Illustrating Economies of Scale

The concept of \”economies of scale\”has been lurking around economics since Alfred Marshall\’s Principles of Economics back in 1890 (see Book IV, Ch. VIII, from the 1920 edition here). It\’s one of the few semi-technical bits of economics-speak to make it into everyday discussions. But in explaining the concept to students I don\’t always have as as many good concrete examples as I would like. Here are some of the examples I use. But if readers are aware of sound citations to academic research to back up these examples, or other other examples with a sound research backing, I\’d be delighted to hear about them.

A number of examples of economies of scale are plausible real-world examples. Why are there only two major firms producing airplanes: Boeing and Airbus? A likely answer is that because of economies of scale make it, it is difficult for smaller firms to get more than a very specialized niche of the market. Why are there two big cola soft-drink companies: Coca-Cola and Pepsi? Why are there a relatively small number of national fast-food hamburger chains: McDonald\’s, Burger King, Wendy\’s? A likely explanation is that there are economies of scale for such firms, partly in terms of being able to afford a national advertising and promotion budget, partly in terms of cost advantages of buying large quantities of inputs. Why is there only one company providing tap water in your city? Because there are economies of scale to building this kind of network and running duplicative sets of pipes for additional water companies would be inefficient.

While I believe that these examples are a reasonable enough approximation of an underlying truth to pass along to students, I confess that I\’m not familiar with solid economic research establishing the existence and size of economies of scale in these cases.
In the second edition of my own Principles of Economics textbook, I give one of my favorite example of economies of scale: the \”six-tenths rule\” from the chemical manufacturing industry. (If you are an instructor for a college-level intro economic class–or you know such an instructor!–the book is available from Textbook Media. The price ranges from $20 for a pure on-line book to $40 for a black-and-white paper book with on-line access as well. In short, it\’s a good deal–and on-line student questions and test banks are available, too). The research on this rule actually goes back some decades. Here\’s my one-paragraph description from the textbook (p. 178):

\”One prominent example of economies of scale occurs in the chemical industry. Chemical plants have a lot of pipes. The cost of the materials for producing a pipe is related to the circumference of the pipe and its length. However, the volume of gooky chemical stuff that can flow through a pipe is determined by the cross-section area of the pipe. … [A] pipe which uses twice as much material to make (as shown by the circumference of the pipe doubling) can actually carry four times the volume of chemicals (because the cross-section area of the pipe rises by a factor of four). Of course, economies of scale in a chemical plant are more complex than this simple calculation suggests. But the chemical engineers who design these plants have long used what they call the “six-tenths rule,” a rule of thumb which holds that increasing the quantity produced in a chemical plant by a certain percentage will increase total cost by only six-tenths as much. \”

A recent related example of how pure size can add to efficiency is a trend toward even larger container ships. For a press discussion, see Economies of scale made steel: The economics of very large ships in the Economist, November 12, 2011,. The new generation of ships are 400 meters long and 50 meters wide, with the largest internal combustion engines ever built, driving a propeller shaft that is 130 meters long and a propeller that weighs 130 tons. Running this ship takes a crew of only 13 people, although they include a few more for redundancy. Ships with 20% larger capacity than this one are on the way.

One useful way to help make economies of scale come alive for students is to link it with antitrust and public policy concerns. For example, a big question in the aftermath of the financial crisis is whether big banks should be broken up, so that the government doesn\’t need to face a necessity to bail them out because they are \”too big to fail.\” I posted about this issue in Too Big To Fail: How to End It? on April 2, 2012  One piece of evidence in the question of whether to break up the largest banks is whether they might have large economies of scale–in which case breaking them up would force consumers of bank services to pay higher costs. However, in that post, I cite Harvey Rosenblum of the Dallas Fed arguing: \”Evidence of economies of scale (that is, reduced average costs associated with increased size) in banking suggests that there are, at best, limited cost reductions beyond the $100 billion asset size threshold.\” Since the largest U.S. banks are a multiple of this threshold, the research suggests that they could be broken up without a loss of economies of scale.

