Central Banks to the Rescue

World financial markets woke up to a rude surprise on the morning of Friday, August 10. The U.S. subprime mortgage debacle, which was originally thought to be well-contained within a small segment of the U.S. mortgage market, had spread to Europe. This was the straw that broke the camel's back, especially after several hedge funds from highly reputable investment companies collapsed due to heavy reliance on mortgage-backed securities. Hearing this news, bondholders and stockholders were quick to sell their risky holdings in exchange for liquidity (also known as money), which is relatively stable in value.

Aside from the fact that a sudden spike in selling activity in financial markets reduces the paper wealth of investors, it could quite possibly reduce real wealth. First, let's examine the money market effects of a sudden bond and stock sell-off due to a rise in risk aversion. For simplicity, we'll assume there are only three forms of financial assets: bonds, stocks, and money. The sell-off raises the demand for money from MD1 to MD2, as shown in the diagram below.

If the central bank does nothing and fixes the money supply at MS1, the equilibrium interest rate increases from 5.25% to 10%. The economy moves from point A to point B.

Second, let's examine the output market effects of a sudden bond and stock sell-off assuming that the central bank keeps the money supply constant. Higher interest rates mean a higher cost of borrowing for households and firms. Since big-ticket items such as automobiles, factories, and machinery are usually debt financed, consumption and investment spending (on physical capital) will decrease. Because consumption and investment spending are the two most important components of aggregate demand, a lack of central bank intervention will lead to a decline in aggregate demand from AD1 to AD2, as shown in the graph below.

If the central bank does nothing and fixes the money supply at MS1, the equilibrium interest rate increases, which reduces aggregate demand and causes a recession in the short run. The economy moves from point A to point B.

Third, let's examine how central banks around the world reacted to the liquidity hoarding. As the New York Times put it, "central banks around the world acted in unison… to calm nervous financial markets by providing an infusion of cash to the system." The Federal Reserve, along with most central banks, believes that fixing the interest rate is a better policy to maintain price stability and full employment. The Fed performed the cash infusion through of a series of government bond purchases known as open-market purchases, which is another term for the purchase of government bonds by the Fed. The cash infusion, or reserve injection, as textbooks call it, shifts the money supply curve from MS1 to MS2. The reserve injection effectively keeps the interest rate constant and avoids a recession.

If the reserve injection fails to calm financial markets and investors continue to hoard liquidity while selling bonds and stocks, central banks could inject additional reserves into the banking system through additional open-market purchases. The amount of money the Fed can create through purchasing government bonds is nearly limitless.

Read the Federal Reserve's actual press release from Friday, August 10, 2007.

Discussion Questions

1. For the most part, the Federal Reserve's main concern is first and foremost inflation, and secondarily unemployment. Given these two goals, should the Federal Reserve intervene every time the stock market takes a plunge?

2. Most economists believe that a permanent increase in the money supply will generate inflation and make the prices of everyday goods and services higher than they are today. Is this scenario likely given the large reserve injections in the U.S. and world money markets? Why or why not?

3. Some economists believe that markets are highly efficient in the sense that prices and interest rates adjust immediately to guarantee full employment. If this were true, would the Fed's reserve injections have any effect on credit markets or the economy as a whole?

A Chinese Dilemma

The People's Bank of China announced on May 18 that it would allow the yuan to float within a 0.5% band around a government-imposed exchange rate. For example, if the government-imposed rate were 7.6938 yuan per U.S. dollar, the central bank would allow the exchange rate to fluctuate between 7.6553 and 7.7323 yuan per U.S. dollar. Due to a soaring economy and a widening trade surplus with the United States, the yuan closed at a record high of 7.6686 yuan per U.S. dollar on the first day of the new exchange rate policy. In other words, after the announcement, the yuan strengthened against the U.S. dollar.

