Blog Post

Where has all the (base) money gone?

The short answer is: into the liquidity trap.

By: and Date: March 27, 2013 Topic: European Macroeconomics & Governance

The short answer is: into the liquidity trap[1].

The longer answer starts from two quotations from Milton Friedman, which give the essence (but not the subtleties) of monetary policy as it stood before the Neo-Wicksellian school concluded that prices, in the guise of interest rate, not quantities, as monetary aggregates, are the alpha and the omega of monetary policy:

1.      “…the links between Reserve action and the money supply are sufficiently close, the effects occur sufficiently rapidly, and the connections are sufficiently well understood, so that reasonably close control over the money supply is feasible, given the will.”

(page 89, Friedman, 1960)

2.      “No substantial movements in the price level within fairly short periods have occurred without movements in the same direction in the stock of money, and it seems highly dubious that they could. Over long periods, changes in the stock of money can in principle offset or reinforce other factors sufficiently to dominate trends in the price level.”

(Page 86, Friedman, 1960)

Even if the neo-Wicksellian school is in the ascendance, the two ideas in the two quotations have not lost their appeal, for economists and policy makers as well as for the layman[2]. In the first quotation one finds the basic idea that a central bank can control the money supply through the supply of reserves or base (or, more evocatively, high powered) money[3]. In the second quotation one finds the other basic idea that there is a long-term relationship between the development of an appropriately chosen monetary aggregate and inflation.

Still in 2011, one could find a simplified exposition of these two ideas in one of the most popular intermediate macroeconomics textbooks, the one by Dornbusch, Fischer and Startz, surely not economists from a pure monetarist school[4]:

In the textbook, the first idea took the form of the money multiplier, according to which there is a constant, or at least an easy to forecast, relationship between high-powered money and a relevant monetary aggregate. The second idea, which was presented more as an hypothesis than as a demonstrated empirical fact, took the form of a stable demand for money, whereby changes in money market equilibrium are ultimately determined by supply changes decided by the central bank and result, over the long run, in changes in the price level. The practical corollary of the two ideas is that the central bank can pursue price stability, in the medium term, by calibrating the issuance of high-powered money. Friedman even translated this into a simple rule: high powered money should be issued in a way that it would lead to a constant 3 to 5 per cent growth for the relevant monetary aggregate.

In the euro area, empirical facts provided mixed support to these two ideas before the crisis.

Unlike in the case of Germany before monetary union, in the euro area, the money multiplier only had some kind of stability for a short period between the Autumn of 2005 and the Autumn of 2008. Before that it was affected by the currency change-over, after that by the crisis.

Chart 1 – Money multiplier in Germany (1980-1999) and Euro Area (1999-2013)

As regards the stability of money demand, this was assumed when the monetary policy strategy of the ECB was communicated in 1999: “The available empirical evidence suggests that broad monetary aggregates exhibit the properties required for the announcement of a reference value. […] In the past the demand for euro area broad money has been stable over the long run, [that] empirical evidence has been judged strong and robust enough for a reference value to be announced […]”. (European Central Bank, 1999)

However, subsequent empirical developments did not confirm this statement. Indeed the most exhaustive paper on money and monetary policy of the ECB (Fischer, Lenza, Pill and Reichlin, 2008), which was presented at a conference organized by the ECB, arguably to defend the “Money pillar” in its strategy, concluded that: “…there is no reliable estimated money demand equation which covers the entire sample period”. Still, the paper argued that, a complex, widely judgmental use of monetary variables can help the conduct of monetary policy, including in the forecast of inflation over the medium to long run. Comments made at the conference showed that not every participant to it was convinced of the usefulness of monetary aggregates to forecast inflation, still probably quite a few would have conceded that a central bank should keep an eye on monetary developments in conducting monetary policy. In addition, probably a majority of participants to the conference would have agreed that it is much easier to find a relationship between the growth of monetary aggregates and inflation when both move away from low growth rates, such as those experienced by the euro, to high ones, as happens in the extreme in hyperinflation. This is indeed the idea that Friedman expressed in 1960 when writing that: “While the stock of money is systematically related to the price level on the average, there is much variation in the relation over short periods of time and especially for the mild movements in both money and prices that characterize most of our experience and that we would like to have characterize all.”(page 87, 1960, emphasis added)

During the Great Recession the evidence turned definitely against the two Friedman´s ideas, at least in their simplest, and strongest, formulation.

