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We may as well wrap around the discussion from the excess demand for money post. To repeat the point I was trying to raise there:

Clearly, the central bank buying assets, say MBS, from non-banks increases deposit money directly, but (1) is it likely that banks will take advantage of the extra demand for MBS to reduce their own holdings of MBS and use the proceeds to cut back their liabilities (eg to improve their capital ratios)? and if so, (2) how quickly would that occur?

If the answer to (1) is "yes" and (2) is "fast", then QE as you describe it would not make any difference.

(Actually I suspect that central banks do deal with non-banks in the normal market operations anyway, although these counterparties must have an account with one of the settlement banks)


First, it’s not necessary for banks to “cut back” on M1 liabilities in order to improve capital ratios, although I don’t know that you necessarily implied it was. They can simply sell to the Fed, replacing risky assets with excess reserves. This improves risk weighted capital ratios, the same as it would if M1 deposits were dropped off. Excess reserves are zero risk weighted.

Along the lines of your question, banks may reduce M1 liabilities if they sell assets to non banks. But you mention the central bank as the source of the demand for the assets, so this might suggest the further brokering of bank sales to the central bank by the non banks. This would reverse your M1 effect.

Further to your point, it’s also possible that banks sell to non banks that retain those assets in portfolio. This is more or less the intention of PPIP. That would indeed have the type of M1 effect you describe.

All that said, the Fed wants to see the banking system resume healthy lending on the basis of a strong capital position. The type of transaction to which you refer frees up bank capital for other purposes. (Substantial capital is allocated to these so-called “toxic” assets.) In addition, the purpose of the stress test exercise, whose results were released today, is to ensure adequate capital in total. To the degree that banks can resume healthy lending, this activity will replenish the type of M1 decline to which you refer.

This entire stew is happening under the shadow of the Fed, which has indicated its intention to do whatever is necessary to ensure a strong banking system and healthy economic recovery, and to use balance sheet expansion and CRE/QE easing as necessary in order to achieve this.

Such Fed balance sheet expansion has an effect on the banking system balance sheet, gross and net, by definition. The entire effect in total obviously depends on the flows happening that are initiated outside of the Fed. This is difficult to predict. But the Fed will respond taking these flows into account.

And if the channel for the related CRE/QE includes M1 expansion, it will increase M1 from what it otherwise would be. And if it doesn't, it won't. But it will still increase reserves from what they otherwise would be.

Whatever the Fed does will make a difference. I think that’s more to the point here.

Great post, Nick. Back with comments later.


The title of your post is excellent. It fully captures an unconventional idea. Banks normally create new M1 as the result of lending. When banks are capital constrained from taking risk in lending, the central bank can step in instead to create new M1 by targeting QE at bank customers. And it does so in a way that creates no additional capital requirement for the banks.

As you write:

“Why doesn't the capital constraint bite? I think the intuition is that, on the margin, the commercial bank is holding 100% reserves against the extra deposit. A bank with 100% cash reserves (currency or deposits at the central bank) does not need capital. Nothing can go wrong (apart from bank robbers). It's just keeping its depositors' cash in a giant safe.”

This intuition is also explicit, because regulators attach a zero risk weighting to reserves as a bank asset. Reserves do not require an allocation of capital. Same idea expressed a little differently.

“But I wish my intuition were stronger on why it can't also work when the central bank injects base money into the commercial banks.”

I wasn’t clear on your reference here; i.e. by “can’t also work”. Do you mean you would instead intuitively expect the multiplier (traditionally viewed) to dominate the capital constraint in this case?

In any case, here’s an additional observation on the direct to bank QE channel:

If a bank sells a risky asset to the Fed, capital will be liberated for other purposes. Reserves don’t require capital. If the bank is undercapitalized, i.e. capital constrained, that liberated capital can help bring risk weighted capital ratios back in line. But suppose the bank is right at the inflection point of capital adequacy; i.e. at the threshold of no longer being capital constrained. Then sales of risky assets to the Fed would liberate capital that could be used to support new lending. And new lending would create new M1.

But until the bank reaches that point, the Fed can create new M1 more quickly (although not improve bank capital ratios on a risk weighted basis) by pursuing QE directly with bank customers.

So in this sense, the Fed’s choice of QE channels depends logically on whether the immediate priority is to improve bank risk weighted capital ratios (direct to bank) or improve M1 liquidity (direct to bank customers).


This doesn't have much to do with theory, but the Fed isn't allowed to buy or sell assets from non-banks. The sections of the Federal Reserve Act pertaining to interactions with individuals, partnerships and corporations limit the Fed to collateralized lending only.

I don't know if lending to non-banks is a good substitute for the QE buying you would like. Central bank buying is more powerful then central bank lending as the former is permanent, loans must be repaid. Second, if you buy outright you don't have to worry about the solvency of the seller, whereas if you lend to them you do. Lastly, do non-banks even want loans right now or do they want cash?

That being said, you can ignore this all if you're willing to look past Fed laws.

Maybe I have missed this in an earlier post, but what is CRE QE?


You’re quite right on the proper operational and legal distinction. “Buying” a financial asset is just lazy short hand for collateralized lending in this case. As well, a loan is a type of financial asset. For purposes here, there’s no technical difference in the pure monetary effect.