Another recent example of the interaction between claims about economies of scale and competition policy came up in the recently proposed merger between AT&T and T-Mobile. The usual counterclaims arose in this case: the companies argued that the merger would bring efficiencies that would benefit consumers, while the antitrust authorities worried that the merger would reduce competition and lead only to higher prices.
Yan Li and Russell Pittman tackle the question of whether the merger was likely to produce efficiencies in \”The proposed merger of AT&T and T-Mobile: Are there unexhausted scale economies in U.S. mobile telephony?\” a discussion paper published by the Economic Analysis Group of the U.S. Department of Justice in April 2012.

\”AT&T’s proposed $39 billion acquisition of T-Mobile USA (TMU) raised serious concerns for US policymakers, particularly at the Federal Communications Commission (FCC) and the Antitrust Division of the Justice Department (DOJ), which shared jurisdiction over the deal. Announced on March 20, 2011, the acquisition would have combined two of the four major national providers of mobile telephony services for both individuals and businesses, with the combined firm’s post-acquisition share of revenues reportedly over 40 percent, Verizon a strong number two at just under 40 percent, and Sprint a distant number three at around 20 percent. …

All of this raises the crucial question: How reasonable is it to assume that under current (i.e. without the merger) conditions, AT&T and T-Mobile enjoy substantial unexhausted economies of density and size of national operations? Recall that the fragmentary estimates made public suggest claims of at least 10-15 percent reductions in cost, and perhaps 25 percent or more. Absent an econometric examination of mobile telephony for the US as a whole as well as for individual metropolitan areas, what can we infer from the existing literature? The literature on at least one other network industry is not particularly supportive. … Most of the existing empirical literature features observations at the firm level, with output measured as number of subscribers or, less frequently, revenues or airtime minutes. These studies tend to find constant returns to scale or even decreasing returns to scale for the largest operators – i.e., generally U-shaped cost curves. …

[I]t is unlikely that T-Mobile, and very unlikely that AT&T, are currently operating in a range where large firm-level economies related to activities such as procurement, marketing, customer service, and administration would have been achievable due to the merger. Regarding both measures, the presence of “immense” unexhausted economies for the two firms seems unlikely indeed. On this basis (and on this basis alone), our results support the decision of DOJ to challenge the merger and the scepticism expressed by the FCC staff.\”

Li and Pittman also raise the useful point that very large firms should perhaps be cautious about claiming huge  not-yet-exploited economies of scale are available if only they could merge with other very large firms. After all, if economies of scale persist to a level of output where only one or a few mega-firms can take advantage of them, then an economist will ask whether this is a case of \”natural monopoly,\” and thus whether there is a case for regulation to assure that the mega-firm, insulated from competitive challenge because it can take advantage of economies of scale, will not exploit its monopoly power to overcharge consumers. As Li and Pittman write of the proposed merger between AT&T and T-Mobile: \”[W]e may justifiably ask whether if one believes the evidence of “immense” economies presented by the merging companies, one should take the next step and consider whether mobile telephony in U.S. cities is a “natural monopoly”, with declining costs throughout the relevant regions of demand?\”

Finally, an intriguing though that economies of scale may become less important in the future, at least in some areas, comes from the the new technology of manufacturing through 3D printing. Here\’s a discussion from the Economist, April 21, 2012, in an article called \”A third industrial revolution\”

\”Ask a factory today to make you a single hammer to your own design and you will be presented with a bill for thousands of dollars. The makers would have to produce a mould, cast the head, machine it to a suitable finish, turn a wooden handle and then assemble the parts. To do that for one hammer would be prohibitively expensive. If you are producing thousands of hammers, each one of them will be much cheaper, thanks to economies of scale. For a 3D printer, though, economies of scale matter much less. Its software can be endlessly tweaked and it can make just about anything. The cost of setting up the machine is the same whether it makes one thing or as many things as can fit inside the machine; like a two-dimensional office printer that pushes out one letter or many different ones until the ink cartridge and paper need replacing, it will keep going, at about the same cost for each item.

