Idea Transcript
The Federal Reserve and Monetary Policy The Fed's Monetary Policy Tools Now that we have examined how adding or reducing reserves in the banking system affects the money supply, let us consider the Fed's role in changing the money supply. Given our discussion, it should come as no surprise that the Fed changes the money supply by altering the level of bank reserves. Remember the definition of the monetary base and the determination of the money supply: the monetary base equals all reserves held by banks and all currency in circulation. Money supply = (Monetary base) x (Money multiplier) and Change in the Money supply = (Change in the Monetary base) x (Money multiplier). So let us focus our attention on how the Fed uses its policy tools. The Fed will alter the monetary base and thus change the money supply by a multiple of that amount. The Fed uses monetary policy to influence economic activity. But the Fed does not have direct control over the pace of economic growth. Rather, it uses policy tools to accomplish this task. The chain of events that we will discuss in this section work as follows: 1. The Fed uses one (or more) of its policy tools: a. Open market operations, which we will emphasize, b. Changes in the reserve requirement, and c. Changes in the discount rate. 2. Open market operations and changes in the reserve requirement change bank reserves and the monetary base. 3. Changes in the monetary base interact with the money multiplier to change the money supply. 4. With changes in the money supply (along with Fed changes in the discount rate), the Fed targets interest rates. 5. Changes in interest rates influence borrowing by businesses and consumers and thus change aggregate demand. 6. As borrowing activity responds to changing interest rates, the Fed's goal is to influence economic activity (the growth rate of GDP). Open Market Operations The Fed's most important and widely used policy tool is open market operations. Remember the reserve requirement, which necessitates that banks keep 10% of the value of existing deposits on reserve with the Fed. This gives the Fed tremendous amounts of money with which to engage in financial transactions. Open market operations involve the buying and selling of government debt (Treasury Bills, Notes, and Bonds) by the Fed. The Fed makes these debt transactions with banks in order to alter total reserves in the banking system. At this point, you may be scratching your head. The banks keep required reserves with the Fed. The Fed pays no interest to the banks on these reserves. And in some cases, the Fed then uses these reserves to buy bonds from banks, with the banks' own money? Yes. Let us consider a specific example. Assume the Fed wants to use open market operations to increase bank reserves. Note that banks use a portion of customer deposits (liabilities) to buy assets in the form of federal government-issued debt. To increase bank reserves, the Fed buys some of the government bonds from banks. For example, if the Fed buys $10 million in bonds from a bank, the bank's reserves increase by $10 million, money which the bank will desire to loan out. The $10 million increase in bank reserves yields an equivalent increase in the monetary base. Finding itself with $10 million in additional reserves from the sale of bonds to the Fed, the bank will rapidly put the money to work earning interest. By creating an additional $10 million in loans, the recipients of the loans will spend the money on goods and services. And through the multiplier process, when the bank makes loans, the money supply will increase by a multiple of the $10 million. The money supply will increase by an amount equal to the change in the money base ($10 million) times the money multiplier. If the reserve requirement is 10% and the money multiplier equals 10 (1/.10), the potential increase in the money supply will equal $100 million ($10 million x 10). We assume that the businesses and individuals that borrow money from the bank do so with the intention of spending that money. Furthermore, as these businesses and individuals buy goods and services this creates income for businesses, employees, and other individuals. The majority of this income finds its way back into the banking system in the form of deposits. To summarize thus far: a. The Fed buys bonds from banks. b. Bank reserves and the monetary base increase. c. Banks don't want money sitting in their vaults, earning zero return, so they attempt to loan out the money. d. To attract borrowers, banks lower the interest rates that they charge. e. The businesses and individuals who borrow the money from the banks spend it on goods and services. f. These expenditures create incomes that are deposited into the banking system. g. The money supply increases by a greater amount than the original Fed purchase of bonds because of the money multiplier. h. Increases in investment activity by businesses will increase aggregate demand and the growth rate of GDP. We see how the Fed can change the money supply, interest rates, investment, and the growth rate of GDP through open market operations. Unfortunately, Fed policy does not