ECO 155 750 LECTURE 34 1 WELL, WHAT WE WANT TO DO TODAY IS PICK UP WHERE WE STOPPED LAST TIME. LET ME JUST KIND OF RUN THROUGH A FEW THINGS, WHAT WE ACCOMPLISHED LAST TIME IN CLASS. FIRST OF ALL, WE SAW THIS RELATIONSHIP: THE M-1 MONEY SUPPLY IS EQUAL TO CURRENCY HELD BY THE PUBLIC PLUS CHECKING DEPOSITS HELD BY THE PUBLIC. OKAY. SO WE TALKED ABOUT THAT FORM OF MONEY SUPPLY AND WHAT WE SAID WAS THAT THIS MONEY SUPPLY WAS ONE THOUSAND, ONE HUNDRED BILLION DOLLARS APPROXIMATELY RIGHT NOW. OKAY. OR ONE POINT ONE TRILLION DOLLARS. SECONDLY, WHAT WE TALKED ABOUT IS THAT THE DD, THE CHECKING DEPOSIT KIND OF MONEY -- AND THAT'S WHAT THAT DD IS, IS CHECKING DEPOSIT MONEY. THAT DD IS CREATED BY BANKS. OKAY. AND THE CURRENCY IS CREATED BY THE FEDERAL RESERVE AND THE TREASURY. AND WHAT I WAS -- THE POINT I MADE TO YOU LAST TIME WAS THIS: IS THAT THERE'S NO BIG MYSTERY ABOUT WHERE THE FEDERAL RESERVE AND TREASURY COME UP WITH THAT MONEY. THEY'VE GOT MACHINES THAT JUST KIND OF PRINT IT OUT OR STAMP IT OUT, AND SO THAT'S NOT THE MYSTERY. THE PART THAT WE WERE REALLY INTERESTED IN IS WHERE DO THE DEMAND DEPOSITS COME FROM, THOSE CHECKING DEPOSITS? WHAT'S THE SOURCE OF THOSE?
ECO 155 750 LECTURE 34 2 AND SO WHAT WE WERE DOING REALLY LAST TIME IN THIS EXAMPLE OF THE FEDERAL RESERVE FLIES A HELICOPTER OVERHEAD, THROWS SOME MONEY OUT, PEOPLE PICK IT UP AND PUT IT IN THE BANK -- YOU REMEMBER ALL THAT STUFF. THE BANK SAYS, "I HAVE EXCESS RESERVES" AND MAKES LOANS. THAT WHOLE PROCESS WAS TO EXPLAIN THE UNDERSTANDING -- EXPLAIN HOW BANKS CREATE CHECKING DEPOSITS. AND IF YOU'LL RECALL, CHECKING DEPOSITS ARE CREATED WHEN BANKS MAKE LOANS. IT WAS THE LENDING PROCESS THAT CREATED THOSE CHECKING DEPOSITS. BECAUSE WHEN YOU GO INTO THE BANK, ASSUMING THE BANKER HAS SOME EXCESS RESERVES, THOSE EXCESS RESERVES ARE NOT DOLLARS OF MONEY SUPPLIED; THOSE ARE JUST -- THEY ARE DOLLARS, BUT THEY'RE SETTING IN THE VAULT OR AT THE FED. WHEN YOU GO INTO THE BANK AND SAY, "I WANT TO BORROW MONEY," THE BANKER SAYS, "OKAY. HERE YOU GO." AND IF YOU'RE, LET'S SAY, BORROWING FIVE THOUSAND DOLLARS, THE BANKER SAYS TO YOU, "I'LL PUT THAT FIVE THOUSAND DOLLARS IN YOUR CHECKING ACCOUNT." AND WHEN THE BANKER TAKES THE FIVE THOUSAND DOLLARS OF VAULT CASH AND PUTS IT IN YOUR CHECKING ACCOUNT, NOW THE MONEY SUPPLY GOES UP. YOU HAVE SOME CHECKING ACCOUNT MONEY YOU DIDN'T HAVE JUST A MOMENT AGO. SO YOU GET THE CHECKING ACCOUNT MONEY WHEN A BANK LENDS YOU MONEY. OKAY. SO THAT'S THE SOURCE OF THAT. AND THE WAY THAT THAT ALL
ECO 155 750 LECTURE 34 3 WORKED OUT WAS THROUGH -- LET'S CALL THIS FRACTIONAL RESERVE BANKING. THAT'S WHAT PERMITS THAT ALL TO HAPPEN. IF YOU'LL REMEMBER, WHAT WERE WE WORKING WITH, TEN PERCENT OR TWENTY PERCENT REQUIRED RESERVE RATIO THE OTHER DAY? SEEMS LIKE TEN PERCENT. BUT THE IDEA THERE WAS I DEPOSIT -- LET'S SAY I'VE GOT A THOUSAND DOLLARS. THAT WAS THE EXAMPLE, WASN'T IT? I PUT THAT THOUSAND DOLLARS IN MY BANK. IF THE BANKER HAD TO HOLD NOT A FRACTION BUT A HUNDRED PERCENT RESERVES, THEN I WOULD TAKE THAT THOUSAND DOLLARS, PUT IT IN THE BANK AND SAY, "HERE, PUT THIS IN MY CHECKING ACCOUNT." THEY WOULD SAY, "OKAY." I WOULD'VE -- AT THAT POINT I WOULD'VE CHANGED ONE FORM OF MONEY, CURRENCY, INTO ANOTHER FORM OF MONEY, CHECKING DEPOSITS. SO MY DEPOSIT WOULD NOT BY ITSELF AFFECT THE MONEY SUPPLY. AND THEN IF WE HAD ONE HUNDRED PERCENT RESERVES -- NOT FRACTIONAL RESERVES, BUT ONE HUNDRED PERCENT, I PUT THE THOUSAND DOLLARS IN THE BANK AND THE BANKER SAYS, "I MUST HOLD THAT." AND THE BANKER PUT IT IN THE VAULT AND THAT'S THE END OF IT. NO MORE STORY. THE REASON THERE WAS EXTRA LOANS AND THEN A MONEY MULTIPLIER, WHICH WE'LL TALK ABOUT IN A MOMENT, THE REASON THAT THAT HAPPENED IS I PUT A THOUSAND DOLLARS IN THE BANK AND THE BANKER SAYS, "I'LL HOLD A HUNDRED DOLLARS ON RESERVE AND I'LL LEND OUT NINE HUNDRED DOLLARS." AND WHEN THAT BANKER MAKES THAT NEXT
ECO 155 750 LECTURE 34 4 LOAN, THEN THE MONEY SUPPLY GOES UP. SO IT WAS THE FACT THAT WE'RE WORKING WITH FRACTIONAL RESERVES THAT ALLOWED THAT MULTIPLIER TO EXIST. OKAY. AND THEN WHAT WE DID IS WE WROTE DOWN THAT FORMULA. WHAT DO WE HAVE? TOTAL CHECKING ACCOUNTS IN THE ECONOMY EQUALS TOTAL RESERVES OF BANKS TIMES ONE OVER R WHERE R IS THE REQUIRED RESERVE RATIO. AND THIS ENTIRE FRACTION, THE ONE OVER R, WE CALL THAT FRACTION THE SIMPLE DEPOSIT MULTIPLIER. MAYBE I USED TWENTY PERCENT LAST TIME WHEN WE TALKED ABOUT THIS. ANYWAY, WHAT YOU WANT TO DO IN PREPARING FOR A TEST WOULD BE -- SUPPOSE R IS EQUAL TO TEN PERCENT. SUPPOSE R IS EQUAL TO FIFTEEN PERCENT. SUPPOSE IT'S EQUAL TO TWENTY PERCENT. AND THEN DO A FEW CALCULATIONS. CAN YOU CALCULATE THAT MULTIPLIER? MAYBE -- AND IT'S HARD FOR ME TO RECALL. NOBODY OUT IN THE CROWD HERE HAS SHOUTED OUT A NUMBER. MAYBE I USED TWENTY PERCENT LAST WEEK AND IF I DID, THE MULTIPLIER WOULD'VE BEEN FIVE. IF I USED TEN PERCENT AS A REQUIRED RESERVE RATIO, THE MULTIPLIER WOULD BE ONE OVER POINT ONE -- TEN. AND SO FORTH. SO ANYWAY, THESE ARE THE THINGS THAT WE TALKED ABOUT LAST TIME AND THE THINGS THAT WE NEED TO BE COMFORTABLE WITH OR FAMILIAR WITH AS WE GO FORWARD. NOW, HERE'S WHAT WE ASSUMED THROUGHOUT -- AND THIS SIMPLE
