"The supply of money is demand-determined"

Rant mode on. It made my flesh creep just to type that title.

Some statements are right. Some statements are wrong. Some statements aren't even wrong. Some statements, like the one in my title, aren't even not even wrong; they are just gibberish.

There are three distinct concepts. 1. "Demand" is what the buyers want. 2. "Supply" is what the sellers want. 3. Then there's what actually happens. What actually happens -- the actual quantity --  usually depends on demand and/or supply, but it's not the same thing conceptually as either demand or supply. Let's try again.

"The actual stock of money is demand-determined".

That's a bit better. It's no longer gibberish. It gets promoted to the "not even wrong" category. Because "demand" is not a number, it's a curve, or a function. The quantity demanded (which is a number) depends on stuff. Let's try again.

"The actual stock of money is determined by the quantity demanded at the rate of interest set by the supplier."

That's a lot better. It gets promoted to the "wrong" category.

It's wrong, but other than that it's a perfectly coherent theory of the world. Draw a picture with the stock of money on the horizontal axis and the rate of interest on the vertical axis. Draw a downward-sloping demand curve. Draw a horizontal supply curve. The actual stock of money is determined by the point where the supply and demand curves intersect. The actual stock of money depends on both supply and demand, but the supply curve is perfectly elastic at a given rate of interest.

There are two things wrong with that theory:

1. The "demand for money" normally means the relationship between the desired average stock of money that people wish to hold and its determinants. And money, as medium of exchange, is very different from other goods. Even if the demand for money were perfectly interest-inelastic (it isn't, but this assumption is just for illustration), it would be possible for the central bank to increase the actual stock of money, and make it exceed the desired stock of money, simply by lowering the rate of interest. By lowering the rate of interest people would want to borrow more money from the central bank. They would borrow that money, not because they want to hold more money (by assumption they don't), but because they want to spend more money. Money's funny like that. When I sell my car for $2,000 that doesn't mean I have decided I would prefer to hold an extra $2,000 money than hold a car. It normally means I have decided I want to hold a different car, or a bicycle, or whatever. I hold that $2,000 in my inventory of money only temporarily until I pass it on to someone else in exchange for a new car. My stock of money is a buffer stock that makes life easier by avoiding the need for perfect synchronisation of ingoings and outgoings.

2. Except for usually very short periods of time, that aren't usually very interesting macroeconomically speaking, the money supply curve is not perfectly elastic at a fixed rate of interest. [Update: and the monetary system would eventually explode or implode if it were perfectly interest elastic for a long enough period of time.]

Take Canada for example. The Bank of Canada has a Fixed Announcement Date every 6 weeks, at which it looks at everything it thinks is relevant and sets a new target for the overnight rate of interest. And it really doesn't like to change that target between FADs unless something big happens. So drawing a perfectly interest-elastic money supply curve is a reasonable approximation to reality for 6 week periods. For any longer period of time, it's totally wrong.

What's right? Well, the Bank of Canada targets 2% CPI inflation. It does whatever it takes to bring inflation back to the 2% target at a "medium-term" horizon, which it defines as about 2 years. The Bank of Canada does not target the rate of interest (except for the 6 weeks between FADs). It targets 2% inflation, and lets the rate of interest (and any other variable) move to whatever it takes to keep inflation at 2%.

At the Bank of Canada's medium term horizon, the supply of money is perfectly interest-inelastic. It's perfectly income-inelastic. It's perfectly almost everything-inelastic, except for one thing. It is perfectly inflation-elastic.

The money supply curve is vertical on the old picture, once we get past 6 weeks. Redraw the picture, delete the rate of interest on the vertical axis, and replace it with the rate of inflation. Draw the money supply curve perfectly elastic at 2% inflation. [Update: just to be clear, the inflation-elasticity of money supply is minus infinity, so it's perfectly negatively elastic.] That's a bit better.

Rant mode off.

Comments

[Sergei]

Sorry Nick but your whole post is a clear indication how little economists know about this world and banking in particular. If you ask any real banker (real means not inflation adjusted by someone from ALM or similar department ;)) about sensitivity of demand deposits and/or overdrafts to interest rates you will get the following answer - almost zero. You do not need to make complex explanations of what demand is and what it is not and how it intersects with that strange stuff called supply. You whole premise that it is interest sensitive to the extent that is interesting to this world is wrong. Demand deposits and overdrafts are NOT interest rate sensitive. Intersection will be at whatever level because demand deposits pay pretty much zero regardless of what Bank of Canada thinks and overdrafts get charged pretty much whatever a bank decides regardless of what Bank of Canada thinks. That is how this world runs.

[Nick Rowe]

Sergei: "Demand deposits .... are NOT interest rate sensitive."

Really?! If that is true, then we all owe the Very Old Extremely Crude Monetarists an apology. If we ignore currency (or if that's also true for currency), then a perfectly interest-inelastic money demand function brings us to what Hicks called "the Treasury View". The money demand curve is vertical. If the central bank fixes the stock of money, we have a vertical LM curve. Fiscal policy is useless.

I can imagine a world in which that is true. It might be true if demand deposits paid competitive interest rates that rose and fell with a fixed spread below other rates. I have always wondered if it might be true in some conditions.

[Sergei]

As for other things the only place where what central bank thinks is important is for mortgages. That takes a big chunk of bank balance sheets and therefore money supply but far from full balance sheet. For the rest of bank balance sheets and economy interest rates set by the central bank are like a rounding error. Whether it is 4.5 or 4.25 nobody would notice a difference. Such marginal effects for any investments projects are too ridiculous to discuss. For housing - yes. For the rest of the economy - no. But then that is why modern monetary policy has reduced itself to a single transmission mechanism - housing market.

Sorry if I was too harsh. I just deal too much with this in my job. There you will never see anything like what you write about above.

[Sergei]

Yes, Nick, really! Sorry if that disappoints you.

A check against reality would be to calculate changes in the value of demand deposits depending щт interest rate changes. If you say that demand deposits are interest rate sensitive then their value should change when interest rate changes. Unfortunately the value of demand deposits is always 100 because that is what you get at the ATM anytime you go there for cash. You can not have two different values separated by the ATM's key-pad.

Apology or not I do not know. I also do not subscribe to your ISLM view of the world. I just say that in real life neither demand deposits nor overdrafts are sensitive to what central bank thinks or does with its interest rates. (ok, they are sensitive but sensitivity is so looooooow that for any typical range of interest rate policy rates we can ignore it).

[Peter N]

We seem to be about to quibble about what money is. You can't talk about how something is controlled if you don't agree what that something is. If when you talk about money, one time you mean cash and demand deposits, and another time you mean M3, we won't get anywhere.

I believe the most useful definition is the sum of all instruments used as media of exchange Divisia weighted by their opportunity costs. The Fed neither calculates such an aggregate nor collects the data necessary to do so.

None of the Fed aggregates is a properly Divisia weighted index, so exactly what kind of money are you talking about?

How do we measure the stock of this money?

How does this money relate to other forms of money, and how is this relationship maintained?

If this is a story of "high powered money", how does it exercise its dreaded power.

[wh10]

Nick,

The more I read you, the more I think I am starting to realize that your disagreements revolve a lot around proper word choice.

"The actual stock of money is determined by the quantity demanded at the rate of interest set by the supplier."

According to your 1), it seems you don't like this statement because of the use of the word "demanded," since "demanded" implies desired stock of money to you and people wanting to borrow more/less doesn't mean people desire a greater stock of money (I might disagree with that from a macro perspective, but let's put that aside). So what word could we use instead to simply mean that the amount borrowed might change? Should we just say "borrowed?" Then would have any beef with this understanding of the world?

Secondly, no one ever argued there is a fixed rate of interest over the short, medium, or long term. The quoted sentence you're labeling as wrong doesn't even say "fixed." I don't get what disagreement arises from looking at things from a 6 wk standpoint vs a longer time frame. After a new 6 week period, maybe a new interest rate is targeted. But still during that period of time, the money supply curve remains interest-elastic. The CB can target whatever they want over the longer term, but the tool they are using is the interest rate. Maybe it matters to some people how interest rates will change over the medium or longer term. Fine - they might think about how the CB will change its policy. So?

[david]

@Nick Rowe

Sergei's description doesn't actually necessarily imply a macroeconomically vertical money demand curve. It merely requires that banks capture the whole surplus from investment to unite Sergei's account with a non-vertical money demand. Banks demand more money at lower interest rates, but they do not pass on the savings (or the money) to their depositors, nor do they invest in things which might lead to more deposits in the aggregate (instead they solely reduce their operating costs).

This is even more indefensible and implausible than endogenous money though!

[David Pearson]

Nick,
It seems you are saying the central bank will adjust the policy rate to target inflation. These changes in rates affect the quantity demanded for money. Isn't that still consistent with the statement that the supply of money is interest elastic at any given rate? Perhaps I'm misunderstanding you.

