Thursday, June 11, 2009

Regarding the Laffer spike 

...I outsource my comments to David Altig:
...we know that the payment of interest on bank reserves�which we have discussed in this forum many times (here and here, for example)�means a higher demand for reserves in the future than in the past. This change, of course, means that levels of the monetary base that would have seemed scary in the past will become the new normal. How big can the "new normal" be? That's a good question, and one I will continue to contemplate. But the assertion in the Laffer article that "a major contraction in monetary base" is required cannot be supported by either current evidence or simple economic theory.
You currently get 0.25% on excess reserves, roughly what is paid on a six-month T-bill. Banks are holding more T-bills too, further indicating their desire for liquidity at present. I wrote three months ago:
We write about the wall of monetary base as if it is an excess supply of bank reserves; it's almost certainly not in the present environment. When it is, only then can it be inflationary.
cf. the Banaian spike?

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