Reserves are old-fashioned; currency is right up to date.

Pretend this post was written in July 2008; later I’ll discuss the most recent 4 1/2 years.

I notice that some commenters think there is something slightly old-fashioned about my emphasis on the lowly currency stock.  On the contrary, it is bank reserves that were a big part of grandpa’s monetary regime.

During the first 35 years of the Fed’s existence, bank reserves mostly fluctuated between 40% and 60% of the monetary base.  That’s a pretty important share. It’s no surprise that the early post-WWII monetarists focused on the banking system.

Today (in 2008) bank reserves are only about 5% of the monetary base.  The rest is currency held by the public.  And most of the “reserves” are also currency, aka “vault cash.”  So the monetary base is actually about 99% currency and 1% bank deposits at the Fed.  Monetary policy is (implicitly) conducted by adjusting the total stock of currency.

The other mistake is to make too much of the supposed “endogeneity” of currency.  Nick Rowe has done some excellent posts on this, but I’ll try to briefly summarize:

Let’s suppose that back in 1964 Milton Friedman’s evil twin Myron Friedman tried to convince the Fed to inflate, as a way of lowering unemployment–so that LBJ could get re-elected in 1968.  He told the Fed to print money like crazy.  But Fed officials scratched their heads:

How do we do that?  The base is mostly endogenous. If we try to conduct monetary policy via control of the base then rates will go haywire.

Myron Friedman responded as follows:

Under interest rate targeting the base is endogenous in the ultra-short run, but exogenous in the medium and long run—which matters for inflation.  Thus you need to adjust interest rates to a level where holding them at that level will require the Fed to increase the base at a faster and faster rate.  For the moment, that might involve a slight rate cut.  But over time the Wicksellian equilibrium rate will rise and you’ll actually be able to raise rates HIGHER than they would be under a tight money policy.  The key is to keep watching that monetary base.  Make sure your fed funds target is always set at a level where the Fed is forced to inject more and more base money into the economy.  That level of base money will equilibrate the feds fund market in the very short run, but will disequilibrate the broader macroeconomy.  It will be more currency than the public wants to hold at the current price level, and thus prices will have to rise.

And here’s the beauty of my plan.  NO ONE WILL BLAME YOU! Remember, it’s December 1964, and “we’re all Keynesians now” (except Milton and I).  So after a tiny drop in interest rates, my plan will call for steadily higher interest rates over the next 17 years.  It will look like tight money. Those stupid Keynesians will never figure out what hit them. They’ll raise incomes taxes in the vain hope that this will stop inflation. But it won’t. Then they’ll try price controls—and just create shortages. Eventually they’ll get around to much higher nominal interest rates, but even that won’t be enough, as they’ll have forgotten about the Fisher effect.

I suppose it won’t work forever, eventually Milton will convince the profession, and a monetarist will be put in charge of the Fed and start reducing the money supply growth rate.  But by then it will be too late.  LBJ will have been re-elected in 1968.

Of course LBJ lost, but not because of the economy (which was in pretty good shape in 1968), but rather because of Vietnam and crime and race riots.

Unfortunately it is no longer July 2008.  We have gone back to the Stone Age. We are back to the Fed policy of the late 1930s, where most of the base is reserves, and nominal rates are near zero because monetary policy has been way too tight since July 2008.  I wish the Fed would go back to a “modern” monetary regime, one where the base was 99% currency.

PS.  I stole the evil twin idea from Steve Waldman.

PPS.  I never called the Keynesians “stupid.”  Myron did.


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24 Responses to “Reserves are old-fashioned; currency is right up to date.”

  1. Gravatar of flow5 flow5
    15. January 2013 at 13:07

    “Monetary policy is (implicitly) conducted by adjusting the total stock of currency”

    The volume of currency in circulation (held by the non-bank public), is impersonally determined by the public, & by the amount necessary to meet the needs of trade.

    The volume of currency is unregulated because it needs no specific regulation. It is impossible for the public to acquire more of a given type of currency without giving up other types of currency, or else bank deposits. In other words, it is impossible for the public to add to the total money supply consequent to increasing its holdings of currency.

    Currency isn’t a part of base money. It has no expansion coefficient.

    The unregulated, prudential reserve, Euro-dollar banking system doesn’t print currency, yet via money & credit creation, affects world-wide price levels.

  2. Gravatar of 123 123
    15. January 2013 at 13:13

    There was a good paper from the Fed (can’t find it now). It said before the crisis Fed used to provide lots of intraday liquidity to the banking system, so it only appeared that demand for reserves by the banking system was low. Monetary base during the day was much higher than reported.

  3. Gravatar of Ritwik Ritwik
    15. January 2013 at 14:29

    “I wish the Fed would go back to a “modern” monetary regime, one where the base was 99% currency”

    Easiest way to do this would be to hike the CRR to, say, 10% and start selling t-bills. Wouldn’t make a whit of a difference to anything, though.

