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Sunday, September 23, 2007

The Repo Man

Jim Hamilton rebuts the appropriateness of the "Helicopter Ben" nickname Ben Bernanke appears to be acquiring. Jim explains why critics who believe the Fed recently increased the money supply substantially have it wrong. Here's Brad DeLong's version of Jim's remarks:

"Helicopter Ben"?, by BradDelong: Jim Hamilton Says: Not Really Jim Hamilton writes:

Econbrowser: Money creation and the Federal Reserve: There seem to be some misconceptions about the monetary consequences of actions that the Federal Reserve has taken to address liquidity needs.... I hope in this post to get beyond these sound bites, beginning if I may with some details of the process whereby money is created in the United States. Where did the cash in your wallet come from? Presumably you got it from your bank or ATM. And the reason that the bank was willing to give you that cash was that you already had deposits in an account with the bank, which were in effect credits to obtain cash when you wanted it.

And where did your bank get that cash? If it is a member of the Federal Reserve, your bank got it from a Federal Reserve Bank... your bank had deposits in an account with the Fed, that give it credits to obtain cash when it wants it.... And where did those reserves come from?... the Fed purchased Treasury bills... paying for them by creating new reserves in the dealers' banks. The Fed now is the owner of the Treasury bills, and those banks now have new reserves, which they could use to obtain new dollar bills, if they desired.

To follow what's happened over the last 6 weeks, it's necessary to add a few details to this basic story. For day-to-day fine-tuning of interest rates and the money supply, the Fed usually does not use outright purchases of Treasury securities, but is more likely instead to rely on repurchase agreements... on any given day the Fed's outstanding repos have created reserves and thus potential dollars in circulation... for the week ended August 8, just before the summer fireworks... the Fed held $791 billion in Treasury securities and $19 billion in repos....

Beginning August 9, the Fed aggressively used repos.... The hundred billion dollar figure that some people use comes from adding together each day's repo operations, which is a completely nonsensical calculation. At the height of these operations (the week of August 9-15), Fed repos created an average of $18 billion in new daily reserves....

[W]hat exactly happened to that $18 billion while it was in the banking system? The answer is-- absolutely nothing. Banks simply held these funds as excess reserves, with nobody withdrawing a single dollar bill. This tremendous increase in banks' desires to hold reserves beyond the amount that they were required was one of the remarkable aspects of this situation and the primary reason that the Fed needed to conduct such repo operations in the first place... reserve balances are now right back where they were on August 8, and currency in circulation is in fact $3 billion lower than it was. The Fed has done its job, and the kvetchers have done theirs....

Now, I realize that this explanation may not be as entertaining as the whole Helicopter Ben meme. But on the other hand, it may be a whole lot more accurate...

Let me present Jim Hamilton's argument in a different way and also say a little bit about the phrase "helicopter money". It's generally possible to write the money supply equation as follows:

     M = mMB

Here, M is the money supply, MB is the monetary base, and m is the money multiplier. [A simple version is m= (c+1)/(rr + c + e) where c is the currency to deposit ratio, rr is the reserve requirement, and e is the excess reserve to deposit ratio. An even simpler version - usually presented in introductory macro -  is m = 1/(rr+e), and the simplest is 1/rr.] The MB can be increased or decreased through open market operations (including the use of repos for short-term changes) and discount loans to banks.

Jim's point is that MB did increase recently, but only temporarily. That is, MB rose by around 18 billion through repo agreements mostly, then fell back to near its original value. But as MB went up, then down, the money supply, M, was largely unaffected. Why didn't M move with MB? As Jim notes, most of the increase in MB was held at banks in the form of excess reserves, and if you remember your basic macro, when excess reserves go up (i.e. e increases in the formula above), m, the money multiplier, goes down (banks hold the money instead of making loans and hence there is no multiple deposit creation). Thus, as MB increased then decreased, m moved in the opposite direction, and the net result was very little change in M.

[Whether we can say money increased or not is partly definitional. High powered money -- another name for MB -- did increase temporarily. But because banks held onto the money rather than loaning it out, the broader money supply was left unaffected.]

Let me say a few words about helicopter money, though there is more to be said. When the money supply is changed, it generally involves an agent in the private sector trading one asset for another, e.g. a T-Bill for a check from the Fed through an open market or repo operation. The term "helicopter money," which is due to Milton Friedman not Ben Bernanke, refers to a different way of increasing the money supply that does not involve the trading of one asset for another. Instead of purchasing T-Bills to increase the money supply, the Fed could instead mail everyone an envelope with cash in it, leave bundles of cash in the street, dump cash from helicopters, give everyone a money financed tax cut, buy gold for more than it's worth - the point is to increase money without taking an asset back in return.

So let's do a Friedman helicopter drop. Typically, you would expect people to begin spending their sudden infusion of cash (manna) and that would drive prices up (and in a frictionless world leave real values unaffected but that is another story). That's how helicopter drops fight deflation. Suppose, however, that instead of spending the money people take it home and put it into the cookie jar and there it sits (this is the same as banks keeping their extra cash in the vault).

In this case, what effect would the helicopter drop have on the economy? It may seem like there would be no effect - that the money just sits there and nothing happens, it's essentially like it was before the drop - but that is not quite correct. Having the extra cash in the cookie jar may provide additional security and the agent may then be willing to take risks or make purchases that would not have been made otherwise. The cash provides a backup if something goes wrong. If people took the money home and burned it in the fireplace, there would be no effect on the economy at all - it would be like the money was never dropped - but having it in the cookie jar means it's still available in the future and that affects economic behavior.

This is analogous to the bank's situation. Essentially, money rained down upon them (I don't mean this was a helicopter drop, they had to trade another asset to get the money, though the assets were in some cases worthless on the private market, at least temporarily). Just as households putting their cash in the cookie jar and doing nothing with it does not change aggregate demand, the banks sitting on their cash does not change the money supply and hence has no impact on aggregate demand either. But the added security that banks get from having the cash in the vault may have allowed them to take risks they wouldn't have taken otherwise. Banks did not have to "call in loans" to get the security they needed - the Fed provided it. So there's some chance that although the Fed's actions did not increase the money supply, by providing banks with the security they needed to cover potential losses, they kept the money supply from contracting. And it's a good thing they did. "Vacuum Ben" - allowing liquidity to get sucked out of these markets - is the guy to fear in these situations.

As to the use of "helicopter money," briefly helicopter money is a means through which the monetary authority can bypass financial intermediaries and increase the money supply in a deflationary liquidity trap.

When a liquidity trap hits (which is not what we just had in mortgage markets) and prices start falling, policymakers need to increase aggregate demand to put upward pressure on the price level. They need to stop the deflation. Generally, when the Fed does an open market operation, the composition of interest bearing assets (bonds, B) and non-interest bearing assets (money, M) changes and this changes the interest rate. When M goes up and B goes down from an open-market operation, the interest rate falls, and the fall in the interest rate stimulates investment, consumption, and net exports thereby stimulating aggregate demand. Thus, an increase in M causes a decrease in i, and the decrease in i induces the changes in consumption, investment, and net exports which are all components of aggregate demand. A key link here to stimulate aggregate demand is that the interest rate falls when M increases.

But as Keynes famously said, "there's many a slip twixt the cup and the lip," meaning a lot can go wrong in this chain of events. In particular, in a liquidity trap, i is already as low as it can go and an increase in M through open market operations has no effect on i at all. If i does not change from the open market operation, then investment, consumption, and net exports do not change either, so aggregate demand does not change, and deflation continues unabated.

So what to do? Bypass the financial markets and drop money from helicopters or some other means. People will feel wealthier and, assuming they don't just stuff it all into cookie jars, aggregate demand will go up and the increase in aggregate demand will combat the deflationary problem brought about by the liquidity trap.

    Posted by on Sunday, September 23, 2007 at 12:51 PM in Economics, Financial System, Monetary Policy | Permalink  TrackBack (0)  Comments (15)


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