\”Additive manufacturing is not yet good enough to make a car or an iPhone, but it is already being used to make specialist parts for cars and customised covers for iPhones. Although it is still a relatively young technology, most people probably already own something that was made with the help of a 3D printer. It might be a pair of shoes, printed in solid form as a design prototype before being produced in bulk. It could be a hearing aid, individually tailored to the shape of the user’s ear. Or it could be a piece of jewellery, cast from a mould made by a 3D printer or produced directly using a growing number of printable materials.\”

Right now, 3D printing is a more expensive manufacturing technology than standard mass production, but it is also vastly more customizeable. For uses where this flexibility matters, like a hearing aid or other medical device that exactly fits, or making a bunch of physical prototypes to be tested, 3D printing is already beginning to make some economic sense. As the price of 3D printing falls, it will probably become integrated into a vast number of production processes that will combine old-style mass manufacturing with 3D-printed components. One suspects that a high proportion of the value-added and the price that is charged to consumers will be in the customized part of the production process.

Robert Kennedy on Shortcomings of GDP in 1968

Every year or two, I run across this lovely quotation from Robert F. Kennedy about the fundamental shortcomings of gross national product as a measure of well-being. It\’s from a speech he gave at the University of Kansas on March 18, 1968, and a transcript is available here.  Here\’s RFK:

\”Too much and for too long, we seemed to have surrendered personal excellence and community values in the mere accumulation of material things.  Our Gross National Product, now, is over $800 billion dollars a year, but that Gross National Product – if we judge the United States of America by that – that Gross National Product counts air pollution and cigarette advertising, and ambulances to clear our highways of carnage.  It counts special locks for our doors and the jails for the people who break them.  It counts the destruction of the redwood and the loss of our natural wonder in chaotic sprawl.  It counts napalm and counts nuclear warheads and armored cars for the police to fight the riots in our cities.  It counts Whitman\’s rifle and Speck\’s knife, and the television programs which glorify violence in order to sell toys to our children.  Yet the gross national product does not allow for the health of our children, the quality of their education or the joy of their play.  It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials.  It measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country, it measures everything in short, except that which makes life worthwhile.  And it can tell us everything about America except why we are proud that we are Americans.\”

Although economists sometimes stand accused of worshiping GDP, this charge is untrue. Every introductroy economics textbook, including my own (available here through Textbook Media), acknowledges these shortcomings, although I confess we lack the poetic cadences of RFK. But the quotation can be a nice supplement when introducing students to the concept of GDP, or when looking for a topic for a short writing assignment or essay question.

The speech isn\’t long, and if you are a connoisseur of political rhetoric, it\’s worth reading. Of the current politicians on the national stage, I don\’t think any of them has the lovely touch with self-deprecating humor at the start of this kind of talk. Here\’s RFK warming up the audience–and remember that there are many Kansas students in the audience who don\’t especially support him:

\”I\’m very pleased and very touched, as my wife is, at your warm reception here.  I think of my colleagues in the United States Senate, I think of my friends there, and I think of the warmth that exists in the Senate of the United States – I don\’t know why you\’re laughing – I was sick last year and I received a message from the Senate of the United States which said: \”We hope you recover,\” and the vote was forty-two to forty. And then they took a poll in one of the financial magazines of five hundred of the largest businessmen in the United States, to ask them, what political leader they most admired, who they wanted to see as President of the United States, and I received one vote, and I understand they\’re looking for him.  I could take all my supporters to lunch, but I\’m – I don\’t know whether you\’re going to like what I\’m going to say today but I just want you to remember, as you look back upon this day, and when it comes to a question of who you\’re going to support – that it was a Kennedy who got you out of class.\”

It\’s also hard to imagine that the speechwriters for any contemporary politician would let them finish a speech with this kind of classical reference and slightly obscure flourish: \” I want the next generation of Americans to look back upon this period and say as they said of Plato: \”Joy was in those days, but to live.\”\”

