Take a look at the monetary base:
In 2008, the monetary base started increasing dramatically. Today, there are two major views on monetary policy that view this increase as supporting evidence. The first view, typically advocated by hawkish, right-wing monetarist-types is that the dramatic increase in the monetary base suggests that the United States is headed for high inflation. The second view, typically advocated by left-wing, Keynesian types, is that the United States is currently in a liquidity trap. The first group sees the substantial increase in the monetary policy as a predictor of inflation on quantity-theoretic grounds. The second group thinks that the fact that the base has increased so substantially without promoting recovery provides support for the hypothesis of a liquidity trap, whereby monetary policy is impotent.
I would like to suggest a third view.
A consistent concept throughout monetary theory is that of monetary disequilibrium. Central to monetary disequilibrium theory is the understanding that money is the medium of exchange. Since this means that money is traded in all markets, it follows from Walras’ Law that when there is an excess supply of money, excess demand will exist in all other markets. Similarly, this means that if there is an excess demand for money, an excess supply will exist in all other markets. Since money trades in all markets, the price level must adjust. If prices do not adjust instantaneously, this will also result in changes in production.
A simple way of looking at this theory is through the equation of exchange:
MV = PY
where M is money, V is velocity, P is the price level, and Y is output. For simplicity, M will be defined as the monetary base. Velocity reflects changes in the demand for the monetary base.
An excess supply of money occurs when the monetary base increases or the demand for the monetary base declines (V increases), ceteris paribus. An excess demand for money occurs when the monetary base decreases or the demand for the monetary base increases (V falls), ceteris paribus. It follows from the equation of exchange that an excess supply of money leads to an increase in nominal income (PY) and an excess demand for money leads to a decline in nominal income.
The first view articulated above sees the expansion in the monetary base as reflecting an excess supply of money and therefore anticipates higher inflation. The poor performance of nominal income over the last two years would seem to call into question this view. However, advocates typically point out that there are long and variable lags associated with monetary change or that current increases in money demand won’t last forever and when they subside, inflation will emerge.
The second view sees the combination of the expansion of the monetary base and the poor performance of nominal income as evidence of a liquidity trap. Under this view increases in the supply of money are offset by increasing in the demand for money and have no influence on the economy.
I believe that both of these views are wrong. A careful discussion of how monetary policy works will elucidate my point.
Monetary policy is typically conducted through open market operations, in which the central bank buys and sells short-term government bonds. The central bank credits or debits a bank’s reserve account depending on the transaction. Suppose that the central bank conducts an open market purchase. In this scenario, bank reserves increase and therefore the monetary base increases.
In the typical monetarist-type view, the exchange of money for bonds generates a disequilibrium in the bank’s portfolio. The bank will then seek to re-align their portfolio through a series of asset substitutions. This results, initially, in changes in output and, ultimately, prices.
In the Keynesian view, when interest rates are zero, money and bonds become perfect substitutes. As a result, an open market purchase just leads to a reduction in velocity and no change in output or prices.
The problem with using either of these methods to evaluate monetary policy in the present context is because the Federal Reserve is not issuing new base money. The Fed has been issuing debt.
In October 2008, the Federal Reserve started paying interest on reserves and therefore effectively issuing debt. As a result, open market operations have not entailed exchanging base money with government debt, but rather Federal Reserve debt with government debt. Given that the yield on a 90-day T-bill is roughly equivalent to the interest payments on excess reserves, the Federal Reserve is literally exchanging perfect substitutes, but it has nothing to do with a liquidity trap. Thus, the effective monetary base is not changing all that much despite the evidence from the graph above.
This has important implications for quantitative easing. More later…