Why Ron Paul is not Taken Seriously

Advocates of U.S. Presidential candidate Ron Paul, seem befuddled that his economic proposals do not receive more support and consideration. I am unsure if their criticisms of the U.S. Federal Reserve System (the Fed) are objections to the existence of paper money, central banks, or to the specific operation of the Fed. Monetary policy for an increasingly interconnected world is complex. It is reasonable that most people do not understand it. But it can be understood. Let me try to address a few issues.

Money is anything that is generally accepted to serve as a medium of exchange (i.e., you can buy things with it), a store of value (i.e., you use it to save purchasing power for use at a later time), and a unit of account (i.e., it is used to measure relative prices). Stated more simply, money facilitates commerce. Without money that is widely accepted, easy to carry and exchange, and difficult to counterfeit, economic transactions become much more difficult. Without money, people must rely on barter for exchanges of goods and services. For example, a yoga teacher would trade yoga instruction for everything she wants to buy. Paper money, such as Federal Reserve Notes, has been used since the 7th century because it conveniently serves the functions of money. Although it has no intrinsic value, paper money has historically been one of the most widely used forms of money. Bank deposits, such as those created under the fractional reserve banking systems that are common throughout the developed world, are another form of money of similar importance in modern times.

The reason why politicians other than Ron Paul are not advocating the elimination of the Federal Reserve System is because there is a broad consensus among politicians, economists, and the leaders of finance and business that central banks, such as the Fed, provide a necessary function for a developed society. Prior to the creation of the Federal Reserve System in 1913, the U.S. monetary and banking systems were chaotic and their instabilities impeded commerce and economic growth. Because central banks oversee the money supply and banking system, every country with its own currency needs a central bank. They all function essentially in the same way as the Fed.

The primary benefit of a central bank, such as the U.S. Federal Reserve System, is that it promotes a healthy and stable banking system capable of supporting economic growth. It also ensures that society has an appropriate quantity of reliable money to facilitate commerce.

The simplest refutation of the desirability of returning the U.S. to a gold standard is that the money supply would not typically increase unless the U.S. acquired more gold. A benefit of this is that it would prevent excessive inflation. But it would almost certainly lead to devastating deflation and it would make it nearly impossible for the U.S. to use monetary policy to reduce the duration and severity of economic downturns, such as the recent global recession.

Here is a simple example. As a country’s population increases and its economy grows, it needs a larger money supply. If there are a million people earning $1 per day, the economy needs $1 million per day to pay these workers. If the population doubles to 2 million, but the money supply has not increased because the country has not acquired more gold, then the existing $1 million must be sufficient to pay 2 million people. So people earn fifty cents per day instead of a dollar. With these lower labor costs, prices of goods and services fall, too. An overall reduction in the price level, which economists call deflation, might seem desirable. But it is devastating to an economy. It causes a dramatic reduction in purchases of newly produced goods and services. (Why buy something today if you know it will be cheaper next week, next month, or next year?) Deflation increases unemployment as businesses lay off workers because there is reduced demand for their products as consumers postpone purchases until the future (when they will be cheaper).

Developed modern economies have a money supply that is primarily composed of currency and bank deposits and is overseen by a central bank. This allows the money supply to be adjusted to the changing needs of society. The money supply can be easily altered to accommodate changes in population and economic growth. And because central banks influence the amount of money created by private commercial banks in the form of loans, monetary policy is a primary instrument of macroeconomic policy. In prosperous times, central banks fight inflation by encouraging banks to lend less money to the public and thereby reducing overall spending on newly produced goods and services. When the economy is sluggish, central banks promote economic growth and reduce unemployment by encouraging banks to lend more money and thus increase the demand for newly produced goods and services. (As sales increase, businesses rehire workers they laid off or hire new ones.) Mainstream society wants governments to take action to promote economic prosperity and reduce the negative impacts of macroeconomic declines. (See "The Economic Role of Government" for elaboration.)

Ron Paul seems to have considerable fears about hyperinflation. A few economies (with currencies not backed by gold and a central bank similar to the Fed) have suffered hyperinflation. But this does not imply that such a fate in inevitable. An examination of the U.S. inflation rates since 1956 provides no evidence that Fed policies have caused excessive increases in the price level.

http://econperspectives.blogspot.com/2008/10/us-inflation-rates-since-1956.html

Indeed, hyperinflation tends to occur in places where government leaders have considerably more influence over the central bank (as Paul seems to want). The relative independence of the Fed from the whims of current politicians is a strength of the U.S. monetary system, not a shortcoming as Paul suggests.

Ron Paul’s opinions of the Fed are viewed by mainstream society the same way it views people who claim the earth is flat, that the sun orbits the earth, that man never went to the moon, that the best way to cure all illness is to drain blood from the body, that there is no such thing as evolution, that the earth is only 6,000 years old, or that President Barack Obama was not born in Hawaii. There is substantial evidence to refute all of those beliefs. But for whatever reason, some people prefer conspiracy theories. There is a lot to like about Ron Paul’s candidacy. But Paul is not taken seriously by mainstream society because many of the policies he advocates are simplistic and seem to be based on wishful thinking rather than reality.

Here are a few resources that may help your understanding of monetary policy:

(1) The Fed Today, a 14-minute video that provides a good introduction to the U.S. Federal Reserve System.
http://www.youtube.com/watch?v=jFnH9MCdpLo

(2) Economic Perspectives, my blog about macroeconomic policy
http://econperspectives.blogspot.com/2009/03/monetary-policy.html

(3) Wikipedia – decent summaries that may provide answers to many of your questions. The article on the gold standard has a section on its advantages and disadvantages.
http://en.wikipedia.org/wiki/Central_bank
http://en.wikipedia.org/wiki/Federal_Reserve
http://en.wikipedia.org/wiki/Gold_standard
http://en.wikipedia.org/wiki/Banknote

Bernanke's Monetary Policy: Why a Little Inflation is Good

In the November 12, 2010 TIME magazine article "Bernanke's Bum Rap: What's Wrong with a Little Inflation?," Michael Grunwald provides a defense for Fed Chairman Ben Bernanke's monetary policy.

Fed holds rates at record low to fuel recovery

In the December 16, 2009 article "Fed holds rates at record low to fuel recovery," Associated Press economics writer Jeannine Aversa reports the Federal Reserve System will maintain extremely low interest rates to encourage banks to lend more funds in an effort to increase the aggregate demand for newly produced goods and services.

WASHINGTON – The Federal Reserve pledged Wednesday to hold interest rates at a record low to drive down double-digit unemployment and sustain the economic recovery.

The Fed noted that the economy is growing, however slowly. And turning more upbeat, it pointed to a slowing pace of layoffs.

Still, Fed Chairman Ben Bernanke and his colleagues gave no signal that they're considering raising rates anytime soon. They noted that consumer spending remains sluggish, the job market weak, wage growth slight and credit tight. Companies are still wary of hiring, they said.

Against that backdrop, the Fed kept its target range for its bank lending rate at zero to 0.25 percent, where it's stood since last December. And it repeated its pledge, first made in March, to keep rates at "exceptionally low levels" for an "extended period."

In response, commercial banks' prime lending rate, used to peg rates on home equity loans, certain credit cards and other consumer loans, will remain about 3.25 percent. That's its lowest point in decades.

Super-low interest rates are good for borrowers who can get a loan and are willing to take on more debt. But those same low rates hurt savers. They're especially hard on people living on fixed incomes who are earning measly returns on savings accounts and certificates of deposit.

Michael Darda, chief economist at MKM Partners, predicted that rates would stay where they are for most of next year.

"We believe the Fed is essentially out of the picture until late 2010 or early 2011," Darda said. The Fed's "optimism was constrained by a long list of caveats," he added.

Noting the stabilized financial markets, the Fed said it expects to wind down several emergency lending programs when they are set to expire next year. That seemed to strike a confident note that the Fed thinks it can gradually lift supports it provided at the height of the financial crisis.

The central bank made no major changes to a program, set to expire in March, to help further drive down mortgage rates.

The Fed in on track to buy a total of $1.25 trillion in mortgage securities from Fannie Mae and Freddie Mac by the end of March. It has bought $845 billion so far. It's also on pace to buy $175 billion in debt from those groups under the same deadline. So far, the Fed has bought nearly $156 billion.

Its efforts to lower mortgage rates are paying off. Rates on 30-year loans averaged 4.81 percent, Freddie Mac reported last week. That's down from 5.47 percent last year.

The Fed said it has leeway to hold rates at super-low level because it expects that inflation will remain "subdued for some time."

Fed policymakers repeated their belief that slack in the economy — meaning plants operating below capacity and the weak employment market — will keep inflation under wraps.

A government report out Wednesday showed that inflation is in check despite a burst in energy prices. Energy prices, however, are already in retreat.

Bernanke, who's seeking a second term as Fed chief, has made clear his No. 1 task is sustaining the recovery. Last week, he and other Fed officials signaled they are in no rush to start raising rates.

At the same time, Bernanke has sought to assure skeptical lawmakers and investors that when the time is right, he's prepared to sop up all the money. Some worry that the Fed's cheap-money policies will stoke inflation.

Some encouraging signs for the economy have emerged lately. The economy finally returned to growth in the third quarter, after four straight losing quarters. And all signs suggest it picked up speed in the current final quarter of this year.

The nation's unemployment rate dipped to 10 percent in November, from 10.2 percent in October. And layoffs have slowed. Employers cut just 11,000 jobs last month, the best showing since the recession started two years ago.

Still, the Fed predicts unemployment will remain high because companies won't ramp up hiring until they feel confident the recovery will last.

Consumers did show a greater appetite to spend in October and November. But high unemployment and hard-to-get credit are likely to restrain shoppers during the rest of the holiday season and into next year.

Obama pushes bankers to increase lending to boost economy

Economists who believe the government should actively manage the economy to buffer the depth and length of economic downturns say that expansionary monetary policy is appropriate for combating a recession. This is accomplished when commercial banks increase the amount of money created when they increase their lending. More loans encourage increased spending which is turn increases the aggregate demand for newly produced goods and services and boosts employment as businesses increase output.

U.S. President Barack Obama chastised commercial banks for failing to lend sufficient funds to the public despite efforts by the Federal Reserve to lower interest rates and encourage more loans.

