Thursday, September 3, 2009

The Federal Reserve

I have been searching, fruitlessly, for a chart depicting the year on year change in price levels before the Federal Reserve and since its creation in the early 1910s. I cannot find it and will instead describe it. It shows a noise chart above and below zero. In the beginning the variance is large if it were a seismograph it would be showing an earthquake. (Shown above) As the Federal Reserve is instituted the variations shrink and adhere more closely to a long-term trend. The chart shows why the Federal Reserve exists and why interest rates are not allowed to freely float.

The Federal Reserve is made up of 12 regional banks and a board of directors. The regional banks are tasked with regulating and keeping the banking system healthy. These banks also act as a lender of last resort or the banks’ bank. The Board has a distinctive but related task to control the country’s money supply. The Board of Governors plus 5 regional bank presidents together make up the Federal Open Market Committee. 4 of the bank presidents rotate, as the New York bank always has a spot.

The committee controls the money supply in three ways:
A) By buying and selling bonds via the open market operations,
B) Reserve requirements, and
C) The discount rate

A) Open Market Operations - When it buys bonds it adds new money to the financial system and when it sells bonds it takes away money from the financial system. This seems counterintuitive but view it from the viewpoint of a bank. When the bank sells its bond to the Federal Reserve it now has cash instead. It can then lend this cash out. However, when the Federal Reserve sells bonds the bank must use its cash to purchase the bonds and thus loses the ability to lend out the money it purchased the bond with.

B) Reserve requirements – regulations on the minimum amount of “cash” reserves a bank must hold against customer deposits. This affects the money supply because if the banks have to hold more in reserve the banks then have less to lend out. Vice versa, lowering the requirement allows banks to loan out more money.

Here is how it works:
Bank A
Reserves 100.00
Deposits 100.00

This is if there was a 100% reserve requirement. Obviously this is untenable as the banks could only keep the money safe, as a warehouse. No entity would undertake this responsibility, as there would be no profit. So the banking system consists of a “fractional reserve system,” which only means that a fraction of each dollar of deposits is actually held at the bank. The rest is loaned out, which is a banking asset, to create profit for the bank.

Bank A
Reserves: 20.00
Loans: 80.00
Total: 100.00
Deposits: 100.00
Total: 100.00

Thus, seemingly the banks has created money, in an earlier post we said that money was currency plus demand deposits. So 80 + 100 = $180. However, it must be said that the economy is not wealthier, there is just more money or liquidity. This is because those 80 dollars of loans, though bank assets, are liabilities to entities that undertake them.

The process does not end here though. If the person, who took the $80 loan, maybe did not have an immediate need for the funds, so he deposited it at his bank.

Bank B
Reserves: 16.00
Loans: 64.00
Total: 80.00
Deposits: 80.00
Total: 80.00

This iterative process can be completed ad infitnitum, so as a general solution we can take the initial deposit and divide it by the reserve requirement ratio. So $100 divided by 20/100= 500. Thus, the money multiplier at this reserve requirement will be 5.

C) The Discount Rate – Acting as the banks’ bank it loans out reserves to bank who find them short of the reserve requirement. Picture the end of the day and a customer comes in at 4:30 PM and withdraws 10 dollars of deposits from Bank A. Bank A would still have 80 dollars worth of loans but now only 10 dollars of reserves. It would need to find 10 dollars of reserves to meet the Federal Reserve’s requirement. It thus can go to the Fed and borrow the 10 dollars at the discount rate. Then it would to try and unwind one of its loans to rid itself of the borrowings from the discount window.

Bank A (after 10 dollar withdrawal)
Reserves: 10.00
Borrowed: 10.00
Loans: 80.00
Total: 100.00
Deposits: 90.00
Borrowings: 10.00
Total: 100.00

The discount rate follows the laws of supply and demand. So when the rate is high banks wants to borrow less and when the rate is low the banks are more willing to borrow. Finally, this also acts as insurance against a bank run, as the banks can borrow from the discount window freely, thus generating the liquidity to survive a financial crisis like in 2008 and in 1987.

