Fallacies of composition and decomposition: the supply of money and reserves

Does the supply of reserves matter? It certainly matters in the simple textbook ECON 1000 model of the money multiplier. But is that model fatally flawed, especially in the context of zero required reserves, and where central banks target an interest rate, so the quantity of reserves is demand-determined?

Some people do argue that the simple textbook model is fatally flawed, and that the supply of reserves, to a first approximation, doesn't matter. See for example the comments on David Beckworth's post about the Fed's exit strategy. Even if this is a minority view (and I'm not 100% sure it is a minority), it's not an insignificant minority. My sense is that this view is widely held by people who describe themselves as: Post-Keynesians; Neo-Chartalists (Modern Monetary Theorists); and "horizontalists" more generally. And at least some of those people know from personal experience a lot more about how banks and central banks operate than academic economists like me ever will. We should take them seriously.

But I think they are wrong. I think the simple textbook model, despite its simplicity, and "lack of realism", contains important insights that its critics miss.

A fallacy of composition is when you say that what is true of each of the parts must be true of the whole. "If each individual stands up, he can see the stage better; therefore if everybody stands up everybody will see the stage better". A fallacy of decomposition is the same thing in reverse. It's when you say that what is true of the whole must be true of each of the parts.

The fallacy of decomposition is just as important as its reverse. If it weren't a fallacy, there would be no free-rider problem, for example. "If everyone free rides, everyone is worse off; therefore if each individual free rides he is worse off, so he won't ever free ride".

What the simple textbook model of the money supply gets right is precisely that. But only if you teach it right, and don't skip the long boring bit that takes you from one equilibrium to another. You know, the bit where Bank A has $100 excess reserves, and so expands loans and deposits by $100, which then end up in Bank B, which then expands loans and deposits by $90, etc. I've always been tempted to skip that bit (especially since I always screw up the arithmetic) and jump straight to the new equilibrium, where deposits expand by 10 times the increase in reserves. I swear I will never skip that bit again. But I think I may change how I teach it.

That boring bit of the textbook story is not really about dynamics, even though it's usually taught that way. It's about marginal costs: more precisely, about the difference between marginal costs for the individual bank vs marginal costs for the banking system as a whole. With a (say) 10% desired reserve ratio, the marginal cost to the banking system as a whole of a $100 expansion in deposits is the cost of needing an extra $10 in reserves. But for the individual bank, the marginal cost of creating a new $100 deposit is the cost of needing an extra $100 in reserves. At the margin, it is as if an individual bank has a 100% reserve ratio, regardless of the 10% (or 0% or whatever) desired reserve ratio. And whether or not something is an equilibrium is determined by individuals' incentives, at the margin. Does every individual's marginal benefit equal his marginal cost? If not, it's not an equilibrium.

To see the importance of this insight, suppose there were only one big commercial bank. That means there can't be any fallacy of composition or decomposition, because there is only one part, so the part is the whole.

Start in equilibrium, where the bank has exactly the desired reserve/deposit ratio. Ignoring currency drains, the bank know that if it advances an extra $100 loan by creating a $100 deposit, it gets to keep that $100 increase in deposits indefinitely (or, at least until the loan is repaid). When the borrower spends the loan, the deposit changes hands, but stays at the same bank. If there's 5% interest on loans, and 2% interest on deposits, the bank's net revenue is $5 per year loan interest, minus $2 per year deposit interest, minus the cost of borrowing extra reserves (from the central bank). If the desired reserve ratio is 10%, and the interest it pays on borrowed reserves is 3%, the cost of the extra $10 reserves is a mere 30 cents. And as the desired reserve ratio goes to 0%, the cost of those extra reserves disappears from its calculation.

The equilibrium condition assuming 0% desired reserve ratio is that the interest rate on an extra $100 loan equal the interest rate on an extra $100 deposit, plus an allowance for risk and admin costs. The interest rate on reserves is irrelevant.

Now suppose instead that each commercial bank is very small relative to the whole banking system.

Again start in equilibrium, where the bank has exactly the desired reserve/deposit ratio. An individual bank knows that if it advances an extra $100 loan by creating a $100 deposit it will not keep that deposit. The borrower will spend it, and it will be re-deposited at a different bank, and so the first bank will need to transfer $100 in reserves to the second bank. The bank's net revenue is $5 per year loan interest, minus nothing on deposit interest, minus $3 per year on the $100 extra reserves it will need to borrow.

The equilibrium condition assuming 0% desired reserve ratio is that the interest rate on an extra $100 loan equal the interest rate on an extra $100 borrowed reserves, plus an allowance for risk and admin costs. The interest rate on deposits is irrelevant.

Notice two differences between the case where there is one big bank and the case where there are many small banks:

1. The interest rate paid on deposits has a 100% weight in the big bank's decision, but a 0% weight in the small bank's decision.

2. The interest rate paid to borrow reserves has a 100% weight in the small bank's decision, but a weight equal to the desired reserve ratio in the big bank's decision. If the desired reserve ratio were 0%, the interest rate on reserves would be irrelevant to the big bank. At the margin, the small bank acts as if there were a 100% reserve ratio, even if the desired reserve ratio is 0%.

To ignore that distinction between the banking system as a whole and the individual bank, or between one big bank and one of many small banks, is to commit a fallacy of decomposition. With 0% desired reserve ratio, the banking system as a whole can expand loans and deposits without needing to borrow extra reserves. But that does not mean the price and availability of reserves is irrelevant. It is 100% relevant to the individual bank at the margin. And it is individual banks' unwillingness to change their decisions at the margin that determine whether an equilibrium is indeed an equilibrium.

If there really were just one big commercial bank, so the fallacy of decomposition would not arise, and if the desired reserve ratio were close to zero, I can't see how the central bank could possibly control that bank through changing the interest rate on reserves. The central bank really would need some sort of quantitative controls instead.

Before ending this post, I might as well deal with a couple more criticisms or misunderstandings of the simple textbook model of the money multiplier.

The first criticism/misunderstanding has to do with the "supply of reserves".

This is mostly a terminological issue. In economics the "supply of apples" does not mean the actual quantity of apples sold. It does not even mean the quantity of apples that sellers want to sell (the "quantity supplied"). It means the supply curve, which is the whole relation between the quantity sellers want to sell and the price of apples. Better yet, since price is only one of many variables that affects quantity supplied, the "supply of apples" means the whole functional relation between quantity supplied and everything that affects it.

Furthermore, we can even think of a supply curve, or a supply function, in an inverse form, as Alfred Marshall did. Marshall saw a supply curve as defining the supply price (the price the seller was willing to accept) as a function of quantity sold, rather than quantity supplied as a function of price. (That's the historical accident that explains why economists' supply and demand curves have the dependent variable on the horizontal axis, rather than the vertical; something that always annoys science and engineering students taking ECON 1000.)

Similarly, the "supply of reserves" does not mean the actual stock of reserves. It does not even mean the stock of reserves desired by the central bank. It means the supply curve, which is the whole relation between the central bank's desired stock and the rate of interest on reserves. Better yet, since that desired stock depends on many things, the "supply of reserves" means the whole relationship between the central bank's desired stock of reserves, the rate of interest on reserves, and anything else that affects it.

Furthermore, like Alfred Marshall, if we want to we can think of the "supply of reserves" in its inverse form, as defining the central bank's desired target for the interest rate on reserves as a function of the quantity of reserves and everything else that affects it.

So to argue that the supply of reserves is irrelevant, because when the central bank sets a target for the interest rate on reserves the supply of reserves is demand-determined, is to misunderstand what is meant by "supply of reserves". It's not a quantity; it's a function.

Now there is a difference, it is true, between a perfectly inelastic supply function and a perfectly elastic supply function. A cap-and-trade system for emissions permits (a "verticalist" policy) may give the same equilibrium as a Pigou tax (a "horizontalist" policy), but if the demand curve shifts the former leads to a change in the equilibrium price of emissions, while the latter leads to a change in the equilibrium quantity of emissions. But that's only if the policy-maker holds the supply curve fixed when the demand curve shifts. But central banks don't hold the supply curve of reserves fixed when the demand curve shifts. Depending on the central bank's ultimate target, whether it be the inflation rate, the price level, nominal income, the exchange rate, or whatever, it will almost certainly shift the supply curve in response to a change in demand for reserves.

Except in the very short run (6 weeks or so) the Bank of Canada does not have a perfectly elastic supply curve of reserves (and even then it reserves the right to change the overnight rate target between Fixed Announcement Dates if needed).

(And the elasticity of supply of reserves to an individual bank can be very different from the elasticity of supply to the banking system as a whole, of course. Each buyer of apples in a competitive market faces a perfectly elastic supply curve of apples at the equilibrium price, even if the market supply curve is inelastic.)

The second criticism/misunderstanding has to do with the supply of money vs loans.

The simple textbook model of the money multiplier is not a model of the supply of loans. It's a model of the supply of money. It's about the liability side of the banks' balance sheet, not the asset side.

Banks make loans. So do I. Banks create money. I don't. That's why banks are special.

If the textbook model were intended as a model of the supply of loans, it would fail miserably. Banks are only a part of the overall supply of loans. Plus, it makes no difference whatsoever to the textbook model if banks create deposits by buying bonds, shares, land, computers, or whatever. When a bank makes a loan it buys a non-marketable IOU, and pays for it by creating a demand deposit. But it could buy anything else instead and still pay for it by creating a demand deposit. It would make no difference to the textbook model. It's the demand deposit that matters, not what the bank buys with it. The textbook model is a model of the supply of money, by banks, and those demand deposits are money, that is to say a medium of exchange.

The textbook model is a model of the supply of the medium of exchange. If you are not interested in the supply of the medium of exchange, and are instead interested in the supply of loans, then of course you will find the textbook model of the supply of the medium of exchange totally unsatisfactory. Since loans are usually risky, you will want to look at things like bank capital, etc.

Now, none of the above means the textbook model is perfect. Far from it. It leaves out lots of stuff. But its main insight, the difference between the individual bank and the banking system as a whole, is precisely what its critics miss.

Afterthought: If we want to explain the quantity of apples, we need to look at both the supply and the demand for apples, and put them together. If we want to explain the quantity of money, don't we also need to look at both the supply and the demand for money, and put them together? How can the textbook model get away with ignoring the demand for money?

Actually, that's not a bug; it's a feature. You can already see in the above that an individual bank will ignore the interest rate on deposits when it decides whether to expand loans and deposits. And the borrower will ignore it too, because he got the loan to spend it, not to leave it sitting on deposit at the bank. New money really is always like helicopter money. Changes in the stock of money are always supply-determined, never demand-determined. But that's a subject for another post.

Comments

[edeast]

I wish I could buy JKH a beer.

[MDM]

Slightly off topic (apologies):

Nick,
Through the preliminary research I have done (I am only a student), there appears to be two different concepts of money*. The first can be broadly termed the “Metallist” theory and the second, the “credit” theory. The former, emphasises the medium of exchange function of money, and sees money originating out of barter and the supply being generally fixed. This view is generally associated with the mainstream school of economies. The latter, emphasises the unit of account and means of payment function of money and sees money originating out of complex social practices, such as various rituals involving ‘primitive money’ and various obligations, such as wergild and the ability of an authority to impose an obligation (tax) upon a populace. Money is and always will be endogenous. This concept of money would be associated with Post Keynesians and Chartalists.