In the December 14, 2009 McClatchy article "Obama pushes bankers to increase lending to boost economy," Steven Thomma explains why President Obama wants bankers to increase loans.

WASHINGTON — President Barack Obama gave the nation's top bankers an earful Monday, telling them in no uncertain terms that it's time for them to start lending again to help boost the economy after being bailed out themselves by the nation's taxpayers.

Although aides called the meeting "positive and constructive," there was little doubt that Obama summoned the bankers to the White House for a high-profile dressing down, pitting the power of the presidential bully pulpit against them.

Beyond pressing them to pump more cash into the economy through new loans, he also told them he'll fight them and their lobbyists if they try to block tough new regulation of their industry, and that they need to do more to rein in exorbitant pay.

"My main message in today's meeting was very simple: that America's banks received extraordinary assistance from American taxpayers to rebuild their industry and now that they're back on their feet, we expect an extraordinary commitment from them to help rebuild our economy," the president said after the meeting.

He acknowledged that some of the drop in lending is due to banks and regulators not wanting to repeat the kinds of high-risk loans that helped cause the financial collapse. He also noted that regulators are requiring banks to increase the amount of cash they keep in reserve.

"No one wants banks making the kinds of risky loans that got us into this situation in the first place," he said.

Nonetheless, he pressed them to "explore every responsible way" to boost lending, which has dropped for five consecutive quarters.

When bankers told Obama they were taking a second look at some potential loans to small businesses, he urged them to go farther. "Go back and take a third and fourth look," he said.

Richard Davis , the chairman and CEO of US Bancorp , said outside the White House that bankers weren't hoarding cash just to boost earnings.

The problem, he said, is that many Americans and businesses are less creditworthy than they were before the recession.

"You don't want us to make loans that aren't strong and well suited" to the borrower, he said.

Republicans called it hypocritical for Obama to press bankers to make more loans.

"It's not every day the leader of the free world blames you for a problem and then tells you to do the exact same thing that caused the problem," said Rep. Tom Price , R- Ga. , the chairman of the Republican Study Committee.

Obama also lobbied for his proposed sweeping overhaul of the nation's financial regulations, challenging the bankers to justify their public support for change in light of their intensive lobbying in Congress to defeat his proposals.

"The industry has lobbied vigorously against some of them, some of these reforms on Capitol Hill ," the president said.

"I made very clear that I have no intention of letting their lobbyists thwart reforms necessary to protect the American people. If they wish to fight common-sense consumer protections, that's a fight I'm more than willing to have."

Obama also noted that many banks have shifted from paying bonuses in cash to paying them in stock that's available only after several years. "But," he said, "they certainly could be doing more on this front as well."

The group included:
— Ken Chenault , the president and CEO of American Express .
— Davis of US Bancorp .
— Jamie Dimon , the chairman and CEO of JPMorgan Chase .
— Richard Fairbank , the chairman and CEO of Capital One.
— Bob Kelly , the chairman and CEO of Bank of New York Mellon .
— Ken Lewis , the president and CEO of Bank of America .
— Ron Logue , the chairman and CEO of State Street Bank .
— Gregory Palm , the executive vice president and chief counsel of Goldman Sachs .
— Jim Rohr , the chairman and CEO of PNC.
— John Stumpf , the president and CEO of Wells Fargo .

Some CEOs participated via conference call, unable to attend because of bad weather. They included Lloyd Blankfein , the chairman and CEO of Goldman Sachs , John Mack , the chairman and CEO of Morgan Stanley , and Dick Parsons , the chairman of Citigroup .

The Bernanke Record

The December 4, 2009 Wall Street Journal editorial "The Bernanke Record" asks "Will he repeat the mistakes of his four years?"

Federal Reserve Chairman Ben Bernanke faces his Senate renomination hearing today, amid signs that the confirmation skids are greased. We nonetheless think someone should say that, as a matter of accountability for the financial crisis and looking at the hard monetary choices to come, the country needs a new Fed chief.

We say this not because of Mr. Bernanke's performance during the financial panic of 2008, for which he has been widely and often deservedly praised. Like others in the regulatory cockpit at the time, he had to make difficult choices with imperfect information and when the markets were shooting with real bullets.

He supplied ample liquidity when it was most needed last autumn, and he has certainly been willing to pull out every last page of the central banker playbook. If some of those decisions were mistakes, the conditions the Fed faced were extraordinary. Anyone at the helm would have made calls that in hindsight he'd regret.

The real problem is Mr. Bernanke's record before the panic, with its troubling implications for a second four years. When George W. Bush nominated the Princeton economist four years ago, we offered the backhanded compliment that at least he'd have to clean up the mess that the Alan Greenspan Fed had made. That mess turned out to be bigger than even we thought, but we also didn't know then how complicit Mr. Bernanke was in Mr. Greenspan's monetary decisions.

Now we do, thanks to the release of the Federal Open Market Committee transcripts from 2003. They show (see "Bernanke at the Creation," June 23, 2009) that Mr. Bernanke was the intellectual architect of the decision to keep monetary policy exceptionally easy for far too long as the economy grew rapidly from 2003-2005. He imagined a "deflation" that never occurred, ignored the asset bubbles in commodities and housing, dismissed concerns about dollar weakness, and in the process stoked the credit mania that led to the financial panic.

This, too, might be forgivable if Mr. Bernanke had made any attempt in recent months to acknowledge the Fed's role in the mania. Treasury Secretary Tim Geithner, Dallas Fed President Richard Fisher and others have conceded that monetary policy was too loose. How central banks can minimize, if not prevent, asset bubbles without inducing recessions would seem to be a subject for candid Fed debate.

But Mr. Bernanke and Vice Chairman Don Kohn have formed an intellectual moat around the Fed, blaming the credit bubble on the "global savings glut" that they themselves helped to create. They are the Edith Piafs of central banking, regretting nothing.

All of this bears directly on how the Fed will operate over the next four years. We are now in another period of extraordinary monetary ease. Mr. Bernanke is assuring the world that, this time, he knows how and when to start removing this stimulus, even as he also promises that the Fed will remain easy for months to come. The guideposts the Fed claims to follow on policy—the jobless rate, "resource utilization"—also remain the same. Price signals, especially the value of the dollar, count for much less in this Fed's decision-making.

Earlier this decade, the Fed had 20 years of sound-money history as a source of credibility. The world's investors were willing to give the Greenspan Fed the benefit of the doubt—too much doubt as it turned out. But now, after the mania and panic, investors are unlikely to show such forbearance. That's already clear in Asia, where the falling dollar is creating monetary distortions, and investors are bidding up assets and currencies on a bet that the dollar is in for further declines. Sooner rather than later, Mr. Bernanke will have to tighten money even if the U.S. jobless rate remains higher than everyone would like.

The Fed chairman has shown he knows how to ease money, and creatively so. But that is the easy part of his job. The hard part, the time when central bankers earn their fame, is when they have to take the money away. We see little in the chairman's policy history or guideposts to suggest he will be willing to endure the criticism that will come with tightening money amid a lackluster recovery, if that is what is required to protect the dollar or prevent an inflation outbreak.

The political irony today is that even as Mr. Bernanke is cruising toward confirmation, the Fed as an institution is under its most sustained political attack in two generations. The political class is especially riled about the Fed's forays into fiscal policy. While that is understandable given the last year, the response to this action should not be to put the Fed under even greater political control from Congress. That is the Argentinian solution.

The better response is to hold policy makers accountable for their actions, including chairmen of the Federal Reserve. At this monetary moment more than any since the late 1970s, the Fed needs a hard-money chairman with the courage and credibility to resist the temptation to escape from the consequences of the last bubble by floating another one.

Bernanke defends record during crisis

In the December 3, 2009 Reuters article "Bernanke defends record during crisis," Mark Felsenthal and Pedro da Costa report:

WASHINGTON (Reuters) - Federal Reserve Chairman Ben Bernanke, making a case for a second term on Thursday, offered a forceful defence of the U.S. central bank's crisis-battling efforts, which he said prevented an even greater calamity.

"As serious as the effects of the crisis have been ... the outcome could have been markedly worse without the strong actions" taken by the Fed and other authorities around the globe, Bernanke told the Senate Banking Committee.

President Barack Obama nominated the former Princeton University economics professor to another four-year stint as Fed chairman in August, praising his handling of the worst financial crisis since the 1930s. His current term expires on January 31.

Under Bernanke's tenure, the Fed has slashed interest rates close to zero and pumped more than a trillion dollars into the financial system to beat back the worst financial crisis since the Great Depression.

However, the soft-spoken Fed chairman, who was first named to the post by President George W. Bush, was likely to face aggressive questioning at the hearing.

Lawmakers are upset over taxpayer bailouts of financial firms such as American International Group and Bear Stearns, and what they see as lax Fed regulation of banks and lenders that laid the groundwork for the credit crisis.

Senator Bernie Sanders, an independent from Vermont who is not a member of the panel, said on Wednesday he was placing a "hold" on the nomination, arguing the Fed chief had done little for average Americans, while going too easy on big banks.

That move could force Senate leaders to round up 60 votes just to consider the nomination, which could slow the confirmation process and give critics an opportunity to press their case.

The Wall Street Journal, in an editorial on Thursday, also said Bernanke does not deserve a second term.

The paper praised him for his response to the financial crisis but took him to task for perceived missteps in the past, such as his support when he was a Fed governor for keeping interest rates low for prolonged period earlier in the decade, which many critics contend fuelled the housing bubble.

The newspaper's editors also questioned whether he will be willing to make unpopular decisions. "The hard part, the time when central bankers earn their fame, is when they have to take the money away," they wrote.

Despite voices of discontent, the nomination appears likely to overcome any hurdles.

Committee Chairman Christopher Dodd opened the hearing by making clear he would support the nomination, saying the reappointment would send "right signal" to financial markets.

However, the committee's top Republican, Senator Richard Shelby, criticized the Fed's pre-crisis policies.

Earlier on Thursday, Treasury Secretary Timothy Geithner rose to Bernanke's defence. "He did things that had never been done in the past with enormous creativity and bravery, frankly," he told CNBC.

"The president has full confidence in him and we are confident he will be confirmed," he said.

Dodd's panel needs to approve the nomination to send it before the full Senate. If the Senate does not confirm him by January 31, Bernanke could continue to serve until replaced.

Even if confirmed, as widely expected, Bernanke faces the prospect of running a diminished institution if congressional proposals to curtail the Fed's powers and political independence become law.

