Monthly Archives: November 2013

QE: Excess Money?

[This is further to my previous posts Central Bank LSAP: Is The Money Stock Supply-Determined Or Demand-Determined? and On Effects Of QE.]

Central bank asset purchases or LSAPs increase the stock of money aggregates compared to the counterfactual when there is no QE. Is there an excess of money?

These are two different things.

The notion of “excess money” is usually associated with Monetarism where the supposed “excess” is eliminated by rise in prices of goods and services. Excess money causes prices rise as much to reduce the value of money to reconcile whatever economic agents want to hold so that money demand = money supply where supply is given exogenously.

Which of course is quite wrong.

The reason it is wrong is that while – as argued in the previous posts – QE causes the stock of money to rise, there is no excess because prices and perhaps even quantities in financial markets (which is different from the market for goods and services) adjust so that the stock of money is still demand determined.

Of course that is not to say that the stock of money is the same as the counterfactual – i.e.,  the stock of money in a QE world is different from what it would have been in the absence of QE. So the stock of money is not exogenously given and adjusts to the demand for money as argued in the previous post and this demand depends on various things such as expected returns on imperfect substitutes – which QE influences.

In the markets for goods and services, there’s hardly an effect because prices are set by producers according to their costs.

Of course there needs to be a few qualifications – in the market for primary products, myths and speculation can lead to a rise in prices – such as the price of oil and this can have inflationary effects but the world we live in is not one in primary products and the original Monetarist idea highlighted at the start of this article is still misleading.

Of course none of this is implies that LSAP/QE has less effect on prices of financial markets – it can indeed cause some unwanted booms.

Another thing is that I mentioned in the previous blog post that supply of money influences demand but doesn’t determine it. Does that mean that the central bank has a “control” on the stock of the money within some limits? Well, not really. Control means influencing whatever is said to be under control to move in the desired direction and this is not always so. For example if the central bank were to behave like what the Bank of England was experimenting in the 70s under Monetarists’ influence, and sell bonds in large quantities in the financial markets, economic units – such as the non-banking sector may expect bond prices to fall and desire to increase their holding of money (as in deposits). This will lead them to sell the bonds to the banking sector which is prepared to buy the bonds acting as dealers in the bond markets. So the outcome may be opposite of the objective with which the central bank started with.

Central Bank LSAP: Is The Money Stock Supply-Determined Or Demand-Determined?

The blog Fictional Reserve Barking … Against Fictions And Other Tall Tales has a nice post titled: On the (ir)relevance of the money multiplier model: The Fed view.

In the post, the blogger Circuit quotes Robert Hetzel who says:

Starting in mid-December 2008 when the FOMC lowered its funds-rate target to near zero with payment of interest on bank reserves, the textbook reserves-money multiplier framework became relevant for the determination of the money stock. The reason is that the Fed’s instrument then became its asset portfolio, the left side of its balance sheet, which determined the monetary base, the right side of its balance sheet. As a result, from December 2008 onward, the nominal (dollar) money stock was determined independently of the demand for real money. Although the reserves-money multiplier increased because of the increased demand by banks for excess reserves, the Fed retained control of M2 growth. Even if banks hold onto increases in excess reserves, the money stock increases one-for-one with open market purchases. (2012:237) (emphasis added)

This post is inspired by the nice comment by JKH in the same post.

JKH says:

Excellent post.

I think Hetzel is wrong though.

What is at work in QE is better described as a money duplication process rather than a money multiplier process. It’s entirely different.

The correlation between base changes and M2 changes during QE has nothing to do with the reserve ratio calculation that is part of the money multiplier math.

It has to do with the fact that non-banks were the ultimate source for most of the assets acquired by the Fed under QE. To the degree that’s the case, there is a 1:1 duplication of reserve expansion and M2 expansion at the point of transaction origin. Non-bank bond sellers basically convert their bonds to M2 at source.

Subsequent commercial bank balance sheet changes may change the one-to-oneness that appeared at origination, but that also has nothing to do with money multiplier dynamics.

So in total this has nothing to do with a standard money multiplier argument. The two should not be confused.

I have a few more things to add on Hetzel.

When the Federal Reserve buys assets such as US Treasuries and agency debt and mortgage-backed securities from the private sector, it increases the stock of money aggregates such as M1 – as most of the ultimate sellers are non-banks, even though the Federal Reserve purchases the bonds via reverse auctions from primary dealers.

Now whether the money multiplier story works or not (it doesn’t!), it superficially looks as if the Federal Reserve is determining the stock of money – supporting Hetzel’s view – again superficially.

But does it?

In Post-Keynesian monetary theory, economists say that the stock of money is “demand-determined” and Hetzel’s arguments seems to be against this view. However what Hetzel forgets is that while the Federal Reserve influences the stock of money, it is still demand-determined. This is because money-demand depends on agents’ portfolio preferences. If agents have “excess” stock of money, they may reflux this by reducing their loans toward the banking system – just like Post-Keynesians claim. The Federal Reserve QE Education page New York Fed 101: The Federal Reserve’s $600 Billion Treasury Purchase Program (Called by some QE or QE2) itself says so:

Fed LSAP FAQIn fact since QE leads to higher asset prices, economic units may in fact borrow more funds to invest (read: speculate) in the stock markets.