[Anders]

Nick - I struggle with the very concept of applying supply / demand to the medium of exchange itself. It seems like a Wittgensteinian category error, like using a ruler to check how long the ruler itself is. Supply and demand mean how much stuff people are willing to buy or sell at a given price in money terms. You obviously can't buy money (even if you can buy a loan); so it seems the supply / demand framework is being misappropriated if used about money itself.

You also don't seem to be giving the post-Keynesian position a fair hearing. Two obvious PK points here are:
1. Reflux channels available to non-banks to shed 'excess' money balances
2. Looking at the PK initiative on building stock-flow consistent models using transaction matrices and balance sheet matrices, Godley & Lavoie establish that any usable model will need to be "complete in the vitally important sense that the nth equation is logically implied by the other n-1 equations". The one obvious equation to drop out of the model as redundant is the one specifying that "money demanded = money supplied".

[Sergei]

david, banks do not demand anything. It is *your* description of banks in terms of supply/demand logic. That is NOT how banks work. There is nothing in banks about "what sellers want". Banks do not sell "money supply" that borrowers want. They simply can not. They do not have "money supply" stored somewhere in the basement which they can draw from. What is demanded is always supplied and what is supplied has been demanded. There are leakages which make the story a bit more complex but I am quite sure it is NOT what you mean. There are constraints on banks but these constraints are NOT *VOLUME* dependent. There is no any meaningful supply of money that you can talk of when talking about banks.

The next claim I make is that demand deposits (MZM in the language of Fed) and overdrafts are not interest rate sensitive. That is to draw the line under the actual stock of money and its alleged sensitivity to interest rates.

[Sergei]

Anders, completely agree. Banks are NOT supply/demand matching mechanisms.

[wh10]

Nick, here's Wiki's definition of endogenous money: "endogenous money refers to the theory that money comes into existence driven by the requirements of the real economy and that ****banking system reserves expand or contract as needed to accommodate loan demand at prevailing interest rates.*****"

How's that do instead? We're avoiding use of the words "demand."

[Anders]

Sergei - there is such a small overlap between people who work with banking, and those who understand monetarist economics (I'm certainly not such a person). Do you blog or publish papers?

[Peter N]

" but they do not pass on the savings (or the money) to their depositors, nor do they invest in things which might lead to more deposits in the aggregate (instead they solely reduce their operating costs).

This is even more indefensible and implausible than endogenous money though!"

It's about right though. Banks are hurting for money because they went on a bad acquisition spree while being disintermediated. Any little extra bit they can get, they'll take. All the action is in fees - swipe fees, overdraft fees, minimum balance fees, ATM use fees. You do have a bank account, don't you? Have you looked closely at your statements.

Also, demand deposits aren't that profitable or important. If they were profitable, banks wouldn't have to keep trying new tricks to screw the depositors. Banks aren't willing to go very far out of their way to get more deposits. Goldman gets by quite nicely without any deposits. I suspect many banks view demand deposits as a loss leader for getting other business.

If they want to spend money being competitive, they'll spend it on other types of customers - wealth management, commercial, services...

[wh10]

Nick you are also still avoiding Tankus's point about risking instability to the payments system. I don't think your answer to him made much sense at all. I don't care what the time horizon is, the CB is always acting to defend "the integrity of the payment system." That's just an operational reality. There is no theory to dispute here, and if you don't incorporate this reality into your theories, the credibility of your theory becomes questionable. “the primary objective of all central banks is to ensure the smooth functioning of their countries payments systems” (Government Accountability Office 2002, 2). http://www.gpo.gov/fdsys/pkg/GAOREPORTS-GAO-02-303/pdf/GAOREPORTS-GAO-02-303.pdf

[Dan Kervick]

I think the point here is that while the supply of money is constrained by the preferences and aims of the supplier, it is not constrained in any measurable way by supplier costs. An automobile manufacturer incurs a substantial cost for each additional automobile produced. Not so the money supplier, since the difference in cost between entering $1000 on a keyboard or $1,000,000,000,000 on that keyboard is negligible.

[Mike Sproul]

Nick:

I have a $2000 car and I want to sell it for a $2000 motorcycle. Normally I'd sell the car to someone who is willing to pay $2000 cash for it, but maybe the community has $2000 less cash than it needs for its level of economic activity. This makes it hard to sell my car on the market, so I offer my car to the Fed for $2000. I then buy the motorcycle, and the community now has the extra cash it needed. If business activity slows and the $2000 is no longer needed by the community, someone with $2000 extra cash will buy the car back from the Fed. The Law of Reflux will have gone full swing.

It's not that the seller of the car wants to hold an extra $2000. It's that the community as a whole wants an extra $2000.

[Nick Rowe]

Sergei: "Yes, Nick, really! Sorry if that disappoints you."

I think you misunderstood my reaction (I wasn't clear enough). I'm not disappointed; I'm excited, because if what you say is correct I can become a much more extreme monetarist! But what you say sounds too good to be true. IIRC, all the econometric studies (with maybe a couple of early exceptions?) found that the demand for money was negatively related to the rate of interest.

"If you say that demand deposits are interest rate sensitive then their value should change when interest rate changes. Unfortunately the value of demand deposits is always 100 because that is what you get at the ATM anytime you go there for cash."

No, that's not what it means. $100 in DD (of a solvent liquid bank) is always worth $100 currency, because the bank will redeem it in currency on demand. Rather, it means that the total stock of DD that people wish to hold is negatively related to the rate of interest on bonds and other assets.

[Nick Rowe]

Peter N "I believe the most useful definition is the sum of all instruments used as media of exchange Divisia weighted by their opportunity costs."

I think I agree with you. (I just wish my math was better so I understood Divisia weighting better.)

"If this is a story of "high powered money", how does it exercise its dreaded power."

I don't have good answers to your other questions, but I think I have an answer to this one. Another way of asking essentially the same question is: "If both the Bank of Canada and the Bank of Montreal create money, what is the difference between them that makes the BoC a central bank able to set monetary policy for Canada (e.g. keep inflation on the BoC's target) while the BMO is just another commercial bank that has to follow the BoC's lead?"

And I think the answer to that question is: "asymmetric redeemability". By analogy to two countries with a fixed exchange rate, the BMO pegs its money to the BoC money, and the BoC does not peg its money to BMO money. If the BoC pegged its money to Fed money, the Fed would set Canadian monetary policy. If the Fed pegged its money to BoC money, the BoC would set US monetary policy.

[Nick Rowe]

wh10: "The more I read you, the more I think I am starting to realize that your disagreements revolve a lot around proper word choice."

I think there's a lot of truth in that. A lot of this disagreement is semantic. But it's not just semantic, because the categories we use both influence the way we view the world and are influenced by the way we view the world. And yes, the time period matters a lot. Most (not all) interesting stuff in macroeconomics takes longer than 6 weeks to happen.

"The CB can target whatever they want over the longer term, but the tool they are using is the interest rate."
What tool are they using to target the interest rate during that 6 week period? Reserves.
"Maybe it matters to some people how interest rates will change over the medium or longer term. Fine - they might think about how the CB will change its policy. So?"
This is not a *change* in policy. The policy remains the same: target 2% inflation. The overnight rate of interest is just a very short term intermediate target. The (perceived) output gap is a slightly longer term intermediate target.

Start with your perspective, then either zoom out, or zoom in, and you get a different perspective. Different patterns emerge. Some constants become variables, and some variables become constants.

[wh10]

Nick, I think you're way oversimplifying the dynamics when you say "the BMO is just another commercial bank that has to follow the BoC's lead." For someone who is so critical of word choice, I don’t understand how you can make such vague and incomplete statements. Again, in some sense, the BoC is subordinate to the banking system since it has to defend the integrity of the banking system at all times. It can’t not do this, or you have a banking crisis. On the other hand, it is the BoC that has ultimate control over interest rates on reserves (perhaps with the hopes that they can control inflation via this tool), but it can’t not respond to the banking system’s reserve needs at any point in time.

From Fullwiler: “Regarding the reserve balance portion of the monetary base, consider a central bank that attempts to supply aggregate balances in quantities that differ significantly from banks’ needs to settle payments or to meet reserve requirements. This would be a highly questionable operating tactic, to say the least. As in Principle 2, central banks are monopoly suppliers of reserve balances and thus are obligated to ensure the smooth functioning of national payments systems; they thereby provide intraday or overnight credit at some price. Similarly, it would “seem inappropriate or even legally questionable that the central bank should use its power to squeeze the market in a way that makes it impossible for banks to comply with [reserve] requirements” (Bindseil 2004, p. 236). In practice, and as previously mentioned, individual banks deficient in meeting reserve requirements automatically receive a central bank loan at a pre-specified penalty rate, much like central bank overdraft policies associated with payment settlement.

