Inflation vs. Unemployment: What Should the Fed Do?

To understand the tradeoff that the Federal Reserve faces in choosing between inflation and unemployment policies, we need to go back to the very basics. We must understand what money is, how banks operate, how the Federal Reserve is structured, and how the Federal Reserve affects the money supply. Then we must understand how the money supply impacts the economy. First this is first. What do we mean by "money" and how do we count it?

Money: Definition and Measurement

A barter system is one in which goods and services are exchanged directly for goods and services. It requires a double coincidence of wants. For example, if I decide that I want a new, red Saturn, I must find someone who has one and she must be willing to trade the Saturn for something that I have. For example, I might have a brand new Chevy Blazer that the Saturn owner wants. We can then exchange the Saturn for the Blazer. Such transactions are difficult and clumsy. We can ease the transition process by using a monetary system.

A monetary system uses some universally recognized currency to facilitate transactions. Now if I wish to acquire a Saturn, I simply go to the owner of the Saturn and pay money for the car. I do not need to have something of equal value that the Saturn owner wishes to have. The double coincidence of wants is unncecessary.

We need to carefully define "money." In common usage, the terms money, income, and wealth are often used interchangeably. But to an economist, money and income are very different things. Income is the flow of revenue over a particular time period. For an income measurement to make sense, one must define it in terms of a particular time period. For example, I earn $10 per hour, or my salary is $2,000 per month, or my income is $25,000 per year. Without a time qualification, income could refer to almost anything. Few of you think of yourselves as millionaires, but in your lifetimes you will indeed earn income over $1,000,000.

Wealth is the value of your stock of assets at a particular point in time. Your assets are things of value that you own. For example, your house, stocks, car, and funds in your savings account are all part of your wealth. Wealth is a stock, it can be added up at any moment in time.

Money is something that serves these three purposes, First, it is a medium of exchange, or a means for making transactions. Second, it is a unit of account, or a standard unit for quoting prices. Third, it is a store of value, a means to store wealth from one time period to the next. You can put your money under your mattress and it will be there next month. Lots of things can be used as money. In much of our history, we used gold and silver. Some places use rocks to trade goods. During wars, cigarettes and chocolates are often used. As long as the commodity serves the three purposes described above, it can be money. In today's world, we use fiat money, or paper money. The money is inherently worthless except for the purchasing power that we trust it will bring. Without trust, the paper money becomes useless pieces of paper.

Measuring the Quantity of Money

Money is measured in terms of its liquidity, how easily it can be converted to cash. Currency, by definition, is highly liquid because it is already cash. Checking accounts are liquid becasue one can write checks as a way to carry out transactions. Houses and cars, however, are not nearly as liquid.

The narrowest measure of money which includes only the most liquid assets is called M1. M1 includes:

Currency,
Demand Deposits (no-interest checking accts),
Other Checkable Deposits, and
Traveler's Checks.

M2 is a slighlty broader definition of money that includes less liquid assets. M2 includes:

M1,
Savings Deposits,
Small Time Deposits, and
Money Market Deposit Accounts.

The distinction between M1 and M2 has been narrowing due to advances in banking. M2 is much more liquid than it used to be. Currently, we have nearly $1.3 trillion in M1 in the economy and over $3.7 tillion in M2.

Click the appropriate text to view a historical data series of M1 and M2.

BANKING

The Fractional Reserve System

Our banking system is called a Fractional Reserve System which means that banks must only keep a fraction of the deposits they hold on hand. The rest can be loaned out. For example, suppose banks are required to keep 10% of deposits on hand. This is called the Required Reserve Ratio (RRR). For every $100 of deposits, only $10 must be held by the bank. Defining the required reserve ratio in percentage terms,

RRR = required reserves/ total deposits x 100, or

required reserves = RRR x total deposits / 100.

Banks are in business like any other private company: to make a profit. They earn profits primarily on the spread between the rate they must pay for funds and the rate they charge for lending funds.

Dangers of a Fractional Reserve System

There are at least two problems with a fractional reserve system. First, the financial system is susestiple to bank runs. If depositors lose faith in their banks, they run to the banks to withdraw the funds. This happened on a large scale during the Great Depression. Since banks have only a fraction of the deposits actually on hand at the bank, only the first customers to get in line will receive their money.

The second problem with a fractional reserve system is the possibility of bank failures. Since banks are in business to make a profit, they can make poor management decisions by making risky loans. Depositor funds are at risk.

We have developed partial solutions to these problems over the years, particularly in the years following the Great Depression. To prevent bank runs, we have implemented a system of deposit insurance. Most banks are members of FDIC, the Federal Deposit Insurance Corp. This is an insurance system that banks pay funds into in order to cover depositors funds if the bank fails. This helps to avoid widespread bank runs because depositors are assured of the security of their deposits. However, this also leads to an incentive system in which depositors do not care how a bank is managed. There is no consumer regulation on quality of banks' operations. Even when Savings and Loans were going bust in the late 1980s, depositors kept putting their money in them.

