Wednesday, March 9, 2011

Why the Ongoing Weakness in Nominal Spending?

Why has total current dollar spending been so anemic?  Even after accounting for the run up in  nominal spending during the housing boom, it is still below trend and continues to be a drag on the recovery.   A useful way to answer this question is to look at the three components of nominal spending: the monetary base, the money multiplier, and velocity

The monetary base is simply the stock of money assets directly created by the Fed.   The money multiplier shows to what extent the monetary base is supporting expansion of  other  more commonly used money assets like checking, saving, and money market accounts.  If the monetary base is not supporting an  expansion of these other money assets it is because there is an elevated demand for the monetary base and vice versa.  The money multiplier, therefore, is an indicator of the demand for the monetary base. Velocity shows how often the more commonly used money assets like checking, saving, and money accounts are used in transactions.  The lower the velocity the less these money assets are being used for spending and vice versa. Velocity, then, is an indicator of the demand for these broader measures of money assets which we call the money supply. 

By definition the product of these components makes up total current dollar spending or nominal GDP:

BmV = PY,

 where B is the monetary base, m is the money multiplier, V is velocity, P = price level, Y = real GDP, and PY = nominal GDP. (Note that this identity is just an expanded version of the equation of exchange. where the money supply , M , is  M = Bm.)  Using the MZM money supply measure and monthly nominal GDP from Macroeconomic Advisers to construct velocity and the money multiplier, the left-hand side of the above identity is plotted below:

 This figure indicates that declines in the money multiplier and velocity have both been weighing down nominal GDP ever since the collapse in late 2008.  Excess demand for the monetary base and  the money supply  thus continues to be a problem. The sustained decline in the money multiplier presumably reflects the ongoing reluctance of banks to lend given the relative safety of parking excess reserves at the Fed and earning 0.25%.  The sustained decline in the velocity indicates that the rise in real money demand has yet to return to pre-recession levels.   This figure also shows that the Federal Reserve dramatically increased the monetary base, which should, all else equal, have put upward pressure on nominal spending. However, all else is not equal as the movements in the money multiplier and the monetary base mostly offset each other. This offset is no coincidence, as most of the monetary base increase was the result of the Fed's attempt to save the financial system under QE1. The figure indicates the problem with QE1 is that it was so focused on saving the financial system it ignored the fall in velocity.  QE2 is an imperfect attempt to address this oversight by the Fed. 

So the reason for the ongoing weakness in nominal spending is that money demand remains elevated and continues to be a drag.     


  1. David -

    Thank you for this excellent post. As a non-economist with a keen interest in the economy, I really appreciate the insights.

    As always, though, I urge you to look at a bigger picture. Here is the M1 multiplier, back to the early 80's.

    After peaking in Jan '87, it endured a more than two decade long slump, then collapsed in the Fall of '08. Now, all it does is twitch.

    What insight does this give us into the Great Stagnation?

    Thanks again, and Cheers!

  2. "Mr.Keynes aggregates conceal the fundamental forces at work" says
    F.Hayek. Your aggregates are equally as unhelpful, DB.
    When I look at the US economy, I see an economy that is very deformed, with real structural imbalances, such as an overhang of houses that are unsaleable at current prices, people with the wrong skills, trapped in the wrong place, a dollar that is overvalued, an absurdly unbalanced income distribution, an economy where the return on bubble assets is greater than the return on real capital. Throw into the mix uncertainty about the trajectory of oil prices.
    I don't think your policy recommendation of a massive boost in the money supply is going to cure these ailments.

  3. Jazzbumpa,

    I think the long-term decline in the M1 multiplier has more to do with the fact that we are increasingly using other types of money assets than those found in M1. M1 is mostly checking accounts and currency. Other measures like MZM which included assets like money market accounts saw their money multiplier actually grow prior to the crisis. See here.

  4. ECB:

    I agree there are significant structural problems, but piling tight money on top of it only makes matters worse. Of course, even if I am correct that monetary easing would help some, it might make easier for policy makers to further avoid the difficult choices.

  5. Very good, you have defined with precision what I suspected. I don´t know if Fed could have follow another way that not to let down the bank. Is it not probable that it cannot save the velocity without saving firstly the multiplier? I don´t know, only I ask myself.