Now if my understanding is correct, I believe you would situated in the ‘Metallist’ camp. My question now for you is, to what extent does your view of money rely upon and in fact require barter to be the primary means of exchange for early society? The way I see it, if the assumption of barter as the early and primary means of exchange becomes untenable, then I can’t see how Metallism could be true. Of course, perhaps I am missing something and the two are exclusive.

Would love to read your feedback.

[Nick Rowe]

edeast; Good idea! I have just poured myself one as well. (Study Week, so no teaching.)

MDM: I think that's a false dichotomy. I'm basically in the Austrian (Menger) tradition on the "origins" of money. Though I don't see "origins" as meaning "historical origins" necessarily. Since barter is so costsly, it is quite possible that exchange and monetary exchange can arise at the same historical time.

I see both money and government as arising out of individual interactions and beliefs, and being maintained in existence by individuals' actions and beliefs. Government is not logically prior to money. Both are creations of individuals. I emphasise money as medium of exchange over its role as medium (unit) of account. An economy with no medium of exchange, but with a medium of account, would be very different. General gluts would be impossible. Say's Law would be true. Post-Keynesians (and others) who (correctly) deny Say's Law but (incorrectly) see money as only a medium of account, and not as medium of exchange, have an internal contradiction in their belief system.

But none of that means that the supply of money is perfectly inelastic ("fixed"), or that money cannot be a liability ("credit").

[Declan]

Back here I commented that, "In a concentrated banking market like Canada, what goes around, comes around, and the added cost of interest on reserves needed because a bank's loan/deposit ratio is high compared to the other banks is small enough to not really be a factor in decision making."

You replied, "In normal times, if a bank is getting (say) 4% interest on reserves, and 6% interest on mortgages, I would say that 4% should be a big factor in decision-making."

So I'm not sure we've made any progress. I still feel that the banking in Canada resembles your first scenario with one big bank. Presumably you still disagree?

[David Pearson]

Nick,

A question: if a small bank's lending decision is purely a function of the marginal cost of funds (which you argue is effectively the IOR rate), and if that cost is close to zero compared to a lending rate of over 5%, then why would that bank ever hold Excess Reserves?

Some might argue that the existence of $1tr in Excess Reserves is evidence that 25bp interest on reserve rate creates enough marginal opportunity cost to dissuade the bank from lending. By implication, a zero interest on reserve rate -- a 25bp delta -- would therefore be sufficient for banks to lend out all Excess Reserves, which at a multiplier of 10 would suddenly result in roughly $10tr in new lending.

Others have argued that the relevant fact is that the IOR rate is above the corresponding T-bill rate, and that the Fed should set it below that rate so that Excess Reserves disappear as they are lent to the Treasury (which brings up issues of monetization, but we'll leave those aside). I wonder, however, whether this view is realistic. As long an individual bank holds Excess Reserves, it will seek to invest in risk-less T-bills as long as the rate is higher, which just means the T-bill rate will be driven down to at or below the IOR rate. So could this argument be a red herring? If so, we are back to being asked to believe that the $1tr in Excess Reserves would create $10tr in credit if the Fed would just reduce the opportunity cost to zero.

Clearly I am missing something. A reasonable answer seems to be that the existence of Excess Reserves under a 25bp IOR is evidence that a banks' lending decision is not purely a function of its marginal cost of funds, and in certain circumstances (large tail risk of losses), the marginal cost of funds matters much less. A further answer is that the Fed can influence the demand for loans from creditworthy borrowers by raising inflation expectations, which it must do by charging a high interest rate on Excess Reserves. But this takes us down the road of arguing that it is the Fed's ability to impact inflation expectations (a very squishy thing, velocity) that matters, and not the marginal cost of reserves for a small bank. Of course, sometimes the two are related, but the causality matters: inflation expectations create demand for lending, and are not a function, directly, of the supply of reserves.

[Nick Rowe]

Declan: with 5 big banks (I can't do the reciprocal of 6), you *might* argue that in Canada, 20% of what goes around comes back around. That still leaves Canada closer to the lots of small banks than the one big bank. But a proper treatment of this issue depends on the "strategy space" (do banks play Cournot-Nash or Bertrand-Nash?). And that's something I can't get my head around.

David: In equilibrium, banks never do hold excess *desired* reserves (as opposed to excess *required* reserves). But that's to duck your question!

I don't know why banks are currently wanting to hold the levels of reserves they do. Presumably it's because the risk of anything they could buy (like IOUs, or loans), plus the admin costs, are sufficiently high that they don't offset the 25bp on reserves. (Though I remember reading a recent blog post that argued that they are waiting for other banks to go bust, at which point the bank with the biggest reserves will be chosen to buy up the pieces at fire-sale prices?).

But certainly the MC of reserves is not the only thing that affects a bank's decision on whether to expand its deposits. The MB (not just the rate of return, but the risk) is also important.

I think inflation expectations are very much a function of the supply of reserves, if by "supply of reserves" we mean the present and *future* supply *function*, and not just today's quantity of reserves. And expected deflation, and recession, or fears thereof, are quite likely major reasons behind the very low expected marginal benefits of banks' expanding their balance sheets.

[edeast]

Cheers Nick! I'd buy you a drink as well but I'm nowhere near Ottawa. Just the amount of ink he spills is impressive for a commenter. I'm on reading week as well, reading, hopefully I'll have something usefull to say someday.
This post was great, I'm looking forward to the supply constraint of money, and I think, I know somewhat how it will go, but I'd like to see how you describe the mechanism. But could the money be supplied but misallocated,ala Austrian.
So ya next time you are in Edmonton, or better yet you should try and get booked for the Erik Hansen memorial lectures. After Tyler Cowen's in the fall there was free drinks and food! I may never miss another public lecture again. Cowen distilled came down to "animal spirits" so I'm sure you could get away with some sociology. "The social construction of central banks, and the failure of interest rate framing to lead expectations" or something along those lines. Just add some witt, a pun, some pandering and voila free drinks!

[Ritwik]

Nick, apropos your second-last sentence 'changes in the stock of money are always ....' , does it not fall prey in part to Patinkin's classic takedown of monetarists: "Atlast I have discovered the cause of Christmas. It's the increase in the money supply." ?

[Nick Rowe]

edeast: there is no way I could possibly keep up with Tyler Cowen!

Ritwik: That didn't sound at all like Don Patinkin, in so many ways. I Googled, and found it attributed to Nicky Kaldor. But it's a good point, nevertheless. I must try to take it on board. Methinks it is increased Christmas spending, rather than increased Christmas demand for money, that increases the stock of money, given current money supply policies.

[David Pearson]

Nick,

In your reply I hear you saying the marginal cost of funds does not determine the level of Excess Reserves, but the piece you posted is about how the marginal cost of funds is determined by the interest rate on reserves. So the question is, what is the practical implication of your conclusion on the fallacy of composition?

[scott sumner]

Nick, I'm afraid I going to keep skipping the boring parts, unless you can convince me that these 4 points are wrong:

1. It is wrong to think of banks as creating loans, and then the liability side responding passively. Banks are intermediaries---they create both assets and liabilities at the same time. It would be just as accurate to say the banks create deposits, and then take the money they get from depositors and go out and make new loans. Or if they can't find borrowers, take the money and buy bonds.

2. The cost of deposits is not the interest rate paid on deposits (on average.) To attract new depositors banks must offer higher rates. Since banking is monopolistically competitive the marginal cost of new deposits will exceed the average cost.

3. Small banks face exactly the same situation as monopoly banks. The issue of new loans being drained out of banks and redeposited elsewhere is misleading. If a bank has $10,000,000 in assets, and decides to increase that by $1,000,000 by making a new loan, they do not hold an extra $1,000,000 in reserves. Rather, the decision to make the $1,000,000 new loan is made jointly with the decision to expand deposits by $900,000 (assuming a desired reserve ratio of 10%.) The fact that it might take a few days to attract the new deposits is immaterial if the loan is for 5 years. When figuring the marginal cost of that loan, they are going to estimate the cost over 5 years of holding the extra deposits, plus the small amount of extra reserves. I would argue that there is no cost at all of teaching the money multiplier process by skipping the dynamic process, and assuming a single consolidated commercial bank balance sheet. (Of course there is also no cost in skipping the multplier process entirely, and instead focusing on the supply and demand for base money, which determines the price level.

4. If the reserve ratio is 0%, banks play no important role in monetary theory. Instead, all base money is currency, and the price level is completely determined by the supply and demand for currency held by the public. For instance, assume the public likes to hold currency in their wallets equal to 4% of NGDP. If the Fed increases the currency stock by 17%, then NGDP will also rise by 17%, regardless of what is happening to bank balance sheets. Or assume the currency stock is unchanged, but the banking system causes demand deposits to double. That will have no impact on the price level, unless it somehow affects the demand for currency, i.e. changes the k ratio away from 4%. But even if that were to occur, the easiest way to model the price level would be to treat banking as something that affects the demand for currency. We don't spend entire chapters in money texts discussing how changes in MTRs affect the price level, by encouraging tax evasion through currency hoarding, or how our drug laws affect the price level by influencing the demand for currency. And yet those factors have a far bigger impact on base money demand that banking (during normal times, not right now obviously, while we are paying banks to hoard base money.)

But we do agree about one thing; post-Keynesianism is worthless. They don't have any model of the price level, as far as I can see.

[Nick Rowe]

David: I'm not sure I understand your question. But here goes:

First, I don't like the term "excess reserves", because it's ambiguous between excess *(legally) required* reserves and excess *desired* reserves. Legal reserve requirements are irrelevant, except insofar as they influence desired reserves (which they normally do, of course).

In equilibrium (by definition) excess desired reserves are zero. Start in equilibrium. Suppose we then shock the system by increasing the (aggregate) supply (curve) of reserves. We can think of this as an increased quantity of reserves for a given interest rate on reserves, or a lower interest rate for a given quantity of reserves. Either way, each individual bank now has excess desired reserves, and responds by increasing loans and deposits.

Scott: Taking a break from the Great Depression, I see! I must now re-position my defences to face an attack from the opposite direction to what I expected!

1. Start the model in equilibrium. Then we hit the model with an exogenous shock and see what happens. The textbook exogenous shock is an increased supply of reserves from the central bank. That's because the textbook is interested in seeing how monetary policy works. But that's not the only exogenous shock we could hit the model with. I think your exogenous shock here is a change in the public's desired cash-deposit ratio. No problem. In this case the individual bank's deposits and currency reserves increase by $100 at the same time. Then it has $90 (or whatever) excess desired reserves, and we are back to my story. The bank buys $90 of something (a loan, bond, or apple tree) and creates a $90 deposit at the same time. (If the seller of the bond or apples tree banks at bank B, that deposit is created at bank B, rather than at bank A, but this makes no difference to my story.)

2. I didn't say how the interest rate on deposits is determined. Each individual bank has two ways to get more reserves: borrow reserves, or attract new deposits to take reserves away from other banks. In equilibrium the marginal cost of the two sources of reserves must be equal. Yes, if bank's deposits are imperfect substitutes in the eyes of depositors (handy local branches, etc.) then the marginal cost will not be the same as the average cost, because banks will be monopolistically (monopsonistically?) competitive. I don't think that changes my analysis any. Just add an elasticity term onto the interest rate on deposits (plus admin costs minus fees).