Because the demand for reserve balances is very interest inelastic on a daily basis (where payment needs dominate the demand for reserve balances) or at least by the end of the maintenance period (where reserve requirements dominate), supplying more or fewer reserve balances than banks in the aggregate desire to hold will simply result in the interbank rate falling to the rate banks earn on balances in reserve accounts (if too many balances are supplied) or rising to the penalty rate assessed on overdrafts from the central bank (if too few are otherwise supplied). As such, a reserve balance “target” would be actually a de facto interest rate target at either the rate paid on balances in reserve accounts or the central bank’s penalty rate. In practice, a reserve balance operating target would send the interbank rate fluctuating between these two rates, as banks’ demand for reserve balances can shift significantly from day-to-day (depending upon the particulars of the national payments settlement system and the reserve requirement regime).
Significant volatility in the overnight rate is not desirable, however. As a member of the Fed’s Board of Governors explained,

A significant increase in volatility in the federal funds rate would be of concern because it would affect other overnight rates, raising funding risks for most large banks, securities dealers, and other money market participants. Suppliers of funds to the overnight markets, including many small banks and thrifts, would face greater uncertainty about the returns they would earn and market participants would incur additional costs in managing their funding to limit their exposure to the heightened risk. (Meyer 2000, 4).

Even within neoclassical economic theory, such volatility in the overnight rate would become problematic from a monetary policy perspective “if [it were] transmitted to maturities which are deemed directly relevant for decisions of economic agents (Bindseil 2004, 100-101). As a result, even when the Fed’s stated strategy during 1979-1982 was to target a reserve aggregate such as non-borrowed reserves, in order to keep volatility in the federal funds rate from becoming excessive—which was highly likely given that reserve balances earned no interest while there were also significant “frown costs” historically associated with borrowing from the Fed—the actual tactic employed ensured that the federal funds rate remained within an acceptable range, as confirmed in Meulendyke (1988). Thus, Moore (1988) labeled this tactic “dirty interest-rate targeting,” the Fed’s public statements notwithstanding.

Overall, then, the operating target in modern central banking is necessarily an interest rate target given a central bank’s obligation to the payments system, its responsibilities associated with regulatory oversight of reserve requirements (where applicable), and the need to minimize volatility in money market rates…”

[wh10]

“What tool are they using to target the interest rate during that 6 week period? Reserves.”
It’s the INTEREST RATE on reserves.

“This is not a *change* in policy. The policy remains the same: target 2% inflation. The overnight rate of interest is just a very short term intermediate target. The (perceived) output gap is a slightly longer term intermediate target.”

Semantics. The obvious point is that the ***operational***tool they are using to try to target inflation is by changing the interest rate on reserves. So I think your critique misses the point and is only one of semantics.

[Tschaff]

lol, what made my skin creep is the use of the word money. Clarify your thinking, and ours of yours, Nick and talk about who's specific liability you're talking about.

[Nick Rowe]

david: you lost me there, sorry.

David Pearson: "Isn't that still consistent with the statement that the supply of money is interest elastic at any given rate?"

Yes, if the BoC were to hold the interest rate fixed, regardless of anything, then the supply curve of money would be perfectly elastic at that rate. But: the BoC does not do this (nor does any central bank); even during the 6-week time period it does (roughly) do this, the stock of money is not determined by the quantity demanded at that rate (that latter is a very controversial unorthodox statement that very few economists believe).

Anders: "Nick - I struggle with the very concept of applying supply / demand to the medium of exchange itself."

So do I. It is good you struggle on that point. The supply and demand for the medium of exchange is conceptually very different from the supply and demand for any other good. Because the medium of exchange does not have a market of its own. It is bought and sold in every other market. I'm not sure if it's a category mistake, but it's sure very different. And most mistakes in monetary economics come from failing to realise how different money is, and treating it the same as any other good.

"1. Reflux channels available to non-banks to shed 'excess' money balances"

I've tried to get my head straight on that. here

"...Godley & Lavoie establish that any usable model will need to be "complete in the vitally important sense that the nth equation is logically implied by the other n-1 equations". The one obvious equation to drop out of the model as redundant is the one specifying that "money demanded = money supplied"."

That sounds like the PK version of Walras' Law (and it sounds just like Patinkin). I think Walras Law is wrong. I argued against it here.

[wh10]

“Start with your perspective, then either zoom out, or zoom in, and you get a different perspective. Different patterns emerge. Some constants become variables, and some variables become constants.”

In this instance, I don’t see why. I don’t see how your responses reveal that. No one ever said the “interest rate is fixed” except you, so I don’t see why your point about 6 weeks vs longer term is relevant. All I see are semantic corrections, and if I am reading you correctly, some theoretical assertions that are inconsistent with operational reality. The two have to jive.

[Sergei]

Nick: IIRC, all the econometric studies (with maybe a couple of early exceptions?) found that the demand for money was negatively related to the rate of interest.

I gave an example of overdrafts which are not interest rate sensitive. This brings us to a large issue that banks are free to charge whatever they want and it does not mean that what they charge is linked to the central bank base rate. The only exception here might be mortgages but that link exists for a completely different reason.

Nick: the total stock of DD that people wish to hold is negatively related to the rate of interest on bonds and other assets

Let me guess here. By bonds you obviously mean bank bonds, correct? Because any other assets do not change the fact of existence of demand deposits. Only banks themselves can change the volume of DD by switching them to bank bonds or term deposits. There is no other force. But do you control for such an important variable as bank profits which come at the expense of demand deposits and which are typically large and growing in the high interest rate environment indicative of a booming economy?

[David Pearson]

"...the stock of money is not determined by the quantity demanded at that rate..."

I'm not sure what you mean here. In a FFR targeting regime, the Fed supplies sufficient reserves to keep the FFR from rising. Thus, the stock of money is determined by the quantity of reserves demanded at that rate.

BTW, I'm not sure the Fed creates "money". It supplies licenses (in the form of bank reserves) to create money. Sometimes these licenses are in demand; at the moment they are not, and so they just pile up in a dusty file cabinet. Whether "money" gets created is not up to the Fed, but to the license holders (or more accurately, their customers).

Further, just how important are these licenses? Just $94b in required reserves support roughly $8.6tr in deposits, and that leaves out the daisy chain of shadow bank repo's. In other words, velocity matters much more than the supply of reserves; and velocity is something that seems both quite variable and poorly understood. I think this is why the "Chuck Norris" concept is so appealing: it magically transforms the Fed's relevance from questionable to utmost.

[vjk]

Sergei:

Only banks themselves can change the volume of DD by switching them to bank bonds or term deposits. There is no other force.

You are not being consistent.

The "other force" is the investor who would want to buy the product, i.e. the bank bond or a term deposit. The situation is no different from extending a loan -- there should be a willing borrower, and with bank bonds there should be a willing investor.

Besides, what Nick actually meant and I am of course guessing here, the DD holders may want to get rid of them in an high interest rate environment through buying government bonds at the primary market. Thus, the investor has more freedom than the bank: he can choose either a bank bond or a government bond to protect against possible inflation. The bank, however, cannot do much except advertise its products.

[Sergei]

vjk, I am fully consistent. Government sells bonds to spend money. So there is no change on demand deposits. What is sold as bonds today will be spent back into the banking system tomorrow if not today or even yesterday.

As for your first point, it takes at least two to dance. But it is banks who is in the lead. If banks do not sell bonds, there is nothing investors can buy. However the obvious question here is why do banks sell bonds? Do you have an obvious answer? I do not. Companies sell bonds to arbitrage bank lending. By selling bonds companies increase their balance sheet size and thus get new assets (financing). When banks sell bonds balance sheets do not increase in size. So why do banks sell bonds?

[Ramanan]

Paul Krugman appeals to the great James Tobin here

http://krugman.blogs.nytimes.com/2012/04/01/tobin-brainard-1963/

Krugman: "Bank loan officers can’t just issue checks out of thin air; like employees of any financial intermediary, they must buy assets with funds they have on hand."

Tobin: Commercial Bank: as Creators of “Money”

http://dido.econ.yale.edu/P/cm/m21/m21-01.pdf

I guess Krugman's appeal to authority failed miserably :-)

[Ramanan]

"That sounds like the PK version of Walras' Law (and it sounds just like Patinkin). I think Walras Law is wrong. I argued against it here."

No Walras Law really. Just an accounting statement.

G&L:

Finally, there is feature (4), which says that agents must respect their budget constraint, both in regard to their expectations and when they assess realized results. In the case of expected results, this is sometimes referred to as Walras’ Law, as does Tobin in his Nobel lecture, but we would rather
refer to a budget constraint or to a system-wide consistency requirement. In a water-tight accounting framework, the transaction flows of the ultimate sector are entirely determined by the transaction flows of the other sectors.Indeed, we shall see that this consistency requirement always implies a redundant equality

[Ramanan]

In my opinion, Marc Lavoie completely nails the problem here in section 9.3.1

http://cas.umkc.edu/econ/economics/faculty/wray/631Wray/Week%205/Lavoie%20(Circuit%20and%20Stock%20Flow).pdf

[Tschaff]

@Ramanan "I guess Krugman's appeal to authority failed miserably :-)"
:D

[Nick Rowe]

Ramanan: but we aren't really interested in the accounting identity 9unless we are accountants). Economists are interested in explaining people's behaviour, which depends on their choices, plans, and expectations. Things like demands and supplies. If Walras' Law applies to n excess demands, then it is an interesting and useful statement about people's choices and actions. Unfortunately, in a monetary exchange economy with n goods (including money) there are 2(n-1) excess demands in (n-1) markets. Walras' Law would be true in an economy with a Walrasian auctioneer running a single central market where all n goods can be exchanged simultaneously. But that is not a monetary exchange economy.

