Are you aware of the role of the Federal Reserve and it’s powers? Whether considering personal finances, investing, buying a house or developing a business strategy, you should have a basic understanding.
In 1913, Congress established the Federal Reserve Bank, in response to bank failures that resulted in sharply decreased credit availability. And during the Great Depression, the Banking Act of 1935 enabled the Fed to initiate policies designed to stabilize the availability of money and credit. This work continues today.
Today, the Fed is an integral part of the U.S. economic system. Because of its importance, it may be more than helpful to understand the role of the Federal Reserve and how it affects business loans, interest rates, and the economy in general.
Helping you Understand How the Federal Reserve Affects the Economy
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Article I, Section 8 of the U.S. Constitution
According to the US Congress’ Joint Economic Committee Report, dated March 1997: “Although the Federal Reserve—our Central Bank (or monetary authority)—is one of the country’s most powerful economic institutions, it is also one of the most misunderstood. For Congress, the Federal Reserve is relevant because (1) the U.S. Constitution (Article I, Section 8) explicitly gives Congress the power over money and the regulation of its value and (2) this responsibility was delegated by Congress to the Federal Reserve… Congress has important responsibilities for overseeing the Federal Reserve and monetary policy.”
In this same “white paper” intended for Members of Congress, it counsels that “Congressional oversight of the Federal Reserve and monetary policy is important because:
- Monetary policy can dominate fiscal policy in certain circumstances.
- Monetary policy can determine the path of inflation.
- The Federal Reserve influences interest rates.
- The Federal Reserve stabilizes the financial system.”
Most macroeconomic textbooks define monetary policy as the regulation of a nation’s money supply to influence its economic activity to be in line with its political objectives; whereas, fiscal policy involves legislating governmental taxing and spending policies to achieve similar goals. Monetary policy can be implemented more rapidly. It is considered more flexible, and possibly a more dominant means to impact economic activity.
To understand the regulation of money supply, we should take a little time to understand money. Why does it exist and how come it impacts our lives the way it does?
Money – currency – exists for our convenience. It serves as a medium of exchange so that we can acquire goods and services without the challenges of bartering – instead of having to exchange goods or services for goods or services; it allows us to exchange goods or services for money for goods or services. Also; it serves as yardstick for pricing goods and services and can be saved or loaned and it can be expected to retain its value – except from the diminishment from inflation or from rising foreign exchange rates.
So, how does the regulation of money impact economic activity?
According to Harvard University economics professor, N. Gregory Mankiw, “a long tradition in macroeconomics (including both Keynesian and monetarist perspectives) emphasizes that monetary policy affects employment and production in the short run …According to this view, if the money supply falls, people spend less money, and the demand for goods falls… the decreased spending causes a drop in [aggregate demand, which leads to a drop in] production and layoffs of workers.”
On the other side of the equation, National Bureau of Economic Research analyst, Anna Schwartz, comments: “An increase in the supply of money puts more money in the hands of consumers, making them feel wealthier, thus stimulating increased spending [or, increased aggregate demand]. Business firms respond to increased sales by ordering more raw materials and increasing production. The spread of business activity increases the demand for labor and raises the demand for capital goods…If the money supply continues to expand, prices begin to rise, especially if output growth reaches capacity limits. As the public begins to expect inflation, lenders insist on higher interest rates to offset an expected decline in purchasing power over the life of their loans.”
This all sounds simple. Right? Well, to me, both of these explanations seem too simple. At the same time, it might lead some of us to believe that monetary policy is an exact science with a cause and effect relationship that is absolute and easily managed. This couldn’t be further from the truth. So, how does one begin to understand the impact of monetary policy on economic activity?
Concepts of Aggregate Demand and Quantity Theory of Money
While there are many schools of thought in economics, those considered to be Monetarists believe that a change in the money supply will lead to a change interest rates causing a change in aggregate demand which impacts economic activity. Did you follow all of that? OK then, let’s take a few steps backward and discuss some basic concepts.
