The Federal government has limited options to address economic issues. These are generally described as “Fiscal policy” and “Monetary Policy.” In the most general terms, fiscal policy involves government tax and spend programs. The underlying theory is that tax cuts increase consumers spending ability by leaving consumers with more money and government spending provides a more direct stimulus by injecting money into the economy. Fiscal policy is generally identified under the popular “Keynesian Economics” label.
Monetary policy, on the other hand, involves the central bank (the Federal Reserve Bank system, or “the Fed”) “adjusting” the money supply through interest rate and reserve requirement policies. The Fed affects the money supply indirectly by adjusting the interest rate they charge to member banks for short term (“overnight”) loans. When rates go down banks respond by lowering their rates to consumers thereby making loans more attractive. This policy also has a direct impact on housing as mortgage rates rise or fall.
The most direct way for the Fed to affect the money supply is to adjust the reserve requirement. Banks are required to have a certain level of cash on hand to meet possible demands. The reserve requirement, in turn, is set as a portion of the demand deposits (checking and passbook savings accounts) being carried on the books. In other words, the bank must have sufficient cash on hand to meet a reasonably anticipated customer demand. Any excess of cash on hand above the reserve requirement represents cash that is available to loan.
The Ecoville Bank is in excellent shape. With $99,000 in demand deposits against cash on hand of $33,000 they are currently in a reserve position of 33%. Since the existing Reserve requirement is 10%, Ecoville is only required to maintain $9,900 in cash. They could make a new loan of $23,100 today and still be compliant with the existing rules. If we assume a velocity of money factor of 5 this would result in the injection of $115,500 into the nation’s economy. This is clearly a very conservative bank with management requiring significant cash reserves well above the minimum required under regulations.
If the reserve requirement was lowered to 8% the impact on Ecoville, given the current state of its balance sheet, would be to reduce the reserve requirement on the demand deposits to $7,920. This simple adjustment raises the amount available to loan to $25,080. With that velocity factor of 5, impact to the economy would be $125,400.
Thus far we have discussed an expansionary policy. If the Fed decided that the economy was “overheated,” typically indicated by an inflation rate climbing above a “target,” the Fed might move to “cool down” the economy. The standing Fed target is 2% (Why does the Federal Reserve aim for 2 percent inflation over time?) and therefore if inflation was to rise to, for example, 2.5% the Fed could establish the reserve requirement at 15%. This would increase the reserve requirement for Ecoville to $14,850 leaving only $18,150 to make new loans for an overall impact on the economy of $90,750.
The actual velocity of money, historically, has been well below 5. In the 55 years since 1960 this factor has ranged from a high of 2.2 to a low of 1.5 (Velocity of M2 Money Stock). The lower factor was seen in 2015 and represents a steady decline from 2007 suggesting that in unsettled times people are reluctant to spend. Ultimately, of course, the Fed could raise the reserve requirement to 100% effectively ending private lending.
The virtue of monetary policy is that it relies on private sector decision making to either stimulate or slow down the economy. By adjusting interest rates or reserve requirements the Fed makes cash available to lend or, conversely, reduces the amount of cash available to lend. All due diligence, underwriting, project review, site visits and the rest of the factors involved in making lending decisions remain in the hands of private banks. As Thomas Sowell points out repeatedly in Basic Economics, when it comes to allocating scarce resources for which there are alternative uses, markets work much more efficiently than any other system.
References
Sowell, T. Basic Economics: A Common Sense Guide to Understanding the Economy (6th Edition). (2011). Basic Books, New York, NY. Kindle Edition.
Velocity of M2 Money Stock. (2016). Federal Reserve Bank of St. Louis Economic Research. Retrieved from https://fred.stlouisfed.org/series/M2V
Why does the Federal Reserve aim for 2 percent inflation over time? (26 January 2015). Board of Governors of the Federal Reserve System. Retrieved from https://www.federalreserve.gov/faqs/economy_14400.htm
