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This is absolutely wonderful. Congratulations on stumbling over it.

Thanks for sharing. Interesting that mainstream opinion seems to be coming around to Friedman's perspective, many years after the fact.

Andrew F: "Interesting that mainstream opinion seems to be coming around to Friedman's perspective"

Yes. Too bad it's nonsense.

I'm almost afraid to ask why you think that.

A great blast from the past! Thanks for finding that, Mike. As I recall, they had trouble with the satelite link that day, so we watched Milton staring dejectedly into what he thought was a nonfunctioning camera for several minutes they got the problems sorted out.

Trust Bordo and Laidler to ask the good questions.....

Friedman was worried non-synchronous shocks. But the problem appears to have been one big shock that affected different countries in different ways depending on their level of private debt. Also the problem is Europe right now pretty clearly is the inability of the whole Eurozone to carry out an expansive program of spending and growth-inducing public investment. If they could monetize a portion of that investment, that would be a plus. But it's the fiscal and parliamentary institutions that are lacking.

Also, it doesn't appear to me that Friedman's claim that, once at the zero bound, the central bank can still have success by buying up treasury debt and pumping the banking system full of reserves is looking very plausible right now.

IIRC, Krugman has in the past quoted the bit about Japan.

Awesome find! So relevant today.

No fear, Stephen! My objection is quite standard. When the CB buys treasury bonds, the sellers are those who are indifferent to holding treasuries vs deposits as an investment. The newly created deposits are excellent substitutes for low risk treasury bond investments. If the zero overnight expected return on treasury bonds is too high to induce people to invest more in risky assets, then so is the zero expected return on deposits. If they weren't wanting to spend their treasury bonds, they wont want to spend their deposits either.

If you want to analyze QE, you need to think of it as two operations: 1) a swap of reserves for T-Bills and 2) and swap of T-Bills for long term treasuries. Friedman contends that step 1, the creation of high-powered money, is expansionary. This is what I describe as "nonsense." There is no economic difference between reserves and T-Bills. The second step, is the portfolio effect that the Fed describes as the mechanism of QE. There are both theoretical reasons and empirical evidence (Operation Twist was a fail) that this second operation might not have any beneficial effect either. But Friedman wasn't even making that case. His argument was based on the assumption that the demand for money was limited by liquidity preference rather than investment portfolio composition which is not tenable at the zero bound.

K: This exact point was tackled by Market Monetarists on many occasions. The key in understanding why bonds and high powered money are not substitutes even if they have the same and close to zero yield right now lies in expectations. The point is that even if we have 0 nominal interest now, it will not be so forever. If central bank would be "credible" about future path of money supply then suddenly printing money now will start to be expansionary.

There one good ad absurdum arguments against this whole bonds are the same as money line of thought - theoretically there is no limit for CB to print new money and buy assets. In an extreme case CB can own all assets in the world in exchange for newly printed cash. Would you insist that in this world there would be no inflation and no fisher effect and bonds would remain at their 0 yield? So we can agree that there exists a path of money supply that will generate inflation and given the role of expectations you may just reverse this process to see that promise of future expansion of money supply should have immediate effect now - no matter the actual interest rate differential between high powered money and bonds.

This is another key understanding of Milton Friedman that he states in this very article. interest rates can be a result of too tight monetary policy in the past. This is a bad thing and setting the monetary policy back into "optimum" will rise interest - which will be good as it will be a sign that the economy is starting to recover.

JV Dubois: "This exact point was tackled by Market Monetarists on many occasions."

Repeated ad nauseum is not the same thing as tackled.

"If central bank would be "credible" about future path of money supply then suddenly printing money now will start to be expansionary."

This is wrong. There are two possible future scenarios:

1) IOER (Interest on excess reserves) close to the Fed funds rate. In this case the "money supply" is determined by investment demand, not liquidity preference. People will hold vastly more reserves/deposits than could ever be justified for liquidity purposes. There is no "hot potato" when money has the same yield as T-Bills.

2) IOER back to zero when the Fed starts raising rates. This is presumable the case the MM's are imagining and it was certainly Friedman's framework. Now we have a hot potato. The problem here is that the Fed no longer controls the money supply in this scenario. If the Fed tries to raise the interbank target above IOER, banks will dump their excess reserves in the interbank market *until* the FF rate is equal to the IOER rate. Why would a clearing bank bid for reserves at a rate that's higher than the rate they earn holding those reserves? If somebody tells you that the CB can control both the money supply *and* the interest rate spread between money and T-Bills, that is a clear signal that that person has no idea what they are talking about. In reality, what happens is that as soon as the Fed raises rates above IOER, the excess reserve quantity collapses to whatever is required by liquidity preference. The Fed, therefore, has *zero* control over the money supply in exactly the scenario that you are claiming that they need it, i.e. after rates start to rise again.

