Monday, January 07, 2008

Why the Monetary Base is Irrelevant

I received an objection to my previous post from a commentator who argued that since the monetary base in America had grown only slowly, monetary conditions really are tight. Caroline Baum argued the same in her latest Bloomberg column:

"A fire can't burn without tinder; inflation can't smolder when the Fed is creating the raw material at a snail's pace. The monetary base, which consists of bank reserves and currency, is growing at an anemic 1.1 percent rate. In inflation-adjusted terms, the base is contracting."

Yet if the commercial banks are creating it at an extremely rapid rate, inflation can take hold. As I pointed out in my previous post, bank lending has increased 6.5% (17% at an annual rate) since early August and MZM money supply has increased nearly as fast , 6.3% (16.4% at annual rate).

And what matters for the economy is total money supply and not the monetary base. A good example of this is provided by the time period of 1921-33. During 1921-29, the monetary base was nearly unchanged, yet we saw rapid growth and a stock market bubble. By contrast, the monetary base grew very fast in 1930-33, yet that was combined with a deflationary depression and a 90% decline in stock prices.

The reason for this is that despite the stagnant monetary base, money supply growth was fast during the 1920s. And despite the soaring monetary base, money supply fell sharply during the depression.

The monetary base is not a reflection so much of Fed policy, but demand for cash. And by cash I mean notes and coins. It is not certain why demand for cash seem to be falling. It could reflect a continued shift away from paper money to electronic money in economic transactions in America. Or, it could reflect falling global demand for U.S. Federal Reserve notes as trust in the dollar declines. In the past hundreds of billions of dollars in Federal Reserve notes have been exported to countries like Russia and many Latin American countries with high inflation as people there trusted the dollar more than their local currency. But as many of those countries have seen a decline in their previously high inflation, and as the euro to many seems like a better currency than the U.S. dollar, Federal Reserve notes are probably increasingly returning to the United States.


Anonymous Anonymous said...

When the topic is M0 and M1 I have no problems understanding the role of the Fed.

However, when it comes to aggregates taking into account various forms of credit money, it is more difficult: the theory of the money multiplier only describes in detail the determinants of M0 and M1.

But how does the Fed influence M2, M3 and MZM? Savings accounts and certificates or deposits are probably not much different from demand deposits in their working. But the rest?

Asset-backed commercial paper depends on asset prices, and it may appear that they react to Fed's pumping, but the exact mechanisms are not clear to me.


4:57 PM  
Anonymous Contrarian Investors' Journal said...

Look at Australia's monetary aggregate chart in Australia’s monetary debasement & credit expansion. In that chart, Australia's money base is stable. It even fell in the month of October. However, the M3 money supply is still growing. In the year to Oct 2007, the M3 money supply grew by a whopping 20.75%! Furthermore, the M3 growth is following a parabolic upward path, outstripping the money base growth.

Australia monetary sin is worse than the US!

1:07 AM  
Anonymous Flavian said...

I agree that the monetary base is irrelevant, especially under the present fiat system.

But if you want to restore the gold standard, the monetary base is more relevant.

Do you know the size of the US monetary base right now and what gold parity would be required to back the monetary base 100% with the Fort Knox gold?

11:34 AM  
Anonymous Anonymous said...


Read your comment and I agree with the heading. However if you look at the money supply growth (M1+M2)in the US and compare this with Nominal GDP growht (Real GDP Plus Deflator), since 1960 and also since 1992, the the average growth is very similar, i.e. 5 % in the later period and 7% in the longer period. This also to my understanding what theroy say. Hence the increases in money supply (up until Q4 2007) would induce inflation as the real GDP growth is slowing down? Or what we might be seeing during this spring is a significant decrease in money supply, however this would be countered with the lowered interest rate. Any comments?

Another Swede just interested in economic development

2:51 PM  
Blogger r s thompson said...

wiki describes the monetary base as - "In economics, the monetary base, or the money base (often called narrow money in the UK) is a term relating to the volume of money in the economy, or money supply. The monetary base comprises only currency (banknotes and coins) and commercial banks' reserves with the central bank. As such, it is a narrow definition of money supply, consisting of only the most liquid forms of money."

jan 1990 AMB (billions) 280.297
mar 2008 AMB (billions) 857.028
an increase of some 630 billion in the us adjusted monetary base

i dont know if the Federal Reserve has other money-creatures (apart from the AMB) and i dont know exactly how this amount affects the additional components of M1,2,3 and the (whatever the MZM is) MZM?

if my employer writes me a paycheck of 100 dollars, i place 20 dollars in a demand checking account with a 10 precent reserve req, well i guess 18 dollars will soon be conjured up and probobly lent out. i keep 20 bucks in paper in my wallet - that paper 20 is part of the monetary base, i guess.
i then take 60 bucks and put it into a CD. the 60 dollars is made into a check and loaned by my bank to someone who deopsits the 60 dollars in a checking another new 54 dollars in conjured up. so rather quickly 72 new M(type) dollars of liquid, usable, but perhaps at this time, 'non-monetary base money' is operating in an economy (along with my paper 20 dollar bill and 20 dollar chkng acct deposit). putting pressure on scarce goods and resources.

that is if banks operate on a 10 percent reserve requirement.

i guess they have a way of keeping track of the base money with series numbers.

11:14 AM  
Anonymous newson said...

"In inflation-adjusted terms, the base is contracting."

adjusting a money aggregate for inflation? ha!

5:17 AM  
Blogger Ralph said...

To say that the Monetary Base is “irrelevant” is going too far. Suppose the US government expanded its monetary base by printing $50,000 per person and dished out this money, are we to believe there would be no effect? Strikes me people would run out and spend the money, which would result in far too big a rise in demand which would quickly be followed by rampant inflation.

Of course the relationship between the monetary base and fluctuations in economic activity is far from close because there are numerous other factors influencing the latter. There were fluctuations in economic activity in the 1800s and before, that is long before governments and central banks played the large role that they play nowadays. Thus it is no surprise that we get fluctuations in economic activity even given a constant monetary base.

Moreover, given a change in the monetary base, it is essential to look at the cause of the change and work out what the effects might be. For example it is pretty obvious what the effects of the above “$50,000 increase” would be. But other big rises in the monetary base might have no effect. A nice example is taking place right now: quantitative easing (i.e. having central banks print money and buy securities). The result of this has been that the US monetary base has doubled in the last quarter. This is unprecedented. But I don’t expect much of an effect in that if someone’s securities are converted to cash, they are not going to go on a spending spree because they regard securities as SAVINGS, and likewise they would regard the newly acquired pile of cash as savings.

8:52 PM  

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