Economics 33600 / Business 33941

Fall 2004

John H. Cochrane john.cochrane@gsb.uchicago.edu HPC 459 702-3059

Class web page

http://gsbwww.uchicago.edu/fac/john.cochrane/teaching/Monetary%20Economics%20PhD%20course/

Sept 28 2004

Class description

This will be primarily a “readings” course. I will assign some exercises, primarily reproducing or extending simple pieces of empirical work. Our primary task though will be meeting and discussing articles. You must read and think about the readings before class, and be ready to discuss the readings in class. I will occasionally ask students to lead discussions on papers or parts of papers. You should be ready to do this. All the readings will be on the class website, except you need to buy a copy of Woodford’s Interest and Prices. It’s impossible to read every word of every paper here; you, like me, will have to develop the skill of figuring out what is important in each papers (usually not the introductions and conclusions).

Grades will reflect class participation, homework, and an exam.

Make sure you are getting class emails! There will be a lot of communication via the class email list. All materials except woodford’s text will be available on the class website.

I presume most students have taken the first year PhD macro courses. Your macroeconomics course should have covered some monetary economics, including a cash in advance and money in the utility function models. You should have one quarter of PhD level time series, and be ready to use simple time series models like AR(1)s, take conditional expectations, etc. with no fuss.

Bring a name card to every class at least until everyone in the class knows everyone else.

Reading list

1. Friedman and the big picture

The (supposed) effects of monetary policy.

· Friedman, Milton, 1968, “The Role of Monetary Policy,” American Economic Review

· J Bradford DeLong “The Triumph of Monetarism” Journal of Economic Perspectives 14, 83-94.

2. VARs

The attempt to document Friedman’s views in data.

Questions: What is a shock anyway? Why is it important to study policy shocks? Does studying responses to shocks mean we implicitly assume a model in which only unanticipated shocks have effects? How important is orthogonalization to the results? Vars are simple and deceptive!

· Christiano, Lawrence, Martin Eichenbaum and Charles Evans, “Monetary policy shocks: what have we learned and to what end?'' In Michael Woodford and John Taylor, eds, Handbook of Macroeconomics North Holland.

This one gets at the question of anticipated vs. unanticipated shocks:

· Cochrane, John, 1998, “What do the VARs Mean?: Measuring the Output Effects of Monetary Policy” Journal of Monetary Economics 41:2 (April 1998) 277-300.

Really short, but brings up an important issue – why aren’t we using interest rates, which arguably have the best power to forecast both output and future interest rates, in VARs? :

· Cochrane, John H. and Monika Piazzesi, “The Fed and Interest Rates – a High Frequency Identification” 2002 American Economic Review 92, 90-95.

I learned quite a bit more about what are and are not shocks by this one:

· Romer, Christina and David Romer, 2004, “A New Measure of Monetary Policy Shocks: Derivation and Implications” American Economic Review 94, 1055-1084.

· Cochrane, John H. 2004 “Comments on A New Measure of Monetary Policy Shocks’’ Manuscript, University of Chicago

For some directions on the mechanics of VARs, beyond obvious textbooks such as Hamilton, see my notes on Time series for macroeconomics and finance

3. Doubts

Can the fed nail the price level by setting the price of chewing gum in the C concourse of the United Airlines terminal at O'Hare? Also, we don’t do helicopter drops, we do open market operations. The Modigliani-Miller theorem says they should have no effect.

· Akerlof, George A., “Irving Fisher on His Head: The Consequences of Constant Threshold-Target Monitoring of Money Holdings,” The Quarterly Journal of Economics, Vol. 93, No. 2. (May, 1979), 169-187.

A model in which velocity is completely endogenous. More M, more V. Also a nice “near rational” analysis of money demand that might help to explain Lucas’ troubles with interest rates. I’ll quickly remind you of background you should know; the Baumol-Tobin and Miller-Orr inventory models of money demand. If these are totally new to you, look at any textbook.

