David R. Henderson  

Hummel on Fed

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Monetary economist Jeff Hummel has posted today a detailed exposition of recent Fed policy. The two most interesting things to me are:
(1) The money supply is increasing. This fact undercuts one part of the "monetary policy is impotent" view of "ultra-Keynesians" (what a great term) like Krugman. In other words, the money supply is increasing in response to the increase in the monetary base. Of course, we still need to be concerned about a decline in velocity and so Krugman's "monetary policy is impotent" view could still hold if the velocity falls by the same percent as the money supply increases. I'm not sure what's happened to velocity, although the decline in real GDP combined with zero or negative growth in prices do imply an even bigger fall in velocity than the increase in money supply. (Remember the most important equation in macroeconomics, the one that was on the late Milton Friedman's license plate: MV = Py.) So Krugman could be right, at least about the last few months.
(2) The Fed moved ahead with its plan to pay interest on reserves, a policy that makes monetary policy less potent, at the same time that it needs monetary policy to be most potent.

I hasten to add, in case Bob Murphy is reading, that I'm not advocating that we have a Fed. But since we have one, I would much rather have it increase the money supply than have bailouts and huge increases in unjust and wasteful government spending. And just as the Fed could have prevented the Great Depression by acting as lender of last resort, I would like the Fed to do so this time and then, when we're on the other side of this recession, be abolished.

We know that the shift to paying interest on reserves has been in the works for a while. My speculation, given what I know about bureaucracies, especially government ones, is that some Fed employees were tasked to do this, Bernanke was busy with the crisis, and so things are proceeding without Bernanke having had much recent input into the decision. This is a problem with central planning.



COMMENTS (6 to date)
whats'what writes:

what do we do without the fed?

who is to print more money and to deliver it to the market?

MV=Py, so V's decreased lately caused by decreasing P and y. If we feed M steroid, how sure are we that y will go up more than P?

If you bail out everybody, what incentive there is for production now that everyone's got money; wouldn't that cause a greater, near term rise in P rather than y? Though y would creep toward potential overtime.

Grant writes:

I'd still like to hear - from Bob Murphy or anyone - what is so bad about the Fed increasing reserves? The demand for money has increased. Why shouldn't the Fed meet that demand? When the demand for money decreases again, the Fed can buy back some of their notes, keeping the overall money supply relatively constant over this period (not that I'm going to argue this is what will happen, but it could in theory).

ionides writes:

I have always thought that velocity is the wrong way to picture this. I prefer the other equation:
M/P = kY, the demand for real balances is a fraction k of national income.

Algebraically, it is the same equation as
MV = Py, allowing k to be Y/V.

But the picture is more realistic. Velocity doesn't really change. You don't have people running to spend money at different speeds. What changes is the amount of money that is circulating vs the amount in idle balances. If there is an increased demand for money, k rises. If k rises, and real money supply M/P is constant, then Y must fall. If k rises as M rises, then the outcome depends on relative magnitudes.

The behavioral picture associated with k is something like this: people get paid at the beginning of the period and their money holdings are at the maximum. As they spend, balances decline. If they want their end-of-period balances to be higher than before, they spend less. I think this is a more realistic picture than velocity.

Floccina writes:

whats'what you might find some answers at the link below:

http://www.econtalk.org/archives/2008/11/selgin_on_free.html

Selgin on Free Banking
George Selgin
Hosted by Russ Roberts

Brad Warbiany writes:

what's what:

MV=Py, so V's decreased lately caused by decreasing P and y. If we feed M steroid, how sure are we that y will go up more than P?

I think this is backwards. I think it was the drop in V (the bursting of the credit market bubble) that caused the drop in P and y.

V is a more mobile factor than M. So if M is increased (as it already has been), and a currently-depressed V then returns to a normalized level, the explosion in P will be immense.

Bob Murphy writes:

Ah, my sarcasm precedes me...

Grant, it's not a debate-ender, but I criticize Lucas's endorsement of Bernanke's actions here.

Also (David), I disagree that the Fed is responsible for the Depression.

It's too bad that Obama & Co. are going through with this stimulus, because now it won't be a clean test. If the Austrians are right, and the economy is in the toilet for the next few years, it won't prove that Bernanke's obedience to Friedman and Schwartz was a bad idea. Because the monetarists in 2012 can say, correctly, "The Obama deficit spending and carbon caps killed the economy."

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