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CHAPTER 22

DOES THE MONEY SUPPLY MATTER?

Money, the Fed, and the Debate Over Optimal Monetary Policy

Money gets a bad rap. The proverb that money is the root of all evil is at least as old as the Bible.¹ The coins and bills that constitute money for most people are called fiat currency because they would have little use if not for the government decree, or “fiat,” that makes them valuable. They are adopted merely as a convenience. Without dollars, there would be no less greed, but every type of commerce for every reason would be carried out with less convenience. When fiat currency is unavailable, buyers and sellers resort to cumbersome bartering and the use of commodity money, such as precious metals, shells, salt, or anything else that has practical value as a commodity. Inmates can’t hold fiat currency in prison, but the number of cigarettes it takes to buy a tattoo is well known in the prison yard.² Some summer camps don’t allow campers to hold fiat currency, but no small amount of commerce goes on between campers for commodity money, such as candy bars.

¹ See I Timothy 6:10.

² I have verified this while conducting economic research at prisons. See http://bkmarcus.com/cache/POW/ for a study of cigarettes as currency in a prisoner of war camp.

A more tenable concern over money might be that the central bank, the Federal Reserve or “Fed,” has made too little (or too much) of it available in the economy at a particular time. There is considerable disagreement about the real and lasting effects of fine-tuning the money supply. As trading consultant Howard Simons notes, “The question of how those influences occur, and to what extent, can ignite the closest thing to a barroom brawl among practitioners of the dismal science.”³ This chapter provides an overview of money, the Federal Reserve System, and the battlefield of economic theory on which the Fed strategizes about monetary policy.

³ See www.thestreet.com/options/futuresshocktsc/10124905.html.

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Money serves three primary functions:

The money supply has several components, beyond cash and standard bank deposits, that deserve mention. A money market mutual fund is made up of short-term, low-risk financial securities, such as Treasury bills, certificates of deposit, and municipal notes. Time deposits (such as certificates of deposit) are deposits that can’t be withdrawn for a specified period without a financial penalty. Eurodollar deposits are large (usually more than $1 million) time deposits denominated in U.S. dollars and held either by banks headquartered outside the United States or by foreign branches of banks headquartered within the United States. A repurchase agreement (repo) is a way for an investor to make short-term loans. The investor gives money in exchange for an asset, such as a Treasury bond. At a specified time, the loan recipient returns a higher amount of money (the loan amount plus interest) to the investor in exchange for the asset.

M1 = Cash + Checking account deposits

M2 = M1 + Savings accounts + Time deposits + Retail money market mutual funds

M3 = M2 + Institutional money market mutual funds + Eurodollar deposits + Repurchase agreements + Time deposits more than $100,000

As exhibited in the accompanying table, the money you can literally grasp in your hands as cash or a check drawn on deposits is called M1. M2 is the roughly $1.3 trillion worth of M1 plus about $5 trillion worth of savings accounts, time deposits, and retail money market mutual funds. M3 is M2 plus $2.9 trillion worth of money market mutual funds held by institutions, Eurodollar deposits, repurchase agreements, and time deposits more than $100,000.

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Does the money supply matter? At the microeconomic (individual) level, there are issues of whether individual wealth really matters in the pursuit of happiness because the conventional wisdom is that “the best things in life are free.” This chapter describes the basics of how the Fed can alter the money supply and takes on the macroeconomic (big picture) issue of whether adjustments in the money supply influence gross domestic product (GDP) and unemployment.

The Federal Reserve System, which serves as the central bank for the United States, has the mission of formulating monetary policy to achieve price stability and economic growth. The Fed oversees a fractional reserve banking system in which only a fraction of bank deposits are actually retained by the banks; the remainder is loaned out. Banks earn profits on the difference between the interest rates they pay depositors and the higher interest rates that loan recipients pay the banks. The board of governors of the Fed determines the reserve requirement, which is the minimum fraction of deposits that a bank must retain either in the vault or in a reserve account at the Fed. When a bank falls short of the necessary or desired level of reserve balances, it can borrow in the federal funds market from banks that have more than enough reserves. The interest rate that banks pay each other in this market is called the federal funds rate.

The Fed has three primary tools for influencing the money supply. The main line of attack is open-market operations, by which specialists at the Federal Reserve’s Open Market Desk in New York manipulate the supply of reserves. To increase the supply, the folks at the Open Market Desk purchase government securities, such as Treasury bonds, on the market that is open to banks and investors. To pay for the securities, the Fed increases the seller’s reserve account by the amount of the purchase.⁴ To decrease the supply of reserves, some of the Fed’s portfolio of more than $700 billion worth of Treasury securities could be sold to commercial banks, which would result in debits against the banks’ reserve accounts. In practice, sales of securities in the open market are rare. Instead, when the Fed wishes to decrease reserves, it usually simply purchases fewer than its usual quantity of securities, resulting in less than the usual supply of reserves. These acts of buying and selling (or buying fewer) securities on the open market to change the supply of reserves are called open-market operations.

