Economics U$A: 21st Century Edition
Monetary Policy (Macroeconomics)
Federal Reserve Chairman Paul Volker pushed us through two deep recessions using monetary policy and increased interest rates to combat inflation in the 1980s. His successor Alan Greenspan used a different tactic in the early 1990s and 2000s: flood the market with liquidity to prevent freezing. And under Chairman Benjamin Bernanke the Fed has struggled to combat the ravages of the Great Recession in the first decade of the 21st century. These stories discuss the relationship between the money supply, economic growth, and inflation, and explain why choosing correct monetary policy can be so difficult.
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To discuss the relationship between the money supply and economic growth and inflation, and to illustrate some of the reason why choosing the correct monetary policy is so difficult.
- Interest rates are affected by the supply and demand for money. The money supply is largely controlled by the Federal Reserve. The demand for money is affected by the level of GDP/GNP (transactions demand) and the level of interest rates.
- High interest rates can be due to either an increase in the demand for money or a decrease in the supply of money. Therefore, it is not always possible to determine the proper monetary policy by simply following a money supply rule.
- The Fed and other central banks around the world have had relatively good luck with inflation targeting—implicit for the Fed, explicit for some other central banks. Inflation has steadily fallen in the past couple of decades.
- Central banks have had less luck in controlling asset bubbles. The U.S. housing bubble of the 2000s is a case in point. By keeping interest rates “too low for too long,” the Fed allowed home prices to rise too much, setting the stage for the subprime crisis.
Meet the Series Experts
Henry S. Reuss
U.S. Congressman from Wisconsin, 1955–1983, a staunch Democrat known for his progressive stands on a wide range of issues. He fought for increased transparency in banking, an inquiry into Watergate, and strategies to check President Ronald Reagan’s economic polices. He was the first in Congress to propose what became the Peace Corps. An early proponent of environmental protection, he took action against 149 Wisconsin companies for pollution and authored legislation to establish the Ice Age National Scenic Trail. In his 1999 book, When Government Was Good: Memories of a Life in Politics, he argued that a golden age in politics existed from 1948 to 1968, when the nation proved that it could achieve full employment, secure civil rights, and prevent nuclear war. In World War II, he won a Bronze Star as an infantryman and after the war served as deputy general counsel for the Marshall Plan. Mr. Reuss received his B.A. from Cornell University and L.L.B. from Harvard Law School.
Winner of the 1976 Nobel Prize in Economics for “his achievements in the field of consumption analysis, monetary history, and theory, and for his demonstration of the complexity of stabilization policy.” From his lifetime base at the University of Chicago, he did trailblazing work on price theory—the theory that explains how prices are determined in individual markets—and “monetarism.” He defied Keynes and most of the academic establishment of the time, resurrecting the quantity theory of money—the idea that the price level depends on the money supply. His solution to the problems of inflation and short-run fluctuations in employment and real GNP was a so-called money-supply rule, which stated that if the Federal Reserve Board were required to increase the money supply at the same rate as real GNP increased, inflation would disappear. He also argued that keeping unemployment permanently lower would require a permanently accelerating inflation rate. He wrote many texts, including Income from Independent Professional Practice; A Theory of the Consumption Function; Studies in the Quantity Theory of Money; Capitalism and Freedom; Free to Choose (which accompanied a PBS television series); and A Monetary History of the United States, 1867–1960. After retiring from the University of Chicago in 1977, he became a Senior Research Fellow at the Hoover Institution at Stanford University. Dr. Friedman received his B.A. from Rutgers University, M.A. from the University of Chicago, and Ph.D. from Columbia University.
Robert C. Holland
Economist appointed to the Federal Reserve Board by President Richard Nixon in 1973, serving as Secretary to the Board of Governors from 1973 to 1976. Until 1990, he was President of the Committee for Economic Development, a nonprofit Washington organization devoted to the study of public policy. Earlier, he was a Senior Fellow at the Center for Advanced Studies in Management at the Wharton School, President and Senior Economic Consultant at the Committee for Economic Development, and Vice President of the Federal Reserve Bank, Chicago. He has spoken and written extensively on banking, finance, and economic development. Dr. Holland attended college in Kansas City and received his Ph.D. in Economics.
Vice Chairman of the Board of Governors of the Federal Reserve System, 2006–2010, and Member of the Board of Governors, 2002–2008. Earlier, he served on the Board staff as Adviser to the Board for Monetary Policy, Secretary of the Federal Open Market Committee, Director of the Division of Monetary Affairs, and Deputy Staff Director for Monetary and Financial Policy. He also held several positions in the Board’s Division of Research and Statistics, including Associate Director and Chief of Capital Markets. He has written extensively on issues related to monetary policy and its implementation by the Federal Reserve; his work has been published in volumes issued by the Federal Reserve System, the Bank of England, the Reserve Bank of Australia, the Bank of Japan, the Bank of Korea, the National Bureau of Economic Research, and the Brookings Institution. Dr. Kohn received his B.A. from The College of Wooster and Ph.D. in Economics from the University of Michigan.
Frederick H. Schultz
Private Investor, owner of Schultz Investments, Vice Chairman of the Board of Governors of the Federal Reserve System, 1979–1982, and member of the Florida House of Representatives, 1963–1970. He served in the U.S. Army, 1952–1954, and was employed by the Barnett Bank of Jacksonville, Florida, 1956–1957. He also served as Chairman of the Board of Barnett Investment Services, Inc., and as a Director of a number of private companies and banks, including Transco Energy Company, the American Heritage Life Insurance Co., Riverside Group, Inc., Family Steak Houses of Florida and Southeast Atlantic Corp, Wickes, Inc., and Barnett Banks, Inc. Mr. Schultz received his B.A. from Princeton University. He attended the University of Florida College of Law, graduating with his law degree in 1956.
- accommodative monetary policy
A central bank policy designed to stimulate economic growth by lowering short-term interest rates, making money less expensive to borrow.
- asset bubbles
Form when the prices of assets are over-inflated due to excess demand.
- consumer durables
Major consumer purchases that generally have a useful life of greater than three years.
A long-lasting form of investment that drives a lot of economic growth, but that historically has not been used primarily to produce other goods and services for sale in the economy.
An increase in the general level of prices economy-wide.
- inflation targeting
A monetary policy strategy in which a central bank (in the U.S., the Federal Reserve) estimates and makes public a projected, or “target,” inflation rate and then attempts to steer actual inflation toward the target through the use of interest rate changes and other monetary tools.
- interest sensitivity of investment
Degree of change in amount of capital stock put in place in response to a change in the market interest rates on money borrowed to finance such endeavors.
- interest rate target
An interest rate that the central bank determines to be appropriate for increasing, decreasing, or holding constant the level of economic activity.
- interest rate vs. monetary aggregates targets
Rate which is charged or paid for the use of money within the money supply.
- monetary aggregate target
A specific level of a money-supply measure deemed appropriate for a desired level of GDP; often implemented in theory by targeting a specific growth rate of a money-supply measure thought to be appropriate for a desired level of GDP growth.