The monetary regime has changed and, as a result, many people are misinterpreting the recent increase in the monetary base. Paul Krugman, for example, posts the picture at right. His interpretation is that the tremendous increase in the base shows that the Fed is trying to expand the money supply like crazy but nothing is happening, i.e. a massive liquidity trap. (Krugman is not alone in this interpretation, see e.g. this post by Bob Higgs). Thus, Krugman concludes, Friedman was wrong both about monetary history and monetary theory.

Krugman’s interpretation, however, neglects the fact that the monetary regime changed when the Fed began to pay interest on reserves. Previously, holding reserves was costly to banks so they held as few as possible. Since Oct 9, 2008, however, the Fed has paid interest on reserves so there is no longer an opportunity cost to holding reserves. The jump in reserves occurred primarily at this time and is entirely under the Fed’s control. The jump in reserves does not represent a massive attempt to increase the broader money supply.

Here’s a bit more background. When no interest was paid on reserves banks tried to hold as few as possible. But during the day the banks needed reserves – of which there were only $40 billion or so – to fund trillions of dollars worth of intraday payments. As

a result, there was typically a daily shortage of reserves which the Fed made up for by extending hundreds of billions of dollars worth of daylight credit. Thus, in essence, the banks used to inhale credit during the day – puffing up like a bullfrog – only to exhale at night. (But note that our stats on the monetary base only measured the bullfrog at night.)

Today, the banks are no longer in bullfrog mode. The Fed is paying interest on reserves and they are paying at a rate which is high enough so that the banks have plenty of reserves on hand during the day and they keep those reserves at night. Thus, all that has really happened – as far as the monetary base statistic is concerned – is that we have replaced daylight credit with excess reserves held around the clock. The change does not represent a massive injection of liquidity and the increase in reserves should not be interpreted as evidence of a liquidity trap.

Addendum: (For the truly wonkish.) If you want more, see my earlier post on excess reserves, posts by Jim Hamilton, and David Altig, and especially two very useful Fed articles, Keister, Martin, and McAndrews (n.b. the last section) and Ennis and Weinberg.