Dodd has proposed stripping the Fed of its regulatory powers in favour of unifying fragmented U.S. bank oversight under a single roof. He also would require presidential appointment and Senate confirmation of regional Federal Reserve bank board chairmen, taking away a prerogative currently enjoyed by the 12 regional Fed banks.

More worrying for the Fed, legislation the House of Representatives could vote on next week would submit the central bank's monetary policy decision-making to review by a congressional watchdog agency. Sanders has backed a matching measure in the Senate, but Dodd voiced support for the Fed's independence at the hearing.

Bernanke told the panel that most signs point to stabilizing financial markets and an economy tiptoeing out of recession. He said the Fed would carefully calibrate its withdrawal of ultra-low interest rates and the cash flood it has pumped in the financial system, he said.

"We are ... keenly aware that, to ensure longer-term economic stability, we must be prepared to withdraw the extraordinary policy support in a smooth and timely way as markets and the economy recovery," he said. "Determining the appropriate time and pace for the withdrawal of stimulus will require careful analysis and judgement."

Bernanke's trillion-dollar decision

In the October 24, 2009 Politico article "Bernanke's trillion-dollar decision," Eamon Javors provides an example of why the chairman of the U.S. Federal Reserve System is one of the most powerful people in the world:

The biggest decision of the economic recovery will be made in the next six months, and Barack Obama will have almost nothing to do with it.

Forget the debate over TARP, and never mind the questions about a second stimulus. This decision is about when to pull out $1 trillion that’s propping up the U.S. banking system. And it will be Federal Reserve Chairman Ben Bernanke and his Fed colleagues who make the call.

That’s hard enough for a White House that knows its political fortunes rise and fall with the economy.

What’s worse is that Bernanke and Obama – like many presidents and Fed chairmen past – won’t necessarily have the same goals for this trillion-dollar decision.

Fed chiefs worry about inflation. Bernanke wants to take the money out quickly enough to prevent the economy from overheating and causing a jump in prices that strangles growth. But move too fast, and the economic recovery runs out of fuel.

Presidents worry about jobs. Obama probably wouldn’t mind a little overheating, say, next summer – when voters are starting to make up their minds about the 2010 congressional elections, and he hopes the economy can shake the 10-percent unemployment rate doldrums.

“Any chairman of the Fed will do what’s right for the country, not what’s right for the administration,” said Ernest Patrikis, a partner at the law firm White & Case who spent 30 years at the New York Fed. “That’s his job – that’s why he’s apolitical.”

“The exit will be so difficult,” said economist Joseph Brusuelas of Moody’s Economy.com. “Bernanke wants to engineer a recovery that does not include inflation. Obama wants a more robust recovery and like many political actors may be willing to forgo a little inflation for a little more employment.”

The White House is already worried that jobs won’t be coming back fast enough next year, Fed or no Fed.

Obama economic adviser Christina Romer warned a congressional panel Thursday that the jobs picture will remain “painfully weak” through 2010, with a seriously elevated unemployment rate for another year.

So all the White House can do is watch and wait, and hope it doesn’t pay a political price for any missteps by Fed officials they can’t control.

“It’s a dicey thing to do, and they know it,” said Sen. Richard Shelby (R-Ala.), the ranking member on the Senate Banking Committee. “They have to be careful.”

The Fed’s moves are shrouded in secrecy, their prerogative to move the levers of the economy closely guarded – so much so that there’s been a recent a rise in populist anger about this all-powerful agency that exists largely outside the democratic process.

But because the Fed is an independent agency, it’s even considered bad form for a president to talk much about it – and indeed, the White House refused to comment for this story.

Last fall, the Fed injected $ 1 trillion-plus into the nation’s banking system – at times, by providing financial institutions with cash to cover their losses as the global meltdown spread. Now Fed officials are already talking about the need to withdraw the funds injected into the economy during the darkest days of the crisis, moves that are credited with largely saving the United States from plummeting into an economic depression.

“Given the highly unusual economic and financial circumstances, judging when the time is appropriate to remove policy accommodation, and then calibrating that removal, will be challenging,” said Federal Reserve Vice Chairman Donald Kohn in a speech to the Cato Institute on Sept. 30. “Still, we need to be ready to take the necessary actions when the time comes, and we will be.”

Translation: “policy accommodation” is the cash, and “the necessary actions” are the decision to ease it out of the economy.”

And is the Fed prepared to the pull the trigger? “We will be” seems to cover it.

Already, the Fed is already showing some signs of restlessness. On Monday, the New York Fed tested its “reverse-repo” process -- one tool the Fed could use to use to pull the money out when the time comes. The test run was widely interpreted as a sign the Fed is getting ready to act – but when, nobody knows.

The Fed can also tap on the brakes at the first sign of inflation by raising interest rates, now near zero. The Fed has said it will keep the rock-bottom rates for an extended period, but it won’t be more specific when they could go up – a decision that is bound to be controversial when it comes.

Patrikis thinks the Fed will make a decision on withdrawing liquidity either during the second quarter of 2010, or after the November elections that year – but that it won’t make any dramatic moves in the run-up to Election Day.

Still, he said, it is too early to predict what the Fed might do. And Patrikis points out that Obama will have indirect input into the decision, because there are two vacancies on the Fed’s board now that Obama will fill in the coming months. The president will surely select board members whose economic judgment he trusts.

Between the two vacancies, a member who Obama appointed earlier this year and Bernanke himself, the president will likely have named four of the seven members of the Fed’s Board of Governors by the time they make the call.

But the Fed knows actions like that can have political consequences. “There are few politicians who like higher interest rates,” said one former Fed official. “And President Obama is a politician.” That said, the official continued, “I suspect they will be broadly on the same page.”

That’s because Obama, too, has a longer-term time frame in mind: 2012, when he will be running for reelection. It’s in Obama’s interest for the Fed to take inflation prevention measures now so that he doesn’t have to run a tricky reelection campaign in a high-inflation environment.

Tensions between Presidents and Fed chairmen are nothing new.

In the 1980s, Fed Chairman Paul Volcker declared war on inflation. His strategy: raising interest rates. Volcker jacked the Fed funds rate to 20 percent, which contributed to the deep early 1980s recession that caused howls of protest from the White House and incumbent Republicans on Capitol Hill. The Fed, grumbled then-Senate Majority Leader Howard Baker (R-Tenn.), should “get its boot off the neck of the economy.”

Nonetheless, Volcker’s strategy worked, and the Fed broke the back of the inflation cycle. Ironically, Volcker is a top economic adviser to Obama today.

In the 1990s, President George H.W. Bush blamed Fed Chairman Alan Greenspan for his election loss to Bill Clinton. Bush didn’t believe Greenspan was lowering interest rates fast enough to pull the nation out of a recession – which gave Clinton, with his famous “it’s the economy, stupid” campaign, an opening to trounce the elder Bush.

Mark Gertler, a professor of economics at New York University, says the lesson of history is that politicians should not interfere with the central bank. “If the Fed doesn’t act independently, the economy is endangered,” said Gertler. “It would be dangerous if the administration appeared to be interfering with the Fed.”

Financial Services Committee Chairman Barney Frank (D-Mass.) doubts they’ll be any daylight between Obama and Bernanke – who Obama just reappointed over the summer at a time when Wall Street needed a signal that there would be continuity at the Fed.

He argues that Bernanke and Obama will have the same agenda in 2010: fixing the economy.

“I think they are very much in sync,” said Frank. Asked about potential divergence between the Fed and the White House, he said, “That reflects a journalist’s hope that there will be friction. Obama and Bernanke have both argued that at some point they’re going to unwind this.”

Bernanke optimistic economy will grow again soon

In the August 21, 2009 article "Bernanke optimistic economy will grow again soon" Associated Press economics writer Jeannine Aversa reports Ben Bernanke, the chairman of the Board of Governors of the Federal Reserve System, thinks the U.S. is on the cusp of economic recovery:

JACKSON, Wyo. – Federal Reserve Chairman Ben Bernanke on Friday offered his most optimistic outlook since the financial crisis struck, saying the economy is on the verge of growing again.

Speaking at an annual Fed conference, Bernanke acknowledged no missteps by the central bank in managing the worst crisis since the Great Depression. But he conceded that consumers and businesses are still having trouble getting loans, even though the financial system is gradually stabilizing.

Economic activity in both the U.S. and around the world seems to be leveling out, and the economy is likely to start growing again soon, Bernanke said in a speech at an annual Fed conference in Jackson.

The mood here was decidedly more hopeful than it was last summer, when a sense of foreboding hung over the forum just before the financial crisis erupted.

Bernanke's hopeful remarks on the economy contributed to a rally on Wall Street. The Dow Jones industrial average surged about 155 points, or 1.7 percent, and broader stock averages also gained sharply.

Despite his upbeat tone, Bernanke cautioned that the recovery is likely to be "relatively slow at first."

Unemployment, now at 9.4 percent, is widely expected to hit double digits later this year and to remain high for many months.

The financial markets have stabilized, and some businesses and consumers have found it easier to get loans. Still, the banking system has yet to return to normal, Bernanke said.

Financial institutions face further losses on soured investments. And many businesses and households still can't get the credit they need to fuel the economy, he said.

"Although we have avoided the worst, difficult challenges still lie ahead," Bernanke told the gathering of fellow bankers, academics and economists. "We must work together to build on the gains already made to secure a sustained economic recovery."

Reviewing the past year's crisis, Bernanke outlined the many emergency measures the Fed and other regulators took to help ward off a global financial meltdown. He declined to acknowledge critics' arguments that regulators failed to detect signs of the crisis before it occurred — or that Wall Street bailouts sent a message that big companies that make reckless bets would be rescued with taxpayer money.

A $700 billion taxpayer-funded bailout program to prop up financial institutions incensed many Americans. So did the repeated bailouts of AIG, which paid hefty bonuses to employees who worked in the division that brought down the firm.

Some analysts said Bernanke appeared to be angling to keep his job for another term.

"The lack of any mea culpa suggests the Fed chairman wants to be reappointed," said Richard Yamarone, economist at Argus Research. "When you go on an interview, you never speak of your shortcomings."

President Barack Obama will have to decide in coming months whether to reappoint or replace Bernanke, whose term expires early next year.

