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[Part IV]

The American Economy and Monetary Policy


The topic in Part IV of this blog is all about Monetary Policy. As you will see this is the other tool the government can use to influence the economy. Is Monetary Policy any more successful than fiscal policy? Well, let’s wait and see. Due to the complexity of some of the material to be presented, you might like to just puruse the topic of “Types of Monetary Policy.” It is sufficient for your education if you simply understand the 3 main tools the Federal Reserve has to manage the nation’s money supply. This will be very clear and understandable. If you wish to read the section on Types of Monetary Policy by all means go right ahead. Not to be flip I just want to warn you—the material is complex and gave me a headache as I was putting it all together. It’s important information but probably, unless you’re an economist, you could just simply gloss over the material from that section.

Money Supply

In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define “money,” but standard measures usually include currency in circulation and demand deposits (depositors’ easily accessed assets on the books of financial institutions).

Money supply data are recorded and published, usually by the government or the central bank of the country. Public and private sector analysts have long monitored changes in money supply because of its possible effects on the price level, inflation and the business cycle.

What is Monetary Policy?

Monetary Policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability.

The official goals usually include relatively stable prices and low unemployment. Monetary theory provides insight into how to craft optimal monetary policy. It is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it.

Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values.

Monetary policy differs from fiscal policy, which refers to taxation, government spending, and associated borrowing.

Types of monetary policy

In practice, to implement any type of monetary policy the main tool used is modifying the amount of base money in circulation. The monetary authority does this by buying or selling financial assets (usually government obligations). These open market operations change either the amount of money or its liquidity (if less liquid forms of money are bought or sold). The multiplier effect of fractional reserve banking amplifies the effects of these actions.

Constant market transactions by the monetary authority modify the supply of currency and this impacts other market variables such as short term interest rates and the exchange rate.

The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals.

Monetary Policy:

Target Market   Variable:

Long Term   Objective:

Inflation Targeting Interest rate on overnight debt A given rate of change in theCPI
Price Level Targeting Interest rate on overnight debt A specificCPInumber
Monetary Aggregates The growth in money supply A given rate of change in theCPI
Fixed Exchange Rate The spot price of the currency The spot price of the currency
Gold Standard The spot price of gold Low inflation as measured by the gold price
Mixed Policy Usually interest rates Usually unemployment +CPI  change

The different types of policy are also called monetary regimes, in parallel to exchange rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is tracking exactly the same variables (such as a harmonized consumer price index).

Inflation targeting

Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price Index, within a desired range.

The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the interbank rate at which banks lend to each other overnight for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar.

The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee.

Changes to the interest rate target are made in response to various market indicators in an attempt to forecast economic trends and in so doing keep the market on track towards achieving the defined inflation target. For example, one simple method of inflation targeting called the Taylor rule adjusts the interest rate in response to changes in the inflation rate and the output gap. The rule was proposed by John B. Taylor of Stanford University. The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It is currently used in Australia, Brazil, Canada, Chile, Columbia, the Czech Republic, Hungary, New Zealand, Norway, Iceland, India, Philippines, Poland, Sweden, South Africa, Turkey, and the United Kingdom.

Price level targeting

Price level targeting is similar to inflation targeting except thatCPIgrowth in one year over or under the long term price level target is offset in subsequent years such that a targeted price-level is reached over time, e.g. five years, giving more certainty about future price increases to consumers. Under inflation targeting what happened in the immediate past years is not taken into account or adjusted for in the current and future years.

Monetary aggregates

In the 1980s, several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc.). In the USA this approach to monetary policy was discontinued with the selection of Alan Greenspan as Fed Chairman.

This approach is also sometimes called monetarism.

While most monetary policy focuses on a price signal of one form or another, this approach is focused on monetary quantities.

Fixed exchange rate

This policy is based on maintaining a fixed exchange rate with a foreign currency. There are varying degrees of fixed exchange rates, which can be ranked in relation to how rigid the fixed exchange rate is with the anchor nation.

Under a system of fiat fixed rates, the local government or monetary authority declares a fixed exchange rate but does not actively buy or sell currency to maintain the rate. Instead, the rate is enforced by non-convertibility measures (e.g. capital controls, import/export licenses, etc.). In this case there is a black market exchange rate where the currency trades at its market/unofficial rate.

Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary authority on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or a fixed band within which the exchange rate may fluctuate until the monetary authority intervenes to buy or sell as necessary to maintain the exchange rate within the band. (In this case, the fixed exchange rate with a fixed level can be seen as a special case of the fixed exchange rate with bands where the bands are set to zero.)

Under a system of fixed exchange rates maintained by a currency board every unit of local currency must be backed by a unit of foreign currency (correcting for the exchange rate). This ensures that the local monetary base does not inflate without being backed by hard currency and eliminates any worries about a run on the local currency by those wishing to convert the local currency to the hard (anchor) currency.

Under dollarization, foreign currency (usually the US dollar, hence the term “dollarization”) is used freely as the medium of exchange either exclusively or in parallel with local currency. This outcome can come about because the local population has lost all faith in the local currency, or it may also be a policy of the government (usually to rein in inflation and import credible monetary policy).

These policies often abdicate monetary policy to the foreign monetary authority or government as monetary policy in the pegging nation must align with monetary policy in the anchor nation to maintain the exchange rate. The degree to which local monetary policy becomes dependent on the anchor nation depends on factors such as capital mobility, openness, credit channels and other economic factors.

Gold standard

The gold standard is a system under which the price of the national currency is measured in units of gold bars and is kept constant by the government’s promise to buy or sell gold at a fixed price in terms of the base currency. The gold standard might be regarded as a special case of “fixed exchange rate” policy, or as a special type of commodity price level targeting.

The minimal gold standard would be a long-term commitment to tighten monetary policy enough to prevent the price of gold from permanently rising above parity. A full gold standard would be a commitment to sell unlimited amounts of gold at parity and maintain a reserve of gold sufficient to redeem the entire monetary base.

Today this type of monetary policy is no longer used by any country, although the gold standard was widely used across the world between the mid-19th century through 1971. Its major advantages were simplicity and transparency. The gold standard was abandoned during the Great Depression, as countries sought to reinvigorate their economies by increasing their money supply. The Bretton Woods system, which was a modified gold standard, replaced it in the aftermath of World War II. However, this system too broke down during the Nixon shock of 1971.

The gold standard induces deflation, as the economy usually grows faster than the supply of gold. When an economy grows faster than its money supply, the same amount of money is used to execute a larger number of transactions. The only way to make this possible is to lower the nominal cost of each transaction, which means that prices of goods and services fall, and each unit of money increases in value.

Absent precautionary measures, deflation would tend to increase the ratio of the real value of nominal debts to physical assets over time. For example, during deflation, nominal debt and the monthly nominal cost of a fixed-rate home mortgage stays the same, even while the dollar value of the house falls, and the value of the dollars required to pay the mortgage goes up. Mainstream economics considers such deflation to be a major disadvantage of the gold standard. Unsustainable (i.e. excessive) deflation can cause problems during recessions and financial crisis lengthening the amount of time an economy spends in recession. William Jennings Bryan rose to national prominence when he built his historic (though unsuccessful) 1896 presidential campaign around the argument that deflation caused by the gold standard made it harder for everyday citizens to start new businesses, expand their farms, or build new homes.

In a nutshell, monetary policy relates to increasing or decreasing the supply of money available in theU.S.Economy. Such actionable policy determines whether the economy heats up (more economic activity) or cools down (less economic activity). In turn, such decisions affect, either way, credit, and, down the road, influences business growth, hiring and employment, as well as everybody’s enemy—inflation.

The Infrastructure for Monetary Policy

While the budget remained enormously important, the job of managing the overall economy shifted substantially from fiscal policy to monetary policy during the later years of the 20th century. Monetary policy is the province of the Federal Reserve System, an independentU.S.government agency. “The Fed,” as it is commonly known, includes 12 regional Federal Reserve Banks and 25 Federal Reserve Bank branches.

All nationally chartered commercial banks are required by law to be members of the Federal Reserve System; membership is optional for state-chartered banks. In general, a bank that is a member of the Federal Reserve System uses the Reserve Bank in its region in the same way that a person uses a bank in his or her community.

The Federal Reserve Board of Governors administers the Federal Reserve System. It has seven members, who are appointed by the president to serve overlapping 14-year terms. The most important monetary policy decisions are made by the Federal Open Market Committee (FOMC), which consists of the seven governors, the president of the Federal Reserve Bank ofNew   York, and presidents of four other Federal Reserve banks who serve on a rotating basis.

