Mar 12 2008

Helicopter Ben and Monetary Policy: the cartoon version!

Monetary Policy

Much hoopla is made over the US Federal Reserve’s power to affect markets through its injections of liquidity into the economy. These days, the Fed appears to have some new tricks up its sleeve, but still uses its traditionally dominant tool of Open Market Operations to affect the Federal Funds rate, and thus the interest rates that commercial banks charge borrowers financing consumption and investment.

The power of monetary policy lies in the fact that spending stimulus can be achieved without running the risk of crowding-out, wherein expansionary fiscal policy drives up interest rates, potentially off-setting any increases in aggregate demand by triggering declines in consumption and investment due to increased borrowing costs.The whole aim of expansionary monetary policy, on the other hand, is to drive interest down by increasing the reserves held by commercial banks.

The cartoon above illustrates the process that leads to lower interest rates and greater spending when the Fed undertakes expansionary open market operations. Government bonds (the blue bills above) are held as assets by both commercial banks and the public. These are illiquid, meaning they cannot be spent. In order to stimulate new spending, the Fed can take some of its reserves of money (the green bills), and buy bonds from the public and banks.

Banks receive cash from the Fed, which increases their excess reserves. Further, the public will deposit the checks they receive from the Fed into their banks, increasing checkable deposits, which add to both the banks’ required reserves and excess reserves. The result is banks now have new liquidity that they want desperately to lend out in order to earn interest (remember, banks rarely want to hold onto their excess reserves, because inflation will erode the value of any money that’s not earning interest!).

When banks’ reserves increase, due to their growing checkable deposits and the inflow of cash from the Fed’s purchase of bonds, the supply of “federal funds” shifts down, lowering the interest rates that banks charge one another for overnight loans. These are loans that banks often give and receive in order to meet their reserve requirements at the end of a business day.

For example: If Bank A has finds at the end of the day that it has received more deposits than withdrawals, and it now has $1m more in its reserves than it is required to have, it wants to lend that money out as soon as possible to earn interest on it. Bank B, it just so happens, received more withdrawals than it did deposits during the day, and is $1m short of its required reserves at day’s end. Bank B can borrow Bank A’s excess reserves in order to meet its reserve requirement. Bank A will not lend it for free, however, and the rate it charges is called the “federal funds” rate, since banks’ reserves are held predominantly by their district’s Federal Reserve Bank.Federal Funds market

When the Fed buys bonds, all banks experience an increase in their reserves, meaning the supply of federal funds shifts out (or down in the graph above), lowering the “price” of federal funds, i.e. the federal funds rate. Lower interest rates on overnight loans will encourage banks to be more generous in their lending activity, allowing them to lower the prime interest rate (the rate they charge their most credit-worthy borrowers), which in turn should have a downward effect on all other interest rates.

Expansionary monetary policy involves the buying of government bonds on from the public and commercial banks by the Federal Reserve Bank. The result of this buying of bonds is an increase in the money supply, a decrease in real interest rates, and hopefully the stimulus of aggregate demand through new consumption and investment. Unlike expansionary fiscal policy (such as the stimulus package announced by Congress last month), crowding-out should not occur. Ideally, lowering the federal funds rate will lead to lower interest rates across the economy as a whole.

This, however, does not always transpire. In a future post, we’ll discuss why, and look at what the Fed is experimenting with today to stimulate investment and consumption, in response to the apparent failure of open market operations at providing the needed stimulus.

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

34 responses so far

34 Responses to “Helicopter Ben and Monetary Policy: the cartoon version!”

  1. Christina Huon 15 Mar 2008 at 10:43 pm

    heeheehee, I LOVE how his torso looks like a bowling ball.

  2. optional.xuon 16 Mar 2008 at 12:52 am

    Even if the Fed increases the money supply by buying bonds, what if the banks EXPECT that people are not going to be able to repay their loans and thus, do not want to lend out as much of the money? I mean then, interest rates would remain high.

    I understand that banks want to lend out as much as they can because thats how they make money (and money loses value over time). But if there is the expectation that borrowers will not be able to pay back their money (e.g. credit crunch), wouldn't banks not want to loan it out regardless of the Federal Funds Rate?

    Just curious.

  3. T. Sunon 16 Mar 2008 at 6:03 pm

    "Even if the Fed increases the money supply by buying bonds, what if the banks EXPECT that people are not going to be able to repay their loans and thus, do not want to lend out as much of the money? I mean then, interest rates would remain high."

    Ceteris paribus.

  4. judychenon 16 Mar 2008 at 11:02 pm

    Monetary policy is good when there's a recession and inflation. But when I was studying for the test, I realized maybe it is not that good after all when a nation encouters both recession and inflation. As in inflation, we want to stablize the price level, so we can't use expansionary OMO. However, in recession, we want to use expansionary OMO. So it's not work at the end.