always work as smoothly as the Fed desires in this scenario. Let us examine in greater detail how open market operations actually work. Using Open Market Operations to Change the Growth Rate of GDP We begin with the Fed funds Rate. The Fed funds rate is the interest rate the Fed targets with open market operations. This is a very short-term interest rate that depends on the level of excess reserves present in the vaults of banks. By engaging in an expansionary policy, the Fed is using open market operations to buy bonds from the asset portfolios of some banks. As these banks sell bonds to the Fed, their cash reserves increase, creating excess reserves, and expanding the monetary base. Since banks do not earn any return on excess reserves, they immediately look to loan out the excess reserves. If a bank with excess reserves cannot immediately find a longterm borrower, it can still earn interest. One way for a bank to make a loan is through the Fed Funds market where other banks borrow money for a short-term duration (overnight or a few days). When the Fed buys bonds from individual banks, it creates excess reserves for those banks. Other banks may need to raise money on a short-term basis if they have fallen below their reserve requirement and/or need to raise money to make a loan to a corporate customer. Or the borrowing banks may desire to engage in other financial transactions and do not want to wait for deposit inflows to raise the necessary money. We can see the connection between Fed open market operations and short-term interest rates. If the Fed is undertaking an expansionary policy (buying bonds), some banks will find themselves with an increased supply of excess reserves when they sell part of their government bond portfolio to the Fed. As the supply of excess reserves rises, banks will lower the interest rate they charge other banks to borrow short-term in the Fed funds market. As a result, the Fed funds interest rate decreases. Having succeeded in lowering the Fed funds rate, the Fed assumes that longer-term interest rates will follow. This is a very important point regarding Fed monetary policy. While the Fed can directly control the Fed funds interest rate, it only has indirect control over longer-term interest rates. The key to attaining the Fed's goal of changing the growth rate of GDP lies in long-term interest rates. Changes in long-term interest rates create a response in business investment activity and consumer borrowing. Lower interest rates reduce the cost and increase the profitability of borrowing through the present value calculation. The same holds for the consumer, who will see a reduction in monthly payments for new loans taken out or for those loans adjusted to falling market interest rates. The critical question is how effective is the Fed in translating policy decisions that change the Fed funds rate (short-term) into actual changes in longer-term interest rates? Only if longer-term interest rates adjust to changes in short-term interest rates will business investment and consumer spending react to Fed policy. And it is through changes in investment and consumption that the Fed will influence the growth rate of GDP. How effective the Fed will be in determining the direction of long-term interest rates depends on changes in the spread or gap between short-term and long-term rates. The historical gap between the 3-month Treasury bill rate and the long-term government Treasury bond is about 2%. The longer the maturity of the debt, the higher is the associated interest rate. If the Fed lowers short-term interest rates by 0.5% (1/2 a basis point), the Fed's goal is to maintain a constant spread. In this case long-term rates will also fall by 0.5% and investment and consumption activity will increase. In the early 1990s, the spread between short-term and long-term interest rates reached a new high. This was a consequence of expected inflation in the future caused by the massive federal budget deficits of the 1980s and early 1990s. Long-term interest rates had an additional inflationary premium built in because of expected future inflation relating to the fiscal budget deficit. For our purposes here, we will assume a constant spread between long and short interest rates. In other words, when the Fed changes the Fed funds rate, all other interest rates will move in the same direction and by a similar magnitude. In this way we can base our discussion on a single rate of interest, r. A restrictive monetary policy is a decision by the Fed to raise interest rates in order to slow the growth rate of GDP. In 1994, the Fed raised the Fed funds rate seven times in order to achieve a soft landing for the U.S. economy. When open market operations are used to implement a restrictive monetary policy, the Fed sells bonds to banks. By purchasing bonds from the Fed, banks have less money to loan out and the monetary base shrinks. The result is a reduction in the money supply by a factor of the money multiplier. The reduction in the money supply and bank reserves raises the Fed funds rate using the opposite of the process described above. As long-term interest rates increase along with the Fed funds rate, business investment and consumer borrowing both decrease, resulting in slower GDP growth. Changes in the Reserve Requirement and the Discount Rate The Fed uses open market operations to carry out the great majority of its policy decisions. On occasion, the Fed will change the percentage of deposits that banks must keep on reserve with the Fed (the reserve requirement). If the Fed lowers the reserve requirement as part of an expansionary monetary policy, banks will have additional money that can be lent out to businesses and consumers. The value of the money multiplier will also increase. The net effect is to increase the money supply, lower interest rates, and increase the GDP growth rate. A restrictive monetary policy by the Fed involves increasing the reserve requirement to reduce bank lending and decrease the value of the money multiplier. The money supply contracts, raising interest rates and reducing GDP growth as investment and consumption decline due to the higher interest rates. Due to the dramatic effects on the money multiplier, the Fed seldom changes the reserve requirement. The Fed will only use this policy in circumstances of severe recession or inflation. The discount rate is the interest rate that the Fed charges banks to borrow directly from the Fed. The discount rate is usually changed after the fact of a policy decision involving open market operations. If the Fed is using open market operations to carry out an expansionary monetary policy, it may follow up on changes in the Fed funds rate with a change in the discount rate. In this way, changes in the discount rate are used to confirm (to the public) the direction of Fed policy.
Monetary Policy In this section we will take a graphical look at the implementation of Fed policy through open market operations. We will start by examining the impact on the Fed Funds interest rate when the Fed uses open market operations to change the money supply. This in turn will have an effect on investment with a change in a composite long-run interest rate, r. In addition, our analysis will look at the impact on aggregate demand when investment changes. Be aware that consumption activity is also responsive to changing interest rates (e.g., falling interest rates increase consumption), although this relationship will not be modeled explicitly. We begin by taking a general look at the chain of events which occur when the Fed decides to use open market operations to change economic conditions. Before we look at the sequence keep in mind some important considerations: If economic growth is considered to be undesirably rapid, the Fed will undertake a restrictive monetary policy with the goal of slowing economic growth and dampening inflationary pressures. If economic growth is considered to be undesirably slow or the economy is in a recession, the Fed will undertake an expansionary monetary policy with the goal of accelerating economic growth and lowering the unemployment rate. The Fed begins at the end of the sequence shown below. In other words, the Fed begins with the conclusion that economic growth is either undesirably rapid or uncomfortably slow. Having made the conclusion that unwanted economic conditions are likely to persist or worsen without some direct policy action, the Fed will implement either a restrictive or expansionary monetary policy. Once it decides to implement a specific policy, the Fed undertakes open market operations which will change interest rates and economic growth. Critically, we will assume that the interest rate spread remains constant(1). This implies that when the Fed changes the Fed funds rate, all other interest rates will change by the same magnitude. In general, the historic spread or difference between the Fed Funds rate and the general long-run interest rate is around 2%. Using this assumption, if the Fed Funds rate starts at 5% and the long bond interest rate will be 2% higher and equal 7%. If the Fed raises the Fed Funds interest rate to 5.5%, then the long bond rate will increase by an identical amount - to 7.5%. There is a lag of approximately 6 months to a year between the implementation of a restrictive or expansionary monetary policy and a change in the rate of GDP growth. It takes awhile for changes in interest rates to work their way through the economy. Due to the lag present between a change in monetary policy and a change in actual economic conditions the Fed will have to wait before policy changes have the desired effect of either slowing or accelerating economic growth. It is important for the Fed to accurately judge future economic conditions in order to minimize economic fluctuations over the course of the business cycle.
Direction of Causality of Monetary Policy when the Federal Reserve Decides to Change Interest Rates »» Open Market Operations, Fed buys or sells bonds »» Change in Bank Reserves »» Change in the Monetary Base »» »» Change in the Money Supply »» Change in the Fed Funds Interest Rate »» Change in Long-term Interest Rates »» »» Change in Business Investment »» Change in Aggregate Demand »» Change in GDP Growth, the Inflation and Unemployment Rates.
