One Boy that Rules Them All

In last week’s post, a big name was mentioned, but not looked into. If you had really thought about the money multiplier, you would realize that what decides the magnitude of this money generator seems to be only one number that is decided by one institution so powerful that it rules all the banks in the United States, including those “giants” that are worth more than 10 billions.

The number is of course the Federal Reserve Rate, and the institution, that we will talk about today, is the Federal Reserve System.

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One major confrontation between Capitalism and Socialism is their economy form. Capitalism believes in market economy which gives all economic entities freedom and respects the spontaneity of the market; while Socialism promotes command economy which has the government take a certain amount control over the economic activities. However, it has been a long long time that Karl Marx wrote his works, and the definition and practices of both types of economies have gradually changed overtime. It would be ignorant to still differentiate Socialism and Capitalism by soley comparing the freedom in their economies, because in fact, China has been practicing what I would like to call Market Economy ft. Socialism (Socialist market economy) and the freedom in the US economy is only a relative term.

I believe in the utility of government interference in economy. In fact, government is like an insurance to all economic activities. Even though government interference can hamper the economic development, without it, the price people had paid (and are still paying) for the 2008 economic crisis would have been much higher. Federal Reserve System is one of the government institutions that affects the economy with its decisions. Its mission is to the direct the economy to a faster and safer lane.

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Beside Federal Reserve Rate, which essentially determines the utility of the money multiplier, the Federal Reserve has another weapon that also controls the growth of the economy: the Federal Funds Rate. The Federal Funds Rate is the interest rate banks are allowed to charge when they borrow and lend money from each other. Why do banks need to borrow money from other banks? Remember there is a reserve requirement that is set by the Federal reserve? Every bank has to reach the requirement at the end of the day and when they are short of reserves they can borrow money from banks that have extra money. The money is usually only borrowed over night and paid back immediately the next day.

So how does this seemingly trivial interest rate that doesn’t even affect firms or individuals directly regulate the growth of an economy? Let’s suppose the Federal Funds Rate is very high, what will the banks react to the situation. They will try to satisfy the reserve rate everyday by themselves, because if they had to borrow from other banks, they will lose a lot to the interest. Moreover, they will try to leave some excess money everyday, so that if some other banks need to borrow money, they can make profits from the interests. Therefore, banks will lend less to their customers during the day. If the Federal Reserve also raises the Federal Reserve rate at the same time, then the only way for banks to make profit is by increasing their interest rate to the public. With the banks lending less at a higher interest rate, firms and entrepreneurs are discouraged to make further investments. Ultimately, growth of the economy is slowed down.

Now why do we want the economy to slow down? The reason is a very familiar phrase: inflation. What does inflation have to do with fast growing economy, you might ask? With no major production or service increase, fast growing economy means that people have more money but only the exact same amount of goods to purchase. The consequence is obvious: prices go up. When inflations occur, or when we can see indicators of an upcoming inflation, the Federal Reserve would use its tools to slow the economy down so that the price level could stay stable. grocery-inflation

I know you want to ask why is inflation a bad thing. It isn’t until its accelerating at a high pace. Think about why inflation is dangerous. I don’t have the space to talk about it here. Talk to me if you really want to know.

Conversely, when the Federal Reserve lowers the Federal Funds rate, banks are more encouraged to lend out money to firms and individuals. With more money available, people are more inclined to consume and invest, which greatly boosts the economy. The Federal Funds rate has been effectively zero since 2008. We all know what happened then, and ever since the Federal Reserve has been stimulating the economy by essentially giving the public more money.

Next time when you watch the news talking about raising the reserve, or lowering the fund rate, hopefully, you will know what is will happen to the economy.

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