What's all the Yellen About? Monetary Policy and the Federal Reserve: Crash Course Economics #10

Summary

Crash Course Economics explores the impact of monetary policy, led by figures like Janet Yellen, on global economies. The script delves into the Federal Reserve's role in regulating interest rates and money supply to either stimulate or curb economic activity. It explains concepts like expansionary and contractionary monetary policy, and the mechanisms used by central banks, such as open market operations and reserve requirements, to adjust the economy. The video also touches on the historical missteps of The Fed during the Great Depression and its innovative responses to the 2008 crisis, including Quantitative Easing, while highlighting the balance between fiscal and monetary policy in economic intervention.

Takeaways

• 🏛️ The Federal Reserve, commonly known as 'The Fed,' is the central bank of the United States, with the European Central Bank (ECB) and other institutions serving similar roles in their respective countries.
• 💼 Central banks have two main responsibilities: regulating and overseeing commercial banks to prevent bank runs, and conducting monetary policy to manage the economy's speed.
• 📉 Monetary policy involves adjusting the money supply to either accelerate or decelerate the economy, making the central bank and its chair highly influential.
• 💰 Interest rates are the cost of borrowing money, and they affect the amount of loans made and the level of spending in the economy.
• 📈 The Fed can manipulate interest rates by changing the money supply, with an increase leading to lower rates and more borrowing, and a decrease leading to higher rates and less borrowing.
• 🌐 There are two types of monetary policy: Expansionary, which increases the money supply to stimulate the economy, and Contractionary, which decreases it to cool down the economy.
• 📊 Historical examples show how The Fed has used monetary policy to combat recessions and inflation, with varying degrees of success and impact.
• 💡 The Fed can change the money supply through three main methods: altering the Reserve Requirement, adjusting the Discount Rate, and conducting Open Market Operations.
• 📉 Open Market Operations involve the buying or selling of government bonds to influence the money supply and interest rates.
• 💸 During the 2008 financial crisis, The Fed used Quantitative Easing (Q.E.) to inject liquidity into the economy by purchasing long-term assets, including Mortgage Backed Securities.
• 🤔 Despite concerns about inflation from increased money supply, factors such as banks' excess reserves and economic uncertainty have contributed to keeping inflation rates low.
• 🔄 The choice between fiscal and monetary policy depends on the economic situation, with monetary policy often being quicker to implement but fiscal policy potentially more effective in severe downturns.

Q & A

What is the primary role of the Federal Reserve in the United States?

The Federal Reserve, commonly known as 'The Fed,' serves as the central bank of the United States. Its primary roles include regulating and overseeing the nation's commercial banks to ensure they have sufficient reserves to avoid bank runs, and conducting monetary policy to manage the economy's speed by increasing or decreasing the money supply.

What is monetary policy and why is it significant?

Monetary policy is the process of increasing or decreasing the money supply to either speed up or slow down the overall economy. It is significant because it influences interest rates, which in turn affect borrowing, spending, and investment behaviors, impacting the economy's performance.

How does the Federal Reserve manipulate interest rates without directly setting them for banks?

The Fed manipulates interest rates by changing the money supply. When it increases the money supply, there is more money available for banks to lend, leading to lower interest rates due to increased competition among banks. Conversely, a decrease in the money supply results in higher interest rates as banks have less money to lend out.

What is the difference between expansionary and contractionary monetary policy?

Expansionary monetary policy involves increasing the money supply to decrease interest rates, leading to more borrowing and spending, which can stimulate economic growth. Contractionary monetary policy, on the other hand, involves decreasing the money supply, which increases interest rates and reduces borrowing and spending, aiming to cool down an overheating economy.

How did the Federal Reserve respond to the economic slump after the Dot Com bust and 9-11?

In response to the economic slump, the Federal Reserve increased the money supply to lower interest rates, making borrowing easier and encouraging increased spending, which helped the economy to begin growing again, albeit slowly.

What was the impact of Paul Volker's actions as the Fed Chairman during the high inflation period of the late 1970s?

Paul Volker, as the Fed Chairman, decreased the money supply, which caused interest rates to rise significantly. This led to reduced consumer and business spending, effectively curbing inflation but at the cost of increased unemployment.