Ken Mayland, president of ClearView Economics, said Bernanke was engaging in a "bit of cheerleading to inspire confidence," especially among consumers whose caution could restrain the recovery.

Elsewhere at the conference, European Central Bank President Jean-Claude Trichet responded to a research paper on the origins and the nature of the financial crisis by saying he was a "little bit uneasy" about talk of a return to normalcy.

"We have an enormous amount of work to do, and we should be as active as possible," Trichet said.

The bulk of Bernanke's speech chronicled the extraordinary events of the past year.

Financial markets took a dizzying plunge starting in September and into October, nearly shutting down the flow of credit. The crisis felled storied Wall Street firms. The government took over mortgage giants Fannie Mae and Freddie Mac, as well as insurance titan American International Group Inc.

Lehman Brothers failed. It filed for bankruptcy on Sept. 15, the largest in corporate history, roiling markets worldwide.

The Fed swooped in with unprecedented emergency lending programs to fight the crisis. It eventually slashed a key bank lending rate to a record low near zero. And Congress enacted programs to stimulate the economy, including a $787 billion package of tax cuts and increased government spending.

"Without these speedy and forceful actions, last October's panic would likely have continued to intensify, more major firms would have failed and the entire global financial system would have been at serious risk," Bernanke said.

Unlike in the 1930s, Washington policymakers this time acted aggressively and quickly to contain the crisis, said Bernanke, a scholar of the Great Depression.

"As severe as the economic impact has been, however, the outcome could have been decidedly worse," he said.
Global cooperation in battling the crisis was crucial, with central banks slashing interest rates and the U.S. and other governments delivering fiscal stimulus, he noted.

"The crisis, in turn, sparked a deep global recession, from which we are only now beginning to emerge," the Fed chief observed.

The conference, sponsored by the Federal Reserve Bank of Kansas City, draws a virtual who's who of the financial world — Bernanke's counterparts in other countries, academics and economists. This year's forum focused on lessons learned from the crisis and how they can be applied to prevent a repeat of the debacles.

Bernanke again urged a rewrite of U.S. financial regulations, something Congress is involved in. He repeated his call for stricter oversight of companies — such as AIG — whose failure would endanger the entire financial system and the broader economy. Obama wants to empower the Fed for that duty, something many lawmakers oppose.

Bernanke also said the U.S. needs a process to wind down globally interconnected companies, as the Federal Deposit Insurance Corp. does for failing banks.

A strengthening of financial regulation is needed, he said, "to ensure that the enormous costs of the past two years will not be borne again."

Fed Chairman Bernanke has supporters and critics

In the August 20, 2009 New York Times articleBernanke, a Hero to His Own, Can’t Shake Critics Edmund L. Andrews explains that Federal Reserve Chairman Ben Bernanke has supporters and critics for his response to the global financial crisis:

WASHINGTON — Ben S. Bernanke, chairman of the Federal Reserve, no longer looks sleep-deprived.

He still works seven days a week, but earlier this month he took two days off — for the first time in two years — to attend his son’s wedding. And he often gets home for dinner and even out to baseball games every few weeks.

As central bankers and economists from around the world gather on Thursday for the Fed’s annual retreat in Jackson Hole, Wyo., most are likely to welcome Mr. Bernanke as a conquering hero. In Washington and on Wall Street, it would be a surprise if President Obama did not nominate Mr. Bernanke for a second term, even though he is a Republican and was appointed by President George W. Bush.

But the White House has remained silent. And despite Mr. Bernanke’s credibility in financial circles, both he and the Fed as an institution have come under political fire from lawmakers in both parties over the handling of particular bailouts and the scope of the Fed’s power.

He has been frustrated that many in Congress do not give the Fed what he believes is enough credit for what it has accomplished. Indeed, Mr. Bernanke has met privately with hundreds of lawmakers in recent months to explain the Fed’s strategy.

Fellow economists, however, are heaping praise on Mr. Bernanke for his bold actions and steady hand in pulling the economy out of its worst crisis since the 1930s. Tossing out the Fed’s standard playbook, Mr. Bernanke orchestrated a long list of colossal rescue programs: Wall Street bailouts, shotgun weddings, emergency loan programs, vast amounts of newly printed money and the lowest interest rates in American history.

Even one of his harshest critics now praises him.

“He realized that the great recession could turn into the Great Depression 2.0, and he was very aggressive about taking the actions that needed to be taken,” said Nouriel Roubini, chairman of Roubini Global Economics, who had long criticized Fed officials for ignoring the dangers of the housing bubble.

But Mr. Bernanke is hardly breathing easy. Unemployment is still at 9.4 percent, and the central bank’s own forecasts assume that it will remain that high through the end of next year. Even if all goes according to plan, Fed officials said, Mr. Bernanke’s current popularity could sink if the recovery proves slower than many people expect.

While the White House keeps mum about Mr. Bernanke’s future, the leading Democratic candidates to replace him include Lawrence H. Summers, director of the National Economic Council; Janet L. Yellen, president of the Federal Reserve Bank of San Francisco; Alan S. Blinder, a Princeton economist and former Fed vice chairman; and Roger Ferguson, another former Fed vice chairman.

Mr. Bernanke faces two major challenges. On the economic front, the Fed has to decide when and how it will reverse all its emergency measures and raise interest rates back to normal without either stalling the economy or igniting inflation.

On the political front, Mr. Bernanke is trying to defend the Fed’s power and independence as the White House and Congress debate plans to overhaul the system of financial regulation.

Democrats like Senator Christopher J. Dodd of Connecticut, chairman of the Senate Banking Committee, contend that the Fed was too cozy with banks and Wall Street firms as the mortgage crisis was building. House Republicans, and some Democrats, complain that the Fed already has too much power.

“Why does the Fed deserve more authority when institutionally it seemed to have failed to prevent the current crisis?” asked Senator Dodd last month.

The political battle over President Obama’s plan to overhaul financial regulation has put Mr. Bernanke in an awkward position.

Fed officials support the administration’s proposals to put them in charge of systemic risk like the growth of reckless mortgage lending or the misuse of financial derivatives. But they chafe at the plan to shift the Fed’s consumer-protection functions, which protect people from deceptive and unfair lending practices, to a new agency.

Mr. Bernanke has avoided publicly criticizing the White House’s call for an independent consumer regulatory agency. While acknowledging that the Federal Reserve did nothing to stop mortgage practices during the housing bubble, Mr. Bernanke has argued that the Fed has since written tough new protections for both mortgage borrowers and credit card customers.

“We think the Fed can play a constructive role in protecting consumers,” he told the House Financial Services Committee last month.

Mr. Bernanke and other Fed officials now concede they failed to anticipate the full danger posed by the explosion of subprime mortgage lending. As recently as the spring of 2007, Mr. Bernanke still contended that the problems of the housing market were largely “contained” to subprime mortgages. When panic over mortgage-backed securities began spreading through the broader credit markets in late July 2007, Fed officials initially refused to cut interest rates.

By December 2007, Mr. Bernanke became increasingly convinced that the economy itself was in trouble but policy makers were unable to reach agreement and decided not to reduce interest rates.

At a meeting on Jan. 21, 2008, the Fed slashed the benchmark federal funds rate by 0.75 percent, to 3.5 percent, the biggest one-time reduction in decades. Nine days later, officials cut the rate again, down to 3 percent.

As the credit crisis deepened, Mr. Bernanke urged Fed officials to devise proposals that had never been tried before. They responded with a kaleidoscope of emergency loan programs to a wide array of industries.

“He has had tremendous courage throughout this episode,” said Frederic S. Mishkin, a professor at Columbia University’s business school and a former Fed governor.

Amid the chaos, Fed and Treasury officials made numerous mistakes. Their original idea for the $700 billion to buy up bad mortgage assets held by banks has yet to get off the ground.

But economists say Mr. Bernanke’s most important accomplishment was to create staggering amounts of money out of thin air.

All told, the Federal Reserve has expanded its balance sheet to $1.9 trillion today, from about $900 billion a year ago. Analysts now caution that Mr. Bernanke’s job is only half complete. He will eventually have to reel all that money back. He has already laid out elements of the Fed’s “exit strategy,” but Fed officials have been careful to say it is still too early to pull back any time soon.

Bernanke’s Assurances

The "Bernanke’s Assurances" article in the Wall Street Journal on July 22, 2009 evaluated Fed chairman Ben Bernanke's testimony before Congress:

Federal Reserve Chairman Ben Bernanke took his “exit strategy” on the road yesterday, promising that he knows how to withdraw excess liquidity from the financial system in time to avoid a new inflation or another asset bubble. We’re glad to hear it, but then few have doubted that the Fed knows how to exit. The issue is whether he and his fellow Governors have the nerve to do it.

In an op-ed for us and in his testimony on Capitol Hill, Mr. Bernanke stressed the Fed’s technical ability to withdraw the liquidity it has injected to stem last year’s financial panic. For example, it can raise the interest rate it pays on the balances held by banks at the Fed, which would induce the banks to keep larger balances and thus remove money from the economy. This is an untraditional mechanism for monetary policy, but we’ve been in similar uncharted territory for at least 18 months. The Fed’s monetary gnomes are certainly up to the technical task.

Mr. Bernanke was far less reassuring on the more potent questions of whether and when the Fed will reduce its balance sheet. In particular, the Fed chief reiterated that it’s too early to start tightening and that the Fed will keep its current policy of near-zero interest rates for “an extended period.” So how long is extended? Mr. Bernanke didn’t say, and we are all supposed to assume that he’ll know the right moment when he sees it.

As readers of these columns know, we’ve been here before—specifically, in late 2003 when Mr. Bernanke was a Governor at Alan Greenspan’s Fed. Despite an expansion that was already well under way, Mr. Bernanke argued at the time that the Fed needed to keep the fed funds rate at 1% for an “extended period” in order to reduce unemployment. Thus began the commodity and credit bubbles that brought us to our current pass. Mr. Bernanke has never acknowledged that blunder, though a couple of his more reflective Fed colleagues have.

This time the Fed’s political and policy dilemmas will be far more acute. The Fed’s current policy is the easiest in its history and continues even as the financial panic has subsided and the big banks are again making money. On the other hand, the jobless rate is 9.5% and likely to climb further even once the recovery begins. With Washington creating policy uncertainty over the future of tax rates, health care, energy prices, antitrust and so much else, businesses will be slow to rehire, if they do at all.