"In an extreme case CB can own all assets in the world in exchange for newly printed cash."

Sure. I agree that buying *positive beta* assets is stimulatory. Treasuries wont work in a deep liquidity trap for reasons I'm happy to discuss. But now you (like Friedman) are pulling a fast one by conflating "money expansion" and the portfolio effects of asset purchases. Friedman was making a (nonsense) claim about "high-powered money." You need to be very careful to distinguish between 1) the swap of money for T-Bills and 2) the swap of T-bills for bonds or real assets. The first is totally bogus. The second is complicated and subject to debate among reasonable people.

Oh god. I was right to be afraid. Sorry I asked.

Sorry I answered. Did I say something wrong?

1) No comment. It is as if you say that you *assume* FED will pay interest on the dollar bill based on the year where it was issued and that is why printing money will not work because people will just hold it and if FED will print too much it will *have* to increase the insterest in order to prevent it. Or in other words, you assume that high powered money don't exist and that all money is just some form of government (or FED) bond.

2) So we keep things real by having actual high powered money in the system. In this scenario FED does not control money supply, because "If the Fed tries to raise the interbank target above IOER" ... Wait a moment here. Who said anything about fed trying to rise this or that interest rate? FED could not care less. In NGDP targeting all FED cares about is GDP deflator and Real GDP growth that if combined make NGDP. FED could not care less about what is the current interest rate as far as it reached its goal under which it assumes that the economy experiences no demand shortage.

This is MMT explanation of how things work - all money in economy somehow automatically ends on commercial bank accounts even with close to zero 0% interest because there is overall excess of it. Let me ask you some question:

1. What sane person would deposit their money in a Bank for 0% interest rate (we asume that IOER is 0)
2. Adjusted point number one - what person would deposit their money in bank for for IOER interest rate that is vastly less then expected inflation

This is now how real world operates say Market Monetarists. People form expectations. If they believe that central bank is going to print a lot of money (CB credibly communicates expansion in the path of money supply) they will have less desire to hold it. They will start to buy real things until hot potato effect dilutes the purchasing power of money. What is more - people will try to borrow more money from banks because they will see an opportunity - borrow for 1% interest rate - buy a lot of oil - sell tommorow and make vast profits. If banks will see that there is a lot of people with similar "sound" business plans they will start to look for deposits so that they may make profit on interest interest rate difference between deposits and loans. They will start to raise interest rates they offer on deposits in order to beat competitors in banking sector. The price of govenrment bonds with nominal returns will plummet, people will refuse to buy government bonds for interest rate that is less then they can get by making bank deposits. Interest rates rise in spite of economy being flooded by money printed by central bank (Fisher effect).

Our problem is that Central Banks are too credible. Everyone knows that they have 2% inflation ceiling. Everyone believes that when the inflation expectations start to get close to 2% inflation central bank will revert the future path of money supply to prevent it from rising.

JV Dubois: "you assume that high powered money don't exist and that all money is just some form of government (or FED) bond"

In *my* country (Canada) we pay IOR on all reserves. That's what defines the lower limit of the corridor. Works fine. We also have a bit of paper money outstanding. The BoC cannot control the quantity of paper money. If there is more outstanding than people need to satisfy their liquidity needs they don't spend it. They just turn it in for interest earning deposits and the BoC destroys it.

First you said: "The point is that even if we have 0 nominal interest now, it will not be so forever. If central bank would be "credible" about future path of money supply then suddenly printing money now will start to be expansionary."

Then: "Who said anything about fed trying to rise this or that interest rate? FED could not care less."

Is it not about money becoming a "hot potato" at some point in the future when rates rise above zero and thereby generating inflation, the expectations of which trigger demand now?

"What sane person would deposit their money in a Bank for 0% interest rate"

It's got nothing to do with nominal rates. If, for example, the natural rate is 0% and inflation is -1% then people will be very happy to deposit at a nominal 0% which is a real 1%, right? If you eliminate paper money, people would even settle for negative deposit rates under depressed circumstances.

"People form expectations. If they believe that central bank is going to print a lot of money (CB credibly communicates expansion in the path of money supply) they will have less desire to hold it."