To reduce the likelihood of bank failure and bad or corrupt management practices, we have developed an extensive system of bank regulation. Banks are probably the most regulated companies in the U.S. They are subject to frequent audits to make sure loan portfolios are sound and that all activities are legal. The system is far from perfect, however, given the recent wave of bank failures and corruption.

Bank Bookkeeping

Banks keep books like any other private company. An asset is an item of value that a bank owns. A liability is an item of value that a bank owes. A bank's capital or net worth is the difference between its assets and liabilities.

Capital = Assets - Liabilities.

The table below lists the most common bank assets and liabilites.

Assets Liabilities

Reserves Checking Deposits

Govt. Securities Savings Deposits

Loans Outstanding Time Deposits

Reserves are funds that the bank keeps on hand to meet depositor demands for funds and to satisfy the minimum reserve requirements set by the Federal Reserve. Reserves can consist of either vault cash or funds held by the Fed for the bank. Many banks, especially those in large cities, prefer the Fed to hold onto the cash for them. The funds can be withdrawn at any time.

Money Creation by Banks

Banks (in combination with the Federal Reserve) are unique in their ability to create money. They do not create the physical money that we touch, but they do create M1. Let's see how this works.

Suppose the required reserve ratio is 10 percent, or .10. First Federal Bank initially has $1,000,000 in deposits so it must have 10% × $1,000,000 = $100,000 on hand as reserves. First Federal also has $1,200,000 in loans outstanding. The bottom of the chart analyzes the reserve position of First Federal. It does not represent new assets. Excess reserves are the amount of reserves that the bank has over its required level. Since First Federal has $100,000 in reserves and is required to have $100,000 in reserves, it has no excess reserves.

Emily has $100,000 in cash. She is obviously concerned about carrying around such a large sum of money for fear of being robbed or losing it. So she goes to First Federal and deposits the $100,000 into her checking account. The bank takes the $100,000 and puts it in the vault, increasing its reserves from $100,000 to $200,000. However, First Federal now has more reserves on hand than it needs. The banks needs to keep only 10 percent of the $100,000, or $10,000 on hand. This generates $90,000 in excess reserves, reserves above and beyond the required amount.

First Federal earns no interest on reserves that simply sit in a vault. So the bank lends out the $90,000 to Bob. First Federal's outstanding loans rise by $90,000 to $1,290,000. Reserves fall, however, to $110,000. First Federal is back to a position of no excess reserves.

It seems like not a lot has changed. But let's count the money supply so we can keep track of its quantity. Recall that M1 is the addition of currency outstanding plus checking account balances. First Federal started with $1,000,000 in deposits and Emily was carrying around $100,000 in cash for a total value of $1,100,000. After Emily deposited her $100,000 in the bank, M1 was still $1,100,000, but now all of it was in the bank and none of it was currency. But what happens after First Federal lends the $90,000 to Bob? Now we have $1,100,000 in checking deposits plus $90,000 in cash that is in Bob's pockets. The money supply has expanded! M1 is now $1,100,000 + $90,000 = $1,190,000.

The process won't stop here. The $90,000 is taken by Bob and put into Second Federal Bank. Second Federal has increased reserves of $90,000 but only needs to keep $9,000 on hand, generating excess reserves of $81,000.

Suppose Second Federal takes the excess reserves and lends them to Amy. M1 is now $1,100,000 + $90,000 + $81,000 = $1,271,000. Amy puts the funds into Third Federal Bank which generates excess reserves of $72,900. The process continues in this fashion.

The Money Multiplier

How much new M1 will ultimately be created? We can answer this by using the Money Multiplier formula:

Maximum Change in Money Supply = Money Multiplier x Initial Change in Exess Reserves

where the money multiplier is equal to 1/RRR.

In our example, the money multiplier is equal to 1/10% = 1/.10 = 10. The initial change in excess reserves was $90,000, so the maximum change in the money supply is 10 x $90,000 = $900,000.

This money multiplier formula calcuates the maximum possible expansion of M1 because it assumes:

everyone deposits their new loans into a checking account at a bank.
banks hold no excess reserves.

If either of these assumptions are violated, the amount of money actually created in the economy will be smaller than the forumla predicts. The same logic still holds, however.

The money creation process works exactly the same in reverse. For example, if someone withdraws money from a bank, a bank will be short of its required reserves and must reduce loans. M1 will decrease by $900,000 in the example above.

THE FEDERAL RESERVE

The Federal Reserve is the United States Central Banking system. It is probably the most powerful yet least understood organization in our economy. It's actions may affect everyday consumers whenever we purchase things on credit, take out a loan, or feel the effects of inflation or unemployment. We will examine the history, structure, and operations of the Federal Reserve.

