# If you were in charge of the Fed, how would you stimulate the economy?

**URL:** <https://boards.straightdope.com/t/if-you-were-in-charge-of-the-fed-how-would-you-stimulate-the-economy/614489>\
**Category:** Great Debates\
**Created:** [March 1, 2012, 10:08pm UTC](https://boards.straightdope.com/t/if-you-were-in-charge-of-the-fed-how-would-you-stimulate-the-economy/614489 "2012-03-01T22:08:27Z")\
**Posts on this page:** 3\
**Page:** 3

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**Author:** ![Hellestal](https://avatars.discourse-cdn.com/v4/letter/h/3ab097/32.png) [@Hellestal](https://boards.straightdope.com/u/Hellestal)\
**Post date:** [March 4, 2012, 2:25am UTC](https://boards.straightdope.com/t/if-you-were-in-charge-of-the-fed-how-would-you-stimulate-the-economy/614489/41 "2012-03-04T02:25:33Z")

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Just for the freshness of an independent perspective, here is [Goldman Sachs](http://www.goldmansachs.com/our-thinking/global-economic-outlook/case-for-nominal-gdp-level-target.html) on the case for an NGDP level target.

It’s been a while since I’ve read it (I read it in October when it came out), so I don’t recall if I fully agree with their reasoning. But the idea that this is all in my “mind” is just so ridiculous, I feel the need to throw this out there. Strange that a person who knows “infinitely more” about finance than I do would have missed this. This report should, I believe, be part of that infinity that I apparently don’t know about.

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**Author:** ![dzero](https://avatars.discourse-cdn.com/v4/letter/d/5f9b8f/32.png) [@dzero](https://boards.straightdope.com/u/dzero)\
**Post date:** [March 4, 2012, 3:01am UTC](https://boards.straightdope.com/t/if-you-were-in-charge-of-the-fed-how-would-you-stimulate-the-economy/614489/42 "2012-03-04T03:01:49Z")

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I won’t even bother quoting you and honestly, I stopped reading after the second paragraph. So this is also for anyone still following.

The only people who will be convinced by your “logic” are those who don’t know any better and are too lazy to go to one of the several web sites maintained by the federal reserve. Anyone who actually follows the financial news will realize how little actual knowledge you possess. And by financial news, I don’t mean the pap they feed you on CNBC. I mean actual financial news.

Since you obviously realize you can’t compete, let me explain some basic concepts and some of my more cryptic remarks.

The money multiplier can be of 2 types - theoretical and observed. The theoretical value will be 1 divided by the reserve ratio. For anyone interested, I’ve explained it [here](http://boards.straightdope.com/sdmb/showpost.php?p=14809003&postcount=15). [The observed multiplier is](http://research.stlouisfed.org/fred2/series/MULT)

> [@](#):
>
> The M1 multiplier is the ratio of M1 to the St. Louis Adjusted Monetary Base. For further information on monetary aggregates, please refer to the Definitions, Notes, and Sources at [http://research.stlouisfed.org/publications/mt/](http://research.stlouisfed.org/publications/mt/).

[Money velocity I’ve defined previously, but for convenience,](http://research.stlouisfed.org/fred2/categories/32242)

> [@](#):
>
> Velocity is a ratio of nominal GDP to a measure of the money supply (M1 or M2). It can be thought of as the rate of turnover in the money supply–that is, the number of times one dollar is used to purchase final goods and services included in GDP.

Do either of these have any practical significance for the average investor? Not really. The fact that we have been below 1 on the observed multiplier tells us that the fed has been “pushing on a string” as they say. For every dollar they create ab nihilo, less than one dollar makes it into the economy. The reason that happens is because banks have kept that money in excess reserves. [Here is a chart that gives you an idea of the magnitude of this issue.](http://research.stlouisfed.org/fred2/series/EXCRESNS)  
So how exactly does monetary policy work in this environment? Well, that’s a bit of a problem. Normally the fed would start by reducing interest rates, but obviously we’re way past that point. Then it tried flooding the market with liquidity. That helped, but not enough. Next the fed selectively bought long-dated treasury obligations in [Operation Twist](http://www.npr.org/blogs/money/2011/09/21/140643696/operation-twist-explained-in-4-easy-steps) so as to help flatten the [yield curve](http://en.wikipedia.org/wiki/Yield_curve). And that’s where we are today.

OK, fine you say. But what does all of that actually mean? Basically the way the fed attacks it’s dual mandate of controlling inflation AND unemployment (a unique requirement among central banks) is to emulate economic activity with money.

When the economy is going through a period of contraction, the fed stimulates economic activity with low interest rates and, if necessary, abundant liquidity. Why would low rates help? I tried to explain this earlier as follows.