Also note that “money-demand” is dependent on various things such as expected returns on substitutes. To the first approximation we may say that the stock of money was determined by the Federal Reserve since it has an eye on the monetary aggregates (although not targeting in the Monetarist sense). But once the process is set in motion, it then becomes endogenous because of behaviour of economic units.

Only in the limited case of settlement balances can we say that a monetary aggregate (monetary base or MB in this case) was set by the central bank.

The correct way of seeing this is via using Wynne Godley’s asset allocation model. In this what the variable Md is still decided by household behaviour – which depends on portfolio preferences, wealth, income and expected returns on all assets. LSAP works by reducing the supply of long-term bonds and hence reducing long-term yields via the “preferred-habitat” theory and hence increasing demand for other assets via imperfect asset substitution and changing their prices.

This itself has an influence on money-demand (because money-demand also depends on expectations of returns of other assets) but the amount of asset purchases by the Fed doesn’t determine the stock of money at any point in time.

Hence Hetzel is both wrong by appealing to the money multiplier mechanism and even if he hadn’t his other point about the stock of money being supply-determined is incorrect.

You can read Nick Edmonds’ blog on how this works – he has the most precise way of describing QE/LSAP.

John Maynard Keynes: Life, Ideas, Legacy

Described as “Award-winning documentary about Keynes by Professor Mark Blaug, which received a Silver Medal at the New York Film and Television Festival circa 1988.” on the University Of Cambridge page of the video.

There’s also a book by Mark Blaug by the same title.

(h/t Louis-Philippe Rochon and Anas Abd Jalil on Facebook)

Happy Diwali

Happy Diwali

picture via

James Tobin’s papers are very interesting. I have a special liking for him even though he sometimes said strange things and used a lot of neoclassical analysis. His asset allocation theory is one of the most interesting things in monetary economics.

I came across this paper from his book Essays In Economics – Vol 1: Macroeconomics titled Money And Income: Post Hoc Ergo Propter Hoc? (also available here if you neither have the book nor jstor access).

The paper is also noted and analysed in Louis-Philippe Rochon’s book Credit, Money, and Production: An Alternative Post-Keynesian Approach (p 124 – )

In this paper Tobin takes Milton Friedman to task by constructing what he calls an “ultra-Keynesian” model which he describes as

In the ultra-Keynesian model, changes in the money supply are a passive response to income changes generated, via the multiplier mechanism, by autonomous investment and government expenditure.

(note: multiplier as in expenditure multiplier and not “money multiplier”).

For some strange reason Tobin says he doesn’t believe in this model but shows how Friedman’s empirical findings (the latter’s assertion that “changes in the supply of money are the principal cause of changes in money income Y”) are all wrong especially his assertion about leads and lags. This was also noted by Nicholas Kaldor in his 1970 article The New Monetarism reprinted in his Collected Essays, Vol 6 as Chapter 1.

… Suppose the initiating change is a decision of some firms to increase their inventories, financed by borrowing. The first impact is to cause some other firms whose sales have increased unexpectedly to incur some involuntary disinvestment. It is only when that is made good by increased orders that productive activity is expanded; any such expansion will cause higher wage outlays which in turn may involve further borrowing. The ultimate effects on income involve further changes in productive activity arising from the expenditure generated by additional incomes. There is every reason to supposing, therefore, that the rise in the “money supply” should precede the rise in income – irrespective of whether the money-increase was a cause or an effect.

So much for the various tests using Econometrics by Friedman – these don’t prove anything.

Again in his 1980 paper Monetarism and UK Monetary Policy, Kaldor states:

… the change in the money supply may be the consequence, not the cause, of the change in the money incomes (and prices), and that the mere existence of time-lag – that changes in the money supply precede changes in money incomes, is not in itself sufficient to settle the question of causality – one cannot rule out the possibility of an event A which occurred subsequent to B being nevertheless the cause of B (the simplest analogy is the rumblings of a volcano which frequently precede an eruption).

Back to Tobin. He says the following from what his “ultra-Keynesian” model:

… The main point of the exercise can be made by assuming that the monetary authority provides the bank reserves as necessary to keep r constant… The monetary authority responds to the “needs of trade”. With the help of the monetary authority, banks are able and willing to meet the fluctuating need of their borrowing customers for credit and of their depositors of money.

… The financial operations of the government and the banks are as follows: The government and the monetary authority divided the increase in debt … between “high-powered money” and bonds in such a manner as to keep the interest rate on target… the monetary authority provides enough new high-powered money to meet increased reserve requirements and any new demand for excess reserves. The remainder of the increase in public debt … takes form of bonds and is just enough to satisfy the demands of the banks and the public.

An important observation made by Tobin is that because the stock of money rises following a fiscal expansion due to a rise in income, an ultra-Keynesian

… would not even be surprised if some observers of the accelerated pace of monetary expansion in the wake of a tax cut conclude that monetary rather than fiscal policy caused the boom.

Tobin shows how “every single piece of observed evidence that Friedman reports on timing is consistent with the timing implications of the ultra-Keynesian model”.

This is quite important. Somehow most observers cannot understand the role of fiscal policy and there is almost total attention given to “what the Federal Reserve is doing or going to do” by economic commentators and “experts” of Wall Street with most comments on fiscal policy being that fiscal deficit should be somehow reduced. “We are all Keynesians now” is quite misleading because most economic commentators are heavily distorted by the quantity theory of money even though sometimes they claim to not believe in Monetarism.

Anyway, have a look at Tobin’s paper Money And Income: Post Hoc Ergo Propter Hoc?