Tag Archives: money supply

Inflation is a Monetary Phenomenon, But This Isn’t Inflation

There has been much talk recently about the potential inflation on the horizon given the unprecedented movement of the Federal Reserve of increasing the monetary base through quantitative easing. The talk has predominantly surrounded the substantial increase in the monetary base. However, increases in the monetary base are not sufficient to cause inflation. Like discussion of other markets, we must consider both supply and demand conditions.

Milton Friedman famously quipped, “inflation is always and everywhere a monetary phenomenon.” Friedman was undoubtedly correct. However, recently a few seem to have taken this claim to mean something different entirely. Namely, that any increase in the money supply necessarily causes inflation. This is something that Friedman himself did not believe.

In his restatement of the quantity theory of money, Friedman pointed out that the quantity theory is primarily a theory of money demand. Specifically, quantity theorists view the level of real money balances as more important than the nominal quantity of money. Thus, if at any point in time people have chosen to hold some level of real money balances that they deem optimal, an increase in the nominal money supply will leave these individuals with a larger level of real money balances than they wish to hold. These individuals will then necessarily try to reduce their holdings of nominal money balances such that their real money balances fall back to their optimal level (perhaps by increasing spending). Unfortunately, as a group, they will not be able to do so because every person’s spending is another person’s receipt (or income). Initially output will increase and gradually prices will rise until the level of real balances falls back to the optimal level.

Given this discussion, it should not be difficult to understand why I prefer a monetary equilibrium framework. What’s more, it should be apparent that what causes inflation is not an increase in the money supply, but rather an excess supply of money.

Ultimately, the question at hand is whether the current increases in the monetary base imply that there is an excess supply for money. If so, inflation is on the horizon. If not, we need not fear inflation.

Personally, I do not believe that the recent increases in base money imply that there is an excess supply of money. There are a couple reasons for this belief. First, it has been well-known — at least among monetarists — since Clark Warburton’s influential work that the peaks in the time series variables important for quantity theorists follow this order: (1) money, (2) output, and (3) velocity. The implication here is that declines in velocity (increases in the demand for money) are an accentuating feature of the business cycle. In other words, after output begins to fall, the demand for money increases. As our previous discussion of monetary equilibrium implies, this creates an excess demand for money, which results in falling output and prices — thereby exacerbating the previous decline in output.

Second, the money multiplier has declined drastically. In fact, the money multiplier for M1 remains below 1. This means that for every increase of $1 in base money, the money supply (as measured by M1) increases by less than $1. In order to determine the cause of the decline in the M1 multiplier, we should first discuss its components. The money multiplier for M1 consists of the currency-to-deposit ratio, the required reserve-to-deposit ratio, and the excess reserve-to-deposit ratio. An increase in any of these ratios implies that the money multiplier will fall. The required reserve ratio is set by the Federal Reserve and has not changed. Thus, the decline in the M1 multiplier must be the result of changes in the currency-to-deposit ratio and the excess reserve ratio. As previously mentioned, the demand for money often increases during the downturn in the business cycle. What’s more, financial crises often induce a flight to quality in which individuals abandon risky investments for safe investments such as bonds or cash. The increase in cash balances increases the currency-to-deposit ratio.

The largest cause of the decline in the money multiplier, however, is the result of the increase in the level of excess reserves. What’s more, this increase in excess reserves can be directly attributed to the fact that the Federal Reserve started paying interest on excess reserves late last year. In doing so, the Fed essentially reduced the opportunity cost of holding excess reserves thereby giving banks the incentive to hold more reserves on their balance sheets. This is why our friend Scott Sumner not only supports eliminating the interest payments on excess reserves, but prefers that the Fed impose a penalty on those who hold reserves above the required level.

Ultimately, the money multiplier (M1) has fallen from around 1.6 prior to the recession to .93 as of June 17. At the beginning of January 2008, the monetary base was roughly $848 billion. Given that money multiplier, this would suggest that M1 was around $1.356 trillion. Thus, given the current money multiplier, this would suggest that the monetary base would have to be about $1.458 trillion today to maintain the same money supply — an increase of roughly 72%. Given that we are currently in a recession, this suggests that the Fed wants to increase the money supply rather than simply maintain the earlier level. Given that the monetary base is about 90% higher than it was at this time last year, this would suggest that the Fed is expansionary, but hardly over-expansionary given the circumstances surrounding money demand.

With that being said, the Fed must be careful and begin pulling money out of the economy when this demand for base money subsides and the money multiplier begins to rise again. A failure to do so would result in a substantial period of inflation. However, at the current time, the evidence suggests that the massive increase in the monetary base is justified by the increase in the demand for base money. Thus, the increase is in the monetary base doesn’t suggest that massive inflation is on the horizon … yet.

(In the future, I hope to post on how the Fed can prevent finding itself in such a precarious situation in the future, but this is clearly enough for now.)

Is Deflation on the Horizon?

There has been a great deal of talk regarding deflation recently. Today, Nouriel Roubini predicted that deflation will be the main concern of policy makers in the next six months. James Hamilton disagrees. Nevertheless, the drastic fall in housing prices and the recent crash in the money multiplier warrant a closer look.

At the onset of the Great Depression, the Fed was already in contractionary mode. The subsequent banking failures of 1930 – 1933 caused a flight to cash as many removed their money from banks. This flight to cash resulted in a severe monetary contraction as money moved from banks to mattresses (or so the saying goes). This monetary contraction led to the worst deflation in U.S. history with percentage price declines in the double digits. Now we have talked about irrational fears of deflation before, however, when deflation is the result of an excess demand for money, the effects can be quite disastrous.

The recent discussion regarding deflation begs the question as to whether we are currently in the midst of a monetary contraction.

On the supply-side, we are clearly not in a contractionary environment. However, as our friend David Beckworth points out, the money multiplier of the monetary base has declined substantially since June. Beckworth (as well as Hamilton) attribute this decline to the fact that the Fed is now paying interest on excess reserves. While Beckworth’s accompanying graph provides ample evidence that bank reserves have drastically increased, a closer look at the data suggests that the spike in reserves began in August (two months after the decline began in the money multiplier).

I draw two conclusions from the previous analysis. First, we are entering (or have entered) a contractionary monetary environment. Keynes’s theory of the liquidity preference is proving as poignant as ever as individuals are fleeing the stock market and other investments for the security of cash. Second, foreclosures are squeezing bank balance sheets and counter-party risk remains elevated (as is continually evident from the LIBOR-OIS spread). Given that the Fed is introducing new facilities each day to ensure that it has to tools necessary to combat the crisis, this implies that cautious banks are simply building excess reserves (and the Fed is now rewarding them for doing so). The result is a massive reduction in the money multiplier.

Thus far, the Fed has been very responsive. The reduction in the money multiplier has been met by a significant increase in the monetary base. So long as the Fed remains proactive, I am prepared to agree with James Hamilton that deflation is not on the horizon.