Federal Reserve Bank

Running the Table: Mechanisms of the Federal Reserve

I. Introduction

The concept of a central bank was designed to stabilize the faltering American economy in the early 20th century. Economics is very much a 'social science' that deals with people's reaction to markets and the shocks which affect it. However, peoples' reactions can be mitigated or exacerbated by the Federal Reserve. For example, when the U.S. market crashed in 1929 the Great Depression was then precipitated by the Fed's contracting of the money supply. More of the depression will be explained in the later sections.

The purpose of this paper is to examine the way inflation and shifting interest rates have impacted the American way of life in the last fifty years. Secondly, the effects of the mechanisms utilized by the Federal Reserve will be explored. Thirdly, the paper will analyze the monetary policies which come in the form of inflation and interest rate shifts when certain shocks occur. The regression will analyze the significance, if any, between the connections of unemployment, inflation, wages, and the federal funds rate. The main purpose of analyzing inflation is to determine how to best sustain the real value of money for the consumer.

Excel and SPSS calculated the coefficients within the Philips curve formula to measure the relevance of each variable: wages vs. the federal funds rate, unemployment vs. wages, and unemployment vs. inflation. Building upon the works of Laidler and Primiceri, this paper will discuss the merits and value of using the expectation-augmented Phillip's curve. The objective is to determine the statistical significance of the mechanisms the Federal Reserve utilizes. This will help to recognize the economic variables which have driven the United States' free market for decades.

II. Interest rates in past half century

Open market operations can be summarized as just that, the sale or purchase of Government bonds by the Fed in the open market. If the Fed buys bonds, the effect would be to expand the money supply and hence lower interest rates; the opposite is true if bonds are sold. This mechanism is the most widely used instrument in the day to day control of the money supply due to its ease of use, and the reasonably smooth interaction it has with the economy as a whole.

A major consequence of the economic policies pursued since the early eighties is the prospect of a continued large federal deficit combined with a high level of the market rate of interest for at least several years to come in the United States. During the period after World War II, this is a dramatic departure from the cycle that prevailed in the United States. Except for cyclical and temporary variations, federal debt as a proportion of net national product declined steadily between 1945 and 1980, while the real rate of interest remained quite low. This sets up the rate of change in the federal funds rate, which is determined by an expectations-augmented Phillips curve. The value-added prices for output are set in accordance with a markup behavior resulting from the cost minimization by firms faced with oligopoly markets for output.

The Federal Reserve maintains the prerogative to raise or lower the interest rates of the nation's banks. Over the course of the century, the Fed has utilized the conventional wisdom that during times of economic 'slow down', more money should be poured into the economy. The reasoning behind is mechanism is two-fold. The Fed will lower interest rates so that there is less incentive for consumers to save money. Basically, they bail out the economy at large by penalizing the American consumer trying to put away money for retirement savings and other long-term ventures. The second way money flows into the economy is that by lowering interest rates, there is a lesser cost to the consumer and the industries in jeopardy to borrow money from the banks. These effects, in tandem, facilitate more money flowing into the economy. Instead, consumers are expected to buy durables or other gadgets such as new I-Pods in exchange for short-term industry gains.

III. Inflationary Relationships

When analyzing the data sets of inflation vs. unemployment, there seemed to be a relationship between the two variables. Upon further research of other economists such as Giorgio E. Primiceri, this relationship had been ascertained previously.

As seen by the yearly average, spikes in unemployment often follow spikes in inflation. One reason for this is stated in Giorgio E. Primiceri's inflation dissertation. Primiceri states that unemployment lagging behind inflation is a general characteristic of the business cycle. However, this feature of the data was particularly evident in the period of high inflation, with unemployment peaking always a few quarters after inflation. This is further evidenced by a representation of the percent change of both unemployment and inflation. While Primiceri does not explicitly detail his support of the expectations-augmented Phillip's curve, he does support the relationships which it is made of. He and Laidler both contend that unemployment and the federal funds rate play a part in inflationary dynamics.

When the data is entered into SPSS, there is expected to be a correlation between the two data sets. Visually, unemployment is positively correlated to inflation. When inflation rises, higher unemployment is only a few cycles behind it. When inflation is down, for the majority of data points, unemployment drops as well.

The same principle seems to hold true for the federal funds rate and inflation, except that it is negatively correlated. When the Federal Reserve raises the federal funds rate, high inflation occurs. When the federal funds rate drops down, for the majority of data points, inflation does as well.

Visually, the federal funds rate is positively correlated to inflation. When inflation rises, the Fed raises the federal funds rate as well. When inflation is down, for the majority of data points, unemployment drops as well. This data will be further supported by the regression analysis completed of inflation against unemployment and the federal funds rate in later sections concerning these topics.