History & Structure of the Federal Reserve

The Federal Reserve ("the Fed") was founded in 1914 after four severe banking panics. Two other central banks were set up in the 1800s but each lasted only a short time. The Federal Reserve is chartered by the federal government, but is largely independent of the authority of the Congress and President. The Fed must only report to the Congress periodically and operate within broad mandates.

The role of the Fed is to conduct stabilization policy and to act as a lender of the last resort to banks to stabilize the banking system. The lender of last resort is probably the Fed's biggest responsibility. Many economists believe that the Great Depression was due mainly to the collapse of our banking system. The Fed did not do enough to prevent its collapse. When a business needs money, it can often run to the bank for help. Before the Federal Reserve was created, banks had nowhere to turn when they were in trouble. The Fed is now there to back them up.

The unique structure of the Federal Reserve is a consequence of history and politics. The chart gives a breakdown of the main divisions within the Fed.

The Board of Governors is the highest governing body of the Federal Reserve. It consists of 7 members including the chairperson, currently Alan Greenspan. The chair is appointed to a 4 year term by the President of the U.S. The appointment is usually staggered with the election of President of U.S., i.e. every two years either the President or chair comes up for election/appointment. However, this staggered cycle was disrupted when Paul Volcker resigned from the Federal Reserve early in 1987.

The other six members of the Board of Governors are appointed to 14 year terms by the President of the United States and they must be confirmed by the Senate. The long terms try to assure stability and continuity in the Fed's policy decisions. Howeve, many of the board members do not serve their full terms and leave to work in the private sector.

The Twelve District Banks (click for a map) were initially designed to decentralize the Federal Reserve. The United States has a long history of being afraid of centralization, and this was a way to diffuse the power. However, though the District Banks have some autonomy, they still fall under the leadership of the Board of Bovernors. The District Banks perform numerous functions in their Districts. They regulate and supervise banks, run a check-clearing service, do research and monitor the economic activity in their areas, circulate the currency in their districts, sell savings bonds, and so on. Moreover the New York Fed conducts open market operations and foreign exchange stabilization which will be explained below.

The F.O.M.C. (Federal Open Market Committee) is responsible for directing monetary policy. The committee is made up of 12 members, 7 from board of governors plus 5 Presidents of the District Banks on a rotating basis, one of which is always from the N.Y. Fed. This committee meets about every 6 weeks to discuss monetary policy and decide what course of action to take. The committee meets more often if there is something pressing to deal with.

MONETARY POLICY

the Federal Reserve, like the government, conducts stabilization policy. In other words, it helps the economoy achieve stable prices, low unemployment, and high rates of economic growth. Fiscal policy is the term used when the government attempts to stabilize the economy. The Fed's attempt at stabilization policy is referred to as Monetary Policy.

Tools of Monetary Policy

There are three "tools" that the Fed can use to conduct monetary policy. They are:

Open Market Operations (OMO)
Change in the discount rate
Change in the reserve requirement ratio.

Open Market Operations is by far the most important tool of the Fed and is used daily. Therefore, we will focus our attention exclusively on this procedure. An Open Market Operation is the purchase or sale of government securities via transactions in the open market. Government securities are government debt, i.e. T-bills, notes, etc. In other words, an open market operation is simply the purchase or sale of secondary government debt by the Federal Reserve. An Open Market Purchase is the Fed's purchase of government securities. An Open Market Sale is the Fed's sale of government securities. The Open Market Desk is on the 8th floor of the New York Fed. This is where the trading in government securities actually occurs. The traders take the orders from the F.O.M.C. and carry them out.

An Open Market Operation impacts the banking system by changing bank reserves initially and ultimately the money supply. Let's look at an example of an Open Market Purchase.

Suppose the Fed purchases $100 million of government securities from commercial banks. How does the banking system and the economy adjust? First, let's stop to think of where the money comes from. Where does the Fed get the $100 million to purchase the government debt? The answer may surprise you. The Fed is off-budget meaning that it generates its own operating revenue. In fact, the Fed makes such a profit that it gives billions of dollars back to the US Treasury each year. The money comes from computer terminals! The money is completely made-up, it is completely "electronic." But once the money is there on the computer, it is as real as a dollar bill.

Now let's answer our original question as to the effects of the $100 Open Market Purchase. To see the effects, we must examine our bank balance sheets again. When the Fed purchases $100 million in government bonds from banks, it simultaneously puts $100 million of reserves in the hands of banks as they exchange their stocks of government securities for the reserves.

Since the $100 million are not deposits, the entire $100 million becomes excess reserves. Banks can begin lending out the $100 million which leads to the money expansion we looked at earlier. The process continues until the new money created is equal to:

Change in M1 = 1/.10 × $100 million = $1,000 million.

