Sunday, April 17, 2011

Magic Money Machine

Alright, so I and some of my esteemed colleagues here at Vassar College have put together a little video for the St. Louis Fed's competition. Every year, they challenge teams to put together a 5 minute film answering some economic question at a level understandable by high-schoolers. This year's query: Why should the central bank (i.e.- Fed) be independent (i.e.- not answerable to the executive branch of government)? Seems like a good topic for an EconStu post, as well.

Here's the reason we covered in our video and though there are countless arguments to be made, this is, in my opinion, the most convincing. Fed non-independence leads to political business cycles. Let's say it's election season (oh boy!!!!), and the incumbent president really needs a boost. Without central bank independence, he can march over to the Fed and say, "Pump out some more money!" What does this do? Well, just as you might imagine, there's simply more money. Expected inflation goes up, and people's wages adjust. However, for those of you who have taken intermediate macroeconomics, you know that prices are "sticky," as in they don't change instantaneously. So, for a little while at least, everybody feels richer, buys more, and is generally peachy. Come voting day, Mr. Incumbent begins planning for his next 4 years in office. Then, slowly, producers and retailers see demand for their goods rising, and they say, "Hmmm, I think I could raise prices." And they do, and now no one feels richer anymore. In fact, in relative terms, $1 is worth less than it was before. Oh the pains of inflation.

But with central bank independence, when that prez picks up the phone and calls up the Fed, Mr. Chairman can say, "I don't have to listen to YOU!"

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