  6. Luis,

    Many, including myself, have been critical of the Fed for so narrowly focusing on saving the financial system (i.e. responding to the drop in the money multiplier) while ignoring velocity. You bring up a good point that had they been less aggressive toward saving the financial system the collapse could have been even worse. Maybe so. What this says to me is the Fed needs to have an explicit nominal target that keeps expectations better anchored.

  7. "where B is the monetary base, ..."

    Why don't you use the amount of medium of exchange because that is what is used out in the real economy for NGDP?

  8. At this point, I think it would be reasonable to dump currency on street corners in lower middle-income neighborhoods across America. They would spend the money and it would trickle up through the economy.

    We can give money to banks, but they have to lend it out. We can buy bonds form investors, but they have to re-invest in economic activity, but they might just put it in the bank.

    Seriously, if anyone will answer me; Would it be so bad to somehow dump currency into lower middle-income communities? Yes, some moral hazard, income without working. The same moral hazard faced by every sexy blonde who marries well.

    And, as it would be uncertain if the money would ever be dropped again, I see no enduring moral hazard.

  9. Benjamin, I would rather see the currency printing with no bond attached being used to fund Social Security and to put more people into retirement.

    Now you can have real GDP grow less than productivity growth and other things that lower the demand for labor.

  10. Doubt concerning Fisher's exchange equation

    The doubts are the following doubts.

    The dealings of every day between the enterprises in real economies of inter-industry relations table, system of national accounts (SNA), and balance of international payments, etc. are not thought for the business-to-business transaction by nor the bank no cash transfers necessarily but multiplications to be reflected at the multiplier of money and the money circulation speed.

    Therefore, it is not thought that the product at the multiplier of money and the money circulation speed at which the monetary base and multiplication are not reflected is corresponding to the product of the general price level and real GDP.

    It might made a mistake in Fisher's exchange equation according to the multiplier of money and the money circulation speed at which multiplication is not reflected.

    It might be more correct to reflect dealings by the multiplication between the enterprises at the multiplier of money and the money circulation speed besides the doubt concerning Fisher's exchange equation.

  11. Possibility concerning Fisher's exchange equation

    If GDP is produced there right a capital stock of the overall industry (K=S), and the general price level is requested, the thing that the monetary base is on the left side might be steady as the balance type.
    It is left monetary basic because of becoming equal savings (S) of the right side in the grounds.

    The expressions are following expressions (??).



    I think the idea as the possibility though it has made a mistake in the above-mentioned expression as Fisher's exchange equation.
    It is the one like a sinful IS=LM analysis.

    Review of Fisher's exchange equation

    m and the money circulation speed are assumed, and V and the price level are assumed and P and real GDP are assumed to be Y the assumption of B and the multiplier of money the assumption of the monetary base.
    At this time, Fisher's exchange equations are the following expressions.


    Remarks: Fisher's exchange equation might be a equilibrium type.

  12. The sign of the equal sign of economics aims at equilibrium by using the variable.
    The purpose of economics is in the request of the supply-demand balance and the equilibrium price.

    Balance stripes cork of expression (??) of possibility of Fisher's exchange equation if monetary base doesn't extend monetary base to product at multiplier of money and money circulation speed and capital stocks until becoming equal as for central bank.

  13. Essence of reflation faction

    I consider the essence of the reflation faction as follows.

    The central bank increases the financing through the window guidance of extending and the financial institution of the monetary base.
    The buying operations ration is done so as not to become an excessive inflation too much through an increase of this financing.
    The monetary base and buying operations are another business.

    It appeals for not inflation targeting by buying operations like New Zealand but central banks to extend the monetary base, to guide the window to a private financial institution, and to increase the financing.
    In that case, amount and the number of financings will expand if the item such as making of the financial institution the business scheme book instead of the entrepreneur is put.
    For instance, the subprime loan might be an aim of the inflation based on the idea of the reflation faction.
    Buying operations are used together to control this inflation if becoming an inflation by the expansion and the window guidance of the monetary base depending on the central bank.
    The passed inflation is prevented by the thing done so.

    It is possible to extend the monetary base even if there is a bank note rule in Bank of Japan for Japan.
    The reason is that there is an increase of the bank note (expansion of the monetary base) before with the long-term debt of the Bank of Japan note rule.
    The rule of suppressing the possession balance of the long-term debt from the issue balance of the bank note is called a Bank of Japan note rule.