What were the two main mistakes made by the Federal Reserve during the early years of the Great Depression?

During the early years of the Great Depression, the Federal Reserve made two main mistakes: allowing several large banks to fail, which led to widespread panic and bank runs, and not providing emergency loans to banks, which would have increased liquidity and the money supply, helping to stabilize the banking system.

What are the three main methods the Federal Reserve uses to change the money supply?

The three main methods the Federal Reserve uses to change the money supply are: 1) Changing the Reserve Requirement, 2) Adjusting the Discount Rate, which is the interest rate the Fed charges banks for loans, and 3) Conducting Open Market Operations, which involve buying or selling government bonds to influence the money supply.

What is Quantitative Easing (Q.E.) and how was it used by the Federal Reserve during the 2008 financial crisis?

Quantitative Easing (Q.E.) is a monetary policy tool where central banks purchase longer-term assets from banks using newly created money. During the 2008 financial crisis, the Federal Reserve used Q.E. to buy not only treasury bills but also longer-term assets like mortgage-backed securities to increase the money supply and stimulate the economy.

Why has the inflation rate in the U.S. remained low despite the Federal Reserve's continuous increase in the money supply since 2008?

The low inflation rate in the U.S. despite an increased money supply can be attributed to several factors, including banks not loaning out the excess reserves, stricter lending regulations, reduced borrowing due to economic uncertainty, and the possibility of foreigners holding dollars due to instability in other regions.

What is the role of fiscal policy in comparison to monetary policy in managing an economy?

Fiscal policy involves changing government spending or taxes to influence the economy. It is often used for long-term economic planning and can be more effective in severe downturns. Monetary policy, on the other hand, is typically quicker to enact and is managed by central banks to adjust the money supply and interest rates to stabilize the economy.

Outlines

00:00

🌟 Introduction to Monetary Policy and Janet Yellen

The script begins with an introduction to the topic of monetary policy by Jacob and Adriene, highlighting the importance of the Federal Reserve (The Fed) and its chairperson, Janet Yellen, in influencing global economics. The Fed's dual role in regulating commercial banks and conducting monetary policy is explained, emphasizing its ability to adjust the money supply to control economic growth. The concept of interest rates as the price of borrowing is introduced, and their impact on borrowing and spending is discussed. The script also explains how The Fed uses its power to manipulate interest rates indirectly by altering the money supply, leading to either expansionary or contractionary monetary policies.

05:01

📉 Historical Monetary Policy Actions and Their Effects

This paragraph delves into real-world examples of monetary policy in action. It discusses the Fed's response to economic downturns, such as the Dot Com bust and 9-11, where it increased the money supply to stimulate the economy. The paragraph also covers the high inflation of the late 1970s and how then-Fed Chairman Paul Volker combated it through contractionary monetary policy, although at the cost of increased unemployment. The Great Depression is mentioned as a case where the Fed's actions were criticized for exacerbating the crisis due to a lack of emergency loans, which would have increased liquidity and the money supply. The paragraph concludes with an explanation of the three main methods The Fed uses to change the money supply: adjusting the reserve requirement, changing the discount rate, and open market operations, which involve buying or selling government bonds to influence liquidity and the money supply.

Keywords

💡Monetary Policy

Monetary policy refers to the actions taken by a country's central bank to control the money supply to influence economic activity, such as increasing or decreasing the money supply to speed up or slow down the economy. In the video, it is the main tool discussed for managing economic conditions, with Janet Yellen and the Federal Reserve being key players in its implementation.

💡Federal Reserve (The Fed)

The Federal Reserve, commonly known as 'The Fed,' is the central bank of the United States. It has the dual role of regulating commercial banks and conducting monetary policy. The video emphasizes The Fed's influence on the economy through its control over interest rates and the money supply, highlighting Janet Yellen's role as the Chair.

💡Interest Rates

Interest rates are the cost of borrowing money, expressed as a percentage of the principal. In the script, they are depicted as a critical tool for economic regulation, where lower rates encourage borrowing and spending, and higher rates have the opposite effect. The Fed influences these rates by manipulating the money supply.

