Macro Economics Assignment- 1

Study of Economic Policies and Contributions of Dr. Alan Greenspan

Submitted To: Prof. Manasi Phadke Course: Macroeconomics SIBM Pune

Submitted by,

34102- Abhishek Asthana 34110- Anjanesh Dhawan 34117- Rajat Girdhar 34128- Afroz Mohammed 34223- Oswin Diniz

I guess I should warn you, if I turn out to be particularly clear, you've probably misunderstood what I've said Alan Greenspan

Monetary policy: Monetary policy involves actions to regulate the nation's money supply, such as trading in government securities and setting short-term interest rates. Through monetary policy, the Fed (U.S Federal Reserve) tries to foster stable economic growth and control inflation. Alan Greenspan was considered as a monetarist when it came to creating government policies. Monetarism deals with a branch of Macroeconomics referred to as Monetary Economics who hold that variation in the money supply has major influences on national output in the short run and the price level over longer periods and that the objectives of monetary policy are best met by targeting the growth rate of the money supply. Allan Greenspan Timeline Date Event March 6, Alan Greenspan is born to Herbert and Rose Greenspan in the Washington 1926 Heights area of New York City. May 1948 Greenspan receives a Bachelor of Science degree from New York University. 1954 Greenspan becomes a partner with William Townsend in the consulting firm Townsend-Greenspan and Company. September Greenspan presents a paper critical of antitrust laws to the Antitrust Seminar 25, 1961 of the National Association of Business Economists. September 4, Greenspan is sworn in as chairman of the Council of Economic Advisers. Ayn 1974 Rand attends the ceremony. January 20, Jimmy Carter becomes President of the United States, ending Greenspan's 1977 appointment to the Council of Economic Advisers. December President Reagan creates a National Commission on Social Security Reform 16, 1981 and appoints Greenspan as its chairman. June 2, 1987 President Reagan nominates Greenspan for chairman of the Federal Reserve Board. Greenspan will also complete the unfished term on the Board of Governors for resigning chairman Paul Volcker. August 11, Greenspan is sworn in as chairman of the Federal Reserve Board. 1987 July 10, 1991 President George Bush nominates Greenspan for a second term as Fed chairman and for a full 14-year term as a member of the Fed's Board of Governors. February 27, The US Senate confirms Greenspan for his second term as Fed chairman and 1992 for a full term as member of the Board of Governors. He is sworn in on March 3. February 22, President Bill Clinton nominates Greenspan for a third term as Fed chairman. 1996 December 5, Greenspan makes a speech in which he refers to "irrational exuberance" in the 1996 stock market. January 4, President Clinton nominates Greenspan for a fourth term as Fed chairman. 2000 June 20, 2000 Greenspan begins his fourth term as Fed chairman. May 18, 2004 President George W. Bush nominates Greenspan for a fifth term as Fed chairman. June 17, 2004 The US Senate confirms Greenspan for his fifth term as Fed chairman. His new term begins on June 19. October 24, President George W. Bush nominates Ben Bernanke to succeed Greenspan as 2005 Fed chairman. Greenspan issues a statement supporting the nomination.

January 2006 2007

31, Greenspan's term on the Federal Reserve Board ends. Greenspan's The Age of Turbulence, including autobiographical material about his relationship with Rand, is published.

Initial years and fighting Prevailing circumstances: Allan Greenspan was appointed chairman of the Board of Governors of the Federal Reserve on August 11, 1987, and for most of the eighteen years since then, he has been widely regarded as an oracle of economic & monetary policy. Barely two months after taking over as the Fed chairman Greenspan was faced with a catastrophic stock market crash referred in financial world as Black Monday refers to Monday October 19, 1987, when stock markets around the world crashed, shedding a huge value in a very short time. The Dow Jones Industrial Average (DJIA) dropped by 508 points to 1738.74 (22.61%). To reassure the markets, he stated that the Fed was ready to provide needed liquidity to the nation's financial system. However, he wrote, as long as the markets functioned, the Fed did not wish to prop up investment firms and banks.