ECO 155 750 LECTURE 34 5 DEPOSIT MULTIPLIER. WHAT WE ASSUMED -- I'LL PUT THE D THERE. ASSUME -- 'CAUSE WE'LL DROP THIS ASSUMPTION LATER. BUT WE ASSUMED THAT CURRENCY HOLDINGS OF THE PUBLIC IS EQUAL TO ZERO AND EXCESS RESERVES HELD BY BANKS EQUALS ZERO. IF WE ASSUMED THAT -- AND THAT'S WHERE WE GOT THIS MULTIPLIER OF ONE OVER R. IF WE HAVE PEOPLE HOLDING CURRENCY, AND IN REAL LIFE THEY DO, OR BANKERS HOLDING EXCESS RESERVES, THEN IN REAL LIFE THE MULTIPLIER WILL BE MORE COMPLICATED THAN THIS ONE OVER R. AND WE'LL COME BACK TO THAT LATER ON. OKAY. THESE THINGS ARE -- ONCE WE SORT OF DROP THESE ASSUMPTIONS, THEN WE HAVE TO START DEALING WITH A CURRENCY DRAIN AND THEN AN EXCESS RESERVE DRAIN. AND THAT DRAIN, WE'RE SAYING THAT THERE'S PLACES FOR THESE RESERVES TO GO -- CURRENCY OR EXCESS RESERVES -- THERE'S SOMEPLACE FOR THOSE DOLLARS TO GO THAT WE HAVE ASSUMED OUT OF THE PICTURE UP TILL NOW. SO I'M SAYING THIS IS LATER, NOT UP TO THIS POINT. UP TO THIS POINT WE HAVE THE MULTIPLIER OF ONE OVER R AND IT'S BECAUSE WE ASSUME NO CURRENCY, NO EXCESS RESERVES. LIKE I SAY, WE'LL COME BACK TO THAT. [STUDENT SPEAKING INAUDIBLY] PARDON ME? WELL, I'M SAYING WE'LL COME BACK TO THIS LATER ON IN LIKE THIS CLASS PERIOD OR NEXT CLASS PERIOD. BUT, NO, THAT'S RIGHT. IF I GAVE YOU A TEST RIGHT NOW, YOU WOULDN'T HAVE TO KNOW THAT. BUT I'M NOT GETTING READY TO DO IT, SO
ECO 155 750 LECTURE 34 6 YOU WILL NEED TO KNOW A LITTLE BIT ABOUT THAT. I'LL COME BACK TO IT. FINALLY -- AND LET ME SORT OF CLOSE THE DISCUSSION WITH ONE MORE POINT AND IT'S THIS: EVERYTHING WORKS IN REVERSE. IF YOU'LL REMEMBER WHAT HAPPENED -- LET'S SEE IF I CAN GET MY HELICOPTER UP THERE AGAIN. AH, WHAT DOES A HELICOPTER LOOK LIKE? AH, I DON'T KNOW. THIS IS MORE -- IT'S LIKE A FLYING SNAIL OR SOMETHING. [STUDENT SPEAKING INAUDIBLY] OH, YEAH, YEAH. YOU NEED THE RUNNER THINGS. LIKE THAT? IT'S LIKE BIG FEET. WELL, YOU CAN WALK AS WELL AS FLY. ANYWAY -- OH, THAT'S LIKE A LADY'S PUMP. DO THEY CALL THAT A PUMP? SO ANYWAY, FORGET ABOUT THAT 'CAUSE THAT HAS NOTHING TO DO WITH OUR STORY. WE THREW OUT A THOUSAND DOLLARS LAST TIME AND PEOPLE PICKED IT UP. AND THEN, IF YOU'LL REMEMBER, THAT GREW TO A MULTIPLE AMOUNT. THIS ALL WORKS IN REVERSE. NOW, IN REALITY, THE FED DOESN'T GO AROUND THROWING OUT A THOUSAND DOLLARS, WHICH IS -- I DON'T KNOW IF THAT'S GOOD OR BAD, BUT THEY DON'T DO THAT. WHEN I SAY IT WORKS IN REVERSE I DON'T MEAN THE FEDERAL RESERVE WOULD HAVE LIKE A GIANT VACUUM CLEANER, TURN THE FAN ON IN REVERSE, YOU KNOW, AND SUCK THE MONEY OUT OF YOUR POCKETS. ALTHOUGH YOU CAN IMAGINE THAT HAPPENING. THE WAY IT WOULD HAPPEN IN REVERSE IS THE FED WOULD SELL A BOND TO THE PUBLIC. THE FED COULD JUST REACH IN TO ITS PORTFOLIO AND SELL SOMETHING TO ME, LET'S SAY. AND THEN I'D PAY THE FED AND
ECO 155 750 LECTURE 34 7 WHEN I PAID THE FED THAT THOUSAND DOLLARS COMES OUT OF MY POCKET AND GOES UP INTO THAT HELICOPTER, SO TO SPEAK. AND SO IF THE FED WANTS TO REVERSE THE PROCESS, THEY WOULD SELL A BOND TO THE PUBLIC -- COULD BE TO A BANKER -- BUT SELL THE BOND, AND THEN SOMEBODY HAS TO PAY FOR THAT BOND. AND WHEN SOMEBODY PAYS FOR THAT BOND, THAT THOUSAND DOLLARS, OR WHATEVER THE BOND IS WORTH, GOES BACK TO THE FED AND THEN EVERYTHING WORKS IN REVERSE. WE HAVE A MULTIPLIER OF ONE OVER R TIMES THE LOSS OF RESERVES. IF THE MULTIPLIER IS FIVE AND THE FED DRAINS A THOUSAND DOLLARS WORTH OF RESERVES OUT OF THE SYSTEM, THEN WHAT HAPPENS IS THE MONEY SUPPLY, CHECKING DEPOSITS, GOES DOWN 'CAUSE RESERVES ARE BEING TAKEN AWAY. THE MONEY SUPPLY WOULD GO DOWN BY FIVE THOUSAND DOLLARS, THE MULTIPLIER, OR TEN THOUSAND. DEPENDS ON WHAT THAT MULTIPLIER HAPPENS TO BE. LET ME WRITE A FORMULA NUMBER -- HERE'S WHAT THE FORMULA THERE FIVE SAYS DD EQUALS TOTAL RESERVES TIMES ONE OVER R. LET ME SORT OF SUPPLEMENT THAT WITH THIS: CHANGE IN DD EQUALS CHANGE IN TR TIMES ONE OVER R. NOW, WHAT I MEAN BY THAT: I MEAN THAT THIS FORMULA, THE FIRST ONE OF THE TWO, YOU WOULD USE THAT IF I SAID, "OH, TOTAL RESERVES ARE TEN THOUSAND DOLLARS. CALCULATE THE VALUE OF THE MONEY SUPPLY." OKAY. THAT'S WHERE I'D GIVE YOU THE LEVEL OF TOTAL RESERVES AND YOU'D CALCULATE THE LEVEL OF CHECKING