McCloskey on the Great Fact of Economic Growth

In a characteristically ornate, well-considered, good-humored and provocative essay, Dierdre McCloskey has a lot to say about \”A Kirznerian Economic History of the Modern World.\” This essay was originally presented at the 2010 Upton Forum at Beloit College, which focused on the work of Israel Kirzner. This link is from a post by Peter Boettke at Coordination Problem. The conference proceedings will eventually be available third Annual Proceedings of the Wealth and Well-Being of Nations, although the essays don\’t seem to be posted on the Upton Forum website yet. Here\’s McCloskey:

\”What I got with a jolt around age 65 was that economic growth since 1800, the Great Fact of an increase of real income per head by a factor of anything from a factor of 16 (using the most conventional statistics in the countries that were richest at the outset) all the way to (if you properly account for improved quality) a factor of 100, had very little to do with routine, Samuelsonian/ Friedmanite/Douglass-Northian adjustment of marginal cost to marginal benefit. That is, mere supply-and-demand efficiency does not explain the modern world. …\”

\”The problem with all the economistic explanations lies deep within classical and most of subsequent economic thought: the conviction that shuffling stuff around makes us a little better off, which is true; and therefore that the shuffling makes us as rich as modern people are, which is false. Trade. Transportation. Reallocation. Information flow. Accumulation. Legal change. … Yet the path to the modern was not through shuffling and reshuffling. It was not by the growth of foreign trade or of this or that industry, here or there, nor by shifting weights of one or another social class. Nor indeed was it by reshufflings of property rights. Nor, to speak of another sort of reshuffling, was it by rich people piling up more riches by shuffling income away from their worker-victims. They had always done that. Nor was it through bosses being nasty to workers, or through strong countries being nasty to weak countries, and forcibly shuffling stuff toward the nasty and strong. They had always done that, too. Piling up bricks and money and colonies had always been routine. … The new path was not about anciently commonplace theft or accumulation or commercialization or reallocation or conquest of foreign kings or any other reshuffling. It was instead about discovery, and a creativity supported by novel words. In terms of the seven principal virtues, the routine of efficiency that Samuelsonian economists love so passionately depends only on the virtue of Prudence …  What I am claiming here is that Austrian discovery and creativity depends also on the other virtues, in particular on Courage and Hope. … As a result, previously unknown inputs were discovered (coal for steam engines; then coke for iron; then natural gas to replace the sickening coke burnt in French kitchens), fresh hierarchies of ends were articulated (in the new political economy, for example, which tended to the democratic end of general vs. privileged prosperity; in the new politics, which tended to the radical end of strict equality), new goods and services were created (black tulips, common stocks, reinforced concrete). All of it was very far from routine Prudence. …

To put it another way, economics in the style of Adam Smith, which is the mainstream of economic thinking, is about scarcity and saving and other Calvinistic notions … In the sweat of thy face shalt thou eat bread, till thou return unto the ground. We cannot have more of everything. Grow up and face scarcity. We must abstain Calvinistically from consumption today if we are to eat adequately tomorrow. Or in the modern catchphrase: There Ain’t No Such Thing as a Free Lunch (TANSTAAFL). But over time, taking the long view, modern economic growth has been a massive free lunch. Discovery, not reshuffling, was the mechanism, and the springs were the nonprudential virtues.\”

All of this and much else in the essay is very well-said, as one expects from McCloskey, but at some level, the posited separation between supply-and-demand efficiency and economic growth seems to me a bit overstated. Yes, basic supply and demand is static and one-time, and economic growth is a dynamic process over time. But at least when I teach supply and demand, I emphasize that the interaction of utility-maximizing consumers looking and profit-seeking producers is an evolving process. Producers are continually attempting to entice consumers, through combinations of new qualities and new products, along with price competition. Consumers are continually seeking a better deal. To me, at least, even the most basic models of mainstream supply-and-demand economics are built on more than penny-pinching Prudence. They are also incorporate discovery, creativity, and even creativity and hope.

I fear that in McCloskey\’s effort to emphasize this broader perspective, she draws too bright a line between supply-and-demand and the Great Fact of economic growth, and thus veers close to a reductionist or perhaps a mechanistic view that if economic models don\’t include a specific variable for Courage or Hope or Creativity or Discovery, then the models can\’t encompass those motivations.  But being reminded of the importance of such concerns and motivations is always useful, and thus McCloskey\’s bracing and entertaining essay is well worth reading.