· Friedman, Benjamin, 1999, “The Future of Monetary Policy: The Central Bank as an Army with Only a Signal Corps” International Finance 2:3 321—338

· Friedman, Benjamin, “Decoupling at the Margin: The Threat to Monetary Policy from the Electronic Revolution in Banking,” International Finance 3:2, 261-272

Friedman’s response to Woodford’s (and others’) response to Friedman

These papers are the tip of an iceberg of worrying that the Fed is powerless. For example, the entire July 1983 Journal of Monetary Economics v12, n1 (July 1983) dealt with the problem. (Fama and Hall’s papers are particularly good)

· Taylor, John, “Expectations, open market operations and changes in the federal funds rate.” St. Louis Fed Review, 2001 Vol. 83, No.4

An excellent reading on the details of fed procedures. What is the quantity side of the 50 bp experiment? – what is the path of reserves/open market operations?

· Deleted Guthrie, G. and Julian Wright (2000), “Open mouth operations” Journal of Monetary Economics 46, 2, 489-516.

It’s always been a puzzle that so large interest rate movements result from such tiny open market operations. In New Zealand, they don’t even do any open market operations. These are two of a recent slew of papers analyzing “open mouth operations.” There is a whiff here of “the fed matters because people think it matters” reflected in some more serious modeling we’ll do below.

4. Fiscal theory

· Cochrane, John H., 2004, “Money as Stock: Price Level Determination with No Money Demand.” Forthcoming (at last) Journal of Monetary Economics

· Cochrane, John H., 2001, “Money as Stock: Price Level Determination with No Money Demand.” NBER working paper 7498 . p.3-8 of this version contain the list of regimes that I will discuss in class.

· Cochrane, John H. ''Long Term Debt and Optimal Policy in the Fiscal Theory of the Price Level'' January 2001, Econometrica 69, 69-116.

For the class, only read from 7.1 on, pp. 99-108. This is why we can’t do Friedman and Schwartz for the fiscal theory. (I’ll do a 5 minute summary of the rest)

Thursday Nov 11:

· Sims, Christopher, 2001 “Fiscal Consequences for Mexico of Adopting the Dollar” Journal of Money Credit and Banking 33, 597-616.

As private firms should issue equity, so should governments issue money. Also starts on the important task of mixing fiscal theory with optimal taxation theory

· Schmitt-Grohe, Stephanie and Martin Uribe, 2004, “Optimal Monetary Policy Under Sticky Prices” Journal of Economic Theory 114, 198-230.

5. Fiscal history and events

· Burnside, Eichenbaum and Rebelo, 2001, “Prospective deficits and the Asian Currency Crisis”' Journal of Political Economy 106 (6) 1155-1197.

Thursday Nov 18:

6. Interest rate rules and “New Keynesian” Economics

We thought for a long time that interest rate targets lead to unstable price levels. And yet, the Fed does follow an interest rate target, and the price level doesn’t seem to be exploding. McCallum then pointed out that perhaps the price level could be stationary with a reactive interest rate – if the interest rate rises faster than inflation, perhaps inflation could be stabilized. Taylor noticed that a rule in which the interest rate rises more than inflation seems to characterize Fed behavior.

There is a huge literature now on “optimal Taylor rules”. For example, should the Fed react to actual or expected inflation? What happens if the Fed reacts to expected inflation, and expected inflation reacts to the Fed?

Questions: Is there a sensible model out there in which the Fed raises real rates to contain inflation? There are two schizophrenic strands to the literature; in one the Fed raises real interest rates in response to inflation and this action lowers future inflation; in the more popular strand threats of explosion select equilibria. Did the Fed conquer inflation by moving to a Taylor rule with a coefficient greater than one on inflation? Does the Fed in fact move the funds rate more than one for one with inflation -- how will it respond to a replay of 1973?

· Clarida, Richard, Jordi Gali, and Mark Gertler. “Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory” Quarterly Journal of Economics, 115 (1), February 2000, pp. 147-180.

