Smith Faculty Opinion Article
The 30 Seconds Outlook
June 1, 2011
Reverse Causation
Chart and Statement by John B. Taylor, May 22, 2011,
johnbtaylorsblog.blogspot.com
“During the panic in the fall of 2008 some interpreted the explosion of the
Fed's balance sheet and the monetary base (MB)—currency plus reserves of banks
at the Fed—as an appropriate monetary policy response to a shift in the demand
for the monetary base. That monetary policy should try to accommodate such
shifts in demand is a classic monetary principle.
However, . . . this striking correlation had another interpretation. It was
due to a reverse causation: the increase in the monetary base caused the
multiplier to decline as banks simply absorbed the inflow of reserves. The cause
of the increase in the monetary base was the need for the Fed to finance its
loans to bailout financial institutions, provide swaps to foreign central banks,
and eventually make purchases of mortgage backed securities in its quantitative
easing program . . ..
The months since the start of QE2 are not even close to the panic observed in
the fall of 2008. So it is much more difficult to argue that the Fed was
responding to a panic-driven or otherwise autonomous increase in the demand for
the monetary base. Much more likely is that—as in the fall of 2008—banks simply
absorbed the increased supply of the monetary base which the Fed used to finance
QE2.”
John A. Haslem
