Econolimerick #5

“The much-touted-by-Milton-and-fans
M1 and M2 in our hands,
We think that we know
The way that things go,
But behold base supply and demands!”

For the economics behind this limerick, see:

My choice of the plural for “demands” at the end of the limerick is significant: there are three qualitatively different sources of demand for the monetary base. Those who don’t understand all of these sources of demand for the monetary base can easily mislead themselves with naive monetarist predictions. The demand (singular) for the monetary base (which is defined as the sum of currency and reserves) is the horizontal sum of these three demands (plural):

  1. demand for paper currency and coins for transactions and storage (which is affected by the secrecy affordances of paper currency and coins),

  2. demand for reserves for required reserves and for precautionary reasons,

  3. demand for reserves in order to earn interest on reserves.

Those who don’t understand the demand for reserves in order to earn interest on reserves can easily mislead themselves into thinking that a large increase in the monetary base and in M1 and M2 must be very inflationary. This is not so because the demand for the monetary base to earn reserves is a demand that tends to immobilize that part of the monetary base, leading a reduction in the base velocity (and typically a reduction in M1 velocity and M2 velocity as well).

Don’t miss my other econolimericks: