Economists Do It With Models

Warning: “graphic” content…

Bookmark and Share
What The Fed Does, Now With Pictures…

March 8th, 2010 · 10 Comments
Macroeconomics · Policy

I enjoyed this video about the workings of the Federal Reserve, courtesy of the Federal Reserve Bank of Cleveland. (HT to Tim Schilling)

Cute. It’s also worth noting that it’s potentially just as important to understand what the Fed *doesn’t* do. More specifically…repeat it with me, people, THE FED DOES NOT PRINT MONEY. Trust me, this is true…unless of course Ben Bernanke has an underground counterfeiting operation that I don’t know about. In case you were wondering, the Treasury department prints money, either via the United States Mint (for coins) or the United States Bureau of Engraving and Printing (for paper money).

But, but…we hear all the time that the Fed controls the money supply. How is this possible if it doesn’t have the printing presses? Well, as stated briefly in the video, the Fed engages in what is called open market operations. This basically entails the buying and selling of government bonds.

You can picture the Fed as sitting on a pile of some combination of cash and bonds. If it were to sell some of the bonds, it would take in money and give out bonds. This would lead to less money in circulation, since it’s now in the Fed’s pile. Conversely, the Fed could buy bonds from people, in which case it would give out money and take in bonds. This leads to more money in circulation. Therefore, the Fed can increase or decrease the amount of money in the hands of the public by buying and selling government bonds. (Technically, it could buy and sell any number of non-perishable products, since the only logistical requirement is that the item can be easily kept on the pile. It just decided that bonds were the way to go.)

The Fed conducts open market operations because what it really wants is to control interest rates. (As you saw in the video, the Fed controls the discount rate directly, but direct control is not really an option for interest rates overall.) When the supply of money goes up, interest rates go down and vice versa. That seems random…so why does it work? The fact of the matter is that, like any other market, demand and supply are pushed to equalize. We just saw how the Fed controls the supply of money, but how do you get people to demand more or less money?

Note that money is just that- currency. (And checking account deposits, technically.) In other words, money is not synonymous with wealth. There are many ways to store wealth, and money is just one of them. The upside of money is that it can always be exchanged for goods and services- in contrast, I’d like to see someone walk into Bloomingdale’s with some gold bars and try to buy stuff with them. Given that people have a number of different ways to store their wealth- cash, gold bars, houses (though nowadays that seems a little funny), vintage beanie babies, whatever- they face a tradeoff between cash and non cash assets. If you hold cash, you can buy stuff with it directly, so cash is a very liquid asset. The downside of cash is that it doesn’t pay any interest, whereas other stores of wealth generally provide some (expected) positive rate of return. This rate of return moves with interest rates. If interest rates are high, there is a big opportunity cost to holding cash (or alternatively to spend rather than save), since I would be foregoing a big return if I were to stuff cash under my mattress as opposed to buy a treasury note or something. On the other hand, if interest rates were low, it might not be worth my while to fish the cash out from under the mattress and go to the bank. (Or you might start eyeing that big-screen TV, since it’s not like the money you used to buy it was going to grow in the bank anyway.) In this way, the demand for money is a function of the interest rate- higher interest rates go with less demand and vice versa, so the demand for money is downward-sloping like the demand curves for virtually all other goods and services.

I feel like I’m a donkey chasing a carrot on a stick with this argument, since now you’re just wondering why the Fed even cares about interest rates. The theory (note the use of that word) is that lower interest rates stimulate the economy by making it cheaper to borrow money in order to invest in business and also because it lowers the opportunity cost of consuming as opposed to saving. In other words, lower interest rates make people want to buy and produce stuff, at least in the short term. In the long run, increases in the money supply generally result in correspondingly higher prices for stuff rather than more stuff. So when the Fed tries to smooth out business cycles by stimulating the economy when it’s down and reining it in when it’s booming, it has to consider the long-run implications on prices and such.

Now that you understand what the Fed does, you are in a better position to evaluate what those “abolish the Fed” people are all about. From what I can tell, their argument is that monetary policy is harmful because it creates bubbles and results in inflation. (That and the fact that the Constitution doesn’t explicitly allow for the Fed in the first place.) I suppose I’ll have to follow up at some point with a lesson on whether inflation is an inherently bad thing. (Preview: not necessarily bad in theory, bad in practice.)