Thanks for tipping me off about the PK link. I'm coming from The Yeager/Laidler perspective, which disagrees with James Tobin's Commercial Banks as Creators of Money. But we end up in about the same place, on this particular relevant question of the role of the central bank.

[nemi]

Could anybody tell me why I should give a damn about the stock/supply/demand of money (since everyone, i think, agrees that a bank never can be out of money as long as the central bank do their thing)?
Central banks generally do not care (to any significant extent)
Isn´t it the interest rate that is important?

Assume that a one % decrease in the interest rate causes X $ increased demand.
Also, assume that as a result:
a: the stock of money stay constant
or
b; the stock of money increase by Y.
Why should I care whether we get a or b? Why is that even relevant information?

[Ramanan]

James Tobin:

"Whatever their other errors, a long line of financial heretics have been right in speaking of “fountain pen money” – money created by the stroke of the bank president’s pen when he approves a loan and credits the proceeds to the borrower’s checking account."

A fact Paul Krugman simply doesn't seem to understand!

Krugman: "Bank loan officers can’t just issue checks out of thin air; like employees of any financial intermediary, they must buy assets with funds they have on hand."

Of course Tobin was writing of the heretics at the time, but things have changed and Post Keynesians have themselves learned from Tobin.

At any rate, it is annoying that a BIG economist like Krugman does not understand this.

[vjk]

Sergei:

What is sold as bonds today will be spent back into the banking system tomorrow if not today or even yesterday

That's a valid point. At the end of the day, deposits just change hands intermediated by the bond, that's all.

Another way to shrink the balance sheet for the bank would be debt securitization where both loan assets and deposits, assuming the investor is at the same bank, are removed from the balance sheet.

So why do banks sell bonds
Well, for the same reason corporations do -- to raise capital, "offensive capital" for mergers and acquisitions and "defensive" in order to "improve" non-performing assets, or in other words to let them survive in the hopes for the assets to start performing again :)

[Ramanan]

Nick @April 01, 2012 at 04:34 PM,

Yes, I referred to a few lines from G&L where they have a system of accounts before jumping into behavioural analysis.

What I intended to write was that the system of accounts - even though has some connections to Walras - and has even been termed Walras' law by James Tobin who propounded such stock-flow consistent macromodelling is a misnomer. That's all.

[wh10]

Nick, how's it feel to have Krugman pull rank with your name :)?

What he said that really got everyone upset was "Bank loan officers can’t just issue checks out of thin air; like employees of any financial intermediary, they must buy assets with funds they have on hand."

I'm not even sure you would agree with that statement. The debate started based upon Krugman's descriptions of banking operations.

Furthermore, no one said "monetary controls" can't be effective.

I also can't even believe this is all being pinned down on MMT. Does he realize this is a much broader Post-Keynesian issue and has support from mainstream researchers and bankers? http://t.co/FrLvjPPb and the list goes on.

Nick, your posts and disagreements with your commenters don’t get me upset. You engage with substance, good faith, and good manners IMO. But Krugman's ad hominens and declarations of ‘irrational’ are unjustified and unsupported, respectively.

Lastly, I wish these debates took place between the academics, rather than you or Krugman vs random internet enthusiasts like me. If we can put up this good of a fight, I’d imagine it be much better with the academics.

[JP Koning]

Nick, just to make sure I am understanding you.

If a central bank were to set it's interest rate at x% from now to infinity, then the quantity of reserves would indeed by demand-determined, endogenous, or set by the market.

But say the central bank wants to target end-of-day reserves at $x. In order to do so, it varies the interest rate minutely during the day via open market operations. This induces commercial banks to either buy reserves by selling the central bank some t-bills, or sell reserves by buying some t-bills, until the magic $x amount is outstanding at market close. In this case, reserves would be supply-determined, exogenous, or set at the whim of the central banker.

That seems to jive with your point on zooming in and out.

[W. Peden]

nemi,

"since everyone, i think, agrees that a bank never can be out of money as long as the central bank do their thing"

Define "do their thing"? You obviously mean lender-of-last-resort, but (1) that doesn't necessarily mean lending to insolvent institutions and (2) when a bank goes to the central bank for cash, it's because it's out of money IF we define "money" as cash.

Anyway, I'm not sure how this blog's discussion can continue fruitfully if we don't start going into quantity bought vs. quantity desired and if asset prices & expectations don't come into the picture more. Talking about monetary economics without including a broad range of assets will inevitably throw up false conclusions, like those that come from a "money & bonds model" of the financial system.

[W. Peden]

* And usually just government bonds.

Oddly enough, despite having learnt most of what I know about finacne from (mostly British) monetarists, the Post-Keynesians always seem to be on a much better track than Paul Krugman and other American economists. Could this be because British monetarists like Tim Congdon were often taught at PK-rich institutions like Joan Robinson-era Cambridge or their ancillary institutions? That could be an interesting article.

[Ramanan]

IMO, the reason there is so much confusion around this topic is that the question arises - if loans make deposits, what happens if there is an "excess" of money over what people "demand".

Some such as Krugman really dismiss this by saying loans do not make deposits and so on.

Nick seems to be accepting that loans are made out of thin air.

More generally, Krugman seems to be touching on the topic - so what??

The reason banks are important is because they are the institutions through which the central bank interest rate setting is transmitted. So one cannot ignore banks. Also, it is impossible to think of an economy without banks but that's a different story.

Now, coming to the question of the supposed excess of money over the demand/desire ... I see some commenters assuming that the interest banks pay have less importance and so on and I do not think this is a correct way of approaching it. Neither is there a need to appeal to the hot potato effect. There were only a few such as Anders talking of the reflux mechanism and I think it is really a very important mechanism because it goes unnoticed.

For example, if households desire to hold higher deposits (irrespective of the interest rate - just due to a change in portfolio preference), firms would be driven to banks to borrow more. If households desire to hold less cash balances - they need to do something. It is Monetarist to say they consume more because that is a different decision. So they may buy equities (for example) which will then trade higher due to supply/demand. Firms may issue more equities and borrow less from banks and hence creating less new deposits in the process(!). Hence the reflux mechanism is a natural way to address this.

I think James Tobin tried to do this many times - maybe we wasn't successful in saying what he wanted to but I believe Post Keynesians have explained this process well.

PS: wh10 @April 01, 2012 at 04:49 PM - good points. Nick's nice!

[Sergei]

JP Koning: If a central bank were to set it's interest rate at x% from now to infinity

When a central bank changes its interest rate it does NOT change to amount of reserves. I.e. there is NO need to do OMO to convince commercial banks of new interest rate. As such you can treat ANY x% from now to infinity. The amount of reserves in the system is defined by minimum reserves requirements plus some cushion for mistakes which in general is defined by the spread between the base rate and discount rate.

[Ramanan]

Tschaff @ April 01, 2012 at 04:33 PM,

Posted it on PK's comments as well.

[W. Peden]

Ramanan,

"If households desire to hold less cash balances - they need to do something. It is Monetarist to say they consume more because that is a different decision."

Curious. If I understand you correctly, you're assuming that people never deal with excess money balances by consuming more?

"So they may buy equities (for example) which will then trade higher due to supply/demand. Firms may issue more equities and borrow less from banks and hence creating less new deposits in the process"

If firms find it considerably easier to sell equity, why wouldn't they just sell bonds instead?

It's very easy to argue that money isn't naively endogenous i.e. that central bankers don't press a button and produce the money supply figures they want. In contrast, it's very hard to get a theory of endogenous money that eliminates exogenous CB action entirely from the money creation process altogether. Nicholas Kaldor really gave it a good try and could never get it to work either empirically or theoretically. I'm not really familiar with Tobin's attempts.

[Nick Rowe]

Ramanan and wh10: "Krugman: "Bank loan officers can’t just issue checks out of thin air; like employees of any financial intermediary, they must buy assets with funds they have on hand.""

I think Paul Krugman misspoke when he said that. I actually started to write my previous post when I read that. I was going to write a post disagreeing with him. But when I read further, and figured out what I thought he was trying to say, I tempered my conclusions, because I realised we seemed to be coming to the same bottom line. We need to look at the whole system, and bring in the fact of asymmetric redeemability, and the central bank's reaction function. Most of his critics don't go past step one.

BTW, on the Nathan Tankus and others' point: that the central bank must have a perfectly elastic supply of reserves to prevent a monetary crisis. If that were true, the Bank of Canada would never be able to adjust the target over time in response to the economy, including reining in the banks, to keep inflation on target. In fact, precisely the opposite is true. If the Bank of Canada had a perfectly elastic supply curve at a given rate of interest the monetary system would eventually either implode or explode.