ECO 155 750 LECTURE 34 8 DEPOSITS IN THE ECONOMY. IN THIS OTHER CASE, THOUGH, I MAY SAY SOMETHING LIKE THIS: "THERE'S AN EXTRA TWENTY DOLLARS WORTH OF RESERVES PUT INTO THE BANKING SYSTEM SO THE CHANGE IN RESERVES IS TWENTY DOLLARS. NOW, CALCULATE THE CHANGE IN TOTAL CHECKING DEPOSITS IN THE ECONOMY." SO WE CAN USE THAT SAME FORMULA IN EITHER ONE OF THOSE WAYS: EITHER TO CALCULATE THE TOTAL MONEY SUPPLY OR CHANGES IN THE MONEY SUPPLY DEPENDING ON WHAT INFORMATION WE'RE GIVEN. QUESTIONS ABOUT THAT? OKAY. LET'S GO ON TO THE NEXT MATERIAL OR THE NEXT TOPIC WHICH IS CALLED THE FEDERAL RESERVE SYSTEM. THIS IS SORT OF THE MECHANICS OF HOW IT WORKS. BUT EVEN THOUGH WE HAVE THE GENERAL MECHANICS OF HOW IT WORKS, WE NEED SOME PARTICULAR INFORMATION ABOUT THE FED. WHEN DID IT START, YOU KNOW? WHO SETS ON THE FEDERAL RESERVE BOARD AND WHAT ARE THEY SUPPOSED TO DO? AND -- YOU KNOW, THE RESPONSIBILITIES AND SO FORTH. LET'S TALK A LITTLE BIT ABOUT THE FEDERAL RESERVE. THE FEDERAL RESERVE SYSTEM. WE WANT TO UNDERSTAND THE FED FOR A COUPLE OF REASONS. ONE, IT'S THE ONE -- I USED THE HELICOPTER HERE, BUT IT'S THE ONE THAT PUTS RESERVES INTO THE BANKING SYSTEM. NOBODY ELSE. IT'S THE SUPPLIER OF THAT STUFF WHICH TURNS INTO MONEY SUPPLY. IF YOU TAKE THE FEDERAL RESERVE AWAY, THEN THAT
ECO 155 750 LECTURE 34 9 MONEY SUPPLY WOULD NOT BE CREATED IN THE SAME WAY AND, ARGUABLY, WE'D HAVE A MUCH SMALLER MONEY SUPPLY. ALSO, NOT ONLY DOES THE FED DO THAT, BUT WE WANT TO UNDERSTAND ITS POLICIES. AND SO IN ORDER FOR US TO, YOU KNOW, ACHIEVE THAT UNDERSTANDING, WE NEED TO KNOW A LITTLE BIT MORE ABOUT THE FED. FIRST OF ALL, THE FED WAS STARTED IN 1913 -- THE LAW WAS PASSED IN 1913 -- THAT CREATED THE FEDERAL RESERVE. WHY WAS THAT DONE? AND THE ANSWER IS, THROUGHOUT AMERICAN HISTORY THE UNITED STATES BANKING SYSTEM AND ECONOMY HAVE BEEN UNSTABLE. AND I DON'T MEAN TO SAY RECENTLY, BUT I'M SAYING IF YOU GO BACK TO THE CIVIL WAR, 1860S, AND LOOK AT THE FIFTY YEARS AFTER THAT, THE 1860S UP TO THE 19- TEENS, WHAT YOU'LL FIND OUT IS THAT EVERY TEN OR FIFTEEN YEARS THE ECONOMY WOULD JUST COLLAPSE. THERE'D BE LIKE A BIG BANKING PANIC -- BANKING IS A KEY TERM HERE. DON'T FORGET THAT THE BANKS ARE THE ONES THAT CREATE THE CHECKING DEPOSIT MONEY. SO WHEN THE BANKING SYSTEM WOULD COLLAPSE, THEN THE CHECKING DEPOSIT MONEY WOULD DISAPPEAR AND THEN PEOPLE WOULDN'T HAVE MONEY TO SPEND AND THEY WOULDN'T SPEND THEN. AND IF THEY DON'T SPEND, THEN THERE'S A RECESSION. COMPANIES DON'T SELL PRODUCTS, THEY LAY OFF THEIR EMPLOYEES, AND YOU HAVE RECESSIONS OR DEPRESSIONS. AND SO WHAT WE HAD THROUGHOUT OUR HISTORY WAS THIS REALLY MISERABLE EXPERIENCE. ECONOMIC GROWTH AND THEN A COLLAPSE OF
ECO 155 750 LECTURE 34 10 THE ECONOMY. AND THEN ECONOMIC GROWTH AND A COLLAPSE OF THE ECONOMY, EVERY TEN OR FIFTEEN YEARS. AND SO WHAT HAPPENED WAS THE CONGRESS BASICALLY SAID, "WE'VE GOTTA DO SOMETHING ABOUT THIS," AND IN 1908 THEY APPOINTED A NATIONAL MONETARY COMMITTEE TO GO OUT AND STUDY THIS TOPIC. WHAT CAN WE DO, HOW CAN WE SOLVE THIS PROBLEM? AND IN 19 -- I DON'T KNOW EXACTLY THE YEAR -- THE NATIONAL MONETARY COMMITTEE CAME BACK WITH A RECOMMENDATION, AND THEN IN 1913 CONGRESS PASSED THE LAW WHICH IS PRETTY MUCH THAT RECOMMENDATION WITH A FEW IMPROVEMENTS. A COUPLE OF THINGS THAT THE FED WAS SUPPOSED TO DO WAS IT WAS SUPPOSED TO PROVIDE AN ELASTIC CURRENCY. THAT IS TO SAY, THE SUPPLY OF CURRENCY SHOULD GROW OR SHRINK TO MEET THE DEMAND FOR IT. OKAY. AND THAT HAD NOT BEEN TAKING PLACE PREVIOUSLY. THE DEMAND FOR CURRENCY WOULD GROW AND THERE WAS NOT CURRENCY THERE, SO PEOPLE WOULD RUN TO THE BANK AND DEMAND CURRENCY. IF YOU HEARD THAT A BANKER WAS HANDING OUT ALL THE CURRENCY, THEN YOU'D THINK, "OH, I CAN'T GET ANY TOMORROW," SO IT SORT OF SET OFF A PANIC OF PEOPLE RUNNING TO THE BANK. THE IDEA WAS, HEY, PEOPLE WANT CURRENCY, PROVIDE 'EM CURRENCY. AND A SECOND THING THAT THE FED WAS SUPPOSED TO DO IS ACT AS LENDER OF LAST RESORT TO BANKS EXPERIENCING RUNS. IF YOU'VE SEEN THAT OLD MOVIE WITH -- WHO'S IN THAT -- JIMMY STEWART, "IT'S A
ECO 155 750 LECTURE 34 11 WONDERFUL LIFE," IF YOU'LL REMEMBER THE WAY THE STORY GOES, JIMMY - - EXCEPT FOR HE'S GOT A DIFFERENT NAME IN THAT MOVIE. WHAT IS HIS NAME? WELL, IT'LL COME TO ME IN A SECOND. ANYWAY, JIMMY STEWART'S UNCLE BILLY, I THINK IT IS, HE'S SUPPOSED TO TAKE THE BANK'S RESERVES DOWN AND DEPOSIT 'EM AND HE LOSES 'EM. I THINK HE'S BEEN DRINKING A LITTLE TOO MUCH BEER AND SO HE LOST THOSE RESERVES AND THEN THERE'S NO CASH AT THE BANK. AND WHEN THE WORD LEAKS OUT, "OH, THERE'S NO CASH AT THE BANK," THEN PEOPLE STARTED WORRYING ABOUT THE SAFETY OF THEIR DEPOSIT. THINK ABOUT IT. IF YOU'VE GOT MONEY AT A BANK HERE IN TOWN AND SOMEBODY TOLD YOU, "HEY, DID YOU HEAR? THAT BANK'S VAULT IS TOTALLY EMPTY. THEY JUST HAVE NOTHING THERE." THEN WHAT YOU'D START DOING IS, "OH-OH. HOW AM I GONNA RECOVER THIS SITUATION?" AND YOU RUN DOWN TO THE BANK AND YOU SAY, "QUICK, GIVE ME THE MONEY BACK. WHATEVER YOU'VE GOT, I WANT IT RIGHT NOW. IF YOU'VE GOT A THOUSAND DOLLARS, I'LL TAKE A THOUSAND DOLLARS. JUST GIVE ME WHATEVER YOU HAVE." AND THAT'S A BANK RUN, IS BASICALLY WHEN PEOPLE WORRY ABOUT THE SAFETY OF THEIR DEPOSITS. THEY RUN TO THE BANK AND DEMAND THEIR CASH BACK. WELL, HERE'S THE DEAL. NO BANK SETS THERE WITH ALL THAT CASH. IF YOU PUT A HUNDRED DOLLARS IN THE BANK, THEY DON'T JUST GO, "OKAY. GREAT," THROW IT IN THE VAULT AND THEN PUT A GUARD OUT IN FRONT. WHAT THEY'LL DO IS THROW, AS WE SAID
