Causation From Base Money To The Multiplier: The QE2 Evidence

During the panic in the fall of 2008 some interpreted the explosion of the Fed’s balance sheet and the monetary base (MB)—currency plus reserves of banks at the Fed—as an appropriate monetary policy response to a shift in the demand for the monetary base. That monetary policy should try to accomodate such shifts in demand is a classic monetary principle.

Evidence offered in support of that interpretation was the sharp drop in the money multiplier (m)—the ratio of money (M) to the monetary base (m = M/MB). The claim was that the Fed offset the decline in the multiplier (m) by increasing MB, thus leaving the money supply (M = m times MB) comparatively unaffected by the drop in m. Indeed there is a striking negative correlation between the multiplier and the monetary base during the late 2008 and 2009 period, as shown in this graph.

However, I argued in a Business Economics article at the time that this striking correlation had another interpretation. It was due to a reverse causation: the increase in the monetary base caused the multiplier to decline as banks simply absorbed the inflow of reserves. The cause of the increase in the monetary base was the need for the Fed to finance its loans to bailout financial institutions, provide swaps to foreign central banks, and eventually make purchases of mortgage backed securities in its quantitative easing program—a strategy I called mondustrial policy in part to drive home this reverse causation.

But the very severity of the panic in 2008 makes it difficult to convince people that there was not a panic-driven increase in the demand for the monetary base at that time, and I frequently hear economists and economic students sticking to the original interpretation. In this respect QE2 provides more convincing evidence for the second interpretation. The months since the start of QE2 are not even close to the panic observed in the fall of 2008. So it is much more difficult to argue that the Fed was responding to a panic-driven or otherwise autonomous increase in the demand for the monetary base. Much more likely is that—as in the fall of 2008—banks simply absorbed the increased supply of the monetary base which the Fed used to finance QE2. In fact, if you look at the chart (which goes through April 2011), you can see the same inverse relationship between the money multiplier and the monetary base during QE2 as during 2008–2009

Regarding nondustrial policy, several new articles written this Spring expore its implications from an Hayekian perspective, raising concerns similar to the ones I mentioned when I coined the term, but with more emphasis on accountability, rules, and discretion.

About John B. Taylor 117 Articles

Affiliation: Stanford University

John B. Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University and the Bowen H. and Janice Arthur McCoy Senior Fellow at the Hoover Institution. He formerly served as the director of the Stanford Institute for Economic Policy Research, where he is now a senior fellow, and he was founding director of Stanford's Introductory Economics Center.

Taylor’s academic fields of expertise are macroeconomics, monetary economics, and international economics. He is known for his research on the foundations of modern monetary theory and policy, which has been applied by central banks and financial market analysts around the world. He has an active interest in public policy. Taylor is currently a member of the California Governor's Council of Economic Advisors, where he also previously served from 1996 to 1998. In the past, he served as senior economist on the President's Council of Economic Advisers from 1976 to 1977, as a member of the President's Council of Economic Advisers from 1989 to 1991. He was also a member of the Congressional Budget Office's Panel of Economic Advisers from 1995 to 2001.

For four years from 2001 to 2005, Taylor served as Under Secretary of Treasury for International Affairs where he was responsible for U.S. policies in international finance, which includes currency markets, trade in financial services, foreign investment, international debt and development, and oversight of the International Monetary Fund and the World Bank. He was also responsible for coordinating financial policy with the G-7 countries, was chair of the working party on international macroeconomics at the OECD, and was a member of the Board of the Overseas Private Investment Corporation. His book Global Financial Warriors: The Untold Story of International Finance in the Post-9/11 World chronicles his years as head of the international division at Treasury.

Taylor was awarded the Alexander Hamilton Award for his overall leadership in international finance at the U.S. Treasury. He was also awarded the Treasury Distinguished Service Award for designing and implementing the currency reforms in Iraq, and the Medal of the Republic of Uruguay for his work in resolving the 2002 financial crisis. In 2005, he was awarded the George P. Shultz Distinguished Public Service Award. Taylor has also won many teaching awards; he was awarded the Hoagland Prize for excellence in undergraduate teaching and the Rhodes Prize for his high teaching ratings in Stanford's introductory economics course. He also received a Guggenheim Fellowship for his research, and he is a fellow of the American Academy of Arts and Sciences and the Econometric Society; he formerly served as vice president of the American Economic Association.

Before joining the Stanford faculty in 1984, Taylor held positions as professor of economics at Princeton University and Columbia University. Taylor received a B.A. in economics summa cum laude from Princeton University in 1968 and a Ph.D. in economics from Stanford University in 1973.

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