Monetary policy of the United States: Difference between revisions

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How money is created - Simplifed

When money is deposited in a bank it can then be lent out to another person. If the initial deposit was $100 and the bank lends out $100 to another customer the money supply has increased by $100. However, because the depositer can ask for the money back, banks have to maintain minimum reserves to service customer needs. If the reserve requirement is 10% then in the earlier example the bank can only lend out $90 and thus the money supply increases only to $90. This relationship between increase in money supply and reserve requirement is expressed as:

m = 1 / RR

where

m = money multiplier
RR = reserve requirement

Further information: Debt monetization

Federal Reserve and Money Supply

The Federal Reserve has three main mechanisms for manipulating the money supply. It can sell treasury securities, which reduces the money supply (because it accepts money in return for a promise to pay in the future). It can also purchase treasury securities, which increases the money supply (because it pays out hard currency in exchange for accepting securities). Finally, the Federal Reserve can adjust the reserve requirement. The reserve requirement is directly related to the money multiplier as shown above.

How money is created - Process Overview

Below is an outline of the process which is currently used to increase the amount of money in the Economy (which is needed to accommodate the growth of the country's production). Much of the movement of the US Economy is artificially engineered through the monetary policy crafted by the Board of Directors of the Federal Reserve System - a group of private banking corporations which are chartered by the national government to influence the economy.

This first step is required for processes which occur later. Prior to expansion of the amount of money in the US Economy, we'll assume that Congress has - at some point - needed more money than it had taken in through taxes. In order to raise money, it increases the amount of the National Debt by ordering the creation of an I.O.U. - typically, this will be a Treasury Bond (see Treasury security). It offers the IOU for sale, and someone pays cold, hard cash to the government for the IOU. The IOUs generally do pay about 5% interest to the owner. It is these IOUs that will play a role later in the process. Note that sometimes your local bank is the one to buy these IOUs.
The 12-person Board of Directors who head the Federal Reserve System meet and determine how they would like to influence the economy. They create a plan called the country's "monetary policy" which sets targets for things such as interest rates.
Your local bank goes through it's daily transactions. Of the total money deposited at banks, only a small bit of it ever is removed. So, banks decide to make use of this bulk of "non-moving" money by loaning it out. Banks do have a legal requirement to keep a certain percentage of money on-hand at all times.
According to it's estimates for it's plan for the US Economy, the Federal Reserve places an order for money with the US Treasury Department. The Treasury Department sends these requests to its operations called the Bureau of Engraving and Printing (to make the paper dollar bills) and the Bureau of the Mint (to stamp the coins).
The US Treasury sells this newly printed money to the Federal Reserve for the cost of printing. This is about 6 cents per bill (even the 100 dollar bills)! Aside from the minimal costs, the only other obligation made is that the Federal Reserve has to simply pledge collateral for the money received.
Every business day, the Federal Reserve System engages in what is called "Open market operations." If the monetary policy has planned to increase the amount of US dollars floating around, then they will hold small bidding contests to buy US Treasury Bonds from banks. So, the banks will send those government IOUs to the Federal Reserve and the Federal Reserve will send that newly printed money to the local bank. The reverse is often done as well, but generally, at the end of the year, there will be more money sent out to local banks, than money taken in from them.
Now that the local bank has more cold hard cash, it loans out the money, and this is how additional money is placed into the hands of the public --- through bank loans. In 2003, bank loans averaged an interest rate of 9%., which also closely matches the 9.84% average interest rate drawn from FDIC data spanning the 21 years from 1980 through 2001 .

In, summary, almost every single US Dollar anywhere in the world represents a current outstanding loan of some US citizen somewhere. By virtue of this process, more loans must be granted than are repaid every month in order to support the amount of US money in the world. If the total amount of loans were repaid to banks, then the entire supply of US dollars would be destroyed (and, actually, not even the entire collection of US money in the world would be sufficient to cover all of the loans due to the interest that is also expected to be repaid).

A very small amount of US money still exists as United States Treasury Notes, which differ from the money created by the Federal Reserve System. The official designation for the bills authorized by the Federal Reserve corporations are "Federal Reserve Notes."

Ramifications of the Economic Regulation Process

Occasional Deficit spending is a requirement in a growing economy. The current economic process uses Treasury Securities which only exist when the nation is in debt. The Federal Reserve is said to hold approximately 45% of the national debt in order to support the monetary base, although that number should generally increase every year. Though gold was once the basis for the money supply, the government gradually transitioned away from precious metals and into the use of the National Debt as the economy's foundation. Experts are hopeful that other assets could take the place of National Debt as the fundamental basis, but comments from Alan Greenspan indicate that there is no clear or easy plan.

