No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Twelve: Money Mischief 279 For introductory learners, it is not terribly important for you to memorize the precise content of these aggregates as in Figure 12.2 ; however, the conceptual differences are important to understand for the following reasons: (1) first, Federal Reserve policy has previously targeted the growth rate of both M1 and M2 to try and guide monetary policy in a stable fashion. While specific monetary targeting is no longer the Fed’s preferred operational approach, many observers also still view these aggregates as indicators of “too easy” or “too tight” a monetary policy. You may read or hear about money supply growth in business news reports or financial shows. (2) Second, since the money supply creation process involves the Fed, the banking system, and individuals, the differing aggregates help us understand how a given Fed policy (which only directly affects the monetary base) translates into broader economic activity. In response to the recent financial crisis, for example, the Fed has greatly expanded its monetary base since 2007 (over 100% annualized in late 2008). Yet there has been no inflationary impact as measured by the consumer price index since the banking system and consumers were either unwilling or unable to expand their balance sheets by borrowing. The effect on M1 and M2 was significantly less than the growth in the monetary base. You can see this in Figure 12.3 , which shows the large spike in the monetary base during the crisis, with a much smaller rise in M1 and M2. Statistical economists (known as econometricians) try to discern various relationships between each of these aggregates and economic activity, but that is well beyond our scope. We are simply going to consider them all as a generic money supply: MS. Monetary Definitions MB = Currency (C) + Reserves (R) M1 = Currency + Checkable Deposits + Other Checkable Deposits (Interest Bearing)+ Traveler’s Checks M2 = M1 + Savings Deposits + Small Time Deposits (<$100k Certificates of Deposit) + Retail Money Market Funds Figure 12.2 2004 2,000 4,000 6,000 8,000 10,000 M1 M3 Base 12,000 14,000 2006 2008 2010 2012 2014 2016 Figure 12.3, Growth in Monetary Base, M1 and M2. In the aftermath of the 2008 financial crisis, the Federal Reserve has significantly increased the monetary base, with three rounds of official “quantitative easing.” The dramatic percentage increase in the monetary base (over 200% since late 2008) has not been matched in the broader aggregates as the banking system has been either unable or unwilling to loan out the additional reserves. [M1 Money Stock, M2 Money Stock, St. Louis Adjusted Monetary Base. Shaded areas indicate U.S. recessions. 2011 research.stlouisfed.org .]