At the same time, the price level increased by only 24%. As Venezuela and Zimbabwe testify, increases in the money supply normally create far more inflation than the United States has experienced. So, what gives?
While there are many explanations, here is one that we find the most important and compelling: Most new money is simply deposited into accounts that commercial banks have at the Federal Reserve to attract interest.
A little reminder on some basics. For the First National Bank of Hoosierburg, the money in its customers’ accounts is the bank’s liability. As a national bank, it is required to hold a certain percentage of its liabilities in an account with the Federal Reserve Bank. Let’s say that for First National, this reserve requirement is 10%.
The Fed typically increases the country’s money supply by purchasing US Treasuries. Jane Doe sells $ 10,000 of her US Treasuries 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 into her checking account at First National. The money supply has just increased by $ 10,000.
In addition, however, First National Bank now has $ 10,000 in additional reserves in its account at the Fed and can lend $ 9,000. Billy Bob might want to borrow this amount to finance his purchase of a used truck. First National would then add $ 9,000 to its checking account, which would further increase the national money supply by $ 9,000.
However, since the Great Recession, the Federal Reserve has embarked on a policy of effectively paying banks like First National interest on deposits it holds in its Federal Reserve account. So should the bank just keep the reserves and earn an absolutely certain interest payment from the Federal Reserve, or take the risk of loaning Billy Bob money?
The data seems to suggest that the banks have overwhelmingly chosen the safe option of holding reserves. Billy Bob does not get the loan which, at the margin, would increase the price of used pickup trucks, which would contribute to inflation.
For better or worse, paying interest on bank deposits to the Fed has become a key monetary variable. •
Bohanon and Curott are professors of economics at Ball State University. Send your comments to [email protected]