Chapter Twenty-Nine

Chapter Twenty-Nine

The Federal Reserve System

Kelvin C. Kelley, Providence College

When introducing money and banking, I have students take out their bills and we see if all 12 Federal Reserve banks are represented. By pointing out that each bill was issued from a particular bank, as the seal on the bill shows, and by noting that through circulation from person to person to store, etc., a particular bill has ended up (for now) in a student's hand in Providence, RI, the circular flow, velocity, the exchange system, etc., all are highlighted. At the same time, you can draw attention to the fact that all bills are now Federal Reserve Notes rather than Silver Certificates, introduce the "gold standard" vs. "no gold standard" points of view, and discuss the notion of the real value of currency.

Simple Deposit Multipliers: A Physical Demonstration

M. Dudley Stewart, Jr., Stephen F. Austin State University

After I have taught my students T‑account analysis with respect to the expansion and contraction of deposit liabilities, I teach them the concept of the simple deposit multiplier and its application. I begin by pointing out that were we to continue to use T‑account analysis we would never reach the end of the expansion process because the numbers become smaller and smaller and smaller. I tell them that this is an example of a convergent infinite geometric series and that by using the formula for the simple deposit multiplier (X = 1/rr), we can calculate precisely the money supply expansion limit for the depository institution system. I then demonstrate how to compute it and how it is applied.

To assist my students in gaining a better understanding of the process, I give them a physical exhibition. I proceed to the right wall of the classroom, and with my back touching it, I tell them that I am going to show them that it is simply impossible to reach the left wall if, with a reserve ratio of, say, 0.50, we continue to take half of the distance thereto. I then walk half the distance from the right wall to the left wall and half of the remaining distance again and again and again until I wind up nearly touching the left wall. At this point, I walk in place to demonstrate that by taking half of the distance each time, I will approach the wall as a limit but never reach it. During this part, the students are very attentive and rather amused.

On the blackboard, I show them that we can calculate the left wall as a limit of two (2) by performing the simple operation called for in the formula, X = 1/0.50 = 2. I have used this method successfully for many years. At the end of each class in which I have done this, invariably, one or two students, sometimes three, will come to me and tell me that they never understood the concept of a convergent infinite geometric series before, not even in their math classes, until now. Moreover, they say that my physical demonstration has given them new insight into the multiplier and the money supply creation process. (See The Concept of the Investment Spending Multiplier.)

Inside and Outside Money

Carolyn Shaw Bell, Wellesley College

In distinguishing "inside money" from "outside money" or between vault cash and currency in circulation, a former student suggested the example of a bank robber. A successful robbery would automatically increase the amount of money supply, because it would move vault cash into circulation without canceling any demand deposits. Students find this notion sufficiently offbeat for them to think about it and they come to a solid understanding of the difference between currency, demand deposits, and "money."

Ann Mari May, University of Nebraska, Lincoln

In discussing the Federal Reserve System, students should be aware that the 12 district banks are geographically dispersed throughout the country. To demonstrate this point, I ask that they take out a bill from their wallets and notice the number in the 4 corners that corresponds to the Federal Reserve bank.

Then I tell them that if they ever need quick money, one easy bet is that you can guess which Federal Reserve a bill was issued from by merely looking at the upper right quarter of the bill. (The student has of course memorized the 12 district banks and can verify the bank by looking at the round stamp on the left side of the face of the bill.)

When the exercise is over, I ask the students to please pass the bills to the end of the aisle and the teaching assistant will collect them! We need financial support from somewhere!