As Sumner has told me (many times) the supply of money is irrelevant while at the ZLB. It is expectations of the supply after we exit. And setting the supply now affects expectations of the post ZLB money supply. OK. So lets imagine that the CB stops setting the interbank rate and instead sets the money supply. After the short rate leaves the ZLB, the supply of money and the money demand function will determine the short rate. So given some money demand function, determining the future money supply is equivalent to determining the future short rate. Therefore, there is *nothing* that setting supply expectations can do that can't be accomplished by setting short rate expectations, which is why MM offers nothing over the standard NK model.

The only question, then, is what's the more relevant framing of what the CB is doing: setting the supply or setting the interbank rate. Here there is no competition:

1) If the current money supply in the US had any implication for the post ZLB supply, we'd be looking at several hundreds of percent inflation. Obviously the current money supply signals nothing about the post ZLB money supply.

2) Banks keep pretty well exactly zero excess reserves when not at the ZLB. Targeting quantity means keeping rates at zero until mandatory reserves grow (due to deposit expansion) to the level of outstanding reserves. After that, unless the Fed targets reserves exactly equal to mandatory reserves, rates will go to either a) infinity as banks compete in a futile fight to obtain their required reserves, or b) zero as they compete in a futile fight to eliminate excess reserves from the system. That's not a system. That's nonsense.

3) You don't even need *any* quantity of reserves in order to run an interbank settlement system. LVTS operates with essentially zero reserves ($25m typically). There is no conceivable "hot potato" mechanism for $25m of reserves to effect the price level. Nobody cares! And the system could just as well operate with zero reserves, though banks would have to become extremely pedantic about resolving even the slightest settlement discrepancy. The CB can enforce a rate without any quantity at all. Which leads me to the last point:

4) Monetary policy doesn't act on the economy via nominal rates. It acts via real rates. I.e. economic agents making arbitrage decisions between risk free real returns and risky investment in real assets. The CB determines expectation of the short rate, which drives expectations of inflation and thereby the risk free real return curve. There is no exchange medium required in that story (just a unit of account and some slightly sticky prices) and adding it causes nothing but confusion. That's the whole point of the New Keynesian model and liquidity trap literature.

"1. What sane person would deposit their money in a Bank for 0% interest rate (we asume that IOER is 0)
2. Adjusted point number one - what person would deposit their money in bank for for IOER interest rate that is vastly less then expected inflation"

Sorry to intervene, J.V. Dubois, but before you get into some theory, MMT or otherwise, can you please confidently answer one simple question :) ... why do banks paying anything at all on deposits?

The next obvious question would be - what choice do non-banks have in a monetary electronic economy as to where to keep there money?

Banks paying *anything* at all on deposits or otherwise is one glaring example of prisoners dilemma. It has nothing to do with the saneness of people but only with the stupidity of banks.

So a wrong question gives you a wrong answer.

Honest question Stephen: are you sorry about sparking another debate about MMT and other monetary theories (I tend to scroll past them anyway).

I think there's some over-thinking going on here. Look at what Friendman said again:

"It’s very simple. They can buy long-term government securities, and they can keep buying them and providing high-powered money until the high powered money starts getting the economy in an expansion. What Japan needs is a more expansive domestic monetary policy." (emphasis added)

If the CB said it was prepared to buy unlimited quantities of long term bonds until it achieved it's goal, I suspect it would achieve its goal.

K: Please will you stop for a moment and review what was written?

1. About being forced to use electronic money or whatnot: you intentionally misunderstood the explanation. If central bank announces a plan to pump some money into economy, like for instance a program of monetizing government debt, people will start to expect inflation. Even if there is only electronic money in the circulation people cannot be forced to hold it. They can always buy real assets diminishing its purchasing parity until they are again willing to hold it. If central bank offers some support rate on reserves, and this rate is does not provide people with expected real interest rate they want given the inflation expectations, then it is irrelevant. It will become low boundary that no-one will be interested in using for deposits - unless CB changes its policy and reverts the path money supply.

2. "So given some money demand function, determining the future money supply is equivalent to determining the future short rate" - man in what hole were you hiding up till now? Our problem right now is that in order to restore demand the Central Bank would need to get the short rate negative. This is the dreaded Zero Lower Bound. This is all Market Monetarist talk about for last few years: zero lower bound is not real, it is just an imaginary wall that can be circumvented by using "nonstandard" monetary policy

Also, what you say is not even true. You cannot determine future money supply solely from interest rate path: http://www.themoneyillusion.com/?p=13294&utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+Themoneyillusion+%28TheMoneyIllusion%29


The first question is whether the central bank has the power to raise inflation expectations when short-term rates are at zero. And I think it's fairly obvious that it does. If it didn't, it could buy up all T-bills and Treasury bonds and write them down to zero (thereby promising that the increase in the monetary base was permanent) with no inflationary consequences. It would be able to create infinite real purchasing power simply by printing base money. And this is obviously ridiculous.

