Monetary Policy and the Federal Reserve

Introduction

Definitions and Basics

Money Supply, from the Concise Encyclopedia of Economics

What Is the Money Supply? The U.S. money supply comprises currency—dollar bills and coins issued by the Federal Reserve System and the Treasury—and various kinds of deposits held by the public at commercial banks and other depository institutions such as savings and loans and credit unions. On June 30, 2004, the money supply, measured as the sum of currency and checking account deposits, totaled $1,333 billion. Including some types of savings deposits, the money supply totaled $6,275 billion. An even broader measure totaled $9,275 billion.

These measures correspond to three definitions of money that the Federal Reserve uses: M1, a narrow measure of money’s function as a medium of exchange; M2, a broader measure that also reflects money’s function as a store of value; and M3, a still broader measure that covers items that many regard as close substitutes for money….

Federal Reserve System, from the Concise Encyclopedia of Economics

The Original Federal Reserve System. Several monetary institutions appeared in the United States prior to the formation of the Federal Reserve System, or Fed. These were, in order: the constitutional gold (and bimetallic) standard, the First and Second Banks of the United States, the Independent Treasury, the National Banking System, clearinghouse associations, and the National Reserve Association. The Fed was the last such institution founded. Although it has endured, the present-day Fed would be unrecognizable to its founders….

The original Federal Reserve Act became law in December 1913. The “Federal” in the title implied that the law applied to the whole country, and “Reserve” emphasized the new institution’s role as a reserve holder and reserve supplier for the commercial banking system….

Monetary Policy, from the Concise Encyclopedia of Economics

Total currency in public circulation outside banks was $664 billion at year-end 2003. Banks’ reserves–the currency in their vaults plus their deposits in the Fed–were $89 billion. The two together constitute the monetary base (M0 or MB), $753 billion at year-end 2003….

A bank in need of reserves can borrow reserve balances on deposit in the Fed from other banks. Loans are made for one day at a time in the “federal funds” market. Interest rates on these loans are quoted continuously. Central bank open-market operations are interventions in this market. When the Federal Reserve (or other central bank) conducts an open-market operation, it typically buys treasury bills, paying for them with reserves, or sells them, taking reserves in payment. Open-market operations thus amount to interventions in the federal funds market. Banks can also borrow from the Federal Reserve banks themselves, at their announced discount rates, which are in practice the same at all twelve banks. Nowadays it is secondary to open-market operations, and the Fed generally keeps the discount rate close to the federal funds market rate. However, announcing a new discount rate is often a convenient way to send a message to the money markets. In addition to its responsibilities for macroeconomic stabilization, the central bank has a traditional safety-net role in temporarily assisting individual banks and in preventing or stemming systemic panics as “lender of last resort.”…

Financial Regulation, from the Concise Encyclopedia of Economics

Financial institutions serve various purposes. Depository institutions (banks, savings and loans [S&Ls], and credit unions) transform liquid liabilities (checking accounts, savings accounts, and certificates of deposit that can be cashed in prior to maturity) into relatively illiquid assets, such as home mortgages, car loans, loans to finance business inventories and accounts receivable, and credit card balances. Depository institutions also operate the payments system where bank balances are shifted between parties through checks, wire transfers, and credit and debit card transactions. Insurance companies fall into two broad categories–life and health insurers, whose policies provide financial protection against death, disability, and medical bills; and property and casualty insurers, whose policies protect policyholders against losses arising from fire, natural disasters, accidents, fraud, and other calamities. Stockbrokers and related investment banking firms are central players in the capital markets where businesses raise capital and where individuals and institutional investors buy and sell shares of stock in business enterprises….

Glossary, at the Federal Reserve Bank of Minneapolis.

Terms related to the Federal Reserve, banking and economics….

In the News and Examples

What does the Federal Reserve actually do? John Taylor on Monetary Policy, podcast at EconTalk

John Taylor of Stanford University talks about the Taylor Rule, his description of what the Fed ought to do and what it sometimes actually does, to keep inflation in check and the economy on a steady path. He argues that when the Fed has deviated from the Rule in recent years, the economy has performed poorly. Taylor also assesses the chances for a monetary or financial disaster and the Fed’s recent expanded role in intervening in financial markets.

Allan Meltzer on the Fed, Money, and Gold, podcast at EconTalk

Allan Meltzer of Carnegie Mellon University talks with host Russ Roberts about what the Fed really does and the political pressures facing the Chair of the Fed. He describes and analyzes some fascinating episodes in U.S. monetary history, discusses the advantages and disadvantages of the gold standard and ends the conversation with some insights into recent Fed moves to intervene with investment banks. This is a wonderful introduction to the political economy of the money supply and central banks.

Milton Friedman on Money, podcast at EconTalk

Russ Roberts talks with Milton Friedman about his research and views on inflation, the Federal Reserve, Alan Greenspan and Ben Bernanke, and what the future holds.

What Would Bagehot Have Thought of the Fed’s Policy after September 11, 2001?, by Antoine Martin on Econlib, September 1, 2003.

Following the terrorist attacks of September 11, 2001… the policy followed by the Federal Reserve resembled Bagehot’s prescription but for one important detail: the Fed provided funds at a very low interest rate….

A Little History: Primary Sources and References

A History of Central Banking in the United States, at the Federal Reserve Bank of Minneapolis.

Nearly every country around the world, and certainly every developed industrial nation, has a central bank. Most serve one or more of the following functions: acting as a bank for bankers, issuing a common currency, clearing payments, regulating banks and acting as a “lender of last resort” for banks in financial trouble. The one thing they all do is serve as banker to their own governments.