IV. Why Federal Reserve does what it does

Firstly, it should be stated that the United States Federal Reserve is not a 'federal' institution. It is a private corporation which has neither congressional nor any other government oversight. It is an entity with no budget and cannot be audited. Being a private organization, its members are selected by committee behind closed doors.

The Federal Reserve exists for a singular purpose: to provide a stable financial infrastructure for the United States. This is achieved by the furnishing of an elastic currency. This affords a means of rediscounting commercial paper. The Fed also establishes a more effective supervision of banking in the United States, and for other purposes. From the federal level, the Federal Reserve has the power to engage its two primary monetary mechanisms: controlling the money supply and interest rates.

With the hopes of quelling economic unrest in the nation by uniting all the currency under a single entity, the Federal Reserve Act of 1913 created the first United States central bank. Up until 1913, if a bank failed, in that it could not cover the cost of the notes they lent. Such insolvency would cause mass panic in the general population. The investors would then liquidate their holdings and deposits from said bank. The result was a mini depression in the area surrounding that regional bank.

Table 1: Bank and business failures in the USA, 1875-1935



Standard Deviation

Coefficient of Variation

Bank failure rate*













Business failure rate*













As seen by the table above, although the mean of bank failures may be lower than that of business failures, the variation is significantly higher. The coefficient is 0.43 for the rate of bank failures and only 0.05 for the rate of business failures from 1875 through 1929. This higher variation may, but does not need to, indicate larger contagious effects in banking than in other business sectors. It was this contagion effect which prompted the idea of collusion between all regional banks and a federal overseer which could prevent such future regional economic fallout. Since at the time the country was still on the gold standard, the currency still retained its relative value. However, the missteps of the Federal Reserve do not end there.

Exorbitant government expenditure is often the result of efforts by the government to redistribute income and wealth. The Congress and Executive branches would like to increase government spending, but they do not wish to raise taxes. Because higher taxes are unpopular, increasing the money supply commonly becomes the answer to deficit financing. If the government prints more money, people don't have to pay additional taxes, but they ultimately realize that the dollars they own are not worth what they previously were. This leads back to section I and the case of the market crash of 1929 and the subsequent Great Depression.

V. Inflation in past half century

The health and wellness of a nation's economy is often measured by GDP growth. GDP is an easy metric to look upon because it encompasses so many factors of the market when money changing hands. However, it also leaves out many variables which affect the average citizen. The American people believe a dollar today is a dollar or more tomorrow, but the old wisdom no longer holds true. For example, in many third world nations, such as Zimbabwe, the inflation is so high, that as soon as someone makes a wage, it is immediately traded for a service or good, because the same money will be worth five percent less the next day. While this nightmare is not so in America, the effect of hyperinflation magnifies the reaction of a population under pressure to spend their currency. The only difference between Zimbabwe's inflation and the United States' is the rate at which it has increased. More of this will be explained in later sections.

A moment of retrospection is required to better examine the inflation that has been pervasive in America since the 1900's. Ever since the international gold standard was abolished, the Fed has been artificially inflating the money supply. The gold standard used to determine how much money could be printed. Without a tangible commodity to back the currency, effectively, it is based on nothing and worthless without the government infrastructure to support its use. As shown in the above graph, the CPI has risen in lockstep with the creation of the Federal Reserve. What this translates into is that the real value of the dollar is less than face value which Americans spend every day. A phenomenon that is reflected in increased prices over the decades and wages that are earned.

In 1960, a modest four person family could be supported by a single working wage. Today this is not only implausible, but highly unlikely. This anecdotal quote by the sitting president reveals this implausibility:

"You work three jobs?  … Uniquely American, isn't it? I mean, that is fantastic that you're doing that." —President George W. Bush, to a divorced mother of three, Omaha, Nebraska, Feb. 4, 2005.

This casual quote is masking the overall crisis facing the American worker by passing the struggle off in classic jingoistic fashion. The idea behind that quip is that the American worker is the best in the world and works their way up the economic ladder by the sweat of their brow and the swiftness of their mind. This would be true if the ladder was not getting taller and its rungs were not coated with axle grease. Maintaining a middle class lifestyle is becoming harder and harder in a country where overall success is measured by a fiat monetary system and a fiat financial marketplace.

The Federal Reserve is the architect of that fiat monetary system. The Phillip's theory of the interaction between wage inflation and unemployment was transformed into one dealing with price inflation by postulating that prices were closely related to money wages. The same concept can be applied to the Federal Reserve and their increasing of the money supply. This is essentially the theory behind large markups in prices which make up the CPI. This was done by either some form of mark-up pricing, or by mechanisms associated with the pricing behavior of profit maximizing competitive firms.

