This is a must-read. The big three are short term domestic securities, long term government securities, and foreign assets. The response to a change in the interest rate by the Fed is chained, and the analysis is in terms of likely effects under different scenarios.
Individual investors can shuffle their portfolios among these three assets; however, asset prices will rise or fall to match supply and demand for each asset. What are these asset prices? Well, there are three prices that might do the job: short-term interest rates, long-term interest rates, and the exchange rate. At any given time, however, one of these is fixed, leaving it up to the other two to do the adjusting. Which two? That depends on the monetary regime, as I’ll now explain.
The United States has independent monetary policy and a floating exchange rate. The Fed uses its independence to set the short-term interest rate, basically at zero these days. So long-term rates and the exchange rate do the adjusting.Now that Krugman and DeLong are debating it, the bond vigilante issue is on the table. Needless to say — important!
It would be better for distribution if this weren't Christmas Eve, but with the fiscal cliff looming, time is of the essence. This is a message to the president.
The New York Times | The Conscience of a Liberal
Bond Vigilantes and the Power of Three
Paul Krugman | Professor of Economics
One statement taht may need clarification is:
"But that can’t happen in the United States, where the Fed retains control over the money supply and of short-term interest rates."
Here "money supply" seems to mean "monetary base." But the amount of base money is irrelevant when the Fed is paying IOR, as it is now. It is true that the Fed adjusts the available reserves to hit its target rate using open market operations.