John C. Williams of the San Francisco Fed discusses “Economics Instruction and the Brave New World of Monetary Policy.” I blogged a couple of weeks ago with some of my own thoughts about how to teach monetary policy after the events of the last few years. Here are some thoughts from John:
“Today the Board of Governors web site lists 12 monetary policy tools. Nine of them didn’t exist four years ago. The good news is that six of those tools are no longer in existence, reflecting the improvement in financial conditions.”
“Now, there’s no question that Keynes, Friedman, and Tobin were among the greatest monetary theorists of all time. Their theories are elegant statements of fundamental economic principles. As such, they deserve to be taught for a long time to come. But viewing them as definitive in today’s world is like thinking that rock and roll stopped with Elvis Presley. The evolution of money and banking since the 1950s is at least as dramatic as what’s happened with popular music—not that I want to compare the Fed with Lady Gaga.”
“The Federal Reserve has added $1.5 trillion to the quantity of reserves in the banking system since December 2007. Despite a 200 percent increase in the monetary base—that is, reserves plus currency—measures of the money supply have grown only moderately. Over this period, M1 increased 38 percent, while M2 increased merely 19 percent. In other words, the money multiplier has declined dramatically. Indeed, despite all the headlines proclaiming that the Fed is printing huge amounts of money, since the end of 2007 M2 has grown at a 5½ percent annual rate on average. That’s only slightly above the 5 percent growth rate of the preceding 20 years.”
“But now banks earn interest on their reserves at the Fed and the Fed can periodically change that interest rate. This fundamental change in the nature of reserves is not yet addressed in our textbook models of money supply and the money multiplier. Let’s think this through. At zero interest, bankers feel considerable pressure to lend out excess reserves. But, if the interest rate paid on bank reserves is high enough, then banks no longer feel such a pressing need to “put those reserves to work.” In fact, banks could be happy to hold those reserves as a risk-free interest-bearing asset, essentially a perfect substitute for holding a Treasury security. If banks are happy to hold excess reserves as an interest-bearing asset, then the marginal money multiplier on those reserves can be close to zero. In other words, in a world where the Fed pays interest on bank reserves, traditional theories that tell of a mechanical link between reserves, money supply, and ultimately inflation no longer hold.”
“Instead, the Fed provided additional stimulus by purchasing longer-term securities, another policy tool absent from standard textbooks. From late 2008 through March 2010, the Fed bought $1.7 trillion in such instruments. Then, in November 2010, we announced we would purchase an additional $600 billion in longer-term Treasury securities by the end of June 2011. … I estimate that these longer-term securities purchase programs will raise the level of GDP by about 3 percent and add about 3 million jobs by the second half of 2012. This stimulus also probably prevented the U.S. economy from falling into deflation.”
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