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The demand for money is not a demand to hold more green pieces of paper, but a demand to hold more purchasing power. Holding money is always a sacrifice, of both consumption and investment. No one holds money without a compelling reason.

Let's say that you are paid every Friday. The primary reason to want to increase your holding of money is that you run out of money on Wednesday. To deal with this, you have to cut back your purchases. (and/or investments, but ignore that). But if you cut back your purchases enough to stretch your paycheck until Friday, that will turn out to be an excessive cutback. That is because other people will cut back on their purchases of the goods that you continue to purchase. This will drop their market prices and effectively increase the purchasing power of the money that you spend.

So there are two mechanisms to satisfy the increase in demand for money without inflating the supply of money. First you reduce your consumption to stretch your paycheck to Thursday, and the market prices of the goods you continue to buy fall as other people reduce their demand for those goods, stretching your paycheck to Friday.

Regards, Don

Interesting. Would unsustainable levels of debt cause an increase in the demand for money? If so, seems to me that debt restructuring would be a good way to reduce the demand for money. Bankruptcy as monetary policy?

Kudos on crediting Clower. He is still under-appreciated.

Interesting talk on policy: http://www.csis.org/component/option,com_csis_events/task,view/id,1828/


I guess I won't restart our debates over the past few weeks, (I must say I've enjoyed them though), but the timing of this post from you along with this one


from Krugman presents a convenient context for rephrasing in less technical language why I think you're wrong.

So the question to you Nick is this: Is the problem an excess demand for money OR and excess demand for REAL SAVINGS?

The difference matters, an excess demand for money is solved by supplying more of it but an excess demand for real savings can't be solved by the money supply alone.

Adam P,

I find that Krugman is just about the only economist I can usually hope to understand on an instructional basis (although Nick can be pretty good). The referenced piece is no doubt subtle, but logically presented, and therefore reasonably understandable with a little work.

I find it amazing that he continues to give these blog mini-lectures to other economists on the rudiments of Keynesian economics. Apparently they don’t understand it.

Both of these facts give me hope.

Don: yes, if the general price level adjusted instantly, so that an excess demand for money were always eliminated instantly (I think of it as a fall in the price level increasing the real supply of money. M/P), we wouldn't have to worry. But I think it doesn't. (Plus, we have to worry about how expected inflation might react to a change in the current price level, because that might affect the demand for money in the wrong direction).

Patrick: I think that if people suddenly realised that debt had become unsustainable, so the risk of default had increased, that might well increase the demand for money (because other assets are now both less safe and less liquid than they were). I would say that is one plausible channel for what actually went wrong.

Josh: absolutely. Does anyone still read Robert Clower? Has anybody even heard of him? Those two papers he wrote, re-published in the little Penguin paperback on monetary economics, are I think real gems. I was echoing them in this post.

rp: looks a worthwhile link. Haven't listened yet.

Adam: It is good to re-open our debate. That was one of the things I was doing in this post: trying to approach it from a new perspective.

According to Paul Krugman's perspective, the recession is caused by an excess of desired "savings" (or insufficient investment, but let's ignore that for simplicity).

"Savings" in modern (Keynesian) terminology is a weird beast. It represents ANYTHING you can plan to do with your income from selling newly-produced goods, EXCEPT spend it on newly-produced consumption goods. It is defined negatively, so to speak.

So planning to buy antique furniture with part of your income is "saving", for example. And what I am arguing is that an excess supply of "saving", if it took the form of a demand for antique furniture, could never cause a recession (unless it caused an excess demand for money as a side-effect).

The same argument would apply if you planned to save in the form of buying bonds, and this is regardless of whether or not the price of bonds clears to eliminate the excess demand for bonds.

It's only an excess demand for money that causes problems.

Here's one thought-experiment, for example: suppose the government passes a law making it illegal to borrow or lend money below 10% interest. And suppose the natural rate is 5%. (Assume zero expected inflation for simplicity). So the market rate of interest cannot fall to the natural rate, just like in Paul Krugman's diagram, only for a different reason. Does this make a recession inevitable? No.

There will be an excess supply of loans at full employment. Unable to lend as much as they want, what will people do with their income? Ignoring other assets, for simplicity, they can either spend it on consumption, or hold it as money. If they spend it on consumption, we can stay at full employment. But if they decide instead to hold it as money, we get an excess demand for money, and we do have a recession (unless the supply of money increases enough to eliminate the excess demand for money, so they spend on consumption instead).

Here's a second thought-experiment. The diagram is exactly like Paul Krugman's, where the natural rate is negative. The zero nominal bound is what prevents interest rates falling to the natural rate. In my way of thinking, the reason this creates a recession is that when interest rates fall to zero, all desired saving will be a desire to save in money. So it's a problem only because it creates an excess demand for money. Suppose people could use barter, with transactions costs only slightly higher than through monetary exchange. Unemployed workers, who cannot sell their labour, would do barter deals with firms, who cannot sell their output. "Gimme a job, and pay me in cars". He then goes to craigslist and swaps the cars for stuff from other workers, who also get paid in their firms' output.

In both thought experiments, people want to buy more claims to future output, and are prevented from doing so (by the legal minimum interest rate in the first case, by the zero bound in the second case). But it doesn't cause a recession. They end up having to consume current output instead. In the first, we can avoid an excess demand for money; in the second, we avoid the consequences of an excess demand for money, by allowing barter exchange.

JKH: But Paul Krugman in that case was pointing out an error made by a historian. It isn't obvious that a fall in interest rates would be good if caused by the central bank's monetary policy, but bad if caused by the government's fiscal policy. Gotta give those guys a break!


Why not?

Because such formulas don't apply to cause and effect relationships.

(In response to the query: Could an excess demand for antique furniture cause a general glut of everything else, a drop in aggregate demand, unemployment, and a recession?)

Nick, sorry just took a quick glance (taking a break from cleaning house!) but do take exception to this:

"So planning to buy antique furniture with part of your income is "saving", for example"

Doesn't that show up in the GDP numbers? I would think the person who sold it to you provided a service and the income they made for the service is counted in GDP. I don't know, I'm actually asking (it's not a retorical question).

asp: I think I get your point. Let me re-phrase my original question:

Start in equilibrium. Then there is a sudden change in preferences, away from newly-produced consumption goods and towards antique furniture. Could that change in preferences cause a drop in aggregate demand, unemployment, and a recession?

Adam: The services of antique dealers, measured (I think) by the spread between their buying and selling prices, is part of GDP. But the sales of antiques themselves aren't. Assume for simplicity no dealers; all private trade.


"Don: yes, if the general price level adjusted instantly, so that an excess demand for money were always eliminated instantly (I think of it as a fall in the price level increasing the real supply of money. M/P), we wouldn't have to worry. But I think it doesn't. (Plus, we have to worry about how expected inflation might react to a change in the current price level, because that might affect the demand for money in the wrong direction)."

I don't think that an instant response is rquired, but it is the dollar prices of goods actually purchased that comes into play within a single pay period that likely attempts to bring dollars held into equilibrium with dollars demanded. While expected inflation will strongly affect investment choices, low/moderate inflation levels are unlikely to much affect pay period money holding since holding is already a sacrifice for positive interest rate opportunity costs even if there is no inflation.

Regards, Don


Following along from Krugman’s suite of diagrams, could you please specify how we should think properly about the demand for money as a stock (LM, I guess) versus the demand for saving as a flow (IS, I guess). Then, exactly how do you describe or categorize in a similar and integrated way the demand for money as an outlet for saving?

Nick, from Sumner's blog: "To illustrate the challenges the nation faced last year, Buffett showed a sales receipt for $5 million in U.S. Treasury bonds that Berkshire sold in December for $90.07 more than face value, ensuring a negative return for the buyer. Buffett said he doesn’t think most investors will see negative returns on U.S. bonds again in their lifetimes."

that's quite a demand for bonds, do they count as a medium of exchange?

Adam: Ah! Now I understand your point (I misunderstood you when you made it on Money Illusion). No, bonds are definitely not media of exchange. If I own bonds, and want to own a car instead, I do not take my bonds to the car/bond market and do a trade. There is no car/bond market. Instead, I first take my bonds to the bond/money market, sell them for money, than take my money to the car/money market, and sell it for a car.

Clower's point is that in a monetary exchange economy, with n different goods, there are n-1 markets. (A non-monetary economy has n(n-1)/2 markets.) And we know which good is money because it is traded in every market, while every other good has only one market in which it is traded.

JKH: Good question. I wish I could give it a good answer. I can't. Because I'm not clear enough on the answer.

An individual's stock of money is a buffer stock/inventory, held to cope with lumpy and sometimes unexpected inflows and outflows (receipts and expenditures). If we take a long enough time period, and smooth the jagged ups and downs of that stock over that time period, we can talk about a desired average target stock, that individuals plan to move slowly towards. The LM curve is an attempt to model that desired average target stock, and the conditions under which the desired would equal the actual stock. The problem arises when we try to model the economy as being "on" the LM curve all the time (or getting there very quickly). When we do this we forget: that the desired stock represents a smoothed average over a longer period of time; and that one individual's attempt to move towards his desired average stock may interfere with other individuals' attempts to do the same thing.

So Nick, back to my question. Is the problem excess demand for media of exchange (plural intentional) or excess demand for saving?

Surely we can agree that treasury bonds are savings instruments.


I have this crazy idea way in the back of my mind that what made Keynes an extraordinary economic thinker was his ability to formulate sentence syntax as a conceptual differential equation. He could do this seamlessly, without numbers, in support of his argument. That’s my impression from reading pieces of The General Theory.

I think Krugman attempts to do that, but he’s not as good at it.

But that’s the kind of thinking I’m looking for in answer to my question. That is, unless I don’t know what my own question means, which is very possible.

Adam: Treasury bonds are certainly "savings" instruments, under the standard definition of "savings". But so are antiques. Neither are media of exchange.

