What Has Been Learned about Monetary Policy?

While this may not be a question that comes up in day-to-day conversation, for those of us who teach economics, it provides a touchstone on what we know and teach. This is particularly applicable for those of us who have students who are amateur Fed-watchers, either through predilection or involvement in programs like the Fed Challenge.

Fed Governor Mishkin presented a paper at a Deutsche Bundesbank conference on monetary policy. The entire paper is probably more than you would share with your students - it's over 40 pages with references and charts. The first 13 pages (15 in the pdf file) include nine key principles about monetary policy developed over the past 50 years. And for those of us teaching, they are worth reviewing.

1. Inflation is always and everywhere a monetary phenomenon. (This is important for students to understand in order to make choices in the civic as well as economic arena.)

2. Price stability has important benefits. (This is important for students to understand that price stability ultimately affects other aspects of the economy, and is worth pursuing.)

3. There is no long-run trade-off between unemployment and inflation. (This is important to understand that anyone offering that as a policy solution is attempting to "pull the wool" over their eyes. This has civic education aspects.)

4. Expectations play a crucial role in the determination of inflation and in the transmission of monetary policy to the economy. (It is important to understand that inflation can feed on itself, and sound policy can reduce that tendency. Again, this has some civic education aspects.)

5. Real interest rates need to rise with higher inflation, i.e. the Taylor Principle. (It is important to understand that there is a connection between real rates, monetary policy and inflation outcomes.)

6. Monetary policy is subject to the time-inconsistency problem. (This is important to understand that adjusting policy to short-term needs can make long-term outcomes harder to achieve.)

7. Central bank independence helps improve the efficiency of monetary policy. (This is important to understand the potential for problems when monetary policy is directed by objectives that are not economic. This also has civic education aspects. See #6.)

8. Commitment to a nominal anchor is central to producing good monetary policy outcomes. (This is important because there remains much debate about the issue of inflation-targets for several central banks, not the least of which is the Federal Reserve.)

9. Financial frictions play an important role in the business cycle. (This is important to understand that information is vital to a well-functioning economy and financial sector; and that business cycle fluctuations can cause information imbalances that have the potential to make matters worse.)

Those are my "take-aways." You may disagree and feel free to debate. You can access the paper and look at each in greater depth. To what extent does your teaching reflect these learned lessons?

Money and Payments

In the past week, I've become aware of two resources that can help teach about different aspects of money and the payment mechanism. The first is fairly straight-forward. The first comes courtesy of a press announcement from the Board of Governors of the Federal Reserve System. I know it was picked up in many newspapers, but you may not have had time to follow up. Now you have another opportunity. The Bureau of Engraving and Printing unveiled the new design for the $5 bill, and a new website that includes educational materials and activities, as well as interactives. Those of you who work with students on money, currency and coin might want to look these over. Additionally, when teaching about money, some teachers will spend time discussing characteristics. If you're one of those, remember money must be recognizable. Showing the new currency and its features will assist in that regard.

The second resource is one that may have been around for a while, but I just ran into it recently. There is now an Electronic Banking edition of Monopoly. I would think this could be integrated into an upper elementary or even middle school environment with the proper preparation, and it would help student learn the ins and outs of money management in an electronic environment.

Please share your thoughts on these resources.

Economics for the "Non-economist"

People will ask from time to time, "Why should I take economics?" They will frequently add that they don't intend to go into business - as if that had much to do with it.

I tell these people that economics is about choosing and decision-making. But mostly about human behavior, and understanding how people, individually and in groups, behave and choose. But there's more.

Today you can find an excellent post on the TCS Daily (link no longer operative) blog by Kate Smalkin. She describes herself as future theologian, and it would appear had a small revelation. I recommend it, and I welcome your observations.

Adam Smith in New Delhi (HT to Mary Kissel at WSJ)

The dynamics of the marketplace are truly amazing. Adam Smith recognized this; others have tried to capture it. One excellent printed description comes in today's de gustibus entry in the Personal Journal.