CRE = credit easing

QE = quantitative easing

This discussion is becoming more contentious than I had intended. I am merely trying to establish that, assuming that the central bank can somehow favour non-bank counterparties, the banks can circumvent this in some way, and if that is the case, whether the banks have the motivation to do so.

The obvious way of circumventing any exclusion of bank counterparties from asset purchases is for non-banks to act as the broker for the banks. To the extent that this accounts for a proportion of the fixed quantity of, say MBS, bought by the central bank, the M1 effect is reduced.

My suggested motivation for banks being more keen to lighten up on MBS than non-banks (and therefore being the marginal seller) was that they wish to contract their balance sheet, say because of a shortage of capital. Actually, I regard capital as more of a restraint than a constraint. Clearly, as yesterday's stress test results show, some banks have been operating with less capital than desirable, and sales of risky assets provide as viable a way to resolve this problem as raising more capital. Now, I suppose I had been making the assumption that the way to reduce a bank's need for capital would be balance sheet contraction, because zero risk weighted assets are (opportunistically) costly to hold. But, come to think of it, the payment of interest on reserves makes such assets less costly, which is a consideration in the debate about whether paying interest on reserves is contractionary.

I began with no opinion on the issue of whether it was worthwhile for central banks to favour non-bank counterparties when purchasing assets for QE, but I am leaning towards thinking that it is.

Of course, all of this depends on whether (as jp wonders) the central bank can actually deal with non-banks, and if so, whether they can exclude the banks when purchasing assets by eg reverse auctions.


I might have qualified my response better by saying I really haven’t explored in detail the facts or the data of the bank/non-bank counterparty split of credit/quantitative easing to date. Nor have I looked at the question of how much control the Fed has over this in the future, or in what way they are concerned about it. So I haven’t thought through the scenarios implied in the kinds of questions you are posing. I’m just looking at how to classify and analyze the implications of the alternative channels at this stage, given the fact that Fed balance sheet expansion must result in outflows through one of these two channels.

JKH: Thanks for the compliment!

And thanks for the very helpful comment. It helps in 2 ways:

1. What you said about reserves being zero risk-weighted absolutely confirms my "100% reserve ratio in the margin" intuition. Getting the same answer from 3 different perspectives (including your bank insider perspective) now makes me confident that that part is basically right. QE can increase M1.

2. Your insights on the capital constraint help me get closer to intuitive understanding and confidence on the other question: why normal monetary policy can't increase M1. Rebel's constraint/restraint distinction is going in the same way as my intuition. Here's how I am now looking at it:

There are two types of capital constraints:

A "hard" capital constraint says that if you don't have enough capital you must immediately call in loans. So in the original equilibrium (and economists always start in equilibrium, to see how a policy change will affect things), the capital constraint is just on the edge of biting. In this case, it matters I think what sort of assets the central bank buys from the banks. If they buy a risky asset, it lets the banks expand equally risky loans by the same amount. M1 expands. If they buy a safe asset (zero risk weighted) it does not expand M1. If they buy an asset with half the risk weight of loans, the banking multiplier is 0.5.

A "semi hard" capital constraint says that if you don't have enough capital you may not make new loans, but you don't have to immediately call in old loans. So M1 is slowly declining over time, as old loans slowly mature. In this case, normal monetary policy (unless it buys so many risky assets that the constraint stops binding completely) will not change M1.

Gotta find a better word for "semi hard". Gotta mull it over some more.

jp: "This doesn't have much to do with theory, but the Fed isn't allowed to buy or sell assets from non-banks." But VERY important for the application of the theory.

As JKH says, when you lend someone money, you get an IOU in return. That IOU is a bond. You are buying a bond. (Just my way of thinking about it). Colateralised lending: you buy a personal IOU/bond, and hold the guy's watch as security, like a pawnbroker.

Still mulling over Rebel's points about whether banks or public would in fact be the ones selling, if the central bank went into the open market.

May I remind you colonials that the Fed is not the only central bank in the world doing QE? I fairly sure that the BoE for one will deal with non-bank dealers.

Another way to source assets from non-banks is to choose assets that the banks tend not to hold. It was, for example, said in the UK press that the BoE was targeting long-term bonds because they tended to be held by pension funds and not banks. If this works, then even if the central bank buys from the banks, the banks serve as the brokers and increase M1 when they buy from the pension funds.


Would it be possible for you to put together a multidimensional matrix showing the various flow possibilities for the UK, US, and Canada systems?

Could we see that within the next hour or so?


At the end of the day, the Fed wants to see healthy banking system capital and asset growth on a risk adjusted basis.

In the absence of Fed intervention, impediments to this may include slow growth, flat growth, or negative growth, with a corresponding range of M1 behaviour. This includes the effect of any bank sales of assets to non-banks.

Assume first a world where QE easing is restricted to targeting non-banks. Then the Fed can offset any or all of the above and more with QE easing directed at non-banks, and corresponding increases in M1.

Now allow QE easing targeted directly at banks. This may include outright asset purchases that are M1 neutral.

From the Fed’s perspective, purchasing assets from banks is a device for improving bank capital ratios. Not only is the purchase M1 neutral, it is also credit neutral for the entire system including the central bank and the commercial banks. But other things equal, this capital relief gets commercial banks closer to generating more new asset and M1 growth on their own. The Fed can take this into account in deciding on the level of QE required in total, including both bank and non-bank directed QE.


random stuff:

I usually interpret the capital constraint as a requirement rather than a condition relative to that requirement.