Ugh. Isn’t macroeconomics fun? But seriously, if you take one thing from this, let it be the fact that the Fed doesn’t control the money supply via a printing press. Please.

Tags: Macroeconomics · Policy

10 responses so far ↓

  • 1 Timothy // Mar 8, 2010 at 3:23 pm

    It drives me crazy when people claim that the fed prints money. And the worst part is that it is often too difficult to explain to them how wrong they are. Or I just have better things to do with my time…

  • 2 econgirl // Mar 8, 2010 at 4:23 pm

    In my world, I think both of those things are true…which is why I’m trying to exploit economies of scale here. 🙂

  • 3 Get A Free Apple Ipad Without Breaking A Sweat | iPads, iPods, iPhones // Mar 8, 2010 at 4:32 pm

    […] What The Fed Does, Now With Pictures… […]

  • 4 Stephan // Mar 8, 2010 at 4:42 pm

    Good post! Can you please explain to folks next time, that the US government can’t go broke because of debt given the fact it’s issuer of the US$ currency non-convertible.

  • 5 Dave M. // Mar 8, 2010 at 6:18 pm

    The criticism of the Fed is not that it “prints money.” It’s that it “creates money out of thin air.” However, some folk have found the analogy of turning on the printing press useful in helping explain the concept to others.

  • 6 john jacob jingleheimer schmidt // Mar 8, 2010 at 11:22 pm

    “When the supply of money goes up, interest rates go down and vice versa.”

    This assumes you refer to the demand for money, aka liquidity preference via Keynes, not the demand for loanable funds.

    In that story, you have to assume that the liquidity effect will be greater than the income, price level, and expected inflation effects.

    Does history offer any proof of the liquidity preference theory?

    Well, plot the rate of growth in M2 and the interest rate on three-month T-Bills to see how the story actually plays out.

  • 7 Tim Schilling // Mar 9, 2010 at 5:44 am

    Dave M.,

    ‘The criticism of the Fed is not that it “prints money.” It’s that it “creates money out of thin air.”’

    You may be right about critics of the Fed. But after working at the Fed for 16 years, and observing many, many tour groups, I can tell you most people, even after their visit, believe the Fed prints the money. This is after repeated statements to the contrary, and after telling them that currency and coins are manufactured by branches of the Treasury (Bureau of Engraving and Printing and Bureau of the Mint respectively).

    I agree with econgirl. Don’t think the Fed prints money.

  • 8 Luke // Mar 9, 2010 at 10:12 am

    If you want to help clarify the money creation role of the Fed, it might be worth describing the money supply effects of reserve requirements. Assuming a 10% reserve requirement, when the Fed buys one $1K T-bill, this effectively increases the real money supply by up to $90K (assuming banks aren’t hoarding reserves). The Treasury manages the supply of paper-money, to be sure, but their money-creation role is negligible when compared with the mechanics of the reserve requirements and the power to issue debt. Isn’t it semantic to claim that the Fed doesn’t “print money?”

    Just my two cents, but I think it warrants a post. I’m also pretty sure I did my math wrong re: the money creation limit, and I know for a fact I am missing assumptions inherent in my analysis.

  • 9 steve // Mar 9, 2010 at 6:27 pm

    print money is semantic. but what is going to happen in a cashless society when money actually is “thin air” transferred on a plastic card?

    the criticism should be that the Fed “creates money” where there is no value, watering down the value of everybody else’s money.

    whether by printing or thin air its all semantics; its about giving something new a value by stealing that value from everything else.

    the reply to the criticism is that it is all in the goal of stability. so long as they also reduce the money supply on occasion, it would be only borrowing the value from existing money, rather than stealing, because it is paid back when the money supply is reduced.

  • 10 Kirk // Mar 11, 2010 at 7:06 pm

    Let us remember financial crisis brought on by asset value inflation otherwise know as a “bubble” existed for centuries prior to the institution of a fiat money system. Under the gold standard, our money supply was not linked to the decisions and projections of some bureaucrats in the Fed Board of Governors, it was linked primarily to the aggregate supply curve of gold. This was very unstable as all kinds of factors including weather conditions at mines, worker strikes in mines, etc would vastly change the money supply as the value of gold that the dollar was pegged to would shift up or down. You could argue the fed is meeting with limited success on its goals of stabilizing the money markets, but you would be completely out of line to say its worse than the gold standard.

Leave a Comment