Congress and the White House want the Fed to stay easy as long as unemployment stays high. But if the Fed does so, it will run the risk of acting too late, well after inflation expectations have begun to build. Such expectations aren’t apparent now, with the economy still on the mend. But signs to watch include commodity prices, long-term bond rates, and especially the dollar. The problem is that Mr. Bernanke has long dismissed both the value of the dollar and commodity prices as guides to monetary policy. Like the Fed staff, he focuses on unemployment and the “output gap,” which is the difference between actual and potential economic growth. Both are lagging economic indicators, which is why the Fed so frequently is behind the curve with its monetary decisions.

All of this is compounded by Mr. Bernanke’s personal “no-exit” strategy, by which we mean his campaign to be reappointed to a second term as Fed Chairman. His current term expires early next year, and Mr. Obama will soon have to decide whether to choose his own chairman or give Mr. Bernanke another four years. Mr. Bernanke has been in full campaign mode for months, and auditions for Fed appointments rarely include raising interest rates.

All of which makes Mr. Bernanke’s assurances yesterday nice to hear but less than reassuring. We’ll believe them when we see the Fed begin to tighten despite political objections from Capitol Hill and the White House.

The Fed’s Exit Strategy

In an editorial in the Wall Street Journal on July 21, 2009, Ben Bernanke, the chairman of the Board of Governors of the Federal Reserve System, explained "The Fed's Exit Strategy":

The depth and breadth of the global recession has required a highly accommodative monetary policy. Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the interest-rate target for overnight lending between banks (the federal-funds rate) nearly to zero. We have also greatly expanded the size of the Fed’s balance sheet through purchases of longer-term securities and through targeted lending programs aimed at restarting the flow of credit.

These actions have softened the economic impact of the financial crisis. They have also improved the functioning of key credit markets, including the markets for interbank lending, commercial paper, consumer and small-business credit, and residential mortgages.

My colleagues and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road. The Federal Open Market Committee, which is responsible for setting U.S. monetary policy, has devoted considerable time to issues relating to an exit strategy. We are confident we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner.

The exit strategy is closely tied to the management of the Federal Reserve balance sheet. When the Fed makes loans or acquires securities, the funds enter the banking system and ultimately appear in the reserve accounts held at the Fed by banks and other depository institutions. These reserve balances now total about $800 billion, much more than normal. And given the current economic conditions, banks have generally held their reserves as balances at the Fed.

But as the economy recovers, banks should find more opportunities to lend out their reserves. That would produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures—unless we adopt countervailing policy measures. When the time comes to tighten monetary policy, we must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy.

To some extent, reserves held by banks at the Fed will contract automatically, as improving financial conditions lead to reduced use of our short-term lending facilities, and ultimately to their wind down. Indeed, short-term credit extended by the Fed to financial institutions and other market participants has already fallen to less than $600 billion as of mid-July from about $1.5 trillion at the end of 2008. In addition, reserves could be reduced by about $100 billion to $200 billion each year over the next few years as securities held by the Fed mature or are prepaid. However, reserves likely would remain quite high for several years unless additional policies are undertaken.

Even if our balance sheet stays large for a while, we have two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves. We could use either of these approaches alone; however, to ensure effectiveness, we likely would use both in combination.

Congress granted us authority last fall to pay interest on balances held by banks at the Fed. Currently, we pay banks an interest rate of 0.25%. When the time comes to tighten policy, we can raise the rate paid on reserve balances as we increase our target for the federal funds rate.

Banks generally will not lend funds in the money market at an interest rate lower than the rate they can earn risk-free at the Federal Reserve. Moreover, they should compete to borrow any funds that are offered in private markets at rates below the interest rate on reserve balances because, by so doing, they can earn a spread without risk.

Thus the interest rate that the Fed pays should tend to put a floor under short-term market rates, including our policy target, the federal-funds rate. Raising the rate paid on reserve balances also discourages excessive growth in money or credit, because banks will not want to lend out their reserves at rates below what they can earn at the Fed.

Considerable international experience suggests that paying interest on reserves effectively manages short-term market rates. For example, the European Central Bank allows banks to place excess reserves in an interest-paying deposit facility. Even as that central bank’s liquidity-operations substantially increased its balance sheet, the overnight interbank rate remained at or above its deposit rate. In addition, the Bank of Japan and the Bank of Canada have also used their ability to pay interest on reserves to maintain a floor under short-term market rates.

Despite this logic and experience, the federal-funds rate has dipped somewhat below the rate paid by the Fed, especially in October and November 2008, when the Fed first began to pay interest on reserves. This pattern partly reflected temporary factors, such as banks’ inexperience with the new system.

However, this pattern appears also to have resulted from the fact that some large lenders in the federal-funds market, notably government-sponsored enterprises such as Fannie Mae and Freddie Mac, are ineligible to receive interest on balances held at the Fed, and thus they have an incentive to lend in that market at rates below what the Fed pays banks.

Under more normal financial conditions, the willingness of banks to engage in the simple arbitrage noted above will tend to limit the gap between the federal-funds rate and the rate the Fed pays on reserves. If that gap persists, the problem can be addressed by supplementing payment of interest on reserves with steps to reduce reserves and drain excess liquidity from markets—the second means of tightening monetary policy. Here are four options for doing this.

First, the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

Second, the Treasury could sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury’s account at the Federal Reserve rises and reserve balances decline.

The Treasury has been conducting such operations since last fall under its Supplementary Financing Program. Although the Treasury’s operations are helpful, to protect the independence of monetary policy, we must take care to ensure that we can achieve our policy objectives without reliance on the Treasury.

Third, using the authority Congress gave us to pay interest on banks’ balances at the Fed, we can offer term deposits to banks—analogous to the certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the federal funds market.

Fourth, if necessary, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market.

Each of these policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.

—Mr. Bernanke is chairman of the Federal Reserve.

Fed says recession easing, inflation not a threat

In the June 24, 2009 story "Fed says recession easing, inflation not a threat", Associated Press economics writer Jeannine Aversa reports the U.S. central bank left the federal funds rate unchanged because is sees signs the U.S. economy is recovering:

WASHINGTON – The Federal Reserve signaled Wednesday that the weak economy likely will keep prices in check despite growing concerns that the trillions it's pumping into the financial system will ignite inflation.
Fed Chairman Ben Bernanke and his colleagues held a key bank lending rate at a record low of between zero and 0.25 percent, and pledged again to keep it there for "an extended period" to help brace activity going forward.
Even though energy and other commodity prices have risen recently, the Fed said inflation will remain "subdued for some time." This new language sought to ease Wall Street's concerns that the Fed's aggressive actions to revive the economy will spur inflation later on.
The Fed also decided to maintain existing programs intended to drive down rates on mortgages and other consumer debt. Instead, the central bank again reserved the right to make changes if economic conditions warrant.
The Fed in March launched a $1.2 trillion effort to drive down interest rates to try to revive lending and get Americans to spend more freely again. It said it would spend up to $300 billion to buy long-term government bonds over six months and boost its purchases of mortgage securities. So far, the Fed has bought about $177.5 billion in Treasury bonds.
The Fed is on track to buy up to $1.25 trillion worth of securities issued by Fannie Mae and Freddie Mac by the end of this year. Nearly $456 billion worth of those securities have been purchased.
Fed policymakers noted that the "pace of economic contraction is slowing" and that conditions in financial markets have "generally improved in recent months." That observation about the recession was stronger than after the Fed's last meeting in April.
Economists predict the economy is sinking in the April-June quarter but not nearly as much as it had in the prior six months, which marked the worst performance in 50 years. The economy is contracting at a pace of between 1 and 3 percent, according to various projections.
Fed policymakers said its forceful actions, along with President Barack Obama's stimulus of tax cuts and increased government spending will contribution to a "gradual "return to economic growth.
Bernanke has predicted the recession will end later this year. Some analysts say the economy will start growing again as soon as the July-September quarter.
Fed policymakers noted that consumer spending has shown signs of stabilizing but remains constrained by ongoing job losses, falling home values and hard-to-get credit.
Even after the recession ends, the recovery is likely to be tepid, which will push unemployment higher.
The nation's unemployment rate — now at 9.4 percent — is expected to keep climbing into 2010. Acknowledging that the jobless rate is going to climb over 10 percent, President Barack Obama said Tuesday he's not satisfied with the progress his administration has made on the economy. He defended his recovery package but said the aid must get out faster.
Some analysts say the rate could rise as high as 11 percent by the next summer before it starts to decline. The highest rate since World War II was 10.8 percent at the end of 1982.
The weak economy has put a damper on inflation.
Consumer prices inched up 0.1 percent in May, but are down 1.3 percent over the last 12 months, the weakest annual showing since the 1950s. The Fed suggested companies won't be in any position to jack up prices given cautious consumers, big production cuts at factories and the weak employment climate.

Government policies to reduce the severity of recessions and reverse economic declines

The government has two broad options for managing the overall economy: monetary policy and fiscal policy.

In the United States, expansionary monetary policy is the Federal Reserve system´s use of the money supply, interest rates, and the banking system to encourage commercial banks to lend more money to the public in the hope that this will increase overall spending on newly produced U.S. goods and services. The collapse of credit markets in 2008 reduced most types of lending and will require a restoration of confidence (perhaps by improved oversight and regulation) before monetary policy can assist in economy recovery (by lending more money to encourage more overall spending).

Fiscal policy is taxation and government spending. The logic of using tax cuts to counter a recession is that if the government takes less money from individuals and businesses, they will have more money to spend. Remember the cause of the U.S. economic downturn is insufficient overall spending on newly produced American goods and services. In this regard, tax cuts are essentially identical to the federal government handing out money. The goal is to put more money in the hands of individuals and businesses in the hope that they will spend it on products that are newly made by U.S. workers. Many debates about tax cuts are essentially decisions about to whom the government should be giving money. Tax cuts and other increases in government handouts are relatively quick ways to inject purchasing power into the economy and increase the potential for increases in aggregate demand. There is no way to guarantee that these income supplements will result in purchases of newly made U.S. products, however. For example, much of the increased disposable income caused by the tax cuts of 2001 and 2003 resulted in paying down consumer debt rather than increased consumer spending. And even when spent, if the products purchased are not American-made there is limited benefit to the U.S. economy and its workers. Even though tax cuts or other government handouts can be done quickly, they may be poor choices if they do not significantly increase overall spending on newly produced U.S. goods and services.