ECO 155 750 LECTURE 34 12 A MOMENT AGO, TEN DOLLARS IN THE VAULT, THE REQUIRED RESERVES, AND LEND THE REST OUT, NINETY DOLLARS, TO SOMEBODY ELSE. THAT BANKER'S NOT HOLDING ON TO ALL YOUR MONEY. SO IF THERE'S A RUN ON THE BANK AND PEOPLE ARE COMING IN SAYING, "GIVE ME MY MONEY, GIVE ME MY MONEY," IT DOESN'T TAKE LONG UNTIL THAT BANK'S CASH IS EXHAUSTED. AND IT'S THE NEED FOR CASH, THAT ELASTIC CURRENCY, THAT WAS PART OF THE FED'S RESPONSIBILITY. AND THE OTHER PART OF ITS RESPONSIBILITY IS LEND THAT CASH OUT. DON'T JUST PRINT IT UP AND HOLD ON TO IT, FEDERAL RESERVE. WHEN A BANKER IS EXPERIENCING A RUN AND PEOPLE ARE LINED UP, LEND CASH TO THOSE BANKS. WHY SHOULD WE DO THAT? AND THE ANSWER IS THIS: IF YOU DON'T LEND CASH TO THOSE BANKS, IF YOU DON'T SERVE AS LENDER OF LAST RESORT, A PLACE WHERE THEY CAN FINALLY GO TO GET CASH, IF YOU DON'T DO IT THAT BANK WILL RUN OUT OF CASH. IT WILL CLOSE ITS DOORS. AND THEN THE PANIC WILL SPREAD TO THE NEXT BANK. NOW, DO YOU -- PRETTY MUCH LIKE THE FLU OR SOMETHING LIKE THAT, YOU KNOW. IT'S LIKE WHEN YOU GET THE FLU YOU COUGH ON SOMEBODY ELSE AND THEY GET THE FLU. WELL, WHEN ONE BANK CLOSES ITS DOORS BECAUSE IT'S OUT OF CASH, IT PANICS PEOPLE AND THEY GO TO THE NEXT BANK. NOT THE SAME PEOPLE BUT OTHER PEOPLE. "OH, IF THAT BIG BANK COULD FAIL, SO COULD MINE." SO WE RUN TO THAT BANK AND FINALLY RUN IT OUT OF CASH. IT CLOSES ITS DOORS AND THE PANIC SPREADS TO
ECO 155 750 LECTURE 34 13 ANOTHER BANK. SO THE IDEA IS, IF WE WANT TO STOP THE CONTAGION FROM SPREADING, WHAT WE HAVE TO DO IS GET OUT THERE AND GET SOME CASH IN THE RIGHT HANDS. SATISFY SOME PEOPLE. IF PEOPLE RUN TO THE BANK AND SAY, "GIVE ME MY CASH," AND YOU GO, "OKAY. HERE YOU GO," AND YOU HAND OUT THEIR CASH AND SAY, YOU KNOW, "HAVE A LOVELY DAY AND I'LL SEE YOU TOMORROW," THEN THAT PERSON WILL GET OUTSIDE WITH THEIR CASH AND THEN THEY START GOING, "MAN, I DON'T WANT TO BE WALKING AROUND WITH THIS MUCH MONEY. I ONLY WANTED THE MONEY BACK, THE CASH BACK, BECAUSE I THOUGHT I COULDN'T GET IT. I WAS WORRIED I COULDN'T GET IT. AND THEY PAID ME OUT IN SUCH A SORT OF A FAST WAY AND WITHOUT ANY SQUAWK -- YOU KNOW, THAT JUST MUST'VE BEEN A BAD RUMOR." AND SO AS SOON AS YOU GET OUT OF THE BANK, YOU COME BACK IN AND SAY, "I WANT TO PUT THIS BACK IN MY ACCOUNT." MAYBE YOU WAIT A DAY OR TWO BUT NOT FOR LONG. PEOPLE WANT BANKS. SO ANYWAY, THE IDEA IS WE NEED THE FEDERAL RESERVE TO GET US THROUGH THOSE ROUGH TIMES, THOSE ROUGH TIMES THAT NOBODY HAD BEEN THERE TO HELP THE ECONOMY IN THAT PREVIOUS FIFTY YEARS. SO ANYWAY, ONE THING I WILL MENTION TO YOU IS THE FEDERAL RESERVE DID NOT HAVE THE RESPONSIBILITY, WHICH IT DOES HAVE TODAY, BUT IT DID NOT HAVE THE RESPONSIBILITY OF SORT OF MANAGING THE ECONOMY. IT'S BASICALLY DEAL WITH THIS PROBLEM: A BANK RUNS AND A LOSS OF
ECO 155 750 LECTURE 34 14 LIQUIDITY IN THE BANKING SYSTEM. BUT THERE'S NO, "OKAY. YOU'RE GONNA WATCH THE ECONOMY. YOU'RE GONNA FIGHT INFLATION. YOU'RE GONNA KEEP, YOU KNOW, THE ECONOMY GROWING, STABILIZE EXCHANGE RATES, KEEP INTEREST RATES LOW." THE FED DID NOT HAVE THOSE RESPONSIBILITIES. ITS JOB WAS TO PROVIDE THE CURRENCY AND LEND IT OUT WHEN THERE WAS A BANK RUN. PRETTY SIMPLE, HUH? NOW, BASICALLY WHAT HAPPENED IS IT TOOK THE FED SOME TIME TO LEARN ITS JOB AND THE TIME IT TOOK WAS ANOTHER THIRTY OR FORTY YEARS. AND SO THE FED MADE SOME MISTAKES IN THESE EARLY YEARS AND, IN FACT, THE FED DID NOT ACT AS LENDER OF LAST RESORT IN 1929 THROUGH '33 WHEN WE HAD THAT HUGE NUMBER OF BANK FAILURES. ONE- THIRD OF ALL BANKS IN THE UNITED STATES CLOSED DURING THIS PERIOD, 1929 THROUGH '33. MORE FAILURES, ONE-THIRD OF ALL BANKS. SO WHAT I'M SAYING TO YOU IS, THE FEDERAL RESERVE WAS CREATED TO PROVIDE ELASTIC CURRENCY AND TO SERVE AS LENDER OF LAST RESORT AND FAILED TO DO SO THE FIRST TIME IT WAS CALLED ON, IN A BIG WAY, TO GET ACTIVE, GET INVOLVED, DO SOMETHING. THEY DIDN'T DO IT. SO IT TOOK THE FED REALLY UNTIL THE 1950S TO SORT OF -- YOU KNOW, IT'S NOT ENOUGH JUST TO HAVE A FEDERAL RESERVE. YOU HAVE TO UNDERSTAND ALL THE PRINCIPLES INVOLVED AND SO FORTH, AND THEY JUST WEREN'T READY TO GET THE JOB DONE FOR QUITE SOME TIME. NEVERTHELESS, THE FED WAS SORT OF ALTERED BY LEGISLATION
