East Coast Economics

Inflation vs. Deflation: The Quantity Theory of Money – M & V

with 12 comments

I’m deliberately being simplistic and reducing the inflation/deflation debate to the monetarist framework; I think it’s useful as a starting point in order to get a grasp of the facts – and I like scary graphs.  So take a look at the St. Louis Fed statistics regarding currency in circulation and monetary base: despite abundant talk of the Fed printing money, currency in circulation on an absolute level has not increased that drastically over the last few months.  Sure, the slope of the curve or pace of increase has accelerated a lot, but from an absolute perspective things don’t look too bad:


Unfortunately, the above graph only shows currency in circulation, or the amount of currency available to consumers.  The picture looks very different when you look at the US monetary base (i.e. Fed reserves and the reserves of commercial banks at the Fed): the monetary base has more than doubled over the course of 2008.


Hard to argue that this looks like it should spell inflation.  Why haven’t we seen any of it so far? The answer is simple: banks have increased their excess reserves and are too scared of what may come to lend to the consumer.  The graph below shows the missing link between monetary base expansion and the growth (or lack thereof) in the volume of currency in circulation, namely bank reserves in excess of Fed requirements.


The above charts suggest that we are currently seeing deflation concerns because banks are increasing their excess reserves faster than the Fed is expanding the monetary base; in other words, all the additional money printed by the Fed is getting soaked up by banks and the consumer is seeing decelerating inflation.  This trend is bound to reverse suddenly and drastically once credit thaws, though.  At that point do you think the Fed will be able to drain excess cash from the system fast enough to prevent massive inflation?


Written by eastcoasteconomics

January 20, 2009 at 9:02 pm

Posted in Monetary Policy

12 Responses

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  1. Well, your assumption is that banks will lend their excess reserves, “once credit thaws.” I would actually like to understand what you mean, that is, what your definition of a “credit thaw” would entail.

    In actuality, I would have to disagree with your analysis on near-term lending. I would postulate thanks banks are hording cash in order to shore-up their balance sheets from mal-investments starting from 2001. In particular, their investments in mortgage derivatives have still not cleared: Even though the U.S. may be at the peak of the Alt-A and sub-prime fiasco, the U.S. banks have still not suffered through the home loans given to the upper-lower-class and the lower-middle-class that have lost their jobs and are on the verge of foreclosure. This particular class of derivatives will have a major effect on banking, hence the banks desire to hold onto cash.


    January 21, 2009 at 8:35 am

  2. I agree with your statement that excess reserves have been increasing (banks are hording cash) to shore up their balance sheets in expectations of further write-downs. I am not predicting that lending activity is going to increase over the near-term, but I do believe that over the medium- to long-term a part of banks’ excess reserves (the part that has not been wiped out by additional write-downs) will go towards renewed lending activity. With a reserve ratio of 10%, this will result in cash flooding the system (–> inflation) unless the Fed manages to effectively deploy measures to drain excess cash. I am not saying it can’t be done… but I’m curious about the “how”.


    January 21, 2009 at 11:34 am

  3. The “how” of draining excess cash from the banking system [although this topic could go off into multiple tangents, I will try to limit this reply as best as I can.]:

    The Fed can increase reserve requirements forcing banks to keep more than 10% of cash on hand, resulting in more limited lending.

    The Fed can force banks to buy back their “distressed assets” that the Fed purchased from various “banks” (this was an attempted on the part of the Fed to shore-up bank’s balance sheets).

    The U.S. Treasury can do the stated above.

    The Fed can sell on the open market the commercial paper, CDOs, MBSs, CLOs, ETCs, that they (the Fed) bought up.

    Lastly, the Fed can actually do their job and regulate banks and other lending institutions to ensure that lending standards are met; that is: Almost-close-to-free-cash is not provided to everyone that asks for a loan, thusly creating a supply of excess cash on the balance sheets of banks, of which the excess supply of cash is not allowed to enter the direct money supply.


    January 22, 2009 at 9:41 am

  4. Found an explanation on the FED site, the source of your graph.You need to read the comments below this graph:


    The graph is misleading and meaningless because the FED changed how this was measured in 2008. If you scroll down the page it explains the changes made in 2008. You’d think they’d adjust for that or something or not publish the graph as it’s meaningless because it measures different things in different years.


    Willi Loehman

    January 23, 2009 at 11:27 am

  5. What’s truly scary is the admission that our economic theory cannot explain the current phenomena: Monetarism points in one direction, reality in the other. You can keep looking for evidence of nascent inflation, if you must, but take a look around your neighborhood, and the mall, and the financial district… That sinking feeling is something other than inflation.

    Here’s a question: What if we inflated the money supply, and it didn’t make a difference? We’d have to make-up a new word (not unlike ‘stagflation’, in an earlier era) — simultaneous monetary inflation and asset deflation. I propose that we call it madness.


    January 23, 2009 at 7:37 pm

  6. Hey eastcoastecon, great blog! I was thinking the exact same thing and I actually found his “exit strategy” in one of his speeches. It’s interesting..


    Let me know what you think..

    Distressed Volatility

    January 23, 2009 at 9:01 pm

  7. Your blog is quite good. I actually think that the banks would not lend until all the credit bubbles have bursted. Think of the credit card , student loans, cars and so on. Businesses and household that will default. All these had to burst and then clean up. Then lending can resume by banks that are left.

    Investors times

    January 29, 2009 at 9:37 pm

  8. If I printed 10 trillion and buried it under my mattress, what is the effect on the economy? Zero, right? We agree that’s what banks are doing. Consider, however, an alternate theory: there is so much debt, good and bad, that there has not been enough inflation. In other words, there’s not enough dollars floating around in the hands of businesses and people to service it. (That has been the implicit assumption of inflationists all along; the current supply of dollars is enough to service the existing debt requirements.)

    If this “unwinding” “deleveraging” stuff is far more egregious than we comprehend, we need to inflate. I’ve heard that it could be as high as 80 to 100 trillion. If so, a 1.4 trillion supply may be a pittance. The only thing I cannot account for is if there is a possibility that the dollar falls in the gutter during FOMC operations. But that wouldn’t cause inflation but even more deflation.


    January 30, 2009 at 6:29 am

  9. […] a comment » This is a visual addendum to my earlier post about inflation vs. deflation and the quantity theory of money.  As a reminder, Friedman postulates that inflation is caused by […]

  10. QTM has lots of problems but is it really necessary to ignore velocity that, as most learned sometime ago, is not so stable as Friedman et al imagined.

    More importantly though, the need to overcome fetishistic beliefs in the ‘power of money’.


    February 24, 2009 at 9:29 pm

  11. […] we’ve seen a drastic increase in bank reserves.  As I’ve pointed out on previous occasions, banks are soaking up the liquidity provided by the Fed’s various programs and the credit […]

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