Steven Den Beste, in his inimitable way, has a fascinating (Hey, I’m a geek an engineer…) new post up on, well, pretty much everything. But he eventually gets around to the main thrust of the topic and it has to do with Greenspan raising the interest rate by a quarter point in an effort to stave off inflation.
Generally, the Fed uses two main tools to try to control the economy. The Fed can pump new money into the system by “buying” federal bonds with money they conjure out of thin air. The Fed does this at a pretty regular rate, but generally they don’t like using this for primary control, and prefer to rely on the discount rate.
When the Fed changes the discount rate, in theory other kinds of interest rates tend to track it up and down. Of course, in practice it’s nothing like that straightforward. Sometimes they respond immediately and proportionally. Sometimes there’s a delay. Sometimes it has no effect. Sometimes other interest rates move in the opposite direction. Sometimes they move the same direction but less far; sometimes they move the same direction but much further. And in terms of larger effects, sometimes changes in interest rates affect overall activity and sometimes such changes don’t. And almost always it takes a long time.
The theory says that lowering the discount rate leads to lower interest rates overall, which tends to stimulate economic activity. But it doesn’t always work that way.
Now, I didn’t even get Father Guido Sarducci’s Five Minute University education in economics (“Supply and-a Demand. That’s it.”) but I remember one thing I read long ago: The Fed has essentially only one control, and that control is like a rope around the neck of the economy. The Fed can pull on that rope and choke the economy with a fair amount of effectiveness – cut the money supply or raise the interest rates and the economy takes note right fast. But if it increases the money supply or lowers the interest rate, it’s a lot like pushing on that rope. The noose might not loosen, and the economy might not notice.
Hey, I’m my expertise is in gun control. Do you come here for economics dissertations? But that mental image stuck with me, and I thought you might find it interesting. And besides, I love Chaos Theory. I strongly recommend James Gleik’s Chaos: Making a New Science if you want to know more about this relatively new field in mathematics, physics, chemistry, economics, medicine….