Thread: Monetary Policy, Money, and Inflation

FRBSF Economic Letter: Monetary Policy, Money, and Inflation (2012-21, 6/30/2012)

A great letter describing how our current environment has forced us to rethink textbook monetary policy.

Key Excerpts:

Before interest on reserves, the opportunity cost for holding noninterest-bearing bank reserves was the nominal short-term interest rate, such as the federal funds rate. Demand for reserves is downward sloping. That is, when the federal funds rate is low, the quantity of reserves banks want to hold increases. Conventional monetary policy works by adjusting the amount of reserves so that the federal funds rate equals a target level at which supply and demand for reserves are in equilibrium. It is implemented by trading noninterest-bearing reserves for interest-bearing securities, typically short-term Treasury bills.

Normally, banks have a strong incentive to put reserves to work by lending them out. If a bank were suddenly to find itself with a million dollars in excess reserves in its account, it would quickly try to find a creditworthy borrower and earn a return. If the banking system as a whole found itself with excess reserves, then the system would increase the availability of credit in the economy, drive private-sector borrowing rates lower, and spur economic activity. Precisely this reasoning lies behind the classical monetary theories of multiple deposit creation and the money multiplier, which hold that an increase in the monetary base should lead to a proportional rise in the money stock.

Moreover, if the economy were operating at its potential, then if the banking system held excess reserves, too much “money” would chase too few goods, leading to higher inflation. Friedman’s maxim would be confirmed. Here’s the conundrum then: How could the Fed have tripled the monetary base since 2008 without the money stock ballooning, triggering big jumps in spending and inflation? What’s wrong with our tried-and-true theory?

A critical explanation is that banks would rather hold reserves safely at the Fed instead of lending them out in a struggling economy loaded with risk. The opportunity cost of holding reserves is low, while the risks in lending or investing in other assets seem high. Thus, at near-zero rates, demand for reserves can be extremely elastic. The same logic holds for households and businesses. Given the weak economy and heightened uncertainty, they are hoarding cash instead of spending it. In a nutshell, the money multiplier has broken down (see a discussion in Williams 2011a).

[...]

The change is that the Fed now pays interest on reserves. The opportunity cost of holding reserves is now the difference between the federal funds rate and the interest rate on reserves. The Fed will likely raise the interest rate on reserves as it raises the target federal funds rate (see Board of Governors 2011). Therefore, for banks, reserves at the Fed are close substitutes for Treasury bills in terms of return and safety. A Fed exchange of bank reserves that pay interest for a T-bill that carries a very similar interest rate has virtually no effect on the economy. Instead, what matters for the economy is the level of interest rates, which are affected by monetary policy.This means that the historical relationships between the amount of reserves, the money supply, and the economy are unlikely to hold in the future. 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. As a result, 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 are no longer valid. In particular, the world changes if the Fed is willing to pay a high enough interest rate on reserves. In that case, the quantity of reserves held by U.S. banks could be extremely large and have only small effects on, say, the money stock, bank lending, or inflation.

The contemporary monetary system is a fraud!

This part is incorrect:

"
Normally, banks have a strong incentive to put reserves to work by lending them out. If a bank were suddenly to find itself with a million dollars in excess reserves in its account, it would quickly try to find a creditworthy borrower and earn a return. If the banking system as a whole found itself with excess reserves, then the system would increase the availability of credit in the economy, drive private-sector borrowing rates lower, and spur economic activity. Precisely this reasoning lies behind the classical monetary theories of multiple deposit creation and the money multiplier, which hold that an increase in the monetary base should lead to a proportional rise in the money stock."

You can't force to people to take out loans, no matter how badly banks want to lend. Bank lending is determined solely by the demand for loans. The money multiplier in this sense is a mythical being like the unicorn.

Ooops I spoke too soon before reading it all

"A critical explanation is that banks would rather hold reserves safely at the Fed instead of lending them out in a struggling economy loaded with risk. The opportunity cost of holding reserves is low, while the risks in lending or investing in other assets seem high. Thus, at near-zero rates, demand for reserves can be extremely elastic. The same logic holds for households and businesses. Given the weak economy and heightened uncertainty, they are hoarding cash instead of spending it. In a nutshell, the money multiplier has broken down (see a discussion in Williams 2011a)."