Although the Federal Reserve System periodically must report on its actions to Congress, the governors are, by law, independent from Congress and the president. Reinforcing this independence, the Fed conducts its most important policy discussions in private and often discloses them only after a period of time has passed. It also raises all of its own operating expenses from investment income and fees for its own services.

The Federal Reserve has three main tools for maintaining control over the supply of money and credit in the economy. The most important is known as open market operations, or the buying and selling of government securities. To increase the supply of money, the Federal Reserve buys government securities from banks, other businesses, or individuals, paying for them with a check (a new source of money that it prints); when the Fed’s checks are deposited in banks, they create new reserves — a portion of which banks can lend or invest, thereby increasing the amount of money in circulation. On the other hand, if the Fed wishes to reduce the money supply, it sells government securities to banks, collecting reserves from them. Because they have lower reserves, banks must reduce their lending, and the money supply drops accordingly.

The Fed also can control the money supply by specifying what reserves deposit-taking institutions must set aside either as currency in their vaults or as deposits at their regional Reserve Banks. Raising reserve requirements forces banks to withhold a larger portion of their funds, thereby reducing the money supply, while lowering requirements works the opposite way to increase the money supply. Banks often lend each other money over night to meet their reserve requirements. The rate on such loans, known as the “federal funds rate,” is a key gauge of how “tight” or “loose” monetary policy is at a given moment.

The Fed’s third tool is the discount rate, or the interest rate that commercial banks pay to borrow funds from Reserve Banks. By raising or lowering the discount rate, the Fed can promote or discourage borrowing and thus alter the amount of revenue available to banks for making loans.

These tools allow the Federal Reserve to expand or contract the amount of money and credit in the U.S. economy. If the money supply rises, credit is said to be loose. In this situation, interest rates tend to drop, business spending and consumer spending tend to rise, and employment increases; if the economy already is operating near its full capacity, too much money can lead to inflation, or a decline in the value of the dollar. When the money supply contracts, on the other hand, credit is tight. In this situation, interest rates tend to rise, spending levels off or will decline, and inflation abates; if the economy is operating below its capacity, tight money can lead to rising unemployment.

Many factors complicate the ability of the Federal Reserve to use monetary policy to promote specific goals, however. For one thing, money takes many different forms, and it often is unclear which one to target.

In its most basic form, money consists of coins and paper currency. Coins come in various denominations based on the value of a dollar: the penny, which is worth one cent or one-hundredth of a dollar; the nickel, five cents; the dime, 10 cents; the quarter, 25 cents; the half dollar, 50 cents; and the dollar coin. Paper money comes in denominations of $1, $2, $5, $10, $20, $50, and $100.

A more important component of the money supply consists of checking deposits, or bookkeeping entries held in banks and other financial institutions. Individuals can make payments by writing checks, which essentially instruct their banks to pay given sums to the checks’ recipients. Time deposits are similar to checking deposits except the owner agrees to leave the sum on deposit for a specified period; while depositors generally can withdraw the funds earlier than the maturity date, they generally must pay a penalty and forfeit some interest to do so.

Money also includes money market funds, which are shares in pools of short-term securities, as well as a variety of other assets that can be converted easily into currency on short notice.

The amount of money held in different forms can change from time to time, depending on preferences and other factors that may or may not have any importance to the overall economy. Further complicating the Fed’s task, changes in the money supply affect the economy only after a lag of uncertain duration.


Monetary Policy and the Presidential Election Cycle

The Federal Reserve sets the monetary policy for the country. Although the Federal Reserve is supposed to be independent of the president and the Congress, monetary policy appears to follow the presidential election cycle as well.

In a paper entitled “The Presidential Term: Is the Third Year a Charm,” prepared by the CFA Institute and published in the Journal of Portfolio Management in 2007, the authors found that monetary policy is more accommodative in the second half of a presidential term and more restrictive in the first term.

These findings suggest that policy makers are reluctant to take a restrictive stance for fear it might slow down the economy in the months leading up to a presidential election. Of the four years, the third year is the year with the most expansionary monetary policy. During that year, the author found that monetary policy was expansionary 65% of the time versus 48% for the other three years.

