All of the buzzwords in one post: quantitative easing, inflation and printing money

News N Economics:

Quantitative easing (QE) by the Fed has begun. But before we can address the Fed’s QE strategy, we must get one thing straight. First, a QE policy is not a zero interest rate policy (ZIRP). The federal funds target is currently 1%, and although the Fed has initiated a QE strategy, it has not declared ZIRP…yet. The next scheduled meeting is December 15-16, where the Fed may very well set the policy rate closer to 0%.

Without explicitly setting the federal funds target to 0%, the Fed is currently engaging in another non-traditional policy, quantitative easing (QE). Under a QE policy, the Fed increases bank reserves beyond levels consistent with ZIRP (technical definition according to Bernanke, Reinhart, and Sack). QE implies that the Fed no longer targets an interest rate.

The flood gates are open. The Fed is injecting the banking system with shiny new reserves (liquidity) and is no longer using open market operations to keep the effective federal funds rate – the overnight interbank loan rate – close to its target, currently 1%.

In laymen’s terms, the Fed is printing money under the QE policy; the idea of the Fed printing money has clearly caused some confusion for readers. Printing money is a pejorative term that is often associated with inflation, or worse, hyperinflation. In normal times, a QE strategy would certainly result in newly available money, but we are not in normal times.

The Fed is not printing money, rather it is printing high powered money, where high powered money is the monetary base (reserves).

What is the difference between money and high powered money? Money is a function of two things

1. The monetary base, which equals bank reserves plus currency in circulation
2. The money multiplier, or how quickly the base switches hands in a fractional reserve banking system (for a discussion of money creation, see this wiki article).

The Fed is raising the monetary base through its QE policy and increasing its balance sheet (credit extended to the banking system) from $884 billion on August 28 to $2.1 trillion on November 28. The Fed simply creates new monetary base (reserves) out of thin air; hence, the printing money connotation.
However, banks are hoarding the new base in the form of excess reserves, and lending has slowed significantly relative to the size of the new reserve base. Therefore, the money multiplier is collapsing.
Will the Fed’s QE strategy lead to inflation? In the short-term, no. The money multiplier is falling because the economy is in a nasty recession alongside a serious credit crisis. In this environment, the surge of high powered money will not cause prices to rise.
Prices can drop in a recession (deflation) because the demand for goods and services falls with rising unemployment and declining income. But the 2008 recession is accompanied (or partially caused) by a credit crisis that induces banks to hoard the new base as excess reserves; this adds to the deflationary pressures (possibly reducing the money supply). If deflation were to become embedded into consumer and firm expectations, then the macroeconomy could be facing a severe problem. So for now, and until the economy emerges from its recession, QE will not lead to inflation.

But what happens when the economy rebounds? Inflation becomes a serious risk if the Fed does not extract the high powered money. If the Fed gets it wrong, or its timing is off, then the money supply will rise quickly as banks start to lend more freely, and inflation results.

Money creation - Wikipedia, the free encyclopedia

Money creation - Wikipedia, the free encyclopedia: Three ways to create money are; by manufacturing paper currency or metal coins, through debt and lending, and by government policies such as quantitative easing.

Money creation through the fractional reserve system

Main article: Fractional-reserve banking

Further information: Money supply

To avoid confusion, keep in mind that a "central bank" is not technically a federal institution - it is a private bank, not unlike other private banks, except for the fact that it has the right to control the initial issuance of debt-backed monies to a central government. Almost all nations have central banks, and almost all of the world's money supply is controlled not by governments, but by private bankers. Fractional-reserve banking creates money whenever a new loan is created. In short, there are two types of money in a fractional-reserve banking system, the two types being legally equivalent:

1. central bank money (M0 or MB = all money created by the central bank regardless of its form (banknotes, coins, electronic money through loans to private banks))
   
2. commercial bank money (M1 - M3 = money created in the banking system through borrowing and lending) - sometimes referred to as checkbook money^[5]

When a commercial bank loan is extended, new commercial bank money is created. As a loan is paid back, the commercial bank money disappears from existence.

Re-lending

The mainstream economics theory of monetary creation is that commercial bank money is created by commercial banks re-lending central bank money: the central bank (a privately-owned institution) lends money to another commercial bank, which re-loans part of it, due to fractional reserves, and this portion is in turn itself re-lent (it is re-re-lent central bank money). This theory is disputed by some schools of heterodox economics, such as monetary circuit theory.
The table below displays how central bank money is used to produce commercial bank money via successive re-lending in this theory.