By the way, to expand on my "Clower, n-1 vs n(n-1)/2 point":

Suppose there are n different goods. Line them up in alphabetical order (apples, bananas, carrots, dates...etc.) Now make a symmetric nxn matrix, with all the goods lined up both vertically and horizontally. (Wish I knew how to draw diagrams, sorry).

There are n^2 cells. How many of the cells contain an active market?

Eliminate the main diagonal, because nobody wants to trade apples for apples, or bananas for bananas, etc. So we are down to n(n-1) possible markets.

Next, eliminate all the cells on one side of the main diagonal, because if there is a market in which apples can be swapped for bananas, it is also a market in which bananas can be swapped for apples. So we are down to n(n-1)/2 possible markets.

We now have a picture of a direct barter exchange economy, with n(n-1)/2 markets.

But if people can use indirect barter, we can eliminate still more markets. If I want to swap bananas for carrots, I can swap bananas for apples, then apples for carrots. So we can eliminate the banana/carrot market as unnecessary. But people are now doing 2 trades where only 1 trade can do the job. (There must be some underlying story of transactions costs to explain why it's cheaper to do 2 rather than 1 trade, and since Menger, Alchian, etc., there is such a story).

If only one good is used in indirect barter (the one with the lowest transactions costs), then we can eliminate all but n-1 markets. And that good is the sole medium of exchange. We have now described a monetary exchange economy. If apples are the medium of exchange, there is a market in the row (or column) next to apples, but none elsewhere. Apples are money. None of the other goods is money.

A market (and only a market) can be in excess demand (or supply). If apples are money, there is a unique market for every other good, which can be in excess demand or supply or equilibrium. But there is no unique market for apples. The apple market is every market. So I am both wrong to talk about the "excess demand for money", because it is not well-defined, as there are n-1 definitions, in principle. But I am right to say that if something is screwed up in "the market" for apples, then the market for every other good must be screwed up as well.

The medium of exchange matters in a way that other goods don't. Money really is special, and weird, because it's the medium of exchange.

So Nick, back to my question. Is the problem excess demand for media of exchange (plural intentional) or excess demand for saving?

Or are you trying to say they're the same?


Thinking out loud here, and way over my knowledge level:

It seems like the medium of exchange has value because it is an accounting mechanism for income. Income is ground zero for non-barter, isn’t it? Or maybe this is the medium of account view that Scott Sumner talks about. I’m not sure of the difference or its importance.

Anyway, as an accounting mechanism it then has two different values:

a) Value in “simultaneous” exchange, a limiting case
b) Value in deferred exchange, which leads to interest rates

Then, is there a distinction between a collateralized and non-collateralized medium of exchange – e.g. gold versus paper?

Make any sense?

A few brief comments. I don't like the Krugman link others talked about, because he assumes that monetary policy cannot shift IS. But it can, as I believe Krugman himself acknowledged in other contexts (when he spoke about creating inflation expectations.) If I'm wrong, show me the effect of the BOJ announcing it will sell unlimited yen at 1000 to the dollar, in terms of the IS diagram shown by Krugman.

JKH raises a good question about media of account. My view is that gold has a value from non-monetary uses, but monetary uses may increase that value. The value of fiat currency comes from monetary uses. For the U.S. dollar the main use of base money is as a tool for hiding income from the IRS. Most base money is hoarded for tax evasion purposes. It is also a convenient tool for small denomination transactions--although I think this use will disappear in a few decades. The U.S. may eventually have to go with interest-bearing electronic cash--in that case we may be back in a Keynesian world where interest rate control is all we need. But I'll be dead by then so I won't have to worry about commenters like JKH saying they were right all along. (Just kidding JKH.)

Nick, I agree with your view on the distinction between money and credit. Nice post.

"Most base money is hoarded for tax evasion purposes"

Whoa. That's quite a claim. Absent supporting data my tin foil hat detector is going to go off.

Scott says: "I don't like the Krugman link others talked about, because he assumes that monetary policy cannot shift IS. But it can,as I believe Krugman himself acknowledged in other contexts (when he spoke about creating inflation expectations.) "

Scott, what you said represents a fundamental misunderstanding both of the IS curve and what Krugman said when he spoke of creating inflation expectations.

In the diagram that Krugman drew, the IS curve, had the REAL interest rate on the vertical axis (the IS-LM model holds prices fixed so in the usual, non-liquidity trap case, changing the nominal rate changes the real rate one for one). The central bank creating inflation expectations does not shift the IS curve it just allows the possibility of choosing a point on that curve with negative r.

Adam P: "

So Nick, back to my question. Is the problem excess demand for media of exchange (plural intentional) or excess demand for saving?
Or are you trying to say they're the same?"

I'm saying they are different. The problem is an excess demand (or excess demands) for the medium of exchange, not an excess of savings in general. If people wanted to save in the form of bonds, stocks, newly-produced investment goods (of course), antiques, etc., we wouldn't be having this problem.

JKH @ 8.55: I think I understand what you mean. You would like a clear verbal description of the dynamics at the back of my mind for the monetary transmission mechanism, with both stocks and flows, and individual and market experiments (what each individual is trying to do, and what is happening when all individuals try to do the same thing). Tall order, unfortunately. Some day I may try. (But I first need to get my own head clear!)

JKH @ 9.39 : The "medium of account" is the good in terms of which prices are quoted. We could measure prices in gold, for example, even if we actually bought and sold goods for dollars (so that dollar bills are the medium of exchange). And the unit of account is the quantity of that the medium of account (ounces of gold vs kilograms of gold, for example). In principle, the medium of account could be a good that doesn't even exist. There is even a small literature on the history of "imaginary" media of account. But I find it hard to figure out how the general price level gets determined with a purely imaginary medium of account. England used to (maybe still does) come close to having an imaginary medium of account, when prices for certain goods were quoted in "Guineas", which disappeared centuries ago. But the convention that "one Guinea" meant one pound and one shilling kept prices determinate.

Normally, the medium of account is some good that actually exists, which may or may not be the medium of exchange (it usually is the same, because it's usually easier, except in hyperinflations or border zones, to quote prices in the same good as what you will actually be using to buy the thing). So there has to be a demand and supply for the medium of account. But, as nobody needs to actually hold a medium of account in order to use it as a medium of account, it is not obvious that the demand for the medium of account is affected by it's being used for that purpose. (Though it is conceivable that price stickiness could make the medium of account a good asset to hold as a store of wealth).

However, the fact that a good is used as a medium of exchange does create an additional demand for it, over and above any non-monetary ("industrial") uses. Given imperfect synchronisation of inflows and outflows of money, we need to actually hold stocks of money in order to use it as a medium of exchange. Without that demand to hold it as a medium of exchange, irredeeemable paper money, for which there is no "industrial" demand (numismatics and Zimbabwe dollars used as toilet paper aside), paper money would be worthless, even if the supply were limited, and so it could not function as a medium of exchange or medium of account.

Scott and Patrick: Scott's statement about most paper money being held for tax evasion and other illegal stuff is not an uncommon view (I hold it myself, roughly). There are economists who do empirical studies of the underground economy based on the demand for currency. Though there is probably harder evidence, the sheer quantity of currency per capita, compared with anecdotal evidence of how much most people hold in their pockets, makes this hypothesis plausible.

In the Mankiw, Kneebone, McKenzie and Rowe first year text (I looked the data up myself) it says $1,550 per adult (>14) in 2003 in Canada. And $2,900 in the US (Mankiw's figure). I hold about $100 on average myself, and I am richer than average.

Scott and Adam: If monetary policy can affect real output (sticky prices), and future real output, and expected future real output, then it can affect current consumption and investment decisions (via the Euler equations), and also shift the IS curve. This is quite apart from any effect it might have on expected inflation and the wedge between real and nominal interest rates. Moreover, the ISLM assumption that an excess supply of money spills over only into the bond market, which clears immediately, and not into any other markets, like the forex market, the stock market, or directly into the market for newly-produced goods, is just that -- an assumption. Maybe the relevant portfolio choice is not (or not just) money vs bonds but money vs consumer durables, or producer durables.

Gotta go argue with Scott at his blog on the importance of medium of exchange vs medium of account!

Nick, Scott: If you're saying that lots of cash is hoarded by a few shady characters (drug dealers with suitcases full of 100's), as opposed to wide spread use of cash to avoid taxes by otherwise law abiding people, then I withdraw my objection.


If oil is priced in dollars and somebody pays for it in Euros, would that qualify as dollar medium of account and Euro medium of exchange?

The medium of account might be considered as the invoicing medium, and the medium of exchange as the payment medium.

Or is FX considered to be an aberration of the basic idea?

I bring up this example because its one way the dollar might gradually lose some of its reserve currency cachet, given your point that there’s more demand for the medium of exchange. (I'm not sure, but I think Iran is paid in Euros for at least some of its oil.)

And the whole account/exchange distinction seems to have an analogue in foreign exchange generally, as in purchasing power parity for example; i.e. an analogue where the medium of account and the medium of exchange are different.

BTW, my comment re Keynes was more an observation than a request. Your previous explanation was good.

Nick: "I'm saying they are different. The problem is an excess demand (or excess demands) for the medium of exchange, not an excess of savings in general. If people wanted to save in the form of bonds, stocks, newly-produced investment goods (of course), antiques, etc., we wouldn't be having this problem."

No Nick, you've got it backwards. In order to say there is an excess of something you have to specify the excess over what. Investment (real investment that is) demand is basicaly the supply of savings, the problem is that the demand for saving is in excess over the demand for investment. The excess only gets held as money because it has nowhere else to go. But the savers are holding money not as medium of exchange but as store of value, they're also holding government bonds.

Furthermore, the problem is desired savings exceed demand for real investment. If it all went into antiques (to be held as store of value) we get exactly the same recession problem BECAUSE NOBODY IS EMPLOYED TO BUILD THE ANTIQUES and the antiques don't add to our aggregate consumption possibilities.

JKH: your oil/dollars/Euros example is exactly the distinction between medium of account and medium of exchange. Forex is probably the best real-world example of the distinction between what prices are quoted in and what people pay with.