3. You lost me here. Maybe your arithmetic mistake (always happens to me when I try to work through this, and I have to teach it on TV as well, so anyone can see me screw it up!), or maybe I'm just not getting something. Assume we start in equilibrium, and the bank has no excess desired reserves. It contemplates expanding loans by $1,000,000, and attracting new deposits (not from the guy to whom they made the loan) of $900,000. So it has a net loss of reserves of $100,000. And yet it wants $90,000 more reserves (at a 10% ratio). ?

4. This is where we have very different perspectives on the macro-implications of money. Yes, if desired reserves are 0%, a doubling in the stock of currency will double the equilibrium price level, and everything real (including the banking system) stays the same, and everything nominal (including the nominal banking system) doubles too. But what happens to real variables during the transition to the new equilibrium depends very much on the excess supply of the medium of exchange. And banks' demand deposits are just as much a medium of exchange as currency.

Plus, it is at least theoretically possible that currency should disappear. And I want a model of money, prices, and the transition that is robust to the disappearance of currency.

I'm more favourably inclined to the PKs than you. Yes, they do have a problem with the determination of the equilibrium price level. But like the Neo-Wicksellian mainstream, they could resolve that problem if they wanted to by suitably re-modelling the central bank's reaction function. They just need to stop thinking of monetary policy as a rate of interest, and think of it as a reaction function. But of course, if they did that, they would have to enter a P* term in the reaction function. And they would then find that all the dreaded classical postulates, including the Quantity Theory and Neutrality of Money, would re-appear under another guise: the Neutrality of P*, and the Quantity Theory of P*.

[David Pearson]

Nick,

I'm trying to link your arguments to some sort of predictive model for the level of Excess Reserves (I'm sure the Fed would like to do the same!). What is the impact of a change in the marginal cost of funds (the IOR) on "desired reserves" at today's level of reserves and IOR: in other words, what would happen to the level of Excess Reserves if the IOR declined to zero, or rose to 1%? How would banks "respond by increasing (or decreasing) loans and deposits"? I'm not looking for specific numbers: within a half a trillion (for the expected level of Excess Reserves) would be nice.

[Josh]

Nick,

I am just thinking out loud, but might the reason for the holding of excess reserves have something to do with the arrangements under which the reserves were acquired? In other words, the Fed has used a variety of repurchase agreements under which they acquire mortgage-backed securities. Banks, knowing that these arrangements are temporary would therefore rather hold the excess reserves, which now pay interest, rather than lend them out over the short-term and bearing non-zero risk.

I will have to go back and look at the Fed's balance sheet to really contemplate this issue, but at first glance it would seem that the way they have acquire MBS's might play a role in determining excess reserves.

[Josh]

"I'm more favourably inclined to the PKs than you. Yes, they do have a problem with the determination of the equilibrium price level. But like the Neo-Wicksellian mainstream, they could resolve that problem if they wanted to by suitably re-modelling the central bank's reaction function. They just need to stop thinking of monetary policy as a rate of interest, and think of it as a reaction function. But of course, if they did that, they would have to enter a P* term in the reaction function. And they would then find that all the dreaded classical postulates, including the Quantity Theory and Neutrality of Money, would re-appear under another guise: the Neutrality of P*, and the Quantity Theory of P*."

Isn't the first sentence contradicted by the remainder of the paragraph? :)

[Nick Rowe]

David and Josh: excuse me first while I have a mini-rant, then I will answer your very good questions together.

[Nick adopts voice of crazed Scots schoolteacher from Pink Floyd's The Wall: "What do I keep telling ye? How can ye call them 'excess reserves'?! They canna be excess reserves, because the banks are just sitting on them! If they were really excess reserves, the banks would be getting rid of them as fast as they can! And we wouldne' be having this problem now, would we?"]

OK. David: I don't have the answer to your question (What's the elasticity of the demand for reserves with respect to the interest rate on reserves?). I wish I did. I am useless at sensible practical questions with real numbers. But the answer would almost certainly depend on whether we are talking about a temporary or longer-lasting change in that interest rate (I was about to say "temporary or permanent" but it would be infinite for a permanent change, as Wicksell knew).

Josh should think out loud more often. I think he nailed it. That's probably why it's expected to be temporary, and why it isn't having much effect.

Josh @12.43 Not really strong enough to be a contradiction. If you take PK theory, and re-frame it, it's not always so different. But people naturally find it hard to think of their theories in a different frame, even when it's as simple as shifting a curve right and left, instead of up and down.

[Nick Rowe]

If it were perceived as longer-lasting, for example, then it would affect expectations of the future price level and real income too, and that would make the assets the banks buy when they expand their balance sheets less risky and more valuable too, which would magnify the effect. Scott Sumner territory here.

[David Pearson]

Nick,

I'll try a less practical one! Is the elasticity of demand for reserves a knowable function of the IOR? Can we know what the probability distribution looks like? I know I'm venturing farther from your post, but the point is, you argue that lending is a function of the supply curve of reserves, but for that statement to have any practical consequence, the elasticity has to have some predictive quality. If the range of estimates on the elasticity is large, then would you advise the Fed to use the IOR as a tool to manage Excess Reserves?

I suppose Scott Sumner would say the elasticity doesn't matter as long as the Fed adopts an NGDP target, because then it can just use expectations and ignore the shape of the curve(?). However, first to "set" expectations the Fed must first have credibility that it can hit that target, and in the absence of some knowledge of the elasticity, then it must slowly "experiment" in much the same way as the Greenspan Fed did with its "measured pace" rate hike campaign, or risk throwing the economy back into deflation.

Mind you, I still believe a consequence of your argument is that we should expect Excess Reserves to evaporate if there was a zero opportunity cost to loaning them out. Would you expect a $10tr explosion in credit created by a 25bp change in the IOR? This "absurd" result tells us that there may be other, more important drivers of bank lending behavior than the supply of reserves. But even if there are not, we still need to know something about the elasticity of reserves before we can use the IOR as the key tool of monetary policy. Pity the Fed never mentions this when they talk about "having the tools" to manage Excess Reserves.

[Winslow R.]

Are deposits/reserves being conflated?

Nick wrote: "Each individual bank has two ways to get more reserves: borrow reserves, or attract new deposits to take reserves away from other banks. In equilibrium the marginal cost of the two sources of reserves must be equal."

I can think of 4 ways (there are now probably many more given recent fed gymnastics) a bank can deal with a shortage of reserves/deposits.

Reserves
1) Borrow reserves from the Fed and pay the published overnight borrowing rate.
2) Buy/sell reserves by contacting a primary dealer who will repo/reverse repo treasury securities.
Even if there was one single bank and required reserves drop to zero, the bank could be forced to borrow reserves from the CB as depositors start paying taxes. The payment of taxes (through a fiscal surplus) would force banks to 'convert' deposits into reserves through borrowing which would eventually bankrupt the financial system.

Deposits
3) Convince people to move deposits from other banks by publishing higher deposit rates.
4) Borrow deposits from other banks at the published interbank borrowing rate.
http://en.wikipedia.org/wiki/London_Interbank_Offered_Rate

[Winslow R.]

Scott wrote: "They don't have any model of the price level, as far as I can see. "

Simplist model I've seen is:
If the government continually raises the prices it is willing to pay as buyer of last resort, we will see inflation of the price level.

[MDM]

Nick: Thank you for the reply. I have numbered and addressed your points below:

1.Could you please clarify what is meant by the separation of the historical origins of money and the origins of money. What other origins can there be?

2.When you state that the barter model is costly, I assume you mean the transactions costs are high because of the need to overcome the double coincidence of wants. But isn’t this assuming that firstly society is comprised of individuals with no social relations with each other and secondly that all transactions have to occur instantaneously? In the real world, individuals have various relations with each other, in this early society, I don’t think it’s a stretch of the imagination to suggest that the individuals trust each other and thereby each individual would be credit worthy. If an exchange was to take place an individual could extend credit to another individual who do not have any means of payment or exchange. Such a relationship could be termed an informal debt-credit relation (I’d just like to add that I am focusing on market exchange and ignoring social exchange, such as gift exchange or socially forced exchanges). Similar instances of partnerships of trust generally occurred throughout history with merchants providing credit to customers, such as in Islamic society and ancient Greece and Rome. What this implies is that the concept of barter is really a non-issue for exchange, there never was a cost of barter which needed to be solved through the spontaneous order of the market. Dalton (1982 p.188) has a similar conclusion, he states:

“...moneyless market exchange was not an evolutionary stage in the sense of a dominant mode of transaction preceding the arrival of monetary means of market exchange. Barter occurs very widely in past and present economic systems, but always as minor, infrequent, or emergency transactions employed for special reasons by barters who know of alternative and more important ways of transacting.”

3. To be honest I don’t see the two concepts as being a false dichotomy. Firstly the two theories represent two different directions of causation, secondly, two different definitions of what credit money is, thirdly, two different views on how banks function and finally, the money as either an illusion or not an illusion.

The two theories express two different ideas on the causation of money creation: either banks need either deposits or reserves before then can lend or loans create deposits and reserves are sought after, as the loan creation may potentially leave them short reserves either because another bank requires payment (when a loan is deposited into another bank) or to meet their reserve requirement. In this latter sense, the only constraint on bank lending is a lack of credit worthy customers, reserves do not fund or in anyway hamper the bank’s ability to lend. The reserves are merely required for payment between different banks or to meet reserve requirements. This view is in complete agreement with a recent BIS paper which states “apart from fulfilling any reserve requirements, bank reserves are uniquely valued by financial institutions because they are the only acceptable means to achieve final settlement of all transactons” (Borio and Disyatat, 2009, p. 16). In regards to bank loans they state “... the level of reserves hardly figures in banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans” (ibid., p. 19). The central bank has no choice but to accommodate the demand for reserves, as reserves are interest-inelastic, any shortfall due to the central bank not accommodating demand for reserves would see a rising and volatile overnight rate. As the central bank is the monopoly supplier of net reserve balances it has an obligation to avoid this volatility and ensure a smooth and reliable payments system. As should be obvious, the direction of causation runs from credit money being created first with base money being created later, rather than the money multiplier view that base money should be created first followed by credit money. The Post Keynesian theory on the causation has also found support in neo-classical circles, with a paper by Kydland and Prescott, who concluded that:

“There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M 1 series are generally procyclical and, if anything, the monetary base lags the cycle slightly.

The difference in the behavior of M1 and M2 suggests that the difference of these aggregates (M2 minus M1) should be considered. … The difference of M2-M1 leads the cycle by even more than M2, with the lead being about three quarters.

The fact that the transaction component of real cash balances (M 1) moves contemporaneously with the cycle while the much larger nontransaction component (M2) leads the cycle suggests that credit arrangements could play a significant role in future business cycle theory. Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics.” (Originally cited in Keen, 2009)

Now I believe you may think that the two concepts of money are a false dichotomy because you can see the existence of credit money in the former model but the credit money in the two models represents two different thinks. In the former model, credit money is essential ‘representation money’ and evolved as a means to overcome the high transaction costs of carting around a bulky medium of exchange (e.g. gold). This is completely different to the second theory, which sees credit money as a credit-debt relationship, which happens to be expressed in a particular commodity.

The two concepts of money have two completely different views on the function of the bank. In the Chartalist and PK view (any Chartalists or Pkers correct me if I am wrong) the main function performed by the bank is to act as a third party for transactions between two parties. They facilitate the transaction by converting by party’s debt into a socially acceptable debt (i.e. their own). They are to the non-bank private sector, as the central bank is to the banking sector, that is, as a means of final settlement. The Metallist theory sees the bank as coordinating savings with borrowers.