> [@](#):
>
> The benefit of low interest rates is that it makes more projects competitive since the funding costs are lower.
> 
> Say you have a project that will generate an 8% return. If your cost of funds are not substantially below 8%, you won’t pursue that project. If the cost is much lower, you will.
> 
> The problem is the statistical distributions of returns. Think of a bell curve. You have many potential opportunities that have just an average return but many fewer than have returns that are 1,2 or 3 standard deviations from the mean. This is where low interest rates help. It lets you dip into the mediocre types of returns but still make a profit.

To put it slightly differently, what the fed is doing is making a broader range of projects (the bulge in the bell curve) profitable for businesses to pursue.

So why doesn’t any of this seem to be working?

There are a variety of reasons, but I’ll hit the high points. First, people, and that includes banks, are still scared. After the worst of the crisis was over, banks tightened up excessively on underwriting requirements. You could have god co-sign your loan and you would still have a hard time getting one. That’s improved, but we still may not be at rational levels. Also, businesses weren’t sure what legislation would be coming out of Washington, if we would have a double dip, etc. So they have been understandably reluctant to hire.

Second, and this is related, companies have been accumulating cash rather than doing what they would normally do – invest it. And by this I mean REAL investment, not what the average person would think of. As noted previously in my discussion of GDP, this falls into 2 of the 3 categories listed – plant and equipment plus inventories. Personally I would include hiring in there as well, but I won’t get off track.

Third, as already noted, banks are keeping huge excess reserves. This is partly out of fear and concern for future loan and securities write-downs, but there are other reasons as well.

I hope this helps people get a better handle on things.

@Hellestal: I’ll let our readers judge which of us actually knows what we’re talking about. But I do have to say it has been entertaining. Cheers!

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**Author:** ![Hellestal](https://avatars.discourse-cdn.com/v4/letter/h/3ab097/32.png) [@Hellestal](https://boards.straightdope.com/u/Hellestal)\
**Post date:** [March 4, 2012, 12:39pm UTC](https://boards.straightdope.com/t/if-you-were-in-charge-of-the-fed-how-would-you-stimulate-the-economy/614489/43 "2012-03-04T12:39:36Z")

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I just want you to know, I think you’re making exactly the right decision.  
Time for sweeping up. This is a bit of silliness I missed earlier:

> [@dzero](#):
>
> Why do you assume inflation is necessary to stimulate growth or employment. That can sometimes be a side effect but is not in any way inevitable.

To which I responded:

> [@Hellestal](#):
>
> An upward sloping supply curve means that some inflation is, in fact, inevitable with more demand-based economic growth. This is just basic supply and demand.

To which he responded:

> [@dzero](#):
>
> Again, irrelevant.

So it is irrelevant to actually answer one of his questions. I guess it’s nice to have his personal confirmation of that. He continues:

> [@dzero](#):
>
> But nice try at attempting to appear erudite.

I wouldn’t call a concept I used to teach in week two of freshman econ particularly “erudite”, but I guess any slightly technical concept can tend to seem highfalutin to a sufficiently reluctant reader. Anyway, elasticity is _important_ regardless of how obscure and esoteric it might seem.

It’s not too hard to explain, though.

Here is [a picture of aggregate supply and demand](http://en.wikipedia.org/wiki/File:Aggregate_supply_%2B_demand_graph.png). Demand slopes down, and supply up. What I want to concentrate on first, though, are the axes of the graph. The horizontal axis is Y, real output (real GDP). The vertical axis is P, the price level (changes in which are inflation/deflation). If you’ve been following this discussion from the beginning, you will remember the equation of exchange I cited earlier: MV = PY = NGDP.

Looking at the graph, we can see that supply and demand cross at a certain level of P and Y. Make, in your mind’s eye, a rectangle with the origin as the lower left corner and the crossing of the curves in the upper right corner. The rectangle has length Y and height P. The area of the rectangle is PY. Oh? What does our equation say again? The area of the rectangle happens to be nominal GDP.

It never goes away folks. All of these different methods are different ways to try to cut straight into one core idea.

How do we increase Y, real output, putting people back to work? Sure, we can try to push out the supply curve, which would both increase real production and also lower prices. To affect supply, though, we basically need some way to make it easier to make new stuff. The payroll tax cut might’ve worked to increase supply… but it was aimed at workers, not owners. It was pushing on demand, not on supply. Maybe that was a mistake? A fantastic source of cheap energy would also work to push out supply, but I don’t expect cold fusion appearing out of nowhere, and the slow economic recovery is actually pushing _up_ energy prices. New technologies would work, too, but that takes both investment dollars and time. No one is investing a lot right now. A huge part of our problem now is how much amazing capacity we have available that’s not currently being used. We have lots of unemployed people who aren’t working because there isn’t enough _demand_

So let’s talk demand. That naturally means talking monetary policy.

Money is about demand. Factories _supply_ things. New money doesn’t automatically change the number of factories we have. Workers _supply_ things. New money doesn’t automatically change the number of workers we have. Technology helps us _supply_ things more efficiently from our factories and workers. New money doesn’t automatically change our technology level.