But even though these central banks have common functions, each still operates in distinct ways, and those distinctions largely stem from the banks’ historical foundations. If you want to understand the nature of a modern central bank, you have to study its history and relationship to commerce and government. This is especially true of the United States, where the Federal Reserve System’s unique structure has been shaped by this country’s earlier experiments with central banking, and by the political response to those experiments. Indeed, the Federal Reserve itself has changed in profound ways since it was signed into law in 1913….

Bank Runs, from the Concise Encyclopedia of Economics

A run on a bank occurs when a large number of depositors, fearing that their bank will be unable to repay their deposits in full and on time, simultaneously try to withdraw their funds immediately. This may create a problem because banks keep only a small fraction of deposits on hand in cash; they lend out the majority of deposits to borrowers or use the funds to purchase other interest-bearing assets such as government securities. When a run comes, a bank must quickly increase its cash to meet depositors’ demands. It does so primarily by selling assets, often hastily and at fire-sale prices. As banks hold little capital and are highly leveraged, losses on these sales can drive a bank into insolvency….

Savings and Loan Crisis, from the Concise Encyclopedia of Economics

Years later, the extraordinary cost of the 1980s S&L crisis still astounds many taxpayers, depositors, and policymakers. The cost of bailing out the Federal Savings and Loan Insurance Corporation (FSLIC), which insured the deposits in failed S&Ls, may eventually exceed $160 billion. At the end of 2004, the direct cost of the S&L crisis to taxpayers was $124 billion, according to financial statements published by the Federal Deposit Insurance Corporation (FDIC), the successor to the FSLIC.

The bankruptcy of the FSLIC did not occur overnight; the FSLIC was a disaster waiting to happen for many years. Numerous public policies, some dating back to the 1930s, created the disaster.

Regulation Q, under which the Federal Reserve since 1933 had limited the interest rates banks could pay on their deposits, was extended to S&Ls in 1966. Regulation Q was price fixing, and like most efforts to fix prices,…

Great Depression, from the Concise Encyclopedia of Economics

The second major policy change was in monetary policy. Following the end of the contraction, banks, as a precaution against bank runs, had begun to hold large excess reserves. Officials at the Federal Reserve System knew that if banks used a large percentage of those excess reserves to increase lending, the money supply would quickly expand and price inflation would follow. Their studies suggested that the excess reserves were distributed widely across banks, and they assumed that these reserves were due to the low level of loan demand. Because banks were not borrowing at the discount window and the Fed had no bonds to sell on the open market, its only tool to reduce excess reserves was the new one of varying reserve requirements….

Competing Money Supplies, from the Concise Encyclopedia of Economics

What would be the consequences of applying the principle of laissez-faire to money? While the idea may seem strange to most people, economists have debated the question of competing money supplies off and on since Adam Smith’s time. Most recently, trends in banking deregulation and important pockets of dissatisfaction with the performance of central banks (such as the Federal Reserve System in the United States) have made the question of competing money supplies topical again….

Gold Standard, from the Concise Encyclopedia of Economics

The gold standard was a commitment by participating countries to fix the prices of their domestic currencies in terms of a specified amount of gold. National money and other forms of money (bank deposits and notes) were freely converted into gold at the fixed price….

Monetarism, from the Concise Encyclopedia of Economics

Monetarism is a macroeconomic school of thought that emphasizes (1) long-run monetary neutrality, (2) short-run monetary nonneutrality, (3) the distinction between real and nominal interest rates, and (4) the role of monetary aggregates in policy analysis….

Evolution of Central Banks and Federal Reserve Bank structure: Lombard Street: A Description of the Money Market, by Walter Bagehot

Advanced Resources

Eugene White on Bank Regulation, podcast at EconTalk

Eugene White of Rutgers University talks with EconTalk host Russ Roberts about the regulation of banks and financial crises. White argues that most regulation tries to limit the choices of banks to restrain them from making choices that create instability or fragility. A better approach, White argues, is to change the incentives facing bankers so that they would be encouraged to make prudent choices without the need for top-down monitoring. He shows how in the 19th century various regulations and market results encouraged stability and prudence while some regulations made the system more fragile. White discusses the lessons for the current crisis and what might be done to improve the current state of regulation.

Belongia on the Fed, podcast at EconTalk. January 11, 2010.

Michael Belongia of the University of Mississippi and former economist at the St. Louis Federal Reserve talks with EconTalk host Russ Roberts about the inner workings, politics, and economics of the Federal Reserve. Belongia talks about the role that power and politics play in Federal Reserve decision-making and how various Fed chairs used their power to suppress dissent within the Fed that was critical of Fed policy. He argues that the Fed faces an unresolvable dilemma when asked to achieve the multiple goals of full employment and price stability using only the federal funds rate as a policy lever. The discussion concludes with Belongia’s indictment of the monetary data that the Fed produces.

Sumner on Monetary Policy, podcast at EconTalk. November 9,2009.

Scott Sumner of Bentley University and the blog The Money Illusion talks with host Russ Roberts about monetary policy and the state of the economy. Sumner argues that tight money in late 2008 precipitated the recession. He argues that the standard measures of monetary policy–growth in reserves or the Federal Funds rate–are misleading. Sumner suggests focusing instead on nominal GDP. He argues that the failure of the Fed to counter the drop in nominal GDP in late 2008 intensified the recession and points to the growth in unemployment. Along the way he discusses the Taylor Rule and other monetary prescriptions.

George Selgin on Free Banking, podcast at EconTalk

George Selgin of West Virginia University talks with EconTalk host Russ Roberts about free banking, where government treats banks as no different from other firms in the economy. Rather than rely on government guarantees to protect depositors (coupled with regulation), banks would compete with each other in offering security and return on deposits. Selgin draws on historical episodes of free banking, particularly in Scotland, to show that such a world need not be unduly hazardous or filled with bank runs. He also talks about Gresham’s Law and an episode in British history when banks successfully issued their own currency.