WASHINGTON (MNI) – The following is the second of three sections
of the remarks of San Francisco Federal Reserve Bank President John
Williams prepared Wednesday night for the AEA National Conference on
Teaching Economics and Research in Economic Education,”

The money multiplier during the crisis and recession

The breakdown of the standard money multiplier has been especially
pronounced during the crisis and recession. Banks typically have a very
large incentive to put excess reserves to work by lending them out.
Thus, our traditional textbook theories predict that banks will hold
reserves only to the extent that they have to do so to satisfy
regulatory requirements and transactions needs. If a bank were suddenly
to find itself with a million dollars in excess reserves in its account,
it would quickly try to find a creditworthy borrower and earn a return
on that one million dollars. If the banking system as a whole found
itself with excess reserves, then it would try to lend the money out.
That would increase the availability of credit in the economy, drive
private-sector borrowing rates lower, and spur economic activity.
Precisely this reasoning lies behind the classical monetary theories of
multiple deposit creation and the money multiplier.

But, this hasn’t happened — not at all. The Federal Reserve has
added $1.5 trillion to the quantity of reserves in the banking system
since December 2007. Despite a 200 percent increase in the monetary base
— that is, reserves plus currency — measures of the money supply have
grown only moderately. Over this period, M1 increased 38 percent, while
M2 increased merely 19 percent. In other words, the money multiplier
has declined dramatically. Indeed, despite all the headlines
proclaiming that the Fed is printing huge amounts of money, since the
end of 2007 M2 has grown at a 5 percent annual rate on average. That’s
only slightly above the 5 percent growth rate of the preceding 20 years.

Why has the money multiplier broken down? Well, one reason is that
banks would rather hold reserves safely at the Fed instead of lending
them out in the still struggling and risky economy. But, once the
economy improves sufficiently, won’t banks start lending more actively
in order to earn greater profits on their funds? And won’t that get the
money multiplier going again? And can’t the resulting huge increase in
the money supply overheat the economy, leading to higher inflation? The
answer is no, and the reason for this is a profound, but largely
unappreciated change in the inner workings of monetary policy.

Interest on bank reserves

I’m referring to the 2008 legislation that allowed the Fed to pay
interest on bank reserves. These reserves consist almost entirely of
bank balances held electronically at the Fed. Until just a few years
ago, bank reserves and cash were the same in many respects. Both were
part of the monetary base. Both earned no interest. And both could be
used to satisfy reserve requirements and settle payments between banks.

But now banks earn interest on their reserves at the Fed and the
Fed can periodically change that interest rate. This fundamental change
in the nature of reserves is not yet addressed in our textbook models of
money supply and the money multiplier. Let’s think this through. At
zero interest, bankers feel considerable pressure to lend out excess
reserves. But, if the interest rate paid on bank reserves is high
enough, then banks no longer feel such a pressing need to “put those
reserves to work.” In fact, banks could be happy to hold those reserves
as a risk-free interest-bearing asset, essentially a perfect substitute
for holding a Treasury security. If banks are happy to hold excess
reserves as an interest-bearing asset, then the marginal money
multiplier on those reserves can be close to zero.

In other words, in a world where the Fed pays interest on bank
reserves, traditional theories that tell of a mechanical link between
reserves, money supply, and ultimately inflation no longer hold. In
particular, the world changes if the Fed is willing to pay a high enough
interest rate on reserves. In that case, the quantity of reserves held
by U.S. banks could be extremely large and have only small effects on,
say, M1, M2, or bank lending. So what about excess reserves and
inflation? Classical monetary theory would take it as given that the
enormous growth of excess reserves of the past few years would spur
inflation. But if all those reserves aren’t lent out, and all they do
is sit at the Fed gathering interest, then the classical conclusion no
longer holds water.

Understanding the Federal Reserve’s asset purchase programs

This raises another question: If those reserves aren’t circulating,
why has the Fed boosted them so dramatically in the first place? The
most important reason has been a deliberate move to support financial
markets and stimulate the economy. By mid-December 2008, the Fed had
lowered the federal funds rate essentially to zero. Yet the economy was
still contracting very rapidly. Standard rules of thumb and a range of
model simulations recommended setting the fed funds rate below zero
starting in late 2008 or early 2009, an obvious impossibility.

Instead, the Fed provided additional stimulus by purchasing
longer-term securities, another policy tool absent from standard
textbooks. From late 2008 through March 2010, the Fed bought $1.7
trillion in such instruments. Then, in November 2010, we announced we
would purchase an additional $600 billion in longer-term Treasury
securities by the end of June 2011. We created bank reserves to pay for
the securities. These purchases increased the demand for longer-term
Treasuries and similar securities, which pushed up the prices of these
assets, and thereby reduced longer-term interest rates. Lower interest
rates, in turn, have improved financial conditions and helped stimulate
real economic activity. Based on econometric analysis and model
simulations, I estimate that these longer-term securities purchase
programs will raise the level of GDP by about 3 percent and add about 3
million jobs by the second half of 2012. This stimulus also probably
prevented the U.S. economy from falling into deflation.

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** Market News International Washington Bureau: 202-371-2121 **

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