ShmoopTube

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macro economics Ah la shmoop monetary policy or our government

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leaders just love to take credit for the economy when

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it's good when it's bad Well of course it's somebody

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else's fault But when the stock market's Hyeon unemployment's low

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inflation is under control well everyone from the president on

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down to the lowliest intern here it shmoop like me

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likes to take a victory lap But how exactly do

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government officials influence the economy Well there are two Big

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East The first is fiscal policy AII taxes in government

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spending And the second is through monetary policy I eat

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controlling interest rates and the amount of money sloshing around

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in the system in and Yank Think of the two

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is the leads in a buddy cop movie Alright well

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fiscal policy is the young brash firebrand who just got

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his detective shield He wants to kick in every door

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and just wants to get the perp alone in a

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darkened alley for five minutes We'll then there's monetary policy

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The old crusty veteran carries a revolver He's named old

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Betsy That guy makes use of snitches stakeouts and while

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painstaking research to get the job done all the point

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they both influence the economy but in very different ways

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But they have different strengths and weaknesses right Sometimes they

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work against each other and you can argue about which

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one is better at getting the job done in different

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environments or situations Okay so let's take a closer look

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at the crusty old monetary policy Well in the U

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S Monetary policy is run by the Federal Reserve It's

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what's called a central bank Basically every currency has won

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The euro has the European Central Bank The pound has

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the Bank of England The yen has the Bank of

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Japan The Monopoly Board has your cousin Jimmy who always

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insists on being a banker and who always mysteriously seems

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to have more hundreds than he should in brief monetary

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policy controls the amount of money in an economic system

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and how quickly that money moves through the system when

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there's too much money or if the money's moving around

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too fast or when both happened at the same time

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Well they're serious likelihood or risk of inflation It's like

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downing three quick double shot espresso so it's fun for

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a while but eventually you're nursing a headache and wishing

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you had stuck with You know the camera on the

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other side of things If there's not enough money or

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if the money moves around slowly sluggishly well then economic

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growth will be sluggish as well It's like if you

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overreact to that tickle in your throat and take a

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double dose of cough syrup Suddenly keeping yourself from face

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planting into your keyboard becomes your main point of focus

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Well how does all this work in real life while

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the Fed controls monetary policy How how did they do

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that Well it sets base interest rates It can run

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what's called open market operations which help control the amount

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of money in the system like buying and selling bonds

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And it can control bank reserve requirements Basically how aggressive

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banks can get when loaning their money how much risk

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they contain We'll touch on each of those in a

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little bit But first a little contrast with fiscal policy

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That brash hot head of economic influence fiscal policy uses

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the federal budget and taxation to change government spending and

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influence consumption By changing the federal budget in the tax

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rates will the government can tryto push aggregate demand up

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or down to affect inflation Unemployment and output in the

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U S Fiscal policy is run by Congress and by

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the president which means it's kind of a hodgepodge of

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compromise and contradictory influences Voters have a closer influence over

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the people in charge so fiscal policy can get moved

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around by general sentiment After fly off the handle rough

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up a suspect Ignore the niceties of securing probable cause

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right well on the other side you've got monetary policy

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which involves open market operations the discount rate and reserve

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requirements But it's more interesting if we call him Detective

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Fed So we will right Well Detective Fed using monetary

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policy also tries to control inflation unemployment and output but

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it uses different tools to affect the money supply Same

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goal Different approach Fed officials are nominated by the president

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approved by the Senate Just like judges And like judges

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they get a bit of a cushion from public scrutiny

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They don't get replaced all that off and and people

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don't generally know what they do either So that's just

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fine Kind of like the veteran cop They like to

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take their time think about what they're doing and look

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at the long term when economists talk about monetary policy

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while they break down into two groups Expansionary monetary policy

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and contractionary monetary policy Those two things that's the coffee

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versus the cough syrup distinction and we're talking about expansionary

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monetary policy well gets things going Contractionary monetary policy slows

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him down well Another way to say it Expansionary monetary

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policy is used when the Fed wants the economy to

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grow Say things get sluggish Too many people are unemployed

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and overall output is low You know it's a three

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o'clock You're getting drowsy It's time for your afternoon cup

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of Joe to push you through to the end of

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the day Contractionary monetary policy on the other hand is

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used when the economy is heating up too fast Inflation

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is a big threat or at least a fear here

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When there's a lot of cash floating around and trading

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hands really quickly well the value of cash starts to