Adam: we both agree that if (starting from full equilibrium) there is an increased desire to save in the form of investment in newly-produced goods, that doesn't cause a problem of deficient aggregate demand. That's why I wrote "(of course)" in the sentence you quoted, because I knew you would agree in that case.

But we disagree in the case of antiques, and that is important. And I realise that what I am saying is against the grain of what is usually taught and understood.

Start in full-employment equilibrium. Hold investment demand constant. Nobody builds antiques any more. There is a fixed stock in existence. In private hands (forget the services of antique dealers).

Everybody decides to save more (demand less newly-produced consumption goods) and spend their savings all on antiques. The result is an excess (flow) demand for antiques.

Hold all prices fixed, including the price of antiques. The result is that people, in aggregate, cannot implement their plans to buy more antiques. What happens next? Each individual, unable to implement his first-best plan (to spend $100 per year on antiques), is forced to go to his second-best plan instead.

The most plausible second best plan is that he spends that $100 on newly-produced consumption goods instead. If so, we stay at full-employment equilibrium. But the excess demand for antiques remains, because that is still their first-best plan. (They keep looking for antiques for sale).

There are other less plausible, though possible, second-best plans. But all of them will have exactly the same result as trying to buy antiques, EXCEPT if they decide to add $100 per year to their stocks of money (medium of exchange).


Unfortunately, I don't think that many read Clower anymore (although everyone is familiar with the "Clower constraint"). I actually have a copy of his collection of essays, Money and Markets, which should likely be required reading for anyone serious about monetary theory.

If this helps to resolve the paradox:

You could say that we stay at full employment because "second-best" desired savings (at full employment income) still equals desired investment.

But "first best" desired savings (at full employment) nevertheless exceeds desired investment, yet we stay at full employment.

It's ironic. I have taught the Keynesian Cross Investment-savings model many many times to first year students. And each year, after I have explained how an increased desire to save causes income to drop, one student, trying to understand it better, will ask "savings: is that like putting money under the mattress?". And I follow the party line and say "No, it could be putting money under the mattress, but it doesn't have to be. All it means is that you don't spend part of your income on newly-produced consumption goods".

And the first year student is basically right, and I and the party line are just wrong. He's basically right, because if you don't put the cash under the mattress, it will eventually have to be spent on newly-produced goods.

Josh: would you happen to know the titles of the two Clower essays I'm thinking about?

The first is all about the difference between the number of markets in a barter vs a monetary exchange economy. The second is about the dual decision hypothesis/constrained demands.

My copy is in my office somewhere.

Nick, you say "The most plausible second best plan is that he spends that $100 on newly-produced consumption goods instead"

No, the basic thing he wants is saving. Why doesn't he then buy a bond or a stock, basically lend/invest the money with someone who will then spend it on a real investment good and pay him back plus returns?

Nick: "There are other less plausible, though possible, second-best plans. But all of them will have exactly the same result as trying to buy antiques, EXCEPT if they decide to add $100 per year to their stocks of money (medium of exchange)."

No, if I don't have any real investment good to invest my savings in why don't I lend the money to someone who does?

Adam: I was thinking that spending that $100 on newly-produced consumption goods was the most plausible second best plan because new furniture is perhaps the closest substitute for antique furniture.

But suppose it isn't. Suppose the second best plan is that he buys a bond or stock, or some such form of loanable funds. Remember that everyone else is trying to do the same thing. I can think of 3 possibilities:

1. If the $100 extra supply of loanable funds finds no willing borrowers, because investment demand stays the same, he is lending constrained, just as he was previously constrained in the market for antiques, and we are right back to where we started, with him spending that $100 on newly-produced consumption goods as a third best plan.

2. If the $100 extra supply of loanable funds does find willing borrowers, who want to invest the whole $100, (they were previously borrowing-constrained), aggregate demand stays the same, because investment expands to offset the decline in consumption.

3. Naturally, if the extra $100 of loanable funds would only find willing borrowers by forcing up the prices of stocks and bonds (forcing down interest rates), and this change in prices leads him to choose to hold some of that $100 as cash, we get a drop in aggregate demand and a recession.

That third scenario is the implicit ISLM story.

Nick : "I was thinking that spending that $100 on newly-produced consumption goods was the most plausible second best plan because new furniture is perhaps the closest substitute for antique furniture."

But that's not how you said it. You said, I want savings and my chosen intrument for savings is antique furniture (presumably because I think it offers a high return). If I bought the furniture because it's pretty then that is consumption, not savings.

Adam: fair point. And it leads in an interesting direction: so much depends on the "framing", on what words we use to describe a decision.

1."I decide to spend part of my income on antique furniture"

2."I decide to save part of my income, in the form of antique furniture"

The first is the more natural way of talking. But the second is correct under the standard economists' definition of "saving".

I am mulling over building a very simple model, where "saving" is defined as "adding to your stock of money". And I'm thinking:

A. Would my new model (at best) just be an easier way to teach students, so they don't get hung up on special meanings of words, but lead to the exact same conclusions as a standard model with the same structure, once the words have been translated?

B. Or does the language, the framing, really matter, because a model *is* just a way of framing reality? Just as the way of framing the decision to buy antiques carries with it a host of implicit assumptions about what people would do as a second-best if they found themselves constrained in the antique market?

I came here looking for JKH (to ask him to look at my blog attempt to explain the practicalities of monetary policy implementation) and got absorbed in the content of this post. Greetings!

It seems to me that one does need an idea of the monetary transmission mechanism with both stocks and flows. It is not obvious to me what happens to a flow like output if a stock like antiques is more or less desired. As one who studied science before encountering economics as a trainee central banker, I was never convinced by ISLM, which seems to depend on various dubious assumptions, so I am sceptical when people like Krugman gloss over such basic steps saying "Econ 101" - as he does in his response to Niall Ferguson. Nor do I see why it matters much if people prefer to save in the form of money. Given that the central bank commits to trade money for debt at a fixed price (interest rate), if people want more money and less interest-bearing debt, they do not have to drive the price of debt down much before they can have all the money they want. The supply of loanable funds is simply channelled via the central bank instead.

Nick: "I am mulling over building a very simple model, where "saving" is defined as "adding to your stock of money"."

If you do that your model is useless before it gets built. Fundamentaly saving is a substitution of less consumption today for more consumption tomorrow. SAVING ONLY ADDS TO YOUR STOCK OF MONEY WHEN THERE IS NO REAL INVESTMENT DEMAND TO ABSORB IT. The fact that right now it seems as though people are saving by hoarding money is a symptom of the excess demand of saving over demand for investment. It is not the cause of anything.

RebelEconomist, Krugman is using ISLM as a simple context for making a point that is valid in proper intertemporal models. I can assure you he knows quite well what he's saying and he's quite correct. I should add that the point is actually far SIMPLER than people seem to be making it out to be.


Maybe Krugman does know what he is talking about, but for me, he fails to prove it. In this case, the handwavy bit was "some of this increase in income will be saved, pushing the savings schedule to the right. There may also be a rise in investment demand, but ordinarily we’d expect the savings rise to be larger, so that the interest rate falls". I immediately thought "Why? It's not obvious". I had a similar impression of his debate with Fama (and made a comment to that effect on his blog, but Krugman does not respond to comments). Considering that he is advocating massive shifting of resources, Krugman's arguments lack rigour.


Briefly the idea is something like this:

1) Consumption: Start out in a case where we are in equilibrium so at the current interest rate you are happy with your consumption levels for today and tomorrow (ignore the uncertainty in tomorrow's consumption). Now I give you more income today but hold tomorrow's consumption unchanged (and prices/interest rates have not yet changed). Since you where before at a maximum you were indifferent between an extra bit of consumption today or tomorrow. Now you have extra consumption today and so by the usual declining marginal utility idea your marginal utility of today's consumption has fallen below your marginal utility of tomorrow's consumption. Thus, to re-establish your first order condition you need to reduce today's consumption and increase tomorrow's. Thus, the fact that you want to save some is not an assumption but comes from the fact that you're maximizing utility.

2) Investment: Still assuming prices/rates have not yet changed. Firms maximization problem says they want to employ capital until the marginal product of capital (MPK) equals the real interest rate. Since rates haven't yet changed there is no change in investment demand. (Firms also started in an equilibrium where they were happy with current investment plans).

3) We now have a situation where desired savings exceeds desired investment. How are they re-equated? Well, the excess saving starts to drive down the interest rate. This has two effects, it reduces saving demand by making tomorrow's consumption more expensive (in terms of today's) and it increases investment because reducing the real rate means firms need to increase the capital stock to re-establish MPK = r (declining MPK). The real rate falls until savings demand and investment demand are equal.

So in the simplest, baseline model you actually expect no extra investment just from the increase in income. The added investment comes from the lower interest rate.

Hi Rebel!:

JKH will probably see it. I may wander over to your blog too, and take a look.

If there's an excess demand for money, and the central bank can and DOES immediately satisfy it by increasing the supply, that solves the problem. But I am not so sure it can obviously satisfy it, under present circumstances, without using quantitative easing to bypass the banking system. Have a look at my recent post http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/04/bad-banks-and-the-effectiveness-of-fiscal-and-monetary-policies-on-ad.html , especially the comments at the end.

On savings, investment, and income:

Let's assume the opposite to Paul Krugman, so that an increase in income causes investment to increase more than savings increases. [This means the marginal propensity to consume plus the marginal propensity to invest must be greater than one.] The result is an upward-sloping IS curve, rather than the normal downward-sloping one.

Provided the LM curve is steeper than the IS curve, (and that the rate of interest adjusts to keep us on the LM curve more quickly than output adjusts to keep us on the IS curve, IIRC), the ISLM equilibrium is still stable. An increase in government spending will shift the IS curve vertically upwards (n.b. not rightwards), and cause income and the rate of interest to increase, as in the normal case.

But monetary policy now has weird effects. An increase in the supply of money, moving the LM rightwards, will now cause income to rise, as in the normal case, but the rate of interest to rise too, which is the opposite of the normal case.