  5. emilyyehon 16 Mar 2008 at 11:25 pm

    I guess there's a good side and bad side to everything, and monetary policy can't be the solution to all of macroeconomics problems. I mean, the Fed can't solve all of America's economic problems with lower interest rates. For instance, how would that affect unemployment due to global outsourcing? American workers perhaps need to learn to accept lower wages rather than no wage at all.

  6. Jeewonon 16 Mar 2008 at 11:33 pm

    The cartoon above is a very good illustration of the Fed's importance in the economy, as it controls the money supply. I agree with Emily that monetary policies can't be the solution to all problems, yet the Fed is fairly effective when the economy is in recession or inflation. It's surprising how the Fed can encourage consumption and investment by simply buying bonds from the commercial banks and the public. What would happen to the U.S. economy without the Fed and Helicopter Ben??

  7. andyxuon 17 Mar 2008 at 6:33 pm

    The picture above does an excellent job of illustrating the cycle of money in regards to the fed, commercial banks and households.

    Many would agree that monetary policy is a more effective means of aiding the economy in times of recession or inflation.

  8. kevinchiuon 17 Mar 2008 at 6:50 pm

    Yeah, I saw the rough draft of the cartoon in its makings.. it was epic. Interesting… Since expansionary monetary policy can drive down interest rates by increasing money supply, doesn't that mean if we combine it with expansionary fiscal policy, we will have less of a crowding-out effect?

  9. Kristie Chungon 17 Mar 2008 at 7:33 pm

    I think that the cartoon does a great job showing the role of the Federal Reserve. The open market operations is clearly illustrated in the cartoon.

  10. Conrad Liuon 17 Mar 2008 at 7:55 pm

    In regard to Kevin Chiu's question, I dunno if I'm answering it correctly, but I think that combining both expansionary fiscal policy and expansionary monetary policy will create a high level of inflation, since the government is investing while the money supply increases even more. Someone tell me the right answer if I'm wrong though…

  11. KatherineYangon 17 Mar 2008 at 8:15 pm

    The monetary policy certainly does seem to be an ingeneous way for the Fed to help manage the economy, but I still wonder what would happen if nothing were done. Wouldn't things level back out to the way they were?

  12. claire425on 17 Mar 2008 at 8:22 pm

    Although the fiscal policy might not be the most helpful method due to its negative effects, still, to lower the interest rate it would be a crucial mean.

  13. Alex Goldmanon 17 Mar 2008 at 8:46 pm

    Are open market operations favored by people who look reduce governments role in the economy, or people who wish to increase the governments role? After all,the fed is a quasi-public institution.

  14. howard linon 17 Mar 2008 at 9:51 pm

    Well i guess the failure part of the OMO expansionary monetary policy would be that…since the country is currently experiencing inflation and recession at the same time, the real d income is decreasing, the public will not be able to pay the money back, thus would later on create a decrease in value of money. so this OMO would be a short term solution but create more problems later on?!

  15. MichaelChowon 17 Mar 2008 at 10:47 pm

    The Federal Reserve Bank's essential aspect that sets it aside as being powerful is indeed the Opened Market Operations, this is used when an inflation or recession occurs. I agree with Howard how the public will not be able to pay the money back which leads to a decrease in the value of money. But I also do believe that OMO can eventually help the long run as well as the short run in the sense that it can help fix problems gradually.

  16. kevinyehon 17 Mar 2008 at 11:36 pm

    Well the whole point of the OMOs are that they create money for the economy by placing money in the hands of commercial banks and the public, driving down interest rates AND increasing disposable income. That's actually two factors of the four possible methods of spending. So OMOs should be pretty effective unless recession is REALLY bad. Also, it's easier for the short run because bonds are more flexible than say, the reserve ratio or discount rate.

  17. Charlie.Gaoon 18 Mar 2008 at 12:57 am

    Personally I think monetary policy is better than fiscal policy because fiscal policy requires mutual consent among government officials and need to hold meetings whereas monetary policy is directed by one man who can make changes overnight.

  18. Annie Sungon 18 Mar 2008 at 4:31 pm

    I agree with Charlie that monetary policy may be effective as it's only directed by one person, but fiscal policy involves other individuals and agencies as well, making it a more collective agreement. Nevertheless, like Emily said, there are good and bad sides to both, and the country needs both.

  19. serenatuon 18 Mar 2008 at 8:42 pm

    Even though monetary policy has its good and bad side, it's still really effective and efficient on fixing the economic problems. Fiscal policy takes a longer time to really be effective.

