Chart of the month
Was quantitative easing necessary when the money supply began to contract sharply in 2009? Much has been written on the subject. Some commentators have claimed it has achieved nothing while others have warned that it would lead to hyperinflation. Both views are wrong. According to the standard theory, the equilibrium level of national income is a function of the quantity of money. A broadly-defined aggregate such as M3 or M4, which includes most or all bank deposits, is by far the most useful in macroeconomic analysis.
The reaction of officialdom in both the UK and the USA following the Lehman crisis of 2008 was to force banks to increase their capital/asset ratios in order to prevent further bank collapses. This caused banks to sell securities, to shrink loan portfolios and to issue new securities in order to increase their capital levels. The inevitable result was a fall in the level of bank deposits and thus a contraction of broad money. As the chart below shows, a credit drought began as soon as the new regulations came into force, and which continues up to the present day. However, QE led directly to the creation of new bank deposits, offsetting the contractive effect of the credit drought on the quantity of money. That stopped the recession, which was bad enough, becoming a depression.
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