In my last post, I wrote that Krugman was wrong to say that the Federal Reserve has no control over the money supply. In the comments section, the astute Barney Rubble pointed out that elsewhere on the blog I stated that central banks have limited control over the money supply. His comment is here:
I think it might be necessary to clarify the apparent contradiction….As in other posts you have mentioned the FED doesn’t have so much control….”In other words, if the central bank wants to boost the money supply from £1 trillion to £2 trillion, it could do so with ease. Today, the central bank does not have this control.”
So am I a hypocrite? No – at least I don’t think I am.
To explain: while a central bank can affect the money supply, it doesn’t have precise control in our current system. The Fed, for instance, could confidently commit to increasing the money supply by “a lot.” And it will probably succeed. What it can’t do, however, is target a specific increase. It can’t say, “We’ll boost the money supply by exactly $1 trillion,” or any number for that matter.
Why not? One big reason is that the Fed has no control of the money created or destroyed through the bank loan channel. That’s entirely in the hands of commercial banks. Money created through the loan channel is endogenous to economic activity. This means it is created or destroyed as needed for production. If the economy produces more, money is created. If the economy produces less, money is destroyed. By manipulating interest rates, the central bank has indirect control over this channel. It can make loans cheaper or more expensive. But its power is limited, especially at the Zero Lower Bound (ZLB).
Similarly, the Fed has only partial control over the investment channel. Let’s imagine, for instance, that the Fed buys $1 trillion of bonds from pension funds. This new money could subsequently disappear. The pension funds could turn around the next day and purchase $500 billion of bonds from banks. If the banks don’t create offsetting loans, the overall increase to the money supply is only $500 billion, not $1 trillion.
My larger point is that given all the factors at play the Fed can never have absolute control over the money supply, not the way it does under neutral money. But its control is still considerable, even at the ZLB.
Once upon a time, economists believed that banks automatically multiplied new reserves into new loans and new money. Those days are over. Most economists now realize – painfully – how wrong this assumption was.
The danger now is that we go too far in the opposite direction, as Krugman has done. The danger is that we start believing that the central bank can never directly affect the money supply. This is wrong. The Fed can do so through the investment channel, which is what Ben Bernanke did with quantitative easing. Bernanke never aimed for a precise number with QE. He just needed to increase the money supply by “a lot.” And he did.
Without Ben’s helicopter, the money supply would’ve continued to contract. And with less money in the economy, interest rates would’ve remained sky high at a time when the economy desperately needed rock bottom rates. In other words, we would’ve entered another Great Depression.