Wednesday, August 17, 2011

What Does Governor Perry Know About Monetary Policy?

Did I hear someone using the Federal Reserve Bank Chairman's name in vain? Oh, that was that Texas Governor Rick Perry, talking about what they would do to the Fed Chairman, Ben S. Bernanke if he printed more money. You all know it is important to get the history right even if it is recent history we are talking about. Just for the record, Ben S. Bernanke, the current Chairman of the Federal Reserve Bank in Washington, D.C. was appointed by President George W. Bush. This all occurred during the Bush presidency as Bernanke replaced Alan Greenspan as Fed Chairman. One more thing, Ben S. Bernanke is a Republican and a former economics professor that specialized in studying the Great Depression and how the Federal Reserve's monetary policy prolonged the depression. Bernanke is known to have written about this period, and hopefully has avoided making the same mistakes that were made in the 1930s.

What does the Federal Reserve Bank do? Well, if you will take a look at your paper money, you will see that at the top of our paper money are the words FEDERAL RESERVE NOTE. That's right, the Federal Reserve Bank issues our money. Now besides printing paper money for circulation, the Fed regulates banking through setting MONETARY POLICY. Monetary Policy works like this:

The Fed traditionally had 3 levers to influence interest rates and thus influence economic activity. Interest rates are thrown into the internal rate of rate formula by corporations, and businesses decide whether projects will fly at a given rate of interest if the money is borrowed from a commercial bank. And, if interest rates are low, economic activity will build and that leads to a higher velocity of money which makes the economy go round.

But, if the economy is moving too fast, the Fed can try to slow the economy by doing one, two or three things. First, the Fed can influence the amount of money in the banking system by buying or selling U.S. Government notes and bonds in the open market. These trades are called Open Market Operations, and if the Fed sells Treasuries, they take money out of the banking system. Second, the Fed can change the Fed Funds rate of interest. Fed Funds are what banks purchase from the Fed at the Fed window. If the Fed wants to slow the economy down, the Fed can raise the Fed Funds rate. The third lever is the reserve requirement and that too the Fed can raise and lower depending upon whether the Fed wants to slow down, or, try and speed up economic activity.

Now why would a Governor from Texas want to get ugly with a Republican Fed Chairman appointed by a Republican President? The only answer I can come up with is that this Republican Governor from Texas doesn't understand central banking or how monetary policy works to help grow the economy and speed up economic activity. Perhaps, some where along the line, someone can explain to him what monetary policy is and how it works.

Stay tuned, it has to get better.

1 comment:

moneythoughts said...

You know, I try hard to write a good piece for my blog, and yet I get not one comment or question! Either everyone that reads my blog already knows everything about how the Fed influences interest rates through monetary policy, or, no one gives a shit.