But if the central bank uses monetary policy to hold the interest rate fixed, so the LM curve is horizontal, the ISLM equilibrium is unstable (under the assumption I made about the adjustment speeds of interest rates and income).

Here's the intuition. If the central bank loosens monetary policy and cuts interest rates, consumption and investment will expand, which causes income to expand, which causes an even bigger expansion in income in the second round, etc. So the simple multiplier, holding the rate of interest constant, is infinite. To prevent income rising to infinity (remember this model ignores the aggregate supply constraint), the central bank needs to raise interest rates enough to choke off further increases in demand. So interest rates must rise by more than the initial fall, and eventually end up higher than where they started.

Actually, once we start thinking about investment responding to expected future income, rather than current income, this weird unstable case is not at all weird. If monetary policy could restore confidence in future demand, investment and consumption demand will increase, and interest rates could actually rise. (This is one interpretation of what Scott is saying when he says that monetary policy can shift the IS curve).

Adam: I'm still thinking how best to respond. Not ignoring your comment.

Nick: "Actually, once we start thinking about investment responding to expected future income, rather than current income..."

Krugman pretty much said he had an econ 101 version of the model in mind which is entirely a comparative statics excercise - you start from equilibrium and then you change current income holding all future expectations constant.

Adam @ 12.25: we were posting at the same time.

That's a clear exposition of the New keynesian approach, but it leaves something out.

Think about the labour market first, before switching to capital.

It's been known since Patinkin (1955, or 1965?), but forgotten by almost everyone, that the MPL(L)=W/P condition for labour demand is invalid when the firm is constrained in the output market, and cannot sell as much as it wants. In the simplest model, it gets replaced by L=F^-1(y), where y is the constraint on sales, given by the demand side. The firm only hires as much labour as it needs to produce the output it can sell, regardless of real wage, provided MPL>W/P

We could do the same thing for capital services. The firm chooses the mix of capital and labour services to minimise the cost of producing the level of output it is able to sell, y. In this case, y enters as an exogenous variable (along with the real rental rate R/P and W/P) in the capital demand function.

That is an interpretation of what the old Keynesians were talking about with their accelerator model of investment. If firms were able to sell more output, they might increase investment, even if the real interest rate stayed the same. Just as they might demand more labour, even if the real wage stayed the same.

(I'm not sure how this gets handled in sticky-price monopolistic competition NK models.)

The IS-LM model leaves lots out, that's why it doesn't appear in graduate school (I had to read myself, after graduation). I was giving the econ101 version, so was Krugman.

We can fight over what complications matter and which don't forever, Krugman's point is valid.

Adam, I agree Krugman had a ec101 model in mind, but is that the model he should be using to prove his points? Models where monetary policy doesn't affect expectations? OK, then we have a long run Phillips curve again, just keep accelerating the rate of inflation. I'll admit I thought he was using the nominal interest rate (as in EC101) but my point remains. You can't assume monetary policy doesn't shift expectations. And by the way, Robert King showed as far back as 1994 that monetary policy shifts the IS curve even using the real rate, again through expectations. After all, in a severely depressed economy if monetary policy creates inflation expectations, it is almost certain to also change the expected real growth trajectory.

Someone asked for evidence of currency hoarding. If anyone is idiotic enough to want to look at my dissertation, it was on that topic. I also published an article in the early 1990s on the subject. I found that hoarded currency in the U.S. was highly correlated with the ratio of marginal tax rates to nominal interest rates. I interpreted that ratio as the number of years you could hoard cash and forgo interest, before you would have been better off reportaing the income and paying taxes in the first place. Nick's evidence suggests that some U.S. cash is hoarded outside the U.S., although the difference with Canada is a bit smaller than he indicated, I believe. Again, tax evasion may be a motive, otherwise foreigners might (in normal times) prefer interest-bearing dollar (or euro) accounts. Yes, rates are now near zero, but cash demand was almost as high a few years ago (surprisingly.)


I did a quick scan of your post the other day. Rather than rush, I’ll plan to drop off a comment hopefully at some point next week.

As I understood the original debate at the time, Krugman rejected arguments by Cochrane et al on the basis that the CURRENT identity between savings and investment is not a constraint on the magnitudes of each changing over time, due to “other factors”, while preserving the identity at each point in time. I believe the interpretation that the identity is a constraint on movements in the current magnitudes is known as the “Treasury View”. What I find baffling about explanations from there by Krugman and others is that the ISLM dynamics are difficult to follow when they venture into savings and investment not being equal. How are they not equal in an actual situation? I get totally lost between such a situation and the ultimate identity constraint. This is the type of thing where I think Keynes had superior pure descriptive ability, as I noted in an earlier comment. Given that Krugman’s original point was on the correct dynamics of the identity, I can’t figure out why the explanation of the true operation of the identity over time is so difficult to follow.

I am truly confused in a fundamental way on this issue.

Scott, I take your point about whether the model is good enough for policy critiques. I wasn't arguing it was, that would be another long discussion no doubt :).

The model (econ 101 variety) keeps prices completely fixed so changes to nominal rates are one-for-one changes in real rates, hence the distinction is not always made clear. Even adding in intertemporal utility maximization gives the model more micro foundation then the usual econ101 variety, usually you just give a constant marginal propensity to consume (assumed between zero and one).

But at the end of the day you're doing comparitive statics, partial equilibrium. If you try to make it dynamic you get silly stuff like a long run phillips curve, that's why I don't do that.

And btw Nick, I actually lied before. I did cover Mundell-Fleming in international macro, basically open economy IS-LM.


Regarding the dual constraint: "A reconsideration of the microfoundations of monetary theory."

Also, I might be wrong, but regarding money and barter, I think that you are referring to his introduction to Monetary Theory: Selected Readings.

Thanks Josh! Yes, "A reconsideration of the microfoundations of monetary theory." was definitely one. I will have to check on the other.

JKH: Let me have a go. It's not really dynamics vs statics. It's the distinction between quantity demanded vs quantity bought. Quantity of apples demanded is the quantity that people want to, or desire to, or plan to buy, ex ante, if you like latinisms. Quantity of apples bought is the quantity they actually buy, ex post. Quantity demanded equals quantity bought only in equilibrium. But quantity bought equals quantity sold by definition.

(And forget quantity supplied, because these models don't have a supply-side, or else we are off the supply curve).

Instead of apples, aggregate over all newly-produced goods and services.

1. Quantity bought = quantity sold, by definition.

2. Quantity demanded = quantity sold, only in equilibrium.

The dynamics work like this: If we start in equilibrium, then suppose quantity demanded increases, we assume that firms will respond to that excess demand by increasing output and quantity sold. So actual quantity bought will adjust to equal quantity demanded. (Remember we are ignoring the supply side, of whether firms would find it profitable to increase output and sales).

Now, you might ask: what's all this got to do with Savings = Investment?
Answer, it just a way to rearrange the above two equations.

Forget government spending, taxes, exports, imports.

Divide all quantities bought (demanded) into consumption (demanded) and investment (demanded).

Define "income" as quantity sold and divide income into consumption and savings, where " is just defined as "income minus consumption", so it's true by definition.

We can rewrite equations 1 and 2 as:

1'. Consumption bought + investment bought = quantity sold = consumption bought + actual savings

2'. Consumption demanded + investment demanded = quantity sold = consumption demanded + savings demanded (aka desired savings)

Simplify 1' and 2' by subtracting consumption from both sides to get:

1" investment bought = actual savings (true by definition)

2" investment demanded = savings demanded. (true only in equilibrium)

So really, it's just a very roundabout way of thinking about whether the quantity of goods that people want to buy will equal the quantity they actually buy, and what happens if they are different.

I have no idea if that helps at all.

I thought it was good Nick. But...

Every thing you said refers to REAL quantities. In the liquidity trap your 1'' doesn't hold. We have investment bought < actual savings, THAT'S WHY PEOPLE END UP HOLDING EXTRA MONEY.

It's not the money they want but the money is giving them a better return then 1) they require to hold it; and 2) real investments. It's not an excess demand for money!!!

Thanks, Nick.

That helps.

"Savings demanded" is a phrase I need to get my mind around. Seems abstract in an unusual way. Also takes me back to the stock/flow thing with money and savings.

Your patience with elementary questions is always appreciated.

JKH: Yep, I find it hard to think about "savings demanded" as well. "Desired savings" is perhaps better. "Savings supplied" sounds much more natural, to my ear, because we can think of people supplying loanable funds. But then desired savings is not really the same as the supply of loanable funds, since desired savings also includes putting cash under the mattress. It includes investment as well: if I want to spend part of my income on newly-produced investment goods, that is both desired savings and desired investment, but we can think of this as me lending money to myself, so it appears both on the supply and the demand side of the loanable funds market, and therefore cancels.

The basic problem is that "desired savings" is defined negatively, as income from the sale of newly-produced goods minus demand for newly-produced consumption goods. That's why it's so hard to think of it in concrete terms.

Adam: I think 1 and 2 (or 1' and 2', or 1" and 2") can be defined in either real or nominal terms. Just divide or multiply by some common P.

But I am really worried by your: " In the liquidity trap your 1'' doesn't hold. We have investment bought < actual savings, THAT'S WHY PEOPLE END UP HOLDING EXTRA MONEY."

I thought our roles were: I'm the old guy, mumbling weird, heterodox heresies, from ancient economists; you are the smart young guy, trying to keep me on the straight and narrow modern orthodoxy.

Now I've suddenly got to switch roles, because you have taken my role! You are echoing a view from 1920s and 1930s British monetary theory: Robertson, Hawtrey, Hayek, etc., that the excess of savings over investment adds to money balances. You only hear that view nowadays from the Austrians, who hold that central banks increasing the stock of money creates some sort of excess of investment over savings -- "forced savings" in the older terminology.

It's not wrong what you said. But you are using "saving" in a non-orthodox way. Actually, the way you are thinking is closer to my way of thinking: you divide income into demand for consumption, supply of loanable funds, and demand for additional money.

