Expansion of the Money Supply

John Galt
Dec 1, 2009 at 1:47 PM

I'm not sure how I stumbled upon this article (as it is rather old) a few days ago, but it left me perplexed for quite some time. Specifically, this part:

While in the last year the size of the Federal Reserve’s balance sheet has grown from a little less than $1 trillion to around $2 trillion, what the Fed detractors neglect to mention is that the Federal Reserve didn’t print money to pay for the purchase of its new assets but rather sucked money out of the banking system that was being hoarded by banks, corporations and individuals. As a result, there was only a tiny net increase in money supply from Federal Reserve intervention. And, with only a small increase in money supply, inflation fears are being blown out of proportion.

Although the author is not technically wrong, he is missing the point. He is misinterpreting the different definitions of the money supply, specifically M0 and M1.

M0 consists of the amount of currency in circulation (including coin) and deposits held by depository institutions at the Federal Reserve.

M1 consists of the amount of currency in circulation (including coin), non-bank travelers checks, demand deposits (e.g., checking accounts), and other checkable deposits at commercial banks and thrift institutions.

The doubling of the monetary base (i.e., M0) was enabled by the increase in the Federal Reserve's balance sheet, as shown below:

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In the graph above, the blue line represents M0 while the red and green lines represent the currency in circulation (including coin) and deposits held by depository institutions at the Federal Reserve, respectively. As one can see, the former has increased slightly while the latter has increased drastically.

The author of the original article wrote that:

Bernanke encouraged banks to deposit their excess funds at the Federal Reserve by persuading Congress to pass a law that allows the Federal Reserve to pay interest on cash deposits at the Federal Reserve.

However, does the author not remember that the very institutions he says were responsible for doubling the monetary base were broke last fall, which is precisely when the doubling occurred? If an extra $800b had been floating around on the balance sheets of the banks, they wouldn't have been broke.

As such, the increase in the monetary base corresponds almost entirely to actions by the Federal Reserve, namely: creating money out of thin air to fund the purchase of legacy assets from the banks (primarily).

Based on the graph above, I'm sure many of you are wondering why prices are not rising rapidly. M0 only tells half the story. The other half is told by M1.

image

In the graph above, the blue line represents M1, the purple line represents demand deposits at commercial banks, the red line represents other checkable deposits, the green line represents non-bank travelers checks, and the gray line represents the currency in circulation (including coin). The purple, red, green, and gray lines are the various components of M1.

As one can see, none of these components exhibit the behavior present in M0. Essentially what has happened is that the vast increase in deposits held by depository institutions at the Federal Reserve has not been factored into M1. How can this occur? It is simple. The Fed created the money out of thin air. Since it has been held at the Fed since its existence, it has not been factored into M1. But, for how long will this be the case?

I do not have that answer. However, I can tell you that as banks begin to withdraw this new money from the Federal Reserve and lend it, the M1 money supply will explode. Currently, M1 rests at approximately $1.7t. Once the new $1.2t component of M0 begins to enter the economy, the M1 money supply will explode.

Consider this: the reserve requirement for commercial banks is only 10%. Therefore, when all of this new money has made its way out into the economy (and thus into M1), the M1 money supply will be nearly $2.8t, which is a 65% increase from before. As the money multiplier takes effect, this new money could theoretically multiply into a maximum of $12t. Although this process would take a long time, it will eventually happen, as evidenced by the divergence between M0 and M1, which has been growing as time progresses.

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The difference between M1 and M0 (i.e., the graph above) illustrates the money multiplier effect.

Similar statistics can be computed for the True Money Supply, which was developed by Rothbard

With that said, price inflation is coming--there is no doubt about it. What exactly can the Federal Reserve do to prevent it? Mop up the liquidity. I don't imagine this happening. One of my past articles illustrated why simplistically. Many more articles concerning the Fed's exit strategy can be found on the LvMI website. I recommend educating oneself on the topic at hand as ignorance will most surely lead to economic destruction.

Good post, we were just discussing this at our YAL chapter's meeting 2 weeks ago. The Fed really has no options. Pull the money out and let the banks crash again or hold onto the MSB's and pray they go up in value to trade them back (which won't happen). 

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Thanks Dave.

A good analogy to the Fed's substantial holding of MBSs is China's substantial holding of USDs. If China attempts to dump the USD, the USD will be destroyed. The same is true for MBSs.

Joseph Gauthier's picture