This was particularly the case for the money multiplier, which was not only unstable, it just disappeared. Two pairs of data suffice to make the point: in the summer of 2009 the 12 month rate of growth of base money was close to 30 per cent, that of M3 was approaching 0; in March 2012 base money was growing at something like 66 per cent, M3 at 3 per cent. A look at the money multiplier itself (look again at Chart 1) shows an instant drop in the autumn of 2008 and wild swings afterwards on an irregular downward trend. A similar development took place in the United States.[5]

Empirical analyses using also data pertaining to the Great Recession (Barigozzi and Conti, 2010) do not manage to get a better empirical relationship between money aggregate growth and inflation. Indeed the two authors reach an analytical and a practical conclusion inconsistent with Friedman´s ideas. The analytical conclusion is that it is “…the role of international financial markets, rather than monetary policy instruments, as the direct determinants of M3 growth rate.” The practical conclusion is that: “ we provide empirical support for a New Two… Pillars Strategy (De Grauwe and Gros, 2009) aimed to achieve financial stability through monetary aggregates and price stability through interest rates.” Hall, Swamy and Tavlas, who also use data including the Great Recession, only salvage the stability of the money demand function introducing, in addition to more standard wealth effects, an uncertainty effect, which of course was particularly strong during the Great Recession. They do not, however, support a return of the ECB to monetary targeting, since the relationship between money aggregates and prices requires interpretation and judgment that can only be pursued in a broadened and deepened monetary analysis.

As the joint result of the breakdown of the multiplier and the weak relationship between money and inflation, variations in the base money growth failed to translate into similar variations in inflation[6].

Chart 2 – Monetary Base and Harmonised Index of Consumer Prices in EA (1999-2013)

A central bank wanting to follow the Friedmanian rule and thus stabilize inflation by calibrating base money would have been in deep trouble. Clearly this is not what the ECB has done, given its impeccable control of inflation since it runs the monetary policy of Europe.

The absence of a relationship between base money growth and inflation during the crisis is a fact, but what can explain this fact. In particular, why did the money multiplier break down during the crisis?

A first way to understand the breakdown of the chain linking base money growth to inflation is provided by Woodford: “These familiar mechanisms may have resulted in a fairly reliable connection between expansions of the monetary base and increases in aggregate nominal expenditure under ordinary circumstances — under which a substantial opportunity cost of holding excess reserves exists — but there is no reason to expect them to work in the same way once the opportunity cost is eliminated, because money-market interest rates are no longer higher than the interest rate paid on reserves.”

Basically the Woodford argument is that bank reserves (the relevant part of base money or high powered money) have a special role in facilitating transactions and thus have a well specified demand as long as their interest rate is lower than that on similar assets, but when the interest rate on reserves is the same as on other assets (in particular 0) reserves have no more special transaction role and they are perfect substitute with other assets also yielding 0, their demand becomes perfectly elastic and their size irrelevant for equilibrium.

Another, not inconsistent, way to look at the issue is that base money has lost its “high power” during the Great Recession, because the liabilities issued by the central bank have substituted those issued by commercial banks as the former was forced to bring on its books part of the inter-bank intermediation previously carried out by the private financial market, which was impaired by extraordinarily high credit and liquidity risk: in a way deposits with the central bank and ordinary inter-bank deposits can no longer be distinguished one from the other (Papadia and Välimäki, 2011). A similar point was made by von Hagen (2009), who interestingly noted that it was the “reserve ratio” that increased precipitously during the Great Recession, unlike in the Great Depression, when it was the “currency ratio” that increased and made the money multiplier plummet[7].

Of course, the loss of “high power” by bank reserves opens up an entirely different issue, namely what was the macroeconomic effect of the very large creation of base money and concomitant increase in the balance sheet of central banks during the Great Recession. To put the issue in (too) stark terms, the question is whether the effort of central banks in expanding their balance sheets was in vain. But this is an important issue, which we leave to another blog.

While base money control was irrelevant for inflation control during the Great Recession would this be the case on a permanent basis? The answer is that the control of the central bank balance sheet and of bank reserves in particular, will be important again when the situation will normalize. This is a much weaker statement than saying that a stable multiplier and a stable, standard money demand will prevail after the crisis. There is no need to believe in the latter stronger statement to make the point that the central bank should care about the growth of its balance sheet in circumstances different from the highly exceptional ones prevailing during the crisis: base money control will remain insufficient to control inflation, still it will be necessary, if only to calibrate appropriately interest rates in a neo-Wicksellian approach. This of course stresses the importance of planning for the exit from the exceptionally easy monetary policy that is now prevailing in most of the advanced economies, which is somehow in contrast with the preoccupation of a number of central banks, with the possible exception of the ECB, to postpone as far as possible into the future any idea of normalization of monetary policy.