So, you can see why I'm flummoxed!

A wonderfully clear explanation Adam, thanks! I was assuming that the rise in income was permanent. I must hang out here more often! Presumably, Krugman is making the assumption that a fiscal expansion can indeed boost income, which gets back to the question raised by Fama or Cochrane about why fiscal expansion boosts income when the government expenditure involved has to be funded somehow (which I guess is the same as JKH's point here). I don't expect you to answer that though; that issue was probably discussed here at the time!

One wonders about the wisdom of teaching ISLM "which leaves lots out" in a first macro course, while leaving the intertemporal microfoundations for a graduate course. No doubt the reason for that is that the intertemporal explanation is normally expressed in terms of difficult mathematics, but it surely does not have to be like that. But then the teaching of economics is another debate.

"We have investment bought < actual savings, THAT'S WHY PEOPLE END UP HOLDING EXTRA MONEY."

This is way about my head, but I would just add this: Does 'investment bought' include deleveraging? In the current environment, I don't see many people holding wads of cash, but their sure seems to be lots of people throwing every dollar they can get their hands on into holes they dug in the 2003-2007 time frame.


As a first thought (it's late here in the UK) on whether it matters who the central bank buys assets from when doing QE, I would say that it does not matter. Assume the central bank could buy, say, government bonds from either a bank or a pension fund. If it buys from the pension fund, the central bank will pay base money into the pension fund's bank, which will in turn credit the pension fund's account with them. If the pension fund subsequently wants to draw down their deposit but the bank wants to hang on to the base money, it can raise a similar amount of base money by selling in the market the bonds that it could have sold to the central bank. In other words, because the central bank pays for the bonds in base money, and because base money is used to settle payments, if desired, the banking system can reach the same position regardless of whether the bonds are purchased from banks or non-banks.

Nick, what I'm saying is a bit more basic than that. We both agree that QE is correct the difference is that you, more or less (I don't want to put words in your mouth) believe that the money supply today is the problem and I think you need to lower real interest rates (in this case by creating expected inflation).

Now the normal way it's supposed to work is if I'm a saver and you're an investor I buy financial assets, for example a demand deposit at a bank. The banking system/financial markets channel the funds to you and you invest (either funding yourself through debt or equity). My point here is nothing more than the fact that even in normal times, from my point of view I save by buying financial assets.

Now, today we have a situation where the amount I want to save exceeds the amount you want to invest. I don't know that though, so I do the usual thing and buy some sort of financial assets. The problem is that the market doesn't have any place to channel the funds so they just sit as money. But, from my point of view, I don't want the money as a medium of exchange. Quite the opposite, I'm trying consume less now in return for more later.

But this: "You only hear that view nowadays from the Austrians, who hold that central banks increasing the stock of money creates some sort of excess of investment over savings -- "forced savings" in the older terminology."

This is not at all what I'm saying. I was trying to make the point more stark that my savings level is determined by feeding the relative prices of today and future consumption into my first order conditions for intertemporal utility maximization (consumption Euler equation), you can't change my behaviour without changing those relative prices (that is, real interest rates). Printing money doesn't "satisfy my excess demand for medium of exchange" because what I really want is higher future consumption and only more real investment can give me that.

Same statements go for real investors trying to maintain MPK = r, you have to change the real rate to get them to invest more. It comes directly from the condition of maximizing discounted present value of all real profits.

Rebel, I agree. It doesn't matter who they buy the assets from. My reasoning is simple though, I think it's all about interest rates.


I might be doing you an injustice, but when you say that "the funds....just sit as money" you seem to be missing the details of how base money is supplied and collateralised (and even if you do know, you may be misleading others). Apart from the facts that money can be used as the medium of exchange and the unit of account, there is not much difference between a banknote and a corporate bond, especially in a QE regime. If savers are so risk averse as to favour a zero duration, zero credit risk, statutorily liquid asset, and the central bank believes that this behaviour is undesirable, the central bank can simply supply more money by buying, say, the corporate bonds that the same savers might have bought in normal times. Given the nature of this extra demand for money, the extra money supply poses no inflationary threat. In this case, the central bank is just acting as a financial intermediary. In fact, in theory, the central bank could buy the corporate bond at the normal price so that corporate activity (eg investment) proceeds undisturbed, and the issue reduces to one of whether the savers are irrational to be so risk averse, in which case the central bank (and ultimately the taxpayer generally) ends up richer, or whether the savers are realistic, in which case the central bank (and taxpayers) end up poorer.

Economics textbooks are poor at covering the practical details of monetary policy implementation, especially recent developments, which is why I wrote the blog post referred to above (as I said, I used to be a central banker, working in market operations). If you are a bit hazy about the mechanics, you may find it helpful; if you are fully aware of how it works, I apologise.


You're not really doing me an injustice since I know nothing of the details of how base money is supplied and collateralised. However, my point had nothing to with the details of how base money is supplied an collateralised.

My statement, "the funds... just sit as money" can be changed to "the funds just sit", in whatever arbitrary form. The "as money" part was because I had in mind a very simple financial structure where the only financial asset savers buy is demand deposit accounts.

When you say "If savers are so risk averse as to favour a zero duration, zero credit risk, statutorily liquid asset..." you're missing the details of how investment is determined. You said "the central bank could buy the corporate bond at the normal price so that corporate activity (eg investment) proceeds undisturbed". That presumes corporate investment activity is not zero.

Suppose that the required return on real, risky investment is 3%, this comes from a risk-free real interest rate of -2% and a 5% risk premium. The central bank intervention you refer to can solve the problem of savers being too risk averse but investors are people too. They also are risk averse, they will only undertake the investment project if the expected return over their financing costs (everything real, not nominal) pays them the risk premium.

Now, suppose that past investment has driven the marginal product of capital, (real, risky capital) to 1%. No investment gets done and the central bank can do nothing about that because these things are all determined on the real side of the economy. MAKING CREDIT MORE AVAILABLE ONLY HELPS IF SOMEBODY, SOMEWHERE WANTS TO BORROW.

Real savings and real investment demands are determined on the real side of the economy by real interest rates and the real risk-premium. Monetary policy only affects these decisions by changing the real interest rate (well in the baseline model). In particular, generating inflation expectations is how you lower the real rate when the nominal rate is zero.

Now, there are many coherent stories in which monetary policy works by changing the real risk premium or relaxing constraints, getting credit to someone who wants to borrow and invest but somehow can't get credit. For example, you might reasonably assume that corporates are risk neutral, then they may want to invest but can't because savers want a higher risk premium then current investment opportunities offer.

However, that's not the story Nick is telling. In the basic model investors and savers, in aggregate, are just people, they're just us. Furthermore, in none of these alternative stories is there really an excess demand for money per se.

BTW, it should be clear that the investment demand being zero is just a stark example. The point is that the demand for funding may be too small to put all the savings to use.

One more follow up, just to pre-empt a potential objection. We usually do not assume that firms are risk-neutral nor do we assume (in the basic model) that they maximize profits. We assume they maximize firm value which is the risk-adjusted, discounted present value of all expected profits. This is, btw, also the correct things for firms to do from the point of view of maximizing social welfare.


“The basic problem is that "desired savings" is defined negatively, as income from the sale of newly-produced goods minus demand for newly-produced consumption goods. That's why it's so hard to think of it in concrete terms.”

That for me is the most profound characteristic. I’m always sceptical of arguments that don’t treat savings explicitly as a residual or dependent function. That’s why I have a problem with “demanded”, or “desired” for that matter, as both of those words seem to imply some independent intention.

“But then desired savings is not really the same as the supply of loanable funds, since desired savings also includes putting cash under the mattress.”

This is very interesting. I’m not sure I agree. I think it probably a false comparison, as follows:

Saving equals investment ex post, in aggregate, and in a closed system.

The aggregate “texture” of saving is fundamentally different than investment, because individual economic units can “short” saving. They can’t short real investment. Saving uses finance as a channel through which to connect to investment, and finance allows short positions in saving; i.e. borrowing more than income in order to spend on consumption. There is no such thing as the shorting of real investment flow, however (leaving aside depreciation, which is an entirely separate measurement area).

Therefore, there is a network of long and short positions of financial intermediation that is either “buried” within, or separate from, depending on how you want to define micro level terms, the net aggregate positive saving position of the economy in question.

Nick, this overlaps with our earlier discussion of gross and net debt. Taken to the limit, you can view all of financial intermediation as consisting of this network of long and short positions. You can define all of these longs and shorts as saving and dissaving, or you can define none of them as such. It depends on your paradigm for the definition of savings at the micro level, where shorting is fundamental to financial intermediation.

E.g. I save by purchasing newly issued stock in a company that makes a real investment. In one measurement paradigm, my saving exists in the form of an equity financial claim. This is offset by the company’s investment. In the event that the company makes no real investment, my saving is offset by the company’s dissaving by having issued a financial claim. Perhaps it offsets that with an operating income loss, or perhaps with zero operating income and saving in the form of cash in the bank. Generalizing beyond this example, saving includes all types of financial intermediation in the sense that the record of saving and dissaving at the economic unit level can be added up from all such micro balance sheet positions resulting from such period flows. However, one must broaden the definition of dissaving in this sort of framework to include not only dissaving from income, but dissaving from the pre-existing stock of financial assets. It gets conceptually complicated. The linkage of saving to some ultimate investment is then passed around the system like a hot potato until the necessary ex post accounting equilibrium is evident.

Returning to the example, in an entirely different measurement paradigm, the saving is not my purchase of an equity financial claim, but the addition of net worth (net personal equity) to my household balance sheet. That balance sheet equity position in itself is not securitized or “financialized” or “intermediated” in any sense, when viewed on its own as representing my saving, because it an accounting record on the liability/equity side of my balance sheet that stands independently of any type of financial intermediation that I’ve chosen in order to “execute” my desired/actual saving on the asset side of my balance sheet. So in that sense, defining micro measurement terms in that way, saving includes no type of financial intermediation. This is the measurement limit of separating the substance of the real economy from the financial economy, because all financial intermediation contributes zero to saving, because all financial claims are offset by the dissaving defined through sale or issuance of those same claims.

