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

Chapter Twelve: Money Mischief 289 You can see the result of an expansionary Fed policy in Figure 12.8 . The effect of Fed purchases will be to lower the interest rate as they increase the money supply. The Fed currently targets a particular interest rate, the Federal Funds Rate (which is the amount banks charge each other to borrow reserves overnight), but their policy actions tend to affect the whole complex of interest rates—from car loans to construction loans to student loans. So our assumption to treat interest rates as a single interest rate is reasonable, given the Fed’s ability to influence them all. REAL VS. NOMINAL INTEREST RATES When you save money today, you want to consume more later because of the natural phenomenon of time preference. The nominal (or stated) interest rate (i) that you receive will contain two components: a real rate of return (r) and an expected inflation premium (π e ), or, if we assume risk free investments (other than inflation risk)... The rationale of this equation (known as the Fisher Equation) is pretty straightforward. Let’s say that you are willing to save $100 today if, one year from now, you can buy goods that cost $103 today. So you require a real rate of return of 3% ($103- $100/$100). However, due to the Federal Reserve’s easy monetary policies, you expect average prices to be 4% higher next year. From the Fisher Equation, you will require a nominal (or stated) interest rate of 7% (the 3% real rate + the 4% expected inflation). This will ensure you get $103 of real purchasing power next year. Real purchasing power refers to the amount of goods you can purchase at any point in time. So in this example, we want to be able to buy goods next year that cost $103 right now. We are willing to give up $100 today if we can buy goods one year from now that cost $103 today . The Fisher Equation is named after the economist Irving Fisher, who was one of the first to study how nominal interest rates are affected by inflation. BUBBLE, BUBBLE, TOIL AND TROUBLE! Now it’s time to use the tools we’ve learned in the last two chapters to understand what most economists fail to recognize: how Federal Reserve policies systematically lead to the boom/bust business cycle. For an entertaining and educational introduction, watch the following video: r (%) Loanable Funds Market Q (#) Q 1 Q 2 D LF r 1 S LF1 S LF2 Figure 12.8, Expansionary Fed Policy. When the Fed buys securities, we’ve seen that it starts a chain reaction of multiple deposit creation through additional loans from profit maximizing banks. When the banks expand their loans upon receiving additional reserves, the supply curve for loanable funds shifts to the right, lowering interest rates and increasing the overall debt. Federal funds rate (FFR): the rate of interest charged by banks to one another for overnight loans of money, used to meet regulatory reserve requirements. i = r + π e Fisher equation: i = r + π e