As evidenced by recent census data, Americans also have more to spend. Census data has show that the median income has risen steadily, with temporary setbacks, over the past sixty years as "the real reward for an hour of work has more than tripled," according to a February, 2007 speech by Federal Reserve Chairman, Ben Bernanke. In 1947, median family income, in 2004 dollars, stood at just $22,500, according to the Census; while in 1973, family income had doubled, and has continued to rise to $57,500 by the year 2000. However, what Chairman Berhanke fails to take into account is the primary reason this income is greater numerically is because of the inflated money supply.

On the subject of wages, the new expectation-augmented Phillips curve provides a different explanation for rising wages. Instead of predicting money wage inflation to be zero in a 'fully employed' economy, with prices therefore falling at the rate of growth of labor productivity, the expectation-augmented Phillips curve now predicts that real wages will grow at the rate of productivity change. Laidler argues that contractionary monetary and fiscal policies affect the rate of inflation by creating excess supply in the economy, and hence creates extra unemployment.

The current economic situation would baffle the 1960's laborer. The idea that both parents in a nuclear family would have to work to send the children to decent colleges when just thirty years ago, a single working wage could do the same job of two, no pun intended. This further reinforces the idea that a dollar today is not worth as much as it will be tomorrow. While we are not exactly carting money in wheelbarrows to purchase goods as was done in post-Nazi Germany. However they do face a fiat currency which can be altered at any time by a select few: The Federal Reserve Board.

VI. Conditions which prompted Federal Reserve to act

There have been several historical instances in which the Federal Reserve was forced to 'flex its muscles' and right the market. These are but a few major examples and critiques from an inflationary control standpoint.

When the market crash of 1929 occurred in New York, the Federal Reserve was presented with its first opportunity to test its metal. Instead, Federal Reserve allowed the quantity of money to decline slowly in order to ship gold bullion to Great Britain. If the Federal Reserve had stepped in, bought government securities on a large scale and provided the currency to the general population, unemployment would not have reached 25 percent. The investors would then have found that they could have gotten their money and they would have stopped asking for it. Despite excellent advice from the Federal Bank of New York, the system refused to buy government bonds, something which would have provided money to the commercial banks with which they could have met more easily the demands of their customers.

More recently, the Fed has reacted sharply to the housing bubble burst. It has not deflated the money supply since 1980. This policy shift led to interest rates toping out at over 20 percent, which plunges nation into worst recession since the 1930's. Billions of dollars in assets are acquired by financial institutions at bankruptcy prices. America's industrial and infrastructure capacity were devastated, including destruction of steel industry. There was a major decline of government infrastructure investment at all levels. This was the beginning of a service vs. industrial economy. In this new economy, jobs begin to leak overseas, thus increasing unemployment.

The root of monetary policy comes from the data of multiple studies of multiple countries' economies. By limiting studies to specific variable or triggers which can bring about a recession or depression, more sound conclusions can be drawn. For example, if the Federal Reserve wanted to determine whether any single indicator reliably predicts inflation, they would need strong empirical evidence.

If such an indicator exists, it would need to display itself adequately under a wide variety of economic conditions and changing economic structures because no country faces an unchanging economic environment. One way to test for such obvious performance is to examine the value of the indicators across a variety of countries experiencing different economic conditions, financial structures, policy shifts, and so on.

An example of the Fed attempting to avert national as well as international crisis can be observed in the recent March, 2008 interest rate slashing which prevented many banks such as Bear Stearns from becoming insolvent. Bear Stearns was heavily exposed to wavering securities tied to the sub-prime mortgage market. As credit markets seized in recent weeks, confidence waned that the company would be able to make good on its own promises. This situation triggered a classic run on the bank, with clients pulling out money and other financial firms refusing to do business with the company.

When the traditional lowering of interest rates did not solve the crisis faced by Bear Stearns, the Fed resorted to a more unconventional approach. The Fed bailed out Bear Stearns the old fashioned way, buying them out of their responsibilities to the shareholders. The Fed spent nearly $30 billion insuring J.P. Morgan, another investment powerhouse to buy the once $176 Bear Stearns shares for a paltry $2. By backing another large investment bank, they completely diminished the moral hazard of the modern financial marketplace.

These examples all had a common thread, the Federal Reserve turning the value of currency, whether macro in the case of the Crash of 1929 or micro-wise in the case of Bear-Stearns. The notion that the Fed's monetary policy should affect inflation dynamics is an old one. Milton Friedman has written that inflation is always a monetary phenomenon. In his famous critique he showed how changes in monetary policy could, in principle, affect inflation dynamics. However, Friedman considered only very stylized monetary policies. The present exercise explores the effects of more realistic changes in policy on inflation dynamics.