  4. Gravatar of Nick Rowe Nick Rowe
    15. January 2013 at 16:07

    Scott: very glad to see that you (and Paul Krugman) are onto this.

    I’m not blogging very much nowadays, because I’m temporarily back in administrative harness, doing associate dean stuff. TA’s, grades, appeals, instructional offences, checking washrooms are clean, etc.

    But I’m still reading.

    (Didn’t Tyler invent the evil twin economist, Tyrone?)

  5. Gravatar of Benjamin Cole Benjamin Cole
    15. January 2013 at 20:43

    Counterfeiters of the world: Please come to the USA and start printing lots of money. You can be a patriot and get rich at the same time!

    And drug lords, black marketeers: please repatriate the nearly $1 trillion in cash somewhere in the world. Perhaps we can arrange an amnesty with the feds if you bring your cash here.

  6. Gravatar of Saturos Saturos
    15. January 2013 at 22:52

    Scott, are you serious? You’re saying that reserves matter little compared to the currency stock? So you think that if the fractional-reserve money multiplier were to double or halve, holding currency constant (somehow, maybe through helicopter drops), then it would have no impact on NGDP or the price level? Contrary to what we are all taught in the textbooks? That’s crazy. Currency has little to do with other forms of money, and all forms of money matter for the nominal aggregates, that’s why central banks care about them all.

    flow5, everyone else except you thinks that currency is part of M0, the monetary base, even if it has no expansion coefficient.

  7. Gravatar of Saturos Saturos
    15. January 2013 at 22:55

    Why are you so convinced that only base money is what is used to price things? Isn’t the US dollar denominated in all dollar assets? not just currency and reserves? Nick and Bill, help me out here.

  8. Gravatar of 123 123
    16. January 2013 at 04:43

    http://marginalrevolution.com/marginalrevolution/2008/12/interpreting-th.html

  9. Gravatar of ssumner ssumner
    16. January 2013 at 05:59

    123, Good point, but I would then say that reported changes in the base are nearly 100% currency during normal times. So if you use that statistic, it’s still almost all about currency. In other words if they want to creat a Great Inflation, they must boost currency sharply. That means they must boost the nighttime base sharply.

    Thanks Nick. And good luck with your new job. A gain for your school, but a loss for the world.

    Saturos, You said;

    “Scott, are you serious? You’re saying that reserves matter little compared to the currency stock? So you think that if the fractional-reserve money multiplier were to double or halve, holding currency constant (somehow, maybe through helicopter drops), then it would have no impact on NGDP or the price level? Contrary to what we are all taught in the textbooks?”

    God help you if that was what you were taught. I teach the complete money multiplier out of Mishkins’ text:

    multiplier = (1 + C/D)/(R/D + C/D)

    Obviously if C is 20 times bigger than R, then a halving of R/D has little effect on the multiplier.

    Some textbooks only teach the deposit multiplier:

    1/(R/D) which is very deceptive.

    A MOA is an asset whose nominal price never changes. Only the monetary base fits the bill. That’s why it’s special.

  10. Gravatar of Federico Federico
    16. January 2013 at 07:35

    This was a fantastic post. These types of thought experiments are probably what have convinced many people of your views.

  11. Gravatar of 123 123
    16. January 2013 at 08:16

    Scott:
    “Good point, but I would then say that reported changes in the base are nearly 100% currency during normal times. So if you use that statistic, it’s still almost all about currency. In other words if they want to creat a Great Inflation, they must boost currency sharply. That means they must boost the nighttime base sharply.”

    I disagree. It does not follow. You have to boost the total base (i.e. daytime base) sharply. If all prices doubled, banks would need the double amount of daytime liquidity for their transactions.

  12. Gravatar of Doug M Doug M
    16. January 2013 at 10:30

    It is all about REPO!

    REPO is the primpary source of bank funds, and it was the collapse of REPO that took banks down in 2008.

    REPO is to modern banking what deposts are to classical models of banking.

  13. Gravatar of David Beckworth David Beckworth
    16. January 2013 at 11:04

    Scott, put up my own response to this converstation here: http://macromarketmusings.blogspot.com/2013/01/the-waldman-krugman-sumner-debate-its.html

  14. Gravatar of JP Koning JP Koning
    16. January 2013 at 11:22

    I like 123’s point. Reserves have always been sizable… like a bullfrog, the Fed puffs up during the day and exhales at night (Tabarrok’s analogy).

    It seems to me that the Fed’s hot-potato super-powers proceed entirely through its control of reserves. Only when prices have changed in response to changes in reserves or IOR do people passively adjust their currency holdings to adapt to the new price level.

  15. Gravatar of Doug M Doug M
    16. January 2013 at 12:30

    Stauros,

    A reduction in reserves increases in the multiplier.

