Paul Krugman - New York Times Blog
MAY 6 6:37 PM May 6 6:37 pm 61
The Fed Does Not Control the Money Supply
Brad DeLong points us to David Glasner on John Taylor; I don’t think I need to add to the pile-on. But I do think Glasner misses a point when he says that
'the quantity of money, unlike the Fed Funds rate, is not an instrument under the direct control of the Fed.'
Actually, under current conditions — in a liquidity trap — it’s not even under the indirect control of the Fed. The same impotence of conventional monetary policy that makes open-market purchases of Treasuries useless at boosting GDP also mean that broad monetary aggregates that include deposits are largely immune to Fed influence. The Fed can stuff the banks full of reserves, but at zero rates those reserves have no incentive to go anywhere, and even if they do they can sit in safes and mattresses.
This is not a new point. Back in 1998 I covered it pretty well:
Putting financial intermediation into a liquidity trap framework suggests, pace Friedman and Schwartz, that it is quite misleading to look at monetary aggregates under these circumstances: in a liquidity trap, the central bank may well find that it cannot increase broader monetary aggregates, that increments to the monetary base are simply added to reserves and currency holdings, and thus both that such aggregates are no longer valid indicators of the stance of monetary policy and that their failure to rise does not indicate that the essential problem lies in the banking sector.
The effects of quantitative easing in Japan a few years later, which failed to raise M2, confirmed this conclusion. And sure enough, here’s what happened to US M2 as the Fed increased the size of its balance sheet:
By the way, in discussing monetary policy I sometimes write “money supply” as shorthand for “monetary base”; it has always been clear, if you read my work, that I know that the Fed only truly controls the base and that this need not translate into changes in broader aggregates.
So we had a simple prediction, completely borne out by experience. And you can therefore understand why I want to bang my head against the wall when economists say things along the lines of “the Fed can just target the money supply” or “we would have had runaway inflation except that for some reason banks just increased excess reserves — who could have predicted?”
So much heavy going over such basically simple stuff. But then, to expand on and somewhat ruin Upton Sinclair, it’s difficult to get a man to understand something when he has strong incentives, which may be ideological rather than or in addition to financial, not to understand it.
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