Fractional-Reserve Lending Cycled 10 times with a 20 percent reserve rate
individual bank	amount deposited	amount loaned out	reserves
A	100	80	20
B	80	64	16
C	64	51.20	12.80
D	51.20	40.96	10.24
E	40.96	32.77	8.19
F	32.77	26.21	6.55
G	26.21	20.97	5.24
H	20.97	16.78	4.19
I	16.78	13.42	3.36
J	13.42	10.74	2.68
K	10.74
			total reserves:
			89.26
	total amount deposited:	total amount loaned out:	total reserves + last amount deposited:
	457.05	357.05	100
	commercial bank money created + central bank money:	commercial bank money created:	central bank money:
	457.05	357.05	100

Although no new money was physically created in addition to the initial $100 deposit, new commercial bank money is created through loans. The 2 boxes marked in red show the location of the original $100 deposit throughout the entire process. The total reserves plus the last deposit (or last loan, whichever is last) will always equal the original amount, which in this case is $100. As this process continues, more commercial bank money is created. For more information on how this system works, see Fractional-reserve banking.
An earlier form of such a table, featuring reinvestment from one period to the next and a geometric series, is found in the tableau économique of the Physiocrats, which is credited as the "first precise formulation" of such interdependent systems and the origin of multiplier theory.^[9]

Money multiplier

The expansion of $100M through fractional-reserve lending at varying rates. Each curve approaches a limit. This limit is the value that the money multiplier calculates.

The most common mechanism used to measure this increase in the money supply is typically called the money multiplier. It calculates the maximum amount of money that an initial deposit can be expanded to with a given reserve ratio – such a factor is called a multiplier.

Formula

The money multiplier, m, is the inverse of the reserve requirement, R:

This formula stems from the fact that the sum of the "amount loaned out" column above can be expressed mathematically as a geometric series with a common ratio of 1 − R.
To correct for currency drain (a lessening of the impact of monetary policy due to peoples' desire to hold some currency in the form of cash) and for banks' desire to hold reserves in excess of the required amount, the formula

can be used, where Currency Drain is the percentage of money that people want to hold as cash and the Desired Reserve Ratio is the sum of the Required Reserve Ratio and the Excess Reserve Ratio.
Example
For example, with the reserve ratio of 20 percent, this reserve ratio, R, can also be expressed as a fraction:

So then the money multiplier, m, will be calculated as:

This number is multiplied by the initial deposit to show the maximum amount of money it can be expanded to.

Money creation through quantitative easing

Main article: Quantitative easing

Quantitative easing refers to the creation of a significant amount of new money (usually electronically) by a central bank. It is sometimes referred to as "printing money". This money is created to stimulate the economy, in particular to promote lending by banks. The central banks use the created money to buy up large quantities of securities from banks. This appears as deposits and gives the banks new money to lend. These securities could be government bonds, commercial loans, asset backed securities, or even stocks. Quantitative easing is usually used when lowering official interest rates is no longer effective because they are already close to or at zero.

See this graph of the Fed's balance sheet to see a history of what happened.  In March 2008, Bear Sterns collapsed which caused the Fed to do "qualitative easing" in which it reduced the quality of its assets from the safest possible short term government debt to loans to the banking industry.  Then when Lehman Brothers collapsed in September, the Fed engaged in quantitative easing in earnest.   Japan pioneered quantitative easing during their liquidity trap deflation, but unfortunately, it has not brought an economic recovery to Japan.  At best it has kept Japan's banks alive. 

Alternative theories

The above gives the mainstream economics theory of money creation. In heterodox economics, alternative theories of how money is created include:

• Chartalism, which holds that money is created by government deficit spending, and emphasizes (and advocates) fiat money.
• Circuitist money theory, held by some post-Keynesians, which argues that money is created endogenously by the banking system, rather than exogenously by central bank lending. Further, they argue that money is not neutral – a credit money system is fundamentally different from a barter money system, and money and banks must be an integral part of economic models.

Fractional-reserve banking

Wikipedia, the free encyclopedia:

Fractional-reserve banking is the banking practice in which banks keep only a fraction of their deposits in reserve (as cash and other highly liquid assets) and lend out the remainder, while maintaining the simultaneous obligation to redeem all these deposits upon demand. Fractional reserve banking necessarily occurs when banks lend out any fraction of the funds received from deposit accounts. This practice is universal in modern banking.

...
Prior to the 1800s, savers looking to keep their valuables in safekeeping depositories deposited gold coins and silver coins at goldsmiths, receiving in turn a note for their deposit (see Bank of Amsterdam). Once these notes became a trusted medium of exchange an early form of paper money was born, in the form of the goldsmiths' notes.^[3]
As the notes were used directly in trade, the goldsmiths observed that people would not usually redeem all their notes at the same time, and they saw the opportunity to invest their coin reserves in interest-bearing loans and bills. This generated income for the goldsmiths but left them with more notes on issue than reserves with which to pay them. A process was started that altered the role of the goldsmiths from passive guardians of bullion, charging fees for safe storage, to interest-paying and interest-earning banks. Thus fractional-reserve banking was born.
However, if creditors (note holders of gold originally deposited) lost faith in the ability of a bank to redeem (pay) their notes, many would try to redeem their notes at the same time. If in response a bank could not raise enough funds by calling in loans or selling bills, it either went into insolvency or defaulted on its notes. Such a situation is called a bank run and caused the demise of many early banks.^[3]
Repeated bank failures and financial crises lead to the creation of central banks – government institutions that oversee and regulate commercial banks, impose reserve requirements, and act as lender-of-last-resort if a bank is low on liquidity. The emergence of central banks mitigated the dangers associated with fractional reserve banking.

St. Louis Fed: Series: MULT, M1 Money Multiplier

St. Louis Fed: Series: MULT, M1 Money Multiplier: "Money Multiplier"

The money multiplier is less than one!!  That is a liquidity trap.