The second question is; why can the central bank affect inflation expectations? And the answer to that it is because controls the supply of base money. Why? Because that, in the end, is all the Fed ultimately controls. When the Fed lowers interest rates what it’s really doing is promising intervene and lend in overnight markets to force short-term interest rates lower. Similarly, when the SNB announces a floor on CHFEUR of 1.20 it can credibly do so because of its ability to create CHF in unlimited quantities. Yes, as in NK models, modern central banks use interest rates (and sometimes exchange rates) as their tools, but their control over the monetary base is what gives them the power to do this.

If I announced that the CHF floor was going to move to 1.30, no one would listen. If the SNB announced it, the market would take the exchange rate above 1.30 in about two seconds. Why? Because the SNB can print CHF and I can’t.

So central banks can change expected inflation (or expectations of any other nominal variable) and the reason that they can is because they control the monetary base.

Determinant: Yep.

Determinant: Yes, you are right it is not worth it so hereby I promise that I am finished with it - for now :). Anyways at least it did not hijack some completely unrelated topic.

What K is saying makes perfect sense to me. It seems very natural to think of money purely as a reference unit, since I hardly ever use it as a payment system. If we don't need money to transact, how can the quantity possibly matter? It's as absurd as saying that the length of a meter is determined by the quantity of meters.

JV Dubois, Patrick, Gregor,

Let me try to be excruciatingly clear in 100 words or less:

There can only be excess reserves if the interbank rate is zero. This should be theoretically obvious and is empirically true:

If the Fed is targeting the quantity of money, it must be targeting a level that is higher than mandatory reserves. Otherwise banks fail. Therefore with a quantity target there will be excess reserves. Therefore, the interbank rate will be zero. Once the Fed no longer wants a zero interbank rate, they must end the quantity target and allow excess reserves to go to zero. Therefore, when Friedman says: "they can keep buying them and providing high-powered money until the high powered money starts getting the economy in an expansion," that is *exactly* equivalent to saying "they can keep the interbank rate at zero until the economy is in an expansion." The quantity of excess reserves while the rate is at zero means nothing.

JV Dubois: " you intentionally misunderstood the explanation"

I promise that to the extent I'm being stupid, it's totally sincere.

Let's not forget this 1998 Friedman gem, via Paul Krugman: http://krugman.blogs.nytimes.com/2010/10/28/friedman-on-japan/

“The Bank of Japan can buy government bonds on the open market…” he wrote in 1998. “Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand…loans and open-market purchases. But whether they do so or not, the money supply will increase…. Higher money supply growth would have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately.”

The central bank creates bank reserves, not money. Bank reserves exist to settle interbank liabilities, and they are only useful for this purpose.

Money to the non-financial sector is claims against the financial sector -- bank deposits. There is no relationship between the quantity of bank reserves and the quantity of bank deposits.

There *was* a constraining relationship, prior to the advent of central banking, in which an increase of deposits not matched by an increase of reserves would eventually, at some unknown point -- lead to a banking crisis that could could plunge the nation into a depression. So it was correct to say that a lack of reserves was responsible for the depression.

But that was a constraining relationship in only one direction. It was not a numerical relationship, in the sense that a 10% increase in deposits required a 10% increase in reserves, but rather an increase in the hazard rate.

The pain of using bank runs to reduce deposits to their historical ratio with reserves was viewed to be too great, and so central banks were formed to sever that relationship. Not to enforce it. There is no reserve multiplier anymore. There is no mechanism for an increase in reserves to cause an increase in deposits.

More important than any form of economic management, the central bank exists first and foremost to ensure that banks are freed from worrying about reserves when deciding to grant a loan or not (e.g. create a deposit), and are only worried about the price of reserves, or the FedFunds rate., together with whether or not they have adequate capital to pledge against the loan. Capital requirements and bank regulations have replaced reserves as a constraining factor on the quantity of new loands made, and therefore on the growth of money -- e.g. bank deposits. Canada has, effectively, zero reserves, its deposit to reserve ratio is infinite.

Central banks are by and large successful at doing their jobs, which is to prove Friedman wrong in that quote. Spectacularly wrong. The existence of the central bank with irredeemable liabilities, as an institution, means that QE is ineffectual.

This is what you get when you are working with poorly defined terms and then apply some rather sketchy theories to them.