⁴ When the seller is a private securities dealer rather than a bank, the Fed credits the reserve account of the “correspondent bank” that performs banking services for the seller.

The Fed sets the wheels of monetary policy in motion by altering the level of reserves. With fewer reserves, banks have less money to lend out and the amount of money in circulation decreases. As our knowledge of supply and demand would predict, a decrease in the supply of reserves also causes the price of borrowing reserves—the federal funds rate—to increase. This makes it more expensive for banks to borrow from each other and triggers subsequent increases in interest rates paid by bank customers. The result is less borrowing and spending in the economy. When the Fed buys securities, payments from the Fed increase reserve levels, the federal funds rate and other interest rates drop, and more money flows into the economy. These monetary policy transactions are orchestrated by the Federal Open Market Committee, which consists of the 7 members of the Fed’s board of governors and = of the presidents of the 12 Federal Reserve System banks.

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The Fed’s control of the reserve requirement constitutes a rarely used but powerful second tool with which to influence the money supply. If the reserve requirement is 10 percent, $100 out of a $1,000 deposit must be set aside, whereas $900 can be lent out. If that $900 loan is deposited by its recipient or by those from whom the recipient made purchases, $90 must be held and $810 can be lent out. Under the simplifying assumptions that each loan is subsequently deposited and every bank lends out as much as the Fed will allow, the $1,000 deposit ultimately creates $9,000 worth of new loans (the $900 plus the $810 and so on) before no more loans are possible because the entire $1,000 is sitting in bank vaults as 10 percent of a total of $10,000 worth of deposits.

The process that generates up to $10,000 in deposits out of $1,000 in cash is called money creation. The amount of money created from each $1 of new deposits is called the banking multiplier, and it equals 1 divided by the reserve requirement. With a reserve requirement of 10 percent, or 0.10, the multiplier is 1/0.10 = 10, which explains why the $1,000 created 10 × $1,000, or $10,000 in deposits. Because the Fed controls the reserve requirement, it controls the amount of money created in this process. If it changed the reserve requirement to 20 percent, the banking multiplier would become 1/0.20 = 5 and a $1,000 deposit would create 5 × $1,000 = $5,000 in deposits. The banking multiplier is diminished when money leaks out of the cycle of loans and deposits, as when people hold significant amounts of money as cash, banks hold excess reserves, or expenditures are made on imports.

As the third tactic for controlling the money supply, the boards of directors of the 12 regional Federal Reserve banks, in consultation with the board of governors of the Fed, control the interest rate paid by banks and other depository institutions when they borrow money from their regional Federal Reserve bank. This rate is called the discount rate, and the lending facility within each Federal Reserve bank is called the discount window. When the discount rate is raised, less money is borrowed, and so there is less money in the economy. Although the availability of funds from other sources limits the direct influence of discount rate changes, a change in this rate is considered an important signal of the intent of Fed policy.⁵ The Fed also uses the informal power of moral suasion—pressure or persuasion without force—to convey its policy interests and intentions through public statements, published studies, educational programs, and conferences.

⁵ See www.chicagofed.org/consumer_information/the_fed_our_central_bank.cfm.

The Fed uses combinations of these tools to address the amount of the money supply. To the Fed’s consternation, the money-creation process has grown more complex in recent decades because banking functions have spread beyond banks. The 1980 Depository Institutions Deregulation and Monetary Control Act made it possible for credit unions and savings and loan institutions to offer checking accounts and a wider variety of loans. Retail firms, such as Sears; insurance companies, such as John Hancock; and securities firms, such as Merrill Lynch started offering banking services in the mid-1980s, and financial innovations, including commercial paper, now allow corporations to borrow from investors by selling promissory notes, which are unsecured⁶ promises for repayment. In the early 2000s, growing levels of nonbank lending and excess capacity (the ability of firms to produce more with existing factories than was demanded) led to record low levels of commercial and industrial lending as a percentage of GDP. This decrease slowed the money-creation activities of the Fed in ways that were hard to control. The money multiplier works best when all loanable funds are lent out, and any excess reserves represent idle dollars that could otherwise be creating more loans and deposits.

⁶ Unsecured loans involve no collateral, which is something of value that the lender gets if the loan is not repaid. In other words, if the borrower doesn’t pay back the money, the lender is out of luck. Most loans are secured with collateral. For example, the collateral for a mortgage loan is a house. If a mortgage loan is not repaid, the lender gets the house.

