Unemployment and Monetary Policy; Taylor Rule

In this box you will connect the earlier labor market box to monetary policy before, during, and after the financial crisis.In the earlier box you looked at the unemployment rate for the 2006-2016 period. Now you are going to add inflation and the Fed Funds Rate (the benchmark interest rate of the US).- Go to BLS.gov and look for 1) the Unemployment Rate, and 2) the Consumer Price Index (inflation).- Get the Effective Federal Funds Rate from the St. Louis Federal Reserve Bank FRED databaseThe relation between interest rates, unemployment, and inflation is clearly stated in the Federal Reserve document accompanying these instructions.In the box you have to document and explain these three indicators during the Great Recession; make sure you plot the variables separately.(1000-1200 words)Required TextsDavis, Morris, Macroeconomics for MBAs and Masters of Finance, Cambridge University PressISBN-13: 978-0521762472ISBN-10: 052176247Chapter 6 in the Davis textbook. Powerpoint for chapter 6 lecture attached, Grading metrics attached. Sample of approved work attached.
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ECON 562
Macroeconomic Analysis & Public Policy
Module 7: Central Banks
Copyright 2017 Montclair State University
Introduction
Central Banks
The Federal Reserve (The Fed)
Monetary Policy
Monetary Aggregates
ECON 562
Macroeconomic Analysis & Public Policy
Module 7a: Central Banks
Central Banks
• Central banks are the monetary
authorities within national governments.
• They have policy, regulatory, and
operational functions.
• The first two central banks were the
Swedish Riksbank (1668) and the Bank
of England (1694).
• The current central banking system of
the United States was established in
1913.
ECON 562
Macroeconomic Analysis & Public Policy
Module 7b: The Federal Reserve (The Fed)
The Federal Reserve
The Federal Reserve System has 3 parts:
1. Federal Reserve Board of Governors (“Federal
Reserve Board”)
2. 12 Regional Federal Reserve Banks, one for
each “district”
3. The Federal Open Market Committee (“FOMC”)
The System has 3 responsibilities:
1. Provide financial services (i.e. check processing)
2. Supervise and regulate banks
3. Conduct monetary policy
The Federal Reserve
Bank supervision is fundamental for a sound financial system.
The U.S. government insures deposits. Bank regulators are
supposed to ensure that banks do not take “excessive” risks lending
these deposits.
The 2007 financial crisis has illustrated (again) that banking panics
appear to precede bad economic outcomes. Appropriate bank
supervision reduces the probability of a banking panic.
Large financial institutions may control, directly or indirectly, a
significant portion of the financial transactions in the United States
and thus may be “too big” to fail. “Stress tests” are aimed at reducing
the probability of a government bailout of those institutions.
The Federal Reserve
The 12-member FOMC (8 permanent
members and 4 temporary members) is
responsible for the setting of monetary
policy.
• The 8 permanent members: All 7 members of
the Federal Reserve Board and the president
of the Federal Reserve Bank of New York.
• The 4 temporary members are rotating
Federal Reserve bank presidents that serve
one-year terms.
• The Chairman of the Federal Reserve Board
is also the Chairman of the FOMC.
ECON 562
Macroeconomic Analysis & Public Policy
Module 7c: Monetary Policy
Monetary Policy
• The main policy tool of the FOMC is
the setting of the “Federal Funds
Rate,” the overnight right at which
banks can borrow bank reserves.
• The FOMC adjusts the Fed Funds
rate through “Open Market
Operations.”
Monetary Policy
To lower the Fed Funds rate:
• The FOMC buys U.S. Treasuries from brokers or dealers and pays
them by depositing reserves into their accounts.
• This increases the supply of reserves, the increase in the supply
implies that the market interest rate on reserves falls.
To increase the Fed Funds rate:
• The FOMC sells U.S. Treasuries to brokers and dealers and
collects payment from their reserve accounts.
• This reduces the total amount of reserves in the economy, causing
the interest rate on reserves to increase.
Monetary Policy
What does the FOMC consider when
deciding on the appropriate Federal Funds
Rate?
• The Federal Reserve Act in 1977 says the
FOMC has a dual mandate “to promote
effectively the goals of maximum employment,
stable prices, and moderate long-term interest
rates.”
• Because long-term interest rates can remain low
only in a stable macroeconomic environment,
these goals are often referred to as the dual
mandate to promote maximum employment and
price stability.
