Creating Money (or Jobs) Out of Thin Air

Today, amid foreign financial market volatility, the Federal Reserve cut the federal funds rate from 4.25% to 3.5% to prevent a recession. You may read the official press release here. The move is rare for two reasons. The Federal Reserve reduced the federal funds rate before its regularly scheduled meeting next week, and the Federal Reserve reduced the rate by 75 basis points, as opposed to its usual 25 or 50 basis point increments. In summary, today’s move is rare for its timing and magnitude.

The federal funds rate, or the interest rate that U.S. banks charge each other for overnight loans, is the benchmark rate for many short-term and long-term interest rates in the United States. A reduction in the federal funds rate, often times (though not always), decreases the interest rate on credit cards, automobile loans, and mortgages. Lower interest rates encourage consumers to spend and businesses to build new offices and purchase computers, machinery, and software. A boost in consumption (e.g. buying new clothes) and investment (e.g. building new offices) spending are exactly what the economy needs when it is slipping into a recession caused by sudden drops in overall spending. Though the U.S. economy is NOT officially in a recession, the Federal Reserve forecasts “slowed growth” and would like to cut rates just-in-case.

The previous explanation shows how the Federal Reserve could use monetary policy to minimize the depth and length of a recession. However, what is less well known is the process with which the Federal Reserve is able to manipulate the federal funds rate. Essentially, the Federal Reserve lowers the federal funds rate by expanding the money supply. This is easier said than done.

First and foremost, the Federal Reserve does NOT print new dollar bills. So how is it able to create new money? There are two main forms of money—cash in circulation and checking deposits held in banks. Separate from the money supply are “reserve accounts” that commercial banks are required to have at the Federal Reserve. These reserve accounts hold cash for the commercial banks in case depositors cash-out some of their deposits.

The Federal Reserve can expand the money supply by expanding the amount of deposits held in the U.S. commercial banking system. One way to do so is to purchase U.S. government bonds issued by the U.S. Treasury department. When the Federal Reserve purchases government bonds from commercial banks, it takes bonds out of circulation and electronically credits reserve accounts. U.S. commercial banks armed with more cash reserves will issue new loans which are then deposited back into the banking system. This method effectively increases the dollar amount of checking deposits in the economy, and hence, expands the money supply.

Discussion Questions

1. Suppose U.S. commercial banks are highly reluctant to issue new loans even if they are armed with more reserves. How would this impact the Federal Reserve’s ability to expand the money supply and lower the federal funds rate?

2. Republican presidential candidate, Ron Paul, believes that the Federal Reserve “debases and depreciates” the currency through its manipulation of the money supply. In fact, he wants to abolish the Federal Reserve altogether. Using the definition of the money supply and the relationship between interest rates and unemployment, how could the money supply be “pro-cyclical” without the Federal Reserve?

Real Wages and Productivity

The New York Times reports that real wages, as a percentage of GDP, have fallen to their lowest level in recorded history. The article contains a number of good nuggets that illustrate some basic points in economics.

First, we need to think about what we mean by "wages." A worker's nominal wages are the dollar value of her take-home pay, not including benefits. For example, if a worker earns $20 per hour before taxes, that is her nominal hourly wage. However, a worker's real wages are the wages adjusted for inflation. For example, if a worker's nominal wage rises by 2% and there is 3% inflation, we actually consider her real wages to have dropped by 1%--that is, the value of goods and services she could afford went down by 1%. (In fact, real wages did decrease in 2005: median weekly earnings increased from $631 to $651, an increase of 3.16%, but since inflation was at 3.4%, the $651 in 2005 was actually worth less than the $631 in 2004.)

However, the article doesn't say that real wages have decreased--indeed, with the exception of 2005, real wages have generally increased over the last few years. The article's main point is that as a percentage of GDP, real wages have been steadily declining. In other words, the growth rate of GDP has been steadily greater than the growth rate of wages and salaries.

But that's only part of the story, because wages are just part of workers' overall compensation packages. Health insurance is the other big component. Due to a historical anomaly, employers tend to pay for health insurance for their workers, rather than workers buying it on their own. Therefore, total compensation to workers can be thought of has having two components: wages, which the workers are free to spend as they wish, and a certain amount of money with which they are forced to buy health insurance. In recent years, the price of health insurance has grown at double-digit rates, far outpacing inflation, while wages, as a fraction of the overall compensation package, have been falling.

Note that the increase in health care spending might very well have had the same effect if workers received all of their compensation in cash, and then paid for health insurance out of their own pockets. Since health care is widely viewed as a necessity rather than a luxury, demand for it is relatively inelastic; therefore, as its price goes up, people might very well decrease their expenditures on other goods and services. In other words, the effect of an increase in the price of healthcare means a decrease in consumers' real income, and the fact that wages and salaries don't include benefits serves to highlight this effect.

However, even if we take into account both wages and benefits, overall compensation has still been falling in recent years as a fraction of GDP, while corporate profits have been increasing. Why? Workers have been more productive--that is, creating more output per hour of labor--which has meant higher revenues for firms. Those revenues accrue to different factors of production: wages to workers, rent to capital, and profits to shareholders. The article's main point is that the gains in worker productivity have not accrued to workers, but instead have gone largely to shareholders.