The hoarding of cash under a mattress then becomes one of those micro economic unit levels of financial intermediation, which may or may not be saving, depending on your micro level measurement paradigm, chosen from the above alternatives.

So I think my point is that the notion of mattress hoarding not being part of loanable funds is a false comparison. Such mattress hoarding must be matched by sale of same from another unit (from either flow or stock) or in the case of newly issued currency, borrowing by the government (unless the central bank is involved in credit easing as well). But such examples of micro level unit intermediation offset by opposite flows from other micro unit intermediation (or disintermediation) occur throughout the economy and financial system. And then the definition of these activities as micro level saving and dissaving or just plain non-saving intermediation activity depends on your measurement definition paradigm. Hoarding of cash under the mattress is another one of these micro level transactions, of which there are numerous other examples that don’t contribute directly to macro level investment, under one definition, and where all such examples contribute zero under the other.

Lots of interesting comments this morning. Not sure my brain is up to it.

Rebel @5.34: Here is my post on Krugman/DeLong vs Fama/Cochrane: http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/01/loanable-funds-and-liquidity-preference-delong-vs-fama.html The key to my way of thinking is that fiscal policy works because the initial excess demand for loanable funds creates an excess supply of money, which creates an excess demand for goods.

Patrick @6.56: No, "investment" does not include de-leveraging.

Consumption + investment (ignore government and net exports) represents purchases of newly-produced goods ONLY. We divide them into the two categories according to whether they goods are durable (investment) or non-durable (consumption). (OK, we often fudge that in practice, and treat consumer durables as consumption expenditure). Again, it's a very different use of the word "investment" than in ordinary language.

Rebel @7.07: I used to think it doesn't matter who the central bank buys the asset from in QE. And I still think it doesn't matter in normal times. But a few days ago I changed my mind, and am now not so sure. If banks have a shortage of capital, and can't extend more loans, then demand deposits can't expand if the central bank buys bonds from a bank, because the bank won't increase loans to individuals, even if it has lots of extra reserves from selling the bond. So the money supply M1 does not expand. But if the central bank buys the bond from an individual, who then deposits the cash in a bank, M1 expands. (But I'm still not fully comfortable with this idea, in my head).

Will post this while mulling over other comments.

"But if the central bank buys the bond from an individual, who then deposits the cash in a bank, M1 expands."

To repeat my view on this, that's a critical distinction in the money effect, and is central to understanding the Fed's QE impact in this environment, and also why they're quite comfortable with paying interest on reserves.

JKH @8.40: Investment is purchases of newly-produced real goods. Think bulldozers. I see no reason in principle why you can't sell bulldozers short. The only difficulty in practice is that each bulldozer (especially after it has some wear and tear) is unique. Unlike financial assets, most produced goods are unique, and so not fungible, so it's practically difficult to short them. (The exceptions are commodities like oil and wheat, which do have futures markets, and you can short them, I think. If all bulldozers were identical, I see no reason why you couldn't short them.

Now savings may take the form of purchases of financial assets, which are fungible (my TD share is identical to your TD share), and so can be shorted. But not all savings are purchases of financial assets. If I use part of my income to buy a new bulldozer (I am an owner-operator, working construction), that is savings (and investment).

At its simplest, at the individual level, if I save part of my flow of income (i.e. do not spend it on consumption goods) I can do 3 things with it: buy capital goods (investment); lend it to someone else (buy a financial asset which is the liability of someone else); hold more cash (which you could argue is the financial liability of the central bank, though I don't see it that way, and in any case, money might be something like cowrie shells, which aren't produced, and aren't the liability of anyone).

To my mind, it's that third component of saving that is crucial to understanding recessions (because money is the medium of exchange). Not sure if you are saying the same thing.

Adam @2.08: (Leaving the hardest till last!)

" We both agree that QE is correct the difference is that you, more or less (I don't want to put words in your mouth) believe that the money supply today is the problem and I think you need to lower real interest rates (in this case by creating expected inflation)."

That's roughly what I think. Except that I agree with you that changing expected inflation is important too. And I would add that changing expectations about future real income are important too. But we can't change those expectations (if they are rational) unless (future) monetary policy did actually have some direct leverage on (future) prices and real income. Otherwise, monetary policy would be like sacrificing a goat: it works only because people think it works.

I think I now understand what you are saying about excess savings and the demand for money. You are saying (just to check I have understood you) that the ORIGINAL cause of the problem is an excess demand for future consumption (relative to current consumption), that is not matched by a willingness of firms to reduce output of current consumption, and increase purchases of investment goods and thereby increase output of future consumption goods. People didn't *originally* want to hold more money. Their "wanting" to hold more money is a consequence of their failure to find investors willing to borrow their money. They don't *really* want to hold more money; they want to lend it.

[This is really helpful for me in getting my head clear(er), BTW]

Now, I disagree with you on that being the original cause, but that's an argument for another day. Let's suppose it is the original cause.

My point, in this post, is that even if that is the *original* cause, it can only create a recession if that original cause in turn causes an excess demand for money.

An excess demand for future consumption relative to current consumption MAY cause an excess demand for money, and if and only if it does so, it will cause a recession.

Similarly, an excess demand for antiques relative to current consumption MAY cause an excess demand for money, and if and only if it does so, it will cause a recession.

In your example, the first best choice is to buy new financial assets from firms wanting to finance new investment. When they are unable to do their first choice, households may want to hold more money as a second best choice. But if their second best choice was to buy present consumption instead, there would not be a recession.

In my example, the first best choice is to buy antiques. When they are unable to do their first choice, households may want to hold more money as a second best choice. But if their second best choice was to buy present consumption instead, there would not be a recession.

Gonna stop there, and mull it over some more.


Consider an example where I use my saving to buy a newly issued bond in a company that invests in a newly produced bulldozer.

My saving is reflected in the increase in the equity of my household balance sheet.

My new financial asset is a bond. The bond is the liability of the company. From a net saving perspective, the two offset. If viewed as my saving, my bond is offset by the company’s dissaving by its “short” bond position. (The company has effectively shorted bonds by issuing them.) This automatic offset of financial asset and liability is why a “purer” form of saving measurement is to identify the actual saving at the level of new equity in my household balance sheet, rather than according to the particular financial instrument I choose to intermediate my saving to real investment. That’s one of my points.

My second point is on the inapplicability of bulldozer shorting in this same context. You say you can short bulldozers. I suppose you can. This means borrowing a bulldozer, selling it, and then buying it later and returning it. I’m not sure that’s done a whole lot as the physical consequence of real investment. But more fundamentally, bulldozer shorting or any other type of real investment shorting is absolutely inapplicable in the context of GDP saving and investment:

Shorting is necessary in order for financial intermediation to occur, by definition. Shorting in this intermediation sense is the incurrence of any monetary liability, such as the issuance of household mortgages, credit card debt, business commercial paper, bonds, and government debt of all types. By extension and for consistency, it includes the issuance of equity claims, given that equity claims are in respect of a firm’s obligation to record residual income for the account of shareholder’s equity, after taking into account all other financial obligations. It includes retained earnings for the same reason. All of these things are on the liability/equity side of the balance sheet as financial claims issued, and therefore are short positions at a fundamental level, as opposed to long positions on the asset side. In my example above, the company’s issuance of a bond was a short position in saving, at the margin, or by assumption. The company shorted money or income that it didn’t have, at the margin, or by assumption. Conversely, my need to use financial intermediation in order to utilize my new equity saving position in a real investment somewhere means that a short position must be created somewhere as a result of using that route.

Conversely, shorting is not an inherent component of real investment at all. That’s the point. Not that it’s impossible to short a bulldozer, but that the act of producing a bulldozer investment as part of GDP does not itself involve shorting. In that sense, shorting a bulldozer is a discretionary balance sheet transaction occurring post the bulldozer GDP production event. Conversely, shorting in the case of issuing a financial liability is a necessary part of the GDP process in order to connect my balance sheet saving from income to the investment expenditure in the bulldozer. Bulldozer shorting, if you want to do it, occurs post that GDP event. It is a balance sheet transaction, but not an income statement transaction.


I wasn’t making a point about hoarding cash and recessions. I’m not sure I’d disagree with you on that, and I wouldn’t disagree with most of your most recent response. My observation was on the technical relationship between hoarding cash and loanable funds. If the private sector increases its cash holdings as a result of saving, then the government must have issued new cash. But this is true of any government liability. So I’m not sure that cash hoarding deserves the special attention it seems to get in this regard. And the relationship between the private sector and the government sector insofar as saving is concerned is just an extension of a similar relationship that exists within the private sector. The aggregate saving of the private sector consists of the sum of its surplus saving units and its deficit saving units. The aggregate saving of the entire economy is the sum of the aggregate saving of the private sector (include the current account as appropriate) less the (typically) deficit saving of the government sector – in other words, the sum of its surplus saving units and its deficit saving units, the same as is the case for the private sector considered on its own.

Almost there but not quite. You said: "excess demand for future consumption (relative to current consumption), that is not matched by a willingness of firms to reduce output of current consumption"

Since the firm borrows the capital it doesn't have to reduce current output. In aggregate we reduce current consuption output to fund the real investment but that's not in the single firm's problem.

Take the example I gave where the risk premium is 5%, the real rate -2% for a required return on real investment of 3%. Now, remember that we assume the firm maximizes it's market value, this basically gives it the same risk prefrences as the market. If there if the firms real investment opportunities only yield a risk-adjusted expected return of 1% neither the firm nor I want that investment.

Thus, I end up holding money as the best investment I can find. Because the risk-free real rate is -2% it actually seems a good investment. But I also am perfectly willing to hold government bonds at zero return.

Here's the money quote:

It's not money I want, it's more future consumption. Printing more money doesn't help me get that (and doesn't satisfy my demand unless I suffer money illusion). In fact, since there are no investment opportunities that I want it's not physically possible to satisfy this demand. The only way to get me to spend the money is to lower real rates so much that future consumption has become so expensive (in terms of current consumption) that I no longer want to substitute more future for less current consumption.

