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.