Sunday, November 30, 2008

Explosion in the Monetary Base Signals Future Inflation

The monetary base is equal to reserves at financial institutions plus cash in circulation. When these reserves are loaned out the money supply expands. Recent actions by the Fed to ease credit conditions have created a massive increase in reserves. Should an expansion occur these reserves, if they are not constrained, can result in a significant increase in the money supply and inflation. The relation between reserves and the money supply is indicated by the money multiplier which is basically equal to the money supply (demand deposits plus cash in circulation) divided by the monetary base. The decline in the money multiplier has offset the increase in the monetary base. These series indicate that the liquidity needed to expand loans exists, but that the loans have not been extended.

Monetary policy is often compared to a string. The Fed can pull it (tighten credit markets), but cannot push on it (expand credit markets). It can make the funds available but it cannot force institutions to lend or borrow.

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