Over the same time, price level has risen only 24%. As evidenced in Venezuela and Zimbabwe, increases in the money supply normally create much more inflation than the United States has experienced. So, what gives?
While there are numerous explanations, here is one we find most important and convincing: Most of the new money is simply sitting in accounts commercial banks have at the Federal Reserve drawing interest.
A quick refresher on some basics. To the First National Bank of Hoosierburg, the money in its customers’ accounts is the bank’s liabilities. Being a national bank, it is required to hold a certain percentage of its liabilities in an account at the Federal Reserve Bank. Let’s say that, for First National, this reserve requirement is 10%.
The Fed typically expands the nation’s money supply by buying up U.S. Treasury bonds. Jane Doe sells $10,000 of her U.S. Treasury bonds and the buyer happens to be the Federal Reserve. The Federal Reserve literally creates $10,000 out of thin air and pays it to Jane. She deposits the $10,000 in her checking account at First National. The money supply just rose by $10,000.
In addition, however, First National Bank now has $10,000 in extra reserves in its account at the Fed and can loan out $9,000 of it. Billy Bob might want to borrow that amount to finance his purchase of a used truck. First National would then add $9,000 to his checking account, which further increases the national money supply by $9,000.
However, since the Great Recession, the Federal Reserve has embarked on a policy of actually paying banks like First National interest on the deposits it holds at its Federal Reserve account. So, should the bank just hold on to the reserves and earn an absolutely certain interest payment from the Federal Reserve, or take the risk of lending the money to Billy Bob?
The data seems to suggest that banks have overwhelmingly taken the safe option of holding on to the reserves. Billy Bob doesn’t get the loan that would, on the margin, bid up the price of used pickup trucks contributing to inflation.
For better or worse, paying interest on bank deposits at the Fed has become a key monetary variable.•
Bohanon and Curott are professors of economics at Ball State University. Send comments to firstname.lastname@example.org.