Kissel does a great job in a short essay of capturing the purposeful hustle and bustle that is a marketplace in Delhi. The ebb and flow of competition, the knowledge gained from meeting the consumer's wishes, division of labor at its most elemental.

I strongly recommend this article for use in your economics, world cultures or geography classes.

I look forward to your comments.

Savings, Interest and Math

One of the fundamentals of financial literacy is saving, and one of the keys to teaching about saving is the phenomenon of compound interest. Terri Cullen talks about teaching her third-grader about this important idea in today's Fiscally Fit column (link no longer available) in The Wall Street Journal.

She offers a good example of explaining percentages to an elementary student, and how those small percentages can result in big bucks. I would recommend that one might also discuss the rule of 72 so that youngsters can see how compounding starts to leverage any amount they save. The rule of 72 is used to give an estimate of "doubling time" for an investment. One only has to take 72 and divide it by the annual interest rate to get the approximate amount of time it will take for the money invested to double. Thus, $1,000 invested at 3% will take 24 years to grow to $2,000. But $1,000 invested at 8% will double in just nine years.

I would also mention (perhaps at a different point) how the rates are indicators of risk. And that higher rates, while attractive, mean having to accept higher risk. But also how higher risk can frequently be acceptable when one is younger. Regardless of what else you add to your presentation, I would recommend Cullen's beginning. It's simple and effective.

Please share your thoughts on Cullen's article, and how you teach compound interest, regardless of grade.

Monetary Policy and the Fed

In the aftermath of Tuesday's FOMC decision, I've been putting together a list of appropriate links for the classroom.

For a sound discussion of the decision, I would recommend William Polley's blog. He's a good Fed-watcher, and seems to have a balanced view.

Although written prior to the decision, Aplia has a good discussion for the classroom, as well as some discussion questions.

As for my view? I'm afraid my opinion can be deduced from the title of this site, and my interest in the works of Milton Friedman. While the Fed has a dual mandate, I believe its best option is focus on inflation. And I think that explains the tilt in the last part of the statement, "However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully. Developments in financial markets since the Committee’s last regular meeting have increased the uncertainty surrounding the economic outlook. The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth." That sounds to me like they intend to watch the price data closely for the foreseeable future, and remain ready to act.

What's your take? What do your students think? I look forward to your comments.

The Income Effect

Russell Roberts at Cafe Hayek (HT) has a very thought-provoking post that links to a site sponsored by Wal-Mart. Roberts berates the state of economic education in the U.S. when a company like Wal-Mart has to spend big bucks to get people to understand what should be a fundamental aspect of economics.

When studying economics (and I hope personal finance), time is or should be spent getting students to understand that their lifestyle is not a function of money, but rather what money can buy. One only has to think about countries like current Zimbabwe, or 1920s Germany to understand that it doesn't take much to be a millionaire, but being one doesn'tamount to much if coffee is selling for hundreds or thousands of currency units per cup, if it's even available.

The lesson of the income effect is that there is nominal income (what you're paid), and real income (the basket of goods and services that you can buy with what you're paid). And a corollary is that when prices of different items in your real income change, this constitutes a change in income. This is because you must now choose (opportunity cost here) how to adjust your basket of goods and services. If the price of one item in the basket goes up, you have some basic options:
1) Buy less of the item in question - this is because you can now get fewer units for the same amount of nominal income.
2) Buy the same amount, but because you must spend more nominal income to get the same quantity of the good in question, you will have to buy less of something else.
3) Buy the same amount of everything, but borrow against future spending/consumption to pay for current consumption (go into debt).
4) Some combination of above.

Conversely, and here's where the link to the Wal-Mart site figures in, if the price of something goes down, you have similar options:
1) Buy more of the item in question - this is because you can now get more units for the same amount of nominal income.
2) Buy the same amount, but because you spend less nominal income to get the same quantity of the good in question, you can buy more of something else.
3) Buy the same amount of everything, and put aside the unspent nominal income to augment future spending/consumption (save).
4) Some combination of above.

