Excess Reserves and Price Inflation

The adjusted monetary base continues to go up at a staggering rate.  It has nearly tripled in the last 3 years.  You can view it here:


The excess reserves held by commercial banks continue to go up with the monetary base.  You can view it here:


One question I haven’t really seen answered (or at least not very well) is whether we can still have significant price inflation if excess reserves continue to increase with the monetary base.  I am not absolutely sure of the answer either, but I have thought hard about it and think I can answer it.  Because there is still slight doubt in my mind, please allow me to revise my answer in the future if I need to.

There are two things that will cause price inflation.  You can have an increase in the supply of money or you can have a decrease in the demand for money (a.k.a. high velocity).  With an increase in excess reserves, the fractional reserve banking process is prohibited.  The Fed is buying assets and more money is being kept on hand at the banks.  The increase in excess reserves means that banks are not lending this new money (probably out of uncertainty).

So basically, the amount of money in the system is increasingly available, but it is not being used.  Unless the reserve requirements are changed, the banks could change their minds any minute and decide to loan out the new money.

But even aside from the supply of money, I believe that the demand for money could also be affected by all of this.  First of all, there is just an expectation of future price inflation due to the easy money policies (QE and QE2) and the massive debt.  In addition, there is actually more money in the system for people to spend.  At some point, the checking account balances of certain individuals and certain businesses will get high enough that they will start to spend more money.  So even if the total money in the banking system basically stays the same, the money may start changing hands faster.  This means there is less demand for money.  Another way to put it is that the velocity of money is higher.  The faster that money changes hands, the more prices will go up.

Just to use an extreme example, let’s say that the Fed buys $10 trillion in government bonds at one time.  The government instantly uses this money to hand out checks to every American citizen in the amount of $30,000.  Americans put this money in the bank and the banks hold it as excess reserves, as opposed to lending it out.  Even though it is sitting as excess reserves, people will undoubtedly start buying more things like cars, televisions, organic food, furniture, etc.  Prices will be bid up, even as money in the banking system stays there (but changes hands).  Money will change hands more quickly and prices will be bid up.

Aside from this, just the announcement of the Fed buying $10 trillion in government bonds would be enough to trigger massive price inflation.  It would happen just upon the announcement.

In conclusion, I have not seen this question answered well by anybody, even the great Austrian economists of our time, but I do believe it is possible and maybe even quite likely that we could see significant price inflation even as bank excess reserves are increasing.

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