There are many variables to consider how monetary policy may have changed. First, monetary policy may have become more reactive to output and inflation fluctuations around the early 1980s. In addition, the reserve board may have become more predictable, implying smaller shocks to a simple monetary policy reaction function. Only until after the recent sub-prime housing market debacle did the Federal Reserve perform a massive interest rate shift to stimulate commercial paper again.

VII. Regression and Data

The model of inflation-unemployment interaction has long been discredited, not just by empirical evidence but also by theoretical arguments: instead of the Phillips curve we now have the 'expectations augmented' Phillips curve. There are not always a number of mutually compatible ways of deriving the latter relationship, but for present purposes differences of opinion on the underlying microeconomics of the function are of secondary importance, in comparison with widespread agreement about its empirical nature.

The term 'Phillips curve' has two common usages. In Phillips' original paper, he discusses the relationship between the percent change in wages and the unemployment rate.

However, many macroeconomics textbooks, such as Taylor and Dornbusch and Fischer use the Hall term 'expectations-augmented Phillips curve' to refer to an aggregate relationship between inflation, expected inflation, and the unemployment rate. The inflation rate is represented on the vertical axis in units of percentage/year. The unemployment rate is represented on the horizontal axis in terms of percentage. The Phillips Curve relates inflation to unemployment via the equation: (dw/dt)/w = h(U). The major criticism of the classic Phillip's curve is that it has become too glib and simple for the modern market.

In the derivation of the new expectations-augmented Phillips curve, the formula follows the approach proposed by Mankiw, whose derivation is based on three relationships. The first relationship concerns a firm's desired price, which is the price that would maximize profit at a particular point in time; the desired price depends on the overall price level and the deviation of unemployment from its natural rate. Price adjustment, however, is assumed to be infrequent and so firms generally do not set prices equal to desired prices. Given these three relationships, the expectations-augmented Phillips curve can be written as such.

Where ΔΠ is the national inflation rate, Et*Πt+1 is expected inflation, RU is the

national unemployment rate, and NR is the natural rate of unemployment. Where Πt is the inflation rate, Ett+1 is the inflation rate expected in the current period for the next period, RUt is the unemployment rate, εt is the error rate and t indexes time. The primary purpose is empirical. With an open economy extension, and from an identification strategy based on using percentage change data, we can estimate a simple Phillips curve with supply shocks and inflation expectations. From these relationships, there is an example graph below with h's in place of R's.

ΔΠt = Ett+1 + γ(NRt- RUt) + εt

Within this relationship, the past unemployment and inflation data is filtered through the new expectations-augmented Phillips curve and descriptive statistics will be collected to determine if this new formula holds to be significant. From that point, the inflation rate for 2008 will be predicted.

After running a regression in SPSS with inflation as the dependent variable and percent change in CPI, real unemployment, and the federal funds rate as independents, a medium R2 value was achieved along with a reasonable standard error.


However, the coefficients were not as large as were predicted by the way each variable appeared on the lead-lag series of graphs. The next step was to enter these coefficients into the altered expectations-augmented Philips curve:

In the next section, conclusions will be drawn from the correlations between the variables used in the expectations-augmented Phillips curve.

VIII. Conclusions

In this paper I have outlined the primary mechanisms of the Federal Reserve. In the model used, the Federal Funds Rate has the greatest significance when determining the change in rate of inflation. When the data was implemented into the expectations-augmented Phillip's curve, it yielded a reasonable expectation of inflation for the year 2008.

ΔΠt = b1(FFRt-1) + b2(Ut-1) + εt

2008 – (-12.0%) = .491(5.02) + (.223)(4.6)

ΔΠ2008 = -8.51%

=2.85*.0851=.242535 , Π2007= 2.85 - .24253

Π2008 = 2.607%

The equation has yielded a relative decrease in the rate of inflation for 2008. Then with simple math is applied, this percentage change forecasts new yearly inflation rate of 2.607%.

It would appear that the theories proposed by Laidler hold true. As he states: the expectations-augmented Phillips curve is not a theory of inflation in and of itself. Instead, it is a factor that can be used in a variety of models of the inflationary process, and depending upon one's view of the source of fluctuations in excess demand in the economy. This was proved by the low correlation between the proposed variables within the expectations-augmented Phillips curve equation. The beta values were simply too low to suggest a serious impact on inflation over time. In the end, the latest regressions served to further explore the inflation-unemployment relationship. The future inflation rates may or may not be determined by the Federal Reserve's monetary policies, but one thing is certain: economic theories will continue to change and be validated by history's lessons and data.

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