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drop Usually prices go up It's a bad sitch and

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now it's time for the medicine Well the Fed sees

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that there's a potential problem brewing time for a little

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cough syrup to get symptoms under control so the system

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doesn't run into a bigger problem down the road We'll

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that dose of syrup might slow them down in the

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short term but they'll be better off in the long

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term like same philosophy for contractionary policy right So to

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keep inflation under control the Fed sucks money out of

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the economy by issuing bonds and they put up restrictions

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to the borrowing of money by raising interest rates Will

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the Fed does all this magic by controlling what's called

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the discount rate I'II more or less the interest rate

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that banks charge each other or the rate that banks

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get for borrowing money directly from the Fed while other

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interest rates are influenced by this base interest rate As

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the discount rate rises so do the rates consumer get

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when they go to the bank Well this discount rate

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allows banks too quickly and easily get cash directly from

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the Fed often overnight to prevent bank failures which are

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like a really bad thing well a bank and also

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call up other banks to get money When the loaned

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money is coming from other banks the borrowing bank pays

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the federal funds rate usually in interest so by adjusting

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the federal funds rate the Fed is able to control

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rates for the economic system is a whole and to

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make a profit of bank has to set its consumer

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interest rates higher than the federal funds rate That's called

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the spread well The Fed funds rate then becomes the

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floor for all interest rates Consumer rates will be some

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rate higher than that right There is a spread or

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so money basis points above the federal raid that consumers

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borrowing money to pay higher interest rates dissuade investors from

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taking risks and putting their money into new capital projects

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The economy slows down and unemployment increases or employment decreases

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But inflation gets curbed and risks of bubbles and other

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big problems for an overheated economy decrease In the 19

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eighties there was an inflation rate of yes 15% a

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month at one point Thank you Vietnam War spending machine

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All right remember Ah high inflation rate is dangerous since

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goods and services increase in cost very quickly which hurts

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people who rely on fixed income I'II bonds and savings

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And we're thinking about you Grandma and Grandpa retiree and

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that whole inflation thing While it generally impact spending decisions

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in a way that distorts the economy Like let's just

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look at a quick example to see how higher interest

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rates impact the cost of things Well a person with

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a 30 year home mortgage for 300 grand with a

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fixed interest rate of 6.5% would end up paying $682,000

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in change On the other hand if interest rates were

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to sky rocket from six and 1/2 percent two on

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eight 18% then they would end up paying 1,000,000 6

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100,000 bucks and change in interest And that higher interest

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rate would mean having to pay almost $1,000,000 mawr in

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the latter case toe pay off that high price alone

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And you can imagine what that does to the price

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of real estate Right High interest rates usually mean a

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little state prices get crushed Well During the late 19

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seventies and early 19 eighties old crusty Detective Fede put

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his gun sights clearly on fighting inflation The Fed increased

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the discount rate significantly Borrowing rates hit almost 20% for

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a few months The downside recession Yeah nobody was spending

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money on nothing and the wheels of the U S

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Economy well ground to a halt But Detective Fede put

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the handcuffs on inflation Eventually price increases fell to acceptable

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levels of just a few percent each year Once the

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economy exited the recession well was set up for a

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strong healthy bull market and a whole lot of growth

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And hence you had the boom of the 19 eighties

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and nineties And yes look up the S and P

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500 stock chart how bad it was in the seventies

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and how good it was in the eighties and nineties

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Well another element of economic control lies in the Fed's

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regulatory grips on banks The US uses a fractional reserve

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banking system which means that when someone walks up to

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a bank and deposit 100 grand the bank keeps and

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will say $10,000 of it in its big fat involved

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And then it loans out while some of the remaining

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90,000 bucks or maybe all of it with interest The

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bank wants to loan out as much as possible That's

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their business They make money on loaning out your money

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toe other people and pocketing a spread or their share

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of the interest right They're paying you 2% loaning out

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at 8% and they're keeping 6% there as spread Nice

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business right Well if a bank it's too aggressive They

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Khun Kit in a bad position Like if something goes

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wrong with those loans that too many people wanna withdraw

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their savings Well banks can get caught without enough cash

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on hand in their vault when people want it And

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then oh panic This exact situation happened in 1930 is

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the U S Slid into to the depths of the

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Great Depression People ran to withdraw their cash money from

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the bank and when they couldn't get it back well

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their hard earned savings went down with the banks Yeah

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banks failed and money was lost And what people thought

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was safe turned out to not be safe And that's

