CFA study session #6: economics: monetary & fiscal policy

Earlier today US President Barack Obama nominated Ben Bernanke to a second term as US Federal Reserve Chairman after fierce controversy regarding his handling of the most severe economic recession in over thirty years. Obama had until January to make the decision. Previously, some speculated that Bernanke might be replaced by Larry Summers who had served in the Clinton administration, and later became President of Harvard University. So, to commemorate Bernanke's success I am posting a blog on monetary & fiscal policy.

After finishing the CFA Volume 2 (Economics) textbook, I am convinced that anyone having taken some introductory economic courses during college will do fine. Further, of the three study sessions found in Volume 2, I believe that macroeconomics will prove more difficult for most readers than the sections on microeconomics and government monetary & fiscal policy.

The most important take-aways on the readings regarding monetary & fiscal policy is that like many other central banks, the US Federal Reserve (Fed) focuses like a laser beam on one principle policy goal: to achieve economic growth with full employment, low inflation, and price stability. To guage the level of economic growth the Fed often looks at changes in the "gross domestic product (GDP)," which represents all the goods produced within the US in a given year. GDP is typically calculated through the "expenditure approach":

GDP = C + I + G + X
C = consumer spending
I = capital expenditures
G = government spending
X = net exports

Like a giant ship navigating through the ocean, the Fed uses monetary policy, accompanied by fiscal policy orchestrated by the US Treasury, to make constant minor adjustments to keep the economy on track. Unfortunately, incremental changes taken on a large ship often take a while before you can see a correction run its course and right the ship. Similarly, government policy often suffers from several time lags, including recognition (it takes time to realize something is wrong), law-making (it takes time to pass the necessary legislation), and impact (it takes time for the solution to work its way through the system). This brings us to the first, and most important, question of how we recognize and measure the economy, and hence, the effect of government policy on it.

Today we commonly hear of the world being awash in liquidity. There exists so much money circulating throughout the world looking for a home that interest rates are temporarily depressed because of "easy money" policies causing a supply imbalance. Central banks believe that such a policy is necessary to provide the fuel needed to jumpstart economic growth. The fear, according to the "quantity theory of money," is that as the quantity of money increases so does price levels, ultimately leading to inflation.

***Incidentally, when accounting for inflation when measuring "real rates of return" it is more accurate to divide the "nominal inflation rate (CPI)" by the "nominal rate of return" (rather than subtract them). For example, if last year you earned 8% on your investments and CPI inflation was 4%, then your "real return" (adjusted for inflation) was not simply 4% (8% - 4%) but rather 3.846% (1.08 / 1.04). Of course inflation can be caused not only by increases in supply ("cost-push inflation"), but also by increases in demand ("demand-pull inflation"), although of course we haven't seen too much of the latter lately - just check the dismal consumer spending trends and the lackluster Consumer Confidence index.***

So, what exactly are we talking about when speak of money supply? The Fed keeps track of how much money is floating around in the economy by looking at M2, which is M1 (checking accounts, traveler's checks, and currency), plus savings accounts, money market accounts, and certificates of deposit. The Fed discontinued publication of M3 date on March 23, 2006. As of April 2008 the Fed calculates that within the United States M1 is $1.4 trillion and M2 is $7.7 trillion ($6.3T+$1.4T). Almost half of M2 can be found in savings accounts.

While it may appear quite clear to us now what counts for money and how it is measured, this was not always the case. Roman soldiers used to be paid in salt (in Latin: salarium, or salary), hence the saying "that a man is worth his salt." And Native Americans used wampum beads as currency. Different cultures have historically adopted different forms of money believing it to be more efficient than a pure barter system.

Money is defined by its ability to serve as a medium of exchange (just about everyone will accept US dollars, but not many will accept salt these days for payment), unit of account (with fiat money [notes & coins] we know exactly how much something is worth to the decimal point), and store of value (it would be unwise to choose a perishable item, such as ice cream, as money since it would be problematic to store). Interestingly, what counts as money is constantly evolving. Some argue for a global digital currency. In 2008 China rebuffed US economic pressure when they threatened to "diversify" their reserve currency away from US dollars and toward "Special Drawing Rights (SDR)" - a weighted-basket of 4 currencies (dollar, euro, yen, and pound) held at the IMF. China currently holds $2 trillion in US dollar reserves - more than any other country.

Now that we know what constitutes money, how governments measure the money supply, and the desired goal of economic policy, we can look deeper into the three methods the Fed uses to control the money supply. Perhaps most important, the Fed constantly buys and sells US Treasuries through the FOMC (Federal Open Market Committee). When the Fed buys Treasuries on the open market they are paying for those notes with dollars that are then circulated through the economy, thus increasing the money supply (somewhat similar to Microsoft buying back company shares on the stock market). In contrast, if the FOMC were to sell Treasuries, then they would be collecting money from investors, essentially taking money out of circulation, thus decreasing supply.

The Fed also influences money supply by regularly adjusting the discount rate, the benchmark rate that banks must pay to borrow directly from the Fed. The discount rate currently stands at 0.50%. The Fed would prefer that banks borrow from each other, and they do so through the federal funds rate, which currently charges 0.25% when banks borrow from each other for overnight lending. Also tied to the discount rate is the prime rate, currently at 3.25%, which is the rate banks typically charge to their best business customers. But they all take their lead from changes in the discount rate.

Finally, the Fed sets the reserve requirements that each bank must keep on deposit rather than lend out. The current reserve requirement may not change for years. Currently the reserve ratio stands at 10% where it has been since 2006. The reserve ratio also affects the money multiplier effect since only a bank's "excess reserves" may re-enter the economy in the form of loans. The formula for the money multiplier is:

(1 + a) / (a + b)
where "a" the "currency drain ratio" (% of consumer cash not held in banks)
where "b" the "desired reserve ratio" (set by the Fed)
Using the date from above, we have:
(1 + .50) / (0.50 + 0.10)
= 1.50 / 0.60
= 2.5 (for every $1 deposited in a bank, $2.50 can be lent out)

While most of this post deals with monetary policy, current US Treasury Secretary, Tim Geitner, might argue otherwise. Through the Treasury Department the government can influence aggregate demand and supply by adjusting tax rates and through government spending programs. The $700 billion TARP program stands alone as the largest of all government spending programs. Many economists continue to disagree whether or not monetary and fiscal policy are effective (Keynesians), or if they just aggravate conditions moreso than if left alone (monetarists).