(An analogy might help but don't get hung up on it. It's basically like equilibrium in an endowment economy. We can't increase tomorrow's aggregate endowment so equilibrium only occurs when real rates adjust so, in aggregate, we are just happy to consume the edowment, that is we no longer want to do any intertemporal substitution.)


I think see what you mean - your concern is the creation of new assets by investment, rather than the transfer of existing assets (eg bank deposits) in trade generally. I dare say that that has become more of a problem after the inital shock of the financial crisis. In such a case, the central bank could buy debt direct from the government, which could do the investment itself, eg in bridges, railways etc. That is printing money, as I define it.

Actually I should be more clear:

At current prices I want more future consumption. Since there are no real investment opportunities that anybody wants to undertake this is not physically possible. However, at current relative prices (ie, current real rates) I'm willing to substitute less current for more future consumption.

Thus the problem,

1)at current relative prices (real rate) I don't want any more current consumption.
2)at current required returns (real rate + risk premium) there are no investment opportunities anyone wants.

Result is I don't demand anything. This has nothing to do with money, it might happen in a world without money (but prices are still sticky). The problem is that prices won't adjust.

Suppying more money does nothing if relative prices don't adjust.

JKH: "Shorting is necessary in order for financial intermediation to occur, by definition." Wow! That's a novel (to me) way of looking at borrowing and lending. But I see what you mean. (But I would take out the word "intermediation", since what you say applies to direct lending from ultimate lenders to ultimate borrowers, as well as if they go through a financial intermediary, though you presumably weren't trying to say anything to the contrary).

I would say what you are saying a bit differently. Yes it does come right back to earlier posts about net debt. Investment is the increase per year of the stock of real capital goods, and real capital goods (like bulldozers) are net wealth. Part of savings (but only part) is the rate of increase in financial assets. Financial assets are not net wealth. (One minor exception to that: outside non-interest bearing fiduciary money, along with other Ponzi schemes, is net wealth).

"If the private sector increases its cash holdings as a result of saving, then the government must have issued new cash." Agreed. But that's like saying the *actual* quantity of cash "bought" must equal the actual quantity of cash "sold". That's true by definition, in or out of equilibrium. I'm talking about an excess demand for cash, which means that the quantity of cash people *want* to add to their existing holdings exceeds the quantity the government actually issues.

If we have an excess demand for X, we are not in equilibrium in the market for X. That's true for any good. But if X is cash (the medium of exchange) it's different, because there is no one market for cash. The market for cash is every market in the whole economy. We "buy" more cash by not buying other goods.

Rebel, yes exactly. As Nick keeps saying, it's all about demand for new stuff.

Agreed that the credit crunch was a problem of capital not getting from savers to investors because the intermediaries were messed up. I suppose you could certainly make the case that that was what made people first start valuing future consumption so much (they started to worry that without enough investment now consumption would be scarce tomorrow). So perhaps fixing the financial system is key.

However, this not fundamentally an excess demand for money and increasing the money supply, all by itself, does nothing.

Let me correct that very last sentence. It should read: "We TRY to "buy" more cash by buying less other goods". Collectively we fail to buy more cash, but our attempts to buy more cash cause a recession.

Of course, we could also TRY to buy more cash by selling more other goods, as well. But we can ALWAYS succeed in buying less, but cannot succeed in selling more, if other people want to buy less. The short side of the market determines the actual quantity bought and sold.


Yes, I was using the term "financial intermediation" in the broader sense of finance per se (i.e. the creation of financial claims), including direct borrower/lender connections as well as the use of financial institutions as institutional intermediaries – amounts to the same as what you said.

"the quantity of cash people *want* to add to their existing holdings exceeds the quantity the government actually issues"

An example of where you lose me when invoking theory. This is not possible in my world, which I like to think correlates with the real world. Cash is a portfolio choice. The bank and the government can't deny you the amount of cash you want unless you don't have the money on deposit with the bank to begin with, which is a contradiction of sorts.

Adam: agreed, we are talking about firms in aggregate.

I find it interesting to compare two variants of the endowment economy example. In variant 1, people can consume their own endowment. In variant 2, there is a taboo against consuming your own endowment (to motivate trade), and also a taboo against consuming the endowment of anyone who consumes your endowment (to motivate monetary exchange, rather than direct barter).

In variant 1, there is an excess demand for money, because money is the only durable good, and everyone want to sell future consumption to buy future consumption, but current consumption is not affected by this excess demand for money. Everybody consumes his endowment. A social planner could not improve the outcome.

In variant 2, consumption falls, as everybody stops buying other people's endowment in an attempt to get more money, so they can spend it next year on future consumption. A social planner could improve the outcome, by forcing everyone to buy more current consumption.

The first economy has no recession, and that's because "money" does not serve as a medium of intratemporal exchange. It's really antique furniture. The second economy has a recession, because money really does serve as a medium of exchange in that economy.

That was the main point of my post.

Now, suppose that endowment model (variant 2) were the truth about the current recession. A helicopter increase in money (outside money), and permanent money, would increase net wealth, and increase current consumption demand, even if prices and expected future prices were assumed fixed. (Though it would need to be a very large increase).

Let's consider a third variant, which is exactly like variant 2, but also has antique furniture as a second durable good. (It's not produced, and you get pleasure from owning it). My hunch is that the larger the stock of antique furniture (or the more pleasure it gave), the less would be the likelihood of a recession, other things equal. Now the real world has lots of assets like antique furniture. Land, old houses, gold, etc. They all ought to rise in price if we got into a recession caused by excess savings, and would be expected to fall in price thereafter.

In other words, even though it is theoretically possible that the excess demand for money that caused a recession could originally be caused by an excess demand for future consumption, how empirically plausible is that theory?

The increased risk premium theory is more plausible as an original cause, I think. Risky interest rates went up, and safe ones went down.

JKH @1.35: This may resolve the issue:

At full employment there is an excess demand for money. So people buy less stuff, because each individual can always get more money just by buying less stuff. But in aggregate they can't get more money this way. But their buying less stuff causes a recession, so income drops. As income drops, people want to hold less money. Income drops until the excess demand for money, at that new lower level of income, disappears. So at the new unemployment equilibrium there is no longer an excess demand for money.

Rereading the post, as well as your last comment, it sounds like the increased demand for money is a portfolio effect of the usual paradox of thrift in terms of saving. Everybody tries to save more income, or everybody tries to hold more money – same result, one in flow terms, the other in stock terms. If correct, this seems perfectly understandable to me.

(I think the specification of cash (i.e. government issued currency) as distinct from bank deposits really complicates the point unnecessarily).

I'm probably coming in late, but I thought I'd make a point about Cochrane's article. If you read the whole thing it is obvious that he understands fiscal stimulus can affect inflation (and hence other nominal aggregates.) The portion cited by Krugman was very poorly worded. In context, it was clear Cochrane was starting with an assumption of fixed velocity, but he didn't say that. In addition, I don't like the sort "real" argument he used. If you are debating AD, you need to focus on what affects NGDP. So I have some problems with both Krugman and Cochrane in that dispute.

Adam, I pretty much agree with your response to me (surprisingly!)

Nick: "Now, suppose that endowment model (variant 2) were the truth about the current recession. A helicopter increase in money (outside money), and permanent money, would increase net wealth"

No, that's money illusion. We all know that the aggregate endowment next period can't increase, if a helicopter gives us all more money and I spend my share but you save yours then YOU will succeed in consuming more next period at my expense! You'll get a greater share of tomorrow's endowment at the expense of giving me a larger share of today's endowment. That's exactly the deal you would like BUT it's not the deal I want. We both want more tomorrow in return for less today. Hence, we both save the helicopter money just to keep up with each other.

the permanence of the helicopter money works, but only by increasing inflation and thus lowering the real rate. Prices are sticky but not fixed forever.


In your comment of May 6 at 10.18, you seem to be saying that you think it matters whether the central bank buys assets from banks or non-banks, because the latter boosts M1. I would be interested to read more about why you think boosting M1, as opposed to base money only, matters.

(I made the point at May 5 at 19.07 that, if the banks held suitable assets that they would have willingly sold to the central bank if invited, they can reach the same position by selling those asset into the space in the market opened up by the central bank's purchase from non-banks)


Not unusually, you raise a critically important question. Here is my quick and dirty response; may not be precisely as right as I would like.

In a normal non-QE environment, the banking system as a whole does not undertake risk lending on the basis of reserves held on deposit at the Fed. They are not reserve constrained. They are capital constrained. Normal non-QE levels of excess reserves are insignificant, and used at the margin to guide the fed funds rate, not to guide bank lending, other than very short term money market manoeuvring that is essentially a response to fed fund rate guidance. Such short term money market operations are not terribly capital constrained. Commercial paper etc. requires some capital, but the duration weighting is very short. The Fed is not stupid. They have designed the normal non-QE system to work this way.

The question then is what does the Fed expect from the way in which it has designed its QE system, at least so far? Part of the answer is evident in the fact that they are paying interest on reserves. This is nearly moot at the zero bound, but they’re doing it beginning now to establish a precedent in case a QE residual is still in place when they decide they want to start increasing the fed funds rate. Anyway, this is evidence of the fact that the Fed isn’t expecting banks to fundamentally change their lending behaviour because of QE. They still expect banks to be capital constrained for risk lending. And as far as short term money market manoeuvring is concerned, the payment of interest on reserves establishes the functional requirement of a lower bound on short term rates. It is a neutral feature of the system in that sense. Money market spreads against fed funds might be narrower under QE than under normal non-QE conditions, but this is no big deal.

The important point is that the Fed isn’t expecting banks to suddenly invoke the classic and classically erroneous “reserve multiplier” in respect of risky assets, just because of QE. That’s not the reaction they’re expecting from the banks because that would be a stupid reaction. Banks need to be capital constrained in the accumulation of risky assets, QE or non-QE.

