THE JETHRO PROJECT
O R G A N I Z I N G F O R E F F I C I E N T O U T P U T
In a monetary economy the Federal Reserve (Fed), banks, and the public interact to determine the stock of money. There are several measures of the money supply: M1 is the sum of currency in circulation (CU) plus demand deposits (DD) and M2 is M1 plus time deposits (TD). For simplicity, economists define the money supply (M) as currency plus deposits:
M = CU + D (1)
From equation (1) it is clear that the public through their demand for currency (CU) and banks by holding deposits (D) influence the money supply. The currency-deposit ratio (CU/D=cu) summarizes the public’s behavior and the reserve-deposit ratio (RE/D=r) summarizes banks’ behavior.
Reserve requirements are the amount of funds that banks must hold in reserve against specified deposit liabilities. High-powered (H) money or the monetary base summarizes the Fed’s behavior; it consists of currency (notes and coins) and banks’ deposits at the Fed:
H = CU + RE (2)
If we multiply and divide currency and reserve requirements by the money supply (M), we can express high-powered money in terms of the money stock:
H = ( cu+r/cu+1 ) M (3)
Equation (3) can also be expressed as:
M = ( cu+1/cu+r ) H (4)
The term (1 + cu)/(cu +r) is the money multiplier. Note that if the currency and reserve deposit ratios are small, the money multiplier would be large and high-powered money (H) would have a greater effect on the money supply. The currency and reserve requirement are small when deposits are large.
According to the Fed, “Depository institutions must hold reserves in the form of vault cash or deposits with Federal Reserve Banks.” The Federal Reserve Board's Regulation D determines the dollar amount of minimum reserve requirements. Some banks may hold “excess reserve,” beyond the levels mandated by the Fed. Holding excess reserves, however, adversely affects banks' profit.
During the economic crisis of 2008, the Fed loaned money to banks at virtually zero interest rate, which increased banks' reserves from about $45 billion to over $900 billion by January of 2009. And, to discourage the banks from loaning the funds to the public, the Fed began for the first time, in October 2008, paying interest on required reserves and excess reserve balances.
Most of the rise in reserves was due to excess reserves, which in the absence of interest payment by the Fed, excess reserve would have been loaned to the public. The graph below shows the abrupt rise in excess reserves; money transferred from the Fed's into banks accounts at the Fed.
For some economists, the surge in excess reserve is a clear indication that banks are hoarding money, which prolongs the recession and heightens unemployment. Banks hoard money because the Fed has given them an incentive to do so. When banks earn interest on reserves they have no incentive to lend at interest rates lower than the rate paid by the central bank. Thus, by paying interest on reserve (IOR), the Fed eliminated the banks' opportunity cost of holding excess reserves.
Therefore, the Fed monetary expansion is illusory and it appears that its primary purpose is to benefit Wall Street bankers and not Main Street taxpayers.
Clearly, the Fed rewarded the banks by loaning them money at zero interest rate and paying them 25 basis point above the federal funds rate on the money loaned money.
And, because the Fed is perennially worried about inflation, it does not allow the expanded monetary base to affect the economy by improving aggregate demand. It appears that the sole purpose the monetary base expansion is to bolster the income of Wall Street bankers.
It appears that the Fed is willing to sacrifice full employment for low inflation or it could well be that Fed policy is to sacrifice Mr. Obama and the Dems politically; by withholding high-powered money from the public it ensures continued high levels of unemployment and political loses for the Dems in November.
Note from the author: Banks as of December 2013 hoard $2.5 trillion in reserves. And, in December of 2013 only 74,000 jobs were created. The rise in discouraged workers appears to be the highest since 1970s. When banks hoard reserves, there can be no lasting recovery.
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