Spotted this question on Yahoo! Answers (I was looking for examples of non-moral values but that's another story):

What is NOT a function of the Federal Reserve?
A. Giving short-term loans to banks
B. Controlling the money supply
C. Regulating depository institutions
D. Lending money to businesses for investment

This is an intro to macro classic. If you said D, that was the correct answer.  At least until the financial crisis.  Some of the recently added facilities look like they could fall into that last category.  For example, the Commercial Paper Funding Facility, which buys commercial paper directly from issuers.  That sounds a lot like "lending money to businesses..." 

Time to add E. None of the Above
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The Reserve Bank of Australia became the first G20 central bank to raise interest rates today, increasing its policy interest rates by 25 basis points to 3.25%.  Of course, Australia has done very well through the financial crisis, relatively speaking.  It's banks have remained pretty strong, China has continued to demand Australia's commodity exports, and Australia has only had one quarter of negative GDP growth.  (Australia's real GDP fell 2.8% at an annual rate in 2008Q4.  while in the United States, recessions are declared by the NBER Business Cycle Dating Committee, many countries simply consider a recession to be in effect after two consecutive quarters of negative economic growth.) 

The RBA's decision to raise interest rates resulted in a drop in the dollar.  With Australia raising interest rates, investors know that there are assets out there where they can get higher returns, so low-yielding Treasuries don't look like such a good deal, despite their safety.  The decision is also a vote of confidence in the world economy, which could increase investor's expected returns on assets other than Treasuries.  As Australia and other countries (possibly Korea?) start raising interest rates ahead of countries like the United States and Japan, keep your eye out for a revitalization of the carry trade, where investors borrow in countries with low interest rates, and invest in countries with higher interest rates.
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One of the House Financial Services Republicans' financial regulation reform proposals is increased oversight of the Federal Reserve, including an explicit inflation target.  Explicit inflation targets, where the central bank announces a specific inflation rate it intends to achieve, are used by a number of central banks around the world, including the European Central Bank and the Bank of England, both of which aim for 12 month consumer price inflation near 2%. 

In recent years, the European Central Bank has managed to keep inflation closer to 2% than the Federal Reserve.
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However, targeting alone doesn't tell the whole story.  The European Central Bank is charged with considering price stability first, and economic growth second.  The Federal Reserve is supposed to consider both equally.  Thus, one would not necessarily expect the two monetary regimes to have identical inflation rates, even if they were both explicitly targeting 2% inflation.

An explicit inflation target can be useful to help build confidence in a central bank and ground inflation expectations-- if the central bank can meet the target.  If it can't, the central bank risks losing confidence. Among central banks, the Federal Reserve may be least in need of building confidence, due to its long, respected record. If public confidence in the Federal Reserve were to falter, implementing an explicit inflation target might help.  However, even though the Federal Reserve has become the target of some public blame for the financial crisis, markets appear to still have faith in its ability to maintain price stability. Inflation expectations (which can be gauged by looking at the difference between the yields on regular Treasury notes and the yields on notes indexed to inflation) have remained close to 2% for the medium to long term. This suggests that an explicit inflation target would do little to improve the functioning of the Federal Reserve.
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This is my first post, so let's get right to the substance.  I just received an email asking me what I thought about this article:  http://www.guardian.co.uk/commentisfree/2009/jan/20/george-monbiot-recession-currencies 

The author proposes allowing local communities to issue their own currencies, rather than have the federal government go deep into debt to stimulate the economy. To encourage spending, the community could impose a fee, called demurrage, for holding the money.

The idea of privatizing money is not particularly extreme to me-- the author gives several instances in which it has been done-- but can it do anything to end a recession that current fiscal and monetary policy can't? Issuing local script could increase money supply, but the Fed can do that with monetary policy now.  Issuing local script might allow local governments to increase spending without issuing debt, which sounds great, but is problematic.  Funding governments by printing lots of paper money tends to be an unsuccessful strategy (ask Zimbabwe!-- and by the way, that source of funding isn't really tax free; consumers pay the "tax" in the form of inflation), and anyway, if we really wanted to go down that road, the Fed and Federal Government could do it too.  The demurrage fee doesn't give much advantage either, since inflation acheives the same result (it makes your money lose value, penalizing you for holding it), although a demurrage fee is more direct and might be a more effective option if we get into a deflation situation.

The main benefit would appear to be that the community could choose its own monetary policy.  There would be benefits to this.  Communities with weaker economies, like Detroit, could have looser monetary policy than communities with stronger economies.

There are definate disadvantages to localized monetary policy too.  People would have to convert their currencies more often. Also, local currencies would likely trade at a discount, since they would be less liquid and people would probably have less faith in them.  Keeping track of exchange rates could be confusing. Lastly, moving towards many local currencies might erode faith in the U.S. dollar.  Faith in the dollar has attracted investors looking for a safe haven.  Were that not the case, we could be facing a full-fledged flight of capital and currency crisis. 

In conclusion, I'd like to register my vote of confidence in the Fed.  The idea of local currencies is worth discussing, though, because it helps identify what monetary and fiscal options might be helpful in our recession.   

 

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