Finally, the credit theory sees the importance of money as a social relation. Money conveys social status and power, an end in itself and an important social structure which plays an important role in the process and development of the economy. This distinction is important as it means any analysis which ignores money and focuses instead the ‘real’ economy completely misses the point.

4. I completely disagree with you on Post Keynesians and Say’s Law. The reason why Post Keynesians reject Say’s Law is because they assume historical time, which leads them to conclude that all individuals face ontological uncertainty and that money performs the role of a medium of exchange. Post Keynesians have written extensively about why Say’s Law is inapplicable in the real world and only holds in the world of perfect information, logical time and a barter economy (i.e. never). Finally it is the unit of account where money is a credit-debt which exacerbates the reaction of the price mechanism to a decrease in demand (i.e. debt deflation). In fact, I would say that there is a contradiction in any model which assumes away uncertainty, by equating it with risk, and emphasises the medium of exchange function. In this model why can’t the price mechanism act as a negative feedback, as the Austrians argue? Finally, it is not correct that PK do not emphasise the medium of exchange (they do), it’s that this function of money is not as important as the others. For example, a medium of exchange would always be someone else’s liability (except in the case of commodity money), such as, currency being the liability of the government and bills of exchange, tally sticks, being the liability of a bank or a merchant. This is completely ignoring the incorporation of the social importance of monetary profit as an end to itself, as expressed by the Marxian circuit M+C+M+, which is completely compatible with the PK concept of money and its rejection of Say’s Law.

I look forward to reading your reply and clearing up any mistakes or misunderstandings I may have made.
Regards,
Mark

Sources:
Borio, C., & Disyatat, P. 2009. Unconvential monetary policies: An appraisal. BIS working papers no 292
Dalton, G. 1982. Barter. Journal of Economic Issues. Vol. XVI no. 1. Pp 181- 190
Finn E. Kydland & Edward C. Prescott, “Business Cycles: Real Facts and a Monetary Myth”, Federal Reserve Bank of Minneapolis Quarterly Review, vol. 14, no. 2, pp 3-18
Keen, S., 2009. www.debtdeflation.com/blogs/2009/08/30/debtwatch-no-38-the-gfc—pothole-or-mountain/

[Nick Rowe]

David:

I think it must be "knowable", at least in principle, in the sense that a sufficiently determined econometrician with a good date set could estimate it. Though even this is problematic. As I have argued elsewhere, if a central bank is using an instrument R to target a target variable P, and so sets R(t) such that E[P(t+1)/{R(t),I(t)}=P*, then an econometerician cannot estimate the effect of R(t) on P(t+1).

My post above says that in equilibrium, when actual reserves=desired reserves, then MB=MC for any expansion in deposits, so changes in MB must be equally important to changes in MC. So other things must matter too, unless the supply of reserves is the only thing affecting MB and MC that ever changes.

The simple textbook model implicitly assumes that the desired reserve/deposit ratio is independent of everything (it's perfectly interest-inelastic, for example). That's an obvious flaw. But what do you expect for ECON1000?

As Josh notes, even if the opportunity cost of reserves today were zero (or very close to it) the expected opportunity cost in future may be much higher. So the marginal cost of making a new multi-year loan would be above zero.

Winslow:

I don't think I was conflating reserves and deposits. By "deposits" I mean the demand deposits people and firms have at commercial banks (a liability of those banks). By "reserves" I mean the demand deposits commercial banks have at the central bank. The first is a liability of the commercial bank, the second an asset.

I see your 1,2, and 4 as essentially the same (assuming that the deposits referred to in 4 are commercial banks' deposits at the central bank, i.e. reserves). They are all just different ways in which a bank borrows extra reserves. 3 is different. But note that 3 doesn't create a new deposit, it just switches it from bank B to bank A.

[Nick Rowe]

Winslow @1.55: If the central bank targets the price of a *real* asset (or real good of some sort), as buyer of last resort, then that target price is in effect the P* I was talking about in my earlier comment. We don't even need to complicate the story by saying that P* changes over time, so you get inflation. But do Post Keynesian's central banks' reaction functions typically include such a variable? I thought they just said: "The central bank sets i=i*"?

(I'm asking, not saying. Those are not rhetorical questions.)

[Nick Rowe]

MDM: Off-topic, but it interests me, so I'm going to answer it. But later.

[TheMoneyDemand blog]

Nick,
This is from the latest Bernake's congressional testimony:
"The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system."
What are you going to do with you textbook model then?

[Winslow R.]

I thought they just said: "The central bank sets i=i*"?

They do under normal circumstances, which is not currently the case. The CB is currently doing things that mess with the PK framework that says the CB should only do monetary policy and the federal government should do fiscal policy. I was referring to fiscal policy setting P through a political process rather than monetary policy through some monetary rule.

It seems the biggest difference between us is our willingness to look at fiscal policy as driving the economy. I'm not sure if this difference is intentional, but each time I bring it up, e.g. how a fiscal surplus (raising taxes above spending) can bankrupt the financial sector by forcing banks to borrow reserves, it gets ignored. Banks don't create net financial assets, each deposit has a loan. The government can force a 'run' on those deposits simply by politically choosing to run a fiscal surplus.

Just curious, do you buy in to the neo classial requirement that the effects of fiscal policy are ignored?

[Winslow R.]

Allowing for the effects of fiscal policy largely absolve the CB from responsibility of our current financial crisis.......

[David Pearson]

Nick,

Earlier you argued the marginal cost of funds was the IOR rate -- an overnight rate. Your latest comment implied the marginal cost of funds is the "term" IOR rate. There isn't one, but an approximation would be term Treasury rates (if the market expected the IOR to remain at zero for one year, then one-year Treasuries would yield close to zero). Alternatively, one could look at Fed Funds futures.

So just to be clear, the Fed should both target the level and shape of the yield curve, and it must know with some degree of certainty the elasticity of reserves to changes in both the level and shape of the curve.

[Nick Rowe]

TheMoneyDemandblog: That just shows how out of it I am! I didn't realise the US still had minimum reserve requirements. I was assuming you had gotten rid of them, like we did a decade or two ago. That explains why you guys keep talking about "excess *required* reserves" as though it meant something! You are Americans!

So I can answer your question as a historical fact, not as a hypothetical future. "Nothing", is the short answer. It does mean that you *must* talk about *desired* reserves, and excess *desired* reserves. But then, we should always have been talking about *desired* reserves in any case. *Required* reserves are irrelevant, expect that required reserves are one of the things that affect desired reserves.

Even if the *desired* reserve ratio fell to 0% (which it won't), the main insights of the textbook model are still valid. The individual bank's experiment is very different from the banking system as a whole. And a shift in the supply curve of reserves will have a multiple effect on the money supply. The whole boring "dynamic" process story is as important as ever, or even more so. It's just that the equilibrium multiplier approaches infinity in the limit, as desired reserves approach zero. So you can't have a finite multiplier with a fixed perfectly inelastic supply curve of reserves. No big deal. Easy to fix in upper year courses. Not quite so easy to find a story simple enough for ECON 1000.

Winslow: must make up an exam. Will return later.

[scott sumner]

Nick, Sorry, I was off in the math on point three. I meant that if you had a bank with $10,000,000 in assets and it wanted to make a $900,000 loan, it would simply attract another million in deposits and hold $100,000 more in reserves. Many textbooks imply that the loan causes deposits to rise. But there is no unidirectional causation here. Banks decide to expand, then they decide to have more deposits, more loans and more reserves. It is all decided jointly. If you to assume the new reserves are injected by the Fed, and none of the ratios change, then everything rises in proportion. An extra $100,000 in reserves from the Fed causes banks to want to make another $900,000 in loans and acquire another $1,000,000 in deposits. They're intermediaries, all those steps are decided jointly.

You said;

"But what happens to real variables during the transition to the new equilibrium depends very much on the excess supply of the medium of exchange. And banks' demand deposits are just as much a medium of exchange as currency.

Plus, it is at least theoretically possible that currency should disappear. And I want a model of money, prices, and the transition that is robust to the disappearance of currency."

I disagree here. If the Fed controls the price level by controlling the base, and 100% of base money is currency, then it is the supply and demand for currency that are key. Real variables respond to unexpected changes in expected NGDP growth. Demand deposits respond endogenously to reflect changes in the public's desired C/D ratio. There is no AD outcame that cannot be explained by a single-minded focus on the S&D for currency. Also note that it is theoretically possible that you had an economy with no banks, but currency was the medium of exchange. How would the price level be determined in that case? Solely through changes in the supply and demand for currency. Of course banks do hold base money, so in the real world they have a role to play. But only because they hold base money. DDs only matter because they are close (but not perfect) substitutes for currency as a medium of exchange.

I am also intrigued by your partial defense of PK econ. You say they could come up with a theory of the price level (and by implication NGDP) if they wanted to. I find that an odd defence, but perhaps I don't know enough about the issue. NKs do incorprate the QTM into their model, as a long run proposition. Unless I am mistaken, the PKs don't. If so, they can't explain the time path of NGDP. That's a pretty big weakness for a demand-side model. The fact that it could be fixed if they became more like NKs doesn't impress me very much. The fact is (unless I am mistaken) there is a huge gap in their model.

[Bill Woolsey]

Scott:

Wrong, wrong, wrong!

If there is no demand for base money, then a fixed quantity of base money won't determine anything. You are right about that.

But as long as there is any demand for base money, then a fixed quantity of base money does tie down the price level.

The price level adjusts so the real quantity equals the real demand.

Now, if you say, banks hold no reserves and no one uses base money for currency (currency isn't used or it is privatized,) then there is no more demand for base money.

In reality, all of those dollar denominated payments, whether checks, electronic payments or banknotes have to be cleared. Generally, they are cleared with base money, and so that is what creates the demand for base money.

But, if banks find a way to do all of their settlements without base money, and they don't worry about having to redeem anything in emergencies, and the demand for base money is zero, then a fixed quantity of base money determines nothing.

If we imagine the demand for base money gradually falling, and the quantity of base money stayed fixed, then the result in a higher and higher price level until money has no value. Presumably, if this is foreseeable, it would occur rapidly. (Well, who knows what would happen, really.)

The other option, however, is for the nominal quantity of base money to be reduced with real demand. And so, when there is no more demand for base money, the quantity of base money is zero.

Banks are clearing with T-bills (or something.) No currency is used, or else private banknotes are used.

However, all of these are claims to base money. None exists because no one wants to hold it.

Interesting puzzle.

Of course, I have thought about this sort of thing quite a bit. First, the approach of using a fixed quantity of base money as the fixed nominal quantity in the economy won't do. But you can use the price level, nominal expenditure, or the price of some particular good, like gold.

You know exactly how it works with gold. The problem is that your ignore this process, assume it works perfectly, and just focus on gold. Not enough process analysis. Too much comparative statics.

Suppose we had nominal expenditure targeting. A dollar is defined in terms of some fraction of GDP. All of those private claims being settled, (checks, electronic payments, or banknotes) are denominated in terms of dollars. They are all claims to that fraction of GDP. But no one wants to hold base money, so the quantity of base money is zero.

