-What does the Federal Reserve do?
The Fed does a lot of things, most notably it manages the money supply to achieve what it perceives is the right balance between inflation and employment. It does this by buying/selling US treasury securities, changing the amount banks must hold as “reserves,” and changing the discount rate (the rate at which banks borrow from their local Federal Reserve branch). The bottom line is that all of these things affect the amount of currency and ease of attainment in the loanable funds market. If there’s a lot of money out there, the ‘price’ of borrowing (the interest rate) is low and aggregate demand goes up. The Fed also acts as chief regulator, the lender of last resort, and many other duties given to it over time since its founding one hundred years ago.
-Why is it important?
The Fed has enormous impact on the economy, to say the least. Markets respond to something the chairman whispers in his sleep. The Fed’s impact on interest rates affects every financial market, from currency trading in Indonesia to the local housing market here. Since an increase in aggregate demand affects everyone, not just those directly in financial institutions, the Fed’s actions are incredibly important. Thinking about taking out a loan? If inflation will be high later you’ll have to pay back less in real terms. Think the Fed will tighten money to cut back on inflation? The lower aggregate demand might mean you forecast lower levels for your business. It’s not an overstatement to say the Fed chairman is a more powerful force in shaping the global economy than the US President.
-What is Quantitative Easing?
This is in the news a lot, and most of the journalists covering it outside of the economics blogosphere don’t seem to understand it. When nominal interest rates approach the “zero bound” aka zero, the Fed cant use their conventional methods to increase lending channels and aggregate demand. QE tries to get around this. When a central bank engages in QE they are buying up financial assets from banks and other financial institutions to try to increase the monetary base, the amount of cash out there. The Fed currently holds more than two trillion dollars in assets on its balance sheet.
-Is QE good or bad?
There are two general sides in the debate over QE: those that think it’s necessary and mitigated some of the effects of the global recession, and those that think it is doing little now and will only lead to massive inflation when banks finally start lending out all that cash they’re sitting on. Proponents of QE like Scott Sumner point out that nominal GDP (our output in terms of dollars out there) crashed during the crisis and has yet to rebound. With inflation incredibly low and unemployment boringly and stubbornly high, it only makes sense to keep increasing the monetary base. A few brilliant economists like John Taylor, Paul Volcker, and Greg Mankiw have expressed skepticism over QE but generally most economists believe it has been a good thing and we shouldn’t taper at this point. The effectiveness of QE thus far will always be inconclusive, much in the way fiscal stimulus is. If you go to a doctor, he gives you medicine, and you’re still sick a week later – did the doctor give you the wrong medicine or not not enough of the right one? This is basically how debates over macroeconomics function. It’s very frustrating, because both sides will always claim victory. But some arguments are better than others.
-Larry Summers vs Janet Yellen as the next fed chair?
Ben Bernanke is stepping down soon and Obama will have to nominate the next Fed chair. These two are considered the favorites, with Summers looking like the inevitable candidate. Relative to all other economists, they aren’t too different. Both are ‘doves’ in that they will focus more on employment than worrying about inflation. Summers is one of the most gifted economists of the last thirty years, with breadth of research equalled by only a couple people if any. But he also is connected to deregulation in the 90s (righty or wrongly) that many think Democrats will have issue with during the nomination process. He also made some uncomfortable statements about women in STEM jobs while at Harvard, is a shrewd man, and has no formal experience or writings on monetary policy. Yellen is the vice chairman of the Fed right now and frankly pretty awesome. Her main issue might be that she is not a White House insider and doesn’t have the political clout Summers has accumulated. She also is cordial and polite during arguments, whereas Summers is known to be, basically, somewhat of an asshole. Here’s one way to look at the debate: the central banker has two situations, one in crises and one in regular times. In regular times one can follow a rule-based policy that a computer could essentially do. In a crisis you need an exceptionally skilled central banker. Summers is overqualified for the first situation and not qualified for the second. Yellen can do the second.