[Determinant]

In Canada, an "excess of reserves" would manifest itself in a low interest rate in the overnight funds market. The Bank of Canada controls interest rates by operating a "spread" between the overnight overdraft rate on clearing accounts and the overnight interest rate on deposits, the latter being lower.

Excess reserves imply that the clearing rate in the overnight market is lower than the overnight deposit rate. This creates an immediate arbitrage opportunity (by design) that banks can and will borrow in the overnight market and deposit the excess funds in their BoC clearing accounts, thus eliminating the excess reserves.

[Sergei]

Nick: If the Bank of Canada had a perfectly elastic supply curve at a given rate of interest the monetary system would eventually either implode or explode.

Well, that is what the Bank of Canada does and the system neither explodes nor implodes. Even worse ... central banks normally provide virtually unlimited and interest rate FREE intra-day overdrafts. That is a perfectly elastic supply without any costs to banks. The only rule for banks is to square their accounts at the end of the day. And that is what interbank market is for. If any bank fails to square its account at the end of the day, it is *automatically* charged the discount rate on the outstanding amount. Again a perfectly elastic supply.

Precise rules might vary from country to country but the general principle holds.

[Nick Rowe]

JP: "Nick, just to make sure I am understanding you.

If a central bank were to set it's interest rate at x% from now to infinity, then the quantity of reserves would indeed by demand-determined,..." (I cut off the last few words of your quote to avoid us getting sidetracked into the meanings of those words).

1. If the CB did that the monetary system would either explode into hyperinflation or else implode into hyperdeflation. Let's ignore that.

2. Setting aside 1, 99% of orthodox macroeconomists would say "yes". I would say "no". See my paragraph in the post beginning: "1. The "demand for money" normally means the relationship...."

[UnlearningEcon]

Nick, you aren't going to get anywhere with this kind of posting.

Endogenous proponents: 'your theory is wrong, look at this evidence'

You: 'no it isn't because *repeats economic theory*'

I align myself with endogenous money for empirical reasons, and have some basic questions for exogenous money proponents regarding that evidence and their theories:

http://unlearningeconomics.wordpress.com/2012/03/30/a-few-questions-for-exogenous-money-proponents/

Keen's most recent post is also helpful - among other things, he notes that two fed economists effectively concluded that the money multiplier model is worthless:

http://www.debtdeflation.com/blogs/2012/04/02/ptolemaic-economics-in-the-age-of-einstein/

[Ritwik]

wh10

Good points about Nick. In general, Krugman has started coming off as very weak not because of the standard 'oh you're a neo-classical who just happens to like government spending' bit, but because he keeps doing such a bad job of parsing the literature that should really be on his fingertips. E.g. the Tobin/ Brainard link today, the conclusion of which was only mildly relevant to the debate. He failed to explore the Tobin paper that Ramanan links above (and David Glasner has linked in the past)which would have automatically given him pause to think. Or even the Adam Posen speech, that Ryan Avent does a much better job of interpreting.

I don't know who/what are the windmills that Krugman is tilting against.

An only somewhat related point - I've realised over the weekend the absolute importance of fully reading the literature that one is linking to/ sees linked. It seems most questions that arise have already been 'answered' somewhere, and a lot of the actual literature is significantly more nuanced to generate new insight (sometimes counter to the purpose intended!). As an example, Leijonhufvud's essay (linked by JW Mason, I think).

Or, in the link that you provided http://rwer.wordpress.com/2012/01/26/central-bankers-were-all-post-keynesians-now/ . Notice how Goodhart is being quoted in the blog post. This made me ponder - Goodhart is surely sympathetic to PK points of view (and goes even beyond - I esp. love his argument about default risk preceding and creating the transactions demand for money) but he is fundamentally in the British central banking tradition (ala Buiter) who have always been keener analysts of the banking/financial system and balance sheets, and have never seen that as an impediment to being basically monetarists. (Nick might not agree that this is an advantage ;) )

And sure enough, here is Goodhart :

"It is the further second line of argument, that we can in practice virtually ignore developments in the monetary aggregates in the conduct of monetary policy, focussing instead solely on a key policy determined interest rate, that I do want to question."

He is opposing Woodford, but the point holds.

He goes on to say :

"Certainly if the demand for money function fits perfectly, and if its
arguments are correctly set out in equation (4), then you learn nothing more from
looking at money, than you already knew from looking at inflation, output and
interest rates. ....

...

But much the same is true of output, or of inflation; they too are endogenous,
dependent variables. If their functional relationships held perfectly, then you would
learn nothing more from looking at output, or inflation, outcomes than one already
knew from a knowledge of its functional (structural) relationship. In reality, however,
a great deal of time and effort is spent analysing whether the deviation of
output/inflation from forecast is due to one kind of shock, or another, e.g. transient or
permanent, demand or supply shock. Why do we not care as much to shocks, to
deviations of the money stock, from its expected value?..

.. "

There is more, much more there. It is a really fantastic piece.

Though, I am not trying to spark a debate here. Just extolling the suddenly dawned (upon me) virtues of engaging with the full rather than the summary. This I think is a must for every macro autodidact.

[Ramanan]

W Peden,

"Curious. If I understand you correctly, you're assuming that people never deal with excess money balances by consuming more?"

Yes. Because the decision to consume more is a decision based on income. It can be erratic of course but it is income-based rather than "money-based". What is left is allocated in deposits and other assets. But my decision to allocate all my wealth in deposits (in extremis) cannot be said to cause me to consume more. It is income dependent and also wealth dependent - but wealth can be in various forms.

"If firms find it considerably easier to sell equity, why wouldn't they just sell bonds instead?"

Yes they could do that as well.

"In contrast, it's very hard to get a theory of endogenous money that eliminates exogenous CB action entirely from the money creation process altogether. Nicholas Kaldor really gave it a good try and could never get it to work either empirically or theoretically. I'm not really familiar with Tobin's attempts."

Yes difficult.

I am not saying that the decision of the economy is not interest-elastic. But it is also income-elastic.

So imagine a situation in which the central bank keeps raising rates from maybe 1%-6%. The government in the meantime is relaxing fiscal policy. These decisions are not coordinated in this hypothetical example. So what happens is a bit uncertain and depends on these things and many things. It may happen that the private expenditure when interest rates were at 3% would be lower than when interest rate was at 4.5% because of the higher fiscal relaxation near 4.5% which may led to a boom.

I think the common criticism of "endogenous money people" is that since they stress less on interest rate changes, it is common to assume that these people think it "doesn't matter" and notions such as that.

[Ritwik]

W Peden

What follows is wildly speculative.

I think the British monetarist comfort (and even fascination) with credit/finance is because of

1) Walter Bagehot's legacy.

2) The UK has for a long time been a medium sized, open, finance-heavy economy. The whole inflation vs. output obsession is a very domestic/inward style of macro thinking that had less relevance there (here, now that I'm in London) than say, banks and international finance.

[JP Koning]

Nick: "2. Setting aside 1, 99% of orthodox macroeconomists would say "yes". I would say "no". See my paragraph in the post beginning: "1. The "demand for money" normally means the relationship....""

Still having difficulties parsing. I noticed that your para beginning 1 uses the word money whereas my comment used reserves. I'm ignoring M1 and such. Perhaps we are speaking by each other due to differences in terminology.

[wh10]

Very much agreed, Ritwik.

[wh10]

Koning, I think it's because of the way Nick is thinking of the word 'demand.' See the first part of my comment at 9:53AM.

[W. Peden]

Ramaman,

"Because the decision to consume more is a decision based on income... It is income dependent and also wealth dependent - but wealth can be in various forms."

The first sentence here nearly made by eyes fall out of their sockets. As for wealth and consumption: yes, we consume at any one point in time based on considerations of our wealth and our (expected future) income. However, notice what this implies: if expenditure decisions aren't based on income (and the slightest bit of introspection reveals that they are not) then we can consider people's consumption decisions as their making trade-offs between their desire to hold particular kinds of wealth over time and their desire to consume.

So, if I have excess money balances (joy!) say because of a big bonus, then I can eliminate that excess in a number of ways: I can invest it in equity or bonds, but I can also use that money to buy something, including a non-financial form of appreciating e.g. I can use it as a down-payment on a mortgage at a time of rising property prices. And we're into pretty simple Irving Fisher style hot potato territory, all by relaxing the unrealistic assumption that people consume on the basis of income.

"Yes they could do that as well."

And a major purchaser of these corporate bonds would be commercial banks, increasing the volume of deposits as the banks create new deposits to finance their purchases.

"I think the common criticism of "endogenous money people" is that since they stress less on interest rate changes, it is common to assume that these people think it "doesn't matter" and notions such as that."