Famous for the claim that the Fed switched from “Passive” (coefficient on inflation less than one) to “active” (coefficient larger than one) around 1980, and this stopped inflation. Also we need to read the theory section to see how this is supposed to work.

· Orphanides, Athanasios, 2004, Monetary Policy Rules, Macroeconomic Stability, and Inflation: A View from the Trenches. Journal of Money, Credit & Banking, 36(2) 151-

Maybe the “fact” isn’t even true – you make a lot of excuses for output responses in looking at the inflation response.

· Robert King, 2000, ''The New IS-LM Model: Language, Logic, and Limits” Federal Reserve Bank of Richmond Economic Quarterly 86, 45-103. p.75 especially on the question of interest rate rules.

This is an excellent preview.

Thursday December 2

· Woodford, Michael, Interest and Prices Ch. 1-4

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Suggestions for Extra Readings

If that wasn’t enough….Believe it or not this is the pared down reading list. Here are some good extra readings on each of the topics.

Big picture

· Robert E. Lucas, Jr., “Nobel Lecture: Monetary Neutrality,” The Journal of Political Economy, Vol. 104, No. 4. (Aug., 1996), pp. 661-682.

· Lucas, Robert E. Jr., 1994, “Review of Milton Friedman and Anna J. Schwartz’s `A monetary history of the United States, 1867-1960’”, Journal of Monetary Economics 34, 5-16.

· Sargent, Thomas J. and Francois Velde 2002 The big problem of small change Princeton: Princeton University Press.

The whole book is pretty much a classic. Chapter 14 on Spanish hyperinflation seems to me to document the fiscal underpinnings of inflation quite well.

· Bernanke, Ben S., “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression,” The American Economic Review, Vol. 73, No. 3. (Jun., 1983), pp. 257-276.

This is a classic you should read at some point. Maybe the output effect has nothing to do with money – maybe blowing up the banks has some independent effect. This view may explain Japan today. This started the whole “credit channel” literature.

VARs

· Uhlig, Harald, “What are the effects of monetary policy on output: results from an agnostic identification procedure” Manuscript.

Uhlig takes to heart what people are evidently doing: identifying the shocks by the results, i.e. getting a pretty picture out of the result.

· Cochrane, John H. “Permanent and Transitory Components of GNP and Stock Prices” Quarterly Journal of Economics CIX (February 1994) 241-266.

No money but nice (I think) use of cointegrated VARs. Also gets at Blanchard-Quah identification of shocks by long run restrictions, i.e. the money shock is the one with no long run effect on output.

· Cochrane, John H. “Shocks” Carnegie-Rochester Conference Series on Public Policy 41, (December 1994) 295-364. A review of money VARs up to that point.

· Cochrane, John H. Comment on ‘What Ends Recessions? By David and Christina Romer, 1994 NBER Macroeconomics Annual 58-74. A precursor to “What do the VARs mean.”

Money Demand

I presumed you’d heard of money demand estimation, the debate starting with Friedman whether it is “stable” and the counterargument that you have to keep muddling with the aggregates to make it look “stable” ex-post. The best paper I know of to document a classic view of money demand is

· Lucas, Robert E. Jr. “Money Demand in the United States: A Quantitative Review” 1988, Carnegie Rochester Conference Series on Public Policy 29, 137-168

Lucas (re) discovers and brilliantly uses cointegration. Previous writers ran it in growth rates, got nice errors and junk coefficients. The latest from Lucas on Money demand is

· Lucas, Robert E. Jr., 2000, “Inflation and Welfare” Econometrica 68

I also like

· Lucas, Robert E. Jr., Two Illustrations of the Quantity Theory of Money, The American Economic Review, Vol. 70, No. 5. (Dec., 1980), pp. 1005-1014.

A cool use of moving averages to show money is neutral in the “long run”

· Cochrane, John H. 1989, “The Return of the Liquidity Effect: A Study of the Short Run Relation Between Money Growth and Interest Rates'' Journal of Business and Economic Statistics 7 (January 1989) 75-83.

A medium frequency analysis of the interest elasticity, to go with Lucas’ long run income elasticity: Band pass filters give money growth negatively correlated with interest rates in the “medium run”

Reynard, Samuel. Universithy of Chicago thesis.

Doubts

· Woodford, Michael, “Monetary Policy in a World Without Money” Manuscript 2000.

A response to Ben Friedman

· Demirlap, Selva, and Oscar Jorda, 2001, “The Pavlovian Response to Fed Announcements'' working paper, University of California at Davis.

More on open mouth operations

Fiscal theory

· Woodford, Michael, “Fiscal Requirements for Price Stability” JMCB Volume 33, Number 3, August 2001

· Woodford, Michael, “Price-level determinacy without control of a monetary aggregate,” Carnegie-Rochester Conference Series on Public Policy, 43 December 1995, 1-46.

These are some of the classic papers (along with Leeper, cited) that established the fiscal theory. I think what they have to say is covered in our readings and in Woodford’s interest and prices, but if you’re interested in this stuff the originals are a must-read

· Sims, Christopher, “Fiat Debt as Equity: Domestic Currency Denominated Government Debt as Equity in the Primary Surplus”

· Sargent, Thomas J., “Some unpleasant Monetarist Arithmetic” Federal Reserve Bank of Minneapolis Quarterly Review 5(3) Fall 1981

This really brought the fiscal side of price determination to modern attention. Note that debt is real, and the reliance on seignorage. It’s taken 20 years to improve on that. We might write a slightly different model for the four hyperinflations now.

· Cochrane, John H. , 1998, “A Frictionless view of U.S. Inflation,” in Ben S. Bernanke and Julio J. Rotemberg, eds., NBER Macroeconomics Annual 1998 Cambridge MA: MIT press, p. 323-384.

Some of the analysis is not as good as in later papers, but I got to tell more fun stories here.

· Bordo, Michael D. and Carlos A. Vegh, 2002 “What if Alexander Hamilton had been Argentinean? A Comparison of the early monetary experiences of Argentina and the United States” Journal of Monetary Economics 49 459-494

· Stokey, Nancy, “Fiscal Desperation and Inflation” Manuscript, University of Chicago.

· Sims, Christopher, “The Precarious Fiscal Foundations of EMU” Manuscript.

Fiscal Events

· Sargent, Thomas J. and Francois R. Velde, “Macroeconomic Features of the French Revolution,” The Journal of Political Economy, Vol. 103, No. 3. (Jun., 1995), pp. 474-518.

· McCandless, George T., “Money, Expectations, and the U.S. Civil War,” The American Economic Review, Vol. 86, No. 3. (Jun., 1996), pp. 661-671.

· Velde, Francois and Marcelo Veracierto, “Dollarization in Argentina,” Economic Perspectives Federal Reserve Bank of Chicago, Winter 2000

· Velde, Francois, “Government Equity and Money, John Law’s System in 1720 France’’ Manuscript, Federal Reserve Bank of Chicago

I plan to ignore the theory and concentrate on the facts in the following papers. They are follow-ups to prospective deficits, and should help us to see if the story works.

· Burnside, Craig, Martin Eichenbaum and Sergio Rebelo, 2001 “On the Fiscal Implications of Twin Crises” NBER working paper 8277

· Burnside, Craig, Martin Eichenbaum and Sergio Rebelo, 2003, “Government Finance in the Wake of the Twin Crises,” Manuscript, Northwestern University

· Burstein, Ariel, Martin Eichenbaum and Sergio Rebelo, 2003, “Large Devaluations and the Real Exchange Rate’’ Manuscript, Northwestern University

I can’t find pdfs so I won’t assign this, but you really should read it at some point!