An alternative fiscal policy to counteract economic declines is an increase in government purchases. The primary benefit of this choice is that government procurement policies can ensure that this increased spending goes to U.S. businesses that employ American workers. A difficulty with this approach, however, is that it may be difficult to spend sufficient quantities of money quickly enough on projects of long-term benefit. Infrastructure projects can take long periods of time to complete and thus may not inject additional income into the economy quickly enough. Similar arguments can be made for proposals to improve energy efficiency, develop alternative fuel sources, or reform the health care industry. Projects that can be quickly implemented, however, may be of questionable long-term benefit. Yet, if the result is increased purchases of new products made by U.S. workers and suppliers, they still may be preferable to tax cuts (if the tax cuts are used to pay down debt or buy used or foreign products).

Tax cuts and increases in government spending both increase budget deficits and the national debt. Criticisms of stimulus proposals on the basis of reluctance to increase public borrowing apply equally to tax reductions and increased spending programs. Running deficits is not always bad, however. For example, many students borrow substantial sums of money in order to attend college. This indebtedness is easily justified, however, because it leads to a college degree that increases earnings potential for the remainder of one´s career. Similarly, it can be reasonable for a society to borrow money from future generations if the funds are spent wisely on things that increase the productive ability of the economy and improve future living standards. Future generations may not mind if money is borrowed from them to develop alternative energy sources that result in less environmental degradation. It is less arguable to accumulate massive public debt based on willful ignorance, selfishness, or simple reluctance to pay one´s way. The 2001 and 2003 tax cuts were the first wartime tax decreases in U.S. history. Previous generations were willing to make sacrifices for causes they believed in.

Tax decreases are popular and are undoubtedly of short-term benefit to those allowed to pay less in tax. The dramatic increases in U.S. budget deficits and public debt since 1980 have been of great short-term benefit to many sectors of the economy. But they have done substantial harm to the long-term benefit of the U.S. and global economies (for many of the reasons cited by critics of current stimulus proposals). It is akin to allowing large numbers of people to go to the mall, stuff shopping bags with items, and walk out without paying. It is of great short-term benefit to those who get away with it. But these strategies are not sustainable in the long-term. Selfish and misguided choices over the previous three decades have left American policymakers with few, if any, desirable options. The more important question may be how long will it take before U.S. citizens become willing to make the sacrifices and tough choices necessary to correct the abuses of the past and demand more honest, reasoned leadership.

See also "Recessions & Depressions: Questions & Answers."

"The Fed Today" video

Join radio and television journalist Charles Osgood as he explains the workings of the Federal Reserve System. 

This 13-minute video covers the Fed's history from its creation in 1913 to the technological innovations of 21st century banking. It explores the structure of the Fed as well as monetary policy, banking supervision, financial services, and more.

Fed set to pay interest on banks' deposits

According to the May 8, 2008 article "Fed set to pay interest on banks' deposits" in The Independent, the U.S. Federal Reserve System is adding a new tool to monetary policy: the ability to pay interest on deposits at the Fed. When commercial banks deposit money in accounts at the Federal Reserve System, that money is not available to be loaned to the public. The Fed can alter the amount of money in circulation by altering the interest rate on deposits to influence how much money is loaned to the public. According to writer Stephen Foley:

The Federal Reserve is adding another weapon to its armoury for dealing with the credit crisis, with plans that would allow it to pay interest on deposits from thousands of US banks.

The scheme, which the Fed chairman, Ben Bernanke, is requesting permission for from Congress, is the latest in a series of innovations designed to help the central bank keep credit markets moving – efforts for which it has so far been roundly praised.

All of the country's commercial banks are required to keep a proportion of their cash at the Federal Reserve in order to ensure their solvency, but they do not currently receive interest. Paying interest will give the Fed an important lever for controlling interest rates throughout the financial system. Congress has agreed to allow the Fed to do so, but there was concern about the costs to the taxpayer, and the law will not take effect until 2011. Mr Bernanke is pressing lawmakers to remove the delay.

Paying interest would in effect set a floor for market interest rates, since banks would have no incentive to lend cash at a lower rate than it can get from the Fed. That means the Fed can flush the financial system with new money, without risking interest rates collapsing and setting off inflation.

Since the credit crisis began last summer, the Fed has made a series of seemingly arcane, but important changes to the way it interacts with financial markets. It has expanded the collateral it will take in when making new loans, acted to remove the stigma for financial institutions borrowing from the Fed and – most importantly – begun lending directly to Wall Street firms as well as just to commercial banks.

Monetary Policy - Questions for Further Study

QUESTIONS FOR FURTHER STUDY

1. The island of Yap is known for an unusual form of money. Where is Yap? What is its unique money? Would you classify it as commodity money or fiat money?

2. Do the components of the M1 money supply serve all three functions of money? How about M2 and M3? What is the relationship between the different definitions of the money supply and their abilities to fulfill the functions of money?

3. Is the Federal Reserve System financed by general tax revenues or does it receive income from other sources? How much of the federal government annual budget is devoted to the support of the Federal Reserve System?

Important Definitions Related to Monetary Policy

IMPORTANT DEFINITIONS RELATED TO MONETARY POLICY


· Monetary policy is the management of the nation’s money supply, interest rates, and banking system to promote economic growth, low unemployment, and low inflation.

· Fiscal policy is taxing and spending by the government.

A central bank is an institution that oversees the banking system and regulates the quantity of money in an economy.

The Federal Reserve System (the Fed) is the U.S. central bank, which oversees the banking system and regulates the quantity of money in an economy.

Expansionary monetary policy occurs when the Federal Reserve System induces commercial banks to increase the amount of money they create through loans and thus increases the money supply.

Contractionary monetary policy occurs when the Federal Reserve System induces commercial banks to decrease the amount of money they create through loans and thus decreases the money supply.

Money is anything that is generally accepted to serve as a medium of exchange, store of value, and unit of account.

· A medium of exchange is something, such as money, that facilitates trade.

· Barter is the exchange of a good or service for another good or service.

· A double coincidence of wants is the need for a trader to find a partner who has a product he wants and who wants what he is offering to trade.

· A store of value is something, such as money, that is used to hold purchasing power for use at a later time.

· A unit of account is something, such as money, that is commonly used to measure the prices of things.

· Currency is paper bills and coins.

· Paper bills are paper or cloth notes with markings that indicate their monetary denominations.

· Coins are hard materials, typically metals, with markings that indicate their monetary denominations.

· Fiat money is money that does not have intrinsic value.

· Fiat lux is the motto of Jacksonville University. It is Latin for “let there be light” or “let the light shine.”

· Commodity money is money that has intrinsic value.

· M1 is the narrowest definition of the U.S. money supply. It includes currency, travelers’ checks, demand deposits and other checkable deposits.

· A traveler’s check is a draft, available in various denominations, that must be signed at the time of purchase and which can be redeemed only when countersigned with a matching signature at the time of redemption.

· A demand deposit is the balance in a checking account at a commercial bank.

· M2 is a definition of the U.S. money supply that includes currency, travelers’ checks, demand deposits and other checkable deposits, savings accounts, money market accounts, money market mutual funds, and small denomination certificates of deposit

· M3 is a definition of the U.S. money supply that includes currency, travelers’ checks, demand deposits and other checkable deposits, savings accounts, money market accounts, money market mutual funds, small denomination certificates of deposit, and large denomination certificates of deposit

· Commercial banks are financial institutions, chartered by the federal or state government, that generate income primarily by accepting deposits from the general public and using these funds to create loans.

· Credit unions are not-for-profit organizations that provide banking services to members.

· Open market operations are the purchases and sales of government securities by the Federal Reserve System’s Federal Open Market Committee (FOMC) to or from the general public.

· Open market purchases are the purchases of government securities by the Federal Reserve System’s Federal Open Market Committee (FOMC) from the general public.


· Open market sales are the sales of government securities by the Federal Reserve System’s Federal Open Market Committee (FOMC) to the general public.

· The discount rate is the interest rate charged on loans from the regional Federal Reserve Banks to commercial banks.

· Discount loans are loans from regional Federal Reserve Banks to commercial banks

· The federal funds rate is the interest rate charged on loans from commercial banks to other commercial banks. It is one half of a percentage point less than the discount rate.

· Federal funds are reserves that are loaned overnight from a commercial bank with excess reserves to a commercial bank with a shortage of reserves.

· The Board of Governors is the seven-member committee that sets policy for the Federal Reserve System.

· The Federal Open Market Committee (FOMC) is the twelve-member Federal Reserve System committee that conducts open market operations to alter the money supply and influence the economy.

· Regional Federal Reserve Banks are the Federal Reserve System institutions that oversee the health of the U.S. banking system. The 12 regional Federal Reserve banks also clear checks, issue new currency, withdraw damaged currency from circulation, evaluate some merger applications, administer and make discount loans to banks in their districts, act as liaisons between the business community and the Federal Reserve System, examine state member banks, collect data on local business conditions, and research topics related to the conduct of monetary policy.

· Fractional-reserve banking is a banking system in which banks hold only a fraction of deposits as reserves.

· Reserves are the cash in the vault of a commercial bank plus its deposits in accounts at a Federal Reserve Bank.

· Vault cash is the currency held in a commercial bank’s vault.

· An asset is a financial claim or piece of property that is a store of value.

· Liabilities are debts.

· Net worth is the difference between a firm’s assets and its liabilities.

· Reserves are a commercial bank’s deposits in accounts at the Fed plus currency that is held in the bank’s vault.

· Required reserves are the vault cash and deposits at the Fed that commercial banks hold to meet the Fed’s requirement that for every dollar of deposits at a bank, a certain fraction must be kept as reserves.

· Excess reserves are the vault cash and deposits at the Fed that commercial banks hold is addition to those held to meet the Fed’s requirement that for every dollar of deposits at a bank, a certain fraction must be kept as reserves.

· U.S. government securities are long-term debt instruments (such as bonds) issued by the U.S. Treasury to finance the budget deficits of the federal government.

· Liquidity is the relative ease and speed with which an asset can be converted into cash. Loans are assets for banks

· The required reserve ratio (rr) is the fraction or percentage of deposits that commercial banks are required to hold in the form of reserves.

· The monetary base is the amount of currency in circulation or held as reserves.

