March 18, 2008

Macroeconomics 101

The Federal Reserve (Fed) is sometimes called the banks' bank. That is to say, it the a central banking system for the United States to which practically all banks must belong. It is where your bank deposits its excess reserves , buys government securities, borrows money. It is through this central banking system that government has a great deal of control over the economy - when not hit by an exogenous shock from some outside source. The main goal of the Fed is to maintain economic stability for the nation; for the most part, that means making sure that inflation rates are in check and that unemployment stays relatively low (within acceptable limits). The Fed has three major tools to help control this:

1) Open-Market Operations: the buying or selling of government bonds and securities to the banks and the general public. This controls the amount of money in circulation. When the Fed buys bonds back from the public or banks, it is putting money back into circulation. When the Fed sells bonds to the banks and the public it is taking money out of circulation.

2) The Reserve Ratio: the percent of all deposits banks must have available in order to pay withdrawals. The lower the reserve requirement, the more money banks have available to loan out.

3) The Discount Rate: the interest rate charged to banks in order to borrow money. This interest rate is often times passed on to the consumer (private individual or company). In other words, if the Fed lowers the discount rate, consumers will likely see lower interest rates at their banks - for both loans and savings - and vice-versa.

Definitions:
Loose-Money Policy - Actions of the Fed to make more money available to consumers. The goal is to have more people borrow money so that they will spend more money, resulting in a boost to the economy. This is used when the economy is slowing, this is usually accompanied by higher rates of unemployment. The idea is that businesses will borrow more money to invest in their production. Such investment will require more workers (lowering the unemployment rate), who themselves will now have more income to spend, ideally creating an upward spiral in the economy. (Fed buys back bonds, the reserve ratio is lowered, the discount rate is lowered).

Tight-Money Policy - Actions of the Fed to make less money available to consumers. The goal is discourage people from spending money in order to slow the economy. This is used when the economy is growing too rapidly, this is usually accompanied by higher rates of inflation. The idea is to discourage businesses from borrowing money thereby decreasing production, in turn decreasing the demand for workers. If not done cautiously, this can cause a downward spiral in the economy. (Fed sells bonds, raises the reserve ratio, raises the discount rate).

The problem with both Loose- and Tight-Money Policy is that the effects are usually not seen right away. Sure the stock market will react that day (big gains for loose-money, big losses for tight-money), but the economy as a whole will not feel the effects for quite some time. Therefore, the Fed does not know if it has done too much or too little, that is why it will usually make small changes.

The perfect example of all this took place today. Ben Bernanke announced another decrease in the Discount Rate: -0.75% down to 2.25%. I know what you are thinking, 3/4 of a percentage point is a small amount, but think about it, 3/4 of 3% is really a big amount. Let's take a look at a 30-year fixed rate mortgage for a $200,000 home.
Fed Cuts Interest; Stocks Soar (Yahoo! News)

At 7.00% Interest the monthly payments are $1,330.60, for a 30-year total of $479,016.00
At 6.25% Interest the monthly payments are $1,231.43, for a 30-year total of $443, 314.80.

This 0.75% difference changes monthly payments by $99.17, and will change the total payout over 30 years by $35,701.20. For the average individual, that is a big difference, the nearly $100 per month is a huge savings. I doubt anyone would turn their nose up to an extra $100 per month ($1200 per year).

Apply what you have learned today (here is the word problem):
If the Fed lowers the Discount Rate, what will happen to unemployment and inflation?
(Answer tomorrow!)