No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Twelve: Money Mischief 285 inflation ultimately manifests itself in consumer price inflation, but no one wants tight monetary policy until consumer prices start to rise. Central banks such as our Fed are therefore unwilling to overtly tackle asset inflation. We’ll see later that this failure leads to the boom bust business cycle . FEDERAL RESERVE TOOLS Before we can explain the business cycle and its monetary roots, we need to review the ways the Fed controls monetary policy. We’ve already mentioned the most important one, so now it’s time to give it a name. Open market operations occur when the Fed buys and sells securities as we illustrated in chapter 11. The process of buying and selling securities changes the amount of reserves in the banking system, and profit-maximizing banks tend to expand their loans when they have additional reserves and decrease their loans when their reserves decrease. Not only are open market operations a powerful tool to implement monetary policy, but they have a number of advantages over the other tools we’ll review. First, the amount of reserves can be tailored to any level—the Fed can precisely control the monetary base. In fact, the New York Federal Reserve Bank (part of the Fed) does just that, with a team of economists that constantly adjust the Fed’s portfolio of securities to maintain or achieve a given level of bank reserves (and ultimately a given amount of money in our economy). Second, they are quick; the Fed can instantly change monetary policy in powerful ways to directly inject reserves into the economy. Policy makers in Washington DC might take years to stimulate the economy through a new fiscal policy, but the Chairman of the Fed can do it with a phone call or email (since you know all central bankers are too stodgy to text!). For example, after the 1987 stock market crash, Fed Chairman Alan Greenspan a ssured markets that the Fed was available to extend liquidity to financial firms; this helped calm markets and avoid a recession. Finally, open market operations are easily reversed. If the Fed made a mistake and expanded or contracted the overall money supply too much, they can just add or drain reserves with another phone call in order to compensate. For all these reasons, open market operations is the Fed’s primary tool of choice. The Fed can and does take other actions to affect monetary policy, including changing the reserve requirements . When reserve requirements are raised, a given monetary base will support less multiple deposit expansion. With the 10% reserve requirement we used in chapter 10, the monetary base can support multiple deposit expansion 10 times the base amount. If the Fed were to increase reserve requirements to 20%, then deposits could only be multiplied five times. Changing reserve requirements is a very powerful instrument, but it is also very blunt. Small changes in reserve requirements can have big effects on money supply. Further, it is more difficult for banks to constantly change to differing reserve requirements (as compared to responding to changes in the level of reserves from the Fed’s open market operations); thus, the Fed seldom changes reserve requirements. Open market operations: the Federal Reserves preferred method of conducting monetary policy; open market operations involves increasing or decreasing the level of reserves in the banking system by the Fed’s purchase or sale of assets in the open market. Reserve requirements: the amount of reserves a bank is required to have by regulation to meet cash withdrawal requirements of its customers. Business cycle: the tendency of market economies to experience boom periods followed by bust periods.