Alpha banks, beta banks, fixed exchange rates, market shares, and the money multiplier

Forget money and banking for a minute. Let's think about international macroeconomics.

Just suppose the US Fed, for reasons unknown, pegged the exchange rate of the US dollar to the Canadian dollar. The Fed makes a promise to ensure the US dollar will always be directly or indirectly convertible into Canadian dollars at par. The Bank of Canada makes no commitment the other way. The Bank of Canada does whatever it wants to do. The Fed has to do whatever it needs to do to keep the exchange rate fixed.

For example, just suppose, for reasons unknown, the Bank of Canada decided to double the Canadian price level, then go back to targeting 2% inflation. If it wanted to keep the exchange rate fixed at par, the Fed would need to follow along, and double the US price level too, otherwise the US dollar would appreciate against the Canadian dollar. The Fed's promise to fix the exchange rate makes the Bank of Canada the alpha bank and the Fed the beta bank. Both Canadian and US monetary policy would be decided in Ottawa. It's asymmetric redeemability that gives the Bank of Canada its power over the Fed.

Doubling the Canadian price level would mean approximately doubling the supplies of all Canadian monies, including the money issued by the Bank of Canada. Doubling the US price level would mean approximately doubling the supplies of all US monies, including the money issued by the Fed. Because the demand for money is proportional to the price level.

The money issued by the Bank of Canada (mostly currency, with a very small quantity of reserves) is a very small share of the total Canadian+US money supply. What exactly that share would be would depend on how exactly you define "money". Let's say it's 1% of the total. The total Canadian+US money supply would increase by 100 times the amount of new money issued by the Bank of Canada. The money multiplier would be the reciprocal of the Bank of Canada's share in the total Canadian+US money supply. 1/1%=100.

Maybe the US Fed keeps reserves of Bank of Canada dollars, to help it keep the exchange rate fixed. Or maybe it doesn't. But it doesn't matter.

Do loans create deposits, or do deposits create loans? Yes. Neither. But it doesn't matter.

The only thing that does matter is the Bank of Canada's market share, and whether it stays constant. And which bank is the alpha bank and which bank is the beta bank.

In the real world, the US Fed does not fix the exchange rate of the US dollar to the Bank of Canada dollar. But the Bank of Montreal and TD Bank do fix the exchange rates of their dollars to the Bank of Canada dollar. The Bank of Canada is the alpha bank, and BMO and TD are beta banks.

(C/D + R/D)/(1+C/D) is the Bank of Canada's share in the total Canadian money supply, where C/D is the currency/deposit ratio, and R/D is the reserve/deposit ratio. The reciprocal of the Bank of Canada's share is the simple money multiplier.

C, R, and D are all nominal variables. C/D, and R/D, being the ratios of two nominal variables, are real variables. If money is neutral in the long run, real variables are independent of nominal variables in the long run. If money is not neutral, those real variables will not be independent of nominal variables. Plus, real shocks will affect real variables, even if money is neutral.

The simple money multiplier story is a story about market shares, and about beta banks fixing their exchange rates to the alpha bank. If all banks expand together, their market shares stay the same. But if one bank expands alone, it must persuade the market to be willing to hold an increased share of its money and a reduced share of some other banks' monies, otherwise it will be forced to redeem its money for other banks' monies, or else suffer a depreciation of its exchange rate. Unless that bank is the alpha bank, to which all the beta banks fix their exchange rates. It is the beta banks' responsibility to keep their exchange rates fixed to the alpha bank. The Law of Reflux ensures that an individual beta bank cannot overissue its money beyond the share the market desires to hold. The alpha bank can do whatever it likes, because it makes no promise to keep its exchange rate fixed.

Just another way of looking at things. I think it's simpler this way. And much more general, because the same story works across international boundaries, under fixed exchange rates. The US Fed used to be the alpha bank for most of the world, when all the other banks pegged to banks which pegged to the Fed's dollar.

Comments

[Tom Brown]

Nick, say the reserve requirement is 0%. What is R a function of? Or R/D if that makes more sense?

[JKH]

"The reciprocal of the Bank of Canada's share is the simple money multiplier."

The "simple money multiplier" is a partial function of currency held by the public?

I'm confused. I thought it used to be a specified function of bank reserves.