First of all you have no tight definition of money, Calling some of it high powered doesn't solve anything. What other kinds of money are there? Exactly how much more powerful is one kind than another? Who creates and destroys this money. Since the different types of money as measured by M1, M2, M3 and M4 have a very complicated and poorly understood relationship, the fractional reserve system doesn't explain this regardless of your position concerning endogenous money (and what that means), the controlling powers of the monetary base, or the function of reserves (Canadians seem to be immune to this foolishness).

Second when I hear terms like liquidity preference and propensity to consume, I know the whole discussion is doomed. These are determining factors, yet they can't be measured. You might as well invoke the tooth fairy. Once you state the blindingly obvious facts that these must be variable both across time and individual, that they're probably not very well behaved functions of anything useful (which we will choose to ignore) you're pretty well done.

Third, while there are problems with the monetarist money story, modeling a debt crisis without mentioning money or banks has to be some kind joke I just don't get.

It's time for economist to take out the trash. Stop teaching and proclaiming things that people in your profession definitively disproved 50 years ago. A few examples:

GDP is not spending, nor is it a constant fraction of it.

So MV ~= PY, since MV should be spending and PY is only a fraction of this. Keynes wrote about this in the 1930s.
He IIR had two different velocities.

GDP isn't production. It's an aggregation category use in our system of national accounts mostly following an international standard.
I could give you a list of its problems, but you all know how to use Google.

Saving is a reasonably useless number, because it's the residual of a several poorly measured and arbitrarily defined variables. It's where all the errors go to accumulate and die.

No company that intends to stay in business will produce down to the edge of marginal cost.

Why do rational expectations models require assuming irrational behavior in order to work?

Any model that requires homothetic preferences is probably useless.

Max: "If we don't need money to transact, how can the quantity possibly matter?"

Well put.

rsj: Amen! You say it brother!

Peter N: I hope you didn't think I invoked liquidity preference under the assumption that it was a useful concept. It isn't.

The Fed creates money. The banks can multiply it. So normally if the Fed creates $1, the banks turn it into $10. If the banks don't cooperate, the Fed has to create 10 times as much money to get the same effect. This causes reserves to pile up. The banks' lending is constrained by their risk weighted assets to capital ratios and whether they have credit worthy borrowers at profitable rates.

Reserves really don't matter. Most of the banks' deposits aren't reservable, and they have other sources of funds.

BTW US Treasury securities are used as collateral all over the world. If the Fed bought enough to cause collateral shortages, this would have interesting effects over and above the money they spent doing it. And, of course, they can buy higher risk securities to reduce the aggregate risk profile, which should have stimulative effects.

And, of course, they can buy higher risk securities to reduce the aggregate risk profile, which should have stimulative effects.

No, that is illegal. The Fed can only buy government backed assets.

The Fed creates money. The banks can multiply it.

It's better to be precise. The Fed creates reserves. Banks create deposits. There is no magic ratio relating the quantity of reserves to the quantity of deposits. Canada has zero reserves (actually a small number), yet many deposits. The Bank of Canada therefore has a very small -- last I checked about 65 Billion (CDN) or so, on a GDP of about 1.7 Trillion (CDN), and M2 (Friedman's favorite) of about 1.4 Trillion, for a ratio of about 22: 1. M2/GDP is about 12:1.

In the U.S., the Fed has a balance sheet of about 2.9 Trillion, on a GDP of about 14.5 Trillion, and M2 of about 9.8 Trillion. The ratio of M2/GDP and M2/CB balance sheet is about: 0.7 and 8 for the U.S. For Canada, it's about: 0.8 and and 21.

Note that the non-financial ratios (M2/GDP) are fairly close for both countries, reflecting the fact that both nations have roughly the same amount of deposits in the non-financial sector. The reserve quantities are hugely different.

What would to Canadian household currency and deposits if, say, the Bank of Canada increased its balance sheet size from 65 B to 200B?

Absolutely nothing. M2 wouldn't change, neither would GDP, nor the price level. All that would happen is that CB liabilities (bank reserves) would increase.

And this is the same result that Japan experienced and that the U.S. experienced in its own rounds of QE. Households deposits remained unchanged. Currency held by households remained unchanged. As far as the non-financial sector is concerned, it was a non-event.

Even though there might be an observed relationship between M2 and the quantity of reserves, this relationship is not structural. if the government attempts to *exploit* this relationship by creating more reserves in an attempt to increase M2, all that will happen is that the government will succeed in creating more reserves while M2 will remain unchanged.

One of the comments made earlier was "What sane person would deposit money in a bank when the interest rate was 0%?" Sadly, I work (as an equity researcher) for a brokerage firm, and our office is next door to the retail fixed-income sales team. Not too long ago, it was not uncommon for our retail clients to buy Treasury bills above par (a negative NOMINAL return), simply because they were more afraid of the banking system than they were of a minor nominal loss of purchasing power.