Gee whiz! Post-Keynesianism and (non-base money orientated) monetarism sound closer and closer as this thread goes on! ;)

[W. Peden]

Ritwik,

I like those Charles Goodhart quotes. I suppose he proves my point about the closeness of some Post-Keynesian ideas and ideas in British monetarism, since he swings from neo-Chartalist analyses of the origins of money to praising monetarists with a lot of comfort.

I agree with both of your points on the British monetarists' interest in finance. I'd also add that almost all of the notable British monetarists are either employed or have been employed in the financial world (which as I'm sure you've noticed is very geographically concentrated in the UK) or as active players in monetary policy, while monetarism had a lot of problems getting traction in the very detatched and Keynesian world of British academia.

The result was that while there were some American-style monetarists (most notably Alan Watson, Margaret Thatcher's longtime advisor) who tended to be dismissive of analyses framed in terms of broad money, credit creation and asset prices, monetarists tended to be of a different sort in the UK. Tim Congdon, Gordon P. Pepper, David B. Smith, David Cobham et al were in quite a different tradition.

Where Friedman falls is probably an essay in itself. I'd actually say he was more British than American at the fundamentals of his approach, since (1) he was primarily interested in broad money and therefore implicitly in credit; (2) his interest in base money was as a possible determinant of the money supply in a hypothetical new monetary policy system with 100% reserve banking and I don't think anyone would doubt that that would make the monetary base important; (3) his criticism of PSBR targets was simply pointing out that the PSBR-money supply link is not tight; and (4) while he greatly disliked the Medium-Term Financial Strategy, Tim Congdon argues that his criticism was largely based on a misunderstanding of the dynamics of British reserve requirements.

It would also be interesting to try and place David Laidler (is there a Canadian school of monetarism?!) and placing Charles Goodhart into anything like a convenient filebox in economic classification is probably impossible.

[vjk]

And a major purchaser of these corporate bonds would be commercial banks, increasing the volume of deposits as the banks create new deposits to finance their purchases.

I disagee on two points:

1. My understanding is that institutional investors, such as mutual funds, pension plans, etc, are major purchasers of corporate bonds, not commercial banks. I'd appreciate seeing data that would either confirm or refute my understanding.

2. When a commercial bank buys a corporate bond, deposits will increase because the bond purchase transaction is indistinguishable from an ordinary commercial loan grant. The new deposit, however, is not a source of funds for the bond purchasing bank unless vacuously, i.e. the deposit is created at the same bank and, therefore, there is no need to settle. In order to settle interbank obligations, the purchasing bank would need to procure reserves in the usual way.

[Nick Rowe]

JP: "I noticed that your para beginning 1 uses the word money whereas my comment used reserves."

In this context, I would say the same thing about reserves.

Unlearning: I skimmed your evidence. It doesn't surprise me, and doesn't change my mind. Your endogenous/exogenous money is a false dichotomy. Nobody believes in "exogenous money" in the way you have defined it.

"Surely in the money multiplier model banks would require reserves before expanding lending?" Nope.

"Surely, if banks can create deposits with loans (which they simply can in the real world), by definition a loan adds new purchasing power and increases nominal demand?"

Nope. Not "by definition".

A couple of hours ago I started to Read Steve Keen's Berlin paper. Then my ADD kicked in badly. It would take me 2 days of solid grinding to fisk that paper thoroughly.

E.G. "The Walras-Schumpeter-Minsky proposition that aggregate demand is income plus the change in debt...." Can anyone make any sense of his equation 1.1 that immediately follows?

I am really not surprised that Paul Krugman is accused of having failed to respond to Steve Keen's paper.

So many of the commenters on this and the last post simply don't understand the theory they are attacking.

[Determinant]

Sergei:

Canada is different. We don't have a Gross Real-Time Settlement System, we have a Deferred Net Settlement System. Financial transactions, by which I mean Large Value Transfer System transactions, are cleared daily at 11PM. They don't clear instantly. The bilateral credit/debit position of each bank has to be secured by a pledged pool of money-market instruments to ensure clearance. This is what is called "Tranche II" of LVTS and it handles 90% of all LVTS transactions because it's cheaper.

Bank of Canada accounts are used for 10% of transaction.

[W. Peden]

vjk,

2. By "finance their purchase" I meant no more than that the process of lending to the borrower is done through creating a deposit. As you say, this is the same as giving a loan.

1. This is the first info I could dredge up in a few seconds on google and shouldn't be taken too seriously-

http://www.emeraldinsight.com/fig/11001_10_1016_S1569-3759_05_86017-6.png

http://www.frbsf.org/publications/economics/letter/2007/el2007-07c.gif

In China and Japan at least, commercial banks and OFIs are both major purchasers.

Being able to sell more equity also helps businesses participate in the wider business borrowing market and I don't think that it's controversial that commercial banks play a big part in that.

Equity is one way at the individual level of eliminating excess money balances, but doing so affects asset prices. Equilibrium is reached only at the point when prices and balances have adjusted to eliminate excess at all levels; the process of moving towards such an equilbrium can be a very inflationary ride, especially since inflationary expectations themselves create a demand for speculative assets that will keep ahead of inflation.

[Nick Rowe]

Determinant: I gotta say, I'm impressed. How come you can always find out (or remember) stuff like that? "Google", I suppose. Just makes me realise: I'm too old; yeah, someone should give you a job.

[dwb]

clear as mud.

wheres the link between money and inflation at full employment? we know empirically there is a link (see the weimar republic). mmt seems peculiarly designed to explain life in a liquidity trap, nothing else.

banks have to be constrained by the base else any level is of inflation is consistent with a given monetary base.

[Ramanan]

W Peden,

Not sure why your eyes fell out of the socket.

Make a model. If your consumption function is dependent on the money balances you have, then it is Monetarist. If it depends on income and wealth, it is not.

Just because I prefer to put my wealth mainly in deposits (such as time deposits) as opposed to an imagined almost identical behavioral twin with the same income and wealth who allocates his wealth into other classes such as government debt doesn't mean I will consume more.

[Determinant]

Nick:

Thanks. Hopefully I'll get to Ottawa this year (new fiscal year for hiring) and I'll tell you my wacky job hunting stories. I tried for a few Aboriginal Affairs positions, my killer pitch was a Treaty history of my house and cottage, which runs from 1800 to today and involves my mother. I live in the Williams Treaty lands, signed in 1923 which covers Ontario from the Humber to the Trent. It was the most screwed up treaty in Canadian history.

My secret weapon this time: http://www.bankofcanada.ca/publications-research/books-and-monographs/planning-an-evolution/

Skip to the chapter on LVTS. When they start saying "The Bank of Canada decided to make this the channel for implementing monetary policy" you know you need to pay attention.

This IS the plumbing, how yon beautiful interest rate target actually hits the road.

[W. Peden]

Ramaman,

"Not sure why your eyes fell out of the socket."

Because-

"Because the decision to consume more is a decision based on income."

- is one of those sentences that I can't even imagine believing, at least not about the planet Earth.

"If your consumption function is dependent on the money balances you have, then it is Monetarist. If it depends on income and wealth, it is not."

What about a consumption function based on permanent income?

[Determinant]

It would also be interesting to try and place David Laidler (is there a Canadian school of monetarism?!)

I think they meet in a pub in Montreal every few months. All three of them.

Don't worry, the five Post Keynesians have a beach party every summer....

[Determinant]

It would also be interesting to try and place David Laidler (is there a Canadian school of monetarism?!)

I think they meet in a pub in Montreal every few months. All three of them.

Don't worry, the five Post Keynesians have a beach party every summer....

[Nick Rowe]

Determinant: "This IS the plumbing, how yon beautiful interest rate target actually hits the road."

Yep. I've read on it in the past, but can never get my head around all the issues. In my simplified understanding: all the banks bring their daily credits and debits to each other to the LVTS. A computer hunts for and cancels all the circles of offsetting debits and credits. What remains is the net debits and credits. Banks then borrow and lend to each other on the overnight market, and what remains is debits and credits on the banks' accounts at the Bank of Canada. Roughly right? hopelessly wrong?

[mdm]

I'm curious Nick, how should we make sense of statements like this, and the way that the Reserve bank of Australia (RBA) conducts itself:

“The Reserve Bank has no prescribed target for the level of settlement balances [reserves], supplying whatever amount is needed to keep the cash rate near the target” (RBA, 2003, p. 4).

The day-to-day operations of the RBA: Each day the RBA will consult with its government and non-government clients as to the timing and size of their payments and receipts. The RBA classifies payments into two categories, low-value payments, which are settled the next business day, and high value payments, which are settled on a ‘real-time gross settlement’ (RTGS) basis. The impact of the latter on system liquidity is almost immediate, and therefore the RBA stands ready to provide intra-day liquidity, (Baker & Jacobs, 2010, p. 41) in the form of an intra-day repo (RBA, 1998, p. 58). These day-to-day activities have allowed the RBA to identify and accommodate the swings in demand for ES balances, whilst forecasting and offsetting swings in the supply of ES balances, and thus maintain the cash rate at the RBA’s target rate (Baker & Jacobs, 2010, p. 42).

