Mixed Moss

Economics lesson for the day:

Today it was announced that the Federal Reserve is expected to raise the discount rate by 0.25%, and to follow it up with several similar small hikes over the next few years. So what, you ask? Well, so a lot.

First, some brief background, so you know why the Fed cares about the discount rate and why it affects you. Take out a dollar bill and look at it. What does it say across the top? “Federal Reserve Note.” You see the treasury just makes the paper, prints the bills, mints coins, and checks for counterfeiting. They don’t actually make any decisions. The Federal Reserve Board makes the decisions. When you want a loan, you go to your bank. But when your bank wants a loan, it goes to the Federal Reserve. Of course your bank doesn’t keep all of the money you deposit with them in the back at all times, like the gold in the vaults of Gringott’s Bank in Harry Potter. It lends it out to other people. So to be safe The Fed also requires banks to keep a certain amount of the money they have on deposit with them on deposit with the Feds. This is known as “reserves.”

Now that we have that out of the way…There’s this thing called the Money Supply. A whole lot of different kinds of money are included in it. But the part of it we care about for this discussion is called the Monetary Base. It consists of Federal Reserve Notes (Cash) in circulation + Reserves + treasury currency (mainly coins). This is the money that’s out there getting used by banks and firms and people a lot, and it is called “High-Powered money”, because there is a process called Multiple Deposit Creation by which it creates more money. This process is too complicated to explain here and has to do with the velocity of money (how fast money turns over through different transactions). Iknow, I know, all of this sounds as though it should be against some law of thermodynamics, but hey, Economics is a social science. They are squishier than the pure sciences, and have less to do with math and matter.

Now, the Fed doesn’t always like all sorts of high powered money circulating and creating more money. It can lead to inflation at times. Inflation is their biggest fear. Understand that if people aren’t sure what a dollar is going to be worth tomorrow, they tend to freak out and not do anything with that dollar. Should they spend it? Put it in bonds? Put it in the bank? They don’t know. Uncertainty is bad for the economy; therefore inflation is generally considered bad. So the Fed likes to keep a leash on the Monetary Base. The way they do this is through controlling the amount of high powered money– by attempting to affect the desirability of banks to borrow money from them through either raising or lowering the ‘discount rate.’ The discount rate is the interest rate the Federal Reserve charges on the money (or “reserves” they loan to banks. So when the interest the banks have to pay on money goes up, they in turn raise the interest people and firms have to pay to borrow that money from the bank. This leads to an increase in interest rates pretty much across the board.

Of course, that said, Econ is after all a social science, which means it relies on the bahavior of people and people, my friend, are quite possibly the least predictable animals on the planet. This makes Economics, as a science, far from exact. And noted economists have been known to state that the history of the Federal Reserve is a history of mistakes. They may screw up yet again.

What’s the bottom line? Pay off your student loans as quickly as possible. Don’t borrow new money. Don’t take out homeowner’s equity. Don’t buy bonds. And do put any large quantities of money you have sitting around that you probably won’t have to use for a while into CDs at the bank (no, not Compact Discs, silly, Certificates of Deposit).

Happy economizing.

This entry was posted on Wednesday, June 30th, 2004 at 7:47 pm and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.