"'And, of course, they can buy higher risk securities to reduce the aggregate risk profile, which should have stimulative effects.'

No, that is illegal. The Fed can only buy government backed assets."

No, that is wrong, even under with the Dodd-Frank.

There are 2 exceptions to the restrictions in section 13. The first is 13(2) for asset backed commercial paper and the like:

"Discount of Commercial, Agricultural, and Industrial Paper

Upon the indorsement of any of its member banks, which shall be deemed a waiver of demand, notice and protest by such bank as to its own indorsement exclusively, any Federal reserve bank may discount notes, drafts, and bills of exchange arising out of actual commercial transactions; that is, notes, drafts, and bills of exchange issued or drawn for agricultural, industrial, or commercial purposes, or the proceeds of which have been used, or are to be used, for such purposes, the Board of Governors of the Federal Reserve System to have the right to determine or define the character of the paper thus eligible for discount, within the meaning of this Act."

Then there's 13(3), "unusual and exigent circumstances" to which Dodd-Frank added a number of restrictions after the Fed used it in 2008.

"In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any participant in any program or facility with broad-based eligibility, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange, the Federal reserve bank shall obtain evidence that such participant in any program or facility with broad-based eligibility is unable to secure adequate credit accommodations from other banking institutions. All such discounts for any participant in any program or facility with broad-based eligibility shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.

As soon as is practicable after the date of enactment of this subparagraph, the Board shall establish, by regulation, in consultation with the Secretary of the Treasury, the policies and procedures governing emergency lending under this paragraph. Such policies and procedures shall be designed to ensure that any emergency lending program or facility is for the purpose of providing liquidity to the financial system, and not to aid a failing financial company, and that the security for emergency loans is sufficient to protect taxpayers from losses and that any such program is terminated in a timely and orderly fashion..."

The gist of it is that the Treasury has to agree and congress gets 30 day updates.

As for other countries, the ECB has the banks and indirectly the sovereigns on life support with a resulting 3 trillion euro balance sheet, with another trillion or 3 inevitably to come, unless Germany pulls the plug on the euro-zone. They're ultimately on the hook for about 1/3 of the ECB liabilities IIR.

I'm sure the People's Bank of China has lots of rules. I'm also sure that as a creature of the ruling Chinese bureaucracy (Government/Communist Party/whatever), it does what it's told, or at least what the currently dominant faction tells it to do, which, since it includes a rather flexible concept of disclosure. They pretty much do what their told and say what they're told to say. Since this means pretending to have the something like the governance of a western central bank, they do so (sort of, mostly, unless it's very inconvenient).

The Bank of England is controlled by Parliament. The Chancellor of the Exchequer, IIR can set interest rate targets. The bank get's a fair amount of independence from its traditions and the English people's respect for them and the bizarre idea of an unwritten constitution (that the government keeps trying to nibble away). It's tradition is in an emergency to lend freely at penalty rates on good security (without being "over nice" about how good the security is).

I'll leave the other central banks to others. And I'm always interested in hearing what the Chinese are really doing. Right now, it looks like they have a bit of a dollar problem, and other things are coming off the rails (even the trains are).

"It's better to be precise. The Fed creates reserves. Banks create deposits."

The Fed can and does lend reserves, but it also writes checks which the banks will cash by creating an offsetting asset-liability pair (deposit and reserves). Banks can and do lend each other reserves at the federal funds rate, which, of necessity, closely tracks the discount rate.

The banks create money by simultaneously putting on their books an asset (a loan) and a liability (the proceeds of the loan). They can draw on reserves to cover the withdrawal of the proceeds, but they have other sources of funds. In any case, if their reserves are insufficient for their needs, the Fed will freely (though possibly with a bit of unwelcome scrutiny, an important issue if you're studying the great depression) lend a bank as much reserves as it needs at the current discount rate. The Federal Reserve open market committee sets this rate at its regular meetings (or in an emergency by telephone meeting).

There is a reserve to deposit ratio, but it's peculiarly enforced and has little consequence because a bank only has to reserve against consumer demand deposits which are a minority of its liabilities, and it also can perform "sweeps".

A banks lending is constrained not by reserves, but by its capital adequacy ratio CAR enforced by regulators like the FDIC. In recent years in the US 10% has been the prudential edge and few banks were over 13%. The CAR in the US is defined according to the Basel I accords. In Europe, they're at Basel II going on Basel III, which is a large part of the problem, as the timing is very inopportune.

