Tools and theories of economic policy 559If an investor thinks that inflation will increase from 3 percent to 6 percent over the next
five years, the investor will demand a higher interest rate for lending his or her money
to the government or a corporation than if he or she thinks inflation will hold steady at
about 3 percent.
The third tool that the Fed uses to meet its monetary targets is open market
operations—the buying and selling of securities. This is the Fed’s most important tool
because it influences the FFR and the level of bank reserves and thus the money supply.
If the Fed wants to increase the money supply and put downward pressure on the FFR,
it will purchase securities such as government bonds from a bank. The bank gives the
Fed its bonds, and the Fed deposits the appropriate amount of money into the bank’s
account at the Fed. The bank can use this money to support new loans.
Where does the Fed get its money to buy the bonds from the bank? Well, the Fed
simply creates the money. You probably have heard the claim that if the government
wanted to, it could just “print money” to pay for its programs and policies. That claim
is literally true, but it would be completely irresponsible. Any government that would
run the printing presses to pay for its programs, rather than raising the money through
taxes, fees, and borrowing, would soon find itself with hyperinflation as experienced
in Germany, Poland, Austria, and Hungary after World War I. (The worst inflation
ever recorded was in Hungary after World War II: between July 1945 and August
1946, prices rose by a factor of 30,000,000,000,000,000,000,000,000!)^50 Our
government prints money only to meet the demand for currency from its member
banks. However, the Fed’s purchase of a government security is like “printing money”
and has the same potential inflationary impact, so this powerful tool must be used
only when new money is needed in the system. The tool may also be used to contract
the money supply or raise interest rates; if this is the desired outcome, the Fed will sell
government securities. The member bank will give the Fed money to cover the cost of
the bond and therefore take money out of circulation.
In 2008, the supply of new money in the economy was significantly limited as a
result of the subprime mortgage market meltdown and related problems in the bond
markets. As we noted above, Fed chair Ben Bernanke responded to this “credit crunch”
by “flooding the street with money,” just as the famous banker Benjamin Strong had
advocated as the appropriate response to the Great Depression.^51 The Fed increased
its assets from $927 billion on September 10, 2008, to an eye-popping $2.26 trillion
by November 11, 2008. Assets held by the Fed, mostly government securities and
mortgage-backed securities, peaked at $4.5 trillion in October 2015 and have fallen
since.^52 This unprecedented intervention in the financial sector clearly prevented
a serious crisis, but as noted, critics argue that the Fed has become a too powerful,
unaccountable player in economic policy making.Regulatory Policy
Government regulation has a huge impact on the economy. For example, the federal
government regulates the quality of food and water, the safety of workplaces and
airspaces, and the integrity of the banking and finance system. In general, regulations
address market failures such as monopolies, imperfect information, and negative
externalities (which we’ll discuss later in the chapter). There are two main types of
regulation: economic and social. Economic regulation sets prices or conditions for entry
of firms into an industry, whereas social regulation addresses issues of quality and safety.^53Economic and Social Regulation A common type of economic regulation concerns
price regulation of monopolies. A monopoly occurs when a single firm controls theopen market operations
The process by which the Federal
Reserve System buys and sells
securities to influence the money
supply.The Fed owns$2.54 trillion
in U.S. Treasury securities, which
is slightly more than the U.S. debt
owned by China and Japan combined.
Source: FederalReserve.govDID YOU KNOW?
Hyperinflation in Germany, Hungary,
and other parts of Europe between the
two world wars was so high that some
countries’ currency became essentially
worthless. In Germany in 1923, it was
cheaper to burn money than to buy
wood, as this woman demonstrates—
using several million deutsche marks
as kindling.Full_16_APT_64431_ch15_530-571.indd 559 15/11/18 2:34 PM