It seems to be a perfectly consistent with accommodationist nature of central banks as suggested by Post Keynesian theory of endogenous money (Horizontalism). The reason according to Post Keynesians is that banks create loans without reference to their reserve position, what matters is the price of obtaining the necessary reserves to ensure a positive end-of-day balance (of course, the actual operations differ country-to-country depending on the institutional arrangements). Reserves are used as means of interbank settlement and to meet reserve requirements (if applicable). As reserves are a liability on the central banks balance sheet, only a change in the central banks balance sheet can change the total level of reserves in the banking system. THe banking system can only shift reserves around, it cannot create or destroy reserves, so a banking system that has excess reserves will see the overnight rate fall to near zero, a banking system that is deficient in reserves, and assuming that banks are interest rate inelastic, will push up the overnight rate, but be unable to find sufficient reserves to offset the deficiency. As Kaldor argued years ago, the central bank has no choice but to provide the necessary amount of reserves demanded by the banking system, otherwise it risks a payment crisis, with a flow on impact to the rest of the economy.

I'm curious to know where this theory goes wrong in its explanation.

Baker, A. & Jacobs, D. 2010. Domestic Market Operations and Liquidity forecasting. Reserve Bank of Australia. Bulletin Quarter 2010

Reserve Bank of Australia. 1998. Reserve Bank Domestic Operations under RTGS. Reserve Bank of Australia Bulletin.

Reserve Bank of Australia. 2003. The Reserve bank’s open market operations. Reserve Bank of Australia Bulletin.

[Nick Rowe]

Ramanan and W. Peden: Let me suggest you change your argument slightly. Instead of arguing over whether an excess supply of money will lead to increased *consumption* expenditure, just drop the word "consumption". What matters I think is whether it leads to increased expenditure, whether consumption or not. It could well be investment.

W. Peden: "It would also be interesting to try and place David Laidler (is there a Canadian school of monetarism?!)"

David is from the UK originally, as you might know. He has lots of students (including me) scattered around the country who he has influenced. I wouldn't really say we make up a Canadian monetarist school. We are all too idiosyncratic. Plus, David never seemed the type to try to create disciples, as such. But a lot of money/macro names you might recognise passed through U Western Ontario. E.g. Roger Farmer, David Andolfatto, Angie Redish.

I'm not sure if there is a monetarist school anywhere any more. MM comes the closest.

[Christyherold]

Thanks for the amusing conversation. Someone will have already mentioned the following three banal usage notes: 1) "jive" is way too cool a word to adumbrate with the near homonym "jibe," the better word to use here, 2) "it's" and "its"; 3) PK--most people here mean, I presume, post-Keynesianism, but at least one uses it for Paul Krugman. I also think of player-killer from MUDs. How about "PKey"?

[Determinant]

@Nick

That's pretty right, except that at the end of each day, the net balance position is given to each bank, which is then expected to finance its position in the overnight market, and if it can't then it may go to the Bank of Canada. Most of the time if things are OK they won't have to go to the Bank of Canada at all.

The key is that the Bank of Canada has an interest rate target and the overnight market is expected to provide better terms than the BoC rate. If the overnight market interest rate is higher than the BoC rate, for example, banks can and will borrow from the BoC instead and force the market down.

This is Lombard banking or Chuck Norris in action.

If the market overnight interest rate is lower than the overnight BoC deposit rate, there is an instant and very strong arbitrage opportunity borrow from the market and deposit at the BoC. This is Chuck Norris' roundhouse kick.

Most of the time, the interest rate is an equilibrium rate and the overnight market doesn't need BoC intervention to provide/take away funds. But during a crisis all bets are off.

The interest rate of course, though it plays a very important role in the plumbing, it set through the policy considerations we all know so well.

[W. Peden]

Nick Rowe,

Good point, not least because it means we can avoid wading into the murky depths of consumption theory. At any rate, personal expenditure does not depend on personal income except over the entire course of human existence, even though in any given period of time and over a closed group it is the case that gross expenditure = gross income.

On David Laidler: IIRC, he was (and is?) very, very close to Friedman theoretically?

Perhaps "school" is the wrong term. "Pattern of ideas" is a vague and woolly way of saying what I want to say: a tendency for a group to be interested in the same variables, the same relationships and have similar beliefs about the important causal pathways.

[mdm]

Nick said:

"A couple of hours ago I started to Read Steve Keen's Berlin paper. Then my ADD kicked in badly. It would take me 2 days of solid grinding to fisk that paper thoroughly.

E.G. "The Walras-Schumpeter-Minsky proposition that aggregate demand is income plus the change in debt...." Can anyone make any sense of his equation 1.1 that immediately follows?

I am really not surprised that Paul Krugman is accused of having failed to respond to Steve Keen's paper. "

Steve is on the edge of the Post Keynesian school, his model is not widely accepted (particularly some of his core assumptions when bank loans are repaid), and neither is his argument that : AD = Y + change in debt. For instance, Marc Lavoie has recently criticised on a blog.

BTW, this is Post Keynesian theory, I'm not sure why it is being labelled as MMT. MMT simply accepts the Post Keynesian theory of endogenous money.

"So many of the commenters on this and the last post simply don't understand the theory they are attacking."

To be fair, shouldn't the real test be whether the actual Post Keynesian economists are attacking the correct theory, rather than the commenters? Krugman makes the point that the commenters don't understand what he is saying, but again, shouldn't he consult the Post Keynesian literature on this, rather than, with a wave of his hand dismiss it, and shouldn't he be engaging with the actual Post Keynesian economists?

[Tschaff]

Here come the heavy hitters: First up Steven Keen
http://www.creditwritedowns.com/2012/04/banks-matter-krugmans-barter-mysticism.html

[Nick Rowe]

mdm: with slight changes on details, you could read exactly the same thing from the Bank of Canada. My response:

1. A visiting anthropologist might listen to the natives' theories of their own behaviour but isn't obliged to make his own theories identical to their theories.

2. An orthodox response would be to say that that theory is perfectly correct in the very short run (6 weeks in the case of the Bank of Canada) but is incorrect/misleading over any longer time horizon, which is what we are interested in, because that target rate of interest is not exogenous but responds endogenously to the actions of the commercial banks and the rest of the economy.

3. My response would not be orthodox. See my point 1. in the post, about the distinction between the demand to accept money and the demand to hold money.

It is a far worse mistake to assume the rate of interest is "exogenous" than to assume that the stock of money is exogenous.

[wh10]

Nick you should do a separate post on the following, because I think you are completely wrong, as Sergei asserted:

"BTW, on the Nathan Tankus and others' point: that the central bank must have a perfectly elastic supply of reserves to prevent a monetary crisis. If that were true, the Bank of Canada would never be able to adjust the target over time in response to the economy, including reining in the banks, to keep inflation on target. In fact, precisely the opposite is true. If the Bank of Canada had a perfectly elastic supply curve at a given rate of interest the monetary system would eventually either implode or explode."

I think you're still thinking that the way the CB changes the rate is by changing the amount of reserves. No- they just change it- they announce it.

[wh10]

"To be fair, shouldn't the real test be whether the actual Post Keynesian economists are attacking the correct theory, rather than the commenters?"

I agree! It'd be great if Nick responded to a Post-Keynesian paper on endogenous money, like Basil Moore's work. And also agree some of Keen's stuff is potentially problematic, such as what Nick identifies.

[Nick Rowe]

wh10: "I think you're still thinking that the way the CB changes the rate is by changing the amount of reserves. No- they just change it- they announce it."

You've just given me the excuse to link to my old Chuck Norris post, where I say exactly the same thing!

Me: "Every 6 weeks, the Bank of Canada announces its overnight rate target for the next 6 weeks. And the actual overnight rate instantly moves to where the Bank of Canada wants it to be. It's pure Chuck Norris. The Bank doesn't actually do anything. It just lets the market know where it wants the market to move, and the market moves there. The market moves because of the Bank of Canada's threat. If the overnight rate is above the Bank's target, the Bank will add however much settlement balances as are needed for as long as is needed until the overnight rate falls to the target. And if the overnight rate is below the Bank's target, the Bank will subtract however much settlement balances as are needed for as long as is needed until the overnight rate rises to the target. And because this threat is credible, the Bank doesn't need to carry it out."

And thanks for your kind words earlier. I'm not sure i always deserve them.

[wh10]

I might take issue with your last two sentences, but putting that aside, then why do you say "Bank of Canada would never be able to adjust the target over time in response to the economy..."?