The Politics of Financial Institutions

Ralph T. Byrns

Point out that long terms for FED board members makes them quite independent. Instead of discussing institutional data, students will be more challenged if you pose questions about the economic factors that have shaped these institutions. Here are some examples.

a.      Why are most banks state‑chartered instead of being chartered by the Comptroller of the Currency? ANSWER: Until recently, states could set lower reserve requirement ratios. Use the Socratic method to guide students to the conclusion that this provided greater profit opportunities for state banks than for federal banks, because state banks could grant more loans from given deposits.

b.      Why are the Kansas City and St. Louis District Banks so close to each other in Missouri in the comparatively unpopulated U.S. Midwest? ANSWER: The Chair of the House Banking Committee when the districts were established was from Missouri.

c.      What will be the impact if the Congress passes legislation allowing full‑fledged interstate branch banking? Will this facilitate or squelch competition in financial markets?

d.      The idea that elimination of Regulation Q lowered interest rates to borrowers while raising interest payments to savers is counterintuitive, and well worth the time spent in class discussing why. ANSWER: Because the greater amounts of funds kept in banks if savers are rewarded for doing so can only be loaned out if bankers are forced by competition to charge lower interest rates.

e.      Compare bankers' desires for retention of these interest ceilings on deposits with the desire of NCAA coaches to hold the line on payoffs for college athletes; the motivation is quite similar.

f.       Discuss why usury laws "protect" low income consumers only the availability of credit. We indicate why in the text.

g.      In discussing the FED's control of margin (down payment) requirements on stock purchases, appeal to the Modigliani‑Miller theorem. Granting the FED control over margin requirements was a misplacement of power if the hope was to check stock speculation because if irrational speculators begin wildly buying stock with low margin payments, more prudent investors will presumably sell; higher stock prices reduce rates of return and make other investments (e.g., real estate) more remunerative. For example, if stocks and real estate each initially yield 10% rates of return, a stock that sold for \$100 per share would yield \$10 per share annually. If the stock rose to \$200 per share, its anticipated yield falls to 5% because the corporate profits determine stock prices, and not vice versa.

Independence of the Fed

Michael Kuehlwein, Pomona College

The Chairman of the Federal Reserve's 4-year term currently does not coincide with the President's 4-year term.  This means a newly elected President usually has to work with the Chairman appointed by his predecessor.  This is a very unusual arrangement, and to drive this home I use the following political analogy.  What if each newly elected President were forced to retain the former Secretary of State and to allow that person to conduct his or her own foreign policy?  Such an arrangement usually strikes the class as ludicrous and sure to create serious conflicts in government policy-making.  Yet it's similar to the system we currently rely on for the formulation of economic policy.

Finger Pointing and an Independent Fed

Gary Galles, Pepperdine University

Every so often there is a move in Congress to eliminate the independence of the Federal Reserve system, making it answerable to Congress. This issue of whether we want a dependent or an independent FED can be used to illustrate several points.

1.      Given the large number of important variables that FED policy affects or can be used to partially control, no matter what the FED does, there will be gainers who approve as well as losers who complain and, as a result, want reform.

2.      Monetary policy has both good and bad effects, whether stimulative or contractionary. Monetary stimulus creates increasing real output and reduced unemployment for a time, which Congress claims credit for, thereby pointing their fingers at themselves), but it also leads to inflationary consequences, which Congress points the finger of blame at the FED for. If contractionary monetary policy is pursued, we get a business slowdown or recession with the FED being blamed, with later effects mitigating inflation, and with everyone else in government trying to claim the credit. An independent FED lets politicians claim credit and deflect blame, no matter what is done, which is why it has maintained its independence.

3.      The opposite of (2) occurs with the politicians currently not in power. While the ins try to take credit for the good effects of FED policy and blame the FED for the bad, the outs blame the ins for the bad effects and credit the FED with the bad. Between (2) and (3) political contention over macroeconomic policy is assured. If desired, this can also lead into a discussion of monetary growth rules or other targets, which restrict FED independence but don't increase dependence on Congress and political pressures.

4.      Choices between congressional dependence or independence of the FED also lead into a discussion of coordination of monetary and fiscal policy, including the possibility that a coordinated stupid policy may be worse than an uncoordinated approach as well as public choice issues such as the short run political bias.

5.      Even if a congressman knew making the FED dependent wouldn't lead to better results, that would not stop some politicians from introducing bills to do it, and telling all their constituents of the noble fight they are waging. The constituent newsletters hint that voters could thereby get the benefits of monetary policy without the costs, but a conspiracy by the bureaucracy in Washington is stopping them. These bills, which are known to be doomed to failure when introduced, are designed to produce political points back home, not effective policy in Washington.