· * Sargent, Thomas J. “The Ends of Four Big Inflations” Ch.3 of Rational Expectations and Inflation New York: Harper and Row. 40-109.

Interest rate rules

· Goodfriend, Marvin, Interest Rate Policy and the Inflation Scare Problem: 1979-1992 Federal Reserve Bank of Richmond Economic Quarterly 79 (Winter 1993) 1-23.

A really nice, detailed and persuasive account of Fed policy in the 80s. You see the Fed reacting to expected inflation as embodied in long term bonds.

· Clarida, Richard, Jordi Gali, and Mark Gertler. "The Science of Monetary Policy: A New Keynesian Perspective." Journal of Economic Literature 37 (1999): 1661-1707.

· Rudebusch, Glenn, 2001, “Term Structure Evidence on Interest Rate Smoothing and Monetary Policy Inertia'' Manuscript, Federal Reserve Bank of San Francisco, Forthcoming, Journal of Monetary Economics.16-21

shows that the errors of a Taylor rule are likely to be serially correlated inducing a false persistence measure

· Woodford, “'The Taylor Rule and Optimal Monetary Policy,'' January 2001.

A quick review of Taylor rules, equilibrium. Then questions whether potential (defining the gap) is the right target, whether a constant intercept rather than a time varying natural rate is optimal, etc.

· Roberts, John M. New Keynesian Economics and the Phillips Curve, Journal of Money, Credit and Banking, Vol. 27, No. 4, Part 1. (Nov., 1995), pp. 975-984.

· Benhabib Jess, Stephanie Schmitt-Grohe and Martin Uribe, 2001 “Avoiding Liquidity Traps,” Journal of Political Economy 110 535-563.

Another paper with explosion threats to “stabilize” the price level.

· Romer, David Advanced Macroeconomics

In particular, Chapter 6, “Microeconomic foundations of incomplete nominal adjustment” 241-308. is a good introduction to “neo-keynesian” models;

· Mankiw N. Gregory 2000, The inexorable and mysterious tradeoff between inflation and unemployment NBER working paper 7884.

Notes that NeoKeynesian Phillips curves are forward looking. This is at great variance with the data which want a backward looking Phillips curve. An expected deflation is a boom to a forward looking Phillips curve!

· Alvarez, Fernando, Robert E. Lucas Jr., and Warren E. Weber, 2001, “Interest Rates and Inflation” American Economic Review 91 219-225.

They analyze Taylor rules without neo-keynesian economics.

Why did US inflation rise and then fall in the 1970 and 1980s? (Preliminary list, and we may not get this far)

Any theory of inflation must have an account of the rise and fall of inflation in the US in the 1970s.. You should know the standard stories.

· Sderstrom, Ulf, and Anders Vredin, “The Conquest of Inflation: and Introduction to Sargent’s analysis.” Svierges Riksbank Economic Review 2000:3 5-11.

· Sargent, Thomas J. and Ulf Soderstrom, “The conquest of American Inflation: A Summary.” Svierges Riksbank Economic Review 2000:3 12-45

· Sargent, Thomas J. “Reactions to the Berkeley story”

· Goodfriend, Marvin, 2002, “The Phases of US monetary policy 1987 to 2001” Federal Reserve Bank of Richmond Quarterly Review 88(4)

Commitment

This is a very important strain of monetary economics, which I don’t cover for lack of time.

Romer, David Advanced Macroeconomics Ch. 9 “Inflation and Monetary Policy”;

1. 9.1 Introduction,
2. 9.2 Inflation money growth and interest rates,
3. 9.4 Dyanmic inconsistency of low inflation monetary policy,
4. 9.5 Addressing the dynamic inconsistency problem.

· Albanesi, Stefania V.V. Chari and Lawrence J. Christiano “Expectation Traps and Monetary Policy” NBER working paper 8912 April 2002

More Ideas

Walsh, Carl, Monetary Theory and policy. See http://www.business.uiuc.edu/seppala/econ421/