💡Expansionary Monetary Policy

Expansionary Monetary Policy is a strategy where a central bank increases the money supply to stimulate the economy. The video describes this as a response to a slump, where The Fed would lower interest rates to encourage more borrowing and spending, aiming to boost economic growth.

💡Contractionary Monetary Policy

Contractionary Monetary Policy is the opposite of expansionary policy, where the central bank decreases the money supply to cool down an overheating economy. The script mentions this in the context of high inflation in the 1970s, where The Fed under Paul Volker increased interest rates to reduce spending.

💡Fractional Reserve Banking

Fractional Reserve Banking is a system where banks are only required to hold a fraction of customer deposits as reserves and can lend out the rest. The video explains how The Fed can change the reserve requirement to influence the money supply, which in turn affects the economy.

💡Discount Rate

The Discount Rate is the interest rate that the central bank charges commercial banks for loans. In the video, it is mentioned as one of the tools The Fed uses to adjust the money supply, where a lower discount rate makes it cheaper for banks to borrow, thus increasing the money supply.

💡Open Market Operations

Open Market Operations are the buying and selling of government securities by the central bank to manage the money supply. The video describes this as the primary method The Fed uses to quickly adjust the money supply, such as during the 2008 financial crisis.

💡Quantitative Easing (Q.E.)

Quantitative Easing, or Q.E., is a monetary policy where a central bank purchases longer-term securities from banks to inject liquidity into the economy. The video discusses Q.E. as an unconventional measure taken by The Fed post-2008, using it to buy assets like Mortgage Backed Securities to stimulate the economy.

💡Inflation

Inflation is the rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling. The script discusses inflation in the context of the 1970s, where it reached as high as 13%, and how The Fed's policies can influence this rate.

💡Liquidity

Liquidity refers to the ability of an asset to be readily converted into cash without affecting its price. In the video, it is mentioned in the context of the Great Depression, where The Fed's failure to provide emergency loans to banks led to a lack of liquidity and contributed to the economic crisis.

Highlights

Monetary policy is the tool used by central banks to influence the economy by adjusting the money supply.

Janet Yellen, as the head of the Federal Reserve, holds significant influence over the world's largest economy.

Central banks have two key functions: regulation of commercial banks and conducting monetary policy.

Interest rates are the price of borrowing money and have a direct impact on the amount of loans taken out and spent.

The Federal Reserve manipulates interest rates by changing the money supply to encourage or discourage borrowing.

Expansionary Monetary Policy involves increasing the money supply to stimulate the economy.

Contractionary Monetary Policy is used to decrease the money supply, raising interest rates and reducing spending.

Historical examples show how monetary policy has been used to combat recessions and inflation.

The Great Depression highlights the importance of maintaining bank confidence and liquidity.

The Fed can change the money supply through adjusting the Reserve Requirement, Discount Rate, and Open Market Operations.

Open Market Operations involve the buying and selling of government bonds to directly influence the money supply.

Quantitative Easing is an unconventional monetary policy tool used to inject liquidity into the economy during crises.

Despite concerns, inflation has remained low in the U.S. due to various factors including bank behavior and global economic conditions.

Economists debate the effectiveness of fiscal policy versus monetary policy in different economic scenarios.

The independence of central banks from political influence is crucial for the effectiveness of monetary policy.

Janet Yellen's role as a central bank leader exemplifies the impact of monetary policy on global economic stability.

Support for educational content like Crash Course Economics can be provided through platforms like Patreon.

Transcripts

Jacob: Welcome to Crash Course: Economics, I'm Jacob Clifford.

Adriene: I'm Adriene Hill and today were talking about monetary policy.

Jacob: So each year, TIME magazine comes out with a list of the worlds 100 most influential people.

Adriene: It includes heads of state, religious leaders, entrepreneurs, artists and activists,

singers and actors of the most famous and infamous.

There's one person on that list -- someone who is arguably the most influential person on earth -- that

most people don't know. Their decisions, good or bad, likely impact billions of people: Janet Yellen.

Jacob: She steers the largest economy in the world. Janet Yellen is a big deal. And she's

a big deal because of monetary policy.

[Theme Music]

Adriene: The Federal Reserve is the central bank of the United States, and it's commonly

called "The Fed." Europe has the European Central Bank or ECB, and other countries have

institutions that play similar roles.