Grade and Risk Aversion

William R. Massey, Santa Rosa Junior College

Economics instructors are often frustrated in attempting to convey the reality of risk aversion, and the human aspects of competition in a capitalistic model. After much trial and error, I finally settled on the following exercise.

I walk in class and announce that the school's administration has changed grading policy effective with this school term. At the end of this term, I must give an "F" for every "A" I give and a "D" for every "B" I give. This grading policy is to take effect after all the drops and will apply to those who are actually still enrolled at the end of the term. I then let a discussion begin which usually starts with a student saying, "That is not fair." I let the discussion continue until some student, and inevitably it happens, suggests that I give all "C's" thereby avoiding flunking someone.

At that point I tell them that this has been only an exercise and ask how many felt that all they had to do was beat the rest of the class to get an "A" and how may feared they would be the "F". I then point out that this policy can account for several things, not the least of which is that some competitors might be willing to cheat, and also that it might explain why socialism may be easier to sell in third world countries. In something less than ten minutes it possible to convey the human meaning of competition more quickly than in a three hour lecture.

Reporting Grades and the Stock Market

David E. R. Gay, University of Arkansas

When I return exams, my students receive the standard measures of performance such as the average, range, median, and mode. In addition, I compare their results to a stock market with the number of exams becoming the number of issues traded on the exam, or trading day. Based upon a previous exam I compare the number if issues which are up to those exams with higher letter grades, those issues which are declines to those exams with lower letter grades and those issues which are unchanged to those exams grades that have remained the same. The students may conclude if the market is a bull market, a bear market, or mixed.

Jerome L. McElroy, Saint Mary's College‑Notre Dame

One technique to pick up a principles class after the mid‑term doldrums is to perform a stock market experiment. The subject is inherently interesting, and the structure of the experiment tends to facilitate heightened student participation. The purpose of the class is two‑fold: (1) to briefly present the role of the stock market (a) in macro classes as a source of capital formation, or (b) in micro classes as an example of perfect competition; and (2) to test the random walk hypothesis concerning the behavior of stock prices.

For the introduction, the pros and cons of standard topics in corporate finance are covered: bank loans, retained earnings, bond and stock issues. This segment can be climaxed by circulating some Wall Street Journal advertisements of both bond and stock new issues. Then several "after issue" topics can be covered: supply/demand dynamics, short and long‑term price movements, price‑earnings ratio, the institutional mechanisms (i.e. broker's fees, etc.), role as an economic indicator, and finally how a WSJ stock quotation is used.

In the experimental segment, the class, say, of 40 is divided into four groups of ten. A complete WSJ stock quotation is distributed to each group from roughly six months earlier. From these data each group must list seven stock picks and their respective closing prices. The only criterion for selection is that students must have some economic rational for their individual picks. This task takes 10‑15 minutes.

During this time, the instructor lists seven "best buys" on the board with their respective six‑month quotations and those taken from the day previous to class. In addition, the two totals are summed and a rate of return is calculated. The instructor can explain these picks are taken from expert analysts, either from Business Week, Barron’s, WSJ, or some other source.

Next, the instructor distributes the previous day's price quotations, and each group must (1) list the respective closing prices of their picks, (2) sum the total of the two‑date columns, (3) and calculate a rate of return on investment. Finally, a spokesperson for each group must report these findings and compare them with how well the experts did. Invariably, some groups beat the experts and some fall short, but the average performance is about the same. This evidence leads easily into an explanation of the random walk thesis of stock price fluctuations.

The remainder of the class can be spent in several interesting ways: (1) examining the implications of the random walk thesis since it is usually quite contrary to student perceptions and beliefs, (2) pointing out the "full knowledge" assumptions of perfectly competitive markets upon which the thesis rests, (3) discussing the why and wherefore of individual stocks that performed considerably above (below) the average.

The technique works best in 75 minute classes, but it can be accommodated to 50‑60 minute classes by reducing the number of groups and/or abbreviating the introductory material.

Notes: