The Differential Effects of Tight Money

When money tightens, some borrowers are squeezed more than others. Banks naturally tend to allocate their scarce funds to old, established customers. Conversely, new small firms and individuals tend to be squeezed out, especially when their credit rating is not high. Tight money squeezes home construction especially, because high interest rates bulk large in total monthly mortgage payments and because many banks rank such loans below those to businesses that they see as long-run customers.

The differential effects of tight money are too complex for examination here. But it is important to see that bitter claims of inequity may be expected from potential borrowers who are shut out when interest rates rise and there aren’t enough loans to go around. There is no way to restrict aggregate demand without turning away somebody, and the big, grade-A borrowers aren’t likely to be the ones turned away.

A further complication arises when the monetary authorities use direct controls (ceiling interest rates) to regulate the flow of savings to different financial institutions. S. and L.’s, for example, lend almost entirely to builders and home buyers. Thus, if they are permitted to pay high rates to the depositors while commercial banks are limited to lower rates, both S. and L.’s and the housing industry are favored relative to commercial banks and industries which borrow from the banks. Use of such direct controls involves open government action to favor some sectors over others. But even general monetary restraint must shut out someone from credit if it is to do its job. There is no way monetary policy can avoid restraining some potential borrowers more than others.

The Problem of Timing and Logs

Consider now another Federal Reserve problem in deciding what to do at any given time. The problem breaks down into two big questions: First, what is the state of the economy now, and where is it going in the absence of further monetary policy action? Second, what shall we do to mold this pattern into one of stable economic growth without inflation? Look at Fig. 12-2, which provides a very rough picture of a business cycle, and put yourself in the position of a member of the Federal Reserve Board.

FIG. 12-2 The Federal Reserve authorities seldom know
where we are in the cycle, or lust how long it will take
their actions to exercise their full effects. What is the
right monetary policy if you think we’re probably at B,
but there’s a good chance it may be C instead?

First, you have to decide where you are now. At A, B, C, or D? You don’t know for sure, and neither does anybody else. Suppose you think we’re probably well along in a strong business upswing—say at about B. Then the problem is, how near the top? And how long will the inflation and prosperity continue if you do nothing? Is the boom weakening, with a downturn just around the corner? Or does the upswing have months or years of healthy prosperity left in it, so that it would be a shame to damp it? Or is the economy overheating so fast that inflation and speculation will generate a collapse unless the pace is slowed? If only you knew!

Second, given your best decision as to where we are and where we’re headed, you have to decide what the Fed should do now. Suppose that you suspect we’re at B, and that inflation poses a serious problem. Should you raise reserve requirements? Sell bonds in the open market to tighten  reserves? Or is the safe thing just to wait till we’re clearly at D if that comes, and then fight the recession, on the ground that it’s better not to risk killing off prosperity?

Note that here you face two subproblems. One is, how much effect will any Federal Reserve action have on the course of business activity? If you sell $1 billion of government bonds, will this drastically check bank lending, or only slow it slightly? How about raising reserve requirements 10 per cent? The second question is, even if you know what the effect will be, how long will it take for the full impact of tighter money to be felt? If you sell bonds tomorrow, this may only gradually shut off lending and that in turn may reduce C and I still later. Thus, the full effects of your action will be spread over months, perhaps over a year or two. By that time the boom may have turned down. Then the (lagged) effect of tight money would be to speed the downturn into recession.

The lags and uncertainties between Federal Reserve actions and their final impact on total spending are substantial. How long will it take the banks to react to tighten reserves? \Vill they try to sell off government securities and thus temporarily evade the desired restriction on business borrowing? How fast will businesses react to tighter credit and higher interest rates? Will the Fed’s action have a strong psychological effect that reduces business investment? Some economists estimate the total lag between Federal Reserve action on reserves and the ultimate major effect on g.n.p. as long as 12—18 months, and suggest that the lag varies depending on prevailing conditions. Most agree that the major effect of Federal Reserve action is felt beginning immediately and spreading over some six to 12 months. But the Fed doesn’t know for sure. And it has to act, or let things go their way without control.

Federal Reserve officials have sometimes de— scribed their policy as “leaning against the wind.” By this they mean that when the economy is moving up they tend gradually to impose a drag on the upswing; and when it is moving down they tend gradually to increase the monetary ease in the system to check the downswing. Question: Suppose the average lag of the effect of monetary policy is six months. Is a policy of leaning against the wind a sound one at all times?