COVID-19: understanding the Federal Reserve’s response and the money supply

Hello and welcome to today's case study. Today I'd like to talk to you about a topic that's on many people's minds as we enter 2020, COVID-19. In particular, I'd like to talk to you about the response from the government and the Federal Reserve as it relates to the money supply and how we've tried to use economic tools to combat the harmful effects of the coronavirus. I'm Dr. Michael McDonald. I'm a professor of finance at Fairfield University in Fairfield, Connecticut. Now, let's go ahead and get started on this important topic, shall we?

To set the stage for this topic, it's important that you understand the US Federal Reserve as a whole. The Federal Reserve System is the US Central Bank. Most modern economies around the world have a central bank of some sort. Most of the major nations in Europe do, certainly the UK does, the US, Canada, etc. The Federal Reserve is the US's version of the central bank. It controls the US money supply and it plays a key role in keeping the economy for the country working smoothly. Now the Federal Reserve is governed by a board of governors, there are seven members to that. It also has 12 regional Federal Banks that help to administer the economy over time. The Federal Reserve's job is to take these 12 banks and try to ensure that the financial system across the US remains smooth and effective.

Specifically, the Federal Reserve has what we refer to as a dual mandate. Their dual mandate is to maximize employment and at the same time, stabilized prices or said differently, keep inflation in check. Now, it might sound like these two objectives aren't necessarily in opposition to one another, but in point of fact, they are. One way to maximize employment is to try to get the economy running really hot, to try to get the economy growing really fast. The problem with that historically has been that it leads to the economy overheating and inflation rising rapidly out of control. Basically, we can get a lot of people spending money and get the economy moving really quickly if we just start handing out green pieces of paper to everybody. If the federal government begins sending everybody a check for $5,000 every single month, people will go out and spend that money and the federal government can do this because it prints the money in the first place. The problem is adding all of that extra money into the system actually creates inflation. Inflation in this case is just rising prices over time, so as there's more and more green pieces of paper out there, they lose their value and the actual underlying value of hard goods and services in the economy is unchanged. Said differently, if everybody's a millionaire, that is they have a million green pieces of paper, that's great, but it doesn't change the number of hamburgers we can actually make in the economy and so people's wealth might go up in dollar terms, but the number of hamburgers there are to consume actually won't change. The idea is that employment, which is a function of how strongly the economy is growing and inflation are in opposition to one another, so we try to balance these two. That's the basic idea. As you might imagine, this is a tricky proposition. Balancing employment against inflation is difficult. This relies on what we call the Phillips curve, which trades out essentially employment against inflation. What it shows is that while we can only do just so much in terms of reducing unemployment, we're never going to be able to get every single person in the country to have a job, why? Well, some people don't want to have a job. Sometimes I might quit my job looking for a better one. Sometimes I might have the wrong skills for a job that's out there as an example. Sometimes I might have no job because of a downturn in the economy. We refer to these as cyclical, secular, and structural unemployment. Our job at the Federal Reserve is to reduce cyclical unemployment. How does the Fed do this? Well, they're going to try to keep the economy running at a nice steady pace, so that unemployment stays relatively low, say in the 3-5 percent range, while at the same time, keeping inflation to, say maybe, two percent per year or less, say in the range of 0-2 percent. That way, people's savings aren't eroded, prices don't rise too fast, but we still have plenty of jobs out there for people. The Federal Reserve accomplishes this by controlling the banking system and controlling the money supply. In particular, the Fed provides oversight and stability to the banking system and more broadly, to the financial markets as a whole.