ECO 155 750 LECTURE 34 15 PASSED IN 1933 AND 1935, AND SO THE FED WAS CHANGED SOMEWHAT. AND SO AFTER THESE CHANGES, THAT'S WHEN WE GOT A MORE MODERN FED. MORE MODERN. AND REALLY THE FEDERAL RESERVE TODAY IS WHAT WAS CREATED BY THE LAWS PASSED IN THOSE YEARS, '33 AND '35. OKAY. SOME OF THE FED'S JOBS OR RESPONSIBILITIES -- BOY, I'LL JUST TICK OFF A FEW OF 'EM HERE BUT IT HAS QUITE A FEW. ONE IS IT'S THE GOVERNMENT'S BANK. DOESN'T SERVE AS A BANK FOR JUST ORDINARY PRIVATE COMPANIES OR INDIVIDUALS, BUT IT IS THE GOVERNMENT'S BANK. IT DOES CHECK CLEARING, PROVIDES CHECK CLEARING SERVICES. IF I WRITE YOU A CHECK AND YOU TAKE THAT CHECK DOWN TO YOU BANK AND PUT IT IN, YOUR BANK MAY SEND IT BACK TO THE FEDERAL RESERVE AND SAY, "HEY, I WANT TO COLLECT ON THIS." AND SO THAT'S SOMETHING THAT THE FEDERAL RESERVE DOES IS IT MANAGES THAT. WHAT ELSE? PROVIDES CURRENCY. WE TALKED ABOUT THE ELASTIC CURRENCY. IT CONTINUES TO DO THAT. OKAY. OTHER THINGS. IT LOANS TO -- WELL, YEAH, MEMBER BANKS. WE'LL TALK ABOUT THOSE LOANS LATER ON. IT REGULATES MEMBER BANKS. THESE MEMBER BANKS, WE'LL TALK ABOUT 'EM IN A MINUTE. MEMBER BANKS ARE JUST COMMERCIAL BANKS AND THEY'VE SIGNED UP TO JOIN THE FEDERAL RESERVE SYSTEM. OKAY. IT CONDUCTS MONETARY POLICY. THE FED HAS GOT A LOT OF DIFFERENT JOBS AND THESE ARE THE BIGGEST ONES. OH, LET ME ADD ONE MORE. IT HOLDS THE RESERVES OF MEMBER BANKS. A MEMBER BANK, A COMMERCIAL
ECO 155 750 LECTURE 34 16 BANK, THAT WANTS TO CAN SEND ITS RESERVES OVER TO THE FEDERAL RESERVE AND SAY, "HERE. HOLD THIS FOR ME, WILL YOU?" AND THE FED WILL SAY, "SURE." LET'S TALK ABOUT THE FEDERAL RESERVE SYSTEM. I'LL DRAW YOU A LITTLE TRIANGLE. IN WASHINGTON THERE'S THE BOARD OF GOVERNORS. IT'S A SEVEN MEMBER BOARD. SEVEN MEMBERS, FOURTEEN YEAR TERMS. THOSE ARE STAGGERED TERMS SO IF YOU'VE GOT SEVEN MEMBERS AND EACH ONE'S GOT A FOURTEEN-YEAR TERM, YOU APPOINT A NEW MEMBER EVERY TWO YEARS. OKAY. AND THIS MIDDLE LEVEL OF THE SYSTEM IS THE FEDERAL RESERVE BANKS. THESE ARE REGIONAL. LET'S SEE IF I CAN MENTION A FEW OF 'EM TO YOU REAL QUICK. BOSTON; NEW YORK; RICHMOND, VIRGINIA; ATLANTA, GEORGIA; CLEVELAND; CHICAGO; MINNEAPOLIS; ST. LOUIS; DALLAS; KANSAS CITY; SAN FRANCISCO. THAT'S PROBABLY MOST OF 'EM BUT PROBABLY I OVERLOOKED ONE OR TWO. ANYWAY, THERE ARE TWELVE FEDERAL RESERVE BANKS AND MISSOURI HAS TWO OF THEM. MISSOURI IS THE ONLY STATE WITH TWO FEDERAL RESERVE BANKS. WHY IS THAT? AND THE ANSWER IS: POLITICS. WE HAD SOME POWERFUL SENATORS BACK WHEN THEY WERE DECIDING WHERE TO PUT THESE PEOPLE -- OR THESE BANKS, AND SO WE GOT TWO OF 'EM. ANYWAY -- AND FINALLY WE HAVE THE MEMBER BANKS AND THESE ARE JUST ORDINARY COMMERCIAL BANKS, FOR PROFIT BANKS, PRIVATELY OWNED, AND THESE BANKS HAVE TO JOIN. THEY'RE NOT FORCED -- YOU
ECO 155 750 LECTURE 34 17 KNOW, THERE'S NOBODY COMES IN WITH A GUN AND SAYS, "OKAY. YOU'RE GONNA JOIN UP HERE." BANKERS COME IN AND SAY, "I WANT TO BE A MEMBER BANK." AND THERE ARE ABOUT -- ABOUT -- OH, I DON'T KNOW -- THIRTY-FIVE HUNDRED OR FOUR THOUSAND. I'LL PUT FOUR THOUSAND DOWN. IT COULD BE A SMALLER NUMBER THAN THAT. BUT THESE ARE JUST ORDINARY BANKS, A MERCANTILE OR SOMETHING LIKE THAT. OKAY. AT THE BOARD OF GOVERNORS, OF THESE SEVEN MEMBER BOARD OF GOVERNORS, B OF G, THERE IS A CHAIRMAN PLUS SIX OTHERS. THIS IS A LITTLE BIT LIKE SANTA'S REINDEERS. WE ALL KNOW RUDOLPH AND THE OTHERS, YOU KNOW, THEY JUST KIND OF FADE INTO THE BACKGROUND WITH THEIR DIM NOSES. ANYWAY, AT THE BOARD OF GOVERNORS, WE HAVE A CHAIRMAN AND THAT CHAIRMAN IS POWERFUL. THAT PERSON IS BASICALLY CHOSEN BY THE PRESIDENT TO SET AT THE TOP OF THE FEDERAL RESERVE AND IT IS UNDERSTOOD -- IT'S UNDERSTOOD IMPLICITLY. IT'S NOT WRITTEN INTO THE LAW THIS WAY. 'CAUSE THE WAY THE LAW READS, IT SAYS THERE ARE SEVEN MEMBERS AND EACH ONE HAS A VOTE. AND THAT'S TRUE. THE ONLY THING IS, THIS ONE VOTE COUNTS, IT SEEMS LIKE, A LITTLE BIT MORE THAN THE OTHER VOTES COUNT, AND SO THE CHAIRMAN HAS GOT THE REAL POWER WITHIN THE SYSTEM. THERE'S KIND OF A FUNNY JOKE ABOUT ONE CHAIRMAN OF THE FEDERAL RESERVE WENT OUT TO DINNER AND TOOK -- HE WAS NEAR RETIREMENT. HIS NAME WAS PAUL VOLKER. HE WENT OUT TO DINNER AND
ECO 155 750 LECTURE 34 18 TOOK THE OTHER MEMBERS OF THE BOARD OF GOVERNORS WITH HIM. AND THEY'RE ALL SITTING AROUND THE TABLE AND THE WAIT COMES UP AND SAYS TO PAUL VOLKER, "WHAT WOULD YOU LIKE FOR DINNER?" AND HE SAYS, "WELL, YOU KNOW, I'LL HAVE SOME STEAK." AND HE SORT OF TOLD 'EM WHAT HE WANTED BUT HE HADN'T SAID ANYTHING ABOUT SALAD OR ANYTHING ELSE TO GO ALONG WITH IT. SO WHEN HE GETS DONE TELLING ABOUT THIS STEAK THAT HE WANTS, THEN THE WAITER SAYS TO HIM, "AND WHAT ABOUT THE VEGETABLES?" AND VOLKER SAYS, "JUST LET 'EM ORDER FOR THEMSELVES." WELL, THE WHOLE POINT HERE IS, YOU KNOW, HE CONSIDERED THEM TO BE VEGETABLES, THOSE OTHER MEMBERS OF THE BOARD OF GOVERNORS, AND SO HE DIDN'T EVEN THINK ABOUT, "OH, I FORGOT THE BROCCOLI." HE JUST THOUGHT, YOU KNOW, "LET THOSE VEGETABLES ORDER FOR THEMSELVES." SO THAT'S THE SIX OTHERS. OKAY. THE CHAIRMAN OF THE FED IS THE MOST POWERFUL. SOMETIMES THAT HAS TO BE PROVED. THAT IS TO SAY, SOMETIMES THE OTHER SIX DON'T GO ALONG WITH IT AND THEN SOMETHING WILL HAPPEN, YOU KNOW. THERE'LL BE A CONFRONTATION. BUT AT THE END OF THAT MEETING, WHAT HAPPENS IS THE CHAIRMAN OF THE FEDERAL RESERVE IS IN CHARGE. AND RIGHT NOW THAT'S A GUY NAMED GREENSPAN. BUT HE'S BEEN AROUND FOR QUITE AWHILE AND MAYBE IN THE NEXT -- GOSH, MAYBE IN THE NEXT FEW MONTHS OR YEARS HE MIGHT RETIRE, MAYBE HE'LL RESIGN OR HIS TERM WILL END.