A "stronger yuan" means that 1 yuan can purchase more U.S. dollars than before. If the exchange rate were 1 yuan per U.S. dollar, yuan holders could obtain $1 for each yuan exchanged. If the exchange rate fell to 0.5 yuan per U.S. dollar, yuan holders could obtain $2 for each yuan exchanged. Hence, the yuan gets stronger as its exchange rate falls, and is stronger at 7.6686 than at 7.7323 yuan per U.S. dollar.

The stronger yuan makes Chinese products more expensive for Americans, reducing net exports and therefore lowering China's real GDP growth rate. Why would the People's Bank of China want to destroy jobs in its exports sector by favoring a stronger yuan? One popular explanation is that the Chinese government is giving in to U.S. political pressure to strengthen the yuan. A stronger yuan would reduce the U.S. trade deficit with China, boosting American goodwill towards China and avoiding the passage of U.S. restrictions on Chinese imports.

There is also an economic explanation for China's new exchange rate policy. Along with China's recent double-digit economic growth comes the prospect of high inflation and economic instability. The standard monetary policy remedy for an overheating economy is higher interest rates. Raising the cost of borrowing reduces overzealous consumption and runaway investment spending. Furthermore, higher interest rates attract more foreign investors, raising foreign demand for Chinese currency, which strengthens the value of the yuan. At the same time, higher interest rates encourage Chinese investors to keep more of their yuan in Chinese assets, leading to a reduction in the supply of yuan, which adds additional upward pressure on the value of the yuan.

Therefore, the People's Bank of China faces an economic dilemma. If it wants to tame the roaring economy, it must allow the yuan to strengthen. But if it wants to maintain a fixed exchange rate, it would need to keep the interest rate unchanged. Today, the central bank has chosen economic stability over exchange rate stability.

Discussion Questions

1. The central bank coupled the exchange rate announcement with a Q&A document for the public. In what ways is the central bank's explanation for widening the exchange rate band similar to our analysis? In what ways is it different?

2. Why would the central bank hesitate to allow the yuan to float freely? In other words, what are the drawbacks of immediately eliminating exchange rate controls?

3. For some time, U.S. policymakers have complained about China's exchange rate policy. How would a weaker U.S. dollar affect American consumers of Chinese products? How would a weaker dollar affect American producers who compete with Chinese producers? How would a weaker dollar affect Chinese consumers of American products and American firms that export goods to China?

Oil Shock, Part II: The Macroeconomic View

Microeconomists examine how the BP oil field shutdown affects oil prices, the behavior of automobile drivers, and profitability of particular industries. Oil Shock, Part I showed that the oil field shutdown raises the price of oil which reduces the profitability of many firms.

Macroeconomists, on the other hand, examine the economy-wide effects such as how a sharp rise in oil prices affects inflation, output, and unemployment. Suppose that the BP oil field shutdown causes the inflation rate to increase from Inflation Rate 1 to Inflation Rate 2 because firms try to pass on some of the higher input prices to higher output prices. In order to simplify the analysis, assume that full-employment output is constant at FE Output. Full-employment output, or potential output, is the amount of output that the economy produces when all the resources in the economy are efficiently utilized.

If the BP oil field shutdown increases the inflation rate, then the Fed will pursue a tight (anti-inflation) monetary policy which raises interest rates. Higher interest rates would reduce consumption and investment, causing output to fall. An output gap opens up as actual output falls below full-employment output in the short run. In the long run, the output gap will cause the inflation rate to fall back to its initial state. As the inflation rate falls in the long run, the Fed will pursue loose monetary policy and return the economy back to full employment.

A fall in output usually leads to an increase in the unemployment rate as firms cut back on production of goods and services and lay-off workers.

If the BP oil field shutdown leads to an inflation shock, then interest rates will rise, output will fall, and unemployment will increase in the short run.

However, inflation's tyranny does not end there. A higher inflation rate also destroys wealth in terms of stocks and bonds. An increase in the interest rate also reduces the price of stocks and bonds (archived entry: Why Does Bernanke's Small Talk Move Markets?)

