Everybody around here has surely come across the formula MV = Py. This basic equation has been used to lecture students and determine economic policies over the years.
Well, what if those constants do not behave themselves?
“M: A precise definition and identification of money is elusive in a modern, credit-money economy, and its volume can change either with or without direct central bank intervention. In addition, the monetary authority cannot raise the supply of money without the cooperation of the private sector. Because central banks almost always target interest rates (the price of holding cash) rather than the quantity of money, they tend to simply accommodate demands from banks. When private banks communicate that they need more reserves for loans and offer government debt to the Fed, the Fed buys it. It’s the private sector that is in the driver’s seat in this respect, not the central bank. The central bank’s impact is indirect and heavily dependent on what the rest of the economy is willing to do (which is, incidentally, why all the QE and QE II money is just sitting in bank vaults).
V: The velocity of money is, indeed, related to people’s behavior and the structure of the financial system, but there are discernable patterns. It is not constant even over the short run.
P: While it is true that factors like production bottlenecks can be a source of price movements, the economy is not so competitive that there are not firms or workers who find themselves able to manipulate the prices and wages they charge. The most important inflationary episode in recent history was the direct result of a cartel, i.e., OPEC, flexing its muscle. Asset price bubbles can also cause price increases (as they are now). The key here, however, is that P CAN be the initiating factor–in fact, it has to be, since M can’t.
y: The economy can and does come to rest at less-than-full employment. Hence, while it is possible for y to be at its maximum, it most certainly does not have to be”
Need a new model, I suppose.
Can the Bernanke helicopter exist?
“How is it that the Federal Reserve increases the money supply? Remember that Friedman used a helicopter–indeed, he had to, for there was no other way to make the example work. This wasn’t just a simplifying device, it was critical, for it allowed the central bank to raise the money supply despite the wishes of the public. However, that can’t happen in the real world because the actual mechanisms available are Fed purchases of government debt from the public, Fed loans to banks through the discount window, or Fed adjustment of reserve requirements so that the banks can make more loans from the same volume of deposits. All of these can raise M, but, not a single solitary one of them can occur without the conscious and voluntary cooperation of a private sector agent.”
Apparently it cannot.
Put the blame where it belongs….
The Dynamite Prize
“Alan Greenspan has been judged the economist most responsible for causing the Global Financial Crisis. He and 2nd and 3rd place finishers Milton Friedman and Larry Summers, have won the first–and hopefully last—Dynamite Prize in Economics.
They have been judged to be the three economists most responsible for the Global Financial Crisis. More figuratively, they are the three economists most responsible for blowing up the global economy.”
“Alan Greenspan (5,061 votes): As Chairman of the Federal Reserve System from 1987 to 2006, Alan Greenspan both led the over expansion of money and credit that created the bubble that burst and aggressively promoted the view that financial markets are naturally efficient and in no need of regulation.
Milton Friedman (3,349 votes): Friedman propagated the delusion, through his misunderstanding of the scientific method, that an economy can be accurately modeled using counterfactual propositions about its nature. This, together with his simplistic model of money, encouraged the development of fantasy-based theories of economics and finance that facilitated the Global Financial Collapse.
Larry Summers (3,023 votes): As US Secretary of the Treasury (formerly an economist at Harvard and the World Bank), Summers worked successfully for the repeal of the Glass-Steagall Act, which since the Great Crash of 1929 had kept deposit banking separate from casino banking. He also helped Greenspan and Wall Street torpedo efforts to regulate derivatives.”
But I wonder if it matters? Sooner or later it would have happened, they just helped it along a little.
And now moving to the banking system, this time to adequacy reserve ratios and interest on reserves held at the Fed.
This report issued by the New York Fed on why banks are holding excess reserves is interesting also because it discusses why the Fed is paying interest on reserves.
The paper also sheds a bit of light on the question of banks holding treasuries and reserves.
“In particular, the central bank could sterilize the effects of its lending by selling bonds from its portfolio to remove the excess reserves”
And from the first article above
“When private banks communicate that they need more reserves for loans and offer government debt to the Fed, the Fed buys it”
For this to make sense, the reserves used to meet the capital adequacy ratios cannot be held in the form of treasuries, but have to be in deposits held at the FED. Maybe my misconception was that I considered treasuries about as close to cash as it gets, due to the vast and deep market for them, and could be used to meet the capital adequacy ratio requirement.
Possibly my understanding has inched forward a wee wee bit today. And maybe not, not only this onion has so many skins, it is able to generate new ones.