Describing how wages, benefits, and profits have changed over past years is the province of positive analysis. The article raises an important normative question as well: is it fair that wages have not kept pace with productivity? Or that the top 1% of earners received over 11% of all wage income, up from 6% three decades ago? These are important questions as well, but economic analysis is less helpful in answering them.

1. Suppose the U.S. government provided national health insurance for everyone. Do you think wages and salaries would still be falling? What about after-tax wages?

2. The divvying up of the economic pie appears to be a zero-sum game: there is a certain amount of economic surplus out there to be divided between profits and wages, and more of it has been going to profits. Jared Bernstein, a senior economist at the Economic Policy Institute, lays the blame for lower real wages on workers' lack of bargaining power. Would a greater rate of unionization help to achieve greater equity? Would it do so at the expense of efficiency? What about using government taxes and transfers to achieve greater redistribution of income from rich to poor households? Would economic policies aimed at a more equitable division of the economic pie mean a decrease in the size of the pie?

3. If labor markets were perfectly competitive, wages would increase directly with productivity. (For a simulation of how this works, see this demonstration of an interactive experiment based on the classical theory of the labor market.) What about the real labor market is a departure from this model?

Update: This has been a hot topic on the blogosphere. Greg Mankiw, Russell Roberts, and David Altig have posted comments on the article (and others' comments on it). More to follow, I'm sure, and we'll keep you updated.

How to Cure Inflation

Argentina is no stranger to inflation and has suffered frequent periods of devastating inflation since 1945. Despite recent praise from the International Monetary Fund for its economic growth, Argentina currently suffers from a 12.3% inflation rate (compared to only 4% in the United States).

Milton Friedman, winner of the 1976 Nobel Prize in Economics, compares inflation to alcoholism in his PBS series, Free to Choose:

Inflation is just like alcoholism, in both cases, when you start drinking or when you start printing too much money. The good effects come first; the bad effects only come later. That's why, in both cases, there is a strong temptation to overdo it, to drink too much and to print too much money. When it comes to the cure, it's the other way around, when you stop drinking or when you stop printing money the bad effects come first and the good effects only come later. That's why it's so hard to persist with the cure.

Source: Free to Choose, Volume 9 of 10, How to Cure Inflation (26:40)

A simple aggregate demand (AD) and aggregate supply (AS) diagram offers great insight into Friedman's analogy and Argentina's inflation woes. The following AD-AS diagram is based on a paper by Professor David Romer. The model might be slightly different from the AD-AS diagram in your textbook.

First, let's look at the assumptions in the model. The aggregate demand curve (AD) assumes that the central bank raises the interest rate in order to combat inflation. For example, if the inflation rate increases, then the central bank will raise the interest rate to reduce consumption and investment, thereby lowering output. The short-run aggregate supply curve (SRAS) represents the inflation rate. The long-run aggregate supply curve represents the output level where the inflation rate has no tendency to change. The long-run aggregate supply curve is often referred to as potential output or full-employment output.

Second, let's look at the short-run effects of an increase in the money supply. In the short run, economists assume that the inflation rate is temporarily fixed. The short run might be a period of 1 day, 1 month, or 1 year. There is no consensus about how long the short run lasts. If the central bank expands the money supply, then the interest rate falls. A fall in the interest rate stimulates consumption and investment spending which shifts the aggregate demand curve to the right from AD1 to AD2.The good effects come first--in the short run, it seems as though the economy has benefited from a higher quantity of money. Output increased from $450 billion to $500 billion which creates more jobs without increasing inflation.

Third, let's look at the long-run effects of an increase in the money supply. The output level at time B is not a sustainable amount of output because $500 billion exceeds full-employment output, which is only $450 billion. An output level above the full-employment output necessarily means that resources in the economy are being over-utilized. Inflation expectations increase in the long run as a consequence of over-utilization, which causes the inflation rate to gradually increase from SRAS1 to SRAS2.

As the inflation rate increases, the central bank frantically tries to contain inflation by increasing the interest rate which reduces output gradually from $500 billion to $450 billion.

The bad effects come later--in the long run, the monetary expansion leads to soaring inflation without creating any new jobs. Historically, a high inflation rate is associated with lower rates of long-run economic growth. High inflation rates create uncertainty about future production costs and the future purchasing power of the currency. As a result, high inflation tends to discourage saving and investment--both important determinants of long-run economic growth.

The following graphs show the time path for the inflation rate and output between time A and time E. Notice that the good effects occur between time A and B, but the bad effects occur between times B and E.1. Despite the central bank's attempts to reduce inflation between times B and E, the inflation rate inevitably still increases. What can explain this?

2. Suppose the economy is at time E. What must Argentina's central bank do in order to reduce the inflation rate from 12% to 2%? Will this be politically popular?

3. Using the AD-AS model, explain what Friedman means by "When it comes to the cure, it's the other way around, when you stop drinking or when you stop printing money the bad effects come first and the good effects only come later. That's why it's so hard to persist with the cure."