It should be noted, that there's a lot of smoke and mirrors at work here, since actual leverage has gone into the 40 times region in the US, and into the 60 times region in Europe, despite using Basel II instead of Basel I.

I'll leave any discussion of monetary aggregates for later, but if money creation only involved loans and deposits, we wouldn't need M4.

I know very little about how Canada handles reserves. I'll leave that for the Canadians among you.
There is no magic ratio relating the quantity of reserves to the quantity of deposits. Canada has zero reserves (actually a small number), yet many deposits.

I suggest that people comment on this and, when there's agreement as to its correctness, we can avoid spending more bandwidth on what should be a simple and noncontroversial question of fact. Questioners can just be referred to the final version as posted here.

Feel free to remove any testy sarcasm.

Just great.

Peter N,

I think you are needlessly complicating the debate with extensive details of CB idiosyncracies. If you want to progress, you'd be far more successful by trying to get people to agree on a simple "model" CB. Who cares if the Bank of Nairobi can buy stocks? Also, the whole debate over the effects of purchases of various kinds of assets is interesting, but irrelevant to Friedman's claim that "they can keep buying [treasuries] and providing high-powered money until the high-powered money starts getting the economy in an expansion," which is the "nonsense" statement that's at issue here.


Assuming no IOR (what else could he mean by high-powered money?), the way I see it there are only three things that matter:

1) The quantity of excess reserves can only be non-zero if the interbank rate is zero
2) The interbank rate can only be non-zero if the quantity of excess reserves is zero
3) The quantity of reserves doesn't matter when the interbank rate is zero.

Lets clarify Friedman's statement:

"We'll keep buying or holding treasuries at levels much higher than mandatory reserves until the economy is in state X, at which point we will allow reserves to return to the mandatory minimum."

Is that an acceptable statement of QE?

When the economy achieves state X, excess reserves will be gone and the interbank rate will rise above zero again. Mandatory reserves will presumably be much higher than at the beginning of the process (in the US, not in Canada) assuming an expansion of deposits, but *nobody* cares what that new level of reserves is.


1) The quantity of reserves during QE doesn't matter
2) The quantity of reserves at the end of QE doesn't matter
3) After QE is done, it's impossible to target the quantity of reserves which returns to the mandatory level

The only thing that matters is that we've achieved state X and the only thing that we have done to get there that is of *any* economic consequence to *anyone*, is that we've held the interbank rate at zero for as long as it took. Recognizing that, expansion of reserves while at the ZLB is a horrible distraction, especially given how many economists think it actually makes a difference. What's needed is a clear elaboration and commitment by the Fed to the contingent path of the policy rate. Buying treasuries is "nonsense."

I was trying to avoid the endogenous money sidetrack and show why reserves don't matter.

This is what the some Fed representatives had to say


Excess Reserves and Interest Rates
Actions by a central bank that change the quantity of reserves
in the banking system also tend to change the level of interest
rates. Traditionally, bank reserves did not earn any interest.
If Bank A earns no interest on the reserves it is holding in
Exhibit 2, it will have an incentive to lend out its excess reserves
or to use them to buy other short-term assets. These activities
will, in turn, decrease short-term market interest rates and
hence may lead to an increase in infl ationary pressures.
This link between the quantity of reserves and market
interest rates implies that the central bank has two distinct
and potentially confl icting policy objectives during a fi nancial
crisis. In choosing an appropriate target for the short-term
interest rate, the central bank considers macroeconomic conditions
and its forecast for output, employment, and
infl ation. In our example, we have assumed that the central
bank’s target rate is unchanged.3 In choosing an appropriate
lending policy, in contrast, the central bank considers the
nature and severity of the disruption in fi nancial markets. A
confl ict arises because the central bank’s lending policy will
tend to push the market interest rate below its target level.
If the amount of central bank lending is relatively small,
this confl ict can be resolved using open market operations. In
particular, the central bank could offset, or sterilize, the effects
of its lending by selling bonds from its portfolio to remove
the excess reserves. Returning to our example in Exhibit 2,
suppose the central bank sells $40 worth of government
3 In practice, the conditions that led to the freeze in the interbank market might
change the central bank’s forecast for the factors infl uencing infl ation and
economic growth and, hence, its desired short-term interest rate. Even in such
a case, however, the central bank’s target rate is likely to differ from the rate that
would result from Bank A’s efforts to lend out its excess reserves.
bonds from its portfolio and these bonds are all purchased by
Bank A. When Bank A pays for these bonds—by giving $40 in
reserves to the central bank—the quantity of excess reserves
in the banking system will return to zero. Because Bank A will
then be holding interest-bearing bonds instead of reserves,
it will not have an incentive to change its lending behavior.
In this way, the open market operation prevents market
interest rates from falling below the central bank’s target.
Note, however, that this approach is limited by the quantity of
bonds that the central bank is able to sell from its portfolio.
A second way in which the central bank could eliminate
the tension between its confl icting policy objectives is to
pay interest on reserves. When banks earn interest on their
reserves, they have no incentive to lend at interest rates lower
than the rate paid by the central bank. The central bank can
therefore adjust the interest rate it pays on reserves to steer
the market interest rate toward its target level. In October
2008, the Federal Reserve began paying interest on reserves
for the fi rst time in its history. This action was taken to “give
the Federal Reserve greater scope to use its lending programs
to address conditions in credit markets while also maintaining
the federal funds rate close to the target established by the
Federal Open Market Committee” (Board of Governors of the
Federal Reserve System 2008).4