So, normally, a bank with favorable net clearing of a dollar receives T-bills with a market value of a dollar (or whatever they use instead of base money.) But, Nominal GDP is above target. Those banks with the adverse clearing balances may be giving T-bills that could be purchased with a dollar electronic payment or sold for that same payment, but those payments buy less that the fraction real GDP that defined the dollar. The T-bills have a market price of a dollar (in terms of electronic dollar payments, checks written in dollar amounts, or private dollar denominated banknotes,) but are worth less than "a dollar" as defined in terms of the nominal GDP target.

[Nick Rowe]

MDM:

1. On "origins". I've decided to do a post on that, since it's something that has always interested me. It's the difference between what Patinkin called an "equilibrium experiment" and a "stability experiment". The Hobbesian State of Nature is a stability experiment, not political history. So is Menger's theory of the origin of money. Post title "Creation Myths and Economic History". I like that title!

2. Again, see 1 above. But there is a big difference between intertemporal bilateral barter, and monetary exchange. Bilateral trust can enable barter exchanges to have an intertemporal dimension. I give you apples today. You give me bananas tomorrow. But monetary exchange is a substitute for *multilateral* trust. Or rather, monetary exchange IS multilateral trust. B gives bananas to A today. C gives carrots to B tomorrow. A gives apples to C the day after tomorrow.

3. Let me give you an example of why it's a false dichotomy. Suppose money is gold. That's a metallist perspective, right? But the stock of gold is endogenous, as well as exogenous. The discovery of a new mine is an exogenous shock to the (flow) supply curve. But if the demand for money increased, the real price of gold would rise (the price of goods in terms of gold would fall), and there would be a movement up along the supply curve of new gold (plus, some jewelry would be melted down, etc.) So the stock of money is at least partly demand-determined in equilibrium even in that extremely metallist world.

On the issue of Granger causality (and Kydland and Prescott, etc.). Here is my old post on why those sort of econometric causality tests of the effectiveness of monetary (or fiscal) policy are worthless:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/01/why-theres-so-little-good-evidence-that-fiscal-or-monetary-policy-works.html
This point was understood back in the 1970's, but then forgotten. Friedman wrote the whole Monetary history of the US to try to get around this problem. Another Dark Age, as Krugman calls it. I have a couple of papers on this question.

4. Having a monetary exchange economy (i.e. one with a medium of exchange), plus imperfectly flexible prices, is necessary and sufficient for violating Say's Law. Say's Law is violated if and only if there is an excess supply or demand for the medium of exchange. I have never been able to understand whether PKs understood the key role of money as a medium of exchange in this regard. They both emphasise that Say's Law is invalid, yet downplay the concept of money as medium of exchange, and the excess demand for money.

So many comments coming in. I can't give them all the lengthy replies they deserve!

[Nick Rowe]

Winslow: "Just curious, do you buy in to the neo classial requirement that the effects of fiscal policy are ignored?"

Basically, no. Though in normal times, if the Bank of Canada uses monetary policy to offset any effects of fiscal policy on AD, so as to keep inflation at 2%, then you can ignore the effects of fiscal policy on AD. Though it will have other effects, like on the real exchange rate, for example.

By the way, I don't see that (that fiscal policy can be ignored) as a "neo-classical" view. It's a very special case, true only under full-blown Ricardian Equivalence plus the assumption that G is a perfect substitute for C and/or I.

As far as I can tell, much of the difference between Neo-Chartalists (MMTers) and the rest of us on monetary vs fiscal policy is purely semantic. Sadly enough. NCs define pure fiscal policy as money-financed (holding Bonds constant). The rest of us define pure fiscal policy as bond-financed (holding Money constant). My old post on that subject is here: http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/11/a-monetarist-theory-of-neochartalism.html

[Nick Rowe]

Scott: but if an individual bank A wants to expand its stock loans, and does it by attracting (a stock of) deposits away from another bank B, then B must lose deposits and must therefore contract loans (unless it seeks more reserves). There is no effect on the system as a whole.

Only if A attracts more deposits away from currency does the banking system as a whole expand. Perhaps that's what you had in mind.

"Many textbooks imply that the loan causes deposits to rise. But there is no unidirectional causation here."

If we start in equilibrium, then the exogenous shock is an increase in the supply of reserves, then I think it's true that the individual bank's desire to increase loans is what *causes* deposits to rise. It's true that the individual bank creates the loan and the deposit in the same act. But it does this knowing that the increased deposits on its books will be spent and disappear almost immediately. So it's the individual bank's *desire* to increase loans that causes the *banking system's* deposits to rise.

It's true that if the *desired* R/D ratio vanishes to 0%, then the desired C/D ratio takes over the full role. And if D and the banking system vanish, then we are back to C determining everything. But I like to imagine a world in which both R/D and C/D vanish. It's a weird world, but quite possible. Start in equilibrium. Then the BoC wants to expand M. It adds reserves. The multiplier is infinite. The excess desired reserves hot potato around the banking system, increasing D=M as they go around. When the BoC decides D=M has increased enough, it withdraws the reserves again. Meta-stable equilibrium. In fact, on a very short time scale (hours, maybe a day or two) this is exactly how the BoC fine-tunes the overnight rate to hit the target, or so I hear.

I can't keep up. I was expecting a 2-way fight: me vs the PKs. Now there's a 5 way argument going on!

[Winslow R.]

Nick: "But I like to imagine a world in which both R/D and C/D vanish."

Nick from reading your posts it appears you are interested in finding a way to move the printing press from the public sector to the private sector and in particular into private corporate banks.

I'd say Larry Summers, Bob Rubin, Clinton thought they had it figured out (while being highly compensated) but instead just created the mother of financial bubbles as it was 'discovered' that the government will only accept R or C (not D) in payment of taxes.

Not sure this is the impression you are trying to give.

[Nick Rowe]

Winslow: "Nick from reading your posts it appears you are interested in finding a way to move the printing press from the public sector to the private sector and in particular into private corporate banks."

I'm a bit of an outlier on the privatisation of money question. As far as I can tell, private monies (in Canada anyway) are already effectively legal, and exist, but they have only captured a miniscule part of the market. Paradoxically, they seem to be run by left-wing local community hippy types, rather than the big right-wing multinational corporations. (Not that there's anything wrong with that!)

Since government money (the Bank of Canada) runs a profitable business, where people can chose the private enterprise product if they wish, but generally chose not to, I see no reason to change anything on this dimension.

But that's talking about genuinely independent private monies, that are not redeemable on demand into government money. The government has already contracted out the provision of demand deposits, redeemable in Canadian dollars, to the commercial banks. Nothing new there since the end of the gold standard.

What I'm exploring here is the relation between the Bank of Canada and its subcontractors.

[RSJ]

Nick,

You are saying that banks require 100% reserves to issue the marginal $1 of loans. But as long as the size of the increase in lending is small relative to the total outflows, the law of large numbers will tell you that this marginal new outflow will be matched by marginal new inflows according to the same rate as your aggregate outflows match your aggregate inflows.

The desired reserve ratio for small banks *is* somewhat larger than for large banks, because the mortgage loans they make are of the same size but their outflows/inflows are smaller in size, so their cash-flows are more clumpy, requiring a proportionally larger buffer stock. But you are talking about 1:100 instead of 1:200. For the purposes of a textbook model, you should assume that R/D is zero.

Btw, before the crisis, total bank reserves in the U.S. was about 20B, total deposits was about 4Trillion, and rarely did the total quantity of borrowed reserves exceed 2 Billion, and most of the time it was effectively zero. Banks, both large and small, were expanding lending throughout.

[Nick Rowe]

RSJ: The Law of Large Numbers (or, rather, the extent to which that Law holds, especially if flows are correlated) will be one of the things determining the desired reserve ratio. But it will have no effect on the marginal costs of an extra $100 in loans. The small individual bank knows that the deposit created will be spent, and it will lose $100 of reserves to a second bank. So it will need to borrow $100 in reserves to restore its original desired reserve deposit ratio, *relative to what would have happened otherwise*.

[Winslow R.]

"What I'm exploring here is the relation between the Bank of Canada and its subcontractors."

Yes, but for what purpose?

In the U.S. we gave near unlimited power to the subcontractor's subcontractors (hedge funds, SIVS, nonbanks). Reserves/Deposits and Currency/Deposits moved towards zero as NBD/D (nonbank deposits/deposits) zoomed higher while NBD/Reserves zoomed towards infinity.

The part that sucks (from my perspective) is given government bailouts the subcontractor's subcontractor might as well have been printing Currency and Reserves rather than creating NBD. Basically the determination of public purpose was subcontracted to the subcontractor's subcontractor. Exactly what Larry/Bob/Bill were aiming to achieve.

[Winslow R.]

Nick: "I see your 1,2, and 4 as essentially the same (assuming that the deposits referred to in 4 are commercial banks' deposits at the central bank, i.e. reserves)."

4 represents an interbank loan not a fed/bank loan.

see line 22

http://www.federalreserve.gov/releases/h8/current/

[RSJ]

"The small individual bank knows that the deposit created will be spent, and it will lose $100 of reserves to a second bank."

How does the firm "know" this? All throughout its history, the inflow from other banks has been correlated with the outflow of the firm, and whenever the firm increased deposits, it was able to get those flows back with a small time lag that resulted in a desire for the firm to hold 1% reserves. Now, all of a sudden, this is no longer the case? Why? As long as the amount borrowed is small in comparison to the size of the flows, or the lending policies of the bank have not materially changed, why should this historical correlation between inflows and outflows cease to hold?

[Ramanan]

Scott Sumner/Nick,

There is tremendous confusion about what PKE is even with people familiar with the subject. For a description of how an economy works an an organic whole, I refer you to the textbook written by Wynne Godley and Marc Lavoie named Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth. As you can make out from the title, it claims to describe everything together. I am happy to say that it does so successfully.

For example, not only the inflation process is described, it is also accounted brilliantly.

There is an advertisement of the textbook by one of the authors here:
http://www.ipc-undp.org/publications/srp/TOWARDS%20A%20RECONSTRUCTION%20OF%20MACROECONOMICS.pdf
TOWARDS A RECONSTRUCTION OF MACROECONOMICS USING A STOCK FLOW CONSISTENT (SFC) MODEL

The approach is closest any school of thought can ever get about how an economy works as a whole.

[Rob]

"The small individual bank knows that the deposit created will be spent, and it will lose $100 of reserves to a second bank. So it will need to borrow $100 in reserves to restore its original desired reserve deposit ratio, *relative to what would have happened otherwise*."

So this bank doesn't take any deposits from people who took loans from other banks? Why would you assume that making a $100 loan would necessarily result in a net loss of $100 in reserves? I can see it leading to a net outflow, but 100%? Seems odd to me

[Ramanan]

Nick,

This is useful - contains a lot of reserve accounting.

Modern Money Mechanics - A Workbook On Bank Reserves And Deposit Expansion (by the Federal Reserve Bank of Chicago)
http://upload.wikimedia.org/wikipedia/commons/4/4a/Modern_Money_Mechanics.pdf

Has the Scourge of Monetarism built into it, but you can compare and contrast this article with what actually happens. In other words, the article linked above is super-correct in its accounting, but the Fed does not control the amount of reserves and/or the money supply - it targets overnight rates and indirectly the yield curve through interaction with the market players and the media.

[Nick Rowe]

Winslow @12.56: I think you raise a very important point there (about subcontractors, and sub-subcontractors of the money supply).

At least, it's a very important point if these sub and sub^2 contractors are creating media of exchange, and you believe (as I do) that the supply of media of exchange is important. It's people who think that the money supply doesn't matter, and that "monetary policy" means merely "the interest rate set by the central bank" who would see it as unimportant (at least, unimportant as part of monetary policy).