  20. Mondon 18 Mar 2008 at 9:39 pm

    The drawing of the Fed looks like a hobo. I agree that both monetary policy and fiscal policy are needed in a country to achieve economic stability.

  21. Drew Venkatramanon 18 Mar 2008 at 10:34 pm

    The fed, can increase its money supply and hope for the best but i believe now more than ever, Americans are going to be cautious while spending so their ideas might not work. Now new developments have been made and the fed has decided to cut interest rates which i believe will be truly more effective.

  22. julie.linon 19 Mar 2008 at 12:26 am

    "I agree that both monetary policy and fiscal policy are needed in a country to achieve economic stability."

    i agree with what mond agrees with.

  23. Jessicaon 19 Mar 2008 at 12:49 am

    Its interesting how everything is connected. I think David has a good point that banks probably wouldn't want to lend money if people weren't paying it back. However, I guess they have to lend out at least a certain amount or else the money supply would decrease, which would cause other problems.

  24. jenniferchoion 19 Mar 2008 at 7:35 am

    The fed, by changing the monetary policy, will have positive and negative aspects. But as people have said, we need both monetary policy and fiscal policy to achieve economic stability.

  25. Dana Y.on 20 Mar 2008 at 12:30 am

    It is fascinating how there are two policies to govern economic stability: that of fiscal policy and the monetary policy. However, I believe monetary policy is more effective as fiscal policies not only require mutual consent but may also come across crowding out effect.

  26. antijapon 11 Apr 2008 at 9:06 am

    Dear Sir,

    Remember Pearl Harbor!

    Boycott Japanese goods and capitals!

    Buy American!

    Raise the Yen value!

    Very sincerely yours,

  27. Jason Welkeron 11 Apr 2008 at 9:45 am

    Dear "antijap", Your proposed boycott of Japanese goods, I'm afraid, would have the exact opposite effect on the yen's value that you hope for. If you had ever taken an econ class, you'd know that the value of a country's currency is determined by the demand for that country's goods. If Americans boycotted Japanese imports, the value of the yen would plummet, making America's products more expensive to Japanese consumers. An American boycott of Japanese products would harm American producers and lead to rising unemployment in the US, since Japanese will be less able to purchase our output after the yen falls in value.

    I'm afraid "remembering pearl harbor" will do no good for either Japan or the US in today's global economy.

  28. Jasonon 15 Aug 2008 at 6:11 am

    Nice. We need to get Bernanke and Greenspan to make a cartoon version of you. Then the circle of anima-nomics will be complete. And, anima-nomics will finally be a word!

  29. ArthP Dannyon 01 Apr 2009 at 9:37 pm

    Our opinion is that if the government keeps spending, a monetary policy will help in the short-run but, correct us if we are wrong, in the long-run, even with a combination of afiscal and monetary policy, the economy will gradually fall.

  30. Bjorn Bon 09 Feb 2010 at 2:47 am

    Interestingly, the diagram illustrates Bernanke throwing away a lot more money than bonds (while it is the Fed's role to both buy and sell bonds), which supports the common misoconception of him throwing away all of the tax-payer's money. In the long run however, (at least in theory) the amount of bonds that the Fed has issued should equal the amount of bonds it buys off of the people. This however cannot be the case in todays financial situation, when the USA's debt is greater than ever, and the economy is only slowly coming out of a recession. In the USA's current situation, it may even have been more accurate if Bernanke was only throwing out bonds to finance the USA's growing debt 🙂

    P.S: I like your answer to antijap Mr. Welker 😉

  31. Bjorn Kvaaleon 09 Feb 2010 at 11:02 pm

    Monetary policy is very important in economics because it can change the amount of aggregate demand, depending on expansionary or contractionary monetary policies. If the Fed wishes to increase AD due to a recession, it can increase the supply of money by buying bonds from the people, which leads to a decrease in interest rates, which increases the investment and consumption, leading to an increase in AD. Otherwise, the Fed can also decrease the money by selling bonds to the people to increase the interest rate, lowering the AD.

  32. Oliver Ton 11 Feb 2010 at 8:52 am

    I'm interested in this idea of overnight loans. Do they simply phone up another random bank and demand a million dollars 15 minutes before the business day ends? or maybe they previously agreed to check on each other after each day and and see who has excess money and who doesn't and then go from there.

    What happens if no bank receives any excess reserves and they are all below the required reserve rate at the end of the business day?

  33. Manuel A.on 20 Apr 2010 at 11:35 am

    It's true. If the money supply were to increase, then interest rates would go down, and if too much is printed then inflation is likely to follow. Again the demand for money would raise interest rates, which is good.

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    Helicopter Ben and Monetary Policy: the cartoon version! | Economics in Plain English