Most central banks have two important jobs. First, they regulate and oversee the nation's

commercial banks by making sure that banks have enough money in their reserve to avoid bank runs.

Their second job, and the job we're gonna focus on today, is to conduct monetary policy

which is increasing or decreasing the money supply to speed up or slow down the overall

economy. Monetary policy is what makes The Fed and The Fed Chair so influential.

Jacob: Let's start with interest rates. An interest rate is the price of borrowing money.

When banks lend money, they expect to be repaid the amount they lent, which is called the

principle, and a percentage of the principle to cover inflation and to make some profit.

That percentage is called the interest rate.

The number of car loans, student loans, home loans, and business loans that get made depends on interest rates.

When interest rates are low, borrowers will find it easier to pay back loans so they will

borrow more and spend more. When interest rates are high, borrowers borrow less and therefore spend less.

In the U.S., The Fed doesn't have the power to tell banks what interest rate to charge

customers. So instead, The Fed manipulates interest rates by changing the money supply.

If The Fed increases the money supply, there'll be plenty of money for banks to loan out.

Borrowers will shop around for the best deal on a loan, and banks will be forced to lower

interest rates because they're gonna have to compete or else no one's gonna borrow from them.

A decrease in money supply has the opposite effect. Less money supply means the banks

have less money to loan out, so they're gonna try and get the highest interest rate possible.

So less money -- higher interest rates.

If the central bank wants to speed up the economy, they can increase the money supply,

which will decrease interest rates, and lead to more borrowing and spending.

That's called Expansionary Monetary Policy.

If the central bank wants to slow down the economy, they decrease the money supply -- less money

available will increase interest rates and decrease spending. That's called Contractionary Monetary Policy.

Adriene: Here's some real life examples.

After the Dot Com bust and then 9-11, the U.S. economy was in a slump or a recessionary

gap. Output was low, and unemployment was high.

To speed up the economy, The Fed boosted the money supply, which lowered interest rates.

This made borrowing easier, which increased spending, and as a result, the economy began

growing again, albeit slowly.

Here's another example. In the late 1970s, prices were rising up to 13% per year. Inflation

is usually more like two to four percent. The Fed Chairman, Paul Volker, decreased the

money supply, causing interest rates to shoot up.

People bought fewer homes and cars, and businesses invested less. Contractionary Monetary Policy

drove down inflation, but with the downside of increasing unemployment.

There are just no easy answers here... sorry.

During The Great Depression though, The Fed blew it! 73 years later, Fed Chairman, Ben

Bernanke admitted, "We did it. We're very sorry. We won't do it again."

So what did The Fed do wrong?

Well there are two things that keep the banking system healthy - confidence and liquidity.

When customers deposit money in a bank, they need to feel confident they're gonna get their money back.

In the early years of The Great Depression, The Fed allowed several large bank to fail,

which caused widespread panic and bank runs in other banks. The result was a third of all banks collapsed.

The banks failed because they didn't have Liquid Assets, which is a fancypants way of

saying the banks had stock, bonds, mortgages, but not cash money. So when depositors rushed

to take money out, the banks couldn't pay.

The Fed gets blamed for prolonging The Depression because it didn't give banks emergency loans,

which would've increased the liquidity in banks and the money supply in general.

But how does a central bank change the money supply? In the U.S., there are three main

ways. Let's go to the Thought Bubble...

Jacob: When you deposit money in a bank, the bank holds a portion of deposits and loans

the rest out. This is called Fractional Reserve Banking. The fraction deposits the banks

are required to hold in reserves is conveniently called the Reserve Requirement. The first way

The Fed can change the money supply is by changing that requirement. Decreasing the Reserve Requirement

will increase the money supply, and increasing the Reserve Requirement decreases the money supply.

The Fed is the banker's bank, so if a commercial bank needs money, they can borrow from The Fed.

The second thing The Fed can do to change the money supply is to change the interest

rate that it charges banks. That interest rate is called the Discount Rate. Decreasing

the Discount Rate will make it easier for banks to borrow, and that'll increase the

money supply. Increasing that rate will decrease the money supply.

The third way to change the money supply is difficult because it requires Janet Yellen

to get approval from the Illuminati, the secret cabal that runs the world.