[Nathan Tankus]

"BTW, on the Nathan Tankus and others' point: that the central bank must have a perfectly elastic supply of reserves to prevent a monetary crisis. If that were true, the Bank of Canada would never be able to adjust the target over time in response to the economy, including reining in the banks, to keep inflation on target. In fact, precisely the opposite is true. If the Bank of Canada had a perfectly elastic supply curve at a given rate of interest the monetary system would eventually either implode or explode."

seems like I made the best impression among the "mystics" ;)

On to your argument. why would the monetary system explode? do you mean the banking system would inflate multiple bubbles? why that's so unrealistic.... oh wait. More seriously, banks are still constrained by their access to capital and the expected profitability of their loans (as long as when they are insolvent they get cut off from the interbank market and the bank/discount rate and/or get foreclosed on by the deposit insurance entity in that country. This is an extra reason why TBTF is so alarming to Post Keynesians). This will certainly lead to periodic financial crisis (I mean this is Minsky's whole argument. That's why it's so amazing to see Krugman claiming he's working in the Minskyan tradition) as long as their are no "thwarting institutions" (Minsky's phrase) actively preventing financial instability.

Somehow however, I don't think this what you're talking about. No one denies that central banks can raise their targeted interest rate. In addition, no one is arguing that a central bank can't have a reaction function where it changes interest rates in response to economic variables (like inflation). However, changing one's targeted interest rate in response to inflation is not the same as targeting inflation in the central bank sense. They are always targeting a chosen interest rate. Saying that changing one's target interest rate in response to inflation is targeting inflation is like arguing that changing one's interest rate based on how many times Lloyd Blankfein smiles in public in a given month is targeting Lloyd Blankfein's smiles. That policy may influence inflation, just like that policy might influence Lloyd BlankFein's public smiles, but it's not targeting it. Making central bank provided reserves more costly in response to inflation, is still providing reserves on demand.

[mdm]

Nick,

Thanks for the reply.

"1. A visiting anthropologist might listen to the natives' theories of their own behaviour but isn't obliged to make his own theories identical to their theories."

Of course not, he should observe their behaviour, and trying to limit theory-ladeness (i.e. priors) and interpret what is going on.

"2. An orthodox response would be to say that that theory is perfectly correct in the very short run (6 weeks in the case of the Bank of Canada) but is incorrect/misleading over any longer time horizon, which is what we are interested in, because that target rate of interest is not exogenous but responds endogenously to the actions of the commercial banks and the rest of the economy."

Fair enough. My question is: if the target interest rate is at the discretion of the central bank, so that any potential structural relationship between it and economic variables will only arise if the central bank has a consistent behavioural function? What if the theory which which informs what the target rate should be changes? What about the supply curve for reserves in the long-run?

Post Keynesians argue that the causal relationship between reserves and bank credit, goes change in bank credit - > change in reserves. That is implicit in my comment above. Does the causality between these two series change in the long-run?

[JW Mason]

The Walras-Schumpeter-Minsky proposition that aggregate demand is income plus the change in debt...." Can anyone make any sense of his equation 1.1 that immediately follows?

While I am generally on the side of the MMTers here, that paper is a real mess. Equation 1.1 is nonsense as written -- the four variables have three different dimensions. You can try to guess at what he might have meant, or should have meant, but that's all. I have a new post on it, if anyone is interested.

[JW Mason]

(actually in the spirit of mdm above, I should say I'm on the Post Keynesian side.)

[Nick Rowe]

Tschaff: Steve keen is responding to Paul Krugman. I just skimmed steve's post, and found this:

"Firstly, there are similar underlying principles to the DSGE models that now dominate Neoclassical macroeconomics, and as with Ptolemaic Astronomy, these underlying principles clearly fail to describe the real world. They are:
1. All markets are barter systems which are in equilibrium at all times in the absence of exogenous shocks—even during recessions—and after a shock they will rapidly return to equilibrium via instantaneous adjustments to relative prices;
2. The preferences of consumers and the technology employed by firms are the “deep parameters” of the economy, which are unaltered by any policies set by economic policy makers; and
3. Perfect competition is universal, ensuring that the equilibrium described in (1) is socially optimal."

3 is totally wrong. *Everybody* knows that New Keynesian DSGE models assume imperfect competition. Imperfect/monopolistic competition is *absolutely central* to NK DSGE models, and has been for over 20 years. It is one of the big advances of NK macro. Jeez, Paul K totally understands this, and made his own name from introducing imperfect competition into international trade theory, and will go ape if he ever reads steve keen on this.

1. is totally false too. Whether NK models are really barter or not is debatable (I say they make no sense as barter models, even though money is inessential), but they certainly have sticky prices, and the rest of his point 1 is total crap.

Only his point 2 is (mostly) true.

What Steve Keen is saying is unadulterated BS. Sorry, but it has to be said. I do *try* to be nice, but Jeeeeez!

[Simon van Norden]

Yikes! What a comment-storm!

On a slightly different note: Nick, if I were to say to you, "The supply of XXX is demand-determined," can you think of any value of XXX where the statement would not make your skin crawl? I tried, but could not. When someone tells me that supply is demand-determined, I cannot help but think that the words "supply" and "demand" are being misused. Perhaps you or your readers can think of exceptions.....

[Nick Rowe]

Steve keen again: "Neoclassical economists like Krugman who believe that capitalism can be modelled without either money or banks are Barter Mystics..."

Umm. ever read the Babysitter coop model that PK is always going on about? It's a monetary exchange model, where a shortage of money causes a recession.

[Nick Rowe]

Simon: welcome to the storm!

"When someone tells me that supply is demand-determined, I cannot help but think that the words "supply" and "demand" are being misused."

Absolutely.

[JW Mason]

I'm afraid Nick R. at 9:30 and 9:42 is absolutely correct. The Keen paper is bad.

[wh10]

JW- Keen isn't MMT. And yes, as has been noted here already, his paper is unique to his views with some potentially problematic elements.

[W. Peden]

Simon van Norden,

"Perhaps you or your readers can think of exceptions....."

How about things in natural abundance e.g. air? Of course, here the phrase "supply of air" must mean "the amount we breathe", rather than the amount exchanged.

If we are talking about supply and demand in exchange, I can think of no exceptions. I go into a shop; I buy a stick of gum. Was it either my going into the shop and buying the gum make the shopkeeper give me the gum or did the shopkeeper having a shop with gum for sale make it possible for me to buy the gum? If the former is true, then gum is demand-determined. If the latter is true, then gum is supply-determined. However, the answer to the disjunctive question is "yes" and the dichotomy is an entirely false one.

I suspect that the reason people get into thinking this way (and thinking that they're putting forward a serious causal theory of how the world works) is the point that Nick Rowe has made so often in the past: "the quantity demanded" and "desired demand" aren't the same thing. However, if one confuses the two, it might seem that "desired demand" (which is not necessarily or even usually identical to "quantity demanded") causes the quantity supplied, since (when the two kinds of demand are conflated) the two are always equal.

It is meaningful to say that the desired demand for credit = the quantity supplied of credit, which is what Kaldor said IIRC. However, that's another case where the slightest introspection reveals the mistake: if you were a banker, would you be willing to lend to a cash-strapped business at ANY price? Even the most profligate banker isn't that stupid!

[W. Peden]

J. W. Mason,

"Y(t) + dD/dt = GDP(t) + (P*Q*T)"

That made my day.

[Nick Rowe]

JW makes a much more determined and careful attempt to understand Steve Keen's Berlin paper than I did. He fails too. JW is well worth reading.

[wh10]

Nick- Ramanan also has a post on this issue, corroborating the Post-Keynesian view of banking but also critiquing Keen's paper, with the help of Lavoie. http://www.concertedaction.com/2012/03/31/is-paul-krugman-a-verticalist/

As I said, I hope you respond to my question about why you said what you said / Nathan Tankus's most recent post. I feel like this is the point at which the conversation usually stops, but it is a quite critical juncture.

[Ramanan]

W Peden,

"is one of those sentences that I can't even imagine believing, at least not about the planet Earth."

Okay so consumption is inversely related to income or what?

Maybe as Nick suggested I should use expenditure.

But let's just talk of consumption only because you find what I say amusing. Ever heard of the "consumption function" ?

You give an example of bonus. But bonus is also a part of income!

One may loosely say "I got a lot of money this year in my bonus" but formally such statements are not used. It is better to say my income was high this year due to the high bonus.

So if I unexpectedly receive a higher bonus, naturally I will consume more. But from your viewpoint it is got to do with the fact that there's higher money balance in my account which is making me take that decision. But I may already be having high money balances in my account because my portfolio allocation decision is such as to keep my previously accumulated wealth in the form of bank deposits.

[Nick Rowe]

wh10: can we imagine circumstances in which the Bank of Canada wants to tighten monetary policy to prevent inflation rising above target, but knows that if it did so a major commercial bank would be illiquid and fail? Maybe.

Does this happen all the time? Obviously not. If it did, the Bank of Canada would never be able to keep inflation on target.

More generally, one of the reasons people keep buffer stocks of money, and banks keep buffer stocks of central bank money, is so we don't go illiquid when some sort of surprise happens. But cue Minsky/Leijonhufvud corridoor at this point.

[wh10]

Nick, sorry, slightly confused on the implications of your thought experiment. Why does that refute that CBs always have a perfectly elastic supply at a given rate of interest?