(1) The spread in interest rates refers to the difference between short-term rates and long-term rates for a debt asset with similar characteristics except for the time until the asset matures. For example, a Treasury bond that matures in 20 years may offer an interest rate 2% higher than a 3 month T-bill. Debt with greater maturities will offer higher interest rates to compensate for the extra risk that interest rates may change unfavorably for the owner of the debt over time.
Restrictive Monetary Policy When the policy making group at the Fed (the FOMC) gathers, they take a detailed look at current and expected economic conditions. The members of the FOMC will be given forecasts of the likely direction of the economy in the upcoming year or so. To be effective, the FOMC desires to anticipate economic problems rather than reacting to current conditions. Let us look at the scenario facing the FOMC in January 1994. The U.S. economy had been growing at a rapidly increasing clip during 1993. As 1994 began, several key indicators of the economy were entering the danger area. For example, capacity utilization was reaching a level that could cause an increase in the inflation rate by the later part of 1994 if high economic growth rates continued. Rather than wait for the anticipated inflation to materialize, the Fed initiated a restrictive monetary policy to slow the growth rate of GDP.
Click on a part of the graph for further information.
Figure 11-1 shows the demand and supply of money in the money market. We show the money supply as a vertical line at a level controlled by the Fed. The equilibrium interest rate, r0 , is determined by the intersection of the demand for money and the supply of money, labeled money supply.
Click on a part of the graph for further information.
In January 1994, the Fed reduced the money supply by using open market operations. The reduction in the money supply is shown by a leftward shift in the money supply in Figure 11-2 from Mso to Ms1 . The decrease in the supply of money raises market interest rates from ro to r1 .
Click on a part of the graph for further information.
Next we show the response of business investment (I), which is a component of GDP and aggregate demand. Investment demand has an inverse relationship with interest rates. As we show in Figure 11-3, when interest rates rise from ro to r1 , investment falls from Io to I1 .
Click on a part of the graph for further information.
Finally, let us look at the macroeconomy using aggregate demand and aggregate supply curves as shown in Figure 11-4. We begin where aggregate demand, AD o , is intersecting aggregate supply, ASo , as the aggregate supply curve begins to rise. Given the policy scenario we described above, the growth rate of aggregate demand was greater than the long-run growth rate of aggregate supply. To reduce aggregate demand, the Fed raises interest rates in order to reduce the level of investment demand and this shifts the aggregate demand curve to AD 1. In reality, the Fed is only trying to slow the rate of expansion in aggregate demand. The way we have shown events here, the level of output actually falls, possibly causing a recession, which certainly is not the Fed's goal (unless high inflation is already present as in 1981). We show a reduction in aggregate demand above to keep things relatively simple. In reality, the Fed is trying to achieve a soft landing. The increase in interest rates causes investment demand to decline. Since investment is a component of GDP and thus aggregate demand, a decrease in investment leads to a reduction in aggregate demand and output (GDP) growth. The consequences are a reduction in inflationary pressures, but the fall in output growth may cause the unemployment rate to rise. This is certainly the case in 1995. Because of the restrictive monetary policy taken in 1994, by the summer of 1995 the inflation fears of 1994 had abated, the unemployment rate had risen slightly, and the pace of GDP growth had dropped significantly. In summary: restrictive monetary policy is used by the Fed to deal with situations of either high inflation or an anticipated rise in future inflation. By raising interest rates, the Fed will either reduce or slow the growth of aggregate demand. If the Fed is counteracting actual high inflation rates, it raises interest rates to decrease aggregate demand, and a recession is the likely consequence. In this case, GDP growth becomes negative and unemployment rates jump upward. If instead, the Fed is dealing with anticipated future inflation, the appropriate Fed policy is to raise interest rates only enough to slow the growth rate in aggregate demand. If done correctly, the growth of aggregate demand will be consistent with the expansion in aggregate supply (productive capacity). Also know as the fabled soft landing. Economic thinking is constantly evolving. Until recently, Fed policy was primarily reactionary. The Fed would see an economy burning with inflation or sinking with unemployment and take a countercyclical policy. However, the policy action would often lead to a swing to the other side of the business cycle. Over time the Fed has been able to significantly improve their empirical models of the