So, the payment of interest on reserves is an unambiguous signal that the Fed expects that banks will conduct their risky lending operations according to capital constraints; not according to massive reserves provided by QE. As far as “risk-free” asset such as treasuries are concerned, banks need to be wary of interest rate risk, which in fact requires capital allocation as well. In short, the Fed does not want QE to provide a signal to the banks to suddenly engage in reckless asset expansion. This is also obviously why the Fed and Treasury have taken such extraordinary steps to assist the banking system with its transition back to capital adequacy. The Fed’s payment of interest on reserves is completely consistent with the overarching emphasis on capital adequacy.

So why do QE at all?

(Here I am defining QE in my own way, which I’ll address also when I post my comment on your blog later.)

QE in my definition IN THIS CASE is a by product of credit easing together with balance sheet expansion.

Therefore, an essential function of QE in this case is to provide funding for the Fed’s balance sheet expansion.

The other function relates to your question. QE when transmitted through the non-bank sector results in an M1 increase.

The two most important stimuli provided by CRE/QE, IN THIS CASE, are the assumption of collateralized credit risk by the Fed, and the expansion of M1 Q when the Fed’s activities are transmitted through the non-bank sector and back to the banks as M1.

The Q and V effect of the additional M1 is what provides the Fed’s intended monetary stimulus, not the expansion of the base.

This is all consistent with the Fed’s longer run structural use of bank reserves for its own purpose, which is to provide a leveraged mechanism of policy interest rate control.

The fact that QE has resulted in expanded banks reserves isn’t a signal for the Fed to suddenly use bank reserves in a different way. Again, this is why they pay interest on reserves.

My rough thesis here is diametrically opposed to that presented on such illustrious blogs as Money Illusions, and perhaps obliquely askance to even more illustrious blogs such as WCI.

JKH, great comment. Care to comment on how one comes to know quite that much on the inner workings of the banking system?

If not then perhaps you'll answer this: what's your view on the stimulative effects of the fed's balance sheet expansion and assumption of credit risk? (That is, I'm asking your view on how it works, the transimission mechanism).

JKH: I think I need to do a post on this. But first, can you clarify this bit: "The two most important stimuli provided by CRE/QE, IN THIS CASE, are the assumption of collateralized credit risk by the Fed, and the expansion of M1 Q when the Fed’s activities are transmitted through the non-bank sector and back to the banks as M1.

The Q and V effect of the additional M1 is what provides the Fed’s intended monetary stimulus, not the expansion of the base."

What did you mean by "M1 Q"? Why the "Q"? Typo? Quantity of M1?

What are "The Q and V effect"?


M1 quantity

quantity and velocity

e.g. additional M1 quantity of X, times velocity of quantity X, gives incremental monetary impact of incremental X

although I know X gets commingled with pre-existing M1, but still ...

I'm guessing quantity and velocity?

Rebel @ 7.44: My tentative answer to your question is that M1 is the medium of exchange (or close to it), because people use cheques and debit cards to pay for stuff using their demand deposits. If an expansion of the monetary base stays as "excess" reserves (can't really talk about "excess" reserves in Canada), but does not increase either demand deposits or currency in public hands, it does not increase the medium of exchange.

Thanks JKH. Is what you are saying here roughly compatible with what I was saying at the end of this post http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/04/bad-banks-and-the-effectiveness-of-fiscal-and-monetary-policies-on-ad.html about QE circumventing the banks' capital constraints?

Adam P @ 3.06 and 3.07:

We don't disagree. It's just my way of explaining things. Take a simpler example: I want to explain why an increase in income increases the price of apples. If I were doing it very slowly I would say: "Suppose the price of apples stays fixed, quantity supplied stays the same. But quantity demanded would increase if income rises and price stays the same. So there is excess demand for apples. That excess demand puts upward pressure on price. So price won't stay the same; it will rise (unless of course we really do *assume* it's fixed)".

I'm doing the same thing here. This is what I should have said: "Suppose the present and future price level stay the same. The new money would increase real wealth. With greater wealth there will be increased demand for consumption. So there would be upward pressure on either output or prices. So prices would rise (either today or tomorrow), unless of course we assumed that one or both of them were fixed."

If prices were fully flexible, the rise in prices would eliminate the increase in wealth at the old price level. But the rise in wealth is what caused the rise in prices which eliminated it.

(This is how Patinkin used to explain the wealth effect.)


Yes, that's the core point.

M1 - to be, or not to be. That is the question.

It's come up a couple of times since in discussion, where I think you said you were still thinking it through.

Nick, I think JKH needs to do a post on this.

Adam P,

I’m a big fan of Bernanke and what he’s doing, as unpopular as that position might be.

With “credit easing”, the Fed has temporarily taken over part of the commercial banking system function. QE is largely an enabling facility for the required Fed balance sheet expansion in order to do this. It also has M1 easing benefits. The Fed has actually shied away from using the term “quantitative easing” because it is fundamentally ambiguous, implying many different things to different people. “Credit easing” is in fact a term that Bernanke has embraced.

The larger US strategy includes the Fed, Treasury and FDIC functions. It targets banking system assets (PPIP), liabilities (Fed), and equity (Treasury), as well as fiscal stimulus. The strategy is to try and defeat a disease by completely enveloping it from all angles. I think it’s the Powell doctrine (overwhelming force) applied to the banking system problem, where force is defined in the sense of surrounding the problem. I prefer it to nationalization, which I think of as a cop out.

I think all of this stuff will work over time. The key is that they tackle it incrementally and remain flexible, which is actually the point that a lot of people criticize.

BTW, Timothy Geithner wrote an important prelude to the stress test results (to be released at 5 p.m. today) in the NYT this morning:

“They applied exacting estimates of potential losses over two years, along with conservative estimates of potential earnings over the same period, and compared them with existing reserves and capital. The results were then evaluated against strict minimum capital standards, in terms of both overall capital and tangible common equity.”


This is quite consistent with what I wrote here:


at April 26, 2009 at 06:40 PM

That was in a discussion with Nick relating to the definition of bank solvency. Treasury will do a dynamic projection of solvency over a two year period. Among other things, such a projection will include estimated operating earnings along with all of the potentially negative inputs relating to asset write downs and losses. Relative to my discussion with Nick, it means that the definition of solvency is anchored in the balance sheet, but it includes allowance for a bank to earn its way out of its problems over a reasonable time period. So the interpretation is the combination of a balance sheet approach and an income statement or cash flow approach.

This is absolutely critical in assessing the state of the US banking system. I’m guessing that the system is capable of generating upwards of $ 250 billion or more per year in operating earnings, pre-tax. That money, $ 500 billion or more, can be used, pre-tax, to offset against additional asset write downs and loan losses over that period of time. This is a fundamentally different view of bank solvency than the Armageddon interpretation favoured by people like Roubini, who mark losses to market and declare the entire system insolvent, and then scale the walls, demanding comprehensive nationalization. It is also linked inextricably to the idea of marked to market accounting and its effect on the interpretation of capital and solvency. MTM accelerates the present value of estimated losses into current capital assessment. Projecting operating earnings levels the playing field somewhat, in the sense that it is equivalent to present valuing the future benefit of the ongoing franchise banking spread along with the bad asset stuff.

Re my own analytical approach, it’s balance sheet centric. I’d love to see monetary economics or economics for that matter embrace more of a balance sheet approach. Then I might start to comprehend some of the theory. As it is, I’m still shaky when it comes to understanding supply and demand curves.

Thanks JKH, I see. I am interested to note that you mention the Q and V effect of M1 rather than something about bank lending. I wrote something similar in a reply to a comment on my blog this morning. It seems to me that piling up M1 is not necessarily a sign that QE is not working.

However, the point is moot if banks are not happy to have a pile of callable liabilities and can reduce them by selling assets. Do you have any view about whether it matters if the central bank buys its assets from the banks or non-banks?

By the way, I had a scan over some of the past posts at Money Illusions, and I think I agree with most of the arguments you made there.

Adam P,

“Nick, I think ...”

Thanks, Adam, but Nick did highlight earlier the potential for a unique M1 effect, and this was also the point that RebelEconomist questioned.

I’ll be interested to see how Nick views this going forward; i.e. as something that is important to the overall interpretation of QE, or as merely one of two scenarios that on balance doesn’t really change the big picture for QE.


“Do you have any view about whether it matters if the central bank buys its assets from the banks or non-banks?”

You could always say that what goes around comes around, and that maybe it doesn’t matter in the end. But my instinct is to say that the purchase of assets from non-banks is an immediate expansion of financial intermediation via the banking system, including an increase in M1, which is expansionary from a monetary perspective. The other way around, banks trade assets for excess reserves. In theory, that might cause banks to open up lending channels, not because of more excess reserves, but because capital is freed up. And such lending will increase M1. But it’s roundabout, so I prefer the non-bank purchase route.

“It seems to me that piling up M1 is not necessarily a sign that QE is not working. However, the point is moot if banks are not happy to have a pile of callable liabilities and can reduce them by selling assets.”

Maybe I’m just punch drunk on the subject, but I’m not sure I understand this. Can you elaborate a bit?

Adam P: that's what I was thinking too. But I need to post on it as well.

JKH: I see the M1/capital constrained banks as one of many potential mechanisms through which QE might work. But in practice it might be the most important one.

I have delayed posting on it, because I wanted to get my head round it from as many angles as possible. I'm still not fully at ease with the idea. But the fact that JKH can see it working, as one who knows how actual real life systems work, (and he and I normally have a very different perspective on things) gives me more confidence. And I wanted to get my head a bit clearer on the M1/base/medium of exchange issue first (hence this post).

I will post on it. It would be great if JKH could post on it too. I will leave it up to you how to do that, JKH. Separate post, addition to my post (I can "hoist from the comments"), or whatever you like.

Too many things to think about. I should probably have been thinking about this last night, rather than the slightly silly post I made at 2.00 a.m. this morning.

And then there's JKH's comment about stress tests, which seems equally important.

Brain overload. Too much to think about.

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