Nah, I'm just kidding.

The third method is called Open Market Operations. This is when The Federal Reserve buys or sells

short term government bonds.

Now a government bond, or something called a treasury bill, is an IOU issued by the government

that says, "I'll pay you back later." Banks hold those bonds because they earn interest

and are generally less risky than stocks.

If The Fed buys these previously issued government bonds from a bank, it increases that bank's

liquidity and increases the money supply. If The Fed issues more bonds, the banks will

have less liquidity and less money to loan out, and that'll decrease the money supply.

In the U.S., deciding how many bonds to buy and sell is done by the Federal Open Market Committee.

Adriene: Thanks Thought Bubble!

With these options at its disposal, The Fed can increase or decrease the money supply

pretty darn quick. The option they use most often is Open Market Operations.

During the 2008 financial crisis, when the economy was in severe recession, The Fed went

straight to work, buying massive of bonds. Boosting the money supply and dropping interest

rates to practically zero.

But it wasn't enough - the economy was still in bad shape, so The Fed did something very

uncommon in the history of central banks.

It increased its monetary stimulus through something called Quantitative Easing. We call

it Q.E. at work because Q.E. rolls off the tongue more easily than Quantitative Easing.

Plus, who knows how to spell quantitative?

Basically it's when central banks buy up longer term assets from banks. So not only was The

Fed buying regular treasury bills, it was also buying things like home loans aka Mortgage Backed Securities.

They did all this with made-up money. This Q.E. has raised worries about massive inflation.

When you add a lot of made-up money to the economy, prices can rise.

Milton Friedman observed, "Inflation is always and everywhere a monetary phenomenon."

So if The Fed has been increasing the money supply steadily since 2008, why has the actual

inflation rate stayed so low?

Of course, as always, the answer is complicated.

Many economists say it's because banks haven't loaned out the money. Remember, banks have

to hold about 10% of their deposits in reserve. The other 90% is called Excess Reserves - pretty

straightforward - which is basically the amount that banks are free to loan out.

Under normal conditions, banks would prefer not to hold a lot of excess reserves because

holding money doesn't make money. But since 2008, excess reserves skyrocketed. This means

that banks held the money, and it never really got into the system.

Why? Some say it's the stricter lending regulations. But also, borrowing a bunch of money for a

house seemed a lot scarier.

Others suggest that low inflation in the U.S. is the result of uncertainty in Europe, and

that's caused foreigners to hold dollars. Some argue that it's because the economy is still sputtering.

One thing's for sure, as the economy continues to pick up speed, we'll see The Fed clamping

down on the money supply to increase interest rates.

After all, it's The Fed's job to take away the punch bowl just as the party's getting started.

Jacob: So now we've talked about the two main ways economists speed up or slow down the

economy. Fiscal policy, which is changing government spending or taxes, and now monetary

policy, which is changing the money supply.

In an ideal world, the economy would always be perfect, and we wouldn't need these tools.

But the world isn't perfect, so sometimes, intervention is necessary. So which one is better?

Well, like any clear, unambiguous question in economics, the answer is... it depends.

It depends on the severity of the slump. Many economists argue that for your garden variety

fluctuations, monetary policy is more effective. It's usually enacted quickly by experts whose

only job is to focus on the state of the economy.

But in a very severe downturn, fiscal policy might become much more effective. In 2008,

the United States did both.

It also depends on whether your country's central bank is tangled up in politics. The

U.S. and many other developed nations have worked hard to isolate their central banks

from politicians who might be shortsighted.

The result is that monetary policy generally works and doesn't have a lot of side effects.

Adriene: So the next time you see Janet Yellen in a magazine, listed as one of the most influential

people, you can shout, "Hey! I know who that is, and I know what she does!"

The people in your dentist office might freak out, but maybe not.

Jacob: Maybe they watch Crash Course Economics.

Adriene: Thanks for watching - we'll see you next week.

Jacob: Thanks for watching Crash Course Economics. It was made with the help of all of these nice people.

Now, if you want to support Crash Course as open market operations, head on over to Patreon.

It's a voluntary subscription platform that allows you to pay whatever you want monthly

to help Crash Course be free for everyone... forever.

Thanks for watching! DFTBA