Time Line of events leading to the Crash

The clouds of recession started pouring in and so the memories of Great Depression of 1929 unearthed. Popular sentiments were negative and the most important task for Greenspan was to take quick measures and manage the banks. Being a monetarist that he is, Greenspan flooded the market with liquidity and ordered banks to continue to make loans despite the greater risk and uncertainty. Greenspan prevented the insolvency of commercial and investment banks and finally steered the

economy out of the situation by a timely reversal of the tight-money policy and an offering of reassurance to the stock market for which he is would be cheered forever. The years of Consolidation of Greenspans policies: Having weathered the financial market panic of 1987, Greenspan then sought to fight against inflation which became his priority. This meant slowing the growth of financial reserves that add to the money supply, which, when spent, put upward pressure on prices. Thus the Fed was faced with the dubious task of fighting unemployment (by expanding reserves) and also fighting inflation at the same time. His four-year term as chairman expired in 1991. However, President Bush announced that he would reappoint Greenspan to another term, although the recession caused tension between them. By 1994. Greenspan felt it was time to raise interest rates, which had not been upped in almost five years. Greenspan also felt the DJIA was too elevated, He lobbied for. and received, a rate increase. The day the new rate increase was announced, the market suffered its biggest loss in two years. Yet, he continued to raise rates, causing one of the biggest bond market routs in years. In 1996, Clinton also reappointed him, despite different financial policies. Greenspan has been criticized for raising interest rates at the first sign of inflation even when the economy has been slow and unemployment high, whereas Clinton believed in strong economic growth, even if it meant a small rise in inflation. Since interest rate hikes mean fewer businesses take out loans to expand, and therefore fewer jobs, the 1996 reappointment surprised many. Asian contagion: In 1997, Greenspan reported to Congress that the U.S. economy was strong. That month, however, the Thai baht (currency) collapsed leading to the "Asian contagion." A ripple in Thailand became a tsunami in the U.S., severely punishing American markets. A few months later, Russia devalued the ruble and suspended payment on its debt. Global credit markets seized up. The Federal Reserve flooded the world with dollars, and organized a bailout of Long-Term Capital Management. Interest Rate Cuts: The Fed cut the interest rates from around from 6.5% in late 2000 to around 1.75% till the end of the year 2001. After such a huge lowering of the interest rates, the Fed further reduced interest rates from 2002 to 2004. At the end of 2004, Greenspan had reduced the interest rate to a record low of 1%. Because of this, he was praised as he could avoid the widespread recession possibility during 2001 but was criticized later for keeping a loose monetary stance. The record low interest rates for a very long duration led to a lot of risky borrowing in the market and in turn fuelled the housing boom later during 2004 to 2006. After 2004, the Fed again started increasing the interest rates gradually which went up from 1% in 2004 to about 5% in 2006. As a result, the house mortgage rates were reset at much higher rates than what the borrower paid during the first few years of the mortgage. This was a major factor that led to the 2007 subprime mortgage financial crisis.

The Crisis: The former chief of the US Federal Reserve, Alan Greenspan, was named as Time magazine's person of the year in 1999 for his ready resort to loosen money. Ironically he was also named as one

of the top 25 People to Blame for the Financial Crisis by TimeMagazine. Though done for good cause, sustained unanticipated high or low interest rates result in transfers of wealth among individuals and across generations in ways that may produce unanticipated and unwanted results. When money is cheap, people are more inclined to invest or spend. So it aids economic recovery. But if there is too much for too long, it ends badly. Exactly a decade later, Time named Greenspan as No. 3 on its list of "25 People to Blame for the Financial Crisis". And I think they let him off lightly. Spending money that had been raised through refinancing or remortgaging amounted to more than 4% of GDP in 2005. From the FOMC transcripts in 2003 and 2004, it emerges that the FOMC in general looked favourably upon home refinance as a source of personal consumption expenditure. It has been reported that people in the US started paying their credit card bills by refinancing mortgages. And also Greenspans reluctance to regulate the Derivatives (which many argue added the fuel to the Crisis) in any manner also led to the crisis.
Time Line of events leading to the Crash

Although Alan Greenspan was responsible for the 30 year low unemployment rate and a 11 year low inflation rate in 1998, this form of interest rate fixation led to the housing bubble in 2008. Economists in the US also argue that the government caused, prolonged and worsened the crisis; it even continues to do so. Following is the interest chart showing the movement of interest rates post 2008 recession including that of the Greenspan tenure.

