In previous posts, we talked about inflation and deflation, why deflation can be as dangerous if not more dangerous than inflation, and some of the economic sources of inflation. In this piece, we discuss some of the ways policy makers and central banks attempt to manage the economy in normal times and in times of crisis.
Manipulating Money Supply Is About Influencing Aggregate Demand
In our last blog, we brought up the money equation, or equation-of-exchange.
MV = PY
In this equation, M is the supply of money and credit, V is the "velocity" of money or the eagerness of consumers and businesses to spend, P is the general price level, and Y is the real output (i.e., output of "stuff") in the economy. Moreover, we pointed out that MV turns out to be the same as total aggregate demand in the economy.
MV = PY = (Aggregate Demand)
[See this week's Appendix for the explanation of why MV = (Aggregate Demand)]
When the Federal Reserve Bank or other central bank manipulates the availability of money (NYSE:M), they are basically attempting to influence the level of aggregate demand in the larger economy. The goal is generally to keep demand from either: 1) expanding so quickly that it causes inflation, or 2) declining so sharply that it produces deflation and unemployment. In practice, this generally means reducing M if demand is expanding faster than real production and increasing it if demand falls suddenly for some reason.
There is a wrinkle, however, which is that the Fed or other central banks can only control the M part of the equation, and even that part imperfectly. The velocity of money (NYSE:V), which, as we pointed out earlier, is highly influenced by the economy's "animal spirits" and desire to consume, also determines the total demand, and is not easily modeled, controlled, or even measured with much accuracy.
Interest Rates and Monetary Policy in Normal Times
In normal times, the Fed influences demand levels by manipulating the rates that banks lend cash reserves to each other (the "Fed funds" rate). It does this by buying and selling (already-existing) short-term U.S. Treasury securities in return for cash. These are called "open market operations," because the Fed acts in the marketplace as if it were any other entity buying and selling securities. These open market actions tie in to the Fed funds rate because the rate that banks lend to each other is typically just a fraction of a percent higher than the short-term U.S. Treasury rate.
When it raises or lowers the Fed funds rate, the Fed effectively changes the cost at which banks can raise more capital. This in turn makes it easier or harder for banks to lend and provide credit to the rest of the economy and still meet their regulatory reserve requirements. In normal times, the Fed does not directly tell banks to whom and how much they can lend; it simply makes it easier or harder for them to do so by altering the relevant interest rates.
When analyzing the money supply (M) and aggregate demand in the economy, it is important to remember that the money supply that matters is not simply the number of bills and currency in circulation (which is almost irrelevant in an age of predominantly electronic transactions), but the currency, bank reserves, and credit available in the economy. Raising and lowering the Fed funds rate has an immediate effect on what banks can borrow, true, but that bank borrowing is ultimately expected to filter out to the rest of economy by enabling or restricting the credit that banks make available to everyone else.
One of the features of the present economy is that there is trouble with the so-called "transmission mechanism" by which Fed easing translates into overall money availability to the rest of the economy. The transmission mechanism problem arises from the fact that the current economic slump was precipitated by a banking crisis, and so banks have been use much of the easing and capital provided by the Fed to repair their own balance sheets before they increase credit available to the remainder of the economy.
Monetary Policy in Extraordinary Times
It is important to emphasize the term "normal times" in the section above, because ordinary Fed funds policy does not always work in extraordinary times like the present. Some of the unusual things the Fed has done and inevitably received criticism for are a result of the fact that the recent crisis was so severe that it pushes ordinary monetary policy to the limits of its effectiveness, and so new alternatives need to be considered.
For example, when large banks themselves are at risk of bankruptcy (such as the "Lehman moment" in 2008), the rate at which banks are willing to lend reserves (unsecured) to each other can suddenly jump substantially higher than the U.S. Treasury rate. During the height of the 2008 crisis, the Fed lowered its target Federal Funds rate to nearly 0% from an already-low 2% practically overnight, and Treasury rates have been at 0.25% or lower ever since. This is often called the "Zero Interest Rate Policy," or ZIRP, and the Fed can be expected to maintain this policy for some time to come.
Few if any dispute that ZIRP was necessary, but one of ZIRP's problems is that nominal interest rates cannot realistically go below zero, since no one will buy a security guaranteed to lose value when just keeping cash/currency under a mattress is an alternative. So when interest rates are already near the 0% boundary, there is no more room to lower interest rates, and so the central banks must look for other monetary tools to (in this case) stimulate aggregate demand.
Lowering reserve rate requirements is potentially a very powerful tool the Fed can use to increase the monetary supply. But in an environment where bank stability is still in question, reducing required bank reserves is particularly risky. Indeed, many banks already have excess reserves (reserves over and above the minimum required by law) at the Fed and so reducing the reserve requirement may not be effective at all; it may be the equivalent of trying to push a string.
Quantitative Easing, or QE, is a mechanism designed to inject money directly into the economy when interest rates are near zero by having the Fed or central bank buy financial assets (other than the usual short-dated Treasurys) in exchange for cash that meets a bank's reserve requirement. This is designed to make it easier for banks to lend because they can convert risky assets to reservable cash, while simultaneously taking those assets off their books.
In theory, QE is supposed to enable banks to lend to new economic actors, since the cash increases their reserves and the removal of existing risk allows them to assume new ones. In practice, banks have not been lending, in part because the need to repair their own damaged balance sheets inhibits their willingness to take on risk, and in part because in the current fragile environment, virtually all business activities now seem extra risky.
Quantitative Easing has been criticized as little more than "money printing" with a scientific-sounding name, and the statement is largely accurate: quantitative easing is essentially "money printing." However, money printing (and the attempt to raise M) is not necessarily inappropriate, particularly when credit availability to the private sector has shrunk substantially and depression fears have reduced the V ("money velocity") part of the money equation.
We will discuss some of the specific issues with quantitative easing and other strategies the Fed has employed in a future post.
This appendix justifies our comment that MV = PY = (Aggregate Demand).
To see why, look at the chart below, which shows an aggregate demand curve [i.e., the overall quantity of "stuff" (NYSE:Y) that economic actors will demand at various price levels (NYSE:P)]. The economy is expected to produce and price items somewhere along this line. As prices go higher, consumers and businesses cannot afford to purchase as much (without more access to money) and so aggregate demand drops off. As prices drop, more purchasing is possible, and so total production (Y) can increase.
Now, say what the economy produces settles at point X over some period of time. We can calculate the area of the rectangle on the chart that has X at one corner. The area is equal to YP, because the horizontal side runs from 0 to Y, and the vertical axis from 0 to P, and a rectangle's area is simply its length times width. But we also know from the money equation that MV = YP, so the area of the rectangle is also MV. What this means is that MY also determines aggregate demand, so changes in M or V ultimately feed back into the total level of aggregate demand. If M or V rises while the other stays constant, aggregate demand will rise; if M or V falls while the other stays constant, aggregate demand in the economy will fall.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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