Archive for March, 2008

Mar 13 2008

Will the Fed’s easy money policy fuel global inflation?

Inflation Reality Check(The Korea Times)

Harvard Economist Kenneth Rogoff points out that inflation is a major problem in many of the world’s largest economies today:

Inflation in Russia, Vietnam, Argentina, and Venezuela is solidly in double digits, to name just a few possibilities.

Indeed, except for deflation-ridden Japan, central bankers could meet just about anywhere and see high and rising inflation. Chinese authorities are so worried by their country’s 7 percent inflation they are copying India and imposing price controls on food.

Even the United States had inflation at 4 percent last year, though the Federal Reserve is somehow convinced that most people won’t notice.

Usually, inflation can be combatted with restrictive monetary policy, or the selling of bonds on the open market, which reduces the money supply, raises interest rates and slows down consumption and investment, and thus the pressure on prices in the economy. Today, however, the US Fed is in the process of expanding money supply and lowering interest rates, in an attempt to avoid a recession at home.

In a world of isolated economies, the US monetary policy would only affect the US economy; however, today the US economy finds itself intertwined in complex ways with other economies of the world.

America’s inflation would be contained but for the fact that so many countries, from the Middle East to Asia, effectively tie their currencies to the dollar. Others, such as Russia and Argentina, do not literally peg to the dollar but nevertheless try to smooth movements.

As a result, whenever the Fed cuts interest rates, it puts pressure on the whole “dollar bloc” to follow suit, lest their currencies appreciate as investors seek higher yields.

Looser U.S. monetary policy has thus set the tempo for inflation in a significant chunk ? perhaps as much as 60 percent ? of the global economy.

The reason other countries must mimic US monetary policies has to do with exchange rates, which many countries try to peg to varying degrees to the value of the dollar. One of the determinants of exchange rates is relative interest rates between countries. If the US lowers interest rates, and a country like Argentina keep rates high, global investors looking for a return on their savings will take their money out of US savings accounts and deposit it in Argentinian savings accounts, where they can earn a greater interest rate. In order to save in Argentina, investors need to convert their dollars to Argentinian pesos, driving up demand for pesos and the dollar/peso exchange rate. A stronger peso could have negative impacts on demand for Argentina’s exports as they become more expensive to foreign consumers. In order to avoid appreciation of its currency and declining demand for its exports, Argentina is thus forced to lower its own interest rates as the Fed cuts those in the US.

When you consider that much of the world adjusts its currency in relation to the dollar, you can see how an easy money policy in the US could lead to falling interest rates worldwide, triggering all sorts of new consumption and investment, driving price levels ever higher.

There is hope for curing the inflation problem. Relief may come at a price for Americans, however:

If the U.S. tips from mild recession into deep recession, the global deflationary implications will cancel out some of the inflationary pressures the world is facing.

Global commodity prices will collapse, and prices for many goods and services will stop rising so quickly as unemployment and excess capacity grow.

Of course, a U.S. recession will also bring further Fed interest-rate cuts, which will exacerbate problems later. But inflation pressures will be even worse if the U.S. recession remains mild and global growth remains solid.

Once again the Fed’s challenge of balancing unemployment, inflation, growth and recession is made clear. The choice of several major world economies to affix their currencies’ values to that of the dollar makes the challenge ever more dire for Mr. Bernanke.

Discussion Questions:

  1. If a US interest rate cut is not matched by countries that tie their currency to the dollar, what would happen to the value of those countries’ currencies?
  2. Why are lower world interest rates inflationary?
  3. What will happen to the value of the Euro if the ECB does not start cutting interest rates soon?
  4. Why might a US recession counter the inflationary pressure caused by rising food and energy prices and loose monetary policy in the US and other nations?

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128 responses so far

Mar 12 2008

Helicopter Ben and Monetary Policy: the cartoon version!

Monetary Policy

Much hoopla is made over the US Federal Reserve’s power to affect markets through its injections of liquidity into the economy. These days, the Fed appears to have some new tricks up its sleeve, but still uses its traditionally dominant tool of Open Market Operations to affect the Federal Funds rate, and thus the interest rates that commercial banks charge borrowers financing consumption and investment.

The power of monetary policy lies in the fact that spending stimulus can be achieved without running the risk of crowding-out, wherein expansionary fiscal policy drives up interest rates, potentially off-setting any increases in aggregate demand by triggering declines in consumption and investment due to increased borrowing costs.The whole aim of expansionary monetary policy, on the other hand, is to drive interest down by increasing the reserves held by commercial banks.

The cartoon above illustrates the process that leads to lower interest rates and greater spending when the Fed undertakes expansionary open market operations. Government bonds (the blue bills above) are held as assets by both commercial banks and the public. These are illiquid, meaning they cannot be spent. In order to stimulate new spending, the Fed can take some of its reserves of money (the green bills), and buy bonds from the public and banks.

Banks receive cash from the Fed, which increases their excess reserves. Further, the public will deposit the checks they receive from the Fed into their banks, increasing checkable deposits, which add to both the banks’ required reserves and excess reserves. The result is banks now have new liquidity that they want desperately to lend out in order to earn interest (remember, banks rarely want to hold onto their excess reserves, because inflation will erode the value of any money that’s not earning interest!).

When banks’ reserves increase, due to their growing checkable deposits and the inflow of cash from the Fed’s purchase of bonds, the supply of “federal funds” shifts down, lowering the interest rates that banks charge one another for overnight loans. These are loans that banks often give and receive in order to meet their reserve requirements at the end of a business day.