    Since reserves usually don’t pay interest, banks will try to hold as minimal reserves as the central bank will let them hold.

    m=1/RR where RR are required reserves is the formula usually taught in elementary economics.

  16. Gravatar of Neil Neil
    16. January 2013 at 14:37

    A minor point, but I’m pretty sure the reason LBJ lost the election of 1968 because he didn’t run…

  17. Gravatar of flow5 flow5
    16. January 2013 at 15:22

    “flow5, everyone else except you thinks that currency is part of M0″

    Saturos:

    I’m crazy, not stupid. This theory was put to me by Dr. Leland J. Pritchard, Chicago, 1933. I did the grunt work (& unlike Edison’s light bulb, without trial & error). It’s not a shared legacy.

    Sumner says the Fed was “ultra tight”. That’s absolutely wrong. Using the actual figures, it was incontestably contractual (negative figures are contractual). So I tell everyone & Bernanke’s murdered in a drive by? Do you see the anti-semitism with Friedman, Greenspan, & Bernanke?

    Sometimes contempt makes genius reclusive. During McCarthyism the FBI profiled Pritchard as a communist when he warned of the exploding money supply. The ABA paid thousands to his debaters not to show & engage him. Everybody at the Fed knew him.

    See: “Profit or Loss from Time Deposit Banking” — Banking & Monetary Studies, Comptroller of the Currency, United States Treasury Department, Irwin, 1963, pp. 369-386.

    Pritchard: “I have a better idea. Multiplying total member bank reserves by a multiplier (M1 (my def,) divided by total member bank legal reserves). The weekly figure on member bank reserves is extremely accurate since it involves only adding up member bank balances with the Federal Reserve banks and estimating the member banks’ vault cash…”

    There’s no controversy. I’m right. Everyone else is wrong.

  18. Gravatar of Luke Carlson Luke Carlson
    16. January 2013 at 17:41

    Look at who ran: http://en.wikipedia.org/wiki/United_States_presidential_election,_1968

  19. Gravatar of ssumner ssumner
    16. January 2013 at 18:14

    123, I don’t disagree, but my argument pertained to the MEASURED base, not the daytime base. The measured base is almost all currency, so to control the price level you have to basically control the currency stock at midnight, not the reserve stock at midnight. You might also need to add reserves during the day–but that’s not the issue I was addressing.

    Thanks David.

    JP, I strongly disagree. The only reason prices rise is people expect the future currency stock to be higher. If they don’t then prices will hardly budge, no matter how much the reserve balloon right now (as we are seeing.)

    Neil, Yes, but he didn’t run because he was likely to lose. Back in 1964 he expected to run, indeed in 1967 he was still expected to run. He was still in the race at the time of the New Hampshire primary.

  20. Gravatar of B.B. B.B.
    17. January 2013 at 06:10

    I think you are still missing something in your interesting post.

    The Fed follows Myron’s advice and cuts the funds rate to boost the demand for currency, which it passively provides. Higher nominal GDP growth results, and that raises the demand for currency.

    But what if we are at the zero rate bound? How does the Fed follow Myron’s advice? What can the Fed do to get more currency in the hands of the public?

    The only tool is to change expectations of future NGDP, which would boost currency demand.

    Alternatively, a fiscal-monetary combo of helicopter drops of cash might do it. But what would people do with the cash? They might just hoard it. They would only spend it if they thought the inflation rate was going to rise. It all comes down to expectations.

  21. Gravatar of JP Koning JP Koning
    17. January 2013 at 06:56

    Scott, do you consider the entire monetary base to be the MOA or just cash?

  22. Gravatar of flow5 flow5
    17. January 2013 at 07:19

    Currency has some of the same characteristics as bank deposits. With the member CBs there are “saved” dds & savings/time deposits (but all demand drafts from all financial institutions clear thru dds with few exceptions).

    “Currency in circulation” is a misnomer as most currency is hoarded (doesn’t turn over – just like bank deposits). But the percentage of currency outside the banks used to “meet the needs of trade” turns over much less frequently than the fraction of transaction deposits to other bank deposit classifications.

    If you multiply currency by Vt it doesn’t equal roc’s in nominal-gDp (is not a proxy for all transactions). If you multiply our means-of-payment money (or transaction accounts) by Vt its roc approximates the roc in nominal-gDp.

    To say that the base comprises all currency is tantamount to saying all bank deposits also belong in the base.

  23. Gravatar of ssumner ssumner
    17. January 2013 at 07:20

    BB. There are several tools. Massive OMOs. Negative IOR. Expectations of higher NGDP. All three in combo.

    JP. Both.

  24. Gravatar of flow5 flow5
    17. January 2013 at 07:30

    Fractional reserve banking is a function of the velocity of money, & not a function of its volume. And currency has no common repository for pyramidying.

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