References:

Matteo Barigozzi, Antonio Conti: On the Sources of Euro Area Money Demand Stability A Time-Varying Cointegration Analysis, ECARES Working Paper 2010‐022

Rudiger Dornbusch, Stanley Fischer and Richard Startz: Macroeconomics, 11th Edition, 2011, McGraw- Hill Irwin, New York

European Central Bank (1999): The Stability-Oriented Monetary Policy Strategy of the Eurosystem, Monthly Bulletin, January, 39-50

Björn Fischer, Michele Lenza, Huw Pill and Lucrezia Reichlin: Money and monetary policy: the ECB experience 1999-2006, in European Central Bank, The Role Of Money – Money And Monetary Policy In The Twenty-First Century, 2008

Milton Friedman: A Program for Monetary Stability, Fordham University Press, New York, 1960

Milton Friedman: The Role of Monetary Policy, American Economic Review, March 1968

Charles Goodhart, Melanie Baker, Jonathan Ashworth, Anthony Obrien, Monetary Targetry: Possible Changes under Carney, UK Economics and Interest Rate Strategy, Morgan Stanley, January 9, 2013.

Stephen G. Hall, P.A.V.B Swamy and George S. Tavlas:  Milton Friedman, the Demand for Money and the ECB´s Monetary Policy Strategy, Federal reserve Bank of St.Louis REVIEW, May/June 2012

Francesco Papadia and Tuomas Välimäki: The functioning of the Eurosystem Framework since 1999, In The Concrete Euro – Implementing monetary policy in the euro area,

Paul Mercier and Francesco Papadia eds. Cambridge University Press, Cambridge, 2011

Jürgen von Hagen: The Monetary Mechanics of the Crisis, Bruegel policy contribution, Issue 2009/08, August 2009

John C. Williams: President and CEO, Federal Reserve Bank of San Francisco. July 2, 2012

Monetary Policy, Money, and Inflation

Michael Woodford: Methods of Policy Accommodation at the Interest-Rate Lower Bound, Mimeo, Columbia University, August 20, 2012


[1] This blog can be seen as an update of the Bruegel Policy Contribution of Jürgen von Hagen, who made a very similar point in 2009. Comments by George Tavlas are gratefully acknowledged.

[2] In a recent article, Hall, Swamy and Tavlas argued that the ECB monetary policy strategy has been “considerably influenced” by Milton Friedman´s ideas. Indeed there is still a monetary policy pillar in the ECB monetary policy strategy, even if it seems dormant.

[3] To be precise, base money includes currency in circulation in addition to bank reserves.  However currency in circulation is entirely demand determined and the central bank has no direct influence on it, thus the part of base money that is relevant for monetary policy is bank reserves.

[4] Macroeconomics, 11th edition, 2011.

[5] Goodhart and al. describe what happened tot he money multiplier as follows: “… the determined upwards leveraging of Central Banks’ balance sheets has been met and offset by a massive deleveraging of private sector balance sheets, in particular amongst banks.”

[6] Different attempts that we conducted failed finding an empirical relationship between the two variables.

[7] The reserve ratio (r) and the currency ratio (c) determine the money multiplier in the formula: M = (1 + c) / (c + r) B, where M is the money supply and B is base money.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.


Warning: Invalid argument supplied for foreach() in /home/bruegelo/public_html/wp-content/themes/bruegel/content.php on line 449
View comments
Read article More on this topic

Opinion

Europe must seize this moment of opportunity

As the EU enjoys a period of growth and relative stability, there is finally room to undertake long-needed reforms. But it is vital to act soon, and priorities must be set. There are three pillars of reform for the coming months: completing a robust euro area; building a coherent EU foreign policy; and harnessing the single market’s potential to deliver strong and inclusive growth.

By: Agnès Bénassy-Quéré, Michael Hüther, Philippe Martin and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: August 12, 2017
Read about event

Upcoming Event

Sep
7-8
09:00

Bruegel Annual Meetings 2017

The Annual Meetings are Bruegel’s flagship event. They offer a mixture of large public debates and small private sessions about key issues in European and global economics. In a series of high-level discussions, Bruegel’s scholars, members and stakeholders will address the economic policy challenges facing Europe.

Speakers: José Antonio Álvarez Álvarez, Agnès Bénassy-Quéré, Pervenche Béres, Grégory Claeys, Zsolt Darvas, Jean Luc Demarty, Maria Demertzis, Anna Ekström, Lowri Evans, Sandro Gozi, Peter Grünenfelder, Patrick Graichen, Reiner Hoffman, Levin Holle, Kate Kalutkiewicz, Steffen Kampeter, Peter Kažimír, Emmanuel Lagarrigue, Matti Maasikas, Steven Maijoor, Nathalie Moll, James Murray, Julia Reinaud, Carlos Sallé Alonso, André Sapir, Dirk Schoenmaker, Mateusz Szczurek, Marianne Thyssen, Reinhilde Veugelers, Nicolas Véron, Liviu Voinea, Johan Van Overtveldt, Ida Wolden Bache, Guntram B. Wolff and Georg Zachmann Topic: Energy & Climate, European Macroeconomics & Governance, Finance & Financial Regulation, Global Economics & Governance, Innovation & Competition Policy Location: Square - Brussels Meeting Centre
Read about event

Upcoming Event

Sep
28
12:30

Unfinished business: The unexplored causes of the financial crisis and the lessons yet to be learned

At this event Tamim Bayoumi will present his upcoming book on the financial crisis, showing how how the Euro crisis and U.S. housing crash were, in fact, parasitically intertwined.

