen) over the last decade relative to their January 1, 2000 values. But what effect do declining exchange rates really have on us?

At the consumer level, it's fairly simple—a weaker dollar means our purchasing power is weaker when buying foreign goods. Effectively, imported goods become more expensive, since the U.S. dollar can buy fewer euros, for example. However, there is another side to this story, because it also means that U.S. goods are cheaper to foreign consumers. This is one of those things that sounds bad, but depending on who you are, can actually be quite good. If you are a U.S. firm, a weaker dollar can be beneficial because it enables foreign consumers to buy more of your products.

In fact, a weaker U.S. dollar is beneficial to U.S. multinationals in a more fundamental way. When a firm sells abroad, it generally sells its goods at a price denominated in the currency of the foreign country it is dealing in. Ultimately, the U.S. firm's shareholders care about dollar-denominated revenues and profits. A declining U.S. dollar means that a firm's euro-, pound-, or yen-denominated revenues can be exchanged for more U.S. dollars than they could have been when the U.S. dollar was stronger. Hence, a U.S. multinational that transacts in several currencies benefits when the dollar declines because its foreign revenues are worth more on a U.S. dollar basis, and vice versa. For example, in the mid- to late 1990s, many U.S. multinationals selling in Asia experienced phenomenal sales growth, yet their profits grew only modestly. During this period, the Asian currencies weakened, decreasing the worth of these firms' revenues in U.S. dollars. Hence, record-breaking unit sales translated into only modest profits in terms of U.S. dollars.

Discussion Questions

1. Who has a greater interest in a strong U.S. dollar—U.S. consumers or U.S. producers?

2. What sort of tax implications may exist for U.S. multinationals as a result of fluctuating exchange rates, especially a weaker U.S. dollar?

3. If a firm owes €100,000 to a German supplier due in 30 days (an account payable), does it prefer that the U.S. dollar strengthen or weaken relative to the euro?

4. Suppose a different firm is owed ₤88,000 from a UK customer due in 45 days (an account receivable). The spot exchange rate is $2.01/₤. How much (in U.S. dollars) would the firm receive if it were paid today? Discuss the gain or loss implications for the firm if the money isn't received for 45 days and the exchange rate moves to either $2.10/₤ or $1.90/₤ during that time.

The Dollar and the Drug Trade

The value of the U.S. dollar (USD) is falling against a number of foreign currencies, including the Canadian dollar (CAD), also known as the loonie. As the dollar weakens against the loonie, imports from Canada, including illegal drugs like marijuana, become more expensive. As American dope-smokers get priced out of the market for high-quality Canadian marijuana, they increasingly turn to lower-quality Mexican varieties and, as this Reuters article points out, Mexican growers become more willing to assume the risks of planting on American soil.

To see how the weakening dollar leads to change in the drug trade, consider the change in the CAD–USD exchange rate over the past year:

October 2006: 1.12 CAD per USD
October 2007: 1 CAD per USD

The value of the USD in October 2007 (1 CAD) is lower than it was in October 2006 (1.12 CAD). The exchange rate between the Mexican peso (MXN) and the U.S. dollar has changed a bit over the past year, but for simplicity, we'll assume it remained constant at 11 MXN per USD. Now that we've got some exchange rates, let's take a look at marijuana prices.

Let's assume that the prices of Canadian and Mexican marijuana remained roughly constant from October 2006 to October 2007. Suppose that 1 pound of top-quality Canadian marijuana sells for 3,500 CAD, while 1 pound of not-so-top-quality Mexican marijuana sells for 19,250 MXN. In October 2006, the price Americans paid for top-quality Canadian marijuana was:

3,500 CAD per pound x (1 USD / 1.12 CAD) = 3,125 USD per pound

Over the past year, the value of the USD declined against the CAD. The two currencies reached parity in September of 2007. As a result, the price Americans paid for Canadian marijuana increased to 3,500 USD by October of 2007 [3,500 CAD x (1 USD / 1 CAD) = 3,500 USD]. Given the roughly constant exchange rate between the peso and the U.S. dollar, the price Americans pay for lower-quality Mexican marijuana would remain the same:

19,250 MXN per pound x (1 USD / 11 MXN) = 1,750 USD per pound

The relative price of a good is the number of other goods that you can purchase for the same amount of money. Consider how the change in the exchange rate affects the relative price of top-quality Canadian marijuana. In October 2006, Americans could purchase approximately 1.8 pounds of lower-quality Mexican marijuana for the same price as 1 pound of higher-quality Canadian marijuana (3,125 USD per pound / 1,750 USD per pound). By October 2007, Americans could purchase 2 pounds of Mexican pot for the price of 1 pound of Canadian pot. As the value of the U.S. dollar declines against the loonie, the relative price of Canadian marijuana increases and the Mexican alternative becomes increasingly attractive.

Discussion Questions

1. What factors explain the decrease in the value of the U.S. dollar against the Canadian dollar? Why do you think the value of the dollar is not declining as quickly against the Mexican peso?

2. How does the oil boom in Western Canada impact the marijuana industry in British Columbia?

3. The Reuters article mentions the expansion of marijuana cultivation inside the U.S. by Mexican criminal groups. How does the rising price of Canadian pot contribute to the expansion of marijuana cultivation within the U.S.?

Loss Aversion and the Housing Market

For many people, the pain of losing $500 outweighs the pleasure of gaining $500. As Austan Goolsbee points out in a recent New York Times column, this aversion to loss is especially acute when it comes to selling real estate. People are stubborn about selling a house for less than they paid for it. If selling at prevailing market prices means accepting a significant loss, some people refuse to sell at all, or else base pricing decisions not on what they would willingly pay to buy a similar house today, but rather on what they paid for the house when they bought it. As a result, sellers who bought houses during the peak of the housing boom will list their properties for a higher price than nearly identical homes purchased earlier on at lower prices. At worst, the strong reluctance to sell at a loss leads to a prolonged freeze in the housing market, with many homes listed for sale at prices that buyers will not pay. Since people who sell a house often go on to purchase another, loss aversion can contribute to weaker housing demand and prolong the housing slump.

The housing correction in the U.S. continues to reduce house prices in many regional markets. The correction raises the risk of a downturn in the U.S. economy. As house prices decline (other things being equal), household wealth declines, and consumption expenditures decrease. The shock to consumption spending may contribute to slower growth or even a recession. As Goolsbee points out, loss aversion in the housing market adds to the gloomy outlook for the broader economy. The reduction in housing-market transactions affects the consumption of durable goods and increases the costs associated with switching jobs. Read Goolsbee's column to find out more.

Discussion Questions

1. According to the article, what fraction of home buyers are moving within a metropolitan area? How will seller reluctance to lower prices during a housing slump affect the number of future buyers in a local housing market?

2. Suppose a beet farmer arrives at the farmers' market only to discover that other beet farmers are selling identical beets for less than he had intended to sell his own beets. He is likely to succumb to competitive forces and sell his beets at the prevailing price. Why are house sellers, unlike beet farmers, unwilling to lower their prices? Does it have to do with characteristics of the sellers or characteristics of the markets?

3. What are durable goods? Why would this type of housing-market freeze impact sales of durable goods? Why do you think the ups and downs of durable-goods sales are closely aligned with the ups and downs of the business cycle?

4. Frictional unemployment refers to the relatively short spells of unemployment associated with finding and transitioning to a new job. For example, a recent college graduate searching for her first job or a banker transitioning between jobs in different areas will be frictionally unemployed until they start at their new positions. How might a prolonged housing freeze increase frictional unemployment? To what extent might a housing freeze cause people to stay in jobs they would otherwise leave?