ECO 155 750 LECTURE 34 19 AND SO THE POINT IS IS THAT WE DON'T REALLY -- IT WON'T BE GREENSPAN FOREVER. FOURTEEN YEAR TERMS. WHY DO WE HAVE FOURTEEN YEAR TERMS? AND THE ANSWER IS: TO INSULATE THE FEDERAL RESERVE FROM POLITICS. THE THINKING IS THIS: IF WE DON'T -- LET'S SAY WHAT WE DO IS WE HAD THE BOARD OF GOVERNORS JUST SELECTED EVERY YEAR. WE JUST PUT SOME PEOPLE UP THERE, SEVEN OF 'EM, AND NEXT YEAR WE'LL PUT UP SEVEN OTHER PEOPLE OR MAYBE THOSE SAME PEOPLE. BUT THE THINKING IS IS THAT IF THAT'S THE WAY IT WERE DONE, THEN EITHER THE CONGRESS OR THE PRESIDENT OR BOTH, AND PROBABLY BOTH, WOULD PARTICIPATE IN THIS PROCESS OF REAPPOINTING OR APPOINTING FEDERAL RESERVE OFFICIALS AND WHAT WOULD HAPPEN IS IT WOULD BE A POLITICAL KIND OF A JOB. AND SO -- YOU KNOW, THERE'D BE FAVORITES PLAYED, THE PRESIDENT WOULD ALWAYS PICK WHATEVER PARTY HE'S IN, REPUBLICAN OR DEMOCRAT, ALWAYS PICK A CHAIRMAN FROM THAT PARTY. ALWAYS SORT OF GET WHAT HE WANTS FROM THAT CHAIRMAN. AT THE END OF THE YEAR DISCARD HIM AND GET ANOTHER ONE OR KEEP THAT ONE IF HE DOES WHAT'S HE SUPPOSED TO, BUT BASICALLY KEEP THE CHAIRMAN ON A SHORT LEASH, THE WHOLE BOARD OF GOVERNORS. ANYWAY, SO THE IDEA IS THIS: IF WE HAVE FOURTEEN YEAR TERMS, THEN LET'S SAY A PRESIDENT WILL APPOINT A FEDERAL RESERVE MEMBER AND THAT PERSON WILL STAY THERE A LOT LONGER THAN THE PRESIDENT.
ECO 155 750 LECTURE 34 20 AND THE PRESIDENT WILL BE GONE AND A NEW PRESIDENT COMES IN AND IT'S STILL THE SAME FEDERAL RESERVE. AND THERE'S SOME CONTINUITY IN THE SYSTEM AND IT'S NOT EASY THEN TO SAY TO THESE PEOPLE, "HEY, I WANT TO SEE THAT MONEY SUPPLY GO UP." YOU CAN SAY IT TO 'EM, BUT WHAT THEY SAY IS, "WELL, SORRY. I DON'T AGREE WITH YOU, MR. PRESIDENT. AND SINCE I'VE GOT ANOTHER EIGHT YEARS OF MY TERM LEFT" -- OR TWELVE OR SOMETHING LIKE THAT -- "I GUESS I'M JUST GONNA DO WHAT MY CONSCIENCE TELLS ME." SO THE PURPOSE OF THE LONG TERMS AND BY HAVING 'EM STAGGERED, WE NEVER HAVE IN ANY TWO- OR THREE-YEAR PERIOD, WE NEVER HAVE VERY MANY OF THESE TERMS SORT OF END AND A NEW PERSON APPOINTED BY THE PRESIDENT. WE TALKED EARLIER ABOUT PACKING THE SUPREME COURT BACK IN THE 1930S, AND WHAT I'M SAYING TO YOU IS WE SORT OF HAVE THIS PREVENTION AGAINST ANY PACKING BY A SINGLE PRESIDENT. AND SO THE PRESIDENT AND CONGRESS DON'T HAVE A LOT OF CONTROL OVER MONETARY POLICY. WELL, WHY DON'T WE WANT THAT? WHY DON'T WE WANT SOME POLITICAL CONTROL OVER MONETARY POLICY? AND THE ANSWER IS: 'CAUSE WHEN THAT HAPPENS -- WE'VE SEEN IT IN THE PAST -- WHEN POLITICIANS CONTROL MONETARY POLICY, THEN HERE'S WHAT THEY HAVE. THEY HAVE A SWITCH. THEY CAN FLIP IT ON AND THESE HUNDRED DOLLAR BILLS COME CASCADING OFF THE PRINTING PRESS. AND THEN THEY JUST
ECO 155 750 LECTURE 34 21 SAY, "OH, BOY. LET'S SCOOP UP A BUNCH OF THOSE AND GO AND SPEND SOME MONEY. LET'S GIVE SOME MONEY AWAY. LET'S BUILD SOME ROADS. LET'S BUILD SOME HIGHWAYS." AND BASICALLY WHAT HAPPENS IS THAT IT'S IRRESISTIBLE FOR THE POLITICIANS. IF THEY CONTROL THE MONEY SUPPLY, THEY'VE GOT TO INCREASE IT THEY THINK. SO THE MONEY SUPPLY GOES UP, SO WE GET INFLATION. AND WE HAVEN'T REALLY GOTTEN TO THAT POINT YET BUT WE'VE SEEN INCREASE IN AGGREGATE DEMAND WILL DRIVE UP THE PRICE LEVEL. AND WHAT I'M SAYING IS THAT IF YOU'VE GOT A PRINTING PRESS AND YOU CAN FLIP THAT SWITCH ON AND THE HUNDRED DOLLAR BILLS COME CASCADING OUT, THEN THE CONGRESS OR THE PRESIDENT WOULD HAVE A TENDENCY TO DO THAT ALL THE TIME. THERE WOULD JUST BE A CONSTANTLY INCREASING AGGREGATE DEMAND OR SPENDING IN THE ECONOMY AND PRICES WOULD RISE. INFLATION WOULD UNDERMINE THE ECONOMY. IF YOU'LL REMEMBER THE OTHER DAY WHEN WE WERE TALKING ABOUT FORMS OF MONEY, I TOLD YOU ABOUT THE FIRST COINS IN LYDIA IN ABOUT 640 B.C., BUT THEN I TOLD YOU THE FIRST PAPER MONEY CAME FROM CHINA IN ABOUT 900 A.D. WELL, THEY DIDN'T KNOW THAT AN EXCESSIVE AMOUNT OF PAPER MONEY WOULD DESTROY THE ECONOMY SO THAT'S WHAT THEY DID. THEY CREATED MORE AND MORE AND MORE OF IT, AND THEY HAD RISING PRICES, AND IT DID DESTROY THE ECONOMY. AND I TOLD YOU THE OTHER DAY THAT'S -- AND, BY THE WAY, IN CHINA THEY DID THAT
