NCPA - National Center for Policy Analysis

How The Fed Controls The Monetary Base

March 27, 2001

While the world anxiously awaits the Federal Reserve Board's next move on the discount rate, which is a benchmark for other interest rates, economist Arthur B. Laffer points out that the true source of the Fed's economic power is not in the setting of interest rates, but in its control of the monetary base.

The discount rate is the interest rate the Fed charges member banks for borrowing reserves -- but at present, member banks have only about $34 million (yes, million) borrowed from the Fed, and that number has stayed below $1 billion for a long time.

  • The key to the Fed's power, says Laffer, is its total control over the monetary base -- the sum of currency in circulation, vault cash and member-bank deposits at the Fed.
  • It increases or decreases the monetary base by buying or selling bonds in the open market.
  • The monetary base, in conjunction with reserve requirements, determines bank liabilities, and bank liabilities along with real output give us the overall price level.

Furthermore, the discount rate always follows the three-month Treasury bill rate. The reason is that if it gets much higher than the discount rate, member banks will borrow all they can for a guaranteed profit. And if the discount rate far exceeds the three-month T-bill rate, only those banks in desperate straits would ever borrow.

"In dynamic terms, the rate of growth of the monetary base ultimately determines inflation, interest rates, the price of gold, exchange rates, etc." says Laffer. "By controlling the monetary base, the Fed really does control our nation's destiny and probably the economic well-being of the world."

Source: Arthur B. Laffer, "So You Thought the Fed Set Interest Rates?" Wall Street Journal, March 22, 2001.

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