Observing the above patterns it can be safely inferred that whenever the interest rates were pulled up dramatically, it led to a recession, whether in 1990, 2001 or 2008.

References: http://www.federalreserve.gov/pubs http://www.federalreserve.gov/boarddocs// http://www.encyclopedia.com/topic/Alan_Greenspan.aspx http://www.creditwritedowns.com/2011/03/us-monetary-policy-and-the-saving-glut.html http://en.wikipedia.org/wiki/Alan_Greenspan http://www.time.com/time/specials/packages/completelist/0,29569,1877351,00.html#ixzz1gEkuEapw

Study of Economic Policies and Contributions of Dr. Kaushik Basu

Introduction: Dr. Kaushik Basu is the Chief Economic Advisor to the Ministry of Finance of the Government of India a Professor (On leave) at the University of Cornell. He finished his schooling in Kolkata, and completed his undergraduate studies at the prestigious Delhi School of Economics. He went on to graduate from the London School of Economics, where he also completed his Ph.D. under the mentorship of Dr. Amartya Sen. The current work of Dr. Basu spans three broad fields: 1. International labour standards and the problems of child labour. 2. The problem of evaluating inter-generational streams of return. Although this work is abstract and has no immediate policy implications, it could be of practical significance in the long run. The environmental decisions we take today will affect our future generations, and Dr. Basus work may have implications here. 3. Decision making and rationality of both, individuals and households. This has policy implications for poverty reduction programs and concepts of strategic decision making. We have tried to present here, our understanding of his recent work. His theory is not only lucid but presented with some gems thrown in, like while explaining the concept of financial stability he very wittily states: A full discussion of these still-unresolved matters of money in general equilibrium is beyond the scope of this paper. Luckily so, since it is also beyond the capability of the author. Understanding Inflation and Controlling it (5th Aug 2011) According to Dr. Basu, inflation is an emotive matter and its occurrence gives rise, understandably, to popular resentment. Yet, its solution cannot be left to popular cures. He calls inflation The emperor of economic maladies. Below are some discussions put forward by him. The Paradox of Predicting Inflation and Controlling It Inflation can get worsened by the very fact of higher inflationary expectations and likewise prices can be stabilized, to a certain extent by virtue of leading people to expect that prices will be stable. Suppose that the treasury takes its job of holding inflation down seriously. Then, keeping in mind that its own forecast of inflation is one of the causes of inflation, what forecast should it make. Clearly, it should forecast inflation to be 0%. The forecast will turn out to be false but inflation will be as low as possible. So, the objective of accurate forecasting and the objective of inflation control, pull in different directions. Widespread expectations of inflation lead government to behave in ways such as running large deficitsthat in fact help fulfil those expectations. One way to break this link is for government to visibly alter its rules of behaviour, such as making an open and credible commitment to maintaining lower deficits in the foreseeable future.

Benefits for the Poor and Inflation Sharp rise in food prices in 2009 and the early months of 2010 were likely caused by the drought of 2009 which led to a decline in food grains production but also by the fact that government had considerably expanded income support to the poor, for instance, through the NREGS and loan waivers to poor farmers. He refers to it as benefits-based inflation hypothesis. Challengers to this hypothesis say that, If it were indeed true that it is the greater demand for food on the part of the poor that caused the inflation, we would expect to see the poor consuming more. But (so goes this argument) there is no evidence for this. Hence, the benefits-based inflation hypothesis is invalid. He calls this consumption-based challenge. He further goes on to prove that the consumption-based challenge doesnt hold true by saying that poor devote 67% of their consumption to food which is much more than the rich. So, if money and financial benefits are diverted to the poor from the rich, it only stands to reason that the demand for food will rise in the nation. If that happens, the price of food will rise disproportionately. Since this is exactly what was happening in the late 2009 and early 2010, the benefits-based inflation hypothesis seems to have plausibility and a greater demand for food does not necessarily mean a greater consumption of food. He attributes this to the inelastic supply curve for food.