economy. During the 1980s the Fed undertook a substantial effort to improve its computer modeling of business cycles. As the Fed has become better at forecasting future economic conditions, Fed policy has evolved to a more anticipatory position. With better models of the economy and forecasting ability, the Fed desires to properly anticipate changes in the business cycle, not react to actual changes. As we have seen in 1994, the Fed has used countercyclical economic policy to try to reduce the magnitude of business cycles. By anticipating an increase in inflationary or recessionary pressures, the Fed can try to prevent the actual inflation or recession, smoothing out economic growth over time. In the past, the Fed has usually resorted to reactive policies, which require an opposite correction of the excess inflation or unemployment present. By anticipating potential economic changes, the Fed hopes to gently guide the economy to steady economic growth rather than the jarring changes in direction required when it is reacting to actual conditions of excessive inflation or unemployment. In a perfect world, the Fed will be able to control aggregate demand growth to a level consistent with the long-run growth rate in aggregate supply at a level of full-employment and no inflation. Expansionary Monetary Policy Now let us consider the economic scenario facing the FOMC in the spring of 1995. The interest rate increases of the prior year had been successful in slowing GDP growth. Perhaps too successful! Some market and economic analysts who ran about the movie theater screaming "fire" in 1994 because of the lurking terror of inflation, now were hiding under their respective seats, frozen in dread of recession. By the summer of 1995, unemployment rates were on the rise (from 5.4% to 5.8%) and GDP growth had slowed to a crawl, growing at only a 1.3% real annual rate in the second quarter (April-June) of 1995. This was the slowest rate of GDP growth seen in 4 years. To some, recession was looming (the figure given here uses the new method of GDP estimation begun by the Department of Commerce in 1995). To deal with the slowing economic growth rate, the Fed cut interest rates in May 1995. Although the Fed reduced interest rates only by 0.25% (a quarter basis point), many analysts believed this was the announcement of a phase of expansionary monetary policy to be undertaken by the Fed. Now as we have done for restrictive monetary policy, let us take a graphical look at expansionary monetary policy.
Click on a part of the graph for further information.
Figure 11-5 shows the demand and supply of money in the money market. We show the money supply as a vertical line at a level controlled by the Fed. In this case the Fed increases the money supply by using open market operations. The increase in the money supply is show by a rightward shift in the money supply from Ms1 to Ms2 . The increase in the supply of money lowers market interest rates from r1 to r2 .
Click on a part of the graph for further information.
Next we graph the response of business investment (I). As we show in Figure 11-6, when interest rates fall from r1 to r2 , investment increases from I1 to I2 .
Click on a part of the graph for further information.
Finally, let us look at the macroeconomy using aggregate demand and aggregate supply curves as shown in Figure 11-7. We begin where aggregate demand, AD 1 is intersecting aggregate supply, AS1 in a flat area of the aggregate supply curve. This is consistent with excess economic capacity and little inflationary pressure. However, with stagnating aggregate demand growth, there is the likelihood of a recession in the near future with steadily rising levels of unemployment. To increase aggregate demand, the Fed lowers interest rates in order to shift aggregate demand to AD 2 . As aggregate demand expands, output growth increases to Y 2 . The decrease in interest rates causes investment demand to rise. Since investment is a component of GDP and thus of aggregate demand, an increase in investment leads to a higher aggregate demand and output (GDP). The consequences are an increase in output, a fall in unemployment rates (the unemployment rate had fallen back to 5.6% by summer's end) and no serious inflationary pressures as long as aggregate demand remains to the left of the steep part of the aggregate supply curve. Weak Links in Monetary Policy and Federal Budget Deficits We wrap up our discussion of monetary policy by discussing why monetary policy may not always have the economic effects the Fed desires. There may be times where the Fed uses expansionary monetary policy to reduce the Fed Funds interest rate, but long-run interest rates or investment fail to respond in kind. Remember our chain of events when the Fed uses open market operations through to the actual change in key economic statistics such as GDP growth: »» Open Market Operations, Fed buys or sells bonds »» Change in Bank Reserves »» Change in the Monetary Base »» »» Change in the Money Supply »» Change in the Fed Funds Interest Rate »» Change in Long-term Interest Rates »» »» Change in Business Investment »» Change in Aggregate Demand »» Change in GDP Growth, the Inflation and Unemployment Rates.
