Class News (335): Final Exam Aids

I have received a number of emails about time-inconsistency and monetary policy.  Accordingly, I dug up an old lecture and updated it: central-bank-independence-and-rules_money-and-banking_spring 2009.

I have also had some questions about why Fed independence may come under attack (and why should we care if it does).  Well first off, the Fed has become one of the largest (if not the largest) financial institution in the world.  At year-end 2008, total Fed assets were $2.2 trillion.  The largest U.S. bank holding company at that time was JPMorgan Chase ($2.175 trillion).  Since the beginning of the financial crisis, the Fed has pumped more than $1 trillion in liquidity into the System – more than either TARP 1 (originally passed at $700 billion) or the stimulus package ($787 billion).  Here is a related article from THE ECONOMIST: Federal Reserve: The Hedge Fund of Foggy Bottom.

Finally, all this matters because of the combination of (1) record excess reserves in the banking system and (2) record projected budget deficits.  As of March 2009, the monetary base was $1.64 trillion, and M2 was $8.32 billion – implying a M2 multiplier of 5.06.  The average M2 multiplier from January 2000 to September 2008 was 8.54.  So if the multiplier were to “mean revert,” M2 would rise to $14.03 trillion (an increase of 68.7%).  The Fed stated in the most recent FOMC statement (4/29/09):

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

The Fed is obviously confident the supply of excess reserves can be drained from the banking system as demand for those reserves declines, so M2 will not spike.  Foreign demand for U.S. financial assets (like Treasury debt) depends on expectations about the Fed’s likely success.  This particularly matters given the record budget deficits projected by the Congressional Budget Office (which will put pressure on the Fed to monetize the budget deficit to keep interest rates low).

Posted at 4:46 pm Eastern

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