What the policy response should be though...

Winslow @1.13. Agreed. And that difference (whether the borrowed reserves come from the central bank or from other banks) matters for the system as a whole. I was talking about from the perspective of an individual bank.

[Nick Rowe]

RSJ: In equilibrium (no exogenous shock) the flows between banks will indeed roughly balance. That is part of what makes it an equilibrium. But we are now talking about an individual bank, at equilibrium, contemplating a move away from equilibrium.

Let me try an analogy. Take the simple Keynesian Income-Expenditure model. Closed economy. No government. For the economy as a whole, income=expenditure. So if every household expands expenditure by $100, income will increase by $100 per household. But if an individual household increases expenditure by $100, that will have $0 affect on that individual household's income (assuming there is a very large number of very small households). It is a fallacy of decomposition to argue otherwise. If that fallacy of composition weren't a fallacy, then there could never be a shortage of aggregate demand in that model. If the economy were at less than full employment, each individual household would increase expenditure, confident that all its increased expenditure would return to it as increased income. The individual household could get itself to full employment just by spending more money.

[Nick Rowe]

I like my above analogy.

Post Keynesians understand (or certainly ought to understand) the Paradox of Thrift. That Paradox (given the underlying model) is based on a correct understanding of the difference between an individual and the economy as a whole. (You only understand the Paradox of Thrift if you understand what is meant by a Fallacy of composition/decomposition). So why can't (some) PK's understand the same difference when applied to the individual bank vs. the banking system?

Nobody ever argues "what goes around, comes around" when we are talking about the Paradox of Thrift.

[TheMoneyDemand blog]

"Even if the *desired* reserve ratio fell to 0% (which it won't), the main insights of the textbook model are still valid. The individual bank's experiment is very different from the banking system as a whole. And a shift in the supply curve of reserves will have a multiple effect on the money supply. The whole boring "dynamic" process story is as important as ever, or even more so. It's just that the equilibrium multiplier approaches infinity in the limit, as desired reserves approach zero. So you can't have a finite multiplier with a fixed perfectly inelastic supply curve of reserves. No big deal. Easy to fix in upper year courses. Not quite so easy to find a story simple enough for ECON 1000."

I agree, but I was hoping for a different answer. When there are no legal reserve requirements, or when they are obsolete (like now in the US when there are lots of excess reserves), the model works better when we recognize that in modern commercial banking practice other assets are able to play the role of the reserves. So we might say that the interest rate paid to borrow reserves has a 100% weight in the decision of a small bank A, T-bill rate has a 100% weight in the decision of bank B, and repo rate on long term treasuries has a 100% weight in the decision of bank C. Such expanded money multiplier model would have greater practical relevance. It will let you explain the true impact of various Fed lending programs. It will also help some people to understand that 25bps rate on reserves has almost no contractionary impact as long as 3m T-Bills trade at zero.

[Winslow R.]

Nick: "The small individual bank knows that the deposit created will be spent, and it will lose $100 of reserves to a second bank."

The small bank will 'lose' $100 in deposits not reserves when a deposit is spent. Interbank loans solve the problem of the deposit shortage. Interbank loans are the first option as the interbank rate is usually lower then the Fed discount rate.

[Winslow R.]

Nick the real difference between the PK's and yourself is the purpose of studying the banking system.

To PK's it is obvious that the monetary system serves a public purpose and they address how best to do that.

To most economists employed by the BOC, Fed or other financial institutions, the monetary system serves an independent, even private purpose (as only then will they recieve continued employment). These economists lack intellectual integrity. It's possible you are trying to restore that integrity though you have yet to address where you stand. History aside you can have an opinion.

Once one understands the position they are coming from, then policy choices can be made on the structure of the system. The current structure is in flux with moves being made in both directions (The Fed purchases MBS, the Fed failure to regulate hedge funds).

[winterspeak]

Nick:

I don't know of the arguments between you, Sumner, and Woosley have made you nervous or not. They should.

Your assertion that PK has missed the fact that reserve outflows (for whatever reason) need to be matched by reserve inflows at an individual bank level reflects poorly on you. PKs talk about this all the time, and it is how the loans->deposits causality works.

It's also a pity no one responded to David's original question about how a bank that's just enjoyed a $1M deposit isn't better off than an identical bank that has not. DAVID, if you're still rolling about this bog, the answer is that the bank with the $1M deposit has a lower cost of capital because of its liability structure, and it can exploit that lower cost in a number of ways, one of which may be making additional loans. Up to the bank.

This raises two important points. The first is that, at an individual bank level, the entity has a number of strategies it can use to generate a reserve inflow to make up a reserve outflow (for whatever reason). It can seek deposits, it can borrow reserves from another bank, or it can borrow directly at the discount window. These all go up in cost of capital, and banks can and do manage their liquidity risk as fits their business model. PKs have always stressed that capital constrains lending, and cost of capital is a factor in that. But claiming that matching reserve inflows and outflows someone makes the "money multiplier" real again is a fallacy. If you want to say "reserves matter because they impact the cost of capital" that's fine. But lending remains capital constrained and NOT reserve constrained (as per your "money multiplier").

Which brings me to my second point, that if a bank gets lots of deposits, it has the option to make more loans because it enjoys a lower cost of capital and note that the mechanism for loan enablement remains the capital channel. Nick -- you have just spilt I don't know how many pixels arguing with other monetarists about what constrains credit extension and the word "capital" was not mentioned even once. Anyone who knows the first thing about Reality will reject the nonsense based on that alone. And it should make you seriously reconsider the monetarist fairy tale about how all this works.

You're getting dangerously close to the last refuge of Monetarists, which is to redefine all fiscal policy as monetary.

[Nick Rowe]

Winslow @10.40: "The small bank will 'lose' $100 in deposits not reserves when a deposit is spent."

Yes, but when the deposit is spent, and redeposited at bank B, bank A will lose $100 in reserves to bank B.

The MoneyDemandblog: as in my reply to Winslow above, the *immediate* cost to bank A is the loss in $100 of reserves, so it must pay interest to Bank B (for example) to borrow those reserves back. I see how it subsequantly responds to that loss, whether by selling $100 of T-bills, or whatever, as a second round response. Yes, I agree, it's interesting to consider such things. Beyond the scope of my post though.

Winslow @11.25: Look, just because some people disagree with you on public policy questions (and on the proper sphere of public policy vs private policy) doesn't mean they "lack intellectual integrity".

[Nick Rowe]

Winterspeak: welcome to the "car crash"! I knew you wouldn't be able to resist doing more than just "rubbernecking" ;-)

"I don't know of the arguments between you, Sumner, and Woosley have made you nervous or not. They should."

Paradoxically, they cheer me. You and I both know there is something unhealthy about a science that claims a monolithic orthodoxy of mainstream knowledge. And PK's apparent sense that there is a monolithic mainstream is I think mistaken. Plus, in some ways, the PKs are actually closer to any mainstream than me, Scott, or Bill.

Bill's an my views don't seem to differ much on this particular issue. And Scott's view is internally consistent. The banking system matters to me (and Bill?) because I think money's role as medium of exchange is important, and bank deposits are media of exchange. If I didn't hold those beliefs, and were interested only in money as unit of account, and the equilibrium price level, then I would I think agree with Scott. *Any* model of banks' creating money would not be so much wrong as irrelevant.

"Your assertion that PK has missed the fact that reserve outflows (for whatever reason) need to be matched by reserve inflows at an individual bank level reflects poorly on you. PKs talk about this all the time, and it is how the loans->deposits causality works."

There is a lot of heterogeneity among PKs, as they themselves generally acknowledge. Perhaps those who commented on David Beckworth's post, and here, who seemed to me to disagree with this point, are not a representative sample? So I am (mostly) preaching to the converted? OK.

Now, you are really losing me on the question of the cost of capital. Because as I understood it, the idea that bank lending is capital constrained (as well-articulated by JKH for example), when it talks about a bank's "capital" means by that the bank's equity (total assets minus total liabilities). I know I'm probably over-simplifying, but getting lots of extra deposits does not increase the bank's capital in that sense of the word (except perhaps slowly, over time, if it can increase retained earnings as a result). The way for a bank to get more "capital", for example, would be to issue more shares (or preferred shares?). So the "cost of capital", in that sense, would be (inversely) related to the P/E ratio at which it could sell new shares, for example. The interest rate on deposits is not a cost of bank "capital", in that sense.

The idea that bank *lending* is capital constrained is interesting and important. How important it is will depend on the supply curve of new capital (people's willingness to buy newly-issued bank shares, and at what P/E ratio. But that's more relevant to the supply of bank *loans*. As I said in the post, the textbook model is not a theory of the supply of bank loans, it's a theory of the supply of bank deposits, i.e. money.

"You're getting dangerously close to the last refuge of Monetarists, which is to redefine all fiscal policy as monetary."

"Close"?! If you adopt the standard monetarist definition of monetary policy -- anything that affects the (current or expected future) supply (function) of money -- and then take the standard MMT definition of fiscal policy -- any change in G and/or T that is financed my changing the stock of money -- then I am not "close" to that "last refuge". Monetarists always and everywhere have already been there!

[winterspeak]

Nick:

I tip my hat to Sumner's consistency just as I do to your graciousness. As for the rubbernecking and involvement, I am weak : (

If you want to find complete confusion about the basic mechanisms of banking cheering, that is up to you. Perhaps you are similarly invigorated by debates concerning the flatness of the Earth?

The capital question is easy to understand. JKHs point about equity liability is exactly correct. Banks with large deposit bases find it cheaper to raise additional equity and thus have lower CoCs than comparables without those deposit bases.

I find your distinction between bank loans and bank deposits trivial.

And yes, once PKs demolish the point of reserves, FFR, QE, and the entire steaming pile that is monetary policy in general, and point out the centrality of fiscal, Monetarists say "fiscal is monetary too". Then they start arguing about the money multiplier again.

[TheMoneyDemand blog]

"The MoneyDemandblog: as in my reply to Winslow above, the *immediate* cost to bank A is the loss in $100 of reserves, so it must pay interest to Bank B (for example) to borrow those reserves back. I see how it subsequantly responds to that loss, whether by selling $100 of T-bills, or whatever, as a second round response. Yes, I agree, it's interesting to consider such things. Beyond the scope of my post though."

In practice selling $100 of T-bills or repoing $100 of longer term securities is what happens in the first round. Especially now in the US when reserves yield more than T-bills.

[TheMoneyDemand blog]

Nick, winterspeak - capital constraints have a serious impact on the money multiplier model as thay sharply increase what Nick calls "an allowance for risk and admin costs". Money multiplier model is 100% correct, you just have to map it correctly to the reality.

[Scott Sumner]

Nick, I understand why you say that DDs associated with a new loan will disappear almost immediately. But that is not true for the entire stock of DDs held by the loan-making bank. Suppose a bank attracts $100 in new base money via an OMO. The bank may decide to increase loans by $900 and DDs by $1000 in equilibrium. The fact that most of the specific DDs associated with the loan may soon disappear is not important. Even if they do, they will be replaced by other DDs. Even if those other DDs come from another bank, that's no problem, as other banks will also be attracting DDs as the loan money is withdraw from the original bank, and deposited elsewhere. I still don't see any problem with analyzing the process by assuming a single monopoly bank. For instance, suppose you had a single monopoly bank with many branches. Wouldn't the process look exactly the same, even if you broke down the accounting statements on a branch by branch basis?