[Tom Brown]

JKH, it's an identity. Say the money multiplier is defines as an identity as:

mm = M1/MB

M1 = currency in circulation + deposits
MB = currency in circulation + reserves

(1+C)/(R+C) = (1+(currency in circulation)/deposits)/(reserve/deposits + (currency in circulation)/deposits)
= (deposits + currency in circulation) / (reserves + currency in circulation) = M1/MB

[Tom Brown]

... I get into a discussion with Sadowski about it here:

http://www.themoneyillusion.com/?p=26355#comment-323668

His Miskin (7th edition) textbook describes

r = R/D as the "lenders' choice" (in excess of required anyway)
c = C/D as the "borrowers' choice"
MB as the CB's choice

I gave him a simply hypothetical: reserve requirements = 0%, and cashless society. Then

mm = (1+c)/(r+c) reduces to mm = 1/(excess reserves).

So I said "what if the CB chooses MB = $1" then then it's lender's choice for r? They pick r = 0.1, then they need to lend $10. But I asked "don't the borrower's have a say in what's feasible for r?" Here was his response:
http://www.themoneyillusion.com/?p=26355#comment-323692

"Well, it’s kind of a simultaneous system with multiple markets each with a set of supply and demand curves and multiple agents each maximizing their utility."

[JKH]

Tom,

I know that particular equation is an identity.

But my question is not about whether its an identity, but what the denominator used to be (according to my recollection).

[Nick Rowe]

JKH: first year textbooks are very careful to assume, very explicitly, that they are ignoring currency. (Probably a mistake; it would be better to ignore reserves, so the multiplier is the reciprocal of the desired currency/M1 ratio). Second year textbooks do it like I said above. You could interpret it as an identity, or as an equilibrium condition, if you talk about desired rather than actual ratios (just like I=S can be interpreted either way).

Tom: desired R/D will be a function of a lot of interest rate spreads, plus risk, the efficacy of the clearing house, etc. Plus required reserve ratios, unless you want to ignore the world's second biggest economy.

[Tom Brown]

Nick, thanks. I put RR=0% so I didn't have to qualify anything like Sadowski always does (following textbook author Miskin's lead) "lenders' choice, when in excess of required" ... I just want to focus on the "in excess" part.

Given that, would you say that borrowers have a hand in determining R (again with RR=0% and no cash, to make it simple)?

[Tom Brown]

... sorry, I meant R/D, not R. Miskin (apparently: I don't have his book) defines r = R/D. So it's this little r, the "reserve ratio" I'm interested in. Do borrowers help determine R/D?

[Nick Rowe]

Tom: in economics, almost everything depends on almost everything else. The best way to think of it is that beta banks directly choose R/D, but the behaviour of potential borrowers may influence that choice via the spreads and the riskiness at which they are willing to borrow.

[Mike Sproul]

Nick:

You didn't mention the profits caused by devaluation. Assume the BoC has issued $100 canadian, against which it holds various assets worth 100 oz of silver, so $1 canadian=1 oz. Then the Fed issues $1000 US, against which it holds various assets worth $1000 canadian, so the Fed can peg $1 US=$1 canadian. Now the BoC devalues by half. That gives the BoC a profit of 50 oz. Of course the canadian public now wants another $100 canadian, so the BoC prints $100 canadian and buys assets worth 50 oz. (The inflation preceded the increase in the money supply, just like Thomas Tooke said back in 1844.)

The Fed's assets have lost half their value, so the Fed earns no profit, even though $1 US is now worth .5 oz. But Americans will want another $1000, so the Fed will issue another $1000 and buy assets worth $1000 canadian (=500 oz). (Tooke was right again.)

Of course, if the Fed's assets were denominated in oz, not $ canadian, then the devaluation would be profitable to the Fed.

[Tom Brown]

Nick,

"The best way to think of it is that beta banks directly choose R/D, but the behaviour of potential borrowers may influence that choice via the spreads and the riskiness at which they are willing to borrow."

Don't forget the CB! Even if RR=0% or is fixed, the CB can force R higher at any time (like now in the US). The bank's choice of "profit maximizing" R/D ratios is surely very dependent on both the actions of the CB and borrowers (e.g. the US over the past five years). Banks in the US seem to be "choosing" a very high R/D right now.

[JKH]

Nick,

I've rarely seen the multiplier used in that second-year way you describe - but then I haven't taken a second year course. It's always about the idea of bank reserves being "multiplied" into bank deposits by recurring lending. That's the whole basis for the rejection of the concept by heterodox people like MMT and non-MMT post Keynesians. That rejection argument has nothing to do with currency held by the public - it has to do with the multiplication of bank reserves into more bank assets and bank liabilities (deposits).

Using currency as part of the denominator may well be a better idea (I don't know), but that concept has nothing to do with the (false) idea of a constraint on bank lending due to the orthodox interpretation of required reserves. There is no way that currency held by the public can be construed as a true or even false constraint on bank lending - nothing direct that I can think of that makes any sense.

