Lecture 7. MONETARY POLICY Economics 1490 THE WORLD ECONOMY: GROWTH OR STAGNATION? with Professor Dale W. Jorgenson Lecture 7. MONETARY POLICY September 21, 2017 Harvard University Department of Economics Fall 2017

THE WORLD ECONOMY: GROWTH OR STAGNATION? A. Comparing Economies B. U.S. Crisis and Recovery C. European Slowdown D. Asian Economic Miracles E. Sustainability of Economic Growth F. World Economic Outlook

B. U.S. CRISIS AND RECOVERY 6. U.S. Financial Crisis 7. Monetary Policy  8. Financial Regulation 9. Fiscal Policy  10. Secular Stagnation

SUPPLEMENTARY READING John B. Taylor (1993), “Discretion Versus Policy Rules in Practice,” Carnegie-Rochester Conference Series on Public Policy 39, pp. 195-214. http://web.stanford.edu/~johntayl/Papers/Discretion.PDF Lars Svensson (2010), “Inflation Targeting,” Ch. 22 in Benjamin M. Friedman and Michael J. Woodford, eds., Handbook of Monetary Economics, Amsterdam, Elsevier, pp. 1237-1302. http://www.nber.org/papers/w16654.pdf Ben S. Bernanke (2015), “The Taylor Rule: A Benchmark for Monetary Policy,” Washington, DC, The Brookings Institution, April 28. https://www.brookings.edu/2015/04/28/the-taylor-rule-a-benchmark-for-monetary-policy/

BEN S. BERNANKE

THE COURAGE TO ACT

BEN S. BERNANKE BIOGRAPHY 14th Chairman of the Federal Reserve, Sworn In February 1, 2006. Born Augusta, Georgia, December 13, 1953; Raised in Dillon, South Carolina. Harvard College, B.A. in Economics, summa cum laude, in 1975. Resided in Winthrop House. MIT Ph.D. in Economics in 1979. Taught at Stanford Business School and Princeton University. Member of the Federal Reserve Board of Governors, 2002-2005. Chairman of the President’s Council of Economic Advisers under George W. Bush, 2005 until appointment as Chairman of the Fed.

THE FEDERAL RESERVE AND THE CRISIS BEN S. BERNANKE: THE FEDERAL RESERVE AND THE CRISIS The Global Financial Crisis and the Great Recession Triggers and Vulnerabilities Analogy with the Dot-Com Bubble Initially Moderate Losses to Subprime Mortgage Holders Cascaded Throughout the System.

PRIVATE SECTOR VULNERABILITIES High Levels of Leverage Excessive Dependence on Unstable Short-Term Funding Deficiencies in Risk Management Use of Exotic Financial Instruments

PUBLIC SECTOR VULNERABILITIES BEN S. BERNANKE: PUBLIC SECTOR VULNERABILITIES Gaps in the Regulatory Structure Failure of Supervisors/Regulators Insufficient Attention to Threats to the Stability of the Financial System as a Whole

THE FEDERAL RESERVE’S REACTION BEN S. BERNANKE: THE FEDERAL RESERVE’S REACTION The Fed Provided Liquidity to Commercial Banks and Other Financial Institutions, Such as Investment Banks and Money Market Funds. The Fed Also Provided Liquidity to Borrowers and Investors in Key Asset Markets. The Fed Approved Currency Swap Agreements with 14 Central Banks. The Fed Conducted Stress Tests of the Largest Banks.

BEN S. BERNANKE: REGULATORY REFORM Bank Capital Regulation under Basel III Comprehensive Capital Analysis and Review (CCAR) Financial Stability Oversight Council Office of Financial Stability and Research

BEN S. BERNANKE: MONETARY POLICY Federal Funds Rate Has Been at Its Effective Lower Bound since the End of 2008 Enhanced Forward Guidance Large Scale Purchases of Longer-Term Securities (Quantitative Easing) Bank of Japan, Bank of England, European Central Bank Policies

BEN S. BERNANKE: UNCONVENTIONAL MONETARY POLICY AND RETURN TO NORMAL The Combination of Forward Guidance and Quantitative Easing Has Helped Promote the Recovery Tools to Normalize Monetary Policy: Interest Rates on Deposits with the Fed, Drain Bank Reserves and Tighten Control over Money Market Rates FOMC Will Return to Conducting Monetary Policy by Adjustments in the Short-Term Policy Rate Operating Framework May Change in Light of Experience with Unconventional Monetary Policy

JOHN B. TAYLOR

JOHN B. TAYLOR BIOGRAPHY Mary and Robert Raymond Professor of Economics, Stanford University. Born in Yonkers, New York, December 8, 1946. Princeton University, B.A. in Economics, summa cum laude, in 1968. Stanford University, Ph.D. in Economics, in 1973. Taught at Columbia, Princeton, and Stanford. Member of the President’s Council of Economic Advisers under George H.W. Bush, 1989-1991. Undersecretary for International Affairs, 2001-2005.

TAYLOR’S VIEW OF THE FINANCIAL CRISIS The Panic of 2008 The Fed Held Interests Rates Too Low, Beginning Around 2003 Affordable Housing Policy Promoted an Expansion of Mortgage Lending The Fed Pursued an Ad Hoc Bailout Policy The Fed Adopted Unconventional Monetary Policy

THE PANIC OF 2008

TAYLOR’S RULE FOR MONETARY POLICY If the Federal Reserve’s Inflation Target is Two Percent: FFR = π + 0.5 GAP + 0.5 (π – 2) + 2 Where: FFR – federal funds rate π – inflation rate GAP – ln GDP(actual) – ln GDP(potential)

NUMERICAL EXAMPLE OF TAYLOR’S RULE Taylor’s Rule Reduces to: FFR = 1.5 π + 0.5 GAP + 1 Example: In 1989 at the beginning of the Great Moderation: The FFR was 10%. 1.5 times the inflation rate (π) of 5% + 0.5 times the gap of 3% (actual GDP was greater than potential) + 1% 7.5% + 1.5% + 1% = 10%

INFLATION TARGETING Inflation Targeting is a Monetary Policy with a Fixed Inflation Target. Flexible Inflation Targeting: The Taylor Rule with a Lag or Lead Before the Crisis Twenty-Five Banks Used Inflation Targeting This Included the Bank of Canada and the Bank of England, but Not the Federal Reserve

CHANGES IN MONETARY POLICY LEADING UP TO CRISIS

CENTRAL BANK PREFERENCES

TAYLOR FRONTIER Source: Figures 4 and 5 and Mervyn King’s Stamp Memorial Lecture, Oct. 9, 2012.

SHIFTING FROM LIQUIDITY OPERATIONS

TAYLOR RULES

THE FEDERAL RESERVE’S AD HOC BAILOUT POLICY Bailout of Bear Stearns The Lehman Bankruptcy The Troubled Asset Relief Program (TARP) Modification of TARP on September 19, 2008

STOCK MARKETS BEFORE AND AFTER

THE SLOW RECOVERY Taylor: Policy is the Problem Reinhart-Rogoff: The Financial Crisis Summers: Secular Stagnation

ECONOMIC GROWTH FOLLOWING RECOVERIES

THE BERNANKE-TAYLOR DEBATE: SUMMARY Bernanke and Taylor Agree on the NICE Period Taylor Argues That the Fed Ended the NICE Period Bernanke and Taylor Disagree on the Zero Interest Rate Bound They Also Disagree on Unconventional Monetary Policy