1. Financial markets are very sensitive to inflation data. Suppose the Bureau of Labor Statistics reports that the inflation rate increased from 2% to 4%. Why would stock and bond prices fall as soon as the report is released, but before the Fed actually changes any interest rates?

2. The Fed, in its last FOMC meeting on August 8, 2006, kept the federal funds rate unchanged at 5.25%. Could this mean that the Fed does not consider the BP oil field shutdown an inflation shock?

3. Inflation expectations matter. The Fed's inflation-fighting credibility has been strong since Paul Volcker (the Federal Reserve Chairman from 1979 to 1987). Suppose consumers and producers always expect the Fed to return the economy to a target inflation rate--would higher oil prices require the Fed to raise interest rates (or raise them by as much)?

A Tale of Two Dragons: China's Trade Surplus and Inflation

In Chinese mythology, dragons can bring prosperity or destruction to villages and empires. China currently faces two dragons: the trade surplus that brings prosperity to Chinese manufacturers and urban workers, and inflation, which threatens China's price stability. Bloomberg reports that China's trade surplus might be fueling China's inflation problems.

One possible explanation is that the increase in the trade surplus outpaces the increase in potential output. Net exports are one component of aggregate demand in China. An increase in net exports pushes the aggregate demand curve to the right. Potential output increases as China utilizes more of its work-force (labor-intensive growth) and increases its capital stock (capital-intensive growth). The graph below shows that the increase in potential output (LRAS1 to LRAS2) is less than the increase in aggregate demand (AD1 to AD2). Whenever the increase in aggregate demand exceeds the increase in potential output, inflation is sure to follow (for example, from SRAS1 to SRAS2).
1. China maintains a relatively fixed nominal exchange rate between the yuan and the U.S. dollar (nominal exchange rate = 8 yuan per U.S. dollar). The real exchange rate is the nominal exchange rate times the ratio between the U.S. price level and the Chinese price level. The real exchange rate also represents the cost of U.S. goods and services relative to Chinese goods and services. How does an increase in China's inflation rate affect the real exchange rate?

2. How does an increase in China's inflation rate affect the trade balance between the United States and China?

3. The People's Bank of China often keeps its nominal interest rate equal to the United States' nominal interest rate in order to maintain the fixed nominal exchange rate (interest rate parity). Can the Bank of China choose to fight inflation and keep the nominal exchange rate fixed?

Sticky Prices and the Xbox 360

If you recently tried to purchase an Xbox 360 at the retail price of $300, then you were probably out of luck. Every retailer in the United States is completely sold out of the console, and retailers have no idea when they will have the console back in stock.

Shortages should cause prices to rise, but the market price of a Xbox 360 debuted at $300 and has stayed there (despite shortages). Microsoft is responding to the shortage by producing more Xbox 360's rather than raising prices.

A Keynesian economist is not surprised by Microsoft's short-run behavior. Let's examine the effects of sticky prices on the macroeconomy if every firm behaved like Microsoft. The graph on your right shows the Keynesian model, or the short-run macro model. Suppose the economy is producing $6 trillion worth of output, a level below the equilibrium output. Notice that when output equals $6 trillion, planned aggregate expenditure equals $8 trillion. In other words, planned spending exceeds output. According to the Keynesian model, prices are sticky, hence firms respond to excess demand by raising output, not raising prices.

Firms like Microsoft will raise output until planned aggregate expenditures equal aggregate output.

Notice that the short-run equilibrium output need not be at full employment output (FE).

1. If prices are sticky and the economy is operating below its full employment output (or potential output), what policies should the Fed and Congress pursue?

2. What causes prices to be sticky? Readings on the possible causes: Tim Harford and Alex Tabarrok

3. What happens to prices if the economy is below its full employment output for 6 months, 1 year, 2 years?

Professor Resource: PowerPoint Slides
Topics: Keynes, Keynesian model, Sticky prices