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The restructuring of banking services also led to difficulties with the traditional measures of money. During the past century, the proportion of the money supply made up of M1 has fallen, indicating a growing number of alternatives to cash and checks. In response, the St. Louis Federal Reserve created a new measure of the money supply called money with 0 maturity (MZM) to provide a better snapshot of available funds. MZM is money that is redeemable immediately at face value, so it includes cash, checking and savings accounts, and money market mutual funds. In some years MZM increases even as M1 decreases and vice versa.

One more term is relevant to the money supply and the debate over its importance: the velocity of money. This is the number of times each year that the same money is spent and is measured by dividing M2 by GDP. An increase in velocity means that the existing money is being respent more often and that a smaller money supply is needed to support a particular level of spending.

Money does matter.

—Milton Friedman⁷

⁷ “The Quantity Theory of Money: A Restatement,” in Milton Friedman (ed.), Studies in Quantity Theory (Chicago: University of Chicago Press, 1956).

The most famous money-supply adversaries are the monetarists and the Keynesians. The monetarists, championed by Milton Friedman and following in the footsteps of the classical economists before them, focus on policy implications in the long run, after the economy has had time to adjust to changes. Monetarist and classical economists believe money is neutral, meaning that the level of output is independent of the money supply in the long run. At the center of this debate is the equation of exchange:

money supply × velocity of money = price level × quantity of output

or, more concisely

MV = PQ

The right-hand side of this equation represents the expenditure on goods in a year, which must equal the amount of money multiplied by the number of times per year that the money is spent. That is, 2 oranges could be purchased for $1 each with a money supply of $2 and a velocity of 1, or with a money supply of $1 and a velocity of 2—the same dollar being spent twice. According to the quantity theory of money, the velocity of money and the quantity of output are relatively fixed, so that with any increase in the money supply, the equation must be balanced by an increase in the price level. Thus, in the long run, Fed policies to alter the money supply would affect the inflation rate but not the growth rate of output.

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Monetarists question the Fed’s ability to fine-tune the economy and achieve short-run stability by using monetary policy. Although they acknowledge that variations in the money supply can have a short-run bearing on demand and output, they are skeptical of the Fed’s ability to adequately master the complex dynamics of the economy and yield the desired result. Even if the Fed accurately assesses a downturn in the economy and flawlessly carries out a monetary expansion, monetarists argue, by the time the additional money reaches the hands of those who will spend it to give the economy a boost, the economy may have already corrected itself, and the monetary policy will only worsen a period of high inflation. Monetarists prefer a more passive “monetary rule” of letting the money supply grow steadily at the rate of real GDP growth rather than making adjustments in response to short-run demand problems.

Classical economists and, more recently, the monetarists believed that the economy could heal itself in a reasonable amount of time. The Great Depression of 1929–1939 convinced John Maynard Keynes that the economy sometimes needs a nudge from changes in taxes and government spending, which economists call fiscal policy. Keynes reasoned that inflexible, or “sticky,” wages and prices would prevent the economy from adjusting swiftly to equilibrium at full employment (full employment is defined not as 100 percent employment but as the absence of cyclical unemployment caused by a downturn in the business cycle). Wages might be slow to adjust because of multiyear contracts and because it is difficult to tell workers that their wages will fall. Prices might be sticky because it is a hassle to make price adjustments in catalogs, price lists, and menus. Keynes focused on total, or “aggregate,” demand as the driving force behind output and employment and on policies that would raise aggregate demand in the event of a recession.

In Keynes’s view, monetary growth would be transmitted to output growth as follows: An increase in the money supply would decrease the price of borrowing money, which is the interest rate. A lower interest rate would spur investment, which is a component of aggregate demand. With higher aggregate demand, the price, GDP, and employment levels would all increase. Keynes pointed out that this chain of events could be broken at several points. If the demand for money is relatively flat, an increase in the supply will not cause the interest rate to fall. And if the demand for investment isn’t responsive to the interest rate, investment won’t increase even if there is a substantial decrease in the interest rate. These are among the reasons why the money supply might not matter and why Keynes preferred to adjust fiscal policy rather than monetary policy.

The monetarist transmission mechanism is more direct: An increase in the money supply leaves consumers with more money than they want to hold on to, so they spend some of it. However, the monetarist economists disliked meddling with aggregate demand. One argument was that increases in aggregate demand would be crowded out by two effects that work against the intended increase in expenditures. First, government expenditures to increase aggregate demand might substitute for private expenditures. For example, when the government expands libraries, private individuals might purchase fewer books on their own. Second, when the government borrows money to make some of its expenditures (as it currently does), it increases the demand for loanable funds, thereby causing the interest rate to rise. Monetarists claim that the higher interest rate and resulting cuts in private investment can lead to either complete crowding out—a total offset of the government expenditure by decreases in private expenditure—or incomplete crowding out that diminishes but does not eliminate the size of the expenditure boost from the government.