The two weak links in the above chain of events are in the: change in the Fed Funds Interest Rate »» Change in Long-term Interest Rates,
and the change in Long-term Interest Rates »» Change in Business Investment.
The second vulnerable link above describes how business investment may be unresponsive to changes in interest rates. This is possible during a severe recession when there is little demand for goods and services. If demand for final goods and services is very weak, there will be no reason for a business to undertake capital investment to expand productive capacity. In this situation, an expansionary monetary policy will do the economy little good, and policy makers should favor fiscal policies such as increased government spending and lower taxes in order to speed economic recovery. In our analysis above, we made the assumption that the interest rate spread between short term rates such as the Fed Funds and long-term rates such as the 20-year Treasury bond (T-bond) remains constant. Using this assumption we can conclude that if the Fed lowers the Fed Funds rate by 0.5% (50 basis points), then the 20-year T-bond will fall by an identical amount. In reality, the problem facing the Fed is although they have nearly precise control over the Fed Funds interest rate, they can only hope that longer term interest rates such as the 20-year Treasury bond follow by a similar magnitude. This is a major problem for the Fed since interest sensitive economic variables such as business investment respond for the most part to longer term interest rates and show little reaction to short-term interest rates. Thus, to influence aggregate demand (which business investment is a part of), the Fed must successfully change both the Fed Funds and longer term interest rates by roughly the same amount. For example consider the recent U.S. recession of 1991 and anemic recovery during 1992. President George Bush was running for reelection during 1992 and a vigorous economy was essential to his chances of winning the election. With the election held in November 1992, President Bush spent the winter and spring of that year exhorting the Fed to slash interest rates in order to insure a prosperous rate of economic growth by that fall. The problem that President Bush faced was not an uncooperative Fed, which was bringing down the Fed Funds rate substantially and at a rapid pace, but long-term interest rates that barely budged. By the Fall of 1992, the spread between short-term and long run interest rates had increased from the typical 2% to in excess of 4%; a historical high. Now let us take a look at President Bush's economic Achilles heel, the federal budget deficit, and how it cost him an election.
Live by the Deficit and Die by the Deficit It is a well known fact of American politics that presidential elections are won and lost by the economy. For an incumbent running for reelection, economic prosperity makes up for other blunders, almost guaranteeing victory. Conversely, economic stagnation essentially leads to defeat. In 1981, President Reagan defeated incumbent President Carter who presided over an economy characterized by stagflation (both high unemployment and inflation). Inheriting a weak economy with a persistent but relatively minor federal budget deficit, President Reagan groaned as the Fed hiked interest rates, tumbling the economy into the worst U.S. recession since the Great Depression. The Fed's goal was simple: reduce the inflation rate to acceptable levels before resuming economic growth. By 1982 inflationary pressures were easing as the unemployment rate climbed up to 10%. While the Fed shifted to an expansionary monetary policy (reducing interest rates), President Reagan used the traditional fiscal policy levers of tax cuts and government spending (tremendous increases in defense spending) to give the economy a swift kick. The remainder of the 1980s was a period of economic prosperity. GDP growth remained strong, unemployment rates dropped and inflation fell and stabilized. The only flaw was a ballooning federal deficit caused by the twin policies of tax cuts and increases in government spending. Despite Reagan's substantial 1986 tax hike, the budget deficit and national debt continued to grow. The sizeable budget deficits and rapidly accumulating debt did not hurt Reagan during his two terms because falling inflation rates helped to bring down long-term interest rates. It was left to his successor, President Bush to fall on the deficit sword. Despite Bush's significant tax increase, the federal deficit continued to soar to record levels during his term. A weakening economy was limiting revenue growth while spending increased at an unabated pace. Financial markets were becoming alarmed, especially when the budget deficit reached 5% of total GDP. Historically, governments that incur large budget deficits and national debts have almost always favored inflating their way out of debt. The easy solution for a government is to print money to pay its financial obligations and let higher inflation reduce the real value of the debt outstanding. Financial markets concluded that with current policy trends, the U.S. would eventually do the same. As a result, financial markets added an inflationary premium on long-term Treasury debt. Despite the falling Fed Funds rate during 1991 and 1992, long-term interest rates remained at high levels. This was because long-term interest rates included the inflationary premium required to protect savers against the uncertainty of future inflation that could result from the tremendous level and growth in government debt. Short-term interest rates did not include the inflationary premium because that debt would mature before any significant rise in inflation rates. In conclusion, President Bush eventually fell victim to the federal budget deficits of the 1980s and his term. Alarmed by the increasing federal deficits and escalating national debt, financial markets kept long-term interest rates at high levels even with the consistent drop in the Fed Funds rate which took place during 1991-92. Despite the control the Federal Reserve has over the Fed Funds rate, the inability of the Fed to also lower long-term interest rates meant that their expansionary monetary policy would have little impact on stimulating aggregate demand.