The Case Against Price Gouging Laws

Michael Giberson of Texas Tech University has written a nice readable essay on \”The Problem with Price Gouging Laws.\” Part of the essay rehearses standard economic arguments over such laws, but with a nice variety of examples and discussion from both economists and philosophers. The case for price gouging laws, of course, is that raising the price for selling necessary goods during an emergency is morally offensive. But economists are congenitally open to the possibility that, upon deeper reflection, people\’s first quick reactions about what is \”right\” or \”wrong\” may be misleading.  Price gouging laws have the following predictable consequences:

Discourage bringing supplies into certain areas. As one example, there is a chain of convenience stores in Tennessee called Weigle\’s. It sells gasoline, and it buys that gasoline on the spot market–not under long-term contracts. In 2008, when Hurricanes Gustav and then Ike tore through the Gulf of Mexico and shut down oil drilling, Weigle\’s ran out of gas. They trucked gas in from other cities, but the extra costs meant that they raised the price of gas by about $1/gallon. This let to an investigation by the state attorney general, which was eventually settle without an admission of wrongdoing, but with a mixture of payments  to the state and consumer refunds. The next time a similar  situation arises, one wonders whether Weigle\’s  will choose to pay the higher costs of trucking in gasoline from other cities. In South Carolina during the same episode, a number gas stations apparently just closed their doors, rather than risk facing charges of price gouging. More generally, if you want people from the cities surrounding a disaster area to bring in ice and food and batteries and other supplies for sale, then you need to be concerned that price gouging laws will discourage them from doing so.

Discourage conserving on key resources. If prices rise during an emergency, people have an incentive to buy only what they need, and not to stock up. As a result, supplies will run out more slowly and remain available for more people. Imagine a situation in which prices of hotel rooms are not allowed to rise, at a time when many evacuated families are looking for a room. A large family might reserve two rooms at the capped rate, but decide to crowd into one room at a higher rate–thus leaving a room available for another family.

Concentrate economic losses on certain economic actors. Price gouging laws often impose costs on merchants, whose costs rise in times of emergencies. They impose larger costs on smaller firms, who have a harder time getting resupplied, than they do on large national chains that have a built-in ability to shift supplies from elsewhere.

Concentrate economic losses on the disaster area. One study sought to analyze what would have happened in the aftermath of Hurricanes Katrina and Rita, if price-gouging laws had been in place. It found that such a law would have caused greater losses in the disaster areas, because if would have discouraged suppliers in neighboring areas from bringing in supplies. However, the neighboring areas would have moderated any costs to the neighboring areas, because supplies from those areas weren\’t being shipped to the disaster area. A web of economic transactions acts as a mechanism for spreading costs of shortages over a wider geographic area.

Before reading this article, I hadn\’t realized that the creation and spread of price-gouging laws is a relatively recent development. Giberson writes: \”The first state law explicitly directed at price gouging was enacted in New York in 1979, in response to increases in home heating oil prices during the winter of 1978–1979. …
Just three states passed similar laws in the 1980s: Hawaii in 1983, and Connecticut and Mississippi in 1986. Then, 11 more states added anti-price gouging laws or regulations in the 1990s and 16 states followed in the 2000s. When price gouging laws are revised, the tendency is for the scope of the law to be broadened, the penalties to become more punitive, and the conditions under which the laws are applied to become less restrictive.\”

