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Understanding M2 Determination in Economics

This chapter delves into causes of non-fed variables affecting M2 determination, exploring factors such as interest rates, market risk, financial innovation, and bank panics. Recent developments and potential future scenarios are also discussed, along with how components impact M2. Examples illustrate real-world implications, including historical events like the 1929-33 panic and the Keynesian liquidity trap of 1934-41, shedding light on the role of the Federal Reserve in influencing M2 dynamics.

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Understanding M2 Determination in Economics

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  1. Causes of Non-Fed Variables: M2 Determination • Federal Reserve controlled variables: HNON (open market operations), rD, rT. • This chapter -- studies key causes of k, t, mmmf, e, and DL.

  2. Key Causes of k = C/D • Interest rates (i), i  k • Bank Panics, Panic  k • Illegal Activity, increases the demand for cash • Financial Innovation towards transactions convenience (e.g. credit cards) (FI), FI  k

  3. Key Causes of t = T/D • Interest rates (i), i  t • Market Risk (Stock) (S), S  t • Uncertainty About the Economy (Y), Y  t • Sweep Programs (SWEEP), SWEEP  t

  4. Key Causes of mmmf = MMMF/D • Interest rates (i), i  mmmf • Market Risk (Stock) (S), S  mmmf • Uncertainty About the Economy (Y), Y  mmmf 

  5. Key Causes of e = ER/D • Interest rates (i), i  e • Expected Deposit Outflows (DOE) DOE  k • Deposit Risk, or Uncertainty About Deposit Outflows (D) D  e

  6. Recent Developments: Increasing the e-Ratio • Increased Vault Cash for Servicing ATMs. • Establishment of Clearing Balances with the Federal Reserve, receives some return from the Fed. • Future – Interest on excess reserves?

  7. Key Causes of Discount Loans (DL) • Interest rates (i), i  DL • The Discount Rate (iDISC), iDISC   DL • Fed Surveillance, Surveillance  DL

  8. Synthesizing the Analysis • Event  • What components of M2 determination are affected, and how?  • How does this change M2 (immediately and/or through bank loaning)?

  9. M2 Determination: A Review M2 = (1 + k + t + mmmf) (HNON + DL) (k + rD + rTt + e) The money multiplier (m2)

  10. How the Components Affect M2: A Review HNON M2 DL  M2 rD  M2 rT  M2 k  M2 t  M2 mmmf  M2 e  M2

  11. Example 1 -- An Increase in Interest Rates i  k M2 i  t M2 i  mmmf M2 i  e M2 i  DL M2 Is there a money supply function?

  12. Example 2 -- 1929-33 (Major Panic/Bank Failures) Panic  k  M2 Could the Federal Reserve have offset the situation (Discount Window, emergency loans)? DL  M2

  13. Example 3 -- 1934-41 (Keynesian Liquidity Trap) • Federal Reserve -- practicing active monetary policy. HNON M2

  14. 1934-41 -- Bank Behavior • But, banks experience high deposit risk (D), expected deposit outflows (DOE), and very low interest rates  desire to hold large amounts of excess reserves. D, DOE, i e  M2 • Offsets the effect of policy.

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