FED is not printing money

It was is common to colloquially refer to  quantitative easing by the Fed – specifically, QE2 – as “printing money”. However, that’s not exactly right.  So what exactly did the Fed do? Well, instead of printing the green paperbacks, the Fed credited the accounts of the banks that are members of the Federal Reserve system. This- in econ talk- is also known as expanding  the Fed’s reserve balances. These reserves are different from printing money because they’re are loaned out to the banks and do not create new money, or M1 in the short-run. With that said, any bank who’s a recipient of such credits could at any time redeem them for real currency. Via FRED, I’ve sketched a composite graph illustrating money in circulation (blue) and reserve balances of the Fed (red). The graph clearly shows a precipitous rise in reserve balances in the 2nd-half of 2008, accompanies by a sober rise in money supply. These two variables essentially offset each other. Note: The rise in reserves during 2011 is attributed to QE2.

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Money in circulation (blue) & Reserves (red)

To understand this distinction better, we need to look at the past 10 years. Prior to 2008, the interest rate on excess reserves was virtually zero; this forced the banks to do two things to make a little profit off these reserves: (1) cash withdrawals OR (2) exchange them with other banks i.e. interbank transfers for a small profit margin. This all came undone once the Great Recession hit. After the bail-outs and averting systemic risk, the Fed introduced interest rates on excess reserves to incentivize the banks to hold on to the reserves, and in effect cushion themselves against the forthcoming period of economic uncertainty. Unlike pre-2008, in the present system as the graph shows, the banks are earning financial rate of returns on their reserves and have no desire to redeem these reserves for actual currency. This consequently has created a huge lag in the overall money supply.

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2 responses to “FED is not printing money

  1. Great blog. It allows a better understanding of what Quantitative Easing has really done to the nations money flow in comparison to the amount of risk of the Federal Reserve. The fact, in my view, is that the Federal Reserve allowed for these Investment Firms and other Banking Agencies to not take a hit when they should have in lieu of making the people pay for these toxic debts. You pointed out the problem nicely. Thank you for that. My main question would be, what would be the solution to the problem?

  2. Thanks, Rich.Without going into the causes of the financial crisis, I would offer a few suggestions. We need to begin by doing the obvious, i.e. enact prudential regulation. The derivative reform and limits on leverage are a necessity to reduce moral hazard. However, in case the banking system evades the regulatory regime (as the financial history tells us); we need to supplement regulations with some sort of rescue fund at the Fed. This fund could be financed by the member banks or financial institutions via a rescue tax. So, if we ever do face bank failures, this fund could be used for capital injections instead of a tax-payers financed bailout.

    This is probably not a panacea, but a common-sense starting step that we could build on.

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