More on Teaching Monetary Policy After the Recession and Crisis

John C. Williams of the San Francisco Fed discusses “Economics Instruction and the Brave New World of Monetary Policy.” I blogged a couple of weeks ago with some of my own thoughts about how to teach monetary policy after the events of the last few years. Here are some thoughts from John: 
“Today the Board of Governors web site lists 12 monetary policy tools. Nine of them didn’t exist four years ago. The good news is that six of those tools are no longer in existence, reflecting the improvement in financial conditions.”
“Now, there’s no question that Keynes, Friedman, and Tobin were among the greatest monetary theorists of all time. Their theories are elegant statements of fundamental economic principles. As such, they deserve to be taught for a long time to come. But viewing them as definitive in today’s world is like thinking that rock and roll stopped with Elvis Presley. The evolution of money and banking since the 1950s is at least as dramatic as what’s happened with popular music—not that I want to compare the Fed with Lady Gaga.”
“The Federal Reserve has added $1.5 trillion to the quantity of reserves in the banking system since December 2007. Despite a 200 percent increase in the monetary base—that is, reserves plus currency—measures of the money supply have grown only moderately. Over this period, M1 increased 38 percent, while M2 increased merely 19 percent. In other words, the money multiplier has declined dramatically. Indeed, despite all the headlines proclaiming that the Fed is printing huge amounts of money, since the end of 2007 M2 has grown at a 5½ percent annual rate on average. That’s only slightly above the 5 percent growth rate of the preceding 20 years.”
“But now banks earn interest on their reserves at the Fed and the Fed can periodically change that interest rate. This fundamental change in the nature of reserves is not yet addressed in our textbook models of money supply and the money multiplier. Let’s think this through. At zero interest, bankers feel considerable pressure to lend out excess reserves. But, if the interest rate paid on bank reserves is high enough, then banks no longer feel such a pressing need to “put  those reserves to work.” In fact, banks could be happy to hold those reserves as a risk-free interest-bearing asset, essentially a perfect substitute for holding a Treasury security. If banks are happy to hold excess reserves as an interest-bearing asset, then the marginal money multiplier on those reserves can be close to zero. In other words, in a world where the Fed pays interest on bank reserves, traditional theories that tell of a mechanical link between reserves, money supply, and ultimately inflation no longer hold.”
“Instead, the Fed provided additional stimulus by purchasing longer-term securities, another policy tool absent from standard textbooks. From late 2008 through March 2010, the Fed bought $1.7 trillion in such instruments. Then, in November 2010, we announced we would purchase an additional $600 billion in longer-term Treasury securities by the end of June 2011. … I estimate that these longer-term securities purchase programs will raise the level of GDP by about 3 percent and add about 3 million jobs by the second half of 2012. This stimulus also probably prevented the U.S. economy from falling into deflation.

Setting up a discussion of the Obama stimulus package

Last week I gave a talk to an alumni group here at Macalester College about budget deficits in the short run and in the long run. For the short-run portion of this talk, I set up my discussion with two figures. I reproduce them here, in part for those who would like to cut-and-paste a copy for their own presentations.

The first figure shows three paths for the unemployment rate. The middle line shows the path for the unemployment rate presented by Christina Romer, head of President Obama\’s Council of Economic Advisers, in January 2009–more specifically, it\’s actual data up though 2008, and then a forecast after that date. The bottom line shows Romer\’s prediction that the unemployment rate would be lower if the \”stimulus package\” legislation — the American Recovery and Reinvestment Act of 2009– was enacted. The top line shows the actual path of the unemployment rate. This version of the figure appears in \”Did the Stimulus Stimulate? Real Time Estimates of the Effects of the American Recovery and Reinvestment Act,\” by James Feyrer and Bruce Sacerdote, NBER Working Paper 16759, February 2011.   

Of course, this figure is often used to argue that the stimulus didn\’t work. But of course, it is equally possible that the January 2009 forecast was too optimistic, and that the stimulus made the unemployment rate lower than it would otherwise have been. 
The Congressional Budget Office publishes regular estimates of the effects of the ARRA legislation. The May 2011 report, for example, states that the legislation: 

— Lowered the unemployment rate by between 0.6 percentage points and 1.8 percentage points,
— Increased the number of people employed by between 1.2 million and 3.3 million, and
— Increased the number of full-time-equivalent jobs by 1.6 million to 4.6 million compared with what would have occurred otherwise …

Here\’s a useful CBO figure for illustrating their case that the stimulus improved matters.
With these two figures to set up the discussion, one can then talk about what makes a stimulus package more or less effective in a variety of contexts. Is it timely, temporary and targeted? What about factors like the pre-existing level of debt, the extent to which the economy is open to international trade, the response of monetary authorities, and other factors?