ECO 155 750 LECTURE 34 22 TWO OR THREE TIMES BEFORE THEY FINALLY JUST SAID NO MORE PAPER MONEY. AND I ALSO TOLD YOU THE STORY ABOUT -- WHAT WAS THAT ISLAND OF NEW GUINEA AND HOW THEY USED THAT SHELL MONEY UP IN THE INTERIOR OF NEW GUINEA. AND THEN THOSE AUSTRALIANS CAME THERE -- THIS IS IN THE 1930S -- AND LOOKED AROUND, WENT BACK TO AUSTRALIA, CAME BACK WITH PLANELOADS, CRATES FULL OF THESE SHELLS AND JUST STARTED BUYING THINGS FROM PEOPLE WITH THE SHELLS THAT WERE SO RARE THERE IN NEW GUINEA AND JUST NOTHING AT ALL BACK IN AUSTRALIA. THEN WHAT HAPPENED WAS THE PRICE OF THINGS WENT UP. THE SHELL PRICE OF GOODS WENT HIGHER AND HIGHER. AND SO THE POINT IS IS THAT WE'VE SEEN THIS INFLATION BEFORE AND THE FEAR IS THAT IF WE DID NOT HAVE THESE LONG TERMS THAT ARE STAGGERED, THAT THERE WOULD BE TOO MUCH POLITICAL INFLUENCE ON OUR MONETARY POLICY. WE'D HAVE THE ECONOMY DESTROYED. THE -- LET'S TALK ABOUT THIS. FIVE MEMBERS OF THE -- I'M SORRY. SEVEN MEMBERS OF THE BOARD OF GOVERNORS PLUS FIVE OF THE TWELVE FEDERAL RESERVE BANK PRESIDENTS, THAT GROUP OF TWELVE MAKES UP THE FEDERAL OPEN MARKET COMMITTEE OR FOMC. SO THERE'S A TWELVE- MEMBER COMMITTEE WITHIN THE FEDERAL RESERVE. THAT'S THE PEOPLE AT THE TOP. IT'S THE SEVEN MEMBERS OF THE BOARD OF GOVERNORS AND FIVE OF THE TWELVE PRESIDENTS. IT'S ALWAYS THE NEW YORK FED
ECO 155 750 LECTURE 34 23 PRESIDENT. ONE OF THOSE TWELVE IS A NEW YORK FED, PLUS FOUR OTHERS. OKAY. AND FOUR OUT OF THE REMAINING ELEVEN. WHAT WILL HAPPEN IS THEY WILL ROTATE AND TAKE TURNS SERVING ON THE FEDERAL OPEN MARKET COMMITTEE. THIS IS THE MAIN -- AND, BY THE WAY, THE NEW YORK FED HAS THIS PERMANENT POSITION ON THE FEDERAL OPEN MARKET COMMITTEE BECAUSE THAT'S WHERE THE POLICIES ARE ACTUALLY CARRIED OUT, IMPLEMENTED IN THE REAL WORLD. AND SO THE NEW YORK FED'S GOT THIS SPECIAL ROLE IN THIS PROCESS. ANYWAY, THIS FEDERAL OPEN MARKET COMMITTEE IS THE MAIN POLICY MAKING GROUP AT THE FEDERAL RESERVE. THEY ARE THE MAIN ONES AT THE FED. AND I GAVE YOU THE STORY OF THE HELICOPTER COMING OVER THE OTHER DAY AND THROWING OUT MONEY. IF THE FED EVER DOES THAT, IT WILL BE THIS TWELVE THAT SAY, "FIRE UP THE HELICOPTER. WE'RE GOING ON A MISSION. WE'RE GONNA THROW SOME MONEY OUT THE WINDOW." THEY DON'T DO THAT. WHAT THE FEDERAL RESERVE REALLY DOES -- AND I GAVE YOU THE EXAMPLE WHEN I TOLD MY REVERSE STORY HERE A MOMENT AGO. WHAT THE FEDERAL OPEN MARKET COMMITTEE DOES IS IT SAYS, "OH. WE NEED TO PUT MONEY INTO THE ECONOMY AND HERE'S HOW WE PUT IT INTO THE ECONOMY." PUT MONEY INTO THE ECONOMY. THE FED BUYS -- WELL, LET'S SAY TREASURY SECURITIES FROM BANKS OR PEOPLE. THAT'S WHEN THE
ECO 155 750 LECTURE 34 24 FED WANTS TO PUT DOLLARS IN THE SYSTEM, IT BUYS SOMETHING. AND WHEN IT BUYS, LET'S SAY -- AND THESE TREASURY SECURITIES, PERHAPS YOU KNOW A LITTLE BIT ABOUT 'EM. IT'S JUST LIKE A BOND. MAYBE YOU'VE GOT ONE OF THESE BONDS. THERE'S TREASURY BILLS, TREASURY NOTES, TREASURY BONDS. ANYWAY, THE FEDERAL RESERVE WILL JUST SAY TO A BANKER, "HEY, WANT TO SELL THAT BOND? HERE'S WHAT WE'RE OFFERING." AND THE FED WILL OFFER SUCH A HIGH PRICE THAT THEN THE BANKER WILL SELL THAT BOND. AND SO ANYWAY, WHEN THE FED BUYS A TREASURY BOND, THEN THE FEDERAL RESERVE HAS TO PAY FOR IT. FED PAYS FOR BOND. AND WHEN THE FED PAYS FOR THE BOND, THAT'S WHEN THEY JUST SAY THIS BASICALLY: "HEY, WE OWE YOU MONEY." AND WHEN THE FED SAYS "HEY, WE OWE YOU MONEY," THEN ALL OF A SUDDEN THERE'S MONEY IN THE SYSTEM THAT DIDN'T EXIST A MOMENT AGO. IF THE FEDERAL RESERVE CAME TO YOU AND SAID, "HEY, I WANT TO GIVE YOU MY I.O.U. THIS IS AS GOOD AS MONEY." THEY WOULD GIVE YOU A FEDERAL RESERVE NOTE. IT WOULD BE GREEN AND IT WOULD HAVE, YOU KNOW, A PRESIDENT'S PICTURE ON IT -- PROBABLY, UNLESS IT WAS, WHAT, BENJAMIN FRANKLIN. THAT WOULD BE A HUNDRED DOLLAR BILL. BUT WHEN THE FED PAYS, THEY BASICALLY JUST SAY, "WE'LL GIVE YOU OUR I.O.U." AND THEY COULD GIVE A PERSON CURRENCY. THEY COULD GIVE A PERSON OR A BANK -- THEY COULD GIVE 'EM A CHECK. BUT THE POINT IS IS THAT'S THE
ECO 155 750 LECTURE 34 25 SOURCE OF NEW FUNDS, DIDN'T EXIST BEFORE. THE FEDERAL RESERVE DOESN'T SAY, "OH, YOU KNOW, WE'VE GOT SOME INCOME NOW. LET'S PAY FOR SOMETHING." WHAT THEY SAY IS, "WELL, LET'S JUST PAY FOR SOMETHING OUT OF THIN AIR. LET'S JUST SNAP OUR FINGERS AND WRITE DOWN AN I.O.U. HERE YOU GO. WE OWE YOU MONEY." AND EVERYBODY TREATS THAT AS MONEY BECAUSE IT IS. SO THAT'S THE FOMC. WHEN THEY SAY, "LET'S INCREASE THE MONEY SUPPLY," THE WAY THEY'LL DO THAT IS THEY'LL ORDER SOMEBODY AT THE FED TO GO OUT AND BUY BONDS. IF THE FED WANTS TO TAKE DOLLARS OUT OF THE SYSTEM, THE FED WILL SELL BONDS. AND THAT'S THE EXAMPLE I SHOWED A MOMENT AGO WHEN WE WERE TALKING ABOUT REVERSING THE PROCESS. THE FED SELLS BONDS AND SAYS, "YOU HAVE TO PAY ME." AND WHEN WE HAVE TO PAY THE FED, IT'S TAKING DOLLARS OUT OF THE SYSTEM. NOW, HERE'S THE REAL KEY. IF THERE'S ONE DOLLAR PUT INTO THE SYSTEM -- THAT IS TO SAY, THE FEDERAL OPEN MARKET COMMITTEE MEETS AND THEY SAY, "LET'S BUY ONE DOLLAR'S WORTH OF BONDS." THAT WOULDN'T BE VERY MANY. BUT IF THEY MEET AND THEY SAY, "LET'S BUY ONE DOLLAR'S WORTH OF BONDS," THEN THEY WILL PAY THE BANKER FOR THE BONDS AND THAT IS TOTAL RESERVES. TOTAL RESERVES GO UP BY ONE DOLLAR. THE FED'S PAYING THE BANK. AND THEN WE HAVE A MULTIPLIER, TIMES ONE OVER R. THAT TELLS US THE CHANGE IN THE MONEY SUPPLY AND CHANGE IN CHECKING DEPOSITS.