Speakers: Tamim Bayoumi, Maria Demertzis and Aerdt Houben Topic: European Macroeconomics & Governance, Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic More by this author

Blog Post

Italian economic growth and the Euro

While the Euro has frequently been blamed for the poor growth performance of Italy over the years, a long-term analysis shows deteriorating growth before the introduction of the Euro. Additionally, Italy has shown worse performance than other euro-periphery countries, such as Spain, implying deeper structural reasons for Italy’s economic malaise.

By: Francesco Papadia Topic: European Macroeconomics & Governance Date: July 26, 2017
Read article More on this topic More by this author

Blog Post

The international effects of ECB’s monetary policy

What’s at stake: the literature on monetary policy spillovers is abundant of studies investigating the impact of the US Federal Reserve’s monetary policy announcements and actions on emerging market economies. More recently, economists have been investigating the effect of the ECB’s credit easing as well.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: July 24, 2017
Read about event More on this topic

Past Event

Past Event

Perspectives on Universal Basic Income

At this event, we discussed the possible benefits but also the possible disadvantages of Universal Basic Income.

Speakers: Grégory Claeys, Olli Kangas, Professor Philippe Van Parijs and Prof. Dr. Hilmar Schneider Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: July 12, 2017
Read article More on this topic More by this author

Blog Post

The forward guidance paradox

What’s at stake: the term “forward guidance” is used in economic jargon to describe central bank communications about the likely future path of policy rates. Standard monetary models imply that far future forward guidance has huge effects on current outcomes, and recent literature has been trying to reconcile this with reality.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: July 10, 2017
Read about event

Past Event

Past Event

Is there a way out of non-performing loans in Europe?

At this event we looked at the issue of non-performing loans in Europe. The event also saw the launch of the latest issue of "European Economy – Banks, Regulation and the Real Sector."

Speakers: Emilios Avgouleas, Giorgio Barba Navaretti, Giacomo Calzolari, Maria Demertzis, Martin Hellwig, Helen Louri and Laura von Daniels Topic: European Macroeconomics & Governance, Finance & Financial Regulation Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: July 6, 2017
Read article Download PDF More on this topic

External Publication

Review of EU-third country cooperation on policies falling within the ITRE domain in relation to Brexit

What is the possible future relationship between the EU and the UK in light of Brexit? The report provides a critical assessment of the implications of existing models of cooperation between third countries and the European Union on energy, electronic communications, research policy and small business policy.

By: J. Scott Marcus, Georgios Petropoulos, André Sapir, Simone Tagliapietra, Alessio Terzi, Reinhilde Veugelers and Georg Zachmann Topic: European Macroeconomics & Governance Date: July 5, 2017
Read article More on this topic More by this author

Blog Post

Eurozone or EU budget? Confronting a complex political question

This week’s European Commission reflection paper is the latest document to ponder a distinction between EU and euro-area budgets. But do we need to split the two, and what would each budget be used for? In this post, I present an analytical framework for assessing this ultimately political question

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: June 29, 2017
Read article More on this topic More by this author

Blog Post

Raising the inflation target: a question of robustness

In an unexpected move, the Federal Reserve Chair Janet Yellen has recently brought up the issue of raising the inflation target. This blog argues that an increase in inflation targets may prove to be beneficial in achieving price stability in the long run. This would increase the credibility of central banks in achieving inflation goals and stave off the distortionary effects of deflation.

By: Maria Demertzis Topic: European Macroeconomics & Governance Date: June 22, 2017
Read article More on this topic

Blog Post

Can EU actors keep using common law after Brexit?

English common law is the choice of law for financial contracts, even for parties in EU members with civil law systems. This creates a lucrative legal sector in the UK, but Brexit could make UK court decisions difficult to enforce in the EU. Parties will be able to continue using English common law after Brexit, but how will these contracts be enforced? Some continental courts are preparing to make judicial decisions on common law cases in the English language.

By: Uuriintuya Batsaikhan and Dirk Schoenmaker Topic: European Macroeconomics & Governance Date: June 22, 2017
Load more posts