IMPACTS OF MONETARY POLICY ON THE ECONOMY

This section establishes the link between monetary policy and the behavior of the economy. It explains how Federal Reserve actions impact the behavior of output, inflation, and unemployment.

Monetary Policy works by changing the level of demand for goods and services in the economy. When the Fed expands the money supply, banks have more reserves to lend out. They will usually "sell" these reserves to the public by lowering the interest rate and prompting more borrowers to come forward. The lower interest rate will induce higher levels of investment and will lead to more demand for goods and services, boosting the economy's level of output.

The Loanable Funds Market

We can best illustrate the impacts of monetary policy by examining the loanable funds market. Demand for loanable funds comes from anyone wishing to borrow money, whether it be to buy a home or go to college. As the interest rate falls, the cost of borrowing funds falls, so more potential borrowers want funds. Therefore, the demand curve is downward sloping. The supply of loanable funds comes from anyone wishing to lend money, whether it be a bank or an individual. As the interest rate rises, the profit opportunity for lending money rises, so more people wish to lend money. So the supply curve is upward sloping. Equilibrium occurs where demand and supply for loanable funds are equal. This determines the equilibrium interest rate and the amount of loanable funds in the economy.

Monetary Policy and Interest Rates

When the Fed conducts expansionary (contractionary) monetary policy, it is giving banks more (less) funds to lend out. Thus the supply of loanable funds shifts to the right (left). This lowers (raises) interest rates and increases (decreases) the amount of loanable funds. In the chart, we move from point A to point B, and interest rates in the economy fall. So expansionary monetary policy lower interest rates while contractionary monetary policy raises interest rates.

The Impact of Monetary Policy on the Economy

How does all this impact the economy? So far we have not talked about any increases in output or employment. Let's examine expansionary monetary policy, or an open market purchase. When interest rates fall due to the increase in loanable funds, expenditures on investment and consumption items that are sensitive to the interest rates rises. (Recall that investment and the interest rate are inversely related.) For example, if mortgage rates fall, demand for new houses will increase. Demand for cars might also increase as the interest paments fall. People may buy more items on credit if credit card rates are reduced, and so on. Therefore, expansionary monetary policy increases spending in the economy. When demand for goods and services increases, more production must occur to meet the demand. This creates jobs and lowers the unemployment rate.

The channel of monetary policy is represented in this diagram:

The Inflation-Unemployment Tradeoff

We have finally arrived at the last piece of the puzzle. We have examined how the banking system works, what the Fed is and how it is structured, and how monetary policy affects the economy. We are ready to examine the tradeoff between inflation and unemployment and determine what sort of monetary policy the Fed should carry out in certain situations. To do this, we need to introduce the Phillips Curve.

The Phillips Curve

The Phillips Curve is a chart that plots the relationship between the inflation rate and the unemployment rate. Typically, there is a negative relationship between inflation and unemployment. This means that the Phillips Curve is downward sloping. The Phillips Curve brings to mind the phrase that "there is never any good news in economics." This chart reminds us that usually something is wrong with the economy. Either inflation is high or unemployment is high. Currently, our economic performance has been unique. We have seen falling unemployment rates and stable inflation rates over the last three years. Many expect our inflation rate to rise soon, but so far this has not happened and we see few signs that it will happen in the near future.

Economic Scenarios

Suppose the economy has a 10 percent inflation rate and a 3 percent unemployment rate. For the United States, a 10 percent inflation rate is rather high but the unemployment rate is very low. What should the Federal Reserve do? In this situation, the best solution is to lower the inflation rate. How should the Fed do this? It should implement contractionary monetary policy which means carrying out an open market sale. The OMO will raise interest rates, slow down spending, and lower prices and increase unemployment. We will move down and to the right on the Phillips Curve. The Phillips Curve shows that we must accept the higher unemployment rate in order to reduce inflation.

Suppose instead the economy has a 2 percent inflation rate and a 9 percent unemployment rate. What should the Fed do? This is the opposite situation of the one posed above. This economy is in recession. The best solution is to stimulate the economy via an open market purchase. This will lower interest rates, increase spending, and put people to work. Of course, we may have to live with higher rates of inflation in the future.

These two scenarios were fairly clear cut. Suppose the unemployment rate is 7 percent and the inflation rate is 7 percent. This solution is not as easy for the Fed to determine a stategy. The choices available are to stimulate the economy and lower unemployment, slow the economy down and lower inflation, or do nothing. There is no clear cut right or wrong answer. The solution depends upon how one views the costs of inflation relative to the costs of unemployment. In the Fed perceives unemployment as much more harmful than inflation, then the best action would be to lower interest rates and unemployment.

The economy is a complicated thing. Often times there are no easy solutions. But at least you should better understand how all the pieces of the macroeconomy fit together.

A PowerPoint slide show is also available for this module.