Monetary policy actions

0:00- [Instructor] In this video, we're gonna talk about monetary policy actions. So just as a little bit of review, there's two basic types of ways that government or government-like entities might try to influence the economy. You have fiscal policy or fiscal policy actions, and you also have monetary, and these don't have to be exclusive.

0:21Both of them or one of them might be acting at any point. In fact, both of them are usually acting in some way, shape, or form at some point. Now, fiscal policy, we're talking about the government, the government, taxing, what their tax policy is or what their spending policy is, maybe to stimulate the economy or maybe to slow down the economy, although it's usually more politically expedient to try to stimulate the economy, while monetary policy is more around central banks, and this is focused around things like interest rates and money supply.

0:57There could be some around bank regulations or reserve requirements, things like that. The focus of this video is monetary policy. And what do we have a picture here? I got an AI to create a picture of the US Federal Reserve. I'm still blown away that the AI can create such nice images for me like this.

1:15So the question is, what is a central bank like the US Federal Reserve trying to do with its monetary policy and how would it actually do it? So, to think about what it's actually trying to do, I will put back, and I've talked about in other videos, what many economists would consider the Goldilocks zone for the economy.

1:36When I say Goldilocks, porridge that's not too hot and not too cold. So, usually folks talk about 2% inflation. Inflation that is higher than this, especially a lot higher than this, can become very destructive. And a growing economy will require some or tends to have some type of inflation, and if it goes a lot lower than this and especially if it goes to zero or even negative, deflation has its own problem.

1:59So this is what most folks target, including the US Federal Reserve. And then most economists would say, "Well, we want a healthy level of employment," and a healthy level of employment is usually around 4% unemployment. Now, I talk about in other videos, why isn't it 0%?

2:19Well, most economists would say, "There's always going to be some frictions "in labor markets." There's people who need to re-skill. There are people who are need to be, may they quit a job or they're looking from one job to another, so you wouldn't expect things to actually be at 0%.

2:34But there could be some debate, maybe 3%, maybe 5% unemployment could be considered full employment. But let's just view that as what the actual targets are. And these are intention to some degree, because if unemployment is high, that tends to go with lower inflation.

2:54And if unemployment is low, if you have a booming economy, that tends to go with high inflation, so there usually is a tension here, where if you're trying to keep inflation down, you might increase unemployment, and if you're trying to decrease unemployment, then you might be boosting inflation.

3:11But let's think about two scenarios. Let's think about when the economy, economy is weak, and in this situation, maybe the Central Bank decides that it wants to stimulate the economy using monetary policy. Now, a lot of times people will hear interest rates. When you watch the news, especially if you read the financial press, they'll talk about the Chairman of the Federal Reserve, and the Board of Governors is trying to decide what the target interest rate will be.

3:42And interest rates matter, interest rates, because this is the rate that people are borrowing from each other, corporations are borrowing money, banks are borrowing from each other. And in general, if interest rates, interest rates are lower, interest rates are the cost of borrowing money, then people are more likely to borrow money, so there's more borrowing, and people are going to tend to borrow money because maybe they want to invest it, and maybe more factories, and maybe they're gonna build things and hire more people or consumers might borrow in order to spend more money.

4:20And actually the way our banking system works, borrowing money actually increases the money supply. How does that happen? Well, let's say that you are the Federal Reserve, and it actually turns out that in most cases they aren't directly setting the interest rate.

4:36They're setting a target interest rate, and what they do is they go out there, or not go out there. They can internally, that's hard to see, but they can essentially print money, and it's not always physical money. It fact, it's usually digital money that they are printing.

4:52And then they use that money and they go out into the open market and they buy usually government bonds with that money. In other videos, I go into a lot more detail about how that happens. But when they use the money to buy government bonds, that money gets deposited in our banking system.

5:11And when it gets deposited in our banking system, so let's say there's a bank here and we've just deposited some of that money that the Federal Reserve has printed and used to buy someone else's bonds, and then they put that money in the bank, that bank doesn't have to keep all of that money there.

5:26It can lend a large fraction of it. It can lend in many cases 80, 90% of it. It depends what the rules are on how much they have to keep on reserve, and that, by the way, is also monetary policy that the Federal Reserve works on. They say, "Hey bank, you have to keep X percent, "you have to keep 10%, but you could lend the other 90%."

5:45So that let's say dollar can then be lent to someone else, or 90% of it could be lent to someone else. If we just for simplicity assumed 10% reserves, And so then you have 0.9 or 90 cents on that dollar. Let me say that this is a dollar. That gets deposited another bank or even into that same bank 'cause it's been lent to someone else, and now that bank, just for the sake of simplicity, could lend out 90% of that.

6:11And so notice, $1 of base money was created, but as it gets lent out, especially if the interest rates are lower and lower, you're having more and more money in the system, which could be used to invest, which could be used to consume and is generally viewed as stimulative for the economy.

6:25Now, with more money in the system, it could drive inflation up, so we have to be careful. If inflation is going up, you can't do this as aggressively. Now, if the economy is really strong, and let's say inflation is going four or five, six, 7%, the Federal Reserve might want to do it the other way.

6:46They might want to increase interest rates, and the way that they would do that is by taking those government bonds and then selling them out there in the market, and then they're slurping up dollars out of the system. You might say, how does that impact interest rates?

7:01Or actually even what I just described this first time, how does that impact interest rates? Well, if there's more money in the system, the cost of borrowing that money goes down. If there's less money in the system like I'm describing just now, then the cost of that money goes up.

7:15And if you're taking money outta the system, then all of this might start to unwind. Less borrowing, less money, less money in people's pockets to buy things. It's harder for people to invest, and so maybe the economy slows down and inflation could slow down. So I'll leave you there.

7:31I know this can be a little bit overwhelming. It's a little bit complicated, but you're already getting the basics. And if you want to go deeper, there's a lot of videos on Khan Academy that go even deeper than this one, and it'll hopefully give you good context now for when you listen to the news and hear about what the Federal Reserve is doing as far as monetary policy is concerned.