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The Fed Temporary Monetary Expansion is Good for the Economy

Byron A. Ellis

December 13, 2007

Yesterday, the Federal Reserve (Fed) established a temporary Term Auction Facility (TAF) and foreign exchange swap lines with other central banks. They noted that these measures were designed to address elevated pressures in the short-term funding markets.

TAF will allow the Fed to auction off funds to banks against a wide variety of collateral that can be used to secure loans at the discount window. Thus, the Fed is providing a vehicle to add liquidity to the economy, which will more than likely relieve the ongoing credit crunch and jumpstart the housing market.

The first TAF auction of $20 billion is scheduled for Monday, December 17, 2007, followed by a second auction on December 20, and a third and fourth auction on January 14 and 28 of 2008, respectively. The Fed indicated that additional auctions might be implemented if needed.

The Federal Open Market Committee also authorized swap lines with the European Central Bank (ECB) and the Swiss National Bank (SNB) to provide dollars for use in their regions.

The move by the Fed is necessary, but risky. The initial impact of an expansion of the money supply is a reduction in nominal interest rates, the liquidity effect. Over time, however, excess cash balances will be used to purchase additional assets, and the lower interest rate will stimulate capital expenditures, the income effect. Both effects, if persistent, can lead to inflationary pressures.

Thus, the Fed has to carefully monitor the increase in demand for assets, since over time income and prices will tend to rise. However, real income will rise up to a point and return to what is considered normal. At this point, the money expansion will be embodied entirely in price increases. As prices rise, the inflation premium also rises, causing interest rates to rise.

The temporary monetary expansion by the Fed is what the economy needs, but it should be limited and carefully monitored.

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