TJP

Did the Fed Fail to Properly Manage the Money Supply?

By Byron A. Ellis – May 18, 2009

The public does not have a good understanding of how money is created, or its effect on the economy. Money is a commodity of exchange used to purchase goods and services. The Federal Reserve creates money by printing it and banks thorough lending. Bank money creation is extinguished when loans are paid off.

It is the responsibility of the Federal Reserve to ensure that the supply of money meets the needs of commerce without allowing inflation, or for that matter deflation.

If the money supply is scarce, less goods and services will be purchased and production and employment will decline. The scarcity of the supply of money leads to economic slowdowns and recessions. Conversely, the oversupply of money increases the demand for goods and services, as well as production and employment, in the short run. However, in the longer run, it leads to inflation, high interest rates, and production and employment curtailment.

Thus, the inability of monetary authorities, the Federal Reserve, to effectively manage the money supply is the principal cause of economic disruptions.

If the real money supply is $100 dollars and the public demand for real money balances is $200, then there would be goods and services, such as automobiles and housing, which the public could not purchase.

The demand for real money balances is the demand for money expressed in terms of the quantity of goods or services that it would buy. For instance, if the nominal demand for money is $100 and the price level is $2, then the real demand for money is 50 (=$100/$2) goods. If the price level increases to $4, then to purchase the same 50 goods, the nominal demand for money would have to increase to $200 to purchase the same 50 (=$200/$4) goods.

When the price of crude oil increased to above $4.50, the nominal supply of money remained flat. The Federal Reserve failed to adjust the nominal money supply to compensate for the crude oil induced inflation (the rise in crude oil prices).

Thus, the public demand for real money balances exceeded the real money supply. As a result, the supply of real assets, which includes housing, exceeded the demand for real assets, because consumers could not buy the same quantity of assets, or goods and services.

Lack of consumer demand caused inventory accumulation, resulting in labor unemployment

To correct for the improper money supply, the Federal Reserve and the U.S. Treasury pumped billions of dollars in the banking system. Both, the Federal Reserve and Treasury believed that with more money in banks would induce them to expand the money supply through the lending process. Banks, however, have not been eager to create money through lending. And, why should they be? They were blamed for expanding the money supply (sub prime loans).

The U.S. liquidity problem is basically a failure of the Federal Reserve to properly manage the money supply.

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