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It might surprise you to learn that there was little inflation in the United States until after World War Two. The major reason for this economic tranquility was the gold standard. Under this system, the money put in circulation by the government was backed by an equal amount of gold held in reserve. Because the amount of gold in reserve was fixed, the amount of money in circulation also remained fixed. These fixed amounts created a balance that kept prices, and thus inflation, in check.
The Federal government, however, was unhappy with this system. With a fixed amount of gold in reserve, the government could not inject new money into the system to finance economic expansion or keep prices stable during times of economic crisis. Without the ability to raise or lower the amount of money in the system, the government felt the economy would remain illiquid and constrained.
The Federal Reserve System was created in 1913, partly to address this problem. It was given the authority to create new money as long as it continued to exchange money for gold. This system was pushed beyond its limits by the stock market crash of 1929 and the Great Depression that followed. Fearing bank failures, panicked depositors withdrew billions of dollars from the banking system, putting banks in great danger of collapse. The depositors then sought a measure of safety by redeeming their cash for gold. All of this put a tremendous strain on the economic system.
As the Depression heightened, the government decided the gold standard had become too great a danger to the economy. It suspended the gold standard in April 1933. This gave control of the money supply to the government, in the form of the Federal Reserve Bank. The Fed was now free to fund economic expansion and stabilize a failing economy by manipulating the amount of money in circulation. But this flexibility brought with it the evils of inflation. Inflation was a nagging problem after World War Two, but in the 1970s it became a serious threat to the economy, and the Fed's attempts to bring it under control by controlling the money supply were largely unsuccessful. Congress stepped in and limited slightly the methods the Fed can use to alter the money supply. It also required the Fed Chairman, under the Humphrey-Hawkins bill, to appear before Congress twice each year to answer questions about its policies.
Today, the Fed controls the money supply by buying and selling government bonds in what is called an open market operation. The Fed maintains a portfolio of government bonds. To increase the amount of money in circulation, the Fed will buy more bonds in the open market and add them to its portfolio. It pays for the bonds by crediting the reserve account of the seller, usually a bank. Banks must maintain reserve accounts with the Federal Reserve to ensure that they have enough money to handle banking transactions. By adding this money to reserve accounts, the Fed effectively pumps new money into the system.
To decrease the amount of money in circulation, the reverse of the above transaction takes place. The Fed sells bonds from its portfolio, debiting the reserve account of the buyer. This money is then effectively removed from circulation.
Interest Rates
Many people believe the Fed raises or lowers interest rates with the stroke of a pen. This is not the case. It manipulates rates through the buying and selling of government bonds, as described above. When the Fed buys bonds from a bank and credits the bank's reserve fund, the bank has more money to lend to the public. With more money to lend, the bank will lower the interest rate it charges borrowers. When the Fed sells bonds, money is withdrawn from the buyer's reserve fund. It then has less money to lend, which means the interest rate will go up. The rate of interest is referred to as the fed funds rate.
Did the Government Make a Mistake?
The ending of the gold standard forever doomed the economy to periods of inflation. But a return to the gold standard would likely be a disaster. The economy would remain fixed, unable to expand and contract as it should. In times of crisis, the government would have no means of adjusting the money supply, which could lead to serious recession and depression. The flexibility of a system based only on the supply of money is far superior to a fixed, gold-based system.
How Our Economy Evolved
We're getting ahead of ourselves, so let's back up a bit. We will return to the current economy later. To fully understand why economic news creates trading opportunities, you need a bit of background information about the economy. The economy described above did not suddenly appear overnight. And it is not the only economy in the world. Every nation on earth has some form of economy based on the production, distribution, pricing and consumption of goods and services. None of these are even remotely as large or robust as the U.S. economy. How did we get so lucky?
Here's a simplified analogy to answer a complicated question. Imagine that you are washed up on a deserted island. Your survival depends on your ability to use the island's natural resources to produce life-sustaining materials. At first, you need food and shelter. If you work hard, you will collect more food than you need immediately, which will leave you free to build a crude shelter. Then, with the surplus you have created stored away, you can afford to spend your time making creature comforts such as a pair of sandals or hunting for more exotic foods. You will thrive, as long as the unexpected does not occur, a hurricane that destroys your hut and washes away your food supply or an injury that prevents you from gathering food.
The U.S. economy has thrived, becoming the giant it is today because people have worked hard and with great ingenuity to turn the available natural resources into a vast surplus of goods and services. We have done well on our deserted island. It's true that we began with an abundance of natural resources in the form of land and labor. But we could have squandered this blessing. Instead, the surplus created by the industry of working people has allowed the economy, and our society, to advance well beyond the survival stage. Collectively, the citizens of the United States have a strong desire to work hard and prosper so that the wealth they create can be passed to their children.
Without doubt, there have been fallow periods and times when a storm suddenly appeared and washed away much of the wealth that had been created by so many hard-working people. Many of you have probably heard stories about the miseries created by the Great Depression, or even about past periods of inflation and recession. We are in such a period right now, a period when future economic growth is under a cloud and the storm flags are flying. We did not use our resources wisely during the bull market.
But we always have and we always will recover from such downturns. If history is an accurate guide, we will not only recover, in time we will enter a period of prosperity unseen before. Our economy moves in cycles, periods of expansion and contraction that are natural and necessary. The excesses created during expansions must be corrected, washed away, in order for a new and even stronger period of growth to begin.
We owe this miraculous, resilient system to a single concept: Capitalism. It is the most effective economic mechanism ever devised by man. It is based on the theory that citizens have the inalienable right to invest their capital in raw materials, to hire workers to turn these materials into goods and services, and to earn a profit by selling these goods and services to consumers. Without this right, we would still be in the dark ages of despotism and financial slavery. The history of the evolution of capitalism featured next week will complete your understanding of the economy and give you the tools you need to be a successful event trader.
PLEASE READ: Auto-trading, or any broker or advisor-directed type of trading, is not supported or endorsed by TradeWins. For additional information on auto-trading, you may visit the SEC’s website: All About Auto-Trading, TradeWins does not recommend or refer subscribers to broker-dealers. You should perform your own due diligence with respect to satisfactory broker-dealers and whether to open a brokerage account. You should always consult with your own professional advisers regarding equities and options on equities trading.
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