Illustrating Fed Strategies

A great way of understanding the Federal Reserve’s monetary policy actions is to use a graphical representation of the market for reserves. Frederic Mishkin’s textbook on money and banking is an excellent print resource. Meanwhile, Mark Thoma illustrates the model, and Fed policy changes, in this YouTube clip:

I love the internet.

HT: David Beckworth

2 responses to “Illustrating Fed Strategies

  1. I am sure this reflects the Fed’s crazed perspective on matters.

    The Federal Funds rate Fetish.

    I am not at all sure that the argument that the Fed cannot sell assets off fast enough holds much water. What I am sure about is that selling off those assets reduces the ability of banks to expand the quantity of money (and the quantity of bank loans) even if the Fed Funds rate is not impacted.

    If the point of the policy is to keep banks from creating too much money and credit as the money multiplier rises, open market sales do the trick. If the purpose of the policy is to manipulate the Federal Funds rate, then maybe it won’t change because it is in a liquidity trap–created by Fed policy of paying interest on reserves.

    As banks increase their lending, and checkable deposits expand, required reserves increase and the demand curve for reserves shifts to the right. Doing this analysis with a unchanging demand for reserves seems a bit odd to me.

    And even if required reserves are a joke (and I guess they are,) then banks will need more reserves for prudential purposes anyway. And, of course, if more economic activity raises currency demand, there could be a reduction in the quantity of reserves.

    But the Fed’s fetish for stabilizing short term interest rates appears to infect not only their policy, but also the explanations economists give of that policy.

  2. Bill,

    I am not endorsing this as the best way to view monetary policy, but rather how the Fed views its alternatives.

    I also don’t believe in a liquidity trap. For this to be possible the marginal rate of substitution of money for all other assets would have to be zero — something that is not an empirical reality. However, the zero lower bound seems to be an impediment not to monetary policy, but to current thought on monetary policy.

    Basically, as I have said in previous posts, the Fed should be focused on removing excess reserves from the system as part of their exit strategy. The problem is that they are too busy serving as the fourth branch of government.

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