One of the policy responses to the economic crisis of 2008 and comparatively subdued economic recovery, was the use of monetary policy.
Central bank policy rates were slashed to the point where the European Central Bank got a reputation for monetary rectitude for having a policy rate higher higher than 0.5%. On top of this, and less conventionally, there was Quantitative Easing, in which central banks printed up new money and used it to buy assets from the financial sector.
Despite this apparent monetary activism, there are some who think that monetary policy was too ‘tight’ – that central bankers were not getting newly printed money out of the door fast enough. Many economists, probably most in fact, think that monetary policy over the period has, by complete contrast, been unprecedentedly loose, for better or worse.
Where does the truth lie? A first step would be to determine what we mean by ‘loose’ or ‘tight’ monetary policy.
I asked this question a while ago. An economist I know told me that monetary looseness could be defined as a situation where MS > MD (money supply, MS, is greater than money demand, MD). It follows from this that monetary tightness would be where MS < MD, and the sweet spot of equilibrium would be where MS = MD. This seems a good place to start.
Well, how do you know whether MS > MD? How do we know when the S of anything is > than the D for it? By a fall in its price.
So what is the price of money? It is the inverse of the price level. To clarify that bit of jargon, think of a DVD that costs £10. That is its price. The inverse of that is that £10 costs one DVD. The DVD buyer gives up £10 to get a DVD, the DVD seller gives up a DVD to get £10.
So, a fall in the price of money would mean that more money could be bought with one DVD. Lets say that the price of money falls so that now the DVD seller only has to give up half of a DVD to get £10. For the buyer, the price of the DVD has risen to £20. In other words, a fall in price of money is better known as inflation.
The same works in reverse. If a DVD seller has to give up two DVDs to get £10, the price of money has risen, in other words, then each DVD will now only cost the buyer £5. As generally understood, prices have fallen and we have deflation.
So if we see inflation we are seeing monetary looseness and if we see deflation we are seeing monetary tightness. What have we seen in recent years?
Consumer Price Indices – RPI indices: 2008 to 2015: September 2008=100
Source: Office for National Statistics
The chart above shows a dip from the September 2008 pre-crash peak on an index of prices of 3.8% until January 2009. In the nearly six years since then, the index has risen to 23% above that trough and 19% above the pre-crash peak. This steady, but by historic standards modest, inflation, which equals a fall in the price of money, suggests a degree of monetary looseness, which equals MS > MD.
In short, by analysing money as thought it was like any other good or service, monetary policy in recent years has been loose, but not very.