In that sense, the constraint may be binding or not.

The actual capital condition is a continuous function relative to the constraint. Banks either have surplus capital or deficient capital, or are at their requirement. Healthy banks normally run a surplus capital position to some moderate degree as a matter of prudence.

At the margin, capital can be liberated or made surplus either by reducing risky assets or increasing capital outstanding (i.e. issuing new capital). Future retained earnings also increase capital, of course.


I will construct a multidimensional matrix as soon as I get a holographic screen (even Vista would be nice)!

By the way, at the risk of starting another debate, I would question whether collateralised lending should, in general, be called credit easing - see paragraph 32 of my Easing understanding post. I would characterise it as liquidity easing.

Rebel, there are plenty of bids in the BoE reverse auctions that aren't from banks.

JKH, putting Rebel to work? Good to see!

One of the best I ever saw was when (I believe it was) Patrick apologised for being slow to comment on one of Nick's posts. Nick asked "busy?". Nick taking his commenters to task.

That's right, I think we should have a rule that if you're gonna critique Nick you at least have to keep up with him. If you want to post comments but aren't willing to properly argue your case then go comment on Krugman's blog!


If this WCI QE exploration were a project (interesting), and I was in charge of running it (unlikely), I would delegate the more granular part of the investigation to fall under the responsibilities of your chosen team.

I would then ask for a presentation, wherein you coordinate your findings here with the comprehensive analysis featured in your post at your blog.

That would leave the easy stuff for me.

That would be my plan anyway.

(Still planning on leaving a comment at your place, in due course; save my reservation)

Re: collateralized lending vs purchasing. JKH and Nick, you seem to say they are each similiar but I'm not sure. From an economic perspective, don't loans to the public satisfy their demand for loanable funds while purchases from the public satisfy their demand for the medium of exchange?

From the point of view of an individual, the central bank buying their car for cash results in the car moving off the individual's balance sheet, satisfying that individual's demand for less stuff. But with a central bank loan collateralized by the individual's car, the car remains on the individual's balance sheet ie. they never had their demand for less stuff satisfied.

If they were legal, central bank purchases from the public would solve your initial condundrum; people wanting less stuff and more money. But central bank loans don't satisfy the public's demand for less stuff, the only thing that central bank lending can satisfy is an increased demand for loanable funds, which the public doesn't have (or does it?). Apologies in advance for missing any point in your earlier discussions relevant to this issue, and the boatload of theoretical errors I have probably made.


In normal monetary policy the central bank buys stuff from the commercial banks.

I apologize for the 'USA' orientation of what follows, but the 'normal' state of the US Federal Reserve is to engage in OMOs with the non-bank public. The model of the FR as exchanging tbills with banks is simply wrong in almost every respect as an operational matter; the bulk of monetary policy is not implemented in this way.

The Primary Dealers who participate in Open Markets trading with the Fed are not depository institutions. They are broker-dealers and at best are trading arms of deposition institutions rather than being banks directly.

Second, the US normal Fed balance sheet contains a mixture of bills and bonds. The mean dollar-weighted maturity of its portfolio is 4 years. Tbills are used to manage small fluctuations in clearing balances but the notional amount needed to do so is quite small. Nonetheless the Fed holds about 1/3 of its portfolio (normally) in tbills. The purpose of which is to have an adequate supply to sterilize sudden volume at the discount window not because the Fed implements policy via tbills. The broad strokes of policy are established by note and bond purchases.

When the Fed's draw down of Treasuries stabilized around 500B last year, the level reached reflected the depletion of the entire tbill portion of the portfolio--stopping short of zero has erroneously been reported as the Fed wanting a reserve for something worse.

The past 1.5 years has been very unusual. Much of the Fed's activity has been directly with depository institutions as counterparties. Indeed, the Fed has primarily auctioned money directly to depository institutions and used the primary dealers to sterilization those actions by draining an equal amount from the non-bank public via offsetting tbill sales. This is contrary to thirty-years of practice. The situation is really quite ironic: just as the banking system implodes the Fed redirects its monetizations efforts to take place through the banks directly.

Jon: Interesting. Another comment for me to mull over. I am interested to see how JKH responds as well. Does it mean the argument in my post is empirically false?

By the way. I don't make any distinction between bills and bonds. To my mind a bond is a long bill, and a bill a short bond. And whether it has a coupon attached (or is sold at a discount to face value) doesn't matter.


Interesting points.

As I commented here earlier, I’ve haven’t spent time yet in attempt to dissect the bank/non-bank split of Fed counterparties in crisis balance sheet management. But here are a few preliminary observations.

In terms of the M1 effect we are addressing here, normal OMO and normal Fed balance sheet conditions are irrelevant. The M1 issue has only become interesting since the Fed started to fund a good chunk of its balance sheet with excess bank reserves. Prior to that, and in normal conditions, most of the funding proportionately is in the form of currency issued. On a cumulative basis, normally, the banking system would monetize the amount of reserves on deposits at the Fed (typical $ 10 billion) and the amount of vault cash held (typically $ 50 billion). This has been a pretty steady time series up until the crisis. It's a very small amount in context.