· The reserve ratio (R) is the fraction of deposits that banks hold as reserves.

· The money multiplier is the amount of money the banking system generates with each dollar of reserves. It is the reciprocal of the reserve ratio.

· A T-account is a simplified balance sheet with lines in the form of a T that lists only the changes that occur in the balance sheet items from some initial balance sheet position.

Example of Fractional Reserve Banking with 20% Required Reserves

Example of Fractional Reserve Banking with 20% Required Reserves

Suppose the Fed conducts an open market purchase of a $1000 Treasury bill from the First National Bank. What would be the total effect on the money supply from this $1000 increase in the reserves if the required reserve ratio is 20%?

If banks do not hold any additional excess reserves, banks will make loans for the maximum amount of any new deposits. When the Fed purchases the $1000 government security from the First National Bank, the bank’s balance sheet changes as follows:

Table 36.
FIRST NATIONAL BANK
ASSETS
LIABILITIES & NET WORTH
Required Reserves
Deposits
Excess Reserves + $1000

Loans
Net Worth
Government Securities - $1000

Property & other assets

Since the bank has not acquired any additional deposits, its required reserves do not change. The sale of the Treasury bill has reduced the bank’s holdings of government securities by $1000. In exchange for the government bond, the Fed has credited $1000 to the First National Bank’s account at the Fed.

Since it is assumed banks do not want to hold any additional excess reserves, the First National Bank will loan out the $1000 to earn additional interest income. Suppose the First National Bank loans the $1000 to Adam Aardvark. It does this by increasing the balance in Adam’s checking account at First National Bank. The money supply has just increased by $1000. (Remember the M1 definition of the money supply is currency in circulation plus the balances in checking accounts plus travelers’ checks outstanding.)

Table 37.
FIRST NATIONAL BANK
ASSETS
LIABILITIES & NET WORTH
Required Reserves
Deposits
Excess Reserves - $1000

Loans + $1000
Net Worth
Government Securities

Property & other assets


Notice that the net affect of the open market operation is that the First National Bank has decreased its holdings of government securities by $1000 and increased its loans by $1000.

When people borrow money, they usually spend it right away. Suppose Adam buys a $1000 painting from Bernice Bear. Bernice now has $1000 she did not have before. Suppose she deposits this in her bank, Second National Bank. This bank will be required to keep 20% of this deposit as reserves, and will loan out $800.

Table 38.
SECOND NATIONAL BANK
ASSETS
LIABILITIES & NET WORTH
Required Reserves + $200
Deposits + $1000
Excess Reserves

Loans + $800
Net Worth
Government Securities

Property & other assets


Suppose Second National Bank loans $800 to Charlie Cheetah. Charlie uses the money to buy a stereo from Diego Dolphin. Diego now has $800 that he did not have before this transaction. Suppose Diego deposits the $800 in his bank, Third National Bank. This bank will be required to keep 20% of this deposit as reserves and will loan out the rest. This means the Third National Bank will increase its required reserves by $160 and will increase its loans by $640.

Table 39.
THIRD NATIONAL BANK
ASSETS
LIABILITIES & NET WORTH
Required Reserves + $160
Deposits + $800
Excess Reserves

Loans + $640
Net Worth
Government Securities

Property & other assets




Suppose Third National Bank loans $640 to Esmeralda Elephant. Esmeralda uses the money to buy a wide screen television from Francesca Ferret. Francesca now has $640 that she did not have before. Suppose Francesca deposits the $640 in her bank, Fourth National Bank. This bank will be required to keep 20% of this deposit as reserves and will loan out the rest. This means the Fourth National Bank will increase its required reserves by $128 and will increase its loans by $512.

Table 40.
FOURTH NATIONAL BANK
ASSETS
LIABILITIES & NET WORTH
Required Reserves + $128
Deposits + $640
Excess Reserves

Loans + $512
Net Worth
Government Securities

Property & other assets


Suppose Fourth National Bank loans $512 to Gary Gorilla. Gary uses the money to buy a sculpture from Helen Hyena. Helen now has $512 that she did not have before. Suppose Helen deposits the $512 in her bank, Fifth National Bank. This bank will be required to keep 20% of this deposit as reserves and will loan out the rest. This means the Fifth National Bank will increase its required reserves by $102.40 and will increase its loans by $409.60.

Table 41.
FIFTH NATIONAL BANK
ASSETS
LIABILITIES & NET WORTH
Required Reserves + $81.92
Deposits + $409.60
Excess Reserves

Loans + $327.68
Net Worth
Government Securities

Property & other assets


Suppose Fifth National Bank loans $327.68 to Ian Impala. Ian uses the money to buy a hand-made rug from Julius Jaguar. Julius now has $327.68 that he did not have before. Suppose Julius deposits the $327.68 in his bank, Sixth National Bank. This bank will be required to keep 20% of this deposit as reserves and will loan out the rest. This means the Sixth National Bank will increase its required reserves by $65.54 and will increase its loans by $262.14.


Table 42.
SIXTH NATIONAL BANK
ASSETS
LIABILITIES & NET WORTH
Required Reserves + $65.54
Deposits + $327.68
Excess Reserves

Loans + $262.14
Net Worth
Government Securities

Property & other assets


The open market purchase of a $1000 government security from the First National Bank has caused an increase in the money supply that is much larger than $1000. So for, the money supply has increased by $4095.10. Bernice Bear still has the additional $1000 in her account at the Second National Bank, Diego Dolphin still has the additional $900 in his account at Third National Bank, Francesca Ferret still has the additional $810 in her account at the Fourth National Bank, Helen Hyena still has the additional $729 in her account at the Fifth National Bank, and Julius Jaguar still has the additional $656.10 in his account at the Sixth National Bank. The additions to people’s checking accounts are $1000 + $800 + $640 + $512 + $409.60 + $327.68 = $3,689.28. This process could continue, however. Eventually the total increase in the money supply would be $5,000. The amount of money the banking system generates with each dollar of reserves is the money multiplier. The money multiplier is the inverse of the reserve ratio. In this example, the reserve ratio is .20. Thus the money multiplier is 1/.20 = 5. Thus, each dollar of reserves generates $5 of money. Since the open market operation increased reserves by $1000, the total effect on the money supply is 5 times $1000 = $5,000.

Notice that with a higher required reserve ratio, the increase in the money supply is smaller.
· A $1000 increase in banking system reserves caused a $10,000 increase in the money supply when the required reserve ratio was 10%.
· A $1000 increase in banking system reserves caused a $5,000 increase in the money supply when the required reserve ratio was 20%.

Example of How the Fed Uses an Open Market Purchase to Increase the Money Supply in a Fractional Reserve Banking System with 10% Required Reserves

Example of How the Fed Uses an Open Market Purchase to Increase the Money Supply in a Fractional Reserve Banking System with 10% Required Reserves

Suppose the Fed conducts an open market purchase of a $1000 Treasury bill from a securities dealer, Adam Aardvark, with a checking account at the First National Bank. What would be the total effect on the money supply?

To examine changes in the balance sheets of banks, economists use T-accounts. A T-account is a simplified balance sheet with lines in the form of a T that lists only the changes that occur in the balance sheet items from some initial balance sheet position.

For simplicity, assume all banks have the same initial balance sheet as illustrated in the sample above for the First National Bank.

Assume the required reserve ratio is 10% (rr = .10) and banks do not hold any additional excess reserves. If banks hold more reserves than required, the reserve ratio, R, is larger than the required reserve ratio, rr. If banks do not hold excess reserves, however, the reserve ratio is equal to the required reserve ratio (R = rr). This implies banks will make loans for the maximum amount of any new deposits. When the Fed purchases the $1000 government security from Adam Aardvark (who has an account at the First National Bank), the bank’s balance sheet changes as follows:


Table 17.
Changes in the Balance Sheet of the FIRST NATIONAL BANK
Assets
Liabilities & Net Worth
Reserves
+ $1000
Deposits
(Adam’s account)
+ $1000



Table 18.
Balance Sheet of the First National Bank
Assets
Liabilities & Net Worth
Reserves
(required = $ 1,000,100)
(excess = $ 400,900)
$1,401,000
Deposits
$10,001,000
Loans
$7,500,000


Government Securities
$900,000


Property & other assets
$600,000
Net Worth
$400,000




Total Assets
$10,401,000
Total Liabilities
& Net Worth
$10,401,000

When the Fed conducts the open market purchase of the $1000 government security, the Fed has credited $1000 to the First National Bank’s account at the Fed. This increases the First National Bank’s reserves. Its reserves are the sum of the currency in the First National Bank’s vault plus the balance in the First National Bank’s account at the Federal Reserve. The First National Bank, in turn, credits $1000 to the securities dealer’s account at the First National Bank. The open market operation has increased the assets of the First National Bank by $1000 (the increase in its reserves) and has increased the liabilities of the First National Bank by $1000 (the additional $1000 deposited in Adam Aardvark’s account).

Since it is assumed banks do not want to hold any additional excess reserves, the First National Bank will keep only the required amount of reserves and will loan out the additional reserves in order to earn additional interest income. Since the required reserve ratio is .10, the First National Bank will be required to keep 10 percent of this additional deposit as reserves. Since the new deposit in the securities dealer’s account is $1000, the First National Bank is required to keep $100 of it as reserves and can create $900 in loans.


Table 19.
Changes in the Balance Sheet of the FIRST NATIONAL BANK
Assets
Liabilities & Net Worth
Loans
+ $900
Deposits
+ $900


Table 20.
Balance Sheet of the First National Bank
Assets
Liabilities & Net Worth
Reserves
(required = $ 1,000,190)
(excess = $ 400,810)
$1,401,000
Deposits
$10,001,900
Loans
$7,500,900


Government Securities
$900,000


Property & other assets
$600,000
Net Worth
$400,000




Total Assets
$10,401,900
Total Liabilities
& Net Worth
$10,401,900


Suppose the First National Bank loans the $900 to Bernice Bear. It does this by increasing the balance in Bernice’s checking account at First National Bank. The money supply has just increased by another $900. (Remember the M1 definition of the money supply is currency in circulation plus the balances in checking accounts plus travelers’ checks outstanding.) The total effect on the money supply to this point is $1900. The securities dealer, Adam Aardvark, still has the $1000 increase in his account (deposits) and Bernice Bear has the $900 increase in her account.