In my view the expected future supply and demand for base money determines the expected future NGDP (perhaps with help from an explicit central bank target). The expected future NGDP determines near-term NGDP. Near term NGDP determines current demand for M2. (M2 is endogenous in that sense). So current M2 is determined by future expected MB supply and demand, nothing at all like the way it's taught in the textbooks. You say you are being attacked on 5 sides? I'm disappointed, there are at least ten ways of thinking about banking. You've got to broaden your readership! (Seriously, you have great commenters.)

If C/D and R/D go to zero, then the price level goes to infinity, in other words people use cash in their fireplace for heat. You can't buy anything with currency.

Bill, I did not mean to assume no demand for base money, just no demand for reserves. I was still assuming a demand for currency, which pins down the price level.

[Winslow R.]

Winslow @11.25: Look, just because some people disagree with you on public policy questions (and on the proper sphere of public policy vs private policy) doesn't mean they "lack intellectual integrity".

If I gave the impression that I believe anyone that disagrees with me "lacks intellectual integrity, I apologize. Economists lack intellectual integrity when their jobs 'keep' them from publicly questioning or stating their stance on the proper sphere of public policy vs private policy.

From your statements I can only infer you believe the printing press should be fully privatized. You still haven't stated your stance, so how can we disagree?

[RSJ]

Nick,

You are using the wrong definition of "equilibrium" in this context. The outflows from the bank will be the rate of increase in loans net of the rate of repayment, with interest. The inflows will be the rate of increase in (time and demand) deposits. "Equilibrium" means that the difference between these two rates is constant, so that the size of reserves is a constant fraction of the size of the bank's assets (or liabilities). All these variables -- loans outstanding, reserves, and deposits, are growing with the overall economy, and are set by the bank's relative aggressiveness in expanding its market share of loans vis-a-vis its aggressiveness in expanding it's market share of deposits.

To deviate from equilibrium means that the bank changes it's policy, i.e. becomes more loose with lending in a way that is not offset with being more aggressive in attracting deposits. Therefore the desired reserve level is a function of overall bank policy (underwriting standards), and the marginal cost of reserves allocated to each loan is the same given that policy. This is where the law of large numbers comes in -- i.e. the bank assumes that if the observed rate of growth of loans given a certain lending standard was on average X, then it will remain X. In the same way, if the rate of growth of deposits due to a certain competitive position was Y yesterday, then it will remain Y today. Therefore the difference, X-Y will remain constant unless the policy changes. So the bank can go ahead and keep making loans under that policy, and each loan will have a marginal reserve cost of (X-Y), because just as the loan officer is busy approving customers at one rate, the depositors are arriving at another rate, and the bank knows this.

[Nick Rowe]

TheMoneyDemandblog: "Nick, winterspeak - capital constraints have a serious impact on the money multiplier model as thay sharply increase what Nick calls "an allowance for risk and admin costs". Money multiplier model is 100% correct, you just have to map it correctly to the reality."

I really like that statement. Nice and clear. I think the practical importance, though, depends on the state of the market for new bank shares. If banks face a perfectly elastic demand for new shares (to take an extreme case) then there isn't really a capital *constraint*. Just a fixed markup for risk.

[Nick Rowe]

Curses! I wrote a long comment in reply to Winslow on whether I want to privatise money. And it disappeared!

Short version: Winslow: basically, I want to keep the Bank of Canada as a Crown Corporation acting (or trying to, as best it can) in the public interest. But if a bunch of hippies (or whoever) want to set up their own private money on the side, *as long as they don't infringe in ANY way on the Bank of Canada's brand name "the Canadian Dollar"*, then I think that's probably OK too.

Those are tentative views, of course.

[Nick Rowe]

Scott: "If C/D and R/D go to zero, then the price level goes to infinity, in other words people use cash in their fireplace for heat. You can't buy anything with currency."

I'm not sure on this. Suppose the commercial banks are still using the Bank of Canada as a clearing house. So each commercial bank has a deposit at the BoC, which can have a positive or negative balance. Suppose the desired balance of each bank is zero. Now suppose the BoC buys or sells (say) gold for settlement balances at a fixed price P*. I think that pins down the price level. If there were an incipient rise in the CPI and price of gold above P*, the BoC would sell gold, so aggregate settlement balances would go negative, so there would be excess demand for reserves, and so an (infinite) multiplier process would kick in, contracting the money supply (all DDs), until the CPI and price of gold fell back to P*. (That's a stability experiment, by the way).

[TheMoneyDemand blog]

"I really like that statement. Nice and clear. I think the practical importance, though, depends on the state of the market for new bank shares. If banks face a perfectly elastic demand for new shares (to take an extreme case) then there isn't really a capital *constraint*. Just a fixed markup for risk."

State of the market for new bank shares is reflected in the Price/Book or even better in the "Price/Tangible book" ratio. If Price/Book ratio is low then banks are capital constrained. The period of too low inflation expectations in the US in late 2008- early 09 had a nice overlap with a period of low price/book ratios in the banking sector. When Price/Book is high as it was in 2007, there are no capital constraints.

[winterspeak]

TheMoneyDemand:

No. When an individual bank credits a receivable, or debits/credits a deposit as part of payment clearance, it does so without reference to its reserve position. It gets back to its reserve target via operational activities, interbank lending overnight, or the discount window. In no way, and at no point, is an individual bank or the banking system reserve constrained, unless credit concerns shut down its reserve account or the Fed decides to close the discount window.

Nick, Sumner, and every monetarist on planet earth tries desperately to jam a money multiplier into this and it is nonsense. Read through earlier comments, and the post itself, to smell the nonsense for yourself.

The CoC for a bank depends on its cost structure, and risk profile (particularly the riskiness of its assets). Remember -- equity is in first loss position against default, at least in theory. Maybe you are now starting to see why banks are pro-cyclical, which adds to the impotence of monetary policy. But I doubt it.

If banks can raise capital at will, then there is no medium/long term capital constraint. Nevertheless, in the short term, there really is a hard capital constraint as you will hit regulatory limits and actually have to raise the capital, without being able to lend more (legally) until you do. This is what a "constraint" is btw., and there is no analogous situation with reserves as that is managed, after COB essentially, to balance the books.

You guys see constraints where there are none, and then wave them away when they do exist! You discussing lending without mentioning the words debt or capital! The intellectual path dependence is remarkable.

[TheMoneyDemand blog]

Winterspeak,
if you want a money multiplier model that is more useful to you, replace obsolete textbook term "reserves" with "liquid assets". And yes, central banks are always adjusting the price of liquidity. That's why monetary policy works. And yes, capital constraints are really important, they have a huge impact on the parameters of money multiplier model. When Fed forgot that in September 2008, we had a huge problem.

[TheMoneyDemand blog]

Winterspeak said:
"You discussing lending without mentioning the words debt or capital! "
This contradicts your earlier assertion "I find your distinction between bank loans and bank deposits trivial." Look, assets = liabilities, so if Nick wants to focus on the asset side there is no harm.

[winterspeak]

TheMoneyDemand:

I do not want a money multiplier model that is useful. I simply want to describe reality, and in reality, there is no "money multiplier" as is plain as day to everyone (except Monetarists) right now. "Liquid assets" is uselessly vague--you are welcome to it.

As for Nick, well, he made a (bogus) statement about bank deposits. Those are liabilities, not assets as you claim. But I have found that Monetarists are clueless around balance sheets, and proud of it.

[Winslow R.]

"Short version: Winslow: basically, I want to keep the Bank of Canada as a Crown Corporation acting (or trying to, as best it can) in the public interest. But if a bunch of hippies (or whoever) want to set up their own private money on the side, *as long as they don't infringe in ANY way on the Bank of Canada's brand name "the Canadian Dollar"*, then I think that's probably OK too."

...and you believe the printing press (the one capable of printing the dollars acceptable for paying taxes) should reside in the Bank of Canada and the commercial banks or in government?

[Jon]

"The idea that bank *lending* is capital constrained is interesting and important. How important it is will depend on the supply curve of new capital (people's willingness to buy newly-issued bank shares, and at what P/E ratio. But that's more relevant to the supply of bank *loans*. As I said in the post, the textbook model is not a theory of the supply of bank loans, it's a theory of the supply of bank deposits, i.e. money."

There is plenty of evidence that banks are not capital constrained. Bank capital is effectively endogenous in the context of monetary policy. The reason for this is that monetary theory is really about the Price Level. Bank Credit expands => demands more capital, inflation => bank credit expands. Whereas being capital constrained has something to do with the slope of the yield curve. A yield curve steeper than equilibrium attracts capital, shallower than equilibrium causes capital attrition.

Bank capital does not moor the price-level. Any inflationary process will generate an equivalent increase in capital provisioned by the market.

Nick: I must say you are wrong vis-a-vis money vs credit. "Credit" is broad money. And monetarists have always focused on broad money not narrow money. I consider your rejoinder about money vs. credit as entirely specious.

This is something I think Mises nailed hard:

Claims to a definite amount of money, payable and redeemable on demand, against a debtor about whose solvency and willingness to pay there does not prevail the slightest doubt, render to the individual all the services money can render, provided that all parties with whom he could possibly transact business are perfectly familiar with these essential qualities of the claims concerned: daily maturity and undoubted solvency and willingness to pay on the part of the debtor.

We may call such claims money-substitutes, as they can fully replace money in an individual's or a firm's cash holding. The technical and legal features of the money-substitutes do not concern catallactics. A money-substitute can be embodied either in a banknote or in a demand deposit with a bank subject to check ("checkbook money" or deposit currency), provided the bank is prepared to exchange the note or the deposit daily free of charge against money proper.

...

If the money reserve kept by the debtor against the money-substitutes issued is less than the total amount of such substitutes, we call that amount of substitutes which exceeds the reserve fiduciary media.

...

The issue of money-certificates does not increase the funds which the bank can employ in the conduct of its lending business. A bank which does not issue fiduciary media can only grant commodity credit, i.e., it can only lend its own funds and the amount of money which its customers have entrusted to it. The issue of fiduciary media enlarges the bank's funds available for lending beyond these limits. It can now not only grant commodity credit, but also circulation credit, i.e., credit granted out of the issue of fiduciary media.

While the quantity of money-certificates is indifferent, the quantity of fiduciary media is not. The fiduciary media affect the market phenomena in the same way as money does. Changes in their quantity influence the determination of money's purchasing power and of prices and — temporarily — also of the rate of interest.

...

The laws which compelled the banks to keep a reserve in a definite ration of the total amount of deposits and of banknotes issued were effective in so far as they restricted the increase in the amount of fiduciary media and of circulation credit. They were futile as far as they aimed at safeguarding, in the event of a loss of confidence, the prompt redemption of the banknotes and the prompt payment on deposits.

...

The second fault of the Currency School was that it failed to recognize that deposits subject to check are money-substitutes and, as far as their amount exceeds the reserve kept, fiduciary media, and consequently no less a vehicle of credit expansion than are banknotes. It was the only merit of the Banking School that it recognized that what is called deposit currency is a money-substitute no less than banknotes. But except for this point, all the doctrines of the Banking School were spurious.

[Nick Rowe]

Jon: "Bank capital does not moor the price-level. Any inflationary process will generate an equivalent increase in [nominal NR] capital provisioned by the market."