As you point out, OMO at the margin in normal times is not material to Fed balance sheet size. So the fact that the normal OMO counterparty is non-bank is interesting, but not material to the issue of M1 effect in the current environment.

The bank/non-bank and M1 question is only interesting and relevant in the context of current CRE/QE, where excess reserves in the form of bank deposits at the Fed have skyrocketed. The question boils down to the bank/non-bank counterparty mix of the Fed’s asset management operations, as that is the pivotal originating force in CRE/QE.

This is all very complicated, but in my view there are some strong indications that the Fed has significantly expanded its non-bank counterparty reach in its balance sheet operations. Those operations include a change in mix and in size of the balance sheet. So it is conceivable that the Fed has expanded its non-bank counterparty reach not only as a result of increasing the size of its balance sheet, but as a result of CRE changes it had already started making to the composition of its balance sheet before the balance sheet actually started to expand. The latter part is difficult to determine, because you have to try and figure out the counterparties for both the assets replaced and the replacement assets. In any event, for both the composition and size pieces, I just haven’t take the time to go through it all. But as I say, there are strong indications that the non-bank expansion of M1 (at the margin) as a result of Fed activity is a substantial issue. So while you say “Much of the Fed's activity has been directly with depository institutions as counterparties”, that may be the case, but I expect a material portion hasn’t.

For example, you’re right about the auction facility, but this was an early stage mechanism instituted prior to some of the more radical credit easing activities. But here is a useful summary from the Fed’s website of most all of the facilities:

“The Federal Reserve has responded aggressively to the financial crisis since its emergence in the summer of 2007. The reduction in the target federal funds rate from 5-1/4 percent to effectively zero was an extraordinarily rapid easing in the stance of monetary policy. In addition, the Federal Reserve has implemented a number of programs designed to support the liquidity of financial institutions and foster improved conditions in financial markets. These new programs have led to a significant change to the Federal Reserve’s balance sheet.

The first set of tools, which are closely tied to the central bank's traditional role as the lender of last resort, involve the provision of short-term liquidity to banks and other depository institutions and other financial institutions. Because bank funding markets are global in scope, the Federal Reserve has also approved bilateral currency swap agreements with 14 foreign central banks. These swap arrangements assist these central banks in their provision of dollar liquidity to banks in their jurisdictions.

A second set of tools involve the provision of liquidity directly to borrowers and investors in key credit markets. The Commercial Paper Funding Facility, the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Money Market Investor Funding Facility, and the Term Asset-Backed Securities Loan Facility fall into this category. All of the programs are described in detail elsewhere on this website.

As a third set of instruments, the Federal Reserve has expanded its traditional tool of open market operations to support the functioning of credit markets through the purchase of longer-term securities for the Federal Reserve's portfolio. For example, on November 25, 2008, the Federal Reserve announced plans to purchase up to $100 billion in government-sponsored enterprise (GSE) debt and up to $500 billion in mortgage-backed securities. On March 18, the Federal Reserve announced plans to purchase up to $300 billion of longer-term Treasury securities in addition to increasing its total purchases of GSE debt and mortgage-backed securities to up to $200 billion and $1.25 trillion, respectively.”

What one needs to do is to go through each of these facilities and determine the possibilities for bank/non-bank counterparty distinction and the related M1 effect. Note the stages and the counterparty distinction, as in:

“A second set of tools involve the provision of liquidity DIRECTLY to borrowers and investors in key credit markets.”

An interesting one that I have actually looked at closely myself is in the first section relating to depository institutions, which is the case of the bilateral currency swaps. This is a very unique one, because even though it is direct to banks, the banks are foreign central banks, and the monetary effect is converse to that of domestic depository institutions. It is much more analogous operationally to the non-bank M1 impact. The dollars swapped to the foreign central bank essentially constitute a Fed balance sheet asset. The money is created by a stroke of the pen, like any Fed asset. Those dollars recycle from those foreign banking systems back into the US and end up monetized as a Fed liability. Think of it as being forced by double entry accounting in the first instance. The Fed balance sheet must balance. The operational reality is that those dollars must be reflected as a credit in an account with the Fed, i.e. the account of a bank that clears with the Fed, with that bank showing a corresponding liability of some sorts. There’s every reason to believe that such a liability can or will be an M1 deposit. So here’s a case where the Fed counterparty is a depository institution, but because the latter is foreign, the associated monetary effect includes M1 creation, just as in the case of a non-bank. Then you have all of the other facilities included in the Fed’s stage two list above, plus possibilities for both types of counterparties in stage three.

I just haven’t gone through them all yet to assess the expected bank/non-bank counterparty effect and potential M1 effect based on the cumulative change in the composition and size of the Fed’s balance sheet since all of these extraordinary activities started. But there’s no question in my mind that the M1 question is empirically relevant in this CRE/QE environment.

BTW, returning to what I think is an important observation you make:

“T bills are used to manage small fluctuations in clearing balances but the notional amount needed to do so is quite small.”

I refer not to the t-bill aspect, but that of “small notional amount”. This is important. In normal operations, the elasticity of the fed funds rate with respect to a change in reserve quantity via OMO is incredibly high (I know that’s an inverse view of elasticity functionality), viewing OMO quantity in proportion to the size of the Fed balance sheet or the size of the banking system balance sheet. This is fundamental to understanding the relevance of the monetary base to interest rate control. If you are the same Jon that comments at Monetary Illusions, this is a point I’ve hammered home there to no avail and no comprehension, apparently. What it means is that only a very small margin of the monetary base is relevant to interest rate control in normal times. Now we have abnormal times, where the excess reserve margin has increased by some 40,000 per cent or so, as I’ve said previously. Then I refer you to Nick’s sage comment on the post that follows this one: “We must be very careful and make sure that lessons only applicable in abnormal times are unlearned when times return to normal.” In the context of the general discussion regarding the monetary effect of CRE/QE, the monetary base, and reserves, I would modify Nick’s caveat as follows: We should be careful in formulating expectations about monetary policy implementation in abnormal times such that they don't effectively contradict the PRINCIPLES of monetary policy implementation in normal times. Contradicting those principles would be problematic for the return trip to normal times. Not the time to elaborate now, but this has something to do with expectations for the multiplier and payment of interest on reserves.

This is all very rushed; perhaps return later if interested responses.

A simplified model:

There is much financial system “deleveraging” going on as a result of the credit crisis.

Much of the problem is in the non-bank “shadow bank” system.

This includes the system of “off-balance sheet” entities structured by banks to move securitized product into portfolios that are remote from mainstream bank capital adequacy standards.

Deleveraging in that system involves shedding assets and non-M1 liabilities such as commercial paper.

The banks in part have been forced to take some of these assets back onto their own books. This replaces some of the former shadow bank funding with M1 bank funding. This has compounded the banks’ own deleveraging challenge, which involves shedding assets and M1 funding as well.

The whole thing is too violent an adjustment to happen without Fed and Treasury intervention.

So the Fed and Treasury are using the consolidated USG balance sheet to provide new leverage to offset the deleveraging of both the shadow bank and mainstream bank deleveraging process. At the same time, the Fed has to be concerned about the capital constraints that are reflected in the deleveraging process, which cause too great a break on credit flows required just to keep the economy going. So the Fed has an interest in replacing/adding to the M1 effect for both of these reasons. It does this by CRE/QE M1 easing with non-bank counterparties, in order to fund the credit risk that the banks are now avoiding because of capital constraints.

The key point is that the Fed has an interest in M1 easing, compared to the counterfactual, whatever the level of M1 might have been in that counterfactual due to deleveraging forces.

Nick, I agree with the thrust of your argument, but have a question and a comment.

Question: Why does the fact that banks are capital constrained mean that OMOs through banks won't increase M1? Why wouldn't a capital-constrained bank simply buy T-bills with newly injected reserves? It seems to me that the argument you are making applies more closely to the zero interest rate "liquidity trap," than to capital-constrained banks.

Comment: Doesn't your excess supply of goods story require price stickiness? Obviously that's a reasonable assumption, but I prefer thinking in terms of nominal shocks, not excess supply of goods. For instance, suppose NGDP fell unexpectedly, prices were completely flexible, but wages were sticky. Then even perfectly competitive firms would choose to reduce output, creating a recession. But supply of goods would still equal demand.

My reading of the interwar evidence suggests that wage stickiness was a much bigger problem than price stickiness. So I like models where you try to model the supply and demand for the medium of account, not the medium of exchange. It seems to me that those models are somehow more fundamental. Thus a shock to the gold market (medium of account) might lead to a reduction in the expected future M1 supply, but no current reduction in M1. Nonetheless, the gold market shock would immediately depress commodity prices, stock prices, and future expected NGDP, and since nominal wages are sticky, it would also cause a recession even before M1 fell. And that's not just a hypothetical, I believe that often happened in the interwar period.

Scott: I'm going to duck your question, while I'm still getting my head around JKH's comment, and the whole intuition of the QE-M1 story.

Regarding wage and price stickiness. I think of both a sticky, and that was the implicit assumption at the back of my mind. But as long as one or the other is sticky, it doesn't really matter much.

1. If prices are perfectly flexible, then the output market clears, by assumption, but there is excess supply of labour.

2. If wages are perfectly flexible, but prices are sticky, the labour market clears, but there is excess supply of output.

But to a first-order approximation (assume labour is the only variable input in the short run), you get exactly the same level of output and employment in both cases 1 and 2.

To prove this assertion, assume first an equilibrium where wages are fixed too high. So we have unemployment, but no excess supply of goods. Now hold the price level fixed at that level, but allow wages to drop. Since real AD is fixed, with P fixed, firms are now constrained in the output market. Their labour demand curve, given that constraint on sales, is vertical. A drop in real wages will not lead them to hire more labour. Forget the MPL=W condition. That's irrelevant if they can't sell more output. Patinking 1965. Barro and Grossman 1971(?).

A second set of tools involve the provision of liquidity directly to borrowers and investors in key credit markets. The Commercial Paper Funding Facility, the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Money Market Investor Funding Facility, and the Term Asset-Backed Securities Loan Facility fall into this category. All of the programs are described in detail elsewhere on this website.

The Money Market Facility is not operational. The Term Asset Loan and the Asset-Backed CP programs are tiny. The CPFF is huge. I am not aware of a list of registered issuers, but the effects of the program visible in the spread over the ff suggest that the program is mostly servicing commercial paper issuance by banks. Thus I'd take a grain of salt to the notion that the banks are not the loci of these operations.

Another way of responding to your comment Scott: the important distinction is between the medium of exchange and all other goods. Labour is just one of those other goods. If apples have a perfectly flexible price, the apple market will clear. But it won't clear at the same real price and quantity as it would if all prices (and wages etc.) were perfectly flexible.

And we would misdiagnose the problem as being caused by the relative price of apples being wrong. Just as we would misdiagnose the sticky wage/flexible price case as the relative price of labour being wrong. And if bond prices are flexible, but other prices fixed, we misdiagnose the problem as interest rates being wrong. The underlying problem in all cases is the excess demand for money.

“Thus I'd take a grain of salt to the notion that the banks are not the loci of these operations.”

You can assume that the Fed is all done with those programs and others. I don’t have that certitude. Anyway, that’s only part of the answer. The existing balance sheet opens up enough questions.

The relevant issue as I described is the potential M1 effect attributable to extraordinary easing of bank reserve balances held at the Fed. Last Wednesday, these totalled $ 821 billion, compared to a pre-crisis average of around $ 10 billion.

The total Fed balance sheet is about $ 2.1 billion. Of that, $ 560 billion was in treasury securities, $ 400 billion in term auction credit, and $ 39 billion in primary credit. The last two items are definitely routed directly into banks.

The remainder of the balance sheet is about $ 900 billion, which happens to approximate the excess reserve balance level we are trying to link to in exploring the potential M1 effect. As far as I can tell, this $ 900 billion is mostly up for grabs as between bank and non-bank counterparty origination. For example, central bank liquidity swaps were $ 249 billion. As I described above, the domestic effect is equivalent to a non-bank channel in this context.

I would also raise questions about the other components, including MBS of $ 365 billion and CP funding of $ 168 billion. I’m a bit surprised by your statement that this is bank CP. You may well be right, but I’d like to see additional proof before concluding this myself. I’d be interested if you have any hard info on this in addition to your spreads. Perhaps I’ll poke around in the interim.

Not to mention the potential for ramp up of programs already announced. Potential treasury securities transactions are up for grabs in this sense. The Fed may buy them from dealers who buy them from clients, which would result in an M1 effect. In this sense, transactions even with bank owned dealers resemble non-bank transactions in terms of their potential M1 effect. Although banks hold the capital position in their captive dealers, the dealer will clear through a deposit account with the parent, aiming to keep it flat each day, similar to accounts held by other non-bank clients.

Above should read total Fed balance sheet of about $ 2.1 trillion.

Do capital requirements act as reserve requirements once did? I think the answer is no. A bank ought to be able to lend to an external vehicle which in turn purchases equity in the bank. Indeed, this is what happens ordinary except in a less nefarious tone. Banks lend and some of the money they create circulates back (in the form of equity and interest). But this process is not subject to the process of diminution that occurs as with reserve ratios. Each round can give the bank more free capital than it had before.

I don't understand your last point, or its relevance.

But some of the CP program may be funding foreign banks. To the degree that's true, it allows them to continue their own lending programs, which increases M1 compared to the counterfactual.

i.e. the US branches of foreign banks

But some of the CP program may be funding foreign banks. To the degree that's true, it allows them to continue their own lending programs, which increases M1 compared to the counterfactual. i.e. the US branches of foreign banks.
Domesticly owned US Banks issue CP as a source of funding free of FDIC insurance requirements. Overall, bank CP is a significant component of the overall CP market--about 1/3. Asset-backed paper amounts to another 1/3. Industrial/Commercial paper the remainder.

The locus of stress in the CP markets was bank paper. This is the segment of the market that experienced significant spreads over overnight-rates, and this is the segment of the market had responded to the CPFF program.

So the notion that this program is bypassing the banks is dubious on a per-se basis. You need "proof".

I apologize JKH, I saw your last remark but not your first one.

I cannot be sure what's happening with the CPFF. I attempted but failed to track down details on what issues were being backed; I also was unable to track down even a list of registered issuers. My suspicions though stem from this data: http://lostdollars.org/static/moneycost.png. A similar picture arises in the notional amounts outstanding. While non-bank paper held fairly steady, bank paper outstanding plunged and then recovered coincident with the CPFF program. http://lostdollars.org/static/cpff.png

Yes; I had guessed it would be foreign bank branches issuing CP; I also don’t know whether such foreign banks would actually have accounts with the Fed or whether they would clear through the domestics. But maybe as you seem to say it’s the big domestic US banks issuing CP. I don’t know.

In any event, I think funding bank CP is a little different than purchasing a bank asset in exchange for excess reserves. As I said, the effect of that CP paper market freezing up would have been the mirror freezing up of the customer lending funded by the CP. (I’m also guessing here that bank CP funding is dedicated fairly narrowly to a specific portfolio of lending, or in the case of smaller foreign bank branches to a correspondingly smaller asset portfolio in total. I’m doing a lot of guessing here right now because I’m not familiar with that market in the US.) In any event, freezing up of the associated lending would in theory have caused a contraction in M1 balances – i.e. the bank accounts of customers to which the banks lend. So the Fed stepping in avoided that effect and restored M1 balances to what they would have been had the CP continued to be funded without the Fed. It’s an “other things equal” or counterfactual type of comparison with respect to M1. But I suspect you’re probably right – that it is largely bank CP of some sort.

Still another possibility is that this includes CP funding for bank sponsored off-balance sheet conduits. This again would be a similar argument for an M1 type of effect, for the same reason as above.