Despite the arguments of many "myth debunkers," Americans actually do have to pay for the money that is printed by our government. This payment is in the form of the interest that is charged on the bank loans - loans which are required in order for money to be injected into the economy, and even simply for existing money to be maintained (as noted in "Step 7" in the above process).

Another supposed myth that is typically "debunked" is about the accountability of this process. One debunker goes through extensive arguments to show how well the process is audited. However, on the very same webpage, the debunker also lists the legal exemptions.

Exemptions to the Scope of GAO Audits

The Government Accounting Office does not have complete access to all aspects of the Federal Reserve System. The Federal Banking Agency Audit Act (31 USCA §714) stipulates the following areas are to be excluded from GAO inspections:

(2) deliberations, decisions, or actions on monetary policy matters, including discount window operations, reserves of member banks, securities credit, interest on deposits, open market operations;

The same author also can be quoted in one related article as saying

In terms of monetary policy, the most important power is ... open market operations.

An additional important ramification of this process is the fact that economic growth becomes coupled with debt, and this coupling is argued to create a social conflict, which may otherwise not exist.

Finally, the involvement of bank loans ties the economy to the problems of compounding interest. Many people theorize (including those at the Federal Reserve) that the amount of money is directly related to the value of each dollar . Thus, this exponential need for more and more money may be contributing directly to inflation in the US. Inflation raises the cost-of-living for everyone, and if inflation exceeds the growth of income, then people are effectively made poorer over time through no fault of their own.

Further information: Inflation tax

Money supply, interest rates, and the economy

When interest rates go down, money supply increases. Businesses and consumers have a lower cost of capital and can increase spending and capital improvement projects. This is encourages growth. Conversely, when interest rates go up, the money supply falls and reins in the economy. The Federal reserve increases interest rates to combat inflation.

Criticism of monetary policy

Some free market economists, especially those belonging to the Austrian School criticise the very idea of monetary policy, believing that it distorts investment. In the free market interest rates will be set by saver's time preference. If there is a high time preference this means that savers will have a strong preference for consuming goods now rather than saving for them. Thus interest rates will rise due to the low supply of savings. With low time preference interest rates will fall. The interest rates send signals to businessmen as to what is worth investing in, low interest rates will mean that more capital is invested.

Monetary policy means that the interest rates no longer represent consumer time preferences and so investments are made by businessmen with the wrong signals. Lower than market interest rates will therefore mean a higher investment than the economy desires. This will mean that there will be capital goods that have been over invested, and will need to be liquidated. This liquidation is the cause of the depression that makes for the business cycle.

Another criticism is that exercise of monetary policy has historically failed to achieve that goals that have been delegated to the Federal Reserve System by Congress.

Goals of Monetary Policy

Sustainable growth, High employment, Stable prices

The worst depression in the country's history occurred a significant time after the institution of the system along with some cycles of recession, which have caused a negative impact on employment levels during those times. Stable prices have also not been achieved in the nearly 100 years of operation under this system. Historic inflation has averaged 3.4% since the establishment of the Federal Reserve, whereas some research indicates that average inflation for the 250 years before the system was near zero percent. Lastly, the growth of the economy may not be sustainable as the ability for households to save money has been on an overall decline.

References

Wasow, Bernard, Fiscal Hangover; AScribe Newswire, Dec 11, 2007
"Money Facts". Retrieved 2008-01-06.
"FDIC Banking Review". Retrieved 2008-01-06.
"An $800 billion freebie, hidden in the national debt". Retrieved 2008-01-06.
"What will happen to the Fed if the national debt is paid off?". Retrieved 2008-01-06.
Flaherty, Edward. "Myth #6: The Federal Reserve has never been audited". Retrieved 2008-01-06.
"Consumer Price Index, 1913-". Retrieved 2008-01-06.
Sahr, Robert. "Inflation Conversion Factors for Dollars 1665 to Estimated 2017". Retrieved 2008-01-06.
"Personal Saving Rate". Retrieved 2008-01-06.

External links

Savings rate viz Fed rate from 1954 Historical relationship between the savings rate and the Fed rate - since 1954
USA Fed rate behavior under various presidencies since 1954

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