A very important point. I missed it. It needed saying. I have added one word to clarify what you meant against possible objections. And the standard nautical metaphor is "anchor", not "moor"! ;-)

But I think you are misinterpreting either me or Mises there (probably me). *Some* credit is a medium of exchange (bank's demand deposits for example). But not all credit is medium of exchange. That's what Mises is saying, and I agree. But I would call those media of exchange "money" too. What I meant was that I am not interested (in this context) in credit per se; only in that subset of credit that is media of exchange.

Yes, many (most) monetarists focus on broader money. I don't. (Maybe I'm not a "true" monetarist, OK). On this point I am closer to Yeager and Clower. And I can never tell if they are monetarists, Keynesians, or what. (And I'm not sure it really matters what we call them.)

[Nick Rowe]

Winterspeak: "As for Nick, well, he made a (bogus) statement about bank deposits. Those are liabilities, not assets as you claim." ?!!!

Not sure who the "you" refers to there: me or TheMoneyDemandblog. But I know (and I'm 99.9% sure that TMDb knows this too, since he obviously knows his stuff very well) that my deposit at the Bank of Montreal is a liability of the Band of Montreal. (On the other hand, the Bank of Montreal's deposit at the Bank of Canada is an asset of the Bank of Montreal).

"I do not want a money multiplier model that is useful. I simply want to describe reality, and in reality, there is no "money multiplier" as is plain as day to everyone (except Monetarists) right now."

Now that is (unless I am misinterpreting it) a very revealing statement. If you merely want to *describe* what is, in the sense of a photograph, or picture (or even a movie), then yep, a set of accounting statements (balance sheet(s), and income statement(s)), is *all* you need. Forget about the money multiplier, or any alternative *theory* of the money supply. Theories are trying to do more than just *describe* reality; they are trying to explain it. And accounting pictures do not do that.

In this context, I think my analogy between the simple Income Expenditure multiplier model and the simple money supply multiplier model is very instructive (I'm wondering whether to do a post on this). Those two models are formally identical (in a mathematical, and game-theoretic sense). They contain exactly the same insight: there's a difference between the individual household/bank and all households/banks. But if you look at the simple Keynesian income-expenditure model from a purely accountant's perspective, you miss the crucial distinction between actual and desired savings, and can end up in fallacies like Say's Law if you mistake accounting pictures for a theory of what *determines* savings. Same with the money multiplier.

(Also, both those models are flawed in the same way: they ignore interest rates. That is indeed a flaw, but it does not prevent them containing an important insight).

[TheMoneyDemand blog]

Jon said:
"There is plenty of evidence that banks are not capital constrained. Bank capital is effectively endogenous in the context of monetary policy. "
You should have told this to Lehman Brothers in September 2008 or to Citi in February 2009.

Winterspeak said:
"I simply want to describe reality, and in reality, there is no "money multiplier" as is plain as day to everyone (except Monetarists) right now. "Liquid assets" is uselessly vague--you are welcome to it."
It is quite obvious that banks actively manage their liquidity position on the asset side of the balance sheet. Banks have a desired mix of liquidity on their balance sheet, this creates money multiplier effect. All the things you mentioned - cost of capital, etc. are very important inputs that change the parameters of the money multiplier model.

[winterspeak]

Nick: TMDB said you wanted to focus on assets, when in fact you were focusing on liabilities. I don't know who got confused, or whether there was a typo somewhere, but I guess it's good enough for Government work in Monetarist quarters.

Call me old fashioned, but I think accurately describing reality is a necessary first step to explaining it. This post is on a very basic point: whether bank lending is at an individual, or system level, reserve constrained. You say it is, I say it is not. You argue that, at an individual bank level, needing 100% reserves makes it so, and I point out that it's just managing a reconciling flows between banks, something that happens as part of payment settlement, and immaterial to credit extension. A bank doesn't check its reserve balance before it clears a check, and a bank doesn't check its reserve balance before it extends a loan. It does not need to.

I think it's revealing that you don't believe accurately describing reality is a necessary prelude to trying to explain it. You are trying to explain fire via phlogiston.

TMDB: No. Liquidity management, neither on the asset side nor on the risk of needing the ON market or discount window, creates the multiplier effect. In fact, the latter eliminates it. And the things that I mention do not change the parameters of the money multiplier model as reserves are simply not multiplied out into money supply.

[Winslow R.]

In Nick's case I find theory isn't guided by actual reality but rather a preferred reality.

Nick, at the risk of provoking an angry backlash, I'll continue to infer you prefer the printing press to be controlled by a crown corporation or ultimately the monarch (who will work in the public interest or try to, as best it can)

http://en.wikipedia.org/wiki/Crown_corporations_of_Canada

Wow! Your preferred reality pushes us into a monetary structure more feeble than the gold standard.

At least the gold standard had some fig-leaf of democracy as it allowed anyone to dig up gold out of the ground to pay their taxes. In your reality, the ability to pay taxes is limited by an unelected monarch. I thought this war was fought a long time ago but I guess there are a still more than a few monetarist monarchists hiding in closets.

Bill, Larry, Bob meet Nick.

[Scott Sumner]

Nick, I must have missed something in the C/D and R/D going to zero example. In the US the base is normally $800 billion. If the numerator of a fraction is $800 billion, how big does the denominator have to be before the fraction goes to zero? That's why I assumed the price level went to infinity.

Here's how I view banking: I see the money multiplier as like the toaster multiplier. If the base rises 20%, then the nominal size of NGDP rises 20%. If the toaster industry is typlical, the nominal size of the toaster industry also rises 20%, and for the same reason. And if the banking industry is typical, the nominal size of the banking industry rises 20%. Loans, securities, deposits, capital, reserves, everything rise 20%. The textbook approach to the money multiplier makes things seems magical, the mysterious fact that deposits rise more than reserves. Everything rises more than reserves, but they all rise in the same proportion. Nothing mystical at all. I still want to stick to a consolidated balance sheet.

No need to respond to this tirade, I see you are off to the next step, I'll pick up there.

[Jon]

TMDb writes:

"There is plenty of evidence that banks are not capital constrained. Bank capital is effectively endogenous in the context of monetary policy. "
You should have told this to Lehman Brothers in September 2008 or to Citi in February 2009.

Please. First, you truncate the quote when I define what it means to be in the context of monetary policy.

Second, what happens in the aggregate is different from what happens to an individual firm. The 'market' withdraws capital from particular firms or prefers to provision capital to different firms differently on a daily basis, and indeed, the firms so discriminated against do feel the effects, but so? The capital went elsewhere. And special-pleading about this firm or that firm does not really describe what happens in the aggregate.

If capital markets don't want to be entangled with bad banking, they'll invest in 'good' banks or start new entities.

[TheMoneyDemand blog]

Nick, Scott,
I tentatively agree with Scott here. One big commercial bank may have a desired reserve ratio equal to zero, but it will need to have another kind of liquidity buffer, for example T-bills. Let's say that one big commercial bank has a desired T-bill/deposit ratio of X. Then central bank can control the commercial bank by buying/selling T-bills, and making other changes to the size and composition of the central bank's balance sheet. The only change is that one big commercial bank will earn excessive monopoly profits, but the central bank will still be able to control monetary policy by manipulating various interest rates.

[Nick Rowe]

Just catching up after a visit to Toronto. Some interesting arguments in my absence!

My view (I think Bill Woolsey said it somewhere in the last week on his blog) http://monetaryfreedom-billwoolsey.blogspot.com/ , is that reserves are the medium of exchange to banks in the same way that deposits at the commercial banks are the medium of exchange for the rest of us.

If you think (as I do, and Bill does) that the medium of exchange is crucially important (and quite over and above the fact that the medium of exchange usually also serves as the unit of account), then the demand for and supply of the quantity of money (medium of exchange) matters far more than the demand and supply of other assets that people hold. And the demand and supply of the quantity of reserves matters far more than the demand and supply of the other assets that banks hold.

I think this is the underlying reason why I would disagree with TheMoneyDemandblog. I have already argued (in earlier posts) why an excess demand for the medium of exchange can cause Say's Law to be false, and create a general glut, but that an excess demand for antique furniture cannot do that. Clearly, I need to make a similar argument for bank reserves. But yes, if you don't see that the medium of exchange should be in such a "privileged" position in macroeconomics, you won't see that reserves should occupy an equally privileged position in monetary theory.

This debate is helping me clarify my thought (always the selfish reason for blogging)!

Apropos of the above: Scott: toasters! This reminds me of Arnold Kling's post on Mackerel! (And at least mackerel begin with 'M'!) An excess demand for toasters or mackerel cannot cause a violation of Say's Law and a general glut.

[Nick Rowe]

Winslow: You Republicans (ooops! I meant republicans) are going to re-start the War of 1812! And a parliamentary system under a constitutional monarchy seems to work no worse than the system south of the border!

[Winslow R.]

Nick "And a parliamentary system under a constitutional monarchy seems to work no worse than the system south of the border!"

True we both operate under an elite, though Canadians seem to relish the situation. South of the border we are in denial and we post-keynesians deny it the most.

Amazing to commit one's life to serving that elite unless somehow you are part of it? Moving the system towards 'independence' from the huddled masses is the life work of most central bankers and is understandable given their situation.

As a professor, I'd think you'd have other goals. 'Independence' has failed, and bankers have been shown to be very dependent. Why try to design a system that just once again hides that dependency? Does the economic system really work best with a monarch (amorphous elite) picking winners and losers?

[Winslow R.]

Nick wrote: "My view (I think Bill Woolsey said it somewhere in the last week on his blog) http://monetaryfreedom-billwoolsey.blogspot.com/ , is that reserves are the medium of exchange to banks in the same way that deposits at the commercial banks are the medium of exchange for the rest of us. "

I think there is something to be desired here. Though I've tried to get the idea across several times, I'll try again.

Reserves are the currency (medium of exchange) that the Federal government uses when it spends and taxes. Banks use deposits/loans just like the rest of us and call it interbank lending. BofA will have an account at Wells Fargo etc.

Only if BofA refuses to give Wells Fargo a loan, due to credit concerns, will Wells Fargo then go to the Fed for a loan of reserves, as reserves are 'legal tender for all debts public and private'.

Reserves matter when we go to BofA and demand that our deposits be converted to pay for our taxes. BofA can't just 'print' money to pay off a federal tax bill. The printing press doesn't reside in the commercial banks for good reason as we don't want an amorphous elite picking winners and losers. BofA deposits are not acceptable as payment for federal taxes.

[TheMoneyDemand blog]

Nick said:
"But yes, if you don't see that the medium of exchange should be in such a "privileged" position in macroeconomics, you won't see that reserves should occupy an equally privileged position in monetary theory."
No, I agree that the medium of exchange should occupy a privileged position. Where I disagree is that only reserves are a medium of exchange for banks. The existence of repo markets means that other assets can serve as media of exchange.

[TheMoneyDemand blog]

Jon said:
"Second, what happens in the aggregate is different from what happens to an individual firm. The 'market' withdraws capital from particular firms or prefers to provision capital to different firms differently on a daily basis, and indeed, the firms so discriminated against do feel the effects, but so? The capital went elsewhere. And special-pleading about this firm or that firm does not really describe what happens in the aggregate.

If capital markets don't want to be entangled with bad banking, they'll invest in 'good' banks or start new entities."
During the crisis markets didn't want to invest in banks, but I agree that many new entities such as distressed debt vulture funds were started. But such new entities are no help for monetary policy.