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really bad Okay well to prevent bank panics and failures

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the Fed Institutes reserve requirements These rules mandate how much

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of its deposits banks need to keep in their vaults

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Well banks will have a minimum fraction of their deposit

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in reserve and 10% 5% for present 8% Something like

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that kind of rainy day fund So when people come

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in to ask for their money it's there The Fed

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can adjust these reserve requirements as needed overtime by setting

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higher reserve requirements while the Fed then acts in a

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similar way to raising interest rates Like banks just won't

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have all the money to loan that they'd liked alone

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And so the prices go up Right Supplies limited with

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demand flat goes up anyway so the bottom line is

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then credit gets restricted Wealthy economy that is less fuel

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to grow and there's less danger of inflation and overheating

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At the other end of the rainbow lower reserve requirements

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open up additional funds for lending amore fuel More potential

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growth like that Kasaba Melon example We always talk about

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Think about what grocery stores incentivized to sell Those melons

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that cost a dollar each were used to selling him

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for $3 but now they've got 18,000 of them in

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the store and they'll lower The price is really quick

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to maybe a dollar 10 just to get him out

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so you don't have a whole bunch of rotting melons

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in the store And that's kind of how banks work

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There's volumes of money that suddenly come in They dropped

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the price of renting that money so that people borrow

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It doesn't rot right Well in 2017 the reserve requirement

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for banks with more than 115,000,000 bucks or so in

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assets was at its highest which was a 10% reserve

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right This means that those banks had to hold 10%

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of all their assets in cash form Banks with less

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than that were only required to hold 3% write really

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small bank It's less volatile and less of an issue

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to national security of the tiny bank goes bust Okay

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well the final tool for the Fed is open market

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operations almost with almost the Fed buys and sells government

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securities in the open market Trading usually happens with large

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institutional investors like Fidelity and Capital Group and Franklin those

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guys and with other government When the Fed sells TV

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lt's notes bonds and other forms of promissory paper on

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the open market well they effectively suck liquidity or liquid

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money from the economy by giving these illiquid papers out

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in exchange for that cash On the other hand when

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the fed vise back their own illiquid paper while they're

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releasing cash money back into the economy increasing liquidity and

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encouraging people to spend think of it like this They're

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trading cash for paper when cash gets put into the

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economy Well that's more money for businesses and consumers to

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spend And when they take cash out of the system

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well it's the opposite depending on the current economic landscape

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while the fat will have to choose which tools to

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use and how to use them using the right tool

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can put the economy in a great position in the

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wrong tool 12 hurts Fortunately the Fed has never screwed

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up the entire economy but they have helped that a

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number of times All right quick recap here All economies

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go through growth and contraction over time It's natural It's

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normal Monetary policy is conducted by the Federal Reserve By

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changing the rate at which money enters the economy the

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Fed can influence end or prevent recessions and inflation When

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the Fed uses the correct type of monetary policy at

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the right time it can flatten out the peaks and

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valleys of the business cycle making it more gentle for

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all of us That is we'll have longer periods of

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growth and shorter periods of contraction with fewer extremes If

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done right it's a matter of a slight adjustments performed

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all the time over time at the right rate a

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little boost of energy to get over the hump of

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a long work week A slight cut in the federal

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funds rate A little oom mow mow mow buying maybe

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tweak reserve requirements a bit lower just a little shot

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of caffeine Or the Fed could dispense a little over

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the counter medicine to take care of a short term

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cold that's slowing things down Maybe EJ interest rate a

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bit higher Ah little almost selling and pick up reserve

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requirements a little bit Expansionary monetary policy is used to

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encourage the economy to grow It's caffeine time Then in

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these situations we see lower interest rates lower unemployment and

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higher inflation rates Contractionary monetary policy is used to slow

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down the economy usually with an eye to controlling inflation

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This type of policy involves higher interest rates higher unemployment

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and lower inflation rates Got those big Three Well the

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reserve requirement is how much the Fed forces the banks

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to hold cash in reserve The discount rate is the

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interest rate that the Fed charges for loaning money to

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banks and the federal funds rate Is the interest rate

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set for loaning money generally between banks Well almost are

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the securities that the Fed buys and sells toe Add

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a remove money from the economy and liquidity story There

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Those are the tools used by you know crusty old

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detective fed If things were going good he likes to

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move slow build a strong case and keep things as

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even keel is possible And let's just hope he doesn't 00:15:00.306 --> [endTime] get too old for this

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