On the other hand, I can see how the idea of using that in a proportionate way to set out an argument for the demand for different types of money can very well make sense - and much more sense obviously that the conventionally (first-year) defined multiplier argument. That sort of argument is one of portfolio composition - along the lines of your "what exactly that share would be" remark as you note in your post here.

So I see wisdom in preferring the second-year version to the first, but its an entirely different analytical concept in my view.

[Tom Brown]

JKH, let me run this past you. Even in the simplified case (the 1st year case I gather): the cashless society, and with excess reserves = 0 (so that R is the just the legally required reserves). I hate the way the concept is usually brought up as a bank starts with a deposit, then it loans out (1-R) times that deposit, which is re-deposited, etc. Then they make an infinite series and show how with an infinite number of loans and deposits this establishes a legal upper bound for the quantity of money (both created by banks and base money). Usually an infinite geometric series is introduced and shown be be equivalent to the ration 1/R. I'll use 1/RR for "required reserves" in the denominator.

This story, IMO, should be relegated to a footnote, and the main way of teaching it should be: "If the CB sets MB as reserves (cashless society), and RR > 0, then the banks can simultaneously create MB*(1-RR)/RR and MB*(1-RR)/RR deposits simultaneously: added to the existing base money, MB, this means MB/RR is the maximum amount of money."

Then the student doesn't mistakenly think this requires a never obtainable infinite series of smaller and smaller loans (like I first thought when I saw this) and thus the maximum is kind of a theoretical abstraction which can never be obtained (again like I first thought). No, instead it's a very realizable limit, and given the constraints of the story, it can be achieved with a single loan immediately.

I think if the story were presented like that it would somehow bring the PKE types and the orthodox types a bit closer, don't you think?

Plus there's another reason I hate the infinite geometric series story: an artificial region of convergence (RoC) limitation on the series itself which doesn't make sense. In reality all you need is a non-negative RR, with a zero RR being a special case (i.e. RR = 0 means the sky's the limit). But when you look at the series:

D*(1 + (1-RR) + (1-RR)^2 + ... ), then this only converges for |1-RR| < 1, or for RR on (0,2). This is totally artificial: presented w/o a geometric series (the way I prefer) shows that clearly RR only need be > 0.

[Tom Brown]

... another way to say my story, which is perhaps better, is that the banks start with an initial capital of MB. Then it's easy to see how RR > 1 also works (not that it's ever been done in practice, but theoretically it shouldn't be a problem). It all becomes a single unified story. For example, right now the US could set RR > 1 if it really wanted to. There are plenty of reserves out there to support that w/o much disruption.

[Nick Rowe]

Mike: that's why I snuck in the weasel-word "approximately", when I said that doubling the price level target would approximately double the amounts of all monies. Seigniorage could make money non-neutral. But my guess is that there would be (approximately) the same amount of approximation in the same direction in the US as in Canada, so that relative shares would not be (much) affected by this.

Tom: true.

JKH: One of the things we want to teach the first year students is that fractional reserve banks *do* create money, and that 100% reserve banks don't create money (they just transform it from $1 currency to $1 demand deposits). Because they don't believe it until you spell it out, in the textbook money multiplier example. They have a fallacy of composition: "since each individual bank cannot lend out more that its deposits, the banking system as a whole can't create money!"

Suppose all (beta) banks decided to create more loans and deposits. If people decided they didn't want to hold more deposits without holding more currency, then they suffer increased currency withdrawals, and are forced to contract, unless the Bank of Canada increases the stock of currency in the same proportion. It would be exactly like an exchange rate crisis.

Scott had a nice clear way of looking at it recently: if base money is held by the public we call it "currency"; if base money is held by the banks we call it "reserves".

Keynes had a clear way of putting it too, somewhere. Something about the difference between an individual bank expanding and all banks expanding. But we need to remember the important difference between beta banks and alpha banks.

[Tom Brown]

Nick,

"They have a fallacy of composition: "since each individual bank cannot lend out more that its deposits, the banking system as a whole can't create money!"

Why not use the example of a single commercial bank, which in one step can create the maximum amount of deposits legally allowed (by the RR ratio and MB) by buying stuff: any stuff, loans or whatever else they want to buy? I agree this applies to the banking system as a whole, but why confuse the issue? A single bank can certainly create more deposits that its starting deposit and/or capital base in a single step. If RR = 1, then that single step might be $0 (depending on whether the bank has initial capital or initial deposits). Or as Scott Sumner would say, it can extend credit (not money!) to the maximum amount given a fixed amount of base money. Lol.

[JKH]

Nick,

I haven't thought much about your currency analogy, but it seems OK at first glance - although with the caveat that it is most clear when you apply it to the currency component of the base.

