Friday, September 7, 2012

Me as Fed Chairman

Following the advice of David Owen, author of The First National Bank of Dad, as heard here on EconTalk, I created a savings account for my nine-year-old daughter to help her understand the value of savings and the power of compound interest. Complete with spreadsheet and graphs, she can watch her money grows at 5% per month while invested with me. We are just a couple of weeks in. So far, so good. She seems interested and is getting the concept. Her track record was good to begin with having just saved up enough to purchase her own iPad.

This post by Scott Sumner got me thinking about my little experiment in financial education. Let’s assume that there is no trade done with the world outside of our household—we are purely self-sufficient. But instead of being ludicrously poor as we actually would be, let’s assume all the goods and services we currently have access to are of our own making. Let’s further suppose that in our little household economy we begin to fall below trend in aggregate demand and a gap opens between potential and actual GDP. I as Fed chairman now feel compelled to deliver a boost to our household economy. I need to get my daughter spending her money. Question: what is the most effective way for me to do so?

I could of course tinker with the interest-rate being paid to her on savings. We are very far from the zero-rate boundary; thus, fears of a liquidity trap are not relevant. But I suspect that interest-rate adjustments downward would have little effect on her spending decisions. Here is an alternative: I can buy her stuff. I start with some of her less appreciated toys and clothes and eventually, if necessary, move up towards American Girl dolls and the iPad. As she realizes money balances far in excess of what she desires, the spending will commence and in force, I can assure you.

This is not a perfect analogy namely because we are talking about physical/use assets rather than financial assets. But I believe it captures the point that interest-rate targeting and manipulations are not the most direct and effective monetary policy to achieve what is actually desired.

PS. In a later post I will expound upon my theory as to the factors that caused this past recession and current recovery to be so difficult, deep and slow. Hint: I don’t believe it is all about AD.