Brandon Palmer
Jay Mutter
Intermediate Macroeconomics
1 May 2013
Federal Reserve Monetary Policy
Going back to the 1980's there has been five recessions according to the National Bureau of Economic Research. Since the creation of the Federal Reserve system in 1913, there has been a large increase of perceived power of the central bank. Monetary policy has been a big tool in how the Federal Reserve has attempted to bring the United States out many recessions.
In the recessions of the 1980's, there were a recessions partially due to the actions of Paul Volcker. This was done by the fact that Volcker had chosen to raise interest rates in order to fight inflation of the 70's (Federal Reserve). While it was both a drastic move, and painful in the short term, it has really helped remove most inflation. Before Volcker had raised interest rates, inflation was in the double digits (Federal Reserve). Since then, we have seen single digit inflation. The early 1980s recession was largely caused by the energy crisis of 1979. Again, Volcker had chosen to fight inflation with low interest rates. This hurt the economy once again. Also during the 1980s, there was the Monetary Control Act of 1980. It required the Fed to price it's financial services competitively against the private sector.
Alan Greenspan was the Reserve chairman during many of the recessions that have happened since the 1980's. The first one of his term being in the 1990's. This was a relatively short lived recession, and viewed as a result of the Gulf War beginning (Walsh). The Gulf War had led to a spike in the price of oil (Walsh). The previous actions of the Federal Reserve, those to combat inflation slowed down the economy too much for the oil spike. Overall, from the 1990's to about 2001 was seen as a great success for monetary policy. In general, the Federal Reserve spent much of the time lowering interest rates rapidly to solve recessions.
Again, Alan Greenspan was the chairman during the recession of the early 2000's. This was due in part to the collapse of the dot-com bubble, a fall in business outlays and investments, and the September 11th attacks (Hall). This was also a brief recession in comparison to others. The Federal Reserve had announced a statement saying, “The Federal Reserve System is open and operating. The discount window is available to meet liquidity needs.” The Fed once again began to lower interest rates and loan money in order to get the economy back on track. The Fed actually loaned $45 billion to financial institutions to provide the stability needed.
The recent recession, that of 2007 to 2009 was caused by subprime mortgages (Federal Reserve).. By luck, Greenspan was out of office and didn't see the result of what could have been in part of his policies. Either way, the easy money that was accessible in the the early 2000's, and Ben Bernanke would be the chairman of the Federal Reserve to see the fall. Home ownership was much more possible than it ever was. The easy credit allowed for the demand of housing go up, and also push up the prices of houses. Housing prices began to fall around 2006, and then led to people owing more than their house was worth. Many of these bad mortgages were packed as securities and sold across the world. This meant the true burst of the bubble in the housing market. The markets essentially stopped. The Federal Reserve had then created lending to financial institutions to continue day to day operations. The Federal Reserve feared what was viewed as a possible domino effect. They believed that if one financial institution collapsed, another would follow suit. What actually appeared to happen was banks buying failing institutions. In order to respond to the crisis, the Federal Open Market Committee slashed its target for the federal funds rate to nearly 0. This helped lower the cost for borrowing for homes. The Federal Reserve also chose to purchase many of the mortgage backed securities. They bought a total of $1.25 trillion of those securities.
As of recent, The Federal Reserve system has become more open. Therefore, more of what the Federal Open Market Committee has done is available to read. Alan Greenspan, shortly before he was on his way out, stated that an open federal reserve may actually help the effectiveness of monetary policy. Now, Ben Bernanke has the most open system we have ever seen, and it appears that the monetary policies of the past aren’t helping. This leads one to think of many possible reasons as to why the policy of lowering interest rates hasn’t helped. One being that monetary policy really isn’t as effective as people believed it was. Maybe it was simply the faith people had in that lead the economy to bounce back. Another possiblity being that maybe openness of the Fed may actually cause an adverse effect to the monetary policy effects. If the policies worked previously when the Fed was relatively closed, maybe the openness changes the way people view the market. A third possiblity could also be that the economy now is going through a structural change, and what worked years ago, is now less effective. No matter the reason for the decrease of effectiveness, we have begun looking at monetary policy a bit differently.
Greenspan during a speech during the dot-com bubble, said,
“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”
While a bit difficult for many to understand, it appears he was talking about how a low interest rate can boost the economy. Not even just to boost an economy, but it can cause assets to raise without any real economic foundation for doing so. It appears that Greenspan had more faith in the abillity of monetary policy.
Above is a graph of the federal funds rate and money stock, both M1 and M2. The M1 would be the money in cash or coin outside of the banking system plus demand deposits, travelers checks and other check deposits. M2 is M1 and savings accounts, money market accounts, mutual funds, and certificates of deposits. These are measured on on the right hand side of the graph. As you can see, whether in recession or not, the Federal Reserve has increased money supply. Looking at the recession in around 2008, the M2 stock increases more sharply than usual. This is likely the fact that money was put into the financial system to prop up the economy. It was expected that loans would be given out as bank now had more money to work with. So, an increased supply of money, and a low prime rate was supposed to enhance money flow. For whatever the reason, this hasn’t been the case. It appears that the monetary policies have lost their effectiveness. Looking at the federal funds rate, it appears like that was the solution to many of the previous recessions. Whenever the economy went into recession, a decrease was made in the funds rate, and the economy recovered. At this point, though, even keeping the rate as close to zero as possible hasn’t helped. In the end, it is surprising to see that the policies of the past are no longer a solution. Bernanke has been put in a tough spot as the economy isn’t recovering in the same way it did with his predecessors. One can only hope that something sparks the economy again. It may need to be done fiscally as it appears to be the only option left.
Works Cited
Hall, Robert, et al. "The business-cycle peak of March 2001." Business Cycle Dating Committee, National Bureau of Economic Research (2001).
Federal Reserve. “History of the Federal Reserve”. Web. 5 May 2013. <
Walsh, Carl E. "What caused the 1990-1991 recession?." Economic Review (1993): 33-48.