Moreover, if the economy were operating at its potential, then if the banking system held excess reserves, too much “money” would chase too few goods, leading to higher inflation. Friedman’s maxim would be confirmed. Here’s the conundrum then: How could the Fed have tripled the monetary base since 2008 without the money stock ballooning, triggering big jumps in spending and inflation? What’s wrong with our tried-and-true theory?

This could only happen at full employment. With full employment, production capacity would max out and then we would have to few goods being chased by too many dollars.

Originally Posted by JP Hochbaum

How could the Fed have tripled the monetary base since 2008 without the money stock ballooning, triggering big jumps in spending and inflation? What’s wrong with our tried-and-true theory?[/B]

Don't forget there is still a serious demand for dollars internationally (the USD being the world reserve currency). So, there is enough cushion. Once foreigners dump the dollar for one reason or another, the prices will go trough the roof (hyperinflation).

I would think that with our rapidly growing technology, that even at full employment, we might not see a lot of inflation (but definately some inflation) due to the fact that companies might find it cheaper (and have the production volume which would cost justify it) to replace older equipment and technology with newer more efficient equipment and technology. We continually get more and more productive.

Also, as incomes rise, particularly from having more than one income per family, people consume less of their income and invest more. The demand for products is not infinate, it it was infinate, no one would ever save or invest a penny - we would spend every penny we made on purchasing consumer goods. At something just over the median income, people start saving, which indicates that for the majority of people, what we now think of as a nice middle class lifestyle (three bedroom house, two cars in the garage, a couple of tv's, a stereo, a house full of furniture, and money to send the kids to college on) is suffecient. A prolonged period of low unemployment would likely eventually lead to a drop in demand for durable goods as the pentup demand for those goods was gradually satisfied and eventually would only exist to the point that we needed new goods to replace what wears out. Personally, I have had the same fridge for about 10 years and it may very well last me another 10 years. I'm also using the same washer and drier that I purchased 25 years ago and they both work fine. Even if I had excess money, I wouldn't run out and replace those appliances, I would most likely save and invest that extra money.

The flood of investment that we would have at full employment would result in lower interest rates, and easier availability of money for companies to borrow to replace old equipment and technology. Also, it is highly likely that additional companies would open, further retarding inflation due to more competition.

What would likely inflate the most would be the stock market, thats what tends to happen when we have too much money and plenty of goods.

Originally Posted by Canell

Don't forget there is still a serious demand for dollars internationally (the USD being the world reserve currency). So, there is enough cushion. Once foreigners dump the dollar for one reason or another, the prices will go trough the roof (hyperinflation).

Exactly what does it mean to "dump the dollar"?
Where would they dump it, and how would that increase the price of goods in the US?

now I could see them deciding to spend those dollars as a way of "dumping" them, but to do unless we were already at full employment, that would just result in the US utilizing our spare workforce to create additional products. I don't think that a reduction in unemployment would be a good thing.

The other "dumping" method that I could think of is if they just gave them away. I really don't think they would want to do that, it runs contrary to human nature. But if they did, i will be the first in line for free bucks from China.

Originally Posted by Canell

Don't forget there is still a serious demand for dollars internationally (the USD being the world reserve currency). So, there is enough cushion. Once foreigners dump the dollar for one reason or another, the prices will go trough the roof (hyperinflation).

There isn't really "demand" for our dollars. There is demand from our citizens to purchase other countries goods, other countries then have our dollars as a result. Our dollars are only meaningful to other countries if we are producing useful goods.

So it isn't our dollars they demand, its our goods and services. That will only collapse if we stop producing useful stuff.

Originally Posted by imagep

now I could see them deciding to spend those dollars as a way of "dumping" them,.

That's exactly right. The problem is those dollars won't buy much. Remember the Weimar Republic?

Originally Posted by Canell

That's exactly right. The problem is those dollars won't buy much. Remember the Weimar Republic?

Man, how many time are people gonna dredge that up again and again?

Both Weimar and Zimbabwe experienced massive production decline, before inflation began.