Inflation control be demand management He tries to defend inflation control by demand management. He states that if the prices of all or virtually all goods increase (inflation) , there is little we can do in terms of supply, because there is no known way of suddenly providing more of all goods. If there was a way to do so, we should have done so already and made everybody better off. This is the reason why, when there is overall higher inflation, we have no choice but to turn to some form of demand management.

Salad bowl stagflation Stagnation in developed economies has led to liquidity infusing measures like Quantitative Easing. But this infused money is increasingly finding its way into emerging economies fuelling inflation. On China and revaluation of Renminbi He believes that Chinas exchange rate policy has been widely misunderstood. It would be foolish of China to keep its currency undervalued, he says. What it is instead doing is good strategy and is best understood by considering habit goods. According to him, buying from a particular country is a habit good. There are so many idiosyncrasies associated with each nations bureaucracy and infrastructure that once we get used to buying from a nation, it is not worthwhile to easily switch to another. Nations have got used to buying from China, even though China profited little from this and may even have incurred a loss. But this strategy would be useless unless you subsequently raise the price and redeem your losses of cheap selling. So he believes that this is what China will do and we will see a steady revaluation of the renminbi.

The Mechanics of Central Bank Intervention in Foreign Exchange Markets In this paper, Dr. Basu analyses central bank intervention for the devaluation of local currency and the effects of such actions. The normal method of buying foreign currency leads to excess forex reserves. Using Industrial Organization theory, Dr. Basu proposes alternate solutions to devalue currency, without the side-effects. Reasons for devaluation Temporary fluctuation (over-valuation) due to an external shock or prevailing market conditions. To boost exports.

Because of the simple principle that buying something makes its value appreciate, most central banks do not think beyond How much currency needs to be bought? Exchange rate management in India India, like most other countries devalues its currency by buying foreign currency. The INR has been classified as on a managed float and going by the increasing forex reserves, it seems that the strategy is to keep the INR under-valued. Dr. Basu argues that this strategy is visible through most of the developing nations. Dr. Basu argues that the current system is a quantity-based system, whereby the price impact depends on the quantity of currency purchased. He believes that an alternate system can provide a stronger impact with the same amount of buying. He calls it Scheduled Intervention. It means that the central bank enters the market with a demand conditional on price and not with a fixed quantity.

Scheduled Intervention The central bank treats the public sector banks at par with the large forex dealers and gives each public sector bank its demand schedule. The treatment of the bank at par with the forex dealer adds another player to the market. Dr. Basu, using complex math proves that as the number of such players keep increasing, the market price of the foreign currency will converge at the desired value. All of this and the central bank accumulates zero forex reserves. The proposition has its set of flaws: 1. Real world factors introduce an error and a small forex reserve will be accumulated 2. Determining the exact demand schedule that creates the desired effect in the market without any real purchasing is very difficult. Nonetheless, the paper serves its aim of demonstrating that the mechanism of scheduled intervention is worth studying. A Simple Model of the Financial Crisis of 2007-09 with Implications for the Design of a Stimulus Package The Model Prof. Basu attempts to explain the financial crisis of 2007-09 by developing a model of how a small credit correction can escalate into a major equilibrium shift with large changes in behavior, in this case, a sudden collapse in the supply of and demand for loans. He builds on some existing ideas concerning equilibria where group behavior influences individual preferences, and which give rise to multiple equilibria. The model differs from existing models of collapse in lending, which are based on the idea of bursting of bubbles. Prof. Basu defines a rational expectations equilibrium as the condition in which actual aggregate supply of credit is equal to the expected aggregate supply of credit (a). He also defines the supply correspondence as all the possible supplies of aggregate credit that have the rational expectations property, for each interest rate. The equilibrium in a credit market is the interest rate r, such that the supply correspondence(S) is equal to the aggregate demand for loans or credit, D. The credit market can have multiple such equilibria (E1, E2, and E3).