Stock markets do well in periods of expansionary monetary policy and do relatively poorly when monetary policy is restrictive; therefore, it is no coincidence that the stock market is generally strong in the third year of a presidential cycle, when the Federal Reserve is in an expansionary mood. (For more insight, read Formulating Monetary Policy.)

Although the relationship between the presidential election cycle and the stock market appears to be strong, this does not mean it is going to play out the same way every cycle. However, when combined with other information, it can provide additional insights that investors can use to improve their investment decisions.

Monetary Policy and Fiscal Stabilization

The Fed’s operation has evolved over time in response to major events. The Congress established the Federal Reserve System in 1913 to strengthen the supervision of the banking system and stop bank panics that had erupted periodically in the previous century. As a result of the Great Depression in the 1930s, Congress gave the Fed authority to vary reserve requirements and to regulate stock market margins (the amount of cash people must put down when buying stock on credit).

Still, the Federal Reserve often tended to defer to the elected officials in matters of overall economic policy. During World War II, for instance, the Fed subordinated its operations to helping the U.S. Treasury borrow money at low interest rates. Later, when the government sold large amounts of Treasury securities to finance the Korean War, the Fed bought heavily to keep the prices of these securities from falling (thereby pumping up the money supply).

The Fed reasserted its independence in 1951, reaching an accord with the Treasury that Federal Reserve policy should not be subordinated to Treasury financing. But the central bank still did not stray too far from the political orthodoxy. During the fiscally conservative administration of President Dwight D. Eisenhower (1953-1961), for instance, the Fed emphasized price stability and restriction of monetary growth, while under more liberal presidents in the 1960s, it stressed full employment and economic growth.

During much of the 1970s, the Fed allowed rapid credit expansion in keeping with the government’s desire to combat unemployment. But with inflation increasingly ravaging the economy, the central bank abruptly tightened monetary policy beginning in 1979. This policy successfully slowed the growth of the money supply, but it helped trigger sharp recessions in 1980 and 1981-1982. The inflation rate did come down, however, and by the middle of the decade the Fed was again able to pursue a cautiously expansionary policy. Interest rates, however, stayed relatively high as the federal government had to borrow heavily to finance its budget deficit

(Speaking of interest rates, 1980 was a very bad time where buying homes was concerned. One of our friends bought her first home that year. She paid a mortgage rate of just over 14%. That was a long ways upward from the no-down GI loan rate of 7% my wife and I paid 11 years earlier). Rates slowly came down, too, as the deficit narrowed and ultimately disappeared in the 1990s.

The growing importance of monetary policy and the diminishing role played by fiscal policy in economic stabilization efforts may reflect both political and economic realities. The experience of the 1960s, 1970s, and 1980s suggests that democratically elected governments may have more trouble using fiscal policy to fight inflation than unemployment. Fighting inflation requires government to take unpopular actions like reducing spending or raising taxes, while traditional fiscal policy solutions to fighting unemployment tend to be more popular since they require increasing spending or cutting taxes. Political realities, in short, may favor a bigger role for monetary policy during times of inflation.

One other reason suggests why fiscal policy may be more suited to fighting unemployment, while monetary policy may be more effective in fighting inflation. There is a limit to how much monetary policy can do to help the economy during a period of severe economic decline, such as the United   Statesencountered during the 1930s. The monetary policy remedy to economic decline is to increase the amount of money in circulation, thereby cutting interest rates. But once interest rates reach zero, the Fed can do no more. The United Stateshas not encountered this situation, which economists call the “liquidity trap,” in recent years, but Japandid during the late 1990s. With its economy stagnant and interest rates near zero, many economists argued that the Japanese government had to resort to more aggressive fiscal policy, if necessary running up a sizable government deficit to spur renewed spending and economic growth.

Measuring Effect of Monetary Policy

Today, Federal Reserve economists use a number of measures to determine whether monetary policy should be tighter or looser. One approach is to compare the actual and potential growth rates of the economy. Potential growth is presumed to equal the sum of the growth in the labor force plus any gains in productivity, or output per worker.

In the late 1990s, the labor force was projected to grow about 1 percent a year, and productivity was thought to be rising somewhere between 1 percent and 1.5 percent. Therefore, the potential growth rate was assumed to be somewhere between 2 percent and 2.5 percent. By this measure, actual growth in excess of the long-term potential growth was seen as raising a danger of inflation, thereby requiring tighter money.

