eco 155 750 lecture 34 1

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?


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


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


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


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


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


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


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


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


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


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


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


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


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


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


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


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


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.


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.


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


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


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


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


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


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.


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


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.


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.

eco 155 750 lecture 34 1

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