In their NBER paper, Fehrer and Sacerdote summarize some of the conflicting evidence about the effects of the stimulus. Their own findings, as summarized in the abstracts are: \”A cross state analysis suggests that one additional job was created by each $170,000 in stimulus spending. Time series analysis at the state level suggests a smaller response with a per job cost of about $400,000. These results imply Keynesian multipliers between 0.5 and 1.0, somewhat lower than those assumed by the administration. However, the overall results mask considerable variation for different types of spending. Grants to states for education do not appear to have created any additional jobs. Support programs for low income households and infrastructure spending are found to be highly expansionary. Estimates excluding education spending suggest fiscal policy multipliers of about 2.0 with per job cost of under $100,000.\”

Teaching Intro-level Monetary Policy After the 2007-2009 Recession

Andrew T. Hill (Temple University and the Philadelphia Fed) and William C. Wood (James Madison University) offer a thoughtful discussion of how the teaching of monetary economics at the intro level needs to evolve in \”It\’s Not Your Mother and Father\’s Monetary Policy Anymore: The Federal Reserve and Financial Crisis Relief.\”

As I see it, Fed actions during the crisis can be summed up in two main categories: 1) Providing liquidity to financial markets in crisis; and 2) Direct Fed purchases of financial securities, both Treasury debt and mortgage-backed securities. In teaching, the issue is to convey these two themes to students, but not get bogged down in institutional details. As Hill and Wood write, \”it\’s very easy to get drawn into the details of the Fed\’s programs and over teach.\”

Most intro econ courses already have some discussion of the lender-of-last-resort function for central banks, and of using the discount rate as a tool of monetary policy. It\’s fairly straightforward to build on these themes to discuss how the Fed extended vast amounts of credit during the worst of the financial crisis: that is, to fulfill its lender-of-last-resort obligations in a complex modern financial economy, the Fed needed to go beyond lending to banks, and extend short-term credit to lots of other market players. A slightly deeper point is that the Fed also figured out ways to extend this credit so that the recipient firms could remain anonymous to the financial market–and thus they didn\’t need to worry that getting credit from the Fed would send a bad signal about their future prospects. 

Hill and Wood provide a table that may be useful for many instructors listing the new monetary policy tools created during the last few years: Term Auction Facility (TAF), Term Securities Lending Facility (TSLF), Primary Dealer Credit Facility (PDCF), Commercial Paper Funding Facility (CPFF), Term Asset-Backed Seucurities Loan Facility (TALF), and others.  But intro teaching should skip this alphabet soup. All of these agencies were closed by mid-2010; in general, the Fed\’s short-term lender-of-last-resort was finished by then.

In teaching about the direct Fed purchases of financial securities, this quantitative easing should be presented as a fourth possible tool of monetary policy, along with the standard triumvirate of reserve requirements, discount rate, and open market operations. Some teachers may try here to present the Fed balance sheet to their classes to show this change, and for those who want to take this approach, Hill and Wood present four illustrative and simplified balance sheets at different points in time.

But for intro purposes, I\’m not sure much is gained by presenting explicit Fed balance sheets. Instead, this material can be presented pretty clearly at an intuitive level by saying that the Fed feared that financial markets wouldn\’t absorb these securities without more disruption, so the Fed took them on. In the short run, this probably helped smooth out the crisis. But the Fed can\’t print money to buy securities continually.So it needs to decide when to stop. It also will need to decide how to wind down the $2 trillion or so in financial securities that it currently owns, either by gradually selling them off or by holding at least some of them to maturity.

One other change that may be important in the next few years is that the Fed traditionally did not pay any interest on bank reserves that it held. As of 2008, the Fed can pay interest. Thus, if it seems like a bank lending boom is getting underway and higher inflation is threatened, the Fed could raise the interest rate that it pays on bank reserves, and limit banks\’ willingness to lend in this way. This tool doesn\’t matter much in a world of near-zero interest rates and low inflation, but if inflation beckons, it will be interesting to see how the Fed uses this new power.