The second gauge is called NAIRU, or the non-accelerating inflation rate of unemployment. Over time, economists have noted that inflation tends to accelerate when joblessness drops below a certain level. In the decade that ended in the early 1990s, economists generally believed NAIRU was around 6 percent. But later in the decade, it appeared to have dropped to about 5.5 percent.

Perhaps even more importantly, a range of new technologies — the microprocessor, the laser, fiber-optics, and satellite — appeared in the late 1990s to be making the American economy significantly more productive than economists had thought possible. “The newest innovations, which we label information technologies, have begun to alter the manner in which we do business and create value, often in ways not readily foreseeable even five years ago,” Federal Reserve Chairman Alan Greenspan said in mid-1999.

Previously, lack of timely information about customers’ needs and the location of raw materials forced businesses to operate with larger inventories and more workers than they otherwise would need, according to Greenspan.

But as the quality of information improved, businesses could operate more efficiently. Information technologies also allowed for quicker delivery times, and they accelerated and streamlined the process of innovation. For instance, design times dropped sharply as computer modeling reduced the need for staff in architectural firms, Greenspan noted, and medical diagnoses became faster, more thorough, and more accurate.

Such technological innovations apparently accounted for an unexpected surge in productivity in the late 1990s. After rising at less than a 1 percent annual rate in the early part of the decade, productivity was growing at about a 3 percent rate toward the end of the 1990s — well ahead of what economists had expected. Higher productivity meant that businesses could grow faster without igniting inflation. Unexpectedly modest demands from workers for wage increases — a result, possibly, of the fact that workers felt less secure about keeping their jobs in the rapidly changing economy — also helped subdue inflationary pressures.

Some economists scoffed at the notion American suddenly had developed a “new economy,” one that was able to grow much faster without inflation. While there undeniably was increased global competition, they noted, many American industries remained untouched by it. And while computers clearly were changing the way Americans did business, they also were adding new layers of complexity to business operations.

But as economists increasingly came to agree with Greenspan that the economy was in the midst of a significant “structural shift,” the debate increasingly came to focus less on whether the economy was changing and more on how long the surprisingly strong performance could continue. The answer appeared to depend, in part, on the oldest of economic ingredients — labor. With the economy growing strongly, workers displaced by technology easily found jobs in newly emerging industries. As a result, employment was rising in the late 1990s faster than the overall population.

That trend could not continue indefinitely. By mid-1999, the number of “potential workers” aged 16 to 64 — those who were unemployed but willing to work if they could find jobs — totaled about 10 million, or about 5.7 percent of the population. That was the lowest percentage since the government began collecting such figures (in 1970). Eventually, economists warned, the United Stateswould face labor shortages, which, in turn, could be expected to drive up wages, trigger inflation, and prompt the Federal Reserve to engineer an economic slowdown.

Still, many things could happen to postpone that seemingly inevitable development. Immigration might increase, thereby enlarging the pool of available workers. That seemed unlikely, however, because the political climate in theUnited Statesduring the 1990s did not favor increased immigration.

More likely, a growing number of analysts believed that a growing number of Americans would work past the traditional retirement age of 65. That also could increase the supply of potential workers. Indeed, in 1999, the Committee on Economic Development (CED), a prestigious business research organization, called on employers to clear away barriers that previously discouraged older workers from staying in the labor force.

Current trends suggested that by 2030, there would be fewer than three workers for every person over the age of 65, compared to seven in 1950 — an unprecedented demographic transformation that the CED predicted would leave businesses scrambling to find workers.
“Businesses have heretofore demonstrated a preference for early retirement to make way for younger workers,” the group observed. “But this preference is a relic from an era of labor surpluses; it will not be sustainable when labor becomes scarce.” While enjoying remarkable successes, in short, the United States found itself moving into uncharted economic territory as it ended the 1990s.

While many saw a new economic era stretching indefinitely into the future, others were less certain. Weighing the uncertainties, many assumed a stance of cautious optimism. “Regrettably, history is strewn with visions of such `new eras’ that, in the end, have proven to be a mirage,” Greenspan noted in 1997. “In short, history counsels caution.”

In Part V ahead I will review the actual accomplishments of President Obama throughout the lion’s share of his first term in office. This will be followed by Part VI-A . In that segment, I will describe the accomplishments of the Republican Party the last four years and describe the background of their presidential candidate in 2012, Mitt Romney.

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