Some stuff from the Fed’s web site on the CP program:

Potential M1 effect in my view via bank customers on the other side of the program:

“The commercial paper market has been under considerable strain in recent weeks as money market mutual funds and other investors, themselves often facing liquidity pressures, have become increasingly reluctant to purchase commercial paper, especially at longer-dated maturities. As a result, an increasingly high percentage of outstanding commercial paper must now be refinanced each day, interest rates on longer-term commercial paper have increased significantly, and the volume of outstanding commercial paper has declined. A large share of outstanding commercial paper is issued or sponsored by financial intermediaries, and their difficulties placing commercial paper have reduced their ability to meet the credit needs of businesses and households.”

CP issued by foreign bank branches is included:

“Only U.S. issuers of commercial paper, including U.S. issuers with a foreign parent, are eligible to sell commercial paper to the SPV. A U.S. issuer is an entity organized under the laws of the United States or a political subdivision or territory thereof or is a U.S. branch of a foreign bank ... if a U.S. branch of a foreign banking organization had commercial paper outstanding between January 1 and August 30, 2008, it may sell commercial paper to the SPV. The U.S. branch may not sell any commercial paper issued by other parts of the banking organization to the SPV. In addition, in determining its issuer limit on the CPFF issuer registration form, the U.S. branch must not include any commercial paper issued by other parts of the organization.”

ABCP of the type issued by off-balance sheet conduits is included:

“The SPV will purchase unsecured and asset-backed commercial paper (ABCP). The commercial paper must be rated at least A-1/P-1/F1 by a major nationally recognized statistical rating organization (NRSRO) and, if rated by multiple major NRSROs, must be rated at least A-1/P-1/F1 by two or more major NRSROs. The commercial paper must be U.S. dollar-denominated and have a three-month maturity.”

This is fundamental to understanding the relevance of the monetary base to interest rate control. If you are the same Jon that comments at Monetary Illusions, this is a point I’ve hammered home there to no avail and no comprehension, apparently. What it means is that only a very small margin of the monetary base is relevant to interest rate control in normal times. Now we have abnormal times, where the excess reserve margin has increased by some 40,000 per cent or so, as I’ve said previously.
JKH, I am the same commenter incidentally, and I think you overstate the dispute. I think we (including Scott et al at MI) agree that achieving the FF target involves very small reserve&clearing balances and concomitantly small excess reserves.

This isn't were our dispute lies: as much as I agree with the dynamics as described before, I don't think short-rates are enough per-se to explain the effect of monetary policy on the economy. In particular, movements in longer-term rates are greatly attenuated to movements in the FF target during time-scales on which we nonetheless see effects from monetary policy.

Quantity Theory provides the answer. Long-rates adjust to match supply and demand. Any shift outward in supply can be absorbed if the bank lowers the rate-of-interest sufficiently. The rates in question 'float' and the MB (among other things) determines the supply.

When the MB rises (or falls) too fast to absorbed in the investment market, short-rates would tend to fluctuate, but the Fed sets a rate-target and drains or adds the relevant base as needed.

"I think you overstate the dispute."

Fair enough.

BTW, I found the last paragraph in this latest post on MI absolutely fascinating:


I'd prefer not to comment, but would be very interested in other reactions to it.

Nick, I think I erred in connecting the wage vs price stickiness question with the media of account vs media of exchange question. I view the key attribute of "money" as being its fixed nominal price. Thus when the real value of money changes, we can't change it's nominal price. Rather we change it's real price by changing the nominal prices of all other goods (including labor.) If all other goods and labor have completely flexible prices, then monetary shocks have no real effects, and we have the same Walrasian equilibrium as in a barter economy.
I was with you until the apple/wage analogy in your second reply. I agree that if the apply market cleared at a distorted price due to wage rigidities elsewhere, we would be wrong to attribute the distortion to a specific problem in the apple market. But that's because the apple market clears. If wage rigidity causes the labor market to not clear, why doesn't that rigidity in some sense "cause" the problem. By the way, I use the term 'cause' loosely as I definitely don't think fixing the labor market is the way to stabilize the macroeconomy--monetary policy is the key.

Scott: suppose we separate the medium of account from the medium of exchange. Start in equilibrium. What would cause more macroeconomic damage?

1. A doubling of all prices, including the price of the medium of exchange, in terms of the medium of account. (this is equivalent to halving the value of the medium of account).

2. A halving of the price of the medium of exchange, in terms of the medium of account, holding all other prices constant.

My view is that 2 is much more damaging.


On the last paragraph of the MI post:

I agree with what Nick Rowe wrote there. It seems to me that the monetary base is indeed the operational instrument and the other variables are indicators.

If I understand the NGDP futures targeting scheme correctly, I would expect it to produce unacceptable results in practice. Unless base money supply is adjusted to accommodate various micro events (for example, I was once involved in attempting to forecast seasonal changes in banknote circulation, and remember being told that a particular horse race could be expected to require an increase in note circulation), overnight interest rates are volatile. Presumably either such adjustments would undermine the credibility of the base money supply response to futures price changes or else short term interest rates would be unacceptably volatile.

But then I dislike the idea of a central bank having an objective that represents a composite of inflation and real activity anyway; in my view, a central bank should have a lexicographic preference for price stability first and foremost.


