Saturday, November 14, 2009

Money & Inflation

To gain an understanding of what is happening in the economy, we must carefully review the Federal Reserve actions. The following is a brief overview of the monetary statistics I follow, which I believe give a good summary into the world of price inflation risk.

1. Adjusted Monetary Base (AMB): this is the liabilities of the FED that can be transformed into money in the economy. It includes currency held by the public and bank reserves. The FED affects the fed funds interest rate, which used by domestic banks to price reserve loans to each other, through the monetary base.

Since September 2008, the level of the monetary base on a bi-weekly basis has been expanding like no other time in history. It went from about $900 billion to approximately $2 trillion as of 11/13/2009.

Considering the continuous compounded rate of change, it is currently expanding at a rate close to 100% annually.

2. M1 (money supply): monetary aggregate made up primarily of currency and checking account balances.

Mathematically = [{(currency/deposits)+1)}/{(currency/deposits)+(reserves/deposits)}]*AMB

The level of the (weekly) money supply has been elevated during the most recent recession and unlike any other time since data have been compiled.

Focusing on the last five years, we note the extent of the monetary expansion.

3. Money Multiplier: the number of dollars that can be created out of thin air from each dollar in the adjusted monetary base.

Mathematically = [{(currency/deposits)+1)}/{(currency/deposits)+(reserves/deposits)}]

The money multiplier decreases when the currency/deposit ratio or the reserve/deposit ratio increases.

As can be noted from the graph, the multiplier (computed on a bi-weekly basis) has declined significantly during the recent financial crisis.

4. Excess Reserves: Reserves are deposits of depository (i.e. banks) institutions. After accounting for the FED imposed requirement, excess reserves are loaned out.

Excess reserves have ballooned during the crisis. Bank are not lending as a result of decreased loan demand and an abundance of unworthy borrowers. As a result, financial firms have decided to lend the money to the FED. Reserves stand close to $1 trillion.

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