A babysitting co-op once had a problem.
And that is why the problems started.
A Co-op’s Money Supply
During the 1970s, the 150 (or so) members of this babysitting co-op each received 60 units of scrip worth 30 hours.
But there is much more.
There were annual dues and scrip that had to be given to new members. Hours were “paid” to the four people who did the bookkeeping and to the person who ran the group. The result was a monetary system.
Imagine that you were in the co-op. It might cost you five hours for dinner and a movie. But let’s say you also had a future weekend wedding. You worry you will need more time and start to save. You go out less and babysit more.
And therein lay the problem.
The Co-op’s Monetary Policy
People started saving too much, Although members wanted to “work,” few were willing to “hire” anyone. The cycle was grinding to a halt. We could even say that the diminished spending had created unemployment and less production — a recession.
The key here though is the balance between spending and saving. If people want to go out too much, there is an insufficient supply of hours to pay the babysitters. But if they “save” too much by staying home, then babysitters receive less. Supply and demand were responding to perverse incentives.
So, the members changed the rules and said everyone had to go out more frequently. When that did not work, by issuing more scrip, they created new incentives. Families felt they had enough hours and began going out. Then though, the co-op experienced a babysitter shortage.
The takeaway? It’s tough to be sure you have the optimal money supply.
Our Bottom Line: Monetary Policy
Starting with Paul Krugman, economists love this tale. Dr. Krugman says the economic lesson is that easy money can cure a recession. Others, citing quite the opposite, focus on the co-op’s double dip recession. The first was caused by too little money, the second by too much, and both they believe were caused by excessive government interference.
Whichever is correct, we can be sure that right now we are in uncharted monetary territory.
Explaining the Federal Reserve’s monetary policy used to be simple. The Fed raises and lowers the discount rate that it charges banks for loans. By buying and selling government securities, it influences the money available to banks and thereby nudges interest rates and the money supply up or down. And rarely, it changes financial institutions’ reserve requirements.
Now, there is much more.
As a lender of last resort, the Federal Reserve will support households, businesses, and financial institutions. It is a congressional fiscal partner through its lending program for mid-size and small businesses and for state and local governments. And finally, as an investor of last resort, the Fed will support riskier loans.
Perhaps though, their most recent decision reconnects us to the babysitting co-op. Instead of a two percent inflation target, they will shift to “average inflation targeting.” The new policy will let them accept a higher inflation rate.
My sources and more: In The Undercover Economist Strikes Back, Tim Harford tells the co-op story. A second version, in this paper from two co-op members complemented the Harford book as did an essay from Paul Krugman. As for Fed policy, my facts come from this recent econlife post while several of today’s sentences were also from a previous post.