I second your agreement.

“short term interest rates would be unacceptably volatile”

I expect that’s the result in any event.

Love the horse race anecdote, and your lexicographic preference belief.

Must look that up now, to see what it means.

Rebel, JKH,

I also agree.

Lexicographic preferences: ranked in the same way as a dictionary ranks words in alphabetical order. The first letter in the word takes absolute priority. Only when two words have the same first letter do we consider the second letter. And only when they have the same first two letters do we consider the third. etc. There's no trade off.

I've just done a post on Scott Sumner's plan. Maybe continue the discussion of Scott's plan (as opposed to QE and M1) there.

(I keep misreading MI (Money Illusion) as M1)!

Tried to follow this thread all the way through - pretty sure I failed at some point along the way. This will probably be confirmed by my questions below.

Unless I missed it, I guess Scott's question was not answered (?), i.e.,:

"Why does the fact that banks are capital constrained mean that OMOs through banks won't increase M1? Why wouldn't a capital-constrained bank simply buy T-bills [not from the Fed presumably] with newly injected reserves?"

It seems like a pretty good question given that an efficient bank operating under rational regulations would presumably be trying to operate at the limit permitted by their capital most of the time. I am assuming that any M1 increases would not always be contingent on banks raising new capital.

Another commenter above (Jon, perhaps? - please don't make me go through them all again) also raised the point that monetary base created by central bank open market purchases could presumably also be used to lend to individuals ultimately purchasing new bank capital. This reinforces the notion that bank capital constraints per se would not necessarily constrain M1 creation.

Am I wrong here?

David: Let me try to answer Scott's question. (And I'm not sure my answer is right!)

If there is zero risk to buying a Tbill, and if Tbills pay a higher interest rate than reserves, then an initial increase in reserves will be spent by the bank in buying Tbills from the non-bank public, and so M1 will increase.

But even though Tbills are low risk, and highly liquid, there is presumably still some interest rate risk, and even liquidity risk, with Tbills. And if the interest rate on Tbills is barely above that on reserves, a capital-constrained bank would have little or no incentive to do so.

I'm not sure that's a fully satisfactory answer. It is certainly easier to think of an implicit model in which there are only three assets: risk-free currency and reserves; demand deposits; risky bonds.

I thought through the implicit model thinking of bank capital as exogenous, and the constraint as either binding or slack. As you say, a profit-maximising bank would already have expanded to the limit of its capital. If we made the capital constraint bind progressively, so that it gets less and less willing to lend new reserves as the capital ratio falls, I think the main results will still come through qualitatively. A sudden exogenous drop in banks' capital ratios would make them less willing to expand loans and M1 if given extra reserves, other things equal.

I don't see a very tight link between bank lending causing people to buy new bank shares.

But David, you are not wrong, or at least not obviously wrong. As I said at the beginning of the post: I wish I understood this stuff better.

Dear Nick,

Thank you for your blog and your post. I'm not a macroeconomist, and have been reading your blog (and the Money Illusion) to try and understand how monetary policy can help in the current economic crisis when nominal interest rates are close to zero, and if there are deflationary expectations.

If there are deflationary expectations, households are fearful of unemployment, and investors are distrustful of non-cash assets, could the demand for money be insatiable? Perhaps a better characterization of the problem is not that there is an excess demand for money, but that there is an excessive aversion to non-risk free investments in physical and human capital.

No matter how much cash is injected into the economy, households and investors will not spend any of the money in consumption or investment. If the expected inflation rate is zero or negative, holding cash would be the most prudent course of action.

Imagine we are all like penguins standing at the edge of the cliff, wondering whether to dive into the sea knowing there are leopard seals. If we all dive-in (i.e., start consuming and investing), there is a good chance we will survive (i.e., make a decent return on our investments). However, if we expect no one to dive-in, doing so would be very dangerous. If the government were to give us cash in return for any assets we may have, we would be better off saving that cash rather than spending it on consumption or making risky investments.

Under those circumstances, how does the increase in money supply cause nominal prices for goods and services to rise?

I do think there is something to be said for quantitative easing. However, it seems to me that it's not so much the increase in money supply per se that is the solution, but the willingness of the central bank (or government) to acquire risky assets and therefore make the oceans safer for investors (e.g., by removing "toxic assets"), or by raising demand for goods/services (e.g., through government expenditure).

The government could also tax risk-free investments (e.g., pay negative interest rates on reserves and treasury bills) to make risky investments (and consumption) more attractive.

Another possible measure is to subsidize private consumption and private investment by (for example) offering conditional tax rebates (e.g., double deduction on business expenditure) or giving households a loan (e.g., for education or housing) that is repayable only if taxable income exceeds (say) the current average salary.

Apologies if my comments reflect my ignorance. I would appreciate your response.


Kien: Welcome to the blog!

I really like your penguin/leopard seal analogy. I think it's accurate.

As to your question, well that is the big question, that many of us are debating. Clearly the most important way in which monetary policy could work is is current monetary policy influences expectations of future monetary policy, and so expectations of the future price level and real income.

But I don't engage in that debate in this post. I just look at the narrower question of whether QE could increase M1 where standard monetary policy could not.

But there are lots of other posts here where I look at that bigger question.

Thank you Nick. I'll do my best to catch up on your other posts. Cheers, Kien

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