Monetary Policy
• So how does the FOMC determine the Fed Funds rate to
satisfy its dual mandate?
• The FOMC meetings are held behind closed doors, and
the FOMC has never announced a formal policy.
• Just recently, after the Financial Crisis of 2007, it
announced a 2% inflation target.
• However, the FOMC appears to set interest rates with
the dual mandate in mind as a function of two variables,
the output gap and the consumer-price inflation rate.
• The output gap, is a measure of the economy’s
deviation from “maximum employment.”
• The inflation rate relates to the goal of “stable
prices.”
Monetary Policy
Academics and analysts commonly use the “Taylor Rule“ to characterize monetary policy, it
is represented by:
??
??
??
• ??
= ? * + ?? ?? + ?1 100 * ??
????
????*
+ ?2 ?? – ? * ,
— nominal Federal Funds, annualized percent
• ?? — four-quarter consumer-price inflation, annual percent
• 100 * ??
????
????*
— percent “output gap
• ?? ?? — The inflation-adjusted annualized Federal Funds rate when the output gap is zero
and inflation is equal to its target rate.
• ? * — FOMC’s “target rate” of consumer-price inflation, annual percent
• ?1 and ?2 are coefficients that measure how the FOMC adjusts the Fed Funds rate in
response to changes in the output gap or the inflation rate.
Monetary Policy
All together. Suppose inflation decreases below its target level.
The Taylor rule suggests the FOMC will reduce the Fed Funds rate.
• To reduce the Fed Funds rate, the FOMC buys Treasury bills to banks and
increases bank holdings of reserves in exchange.
• Banks can lend out excess reserves, so any increase in reserves also increases the
quantity of loanable funds.
• Loanable funds are allocated as loans that go as spending into the economy.
ECON 562
Macroeconomic Analysis & Public Policy
Module 7d: Monetary Aggregates
Monetary Aggregates
Since Central Banks control the money supply, episodes
of very high inflation are associated to “too” much printing
of money.
How to measure the money supply? Three definitions of
the stock of money are commonly used, M0, M1, and M2.
• M0 is the stock of currency plus reserves held by banks in
their accounts with the Federal Reserve. M0 is
sometimes called the “monetary base.”
• M1 is currency in circulation, demand and other
checkable deposits, and travelers checks. This is
typically what people think of as “money.”
• M2 is equal to M1 plus close substitutes: money market
accounts, savings accounts, and (small) time deposits.
Kurek 1
Melanie Kurek
ECON562_52: Macroeconomic Analysis and Public Policy
Luis San Vicente Portes, Ph.D.
26 November 2017
Module 4 Box – Participation; Alternative Measures
Introduction to the Study of Labor and Leisure:
The battle between consumption and leisure has affected households for hundreds and hundreds of
years. Individuals produce labor to earn wages to then be able to spend these wages on consumption or
in other words, goods and services. The reality is that households need to work in order to have
discretionary income to purchase products, while households also want to enjoy leisure. Households
ultimately receive utility from two goods, consumption and leisure (Davis, 2009). When a household
works extra hours of labor to earn wages, they may have more income but then there is also not a lot of
time for leisure activities. The work-life balance is a trade-off that consumers have been trying to
perfect for ages, however, when economic factors such as interest rates and the recession affect labor
and wages, this also influences labor and leisure.
In order to understand how economics such as the financial crisis affects consumer spending it is
important to first recognize the various aspects of current consumption and future consumption.
Interest rates play a vital role in influencing whether money gets spent today or saved for the future.
During periods of low interest rates, households will most likely spend their wages on consumption
today and not invest as much for the future due to the investment not earning enough interest to make
it worth investing. On the other hand, when interest rates are high the rate of future consumption
increases while current consumption decreases. When money has the potential to be worth more in the
future then consumers will take this opportunity to invest. As interest rates begin to increase,
households begin to also have more options as to where they invest their money whether it be in the
stock market or bonds. This opens up a whole new aspect into how various types of households invest
depending on their level of risk, whether it be neutral, adverse or seeking.
Before households can invest their money for future spending or spend money now, a crucial factor
before this can even happen is the fact that labor and wages need to occur. Labor influences leisure and
also determines the amount of income able to be spent. With consumption (C) and leisure (N), the
formula below can be used for interpreting the optimal hours of work:
? = ???.
It is important to note that households are assumed to have 16 hours in a given day to devote to
whatever activities they chose whether it be labor or leisure. Two constraints which are time and
budget play a large part in determining the optimal hours of work. To gain more insight, households
much ask themselves three basic questions:
1. How much should I work?
2. How much should I consume?
3. How much leisure should I enjoy?
Kurek 2
The phenomenon that income and substitution effects cancel out are telling in that it shows that the
household and the wage are independent from one another.
The Unemployment Rate:
During times of a financial crisis such as the recent recession in the United States, the unemployment
rate becomes almost at an all time high. The economic concept of a recession creates a domino effect
where the unemployment rate rises, consumer spending falls, which in turn affects businesses who have
no choice but to lay off a large portion of the labor force to save money (Nickolas, 2015). In a true
recession there is a negative gross domestic product growth and during this perfect storm, discretionary
income decreases as unemployment rises amongst households. The graph below depicts the
unemployment rate in the United States from 2006 to 2016:
USA Unemployment Rate from 2006 to 2016
12.0
10.0
6.0
4.0
2.0
0.0
January
May
September
January
May
September
January
May
September
January
May
September
January
May
September
January
May
September
January
May
September
January
May
September
January
May
September
January
May
September
January
May
September
Unemployment Rate
8.0
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Year
Unemployment Rate
Linear (Unemployment Rate
)
Data from www.bls.gov
The fascinating part is within this decade long data, the unemployment rate at the start, January 2006,
was the same as at the end, December 2016, which were both at 4.7%. Within this time period as
shown in the graph, the level begins to rise in 2008 and peaks with a high of 10% in October of 2009.
During this peak, economic growth in the US slows exponentially. After the effects of the recession, it is
difficult for the economy to turn around and takes time for the effects to wear off. The average annual
unemployment rate was over 9% during 2009 and 2010 and did not even go under 6% until 2015 when
the average for the year was 5.3%. This indicates it took over 5 years to drop 4% and concludes the
country had a challenging time economically during these years. The aftermath of a financial crisis
resulted in businesses not having enough money to pay employee wages. Organizations either lowered
wages or reduced labor by letting workers go, which caused the money supply to tighten due to
households spending less.
Kurek 3
Labor Force Participation Rate:
Just as the unemployment rate rises during an economic financial crisis, the labor force participation
rate of individuals, aged 16 and older, falls. The graph below shows the civilian labor force participation
rate from 2006 to 2016 in the United States, which clearly shows the steady downward trend over the
last 10 years with a 3.3% drop from January 2006 to December 2016. During a recession, many older
workers reevaluate their position in the labor force and while some generations such as the babyboomers may retire, other younger workers may go back to school which also lowers the amount of
individuals currently seeking employment opportunities. The extensive margin correlates with whether
or not to work and given a financial crisis, many households must make the decision to retire early or go
back to school in the hope of upon graduating the market recovers.
67.0
66.0
65.0
64.0
63.0
62.0
61.0
60.0
59.0
Civilian Labor Force
Participation Rate
January
September
May
January
September
May
January
September
May
January
September
May
January
September
May
January
September
Labor Force Participation Rate
USA Civilian Labor Force Participation Rate from 2006
to 2016
Linear (Civilian Labor
Force Participation Rate)
20062007200820092010201120122013201420152016
Year
Data from www.bls.gov
A lower participation rate generally equates to a lower unemployment rate (Sherk, 2014). While on the
surface it may seem that the recovery period for the financial crisis is helping to improve the overall
economy, it is important to not just look at the unemployment rate but also other factors such as the
trend of the civilian labor force participation rate. When analyzing these two rates, it can be concluded
that the unemployment rate is actually lower because there are less households actively seeking work,
thus showing that the recovery period is still not over. In 2006, before the economic crisis, the labor
force participation rate was high at around 66.2% and stays relatively the same at an average of 66% for
both 2007 and 2008. It isn’t until 2009 the rate begins to steadily decrease and year after year the
percent drops. The numbers year after year show that even during the recovery period households
made the decision to enjoy leisure and lower consumption by no longer providing labor and gaining
wages.
Hours of Work:
Along with analyzing the unemployment rate and the percent of the civilian labor force, it is just as
imperative to see the large picture which includes also looking at the average weekly hours of all
Kurek 4
employees (total private, seasonally adjusted). The graph below shows the average weekly hours from
2006 to 2016 in the United States.
