With the United States economy officially in a recession, the Obama Administration has vowed to save it by assembling an $800 billion plan that is supposed to revive our economy. As the second stimulus bill is passed, it is important to know the basic fundamentals of such a bill, and what impact it will have on our economy. This stimulus has no guarantees of creating jobs, saving jobs, or even saving the economy. No matter how large and powerful the government is perceived, it has almost no control over the economic repercussions that will result from their intervention. As college students, we might not yet be paying for this bill currently, but we surely will be in the future for years to come, and so will our children.
The 'monetary base' represents the supply of liquid, physical money in an economic system, currency and commercial bank reserves. The monetary base is controlled through "Open Market" operations, known as Monetary Policy. In order to regulate the supply of money in the United States Economy, the Chairman of the Federal Reserve, currently Ben Bernanke, will utilize the open market tactic of changing a key interest rate known as the Federal Funds Rate. The Federal Funds Rate, the interest rate at which banks charge each other for loans, in 2008 alone has decreased by 325 basis points (from 3.50% to 0.25%; currently at 0.25%). What does this usually mean in a time like this? When real money is tight, the Fed encourages banks to lend to each other at a cheaper rate, in order for business commerce to remain active across the economy.
With inflation usually being described as a general rise in the level of prices for goods and services, this instance would relate more to "monetary inflation" which results from an increase in the money supply. However, it is important to remember that the stimulus package will not increase the money supply. The tax payers are paying for the package with money that is already in circulation, as well is the government by issuing treasuries. However, the extremely low interest rates from the Fed will increase the money supply in the economy.
The way that the stimulus package is funded is through the issuing of treasury securities (T-bills, T-notes, T-bonds) which are government-guaranteed bonds from the United States Department of the Treasury, at security auctions. Recently, the Treasury issued about $100 billion in treasuries, the most on record at any single auction. Several more auctions of this type will be held until the US Treasury has raised the entire $800 billion of the stimulus package. Banks, individuals, and large foreign governments like China, Japan and some oil exporting countries buy these treasuries. Once the treasuries are sold to establish value, money is created by the literal printing of dollars by the Federal Reserve. The Fed increases the money supply itself by buying treasuries from banks and institutions, and exchanging them for these freshly printed dollars.
These treasuries have different time frames and yields, for example 3 months at 0%, 10 years at 2.75% and 30 years at 3.5%. When the treasuries reach maturity, the government has to pay the principle back along with the given interest. The concept behind this is that the government issues treasuries to fund the projects of the stimulus package in hope that those new projects will create more money and, as a result, increase tax revenues. With increased tax revenues, the government is then able to pay back treasury holders with their appropriated interest. However, currently tax revenues are falling drastically due to the fact that over three million jobs have been lost over the past year or so. As a result, the government has to become creative to find ways of creating tax revenues – for example new tolls on highways or increased parking meter rates.
What does this do to the value of the dollar? The stimulus package should not increase the money supply, but Federal Reserve Chairman Ben Bernanke still wants to keep the Federal Funds Rate low on the longer end of the treasury yield curve, meaning that he wants to keep 10 year and 30 year treasury bonds around 2% to minimize the amount of interest the treasuries will accrue. Bernanke has threatened to purchase several of these long-term treasuries by printing trillions of dollars. If this were to happen, the value of these treasuries would be replaced with paper money and, as a result, the dollar should significantly devaluate. It is hard to predict the value of the dollar in the future because currency markets at large are all relative to one another. Still, the definition of inflation is an increase in the money supply and due to the fundamental fact that the economy would have more dollars in circulation for roughly the same amount of goods (resulting in prices increasing faster than wages can increase), savings and assets should devalue, perhaps rapidly. But, since much of the world is in a primarily worse situation than the United States, this devaluation will be reflected in the value of other countries currencies too. Since the dollar is arguably the lesser of two devalued currencies, it should remain relatively "strong".
In the near future, this "strong" dollar could lead to a possible trend of deflation. Deflation, an increase in the real value of money, comes as a result of decreased credit, a decrease in the level of aggregate demand, and also a decrease in investment. This decrease in investment is caused by investors and buyers who have become overwhelmed by risk, and therefore hoard money. Unless the credit markets unfreeze and the economy begins to recover on a fundamental basis, after a few years the United States economy could experience hyper-inflation. History has shown for every fiat currency that has existed, this has been the case. This is a scary concept but its becoming more of a reality everyday. In a classic example of hyperinflation, in 1921, one US dollar was worth about 60 Deutchmarks; but only 2 years later, in 1923, one US dollar was worth over 1 trillion Deutchmarks.
As the credit markets begin to unfreeze and the housing and financial markets begin to stabilize, the Fed can contract money supply by buying back the securities they had previously sold to banks in exchange for the dollars they had previously printed, removing money from the monetary base and easing inflation.
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