Monetary Policy and the Federal Reserve
Definitions and Basics
Money Supply, from the Concise Encyclopedia of Economics
What Is the Money Supply? The U.S. money supply comprises currency—dollar bills and coins issued by the Federal Reserve System and the Treasury—and various kinds of deposits held by the public at commercial banks and other depository institutions such as savings and loans and credit unions. On June 30, 1990, the money supply, measured as the sum of currency and checking account deposits, totaled $809 billion. Including some types of savings deposits, the money supply totaled $3,272 billion. An even broader measure totaled $4,066 billion.
These measures correspond to three definitions of money that the Federal Reserve uses: M1, a narrow measure of money’s function as a medium of exchange; M2, a broader measure that also reflects money’s function as a store of value; and M3, a still broader measure that covers items that many regard as close substitutes for money….
Federal Reserve System, from the Concise Encyclopedia of Economics
The Federal Reserve System (the Fed) has been the central bank of the United States since it was created in 1913. The main purpose of a central bank is to regulate the supply of money and credit to the economy. The board of governors, the Fed’s principal policy-making organization, plays a key role in this process….
The responsibility for regulating the nation’s money supply requires the Federal Reserve to influence the amount of reserve funds available to banks and thus the level and direction of short-term interest rates. For example, whether banks and other financial institutions will make loans depends on the profit margin—the difference in the rate of interest they must pay to attract deposits or borrow funds and the interest rate they can charge customers for credit. The greater the profit margin that banks can realize on new loans, the more they will want to lend. To influence interest rates on deposits and interest rates that banks pay to borrow funds, the Fed uses its congressionally granted authority to create money. The Fed creates money in three ways….
Monetary Policy, from the Concise Encyclopedia of Economics
Paul Volcker, while chairman of the board of governors of the Federal Reserve System (1979-87), was often called the second most powerful person in the United States. Volcker and company triggered the “double-dip” recessions of 1979-80 and 1981-82, vanquishing the double-digit inflation of 1979-80 and bringing the unemployment rate into double digits for the first time since 1940. Volcker then declared victory over inflation and piloted the economy through its long 1980s recovery, bringing unemployment below 5.5 percent, half a point lower than in the 1978-79 boom….
Monetary policy is the subject of a lively controversy between two schools of economics, monetarist and Keynesian. Although they agree on goals, they disagree sharply on priorities, strategies, targets, and tactics. As I explain how monetary policy works, I shall discuss these disagreements. At the outset I disclose that I am a Keynesian….
Glossary, at the Federal Reserve Bank of Minneapolis.
Terms related to the Federal Reserve, banking and economics….
In the News and Examples
What Would Bagehot Have Thought of the Fed’s Policy after September 11, 2001?, by Antoine Martin. Library of Economics and Liberty, September 2003.
Following the terrorist attacks of September 11, 2001… the policy followed by the Federal Reserve resembled Bagehot’s prescription but for one important detail: the Fed provided funds at a very low interest rate….
Allan Meltzer on the Fed, Money, and Gold. EconTalk podcast episode, May 2008.
Allan Meltzer of Carnegie Mellon University talks with host Russ Roberts about what the Fed really does and the political pressures facing the Chair of the Fed. He describes and analyzes some fascinating episodes in U.S. monetary history, discusses the advantages and disadvantages of the gold standard and ends the conversation with some insights into recent Fed moves to intervene with investment banks. This is a wonderful introduction to the political economy of the money supply and central banks.
Milton Friedman on Money. EconTalk podcast episode, August 2006.
Russ Roberts talks with Milton Friedman about his research and views on inflation, the Federal Reserve, Alan Greenspan and Ben Bernanke, and what the future holds.
A Little History: Primary Sources and References
Bank Runs, from the Concise Encyclopedia of Economics
A run on a bank occurs when a large number of depositors, fearing that their bank will be unable to repay their deposits in full and on time, try to withdraw their funds immediately. This creates a problem because banks keep only a small fraction of deposits on hand in cash; they lend out the majority of deposits to borrowers or use the funds to purchase other interest-bearing assets like government securities. When a run comes, a bank must quickly increase its liquidity to meet depositors’ demands. It does so primarily by selling assets, frequently at fire-sale prices. Losses on these sales can make the bank insolvent….
Savings and Loan Crisis, from the Concise Encyclopedia of Economics
The extraordinary cost of the S&L crisis is astounding to every taxpayer, depositor, and policymaker. The estimated present value cost of the bailout of the Federal Savings and Loan Insurance Corporation (FSLIC) is $175 billion or more. Present value means the dollar amount of a check written today that would pay the full cost of cleaning up the S&L mess.
The bankruptcy of FSLIC did not occur overnight; the FSLIC was a disaster waiting to happen for many years. Numerous public policies, some dating back to the thirties, created the disaster.
Regulation Q, under which the Federal Reserve since 1933 had limited the interest rates banks could pay on their deposits, was extended to S&Ls in 1966. Regulation Q effectively was price-fixing, and like most efforts to fix prices, Regulation Q caused distortions far more costly than any benefits it may have delivered….
Great Depression, from the Concise Encyclopedia of Economics
Nor was the Federal Reserve entirely passive. During the crash the Fed lent liberally to banks so they could sustain securities lending. Interest rates were allowed to drop rapidly. The discount rate (the rate at which the Federal Reserve lends to commercial banks) fell from 6 percent in October 1929 to 2.5 percent in June 1930. The money supply (cash in circulation plus checking and time deposits at banks) declined only slightly in the next year. Tighter Federal Reserve policy in 1928 and early 1929—intended to check stock market speculation—may have helped trigger the economic downturn. But the Federal Reserve was not stingy in early 1930 and was not driving the economy into depression at that time. It was not until 1931 and later that the Federal Reserve failed to act as the “lender of last resort” and allowed so many banks to fail….
Competing Money Supplies, from the Concise Encyclopedia of Economics
What would be the consequences of applying the principle of laissez-faire to money? While the idea may seem strange to most people, economists have debated the question of competing money supplies off and on since Adam Smith’s time. Most recently, trends in banking deregulation and important pockets of dissatisfaction with the performance of central banks (such as the Federal Reserve System in the United States) have made the question of competing money supplies topical again….
Evolution of Central Banks and Federal Reserve Bank structure: Lombard Street: A Description of the Money Market, by Walter Bagehot