Supply and Demand
Quoting from Investopedia.com, “Supply and demand is perhaps one of the most fundamental concepts of economics and it is the backbone of a market economy. Demand refers to how much (quantity) of a product or service is desired by buyers. The quantity demanded is the amount of a product people are willing to buy at a certain price; the relationship between price and quantity demanded is known as the demand relationship. Supply represents how much the market can offer. The quantity supplied refers to the amount of a certain good producers are willing to supply when receiving a certain price. The correlation between price and how much of a good or service is supplied to the market is known as the supply relationship.”
So, what is the rationale for interest rate and aggregate demand changes occurring as a result of changes in the money supply?
One theory hinges on the belief that, when a central bank, like the US Federal Reserve Bank, increases the cash reserves held by its member banks, those banks will have more money available to loan and can reduce their interest rates to encourage borrowing. At lower interest rates, consumers and firms are likely to be more willing to borrow to make purchases, and aggregate demand can increase. Alternatively, when a central bank decreases the reserves held by its member banks, the banks will have less money available to loan and will increase their interest rates in an effort to coordinate with the central bank’s desires. At higher interest rates, consumers and firms are more apt to repay debt, begin saving and reduce purchases. This should have an effect of reducing aggregate demand.
By definition, aggregate demand is considered to be the total demand for goods and services in any given economy. And, when defining aggregate demand as a measurable macro-economic value, it is considered to be equal to the sum of all personal consumption, business investment and government expenditures during or within a particular time period.
In equation form, AD = C + I + G + (X – M) which is also the equation for GDP, or gross domestic product. In this equation, C represents consumers expenditure on goods and services; I represents investment spending by companies; G represents Government spending on publicly provided goods and services including public and merit goods while excluding transfer payments like welfare and entitlements (a substantial increase in government spending would be classified as an expansionary fiscal policy); X represents exports and M represents imports of goods and services to other countries. (X-M is the current account of the balance of payments.)
Another Expression for Aggregate Demand
While a highly criticized concept, the Quantity Theory of Money offers yet another expression of aggregate demand. In equation form, M x V = AD. This theory is derived from the Fisher Equation of Exchange, MV = PT, named after Irving Fisher (1867–1947), where M is the supply of money, V is the velocity with which money is spent on final goods and services (also referred to as final output, or T) during any given time period, and P is the average price level of this output.
The equation simply suggests that the quantity of money spent equals the quantity of money used. The quantity theory, in its debut as a popular theory, assumed that V and T were both constant. Thus, it was argued that any change in M leads directly to a change in P. In other words, increase the money supply and you simply cause inflation. Haven’t you heard the adage that inflation is the result of “too many dollars chasing too few goods”? The roots of that old saying come from this equation.
Yet, I don’t for a moment believe that velocity (V) or final output of goods and services (T) ever remain constant. Didn’t we just discuss that increasing the money supply is supposed to increase spending? As well, doesn’t it seem logical that companies will increase capacity to supply goods and services to meet demand? That is, until resources start becoming scarce and profit margins have reached a point of diminishing returns. Then price inflation would be reasonable resultant expectation. Right?
So, now with this understanding, what does the Federal Reserve Bank do and how do they influence economic activity?
The Federal Reserve and Its Powers
Congress created the Federal Reserve System (the “Fed”) Congress on December 23, 1913. This was government’s response to a number of financial panics that plagued the nation since the establishment of the first US banking institution in 1791. And, it laid the framework for the structure of the Fed as we know it today.
The Fed’s structure is comprised of (a) a Board of Governors who provides national level leadership; (b) twelve regional Federal Reserve Banks that serve as the operating arms of the Fed; and, (c) the Federal Open market Committee (or, “FOMC”) which acts as the monetary policy decision-making unit. It is an independent agency of the US federal government and its Board consists of seven governors, including a Chairman. The President of the United States recommends potential members for appointment. Then, the Senate must confirm the appointment. The Board oversees the activities of the Fed Banks and guides monetary policy through them. And, the Board of Governors and five of the twelve Fed Bank presidents comprise the FOMC.
