Monday, August 29, 2011

More on the Fed and “Printing Money”

As discussed in the previous post, the ratio of the money supply to bank reserves, the supply of which is under the control of the Fed, has been increasing. This does not mean, though, that the Fed has not been able to increase the money supply. Using monthly, non-seasonally adjusted data, this graph shows that reserve balances held at the Fed increased dramatically beginning around September 2008, as did the M2 money supply. (The graph shows dollar amount changes from a year previously, for each month.)

Month to month changes show the same story:

And this is what a graph of the levels of M2 and reserve balances looks like:

In other words, the Fed can increase the money supply and it has been doing it. The data suggests, though, that in order to get the banking system to create an increase in M2, the Fed has had to increase reserves substantially. The increase in the money supply and the huge creation of bank reserves is what worries inflation hawks. Even many of those who believe that the Fed should continue to be expansionary probably worry about the Fed's ability to time correctly the withdrawal of reserves at such time as it risks an unwanted increase in the inflation rate, and to do this without causing an economic downturn.

However, as for the current situation, the ratio of nominal GDP to M2 (velocity), has decreased sharply:

All this suggests that, in order to increase nominal GDP, the Fed has to expand its balance sheet more than it has in the past, since the money multiplier has been increasing while the velocity of money has been falling. To the extent that the Fed does succeed in increasing nominal GDP, this can be due to either inflation or an increase in real activity. 

The current political situation means that fiscal policy cannot be used to help increase the economy's growth rate, at least for the time being.  At the same time, the Fed's ability to use monetary policy as much as some policymakers and some economists might want is hampered both by internal dissents by some Fed Bank presidents on the Federal Open Market Committee and by criticism coming from politicians. (David Leonhardt wrote an interesting article about the political pressures on the Fed in yesterday's New York Times.)

Those who believe that the federal government needs to do something to get the economy back on track are worrying. This is not limited to liberals, such as Paul Krugman. As mentioned in the previous post, Ken Rogoff suggests that the Fed target explicitly an inflation rate. Bruce Bartlett, whom I knew when he was a Treasury Deputy Assistant Secretary (Economic Policy) in the George H.W. Bush Administration, is hardly a liberal, but he has probably angered some conservatives by writing what he believes the facts dictate about the economic situation. He has been prominent in a number of venues arguing that the current economic situation is due to weak aggregate demand. (A recent example is on the New York Times' website: "It's the Aggregate Demand, Stupid.")

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