Greg Mankiw in his Principles of Economics points to two major problems with controlling the money supply through these three mechanisms. First, the Fed cannot control how much money people will want to hold on deposit with banks. Thus, a bank run can have systemic effects on the money supply. Secondly, the Fed cannot control how much the banks lend. Unlike China, you cannot force the banks to underwrite loans that the banks deem too risky given a current economic situation.

These two forces have been a key puzzle for economist over the past century. It is described by a simple equation M x V= P x Y, where:

M= quantity of money
V= velocity; the link between money, price and output
P= price level
Y= aggregate income or GDP

In the short run V and Y can be held constant thus the price level would be affected only by the money supply. This is how Milton Friedman came out with the proclamation that “inflation is always and everywhere a monetary phenomenon.”

However, as we have experienced lately the Federal Reserve and the Treasury have instituted a number of initiatives to increase the money supply and velocity but velocity has only declined to negate their works. I will expand on this in the next post on Inflation.

Money, it's what you want?

Why? The money we use today, the pieces of green paper with some old dudes on it, funny symbols and words, and pictures of architecture is essentially worthless, fiat. Why do we exchange them for goods and services, that is, why can you give them to a cashier at Starbucks and receive a latte?

There are three basic functions of money: medium of exchange, unit of account and store of value. Medium of exchange is the most obvious. Imagine that instead of money we had a barter system. You would create a pair of socks and you would then try and find me a person who needed socks. Then of course I would need to be able to give something back to you that we felt equaled the value of the socks. Basically you needed to have a "double coincidence of wants." Money obviates the above situation by its ability to be freely substituted for goods and services. Thus, you can sell your socks for money and then use your money to buy a bushel of grapes without having to find someone who had a need for socks and owned a bushel of grapes.

It also works as a yardstick, like an inch of a foot. It makes it easy to compare two relatively different goods or services into like terms. So having a maid clean your house is equal to 10 car washes. Instead we would just say that the maid's services cost 100 dollars and a car wash is 10 dollars.

Finally, it holds value. When the Starbucks or the sock maker takes the cash, they can delay their consumption to a later period. Thus, money can be a holder of wealth.

Here is where money becomes tricky though. It is enough to look in your piggy bank and see a collection of metallic coins and the occasional two-dollar bill which is money, but what else is money? How about the money in your checking account known as a demand deposit? What about CDs. or savings or money market accounts? There are several definitions of money as categorized by the Federal Reserve. M2 is probably the most appropriate measure. It includes:
  • demand deposits - checking accounts
  • traveler's checks
  • other checkable deposits -
  • currency
  • savings deposits
  • short time deposits
  • money market funds
  • various accounts

Sunday, August 30, 2009


Just a few charts to discern what happens to employment during a recession. Really more of a vocabulary post.

So this is the the percentage of the adult civilian population (> than 16 years old) that could be employed. It is divided into three subsections: employed, unemployed and not in the labor force. The not in labor force are generally retirees and students. Now the percentages look different than what you may hear described on tv or in print. This is because they are again percentages of the total employable universe. The unemployment rate measures only the unemployed versus the labor force. This is shown below.

So here you can see the 9.4% unemployment figure that economist describe.

So the largest category is Civilians over the age of 16 and it is right now approximately 235.9 million people. It is made up of the labor force and the aptly titled Not in Labor force, which stand at 154.5 and 81.4 million people respectively. 9.4% of the labor force is unemployed currently and that represents 14.5 million people.

I wanted to look at the chart again. There are some interesting nuances going on in the data. One is that the not in labor force number is growing both in percentage terms and nominal terms as the population has increased. This most likely stems from the baby boomer generation entering their retirement years. This is why the employment as a percentage of adults has fallen below 60%.This is the first time it has been this low since 1984.