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Tuesday, July 20, 2010

Macroeconomics Post 3: The Role of the Federal Reserve

So the last chapter before the final was an illuminating one, in part because it dealt with one of the central debates of economic policy.  In the the common parlance of liberals and conservatives, the issue has been framed by conservatives as the role of "big government."  But, the book explains, this is a read herring.  The issue for Macroeconomists has nothing to do with the size of government, because that is fiscal policy--it's a different issue.  Most economists believe in the economy's auto-stabilizers like unemployment insurance and the graduated income tax.  The issue, says Baumol, is actually the degree to which the government attempts to regulate the economy, or to what degree the "self-corrective" market is allowed to be free.  This battle largely takes place at the Federal Reserve.

So the Federal Reserve can affect the economy in several ways.  1)  They can change the interest rate 2)  They can change the money supply.  There is a third way that is rarely used 3)  It can change the reserve ratio for banks.  The Big Debate in Macro is whether or not the Fed should worry about 1, or 2. 

Keynsians think the Fed should concentrate on the interest rate.  This keeps the interest rate relatively stable, and with several underlying assumptions, it helps expansionary policy work effectively to stimulate the economy.  The monetarists, lead by Milton Friedman and his ilk, believe that the key is actually the money supply.  They think the interest rate should be determined by supply and demand.  The key concern of the monetarists is inflation, and when the Fed lowers the interest rate, they expand the money supply--and chance inflation.  Now in practice this hasn't really been the case.  The correlation between low interest rates and high inflation hasn't really born out.  Even when adjusted for the "two year lag" that monetarists believe affect inflation numbers.

Anyway, economics is over now, but it was a fascinating class that I wish we could have gone more into depth on.  Next stop Forensic Accounting and Tax!

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