"Scott had a nice clear way of looking at it recently: if base money is held by the public we call it "currency"; if base money is held by the banks we call it "reserves"."

I think that's not only clear - I think it's essential.

And I think you guys run into a problem - and this is not meant as snark - by denying as a sort of club theme the importance of institutional arrangements - i.e. by denying the importance of banking.

That FX analogy and that bifurcation that Scott refers to means you should be thinking about institutional structure as between banks who want reserves and the public who wants currency.

And I think the efflux/reflux stuff needs to be tackled separately according to institutional arrangements.

I've been thinking about a post on this for a while now.

[Nick Rowe]

JKH: actually, the bit that is still puzzling me is the opposite question. Suppose the alpha bank expands, and all the beta banks except one expand too, but that one bank doesn't want to expand. Now, any bank can refuse to expand its loans, if it doesn't want to expand its loans (never mind the profitability). But, can an individual bank refuse to expand its deposits? It can refuse to accept new customers, but I can't figure out if it can refuse to accept new deposits from existing customers. It could do things to drive away existing customers, I suppose. Put it another way, if all the other banks expanded, and it refused point blank to expand, would its exchange rate appreciate??? Weird.

[Nick Rowe]

Tom: "Why not use the example of a single commercial bank, which in one step can create the maximum amount of deposits legally allowed (by the RR ratio and MB) by buying stuff: any stuff, loans or whatever else they want to buy?"

That is exactly what Mankiw's first year text does. First one big commercial bank, then repeat with lots of commercial banks, showing the (eventual) answer is the same in both cases.

The key point is that when BMO makes a loan to one of its customers, and that customer spends it, he might buy something from someone who banks at TD bank. BMO does not increase its market share.

[Ralph Musgrave]

Nick, Re your reply to JKH just above (03:23 PM), I read somewhere that during the recent recession, some banks HAVE actively discouraged deposits.

[JKH]

Nick,

Assuming that beta bank accepted deposits, but refused to make loans, then its reserve balance with the CB would have to build up.

The CB would have to accommodate that in the sense of ensuring a supply of reserves that met the demand from the other banks.

The loan-averse beta bank's risk profile would become lower risk.

So it's stock would become less volatile.

It's stock might appreciate (depreciate less) relative to the others, depending on circumstances, but in any event it would be less volatile by usual measures, I think.

Does that correlate with your idea of exchange rate appreciation? I don't know.

[Tom Brown]

Thanks Nick. Do you prefer Mankiw's text or Mishkin's? (Someday I may even try to educate myself beyond reading blogs)

[JKH]

Tom / Nick,

In general, I'd like to see more focus on bank capital and less on bank reserves.

That would really change the blogosphere discussion.

The reserve story is intriguing to debate as an operational issue, but I don't think its at the heart of the issue of money or banking.

And it shouldn't be a the heart of monetarism, IMO.

Monetarism could thrive under a new centricity of bank capital rather than bank reserves - insofar as monetarism considers bank reserves now.

Expel bank reserves from the definition of the monetary base!!!!

[Tom Brown]

JKH,

"Expel bank reserves from the definition of the monetary base!!!!"

We already have a name for that: M0

It's funny, because I always want to keep the reserves and expel the cash... only because that's makes it easier for me to visualize usually. BTW, when I wrote about "capital" above, perhaps I wasn't using precisely the correct term, but what I had in mind was contrasting two (cashless society, single commercial bank) starting points:

1. CB starts off having done an asset purchase, putting MB of reserve-assets on the bank's BS and MB of deposit-liabilities as well... thus assuming the CB is now out of the picture (not doing any more OMOs) then the bank can buy a maximum of MB*(1-RR)/RR of stuff.

2. Somehow (not clear how!) investors pool MB in starting capital to invest in the one commercial bank which is just starting up: it's total liabilities (not counting shares) is $0, but it has MB in reserve-assets, so now it can buy a maximum of MB/RR (e.g. it could buy loans), which will always be of an amount > $0, provided RR > 0 but finite.

I think you're talking about something else though.

[Tom Brown]

"maximum amount" ... it should be noted, that this holds as a maximum unless the bank can convince depositors to buy savings deposits or they can charge fees, points, interest etc up front from the sellers (of whatever it is they're buying) so as to boost the bank's capital in the process. That's my John Carney inspired "Banking Example #3: Capital Requirements"

[JP Koning]

Nick, I agree with the importance you place on asymmetric redeemability. The base can cease being the medium-of-account but still "cause" the price level as long as the replacement media-of-account are redeemable into base.

Has your thinking on reflux changed since this post?

http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/09/all-money-is-helicopter-money.html

[JKH]

Tom,

"We already have a name for that: M0"