(New money can spur investment demand for new tech and new factories, and these nifty new things can _eventually_ push out supply. That’s actually the story of our civilization, in brief. But the new machines have to be honest-to-god built before supply pushes out. New money’s immediate effect is on investment demand, and only _after_ the amazing new capital goods are built and operational will supply push out. Money’s immediate effect is on demand.)

If aggregate demand pushes out – the immediate effect of money is on demand, and only demand – both Y and P will go up. The supply curve slopes up, so _prices must go up_. In addition, the size of the rectangle gets bigger, which is to say that NGDP must also go up. The supply curve is fairly flat right now, but it’s not _perfectly_ flat. Supply is not perfectly elastic. In order for monetary policy to have a positive effect, there must be some increase in the price level. This is just basic supply and demand, and nothing more. In order not to see the relevance of this, a person has to be pretty much entirely ignorant of macroeconomics. That’s not really a bad thing! Most people are in the same situation. I would hope that some people, however, would want to learn a thing or two.

As for **dzero** ’s last post…

I want to say, as far as I can see, that everything he mentioned about conventional monetary policy is absolutely, totally, 100% _correct_. He accurately outlined, in brief, the way the Fed and other central banks typically operate. He accurately explained why conventional policy is having such problems. The one thing you need to careful about is his definition of investment, as used for GDP calculations. As is clear from previous posts, he thinks it’s [this](http://en.wikipedia.org/wiki/Investment#In_finance), the finance definition. It’s actually [this](http://en.wikipedia.org/wiki/Investment#In_economics_or_macroeconomics), the economic definition. (Unfortunately, I was being lax previously and was using [this third definition](http://en.wikipedia.org/wiki/Investment#Investment_related_to_business_of_a_firm_-_business_management), (yes, there are three definitions) which made him think I was entirely ignorant or something. I was just trying to be nice and not rely on the rather erudite and technical econ definition – the one that is actually used for GDP calculations, as you can tell from the link he cited previously but didn’t bother to read – but my lax choice of definition fudged up the discussion something good, didn’t it? I’m not always the best writer. Well, live and learn.)

The problem is that somehow he got into his head the entirely silly notion that What He Knows = Monetary Policy, and Monetary Policy = What He Knows. So when he met some new thoughts on the issue, something he hadn’t learned in MBA school, he recognized immediately that it was Not What He Knows, and summarily concluded, without justification, that it was Not Monetary Policy. He has also apparently decided to leave the discussion, which is a shame, because he’s plenty smart enough to figure this out.

Financiers tend to get only the conventional definition of monetary policy and nothing more. Why? Well, normally, it’s the only relevant one to people who work in banks. Most times are conventional times, and learning a lot of economic history is just a waste of time if all you want is highly skilled finance advice. Of course, actual economists, if they’ve been well trained, learn a whole variety of different transmission mechanisms of monetary policy. There’s all sorts of squabbling about which are most important. He mentioned interest rates, and he was right to do so. He mentioned liquidity, and he was right to do so.

However, he missed the Hot Potato Effect. (Unlike GDP expectations, this particular term might be used only in my own particular circles. I really like it because it’s evocative, gets the point across very quickly, but maybe most economists just talk about “velocity” and leave it at that.)

Why did he miss the Hot Potato Effect? Because it’s unusual in the developed world. You have to know a few international and historical examples to adequately appreciate what a touch of higher inflation expectations (higher NGDP expectations) can do to money velocity without necessarily affecting the money multiplier in the slightest. If the ink is still wet on your degree, you’re likely to miss the importance of this effect.

I can cite all sorts of examples, but maybe most convenient would be This American Life which had an interesting program not very long back on [“The Invention of Money”](http://www.thisamericanlife.org/radio-archives/episode/423/the-invention-of-money). They talk about the previous Brazilian experience of 80% _monthly_ inflation, and how they fixed it. Naturally, I had some quibbles with some of their descriptions – I don’t think I listened to all of the second part about the Fed – but the Brazil stuff is great and really hammers the point home.

They interviewed a guy who actually had had nightmares about leaving a wad of cash on his dresser. In a high inflation world, that is something that is Simply Not Done. Every single day you don’t spend that wad of cash, it loses value. 80% monthly inflation will obliterate the value of cash in practically no time. Nightmares. He actually had nightmares about forgetting to spend his cash when he could. The money has to move. 80% monthly is way out of line, but if we increase inflation (NGDP) expectations just a touch, then _of course_ money is going to move more quickly. It will start buying things up. When interest rates are already zero, and the banks already have plenty of liquidity, the Hot Potato is the next step. Make it just a smidge more painful to hold cash, and that cash won’t sit idly on the dresser. _Money will move_.

And it will move regardless of which one of the three definitions of investment we happen to be using at any particular moment. It can be confusing to talk about, yes? Human beings keep talking to each other – when they actually decide to keep talking to each other – in order to work through these confusions. Or we can ignore what other people say for petty ego-saving reasons, in which case, you probably shouldn’t have read this post.

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