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Keynes said that inflation could be countered with higher taxes or less government spending, either of which would lower aggregate demand. Unemployment, conversely, could be remedied by lower taxes or higher spending to boost aggregate demand. Named after British economist William Phillips, the proposed trade-off between unemployment and inflation is known as the Phillips relationship. But in the 1970s the United States experienced stagflation: high rates of inflation accompanied high levels of unemployment. Just as the Great Depression made people question the laissez-faire (hands-off) policies of the classical economists, stagflation created concern over Keynesian policies. How could aggregate demand be used to moderate the economy if the Phillips relationship did not hold and unemployment and inflation both increased? An increase in aggregate demand might cure the unemployment problem, but the corresponding inflation would go through the roof. It would be a futile contradiction to apply expansionary policy to boost employment and contractionary policy to limit inflation at the same time.

Skepticism about Keynesian policy in the 1970s left an opening for alternative schools of thought. Nobel laureate Robert Lucas wrote that rational expectations would undermine monetary or fiscal policy. His theory was that individuals and firms would anticipate policy responses to upturns and downturns in the economy. For instance, at the onset of a recession, people would anticipate the government response of increasing aggregate demand and the subsequent price increases. They would respond with price and wage increases that increased the cost of production, decreased the quantity demanded, and negated the influence of the expansionary policy.

In the late 1970s and early 1980s, the Fed policy more closely resembled the monetarists’ suggestion of steady monetary growth without countercyclical responses. During that period, the alarming inflation rate came down, but the economy remained sluggish. Friedman argued that monetary policy was not applied in the way that it should have been, but that’s another story. In the 1980s, there was much fanfare for supply-side economics, which emphasized shifting aggregate supply with tax cuts rather than attempting to move aggregate demand. The results were mixed, with inflation under control but another recession in the late 1980s and a burgeoning government debt.

Although Keynes himself did not favor adjustments in the money supply to moderate the economy, the activist, Keynesian approach to policymaking was gradually coupled with the classical belief that the money supply does matter. The outcome was the neoclassical–Keynesian synthesis—a hybrid of the previous schools of thought that embraces activist fiscal and monetary policy. Throughout the 1990s and beyond, both types of policy were used in efforts to moderate the economy, with modest success.

Don’t think the synthesis compromise is the end of the story. As they say, everything old is new again, and a neo-Keynesian school of economics is also afoot. The new Keynesians have improved arguments for the existence of sticky wages and prices that prevent the economy from self-adjusting to full employment. The reasons include the following:

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Neo-Keynesians also argue that sticky wages and prices debunk the rational-expectations hypothesis because stickiness means that prices can’t easily be adjusted to a level that negates the influence of policy changes.

With each of these schools of thought having gone through the wringer of bad times and policy ineffectiveness, none is as strong as it once was. Today, there is plenty of activist countercyclical policy on both the monetary and fiscal sides. And although they are tame relative to the Great Depression, wide swings in the economy still occur, so economists are still tinkering with these theories to try to find the best possible bases for stabilization policy.

Whether the money supply should be manipulated for the sake of employment and growth depends on a larger set of puzzles: How rigid are prices, wages, the velocity of money, and the level of output? How responsive are interest rates to changes in the money supply, and how responsive are investments to changes in interest rates? Can the economy heal itself? And can the central bank or the government act quickly and accurately enough to rescue an economy in trouble? These are some of the battlegrounds of macroeconomics. Disagreements continue in earnest, fueled by periods of economic history that support each contention. The salient question is this: Whose favored assumptions will hold in the years ahead?

Monetarists and their champion, Milton Friedman, believe that money matters to long-run inflation rates but not to long-term growth. Their concern that unchecked inflation creates uncertainty and inefficiency in the economy leads them to advocate steady growth in the money supply that is in line with GDP growth. Although they see the money supply as having a short-term influence on business cycles, monetarists do not favor short-run adjustments in the money supply as a remedy for economic instability. As reasons against activist policies, monetarists cite policy lags and the possibility of unintended results stemming from the Fed’s inability to master the structural complexities of the economy.

Keynes favored policy responses to undesired swings in the economy. He suggested expansionary fiscal policy to bolster sagging aggregate demand, saying that the transmission mechanism between the money supply and aggregate demand may be disjoined. Neoclassical economists, neo-Keynesians, supply-siders, and believers in rational expectations have their own perspectives on appropriate policy. (Of course, using these labels oversimplifies the situation; there is a range of beliefs within each camp.) Of greater importance is an understanding of the issues and dilemmas that surround the money supply because there is much progress to be made and handsome benefits to be had from improvements in macroeconomic policy.

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