A small shock can cause supply of credit to fall a little and cause the supply correspondence to shift up. This can result in several prior equilibria, in particular, the high credit availability equilibrium, to disappear. After the small decline in supply there is a large tumble-down affect and the economy moves to the only existing equilibrium, which corresponds to a collapse in credit availability, and a rise in the interest rate. Reasons for initial small shock: 1. Increased defaults by the rising subprime borrowers leading to more houses returning to the market with declining values. This led to some firms discovering that their asset position had weakened. 2. Investment banks mixed, matched, and spliced assets to create CDOs such that he average quality of assets in each rate category was invariably at the bottom end of the interval. 3. A short-run phenomenon can cause an increase in the supply of credit and thus push the equilibrium credit a little higher. When this exuberance dies down and the supply moves down to the original one, there can be an overreaction, which sends the equilibrium lending activity tumbling down in the manner described in this model. In order to get the economy back to the original high credit-availability equilibrium, Prof. Basu identifies two distinct tasks.

Increasing the supply of credit: Instead of rescuing all failed banks or investment corporations, Prof. Basu suggested having one or two nationalized banks deliberately lower the creditworthiness cut-off of potential borrowers and give out loans to them. The fiscal cost incurred will be much less than helping all loss-making banks. Liberal lending by one large bank will improve the lending environment of all lenders and encourage them to lend more. Though, the supply correspondence will improve, this is unlikely to be enough as the equilibrium will probably move to the nearest available equilibrium, with only marginal improvement in credit availability. Move the market from low transaction equilibrium to one with higher transaction: Governments have failed to pay attention to this task. Instead of appealing to financial organizations to lend more freely, Prof. Basu advocates that some state-owned banks should lend so much more that the supply correspondence moves significantly to the right of the original good equilibrium, so much so that the demand curve has only one intersection with the new supply correspondence, which is to the right of the good equilibrium and the low transaction equilibrium ceases to exist. Then the state should slowly reduce the fiscallypromoted stimulus and let the supply correspondence drift back as long as there are two

equilibria. There is reason to expect that, even though there are two equilibria, the economy once situated at the high-transactions equilibria, will remain there. Since the large fiscal support will be a temporary measure, persistent fiscal drain and the consequent risk of inflation is ruled out. Travellers Dilemma Although this game concerns microeconomics, it is a noteworthy contribution of Dr. Basu. The game, formulated by him in 1994, is one in which two players try to maximize their payoff without concern for the other players payoff. The game involves two travellers who have lost their baggage and must submit the cost of the baggage to the airline for reimbursement. The travellers are isolated from each other. They may select values between $2 and $100. The catch is: If both give the same cost, both get the same amount If not, then both get the lower amount with a $2 bonus to the one who wrote the lower amount and $2 penalty to the one who wrote the higher amount

Backward integration will lead us to the Nash equilibrium of $2 for each traveller. However, live experiments show that most pairs of players end up choosing $100 and thus get a higher payoff. In this case, the players who deviate from the logical/rational choice (of Nash equilibrium) end up getting a larger payoff. These experiments show that it is not certain that most people use pure rational strategies, and that pure rational strategies may not be the best for them. This game has led to the questioning of game theory and the suggestion that a new kind of reasoning is required to understand how irrational choices may actually be the rational ones.

References

http://www.kaushikbasu.org/Inflation%20%20Gautam%20Mathur%20lecture%2014.pdf (Understanding Inflation and controlling it) http://www.arts.cornell.edu/econ/cae/09-02.pdf (The Mechanics of Central Bank Intervention in Foreign Exchange Markets) http://www.arts.cornell.edu/econ/cae/09-11.pdf (A Simple Model of the Financial Crisis of 2007-09 with Implications for the Design of a Stimulus Package) http://en.wikipedia.org/wiki/Kaushik_Basu http://www.unisi.it/santachiara/pdf/chair_cv/Basu_CV_Pubb.pdf http://www.kaushikbasu.org/monographs.php http://www.kaushikbasu.org/bio.php http://news.bbc.co.uk/2/hi/south_asia/6365851.stm