34.8
34.6
34.4
34.2
34
33.8
33.6
33.4
33.2
Average weekly hours of all
employees, total private,
seasonally adjusted
January
September
May
January
September
May
January
September
May
January
September
May
January
September
May
January
September
Average Weekly Hours
USA Average weekly hours of all employees, total
private, seasonally adjusted from 2006 to 2016
Linear (Average weekly
hours of all employees,
total private, seasonally
adjusted)
20062007200820092010201120122013201420152016
Year
Data from www.bls.gov
Before and after the recession hit the average weekly hours were around the same rate, however, in
2009 there was a slight drop which indicates that a downward trend in the economy also affects the
average hours worked. The only time the annual average was lower than 34 hours was in 2009, at the
height of the crisis. Although the decrease was not as significant as the unemployment rate and the
labor force participation rate during the recession, it is still enough to warrant the trend. The interesting
part of labor hours is there is only so many hours in a day that households can dedicate to labor. While
it is ultimately up to the household to decide where to spend their 16 hours a day, whether it be leisure
or labor, there is a connection to hours worked and a financial crisis.
Another fascinating notion is that the hours worked were not as affected as the other analyzation
factors such as unemployment. This poses a question: why does the wage rate not affect the amount of
hours? This can be answered with two concepts:
•
•
the income effect: when wages go up, a household becomes richer and households gets to
consume more of what they like, for example leisure
the substitution effect: when ages go up the cost of staying home also increases making
households want to work more and consume less leisure (Davis, 2009).
Given these factors, since the intensive margin refers to how many hours a household works, it can be
concluded that the wage rate does not affect hours. Since wage does not correlate to hours, there must
be another reason why labor hours can drop, even if it is only slightly. Based on the information for
average hours worked from 2006 to 2016 it can be predicted that a financial crisis can decrease hours,
even if it is only a minor difference for a short period of time.
Kurek 5
Conclusion:
The financial crisis affects more than just businesses and the stock market; it raises the unemployment
rate, while lowering the amount of workers willing and able to work and slightly decreases the amount
of hours worked weekly. During a recovery period, unemployment rates take longer to decrease and
many drop out of the labor force as shown in the steadily decreasing labor force participation rate from
2006 to 2016. On the other hand, the average amount of hours worked weekly mostly holds constant
other than a slight decrease during a large economic downturn. While interest rates may affect a
households ability to save for future consumption versus current spending, tax on wages have no
fundamental affect to the amount of hours worked and workers must decide between labor and leisure.
Kurek 6
References
Bureau of Labor Statistics. (n.d.). Retrieved November 20, 2017, from https://www.bls.gov/home.htm
Davis, M. A. (2009). Macroeconomics for MBAs and Masters of Finance. Cambridge: Cambridge
University Press.
“M4: Households: Labor-Leisure Decision,” Macroeconomic Analysis and Public Policy, Luis San Vicente
Portes, Ph.D., Montclair University, Feliciano School of Business
Nickolas, S. (2015, March 25). Why does unemployment tend to rise during a recession? Retrieved
November 20, 2017, from https://www.investopedia.com/ask/answers/032515/why-does
unemployment-tend-rise-during-recession.as
Sherk, J. (2014, September 4). Not Looking for Work: Why Labor Force Participation Has Fallen
During the Recovery.Retrieved November 20, 2017, from http://www.heritage.org/jobs-andlabor/report/notlooking-work-why-labor-force-participation-has-fallen-during-the-recovery
Box 7
(24 points)
In this box you will connect the earlier labor market box to monetary policy before, during, and after the
financial crisis.
In the earlier box you looked at the unemployment rate for the 2006-2016 period. Now you are going to
add inflation and the Fed Funds Rate (the benchmark interest rate of the US).
– Go to BLS.gov and look for 1) the Unemployment Rate, and 2) the Consumer Price Index (inflation).
– Get the Effective Federal Funds Rate from the St. Louis Federal Reserve Bank FRED database.
The relation between interest rates, unemployment, and inflation is clearly stated in the Federal Reserve
document accompanying these instructions.
In the box you have to document and explain these three indicators during the Great Recession; make
sure you plot the variables separately.
The charts should have a title, distinguish the series, and the axis labeled (with time in x-axis, and label
variable(s) and units in the y-axis). (2points x 3charts = 6p)
– Unifying the analysis into a common framework with emphasis on the Fed’s mandate. (10 points; 5p)
Clarity (2 points)
Conciseness (2 points)
Continuity (2 points)
Cadence (2 points)

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