The Federal Reserve 101

By Carissa Chen

We've recently received requests to explain the basics of the Federal Reserve. This post answers the two basic questions at the heart of monetary policy in 6 minutes.

Why does the Federal Reserve exist?

The macroeconomy is made of trillions of basic exchanges – buyers spend credit or money to purchase goods, assets, or services from sellers. Long-term trends, like demographics and technology, determine the economy’s overall growth and productivity, but spending through credit is the main cause of short-term business cycle. When people rapidly increase their spending, using either money or credit, the economy is in the expansionary phase of the business cycle. Since one person’s spending is another person’s income, increased spending leads to a positive feedback cycle in which people can spend even more due to higher incomes. During the contractionary phase of the business cycle, people cut back on their spending to pay back their debt. Lower spending leads to lower income, which in turn decreases spending.

For example, imagine that you typically spend all of your $50,000 income on courses. If interest rates are favorable, you could choose to borrow an extra $10,000 to pay your teacher for additional lessons, which you agree to pay back next year. By borrowing, you choose to spend more now, at the cost of spending less in the future to pay back your debt. Your teacher now has an extra $10,000 in addition to the usual $50,000 she receives – her income has risen, allowing her to spend more and giving her more collateral to attain more credit herself. The next year, since you have to pay back your debt, you have only $40,000 in income after paying back $10,000 in debt. As a result, your teacher’s income falls as well, so she also spends less. The self-reinforcing nature of spending and income works in both directions.

As spending and demand increase during an expansion, prices begin to rise. Too much inflation can harm the economy, such as by costs of inflation. Central banks respond by raising interest rates, which increases the cost of borrowing, making it harder for people to spend using credit, which limits inflation. On the other hand, if people spend too little, then firms may not need to employ as many workers, so unemployment may rise. Asset values generally decline relative to debt, which causes bankruptcies and makes it even more difficult for people to borrow. The economy may fall into a recession. Central banks respond by lowering interest rates, which decreases the cost of borrowing, and makes it easier for people to spend using credit.

Central banks, as such, help stabilize the economy. If central banks did not exist, markets would determine interest rates, or the cost of borrowing, and could cause them to reinforce the inflationary highs of an expansion and the woes of a recession. The U.S. economy prior to the creation of the Federal Reserve in 1913 reflects this reality. The Panic of 1907, a recession which led to the creation of the Federal Reserve, shares many parallels with the advent of the 2008 Financial Crisis. Both crises started in the financial sector and spread to the rest of the real economy. Both crises began when the stock of a nonbank financial institution, Union Pacific in 1907 and Bear Sterns in 2007, halved in value at the beginning of the year. These stocks were frequently used as collateral. In 1907, the fall of the Knickerbocker Trust Company mirrored the bankruptcy of Lehman Brothers. Both companies were giants of the financial industry, and the economy seemed to face a free-fall descent. Unlike 1907, the Federal Reserve quickly stepped in by significantly lowering interest rates and saving insurance giant AIG. Although John Pierpont Morgan, one of the most powerful bankers of the era, saved the Trust Company of America to restore balance eventually in the markets, the recovery in 1907 took a longer time and caused greater distress.

While the events of the two crises mirror each other, institutional responses differed vastly. The Federal Reserve helped stimulate spending by lowering interest rates and served as a public lender of last resort. Although it is impossible to perfectly isolate the effect of having a central bank to determine causation, a comparison of the changes in the real economy show stark differences in overall trends as well. Prior to the creation of the Federal Reserve, banking caused ten crises in the 1800s. In contrast, the only banking-led crisis of the 20th century was the savings and loans crisis. In the past hundred years of Federal Reserve oversight, the U.S. economy experienced 22 years in recession and one depression; the one hundred years prior to the creation of the Federal Reserve experienced 44 years in recessions and six depressions. Although these number do not prove causation, the Federal Reserve’s actions to stabilize the United States economy are reflected in the trends. The Federal Reserve conducts monetary policy that influences money and credit conditions to achieve price stability and full employment, supervises banks, and serves as a lender of last resort.

How does the Federal Reserve influence credit conditions with interest rates?

Interest rates are the cost of borrowing or the price for a loan. The Federal Reserve maintains price stability and low unemployment by changing interest rates. During the crisis, chairman Ben Bernanke described credit as the “lifeblood of the economy.” If the economy were a body, the blood would be credit, the heart would be the central bank, and the valves would be the commercial banks.

Economic textbooks often introduce central and commercial banking through the money multiplier theory – the idea that the central bank sets the quantity of reserves, which then multiplies up through a cascading series of commercial bank loans and deposits. In the post-crisis reality, however, the central bank does not set the quantity of reserves to control interest rates. The money multiplier theory as taught in introductory textbooks does not apply in the post-crisis environment because reserves fund a negligible fraction of bank lending or funding and do not practically limit the amount that commercial banks can lend. Although the quantity of reserves used to matter due to central bank reserve requirements, these requirements do not play a central role in the post-crisis economy due to the IOER framework. Today, central banks set the price of reserves through interest rates to control the amount of credit in the economy.

Two key Federal Reserve measures of the money supply are the MB and M2 aggregates. MB, or the monetary base, is composed of money guaranteed by the central bank in currencies (guarantees from the Fed to households/firms) or central bank reserves (guarantees from the Fed to commercial banks). M2 focuses on the money supply of spenders. The M2 aggregate is composed of outstanding currency (a guarantee from the Fed to consumers) and bank deposits (guarantees from commercial banks to consumers). On average, deposits compose about 90% of the M2 money stock. Bank deposits compose the vast majority of money held by the public and these IOUs from commercial banks to consumers serve as the key intermediary for how Federal Reserve interest rates pass through to the economy.

Commercial banks profit from the spread between the interest they receive from loans and the interest they pay to depositors. In the standard economic textbook, banks take customer deposits and lend them to earn profit from interest income. While most textbooks imply that deposits are created by household saving decisions which banks then aggregate and lend out, the reality works in the reverse order in the modern day. Rather, commercial banks lend to customers, and in doing so, create bank deposits. When Bank of America gives you a loan of $100K for college, it does not hand you thousands of dollar bills – rather, it credits your online bank account with a deposit of the same value as your tuition. When Bank of America does this, new money is created – the M2 supply increases. In Tobin’s 1963 “Commercial Banks as Creators of ‘Money,’” he describes this phenomenon as the bank’s ‘fountain pen money,’ or the “widow’s cruse.”

Let’s return to the Bank of America example. Your liabilities have increased by your $100K loan, while your assets have increased by the new $100K Bank of America inserted into your account. Commercial banks credit your deposits as liabilities, and your loan as an asset. $100K in M2 money has been created. How does the Federal Reserve play into this? What limits the amount of money banks can create?

The Federal Reserve sets the interest rate paid on the reserves commercial banks can hold at the Fed. This rate influences the effective federal funds rate, the rate banks charge each other for overnight loans. These rates spill through to the economy through multiple channels. Economist David Altig describes the system through the metaphor of a long rope. At one end of the rope are short-term interest rates on reserves. In the middle, there are longer-term relatively safe asset interest rates like 10-year treasuries and on the other end are interest rates on corporate bonds, mortgages, and auto. When the Federal Reserve changes short-term rates on reserves, it acts as if grabbing and snapping the short end of the metaphorical rope, and each of the subsequent interest rates follow in succession. Ultimately, the Federal Reserve sets credit conditions and the money supply through the interest it offers on commercial bank reserves.