Subprime Crisis Background Information - Effect On The Money Supply

Effect On The Money Supply

One measure of the availability of funds (liquidity) can be measured by the money supply. During late 2008, the most liquid measurement of the U.S. money supply (M1) increased significantly as the government intervened to inject funds into the system.

The focus on managing the money supply has been de-emphasized in recent history as inflation has moderated in developed countries. Historically, a sudden increase in the money supply might result in an increase in interest rates to ward off inflation or inflationary expectations.

Should the U.S. government create large quantities of money to help it purchase toxic mortgage-backed securities and other poorly-performing assets from banks, there is risk of inflation and dollar devaluation relative to other countries. However, this risk is of less concern to the Fed than deflation and stagnating growth as of December, 2008. Further, the dollar has strengthened as other countries have lowered their own interest rates during the crisis. This is because demand for a currency is typically proportional to interest rates; lowering interest rates lowers demand for a currency and thus it declines relative to other currencies.

During a January 2009 speech, Fed Chairman Ben Bernanke described the strategy of lending against various types of collateral as "Credit Easing" and explained the risks of inflation as follows: "Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve is effectively printing money, an action that will ultimately be inflationary. The Fed's lending activities have indeed resulted in a large increase in the excess reserves held by banks. Bank reserves, together with currency, make up the narrowest definition of money, the monetary base; as you would expect, this measure of money has risen significantly as the Fed's balance sheet has expanded. However, banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed. Consequently, the rates of growth of broader monetary aggregates, such as M1 and M2, have been much lower than that of the monetary base. At this point, with global economic activity weak and commodity prices at low levels, we see little risk of inflation in the near term; indeed, we expect inflation to continue to moderate."