Wednesday, 29 February 2012

Graph of the week: money multiplier

So the M1 multiplier for the US is still below 1:

Source: St. Louis FED, FRED database
What does this mean? Essentially it means that every dollar created by the FED (an increase in the monetary base M0) will result in a <1 dollar increase of the money supply (M1), as is evident from the figure below. So, the credit and deposit creation of commercial banks is limited in this case. The banks are still holding on to a lot of excess reserves. 

M0 (St.Louis adjusted, green) and M1 (red) are both on the right scale.
Source: St. Louis FED, FRED database
The effect of a 0<m<1 multiplier is that the monetary base is larger than the M1 money supply (remember that M1 doesn't take into account savings deposits or time deposits, which are included in the M2). This kind of a situation is obviously not good, as there is more money in the economy created by the central bank than it is created by commercial banks. One could say this is a clear example of a liquidity trap, as the central bank is powerless in trying to encourage banks to take on more lending. 

The multiplier is reciprocal to the reserve requirement of a bank (meaning the more money a bank is required to hold as reserves, the less it can use it for credit and deposit creation), so the reason it is low is the fact that banks have increased their reserves and are not producing as much credit as the economy needs (not lending enough). And the reason why banks are still careful is that they are unwilling to accept any further losses or take on risks partially due to the already high levels of public anger aimed against them (hint: bailouts). So they lower their lending to businesses and consumers, increase their reserves, meaning that the multiplier decreases. And the fact that it's below 1 means that the recovery is still holding back. A way to get it started isn't via quantitative easing or any other form of increasing the money supply; rather the focus should be on restoring confidence

12 comments:

  1. I really don't believe in a liquidity trap. Banks are not making commercial loans because of regime uncertainty, and because the Fed is paying them for their deposits. So they can make money without risk.

    The money multiplier results from simple monetary inflation. More money facing the same number of goods and services.

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    1. What I meant by liquidity trap was simply that the Fed is powerless in trying to make the banks increase lending, but I admit it might have been a bit misleading to use that particular term.

      and I agree with you, regime uncertainty and risk-less profits are furthermore discouraging the banks from any lending to the real economy.

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  2. From the graph the multiplier started to go down as soon as the monetary base jumped up (in fact the gap was closing between them in the last 10 years - it's a typical inverse relationship). So does this mean that more money created by the Fed automatically reduced the propensity of banks to lend?
    Also, when would we expect the multiplier to rise up again? If the Fed reduces the money supply? How is that possible?

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    Replies
    1. I wouldn't say automatically (directly), I would rather say the effect is indirect. A response of the banks to easy money from the Fed is that they hoard as a way to obtain risk-less profits (see the previous comment).

      As for the multiplier, it will rise once the M1 is again growing at a faster rate than the Base, i.e. when the banks restart their lending.

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  3. http://www.bankofengland.co.uk/publications/Pages/news/2014/051.aspx

    Where does money come from? In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood. The principal way in which they are created is through commercial banks making loans: whenever a bank makes a loan, it creates a deposit in the borrower’s bank account, thereby creating new money. As ‘Money creation in the modern economy’ explains, though, banks cannot create money in this way without limit: how much banks lend will rest on the profitable lending opportunities available to them which will, crucially, depend on the interest rate set by the Bank of England. In this way, monetary policy acts as the ultimate limit on money creation.
    This description of how money is created differs from the story found in some economics textbooks. For instance, in normal times, the central bank does not in practice choose the amount of money in circulation. Nor is central bank money ‘multiplied up’ into more loans and deposits. Rather, the Bank of England implements monetary policy – which is set to be consistent with low and stable inflation – by setting the interest rate on central bank reserves (‘Bank Rate’). This then influences a range of interest rates – including those on bank loans – and, in turn, the aggregate amount of spending in the economy.

    ReplyDelete
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  6. hey thanks for the article! i am currently reading on the money multiplier. one thing i stumbled across in your article: i found the fed to be using the st. louis adjusted monetary base for their money multiplier. this mb includes bank reserves at the fed and the banks' vault money which is different from m0. all the best!

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  7. Thank you for the article. I'm not an expert on this field as I simply teach high school economics, but I've been trying to wrap my head around this concept. I think there is a lot of misinformation regarding money supply, and AP textbooks don't even address M0 so maybe you can help.

    I've read people say the following...

    M0 = All physical currency that exists.
    M1 = M0 + checkable deposits, travelers checks etc...
    M2 = M1 + Near Money's (Savings accounts and such).

    I get M1 and M2, there's nothing that's confusing there, but I don't see how all of the physical currency + checking accounts could be less than all of the physical currency that exists (Since M0 is presently greater than M1). That would imply that on the whole we have overdrawn our checking accounts which does not seem likely at present.

    So my guess is that prior definition of m0 and m1 are incorrect, and that there has to be a different definition, which I think is this...

    m0 does include all physical currency that exists, which would include all money held by individuals, commercial banks AND the Federal Reserve. m1 on the hand only includes physical currency held by individuals and commercial banks, but does not include money held by the Fed. This would therefore explain why there is a discrepancy and also would show that m1 does NOT equal m0 + checkable deposits. Taking this a step further, and based on your article, there is a lot of cash sitting with the Fed not being used, likely because banks are already flush with cash and have no need to use the Fed for lending purposes. I look forward to hearing a response.

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    Replies
    1. Exactly, so the M0 also includes money held by the Fed. The definitions that you provided are usually right, but in the context of the crisis and the subsequent recovery, we have a strange situation where the money created by the Fed is not in the system, i.e. it is not being held by individuals. The explanation is that this money was created to buy off toxic assets (MBSs and CDOs) from the troubled banks in 2008 and 2009. The banks were hoarding it for a long time to satisfy their liquidity requirements.
      Essentially the Fed has expanded its balance sheet and has been expanding it ever since 2008 in a response to the crisis (it is even bigger now than when I wrote this piece, see here)
      How long will this continue? Who knows. Many economists have been worried about potential inflation being triggered by this, but currently this is unlikely. We are thus facing a "new normal", meaning that the very definitions of M0 and M1 need to be altered.
      Hope this helps!

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