Thursday, May 26, 2011

Teaching Intro-level Monetary Policy After the 2007-2009 Recession

Andrew T. Hill (Temple University and the Philadelphia Fed) and William C. Wood (James Madison University) offer a thoughtful discussion of how the teaching of monetary economics at the intro level needs to evolve in "It's Not Your Mother and Father's Monetary Policy Anymore: The Federal Reserve and Financial Crisis Relief."

As I see it, Fed actions during the crisis can be summed up in two main categories: 1) Providing liquidity to financial markets in crisis; and 2) Direct Fed purchases of financial securities, both Treasury debt and mortgage-backed securities. In teaching, the issue is to convey these two themes to students, but not get bogged down in institutional details. As Hill and Wood write, "it's very easy to get drawn into the details of the Fed's programs and over teach."

Most intro econ courses already have some discussion of the lender-of-last-resort function for central banks, and of using the discount rate as a tool of monetary policy. It's fairly straightforward to build on these themes to discuss how the Fed extended vast amounts of credit during the worst of the financial crisis: that is, to fulfill its lender-of-last-resort obligations in a complex modern financial economy, the Fed needed to go beyond lending to banks, and extend short-term credit to lots of other market players. A slightly deeper point is that the Fed also figured out ways to extend this credit so that the recipient firms could remain anonymous to the financial market--and thus they didn't need to worry that getting credit from the Fed would send a bad signal about their future prospects. 

Hill and Wood provide a table that may be useful for many instructors listing the new monetary policy tools created during the last few years: Term Auction Facility (TAF), Term Securities Lending Facility (TSLF), Primary Dealer Credit Facility (PDCF), Commercial Paper Funding Facility (CPFF), Term Asset-Backed Seucurities Loan Facility (TALF), and others.  But intro teaching should skip this alphabet soup. All of these agencies were closed by mid-2010; in general, the Fed's short-term lender-of-last-resort was finished by then.

In teaching about the direct Fed purchases of financial securities, this quantitative easing should be presented as a fourth possible tool of monetary policy, along with the standard triumvirate of reserve requirements, discount rate, and open market operations. Some teachers may try here to present the Fed balance sheet to their classes to show this change, and for those who want to take this approach, Hill and Wood present four illustrative and simplified balance sheets at different points in time.

But for intro purposes, I'm not sure much is gained by presenting explicit Fed balance sheets. Instead, this material can be presented pretty clearly at an intuitive level by saying that the Fed feared that financial markets wouldn't absorb these securities without more disruption, so the Fed took them on. In the short run, this probably helped smooth out the crisis. But the Fed can't print money to buy securities continually.So it needs to decide when to stop. It also will need to decide how to wind down the $2 trillion or so in financial securities that it currently owns, either by gradually selling them off or by holding at least some of them to maturity.

One other change that may be important in the next few years is that the Fed traditionally did not pay any interest on bank reserves that it held. As of 2008, the Fed can pay interest. Thus, if it seems like a bank lending boom is getting underway and higher inflation is threatened, the Fed could raise the interest rate that it pays on bank reserves, and limit banks' willingness to lend in this way. This tool doesn't matter much in a world of near-zero interest rates and low inflation, but if inflation beckons, it will be interesting to see how the Fed uses this new power.