Many folks will argue that when a Wal-Mart moves into town, this creates "unfair" competition with local businesses. I must admit, I am unclear by what they mean by "unfair." If another business opens in town and manages to offer products at lower prices, is that business "unfair?" Or is it a matter of size? If so, at what point does size become unfair? Many firms (not just Wal-Mart) are able to offer reduced price because they are able to take advantageof economies of scale. If those costs get passed on to the consumer, how are they hurt? If pressure is put on producers to meet quality and price, that makes for a more efficient economy and more "real income" for consumers.

I know there's more to this, but I think the opportunity to discuss an important aspect of economic thinking is too good to pass up.

Let's hear more. (Oh, and don't overlook the "comments" on the Cafe Hayek post.)

Discussion Starter

Since I moved to Virginia back in mid-August, my reading has fallen off a cliff. (I did manage to read Harry Potter and the Deadly Hallows, but I don't have any insights on that...yet.) It has only recently gotten restarted because we are still emptying book boxes at the new house; which brings me to the subject of this post.

I picked up an older book in my library, The Wealth and Poverty of Nations: Why Some Are So Rich, and Some Are So Poor by David Landes. I was especially interested in Landes' book because of a newer book by Gregory Clark, A Farewell to Alms. Early in Landes' book, he quotes Hippocrates, and the quote has some potential for use in the classroom.

"Where there are kings, there must be the greatest cowards. For men's souls are enslaved and refuse to run risks readily and recklessly to increase the power of somebody else. But independent people, taking risks on their own behalf and not on behalf of others, are willing and eager to go into danger, for they themselves enjoy the prize of victory."

Now we can discuss the evolution of monarchy from the time of Hippocrates until the present, but I think in this case, we can substitute tyrant, dictator, or some other adjective referring to one with absolute power (as was in Hippocrates' time). Agreeing to that, focus on the second sentence and apply it to economic systems. Does an open, market-driven economy have the effect described? Is that good or ill? What alternatives are there if one is to efficiently promote growth and change?

Please share what you (and your students) think.

Where Do I Start?

What's wrong with this picture (link no longer available).

I mean in addition to the fact that it speaks more to politics than economics, despite what the character says.

Swimming Against the Tide

One of the key issues for many people pushing for more financial literacy programs in the schools is credit. They point out (correctly, I might add) the levels of debt many adults carry, they bemoan the levels of debt students are burdened with upon graduation, and they attack the purveyors of credit for making credit available, particularly to student.

They advocate (again correctly) teaching young people about credit. But for some, the issue is not the wise and proper use of credit. For these, the issue is "credit is bad." Now, given the current media focus on subprime mortgages, there is a feeling abroad that maybe the "credit is bad" faction is correct. I don't stand with that group.

I have long advocated teaching students about the "wise and proper use of credit." I personally see nothing wrong with (horror of horrors) giving credit cards to teens while still in high school.

Jonathan Clements, in today's issue of The Wall Street Journal talks about the importance of helping your students develop a good credit history, and provides some sound recommendations on how to do so -- including a secured credit card.

This option makes a great deal of sense. The idea is that a sum of money is deposited with the financial institution as collateral. It can be $300 or $500. That determines the card's credit line. Use up the collateral, the card is maxed out.

However, the key is what to do then. My advice is when confronted by a teenager with a bill and maxed out card; you should sympathize and then ask how they plan to pay off the bill. You can even offer to hold the card to help them stay on the straight and narrow, until it's paid off.

What are your thoughts?

Some Resources to Grow By

This may be a bit late, but better late than never. If you check out the August 29 post of Aplia Econ Blog, you will find some interesting resources for your discussions on economic growth.

First, you'll find a link to a podcast interview with Paul Romer. Romer is one of the founders of the Aplia site, and is well-known in economic circles for his work on economic growth theory. You will also find a link to Romer's entry on "Economic Growth" from The Concise Encylopedia of Economics. While the podcast is long for classroom use, you may want to listen to it and use parts for purposes of discussion. Or you may want to absorb the material yourself on background, and then develop your own lesson.