For example: If Bank A has finds at the end of the day that it has received more deposits than withdrawals, and it now has $1m more in its reserves than it is required to have, it wants to lend that money out as soon as possible to earn interest on it. Bank B, it just so happens, received more withdrawals than it did deposits during the day, and is $1m short of its required reserves at day’s end. Bank B can borrow Bank A’s excess reserves in order to meet its reserve requirement. Bank A will not lend it for free, however, and the rate it charges is called the “federal funds” rate, since banks’ reserves are held predominantly by their district’s Federal Reserve Bank.Federal Funds market

When the Fed buys bonds, all banks experience an increase in their reserves, meaning the supply of federal funds shifts out (or down in the graph above), lowering the “price” of federal funds, i.e. the federal funds rate. Lower interest rates on overnight loans will encourage banks to be more generous in their lending activity, allowing them to lower the prime interest rate (the rate they charge their most credit-worthy borrowers), which in turn should have a downward effect on all other interest rates.

Expansionary monetary policy involves the buying of government bonds on from the public and commercial banks by the Federal Reserve Bank. The result of this buying of bonds is an increase in the money supply, a decrease in real interest rates, and hopefully the stimulus of aggregate demand through new consumption and investment. Unlike expansionary fiscal policy (such as the stimulus package announced by Congress last month), crowding-out should not occur. Ideally, lowering the federal funds rate will lead to lower interest rates across the economy as a whole.

This, however, does not always transpire. In a future post, we’ll discuss why, and look at what the Fed is experimenting with today to stimulate investment and consumption, in response to the apparent failure of open market operations at providing the needed stimulus.

34 responses so far

Mar 11 2008

IB program “anti-American”?

Published by under IB Economics,Teaching

Utah lawmakers, fearing UN conspiracy, kill funds for International Baccalaureate program – Salt Lake Tribune

In Utah, law-makers fear the IB program, which they believe is a United Nations conspiracy to take over the minds of young, patriotic Americans and corrupt them with a global-perspective of the world.

Lawmakers decided against helping Utah schools pay for International Baccalaureate (IB) programs after one legislator called IB’s philosophy “anti-American” today.

“I’m not opposed to understanding the world,” Sen. Margaret Dayton, R-Orem, told members of the Senate Education Committee. “I’m opposed to the anti-American philosophy that’s somehow woven into all the classes as they promote the U.N. [United Nations] agenda.”

Remind me never to go teach in Utah. This is an absurd and frightening statement about America. I understand these legislators’ views don’t by any means represent any sort of consensus among Americans; in fact, the US graduates more IB Diploma students each year than any other country. That any law-maker would vote against a modest proposal to fund this program on the grounds that it “anti-American” puts on stark display for the world the insecurity, fear, and close-mindedness a certain, right-wing section of the American population.

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23 responses so far

Mar 10 2008

Welker’s Wikinomics celebrates its 1st birthday with exciting new features for Economics teaches and students

Welker’s Wikinomics – the Universe

AP/IB Exam Prep – Smartboard Study Guides

Exciting things are happening here at Welker’s Wikinomics. In February the blog and wiki had their first birthday; it was one year ago that I launched the wiki as a tool for extending the AP Economics program beyond the classroom and into the world of Web 2.0. What started as a small experiment in learning the wiki way has expanded into an online learning environment encompassing multiple Web 2.0 technologies.

Between the wiki and the blog Welker’s Wikinomics has welcomed over 70,000 visitors since June of 2007! Besides SAS students, the wiki and blog are visited by readers interested in economics from every continent!

Since September, two new exciting features have been added to the online learning environment here. First, the SAS Economists Blog, written by AP Econ students, which has seen dozens of posts, had thousands of readers, and enjoyed comments and feedback from people around the world.

Most recently, Welker’s Wikinomics Universe was launched using the Netvibes platform. This website, linked from the home page and in the menu bar above, is a resource for anyone who wants to read economics news and blogs, listen to econ podcasts, follow the progress of our student wiki and blogs, or find links to valuable resources for teaching economics. The page integrates RSS feeds to keep readers posted on the latest news stories, blog posts, and podcasts from leading media sources and economics bloggers. The site serves as an excellent research tool for students needing articles for their classes, or those simply interested in understanding how economics relates to the real world.

Finally, another technology I’ve been lucky to use here at SAS over the last year is the digital Smartboard, which has enabled me to save every lesson and lecture from each unit of the AP syllabus all year. Lately I’ve been refining these pages, and have created .pdf files for each unit from the AP syllabus, assembled them as a study guide, and uploaded them to make them available for all AP Econ students to use as review for the upcoming exams (2 months away!). These documents can be found in the “AP/IB Exam Prep” page, linked from the menu bar above. They are not intended as a stand-alone study guide, rather are meant to accompany the class wiki, which contains far more comprehensive information on the details of the AP Econ course.

I sincerely hope that the resources here in Welker’s Wikinomics World have proven useful for Econ students and teachers. I sense that students here at SAS seem to benefit from these tools, although I suppose we’ll know for sure when their exam results come back at the end of the summer! Good luck, students, in these final few weeks before your AP exams!

6 responses so far

Mar 10 2008

Advice to Republican presidential nominee on taxes – “raise ’em!”

What McCain Could Do About Taxes – New York Times

McFlation?

[youtube EaR1CnfyrEo]

John McCain admits that economics is not his strongest suit. He recently claimed that he  wished “interest rates were zero.” Perhaps the fallacy of this policy position is over his head, but I think there are at least 74 AP Econ students here in Shanghai who could explain to Mr. McCain the inflationary impact zero percent interest rates would have.

Regardless, the article above is not about interest rates (thankfully, interest rate and monetary policy decisions will never be his to make even if he does end up in the White House, granted Fed independence remains intact!), rather, tax policy, which would be within McCain’s powers as the designer of the US federal budget. Ben Stein, economist, actor, and humorist, writes a letter to Mr McCain offering his advice on tax policy. Continue Reading »

17 responses so far

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