When people borrow money, they usually spend it right away. Suppose Bernice buys a $900 painting from Charlie Cheetah. Suppose Charlie deposits this in his bank, Second National Bank. Bernice’s account balance at First National Bank decreases by $900 and Charlie’s account balance at Second National Bank increases by $900. One of the Fed’s functions is to clear checks in the banking system. In this case, the check is cleared when the Fed deducts $900 from the First National Bank’s account at the Fed and adds $900 to the Second National Bank’s account at the Fed. Notice that the First National Bank’s reserves decrease by $900 and the Second National Bank’s reserves increase by $900. The total amount of reserves in the banking system remains unchanged, however.


Table 21.
Changes in the Balance Sheet of the FIRST NATIONAL BANK
Assets
Liabilities & Net Worth
Reserves
- $900
Deposits
- $900


Table 22.
Balance Sheet of the First National Bank
Assets
Liabilities & Net Worth
Reserves
(required = $ 1,000,100)
(excess = $ 400,000)
$1,400,100
Deposits
$10,001,000
Loans
$7,500,900


Government Securities
$900,000


Property & other assets
$600,000
Net Worth
$400,000




Total Assets
$10,401,000
Total Liabilities
& Net Worth
$10,401,000

Table 23.
Changes in the Balance Sheet of the SECOND NATIONAL BANK
Assets
Liabilities & Net Worth
Reserves
+ $900
Deposits
+ $900

Table 24.
Balance Sheet of the Second National Bank
Assets
Liabilities & Net Worth
Reserves
(required = $ 1,000,090)
(excess = $ 400,810)
$1,400,900
Deposits
$10,000,900
Loans
$7,500,000


Government Securities
$900,000


Property & other assets
$600,000
Net Worth
$400,000




Total Assets
$10,400,900
Total Liabilities
& Net Worth
$10,400,900

The total change in the money supply to this point is still $1900. Adam still has the additional $1000 in his account at First National Bank and Charlie now has an additional $900 in his account at Second National Bank.

With Charlie’s $900 deposit, the Second National Bank also has a $900 increase in its reserves. The bank is only required to keep 10% of deposits as reserves and it is assumed banks do not hold any additional excess reserves. Thus, the Second National Bank will keep $90 of the new deposit as reserves and will create $810 in new loans.

Table 25.
Changes in the Balance Sheet of the SECOND NATIONAL BANK
Assets
Liabilities & Net Worth
Loans
+ $810
Deposits
+ $810


Table 26.
Balance Sheet of the Second National Bank
Assets
Liabilities & Net Worth
Reserves
(required = $ 1,000,171)
(excess = $ 400,729)
$1,400,900
Deposits
$10,001,710
Loans
$7,500,810


Government Securities
$900,000


Property & other assets
$600,000
Net Worth
$400,000




Total Assets
$10,401,710
Total Liabilities
& Net Worth
$10,401,710


Suppose Second National Bank loans $810 to Dino Dolphin and increases his account balance by $810. The creation of this loan will increase the money supply by an additional $810. The total effect on the money supply so far is $2710. Adam still has the $1000 increase in his account at the First National Bank, Charlie still has the $900 increase in his account at the Second National Bank, and Dino now has a $810 increase in his account at the Second National Bank. ($1000 + $900 + $810 = $2710.)

Suppose Dino uses the $810 to buy a decorative ceramic bowl from Esmeralda Elephant. Suppose Esmeralda deposits the $810 in her account at the Third National Bank. Dino’s account balance at the Second National Bank decreases by $810 and Esmeralda’s account balance at the Third National Bank increases by $810.

When the Fed clears this check, it deducts $810 from the Second National Bank’s account at the Fed and adds $810 to the Third National Bank’s account at the Fed. Notice that the Second National Bank’s reserves decrease by $810 and the Third National Bank’s reserves increase by $810. The total amount of reserves in the banking system remains unchanged.


Table 27.
Changes in the Balance Sheet of the SECOND NATIONAL BANK
Assets
Liabilities & Net Worth
Reserves
- $810
Deposits
- $810


Table 28.
Balance Sheet of the Second National Bank
Assets
Liabilities & Net Worth
Reserves
(required = $ 1,000,090)
(excess = $ 400,000)
$1,400,090
Deposits
$10,000,900
Loans
$7,500,000


Government Securities
$900,000


Property & other assets
$600,000
Net Worth
$400,000




Total Assets
$10,401,710
Total Liabilities
& Net Worth
$10,400,900

Table 29.
Changes in the Balance Sheet of the THIRD NATIONAL BANK
Assets
Liabilities & Net Worth
Reserves
+ $810
Deposits
+ $810

Table 30.
Balance Sheet of the Third National Bank
Assets
Liabilities & Net Worth
Reserves
(required = $ 1,000,090)
(excess = $ 400,810)
$1,400,810
Deposits
$10,000,810
Loans
$7,500,000


Government Securities
$900,000


Property & other assets
$600,000
Net Worth
$400,000




Total Assets
$10,400,810
Total Liabilities
& Net Worth
$10,400,810

The total change in the money supply is still $2710. Adam still has the $1000 increase in his account at the First National Bank, Charlie still has the $900 increase in his account at the Second National Bank, and Esmeralda now has a $810 increase in her account at the Third National Bank. ($1000 + $900 + $810 = $2710.)

The Third National Bank is required to keep 10% of this new deposit as reserves and can loan out the rest. This means the Third National Bank will keep $81 of reserves and will create $729 of new loans.

Table 31.
Changes in the Balance Sheet of the THIRD NATIONAL BANK
Assets
Liabilities & Net Worth
Loans
+ $729
Deposits
+ $729





Table 32.
Balance Sheet of the Third National Bank
Assets
Liabilities & Net Worth
Reserves
(required = $ 1,000,090)
(excess = $ 400,810)
$1,400,810
Deposits
$10,001,539
Loans
$7,500,729


Government Securities
$ 900,000


Property & other assets
$600,000
Net Worth
$ 400,000




Total Assets
$10,401,539
Total Liabilities
& Net Worth
$10,401,539


Suppose the Third National Bank loans $729 to Francesca Ferret. Francesca’s account balance at the Third National Bank increases by $729. The total increase in the money supply at this point is now $3439. Adam still has the $1000 increase in his account at the First National Bank, Charlie still has the $900 increase in his account at the Second National Bank, Esmeralda still has the $810 increase in her account at the Third National Bank, and Francesca now has a $729 increase in her account balance at the Third National Bank. ($1000 + $900 + $810 + $729 = $3439.)

Suppose Francesca uses the $729 to buy a tapestry from Gary Gorilla. Suppose Gary deposits the $729 in his bank, the Fourth National Bank. Francesca’s account balance at the Third National Bank decreases by $729 and Gary’s account balance at the Fourth National Bank increases by $729.

The total change in the money supply is still $3439. Adam still has the $1000 increase in his account at the First National Bank, Charlie still has the $900 increase in his account at the Second National Bank, and Esmeralda still has the $810 increase in her account at the Third National Bank and Gary now has a $729 increase in his account at the Fourth National Bank. ($1000 + $900 + $810 + $729 = $3439.)

The Fourth National Bank is required to keep 10% of this new deposit as reserves and can loan out the rest. This means the Fourth National Bank will keep $72.90 of reserves and will create $656.10 of new loans.

Table 33.
FOURTH NATIONAL BANK
ASSETS
LIABILITIES & NET WORTH
Required Reserves + $81
Deposits + $810
Excess Reserves

Loans + $729
Net Worth
Government Securities

Property & other assets


Suppose Fourth National Bank loans $656.10 to Gary Gorilla. Gary uses the money to buy a sculpture from Helen Hyena. Suppose Helen deposits the $656.10 in her bank, Fifth National Bank.

This bank will be required to keep 10% of this deposit as reserves and will loan out the rest. This means the Fifth National Bank will increase its required reserves by $72.90 and will increase its loans by $656.10.

Table 34.
FIFTH NATIONAL BANK
ASSETS
LIABILITIES & NET WORTH
Required Reserves + $72.90
Deposits + $729
Excess Reserves

Loans + $656.10
Net Worth
Government Securities

Property & other assets


Suppose Fifth National Bank loans $656.10 to Ian Impala. Ian uses the money to buy a hand-made rug from Julius Jaguar. Julius now has $656.10 that he did not have before. Suppose Julius deposits the $656.10 in his bank, Sixth National Bank. This bank will be required to keep 10% of this deposit as reserves and will loan out the rest. This means the Sixth National Bank will increase its required reserves by $65.61 and will increase its loans by $590.49.

Table 35.
SIXTH NATIONAL BANK
ASSETS
LIABILITIES & NET WORTH
Required Reserves + $65.61
Deposits + $656.10
Excess Reserves

Loans + $590.49
Net Worth
Government Securities

Property & other assets


The open market purchase of a $1000 government security from the First National Bank has caused an increase in the money supply that is much larger than $1000. So far, the money supply has increased by $4095.10.

Bernice Bear still has the additional $1000 in her account at the Second National Bank, Diego Dolphin still has the additional $900 in his account at Third National Bank, Francesca Ferret still has the additional $810 in her account at the Fourth National Bank, Helen Hyena still has the additional $729 in her account at the Fifth National Bank, and Julius Jaguar still has the additional $656.10 in his account at the Sixth National Bank. The additions to people’s checking accounts are $1000 + $900 + $810 + $729 + $656.10 = $4095.10. This process could continue, however. Eventually the total increase in the money supply would be $10,000. The amount of money the banking system generates with each dollar of reserves is the money multiplier. The money multiplier is the inverse of the reserve ratio. In this example, the reserve ratio is .10. Thus the money multiplier is 1/.10 = 10. Thus, each dollar of reserves generates $10 of money. Since the open market operation increased reserves by $1000, the total effect on the money supply is 10 times $1000 = $10,000.

If we continued this example, new loans would be created and deposited, creating new loans to be deposited, creating new loans, etc.
So what is the total effect on the money supply?

The increase in the money supply from a $1000 increase in the reserves when the reserve ratio is 10% and banks loan out all additional excess reserves is:

Change in money supply = 1000 + $900 + $810 + $729 + $656.10 + . . . + . . . + . . . = $10,000.

The formula for making this calculation is:

Increase in reserves / reserve ratio = total increase in the money supply

or

$1000 / .10 = $10,000