I get the impression Central Banks can do whatever they want, change the rules and reserve ratios and powers, in a crisis, as long as inflation isn't an issue. IDK the Fed in USA well, but they took really crappy assets (homeowners bought homes they couldn't afford in the first place even without recession) when they were supposed to only take temporary undervalued (illiquid) assets. I wish we'd used our Industrial Policy B of C powers to bolster hydro power instead cut interest rates to 0.5%...but both work as long as no inflation. If inflation happens or already is happening, then all these little details matter, because if the bank keeps throwing money in the system, it will cause hyperinflation.
So I propose none of these powers matter yet as they would be fudged anyway while ROI of B of C created debt is only costing 0.5% interest. What scares me is federal debt. If it gets high enough a little bit of rich people being scared off causes debt to rise, limits stimulus job-creation, leads to stagflation or even hyperinflation.
So I think you need to consider alternate investments of rich people (right now we have massive deficit but still better than many such as USA, Japan and much of EU), employment (good to kill EI, CPC), and inflation., when talking about reserve ratios and just who prints M-whatever assets). If we need to be thrifty, creating a tax base by giving money to those who create essentials, say the inflation basket of goods (ie. farm credit and utilities credit), may be superior than giving the money to the big banks.
We should be targetting computer goods at 50% deflation a year or something like that.

OK, seriously, when is Nick coming back? This was a great post, but I miss the hardcore monetary stuff.

"OK, seriously, when is Nick coming back? This was a great post, but I miss the hardcore monetary stuff."

What? While he was gone we resolved one of the greatest current disagreements in monetary theory. Nick's going to be so happy when he gets back!

How about killing pricing to marginal cost while you're hot. This was part of something posted here a few years back and recently recommended elsewhere.

"Sure, the firm would want to adjust price in response to shifts in the demand or MC curves, but if it can't adjust price (for some reason), the firms wants to sell as much output as it can; it will only ration sales if sales increase past the point where MC=P. Until it hits the MC=P limit."

How about a sort of poll. How many of you believe this? How many teach it? How many of you would invest in a company that did this?

Determinant: Yes, you are right it is not worth it so hereby I promise that I am finished with it - for now :). Anyways at least it did not hijack some completely unrelated topic.

Advanced monetary theory just doesn't interest me, I have nothing to contribute and I get bored reading it. That isn't to say it isn't important, but it's just not my thing.

The only thing I will say about Canadians is that since Canada only has 5 large banks controlling 90% of the market, two smaller banks and credit unions, studying the behaviour and actual practices of bankers is easy to do since there are so few firms and they have standardized procedures.

Answering the question "how to commerical banks operate, where do they get their funds and what effect does their lending have on the rest of the system" is an easy question to answer in this country. Similarly the question of "how does the Bank of Canada's interest rate lever operate" is easy to answer, there is a complete description of the actual procedures on the BoC's website. It's easy in this country to see what people use as money and how it passes through the banking system.

Peter N, replace it with what? You are very close to carbon pricing, full employment and fixing recessions with that thinking.

...you've discovered the economic 4th dimension...it gets pretty screwy past the length of a mortgage...

Yep, if you read the whole thing he sounds less prescient. Only two years before the Argentine collapse here was what he had to say:

"Charles Freedman: Recently, Ecuador and Costa Rica have dollarized. In
your view, would dollarization make any sense for a country like Canada?
Milton Friedman: I think that it makes most sense for those countries who
would otherwise have a very bad internal monetary policy.
My position has always been that a small country should do one of two
things: eliminate its central bank and really hard peg—that is, unify its
currency with the dominant currency the way Argentina has done with its
currency board and Hong Kong has done with its currency board; or it ought
to float completely."

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