Teaching monetary policy after the crisis

Andrew Hill and William Wood of Philadelphia Fed have a  nice write-up on the topic. After mentioning about changes in general economic teaching economists are getting more specific. First there were some proposed changes in teaching of finance (this and this). Now let us look at monetary policy.

Hill and Wood say current monetary policy is not your mother and father’s monetary policy anymore. In order to make it realistic, profs need to teach monetary policy in both good and bad times.

There is a nice discussion on how textbooks have treated mon pol so far. They would mention three tools for mon pol:

  • Reserves — The text would explain that commercial banks are required to hold funds in reserve against their deposits, and that the Federal Reserve can change the quantity of money to achieve economic goals. For example, if the Federal Reserve reduces the reserves that banks are required to hold, banks have a greater ability to lend, and can expand lending, creating multiple new deposits through the process summarized in the “money multiplier.”
  • Discount Rate — Next, students would be shown how the Federal Reserve can encourage lending through changes in the discount rate, or the interest rate it charges member banks for loans.
  • Open Market Operations — Finally, students would see how the Federal Reserve’s purchases and sales of government securities, called open market operations, can change bank reserves and therefore the quantity of money.

OMOs in turn determine the fed funds rate. Unlike other central banks which just announce the policy rate, Fed actually achieves its announced rate by conducting OMOs.

Books mention it in the same order implying reserves would be very important. However, Fed hardly uses this tool in normal times. Same with discount rates. It is OMOs which is the most important tool but is less talked about:

The order in which textbooks present the elements of monetary policy makes sense because reserve requirements, coming first, are the easiest of the Fed’s policy tools to understand. Open market operations are the hardest. And yet the textbook treatment leaves the impression that changes in reserve requirements are a viable monetary policy option for the Federal Reserve in ordinary times. In fact, reserve requirements have not been changed since the 1990s, and were not changed during the crisis that began in 2007. The textbook treatment also tends to leave students believing that discount rate changes are important. In fact, discount rate policy has become passive in ordinary times, in that the discount rate only reflects other Federal Reserve policies — rather than being an independent way of influencing the quantity of money.

As the Federal Reserve Board states on its website, open market operations are the Fed’s “principal tool for implementing monetary policy.”1 For teachers, the implication is that the most important tool of monetary policy is the hardest one for students to learn. The Federal Open Market Committee (FOMC) guides open market operations by specifying targets for an important short-term interest rate, the federal funds rate. It is open market transactions, usually carried out on a daily basis, which affect the amount of money and credit available in the banking system. In turn, these changes in the supply of money and credit affect interest rates, which in turn affect the spending decisions of households and businesses and ultimately the overall performance of the U.S. economy.

So there were problems even before the crisis.

Post crisis, authors say many changes need to be explained. This business of interest rates reaching zero and introducing so many programs to support markets has never been done before. Post-crisis main idea which needs to be explained is liquidity:

The most important idea for students to understand about financial crisis management is the concept of liquidity. Liquidity is the ability to quickly convert something of value into spendable money. For example, a savings account has a great deal of liquidity for an individual bank depositor. The depositor can get cash with a quick visit to the bank — or can convert the savings to checking money with the click of a mouse. A home has much lower liquidity, in that an individual could convert its value to spendable cash only with a long process of selling the real estate.

Just like individuals, banks and other financial institutions sometimes need more liquidity. Think about a bank that has valuable holdings, such as sound and well-secured loans. Because the payments on the loan come in periodically over time, the bank does not have immediate access to the amount of the loan. It can therefore face liquidity troubles if it is confronted by sudden demands. In ordinary times, banks and the Federal Reserve work together to ensure sufficient amounts of liquidity. In a crisis, however, liquidity can dry up. At such a point, the Federal Reserve will almost certainly be called on to restore liquidity.

They explain in plain english the various programs started by Fed. Superbly done.

In sum, one needs to teach following:

  • We need to continue to teach students about the Federal Reserve’s conduct of monetary policy, implemented, in ordinary times, day-to-day through open-market operations.
  • In addition to making certain that our students understand the causes of the financial crisis that began in 2007, we need to ensure that we teach them about the importance of liquidity in a time of crisis. This provides the foundation for teaching about the extraordinary measures that the Fed took as lender of last resort to increase liquidity in specific credit markets and the economy as a whole.
  • We need to emphasize to our students that providing liquidity in times of crisis can reduce financial damage and increase overall stability.
  • We need to ensure that our students understand how and why the Federal Reserve expanded its balance sheet, making it possible to increase liquidity through lending programs during the height of the crisis and to implement so-called quantitative easing during the lingering period of weak economic growth.
  • We need to present our students with comparisons to other times in our nation’s history (i.e., the Panic of 1907 or the Great Depression) when, with less understanding of monetary economics, policymakers had few tools to mitigate the effects of a financial crisis or used the wrong policy for the economic conditions.

Hmm…A nice simple note…Teachers could use it right away…

But this is too US specific. Students would also need to know what other/their central banks did in brief. Profs need to just add that as well in brief to give a better perspective.

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2 Responses to “Teaching monetary policy after the crisis”

  1. Parul Says:

    Only learning about the monetary policies is not enough…we have been learning about them from 12th standard..it would have been more better if that knowledge is also applied practically.. by making the courses teaching these monetary policies more application based.

  2. loan Says:

    loan…

    […]Teaching monetary policy after the crisis « Mostly Economics[…]…

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