However, I would also encourage you to pick up David Warsh's book, Knowledge and the Wealth of Nations. Warsh goes into the history of growth theory and how Romer developed his insights. One of the more interesting insights to me was the idea of knowledge spillovers, and how knowledge that allows for a change in productivity, spreads and benefits the larger economy, allowing for improving growth rates that are referenced in the podcast and article. While this may seem like a lot of time to spend on a topic, the potential return in "increased growth" in your students' understanding can make it worthwhile.

I look forward to your comments and ideas.

Economic Development and Interdependence

I recently stumbled across an interesting tool that I think can be used in economics classes when discussing either of the two concepts that make up the title of this post. The tool (which I will get to) first got my attention in a post over at The Big Picture, which linked to an article at Slate.com by Tim Harford, also known as The Undercover Economist.

Tim's article talks about one of the most fundamental questions in economics (at least at the macro level), "why are poor countries poor?" He cites research done by the NBER that links a nation's economy to clusters of relationships between industries and industry groups. I think this idea ties in nicely to some of the "new growth" economic research described in David Warsh's Knoweldge and the Wealth of Nations. It seems to me that this relates to the idea of "spillovers" wherein new technology, methods, etc. in one industry get adapted by related firms. Sometimes those ideas can even transfer to other industries, but the idea of knowledge as capital is important.

Now down to the link. Harford links to a site that borrows from physics to describe these relationships. The Product Space and the Wealth of Nations site allows you see the resource map of any of a number of nations. (Note: for some reason, some of the recent data maps are not displaying.) It will take me some time studying these (there are usually two maps - 1975 and 2000 - available for each country), but the idea of borrowing from physics to display graphically how an economy is structured is interesting. I'm also not sure how one could use this in the classroom. But I invite your ideas and comments.

Economic Concepts and the Museum of the Confederacy

When I left my previous job with the Federal Reserve Bank of Chicago, one of my colleagues said he suspected one of my motivations for taking up my new job in Virginia was my interest in the American Civil War. While I will admit it was a positive influence, it was far from the determining factor. Nevertheless, I noticed an article in the Richmond Times-Dispatch (link no longer available).

The article talks about the decision to move the current Museum of the Confederacy in Richmond, and divide its holdings among three sites. The two named today were the Appomattox Court House National Park, and the Chancellorsville Battlefield Visitors Center, located in the Fredericksburg and Spotsylvania National Military Park. A third will likely be named later this month.

I was struck by the clear examples of some basic economic concepts in the story. The concepts I was immediately aware of were "place utility", "supply", and "complimentary goods." Allow me to explain my thinking.

Place utility is one of three types of utility that are added to resources in the production process. (The other two are form and time utility.) Place utility simply is putting the good or service in a place where it is more easily consumed. It is utility that gives a product value, whether good or service. Indeed, the same product can have different value depending on the type of utility. This explains why a gallon of milk at a 24-hour convenience store may have a higher price than a gallon of the same brand of milk located at a large supermarket. In the former case, additional utility in the form of place and time (more convenient) make the product add more value. In the case of the Museum relocation, moving the collections to various spots adds more place utility. It makes the "product" easier to consume by increasing the number and locations of the product.

Supply is increased by the fact that the new locations will have combined exhibit space that is more than twice the space the Museum has now. Quantity supplied is increasing, this could reduce the cost (notice I didn't say price) to the Museum of displaying the collection as more should be able to be on display without changing the displays.

Finally, we come to the concept of complimentary goods. These are goods that increase their respective values when consumed together. (Think about peanut butter and jelly here.) The value of both the parks and the Museum holdings are increased by proximity. The Museum collection can be more relevant if in the setting where the various pieces were found. And the park becomes more relevant and interesting through the addition of actual specimens.

I suspect there are other lessons to be garnered here. But these are the first that jumped out at me. I invite your observations and comments.