From the Federal Reserve Bank of Atlanta's Macroblog:
Suppose you run a manufacturing business—let's say, for example,
widgets. Your customers are loyal and steady, but you are never
completely certain when they are going to show up asking you to satisfy
their widget desires.
Given this uncertainty, you consider two different strategies to meet
the needs of your customers. One option is to produce a large quantity
of widgets at once, store the product in your warehouse, and when a
customer calls, pull the widgets out of inventory as required.
A second option is to simply wait until buyers arrive at your door
and produce widgets on demand, which you can do instantaneously and in
as large a quantity as you like.
Thinking only about whether you can meet customer demand when it
presents itself, these two options are basically identical. In the first
case you have a large inventory to support your sales. In the second
case you have a large—in fact, infinitely large—"shadow" inventory that
you can bring into existence in lockstep with demand.
I invite you to think about this example as you contemplate this familiar graph of the Federal Reserve's balance sheet:
I gather that a good measure of concern about the size of the Fed's
(still growing) balance sheet comes from the notion that there is more
inherent inflation risk with bank reserves that exceed $1.5 trillion than there would be with reserves somewhere in the neighborhood of $10 billion (which would be the ballpark value for the pre-crisis level of reserves).
I understand this concern, but I don't believe that it is entirely
warranted. My argument is as follows: The policy strategy for tightening
policy (or exiting stimulus) when the banking system is flush with
reserves is equivalent to the strategy when the banking system has low
(or even zero) reserves in the same way that the two strategies for
meeting customer demand that I offered at the outset of this post are
equivalent....MORE
