0:36 Intro. EconTalk survey thanks. Money, monetary policy, supply of money. What is the money supply and why do we keep track of it? Money used as medium of exchange. Different measures. Quantity is a rough indicator of extent of inflation, which has costs but in some special circumstances, benefits. Job of Federal Reserve (Fed) is to judiciously manage those costs and benefits. Inflation. If we just left the nominal quantity of money the same, what would happen? We could fix the monetary base, which is supply of currency plus bank reserves held at the Fed. Some broader measures of the money supply probably would grow through supply of credit. Nevertheless, since more goods and services would be produced, there would be deflation--price level would fall. Advantage: we would see in a transparent way the growth of the economy. But economists have argued that that's a bad idea. Friedman argued for stable prices, Fed increases money supply at roughly the same rate as growth in the economy. Human irrationality: Employees don't like hearing that their wages will be cut by 3% this year but that the price level will also fall by that much or even more. These are our current expectations, which won't go away soon. Don't want to have the wages of a large number of people have to fall. Larry Summers. With small amount of inflation, wage rises even though price level rises by more, so tricks people into being satisfied with their wages. Historical issue of variability. Want to try to distinguish between nominal and real changes. If inflation is unpredictable and uncertain you can't distinguish if your product's price is higher because of increase in demand or because of inflation. So economists have tended to argue in favor of low but stable inflation. Business investment decisions tend to be made for large rates of return relative to small rates of inflation.

9:16 Fed, Central Bank. Standard macroeconomic argument for how a change in Fed policy will ripple its way to higher prices. Simple version: More money in the system, people spend or lend more, greater flow of purchasing power, and over time prices rise. Pretty clearly is true. More complicated version: What Fed is really doing is buying up Treasury Bills with cash. From the point of view of a bank, why is a cash holding different from a Treasury Bill holding? Different for tips in coffee shop, but not for financial institution. But they have different effects on the economy. Why? Friedman used to use idea of a helicopter drop, mental experiment. Experiment Number 1: Fed adds money to the system--say, it doubles the money supply--and people find they have more green pieces of paper, higher liquidity than they want, so they try to spend it. But no more stuff available than before, so price level doubles as people bid for the goods. Other version, experiment Number 2: the stores that find people trying to spend money find themselves with more money, and then think their goods are more popular; hire more people, produce more. In this version, real effects; but they are temporary. Eventually people catch on, businesses fire the extra people. If everyone knows the government is doubling the money or just adding zeros to bills, they are not fooled and there are no real effects. Monetary surprise can only work now and then. If there is unemployment and no one expects monetary increase, then the economy can be "stimulated" but it's temporary. (Or with strong minimum wages as in some of Europe.) If you try to play this game too often, you end up with lots of inflation and no increase in employment. This is what is going on now in U.S. Stagflation, thought to be impossible; Phillips Curve, idea that in the short run you can increase inflation and decrease unemployment. Doesn't mean you should inflate, but the grab bag option is there. It's not a universally exploitable idea. In 1970s, it didn't work--high inflation and high unemployment; money supply could not be used to manipulate the employment rate. With a real shock, monetary policy typically doesn't do very well. In the 1970s, the Fed first tried to deflate; then tried to inflate.

17:47 Today we have another kind of real shock, collapse of real estate bubble. A good rule of thumb is that with a real shock, there is nothing the Fed can do. But is the real estate bubble a real shock or is it a nominal shock? Isn't the housing situation just a nominal change to an asset price? Shock to credit. Risky assets were thought to not be risky, but they've decided they were risky. Readjustment of asset portfolios is real, not nominal. But will there really be a shrinking of credit because of the lack of transparency? Sectoral reallocation away from risky assets. Global savings not down, just not funding risk. Bumpy path. Why trading in so many assets has dried up is the fundamental price. You'd think there still would be some price at which even junk bonds would trade. Price signals have been removed from the market and people don't know what to do. Agency problem. Pulls information out of market prices. Have markets, but don't have as much information injected into the markets.

22:28 Fed. Open market operations, buying and selling of Treasuries. All the focus today is on the rate that the Fed charges member banks. By changing the interest rate, they are either encouraging (by lowering the rate) or discouraging (by raising it) member banks to borrow. Banks use the Fed as a lender of last resort. Is the Fed trying to affect bank costs or interest rates? Discount rate vs. Federal Funds rate. Fed admits discount rate--rate to lend to a bank in distress--is not effective. Term auction facility set up to bypass discount window. Federal Funds rate is what newspapers are talking about. It does that by buying more T-bills, which creates more liquid money, more available loanable funds, which pushes down the (short term) Federal Funds rate. Fed can't lower long term rate (or maybe by only a tiny amount), though it can through inflation raise them. Irving Fisher broke interest rates into real and nominal parts: productivity of the loan in real terms, what would grow; and the nominal part, the part that's due to inflation. If everyone expects inflation to be 10% per year, I'll never loan money at less than 10%. Inflation premium is built into interest rates. Leads to a paradox: Normally we think of supply and demand of money as lowering interest rates when we expand the supply of money. The interest rate is something like the price of money. But if the Fed puts money into the system, it will actually raise the nominal interest rate via inflation. Inevitable tension. If the Fed only does it once they can lower the real rate without the higher nominal rate; but if you keep on doing it you end up with high nominal rate. With a high nominal rate you also end up with greater uncertainty, greater variability. Some people have a low and others a high real rate.

31:18 When we read that the Fed has raised interest rates (the Federal Funds rate), what has actually happened is that the Fed has intervened in the market for Treasuries. Often talked about through a different mechanism. The press often says things like "The economy is growing too quickly. The Fed is raising rates to try to slow the economy down. If interest rates are higher, people will invest less, take fewer risks. Now, they are worried the economy is slowing down, so they are stimulating the economy by lowering interest rates, trying to influence investment decisions." But that is not what the Fed is trying to do, is it? Complicated. Hard to show that higher or lower real interest rates actually have any effect on investment. If you are aiming for a 30% return on investment (likely will result in smaller rate of return after including failures), small changes in interest rates may have little effect on you. How credit markets perceive risk, framing of credit risk, psychological contagion effect; may be where a lot of where the Fed's influence comes from. Stock market often reacts strongly to the Fed. Information gained from what the Fed does. Behavioral economics: lending, risk perception, banks.

36:26 Alternatives to the Fed. Some people think the Fed is harmful to the economy. Macroeconomic variability in the United States has become much smaller than 50 or 100 years ago, maybe because of Fed's performance (even though it's made many mistakes). What about private money or the gold standard? Throughout most of world history central banks have mostly been a disaster but in the last years worldwide they have done a good job. Mexican central bank example. Financial markets may have the ability to monitor central banks better than previously. Politicians showed that policies against inflation are popular, Reagan, Thatcher, Volker. Should we have free banking? Imagine that we had American Express Travelers' Checks as money, competing with Thomas Cook's Travelers' Checks. Risk. But what would advantage be? Right now we have something that looks like private money--credit cards. How would private money work in today's world? Is it legal? My bank check right now is a form of private money. Works because we have deposit insurance, so even if the bank had a problem my check would still be good. Private company could issue the money; what makes the difference is what kind of guarantee is behind it all. Colorful money, athlete faces, attractive women, trading cards. Why don't we have such money now? Originally governments wanted to earn seignorage, printing money and buying up services getting something for nothing, like a counterfeiter. Seignorage is no longer an important source of revenue in most countries. Government is loathe to give up something it has a claim on doing. Two functions of money: unit of account, and medium of exchange. Private monies are not legal tender--we can't force others to accept them. Currency swaps in foreign currencies. Economies of scale to liquidity.

44:15 Because the currency value is not kept up with a regimented amount of gold, some argue that the whole thing is a house of cards. No backing. If you feel they are a sham, I'd be happy to accept them and sell you some services in return. Gold standard argument: some psychological. Some believe price level will be more stable and there would be fewer business cycles because the supply of gold is pretty stable. Slower to mine it than to print paper money. But look at the price of gold--it's very volatile. On a gold standard, the price level would thus be volatile. Would work best if all countries were on it. Is price of gold erratic mostly because it's speculative? Gold is a hedge against bad times and also against bad fiat (paper) money performance. Why take the chance? Why is gold a hedge against risk? True empirically. Russian ruble example, wallpaper. Why would you turn to gold? It's just a piece of metal. It's become a norm, but it's kind of no more reliable than fiat money. No necessary reason for that. Psychology. Historically, small amounts were quite valuable, you could hide or store it and it would be worth a lot. May not apply in today's world. Diamonds: little, associated with promises kept. On gold standard, more swings in a downward direction; greater chance of negative monetary shock with a gold standard. Great Depression and monetary shock. Could argue that gold standard could possibly do as well as we do now. Transition question: what is the right price of gold? If we make a transition at the wrong rate there would be a sudden inflation or deflation, and we'd give up on it.

54:34 Independence of the Fed. Political economy: Is it plausible to think that the stabilities will persist in the next 25 years? New Zealand has Central Bank that is required to have inflation per the legislature, stable. Friedman podcast, attributed improvement in N.Z. performance to Donald Brash. Brash took over in 1989; by 1992 Act in full swing. Fed independence is something of a misnomer. They track public opinion. Supreme Court: political forces do matter and behavior appears to be responsive. Friedman's prescriptive rule for monetary growth idea has been abandoned (originally 3% per year handled by a computer), early 1980s. One problem: which money supply? But also, perception that if you freeze rate of growth of money supply, could have short term interest rate or exchange rate volatility would be unacceptable. Swiss example, ended up in price growth rules instead of monetary growth rules. Big learning process, 1980s. Focus on the outcome rather than on the tool. Maybe because the Fed can't really control "the" money supply. Independence: Fed's mandate is not only to control inflation, but also to achieve a stable "economy." But they do not have enough instruments to do this.