There is an Economic Free Lunch Setting federal budget reduction as his primary economic objective, President Clinton raised taxes shortly after taking office. Traditional economic theory emphasizes that higher taxes will reduce the rate of aggregate demand growth and economic growth. For President Clinton the effect was just the opposite. Because of the large budget deficit he inherited when taking office, President Clinton was able to both raise taxes and stimulate economic growth. By raising taxes, he increased revenues and reduced the deficit. Pleased with Clinton's policies that reduced the budget deficit by over 50% (both in total amount and as a percentage of GDP) financial markets gave their blessing by reducing long-term interest rates substantially. Long-term interest rates fell with President Clinton's deficit reduction program because future inflationary fears subsided and the inflationary premium on long-term interest rates was reduced. Soon long-term interest rates fell back into line with short-term interest rates, as the spread or gap between the two returned to the historical norm. The Federal reserve has a rough estimate that for every 0.10% decrease in long-term interest rates, economic activity increases by $10 billion. When President Clinton reduced the budget deficit, long-term interest rates quickly fell by about 2.0% (from around 8% to 6%). For the economy as a whole this resulted in an extra $200 billion stimulus to GDP growth. In this section we have looked at the use of Fed policy in theory and in practice. By making the assumptions that the spread between short-term and long-term interest rates remains constant and that investment demand is responsive to changes in long-term interest rates, we can see how the Fed has tremendous control over U.S. economic conditions. For the majority of time in practice, Fed policy works very closely to the theory presented here. But Fed policy has its weak links, especially the Fed's lack of direct control over long-term interest rates. This connection primarily fails when the Fed is undertaking an expansionary monetary policy.
Political Money Money is an integral part of the development of modern economic systems. In this course we look at the economic role of money, but often the political aspect of monetary policy can not be separated from its economic purpose. Consider the case of Russia, where politicians often have used the control of the money supply to advance political goals at the cost of the overall economy. In the earliest days of communism, the Russian government printed rubles endlessly with the stated goal of driving the value of the currency to zero. The reasoning was that in a truly communist system there was no need for money. Instead, there would be a direct exchange of goods and labor. Although money never disappeared from communist Russia, a token or closed economy dominated. In a token system, the tokens (rubles) distributed could only be redeemed for goods within that system.The system was limited to Russia and its satellite countries since trade outside the Soviet block scarcely existed. Furthermore, the value of the currency was not the same for all. Those who held a favored status in Russia would pay less in rubles for goods than the typical Russian would pay for the same item. Communist Russia featured a centrally planned system when government Bureaucrats would make decisions regarding all aspects of the economy. The government replaced the market in the allocation of inputs such as labor and capital to the production of goods. Officials would decide what goods would be produced and in what quantity. What was created was essentially a barter system where labor was immediately exchange for goods. Lacking a private banking and financial system, there was no return on savings and little reason or opportunity to save. Copyright (C) 2002, Jay Kaplan All rights reserved