ECO 155 750 LECTURE 34 26 AND SO THERE'S A CONNECTION HERE FROM THE FEDERAL OPEN MARKET COMMITTEE TAKING THE DECISION, "WE WANT TO BUY SOME BONDS." NOW, A DOLLAR IS PUT INTO THE SYSTEM WHEN THE FED PAYS AND THEN WE USE OUR MULTIPLIER THAT WE TALKED ABOUT THE OTHER DAY. FIVE OR TEN OR WHATEVER IT MIGHT BE. OKAY. QUESTIONS ABOUT THIS? AND THEN IT WORKS IN THE OPPOSITE DIRECTION. THE FED SAYS, "LET'S SELL BONDS." THE INDIVIDUAL OR THE BANK HAS TO PAY THE FED. THE FED'S TAKING DOLLARS OUT OF THE SYSTEM, TOTAL RESERVES ARE GOING DOWN IN THAT PARTICULAR CASE, AND THEN THERE'S A MULTIPLIER EFFECT. QUESTIONS ABOUT THIS? WHAT WE WILL DO IS WE WILL COME BACK AND TALK ABOUT THE MORE COMPLICATED MULTIPLIER WHEN WE HAVE THESE OTHER THINGS LATER ON, SO I DON'T WANT TO STOP AND TALK ABOUT THAT RIGHT NOW. LET'S TALK ABOUT THE FED'S MAIN POLICY. FIRST OF ALL, THIS WAS THE MAIN POLICY, THIS THING THAT I JUST DESCRIBED RIGHT HERE. LET ME JUST SORT OF MENTION, THOUGH, A LITTLE BIT MORE DETAIL ABOUT THIS POLICY. THE FED HAS THREE MAIN POLICIES. THREE POLICY TOOLS. ONE, OPEN MARKET OPERATIONS. AND WE JUST TALKED ABOUT OPEN MARKET OPERATIONS. IT'S CARRIED OUT BY THE FEDERAL OPEN MARKET COMMITTEE. IT IS THE -- BY THE WAY, LET ME PUT A DEFINITION UP HERE EVEN THOUGH WE HAVE BEEN TALKING ABOUT IT. PURCHASES AND SALES OF GOVERNMENT SECURITIES OR BONDS BY THE FED. THAT'S THE
ECO 155 750 LECTURE 34 27 DEFINITION OF WHAT I MEAN BY OPEN MARKET OPERATIONS. THE FED BUYING AND SELLING GOVERNMENT SECURITIES. THE POLICY IS MADE BY THE FOMC, FEDERAL OPEN MARKET COMMITTEE. THIS IS THE NUMBER ONE MOST USED POLICY TO CONTROL THE MONEY SUPPLY. OKAY. THE FOMC MEETS ABOUT NINE TIMES A YEAR. FOMC MEETINGS, NINE TIMES A YEAR. THAT'S A BALLPARK NUMBER. THEY MEET ABOUT ONCE EVERY FIVE OR SIX WEEKS. OKAY. AND DON'T FORGET HOW THIS WORKS. THE FED BUYS SECURITIES -- I'LL SAY BONDS -- AND THAT INCREASES TOTAL RESERVES OF BANKS, AND THAT INCREASES CHECKING DEPOSITS AND M-1 MONEY SUPPLY. IN THE OTHER DIRECTION, IF THE FED SELLS BONDS THAT WILL DECREASE TOTAL RESERVES WHICH WILL DECREASE CHECKING DEPOSITS IN THE ECONOMY AND DECREASE M-1 MONEY SUPPLY. SO THE REAL KEY IS, ARE YOU BUYING OR ARE YOU SELLING? ARE YOU PURCHASING OR SELLING? FINALLY, WHEN THE FED BUYS BONDS -- IF THE FED BUYS BONDS, THAT WILL INCREASE THE PRICE OF BONDS AND DECREASE INTEREST RATES. FOR THE TIME BEING, I WANT YOU TO JUST TAKE MY WORD FOR IT THAT THE PRICE OF BONDS IS GOING IN ONE DIRECTION AND INTEREST RATES IS GOING IN THE OPPOSITE DIRECTION. IF THE FED SELLS BONDS, THEN THE PRICE OF BONDS GOES DOWN. AND, BY THE WAY, THIS IS REALLY JUST SIMPLE SUPPLY AND DEMAND, ISN'T IT? IF THE FED'S BUYING SOMETHING, IT DRIVES UP THE PRICE. IF THE FED'S SELLING, IT DRIVES DOWN THE PRICE.
ECO 155 750 LECTURE 34 28 AND IF THAT HAPPENS INTEREST RATES ARE ALSO GOING UP AT THE SAME TIME. PRICES OF BONDS AND INTEREST RATES IN OPPOSITE DIRECTIONS, SO DON'T LET THAT CONFUSE YOU. A LOT OF INDUSTRIES, LIKE THE AUTO INDUSTRY, THE HOUSING INDUSTRY, THEY LIKE LOW INTEREST RATES, RIGHT? IF YOU'RE SELLING CARS, YOU WANT TO BE ABLE TO SELL A LOT OF CARS. AND THE WAY THAT HAPPENS IS IF YOUR CUSTOMERS CAN AFFORD TO BUY CARS AND THEY CAN DO THAT IF INTEREST RATES ARE LOW. SO A LOT OF INDUSTRIES -- CARS, HOUSING, AND SO FORTH, THE DURABLE GOODS INDUSTRIES, THEY LIKE LOW INTEREST RATES, SO THEY'RE ALWAYS PUSHING ON THE FEDERAL RESERVE. "BUY BONDS, BUY BONDS. WE WANT TO EXPAND THE MONEY SUPPLY AND BRING DOWN INTEREST RATES." THE SECOND AND THIRD POLICIES WE WILL TALK ABOUT AT THE BEGINNING OF THE HOUR NEXT TIME. SO LONG.