The Fed’s Money Supply Tools
The Fed can use four tools to achieve its monetary policy goals. These four tools are: open market operations, the discount rate, reserve requirements, and interest on reserves.
Open-Market Operations makes up the primary and most frequently used tool. This reliable tool alters bank reserves and influences short-term interest rates. When the Fed buys US Treasury and agency securities on the open market, the money paid for these purchases expands the money supply. Conversely, when it sells these securities, the money received from these sales shrinks the money supply.
The Discount Rate is the interest rate Reserve Banks charge commercial banks for short-term loans. Lowering the discount rate is expansionary because the discount rate influences other interest rates. Likewise, raising the discount rate is contractionary because the discount rate influences other interest rates.
Reserve Requirements are the portions of deposits that banks must hold in cash, either in their vaults or on deposit at a Reserve Bank. A decrease in reserve requirements is expansionary because it increases the funds available in the banking system to lend to consumers and businesses. An increase in reserve requirements is contractionary because it reduces the funds available in the banking system to lend to consumers and businesses.
Interest on Reserves is the newest and most frequently used tool. The current policy of paying interest on reserves allows the Fed to use interest as a monetary policy tool to influence bank lending. If the FOMC wanted to create a greater incentive for banks to lend their excess reserves, it could lower the interest rate it pays on excess reserves. In turn, if the FOMC wanted to create an incentive for banks to hold more excess reserves and decrease lending, the FOMC could increase the interest rate paid on reserves, which is contractionary policy.
The Power of Persuasion
The Fed can also rapidly implement an informal tool. Moral suasion is the act of persuading others to act in a certain way through rhetorical appeals or implicit threats. the Fed uses moral suasion to influence and pressure banks, investors and consumers into adhering to desired policy goals. It is the Fed’s way of exercising the persuasive power of talk rather than legislation. Most importantly, is that its impact can be both immediate and formidable. This can send global financial markets falling or flying.
Leading Up to the Great Recession of 2008-09
In mid April of 2004, then Fed Chairman Greenspan provided his most optimistic assessment yet on the US economy. Greenspan told the Joint Economic Committee of Congress, “growth has come into a period of more vigorous expansion… As noted previously, the federal-funds rate must rise at some point to prevent pressures on price inflation from eventually emerging”. Greenspan did not known make use of moral suasion very often. This startled fixed income investors. Many sold and took losses. Then, he prepared them for rising interest rates and the possible threat of inflation.
During this time, Ben Bernanke began promoting more transparency. At the time, Bernake was a member of the Fed’s Board of Governors. He became Fed Chairman on February 1, 2006. Bernanke advocated that the Fed should begin to operate in a manner that would be more transparent to the public. Little did he realize the challenges of doing so. Initially, many misconstrued his efforts of transparency as exercising moral suasion.
Despite The Best of Intentions
When minutes were released from the Fed’s March 2006 meeting, markets believed the Fed would soon pause on lifting the Fed Funds rate. This seemed reinforced when Bernanke hinted that policy makers may soon pause. This came out during testimony before Congress in April of that year. The markets rallied to new highs. Bernanke later stated that his comments were misinterpreted. His statement created massive uncertainty. He did this in an interview with CNBC’s Maria Bartiromo.
It wasn’t long after the April CPI figures came out in mid-May that Fed officials came out hawkishly. They stated that: “If inflation turns out to exceed … our target range, I do not believe we can count on a slowing economy to bring inflation down, by itself, quickly”. This prospect incited a sell-off in stocks, globally. Investors were wary that the Fed would lean toward risking a recession. Most hoped the Fed would gamble that prior interest rate increases and record oil prices would tame the inflation outlook.
At that time, there seemed to be doubt that the new Bernanke Fed would pull the US economy through softly; especially, when they had already contributed to great volatility in the financial markets. Then came the Great Recession.
It may be clear that the Fed can regulate money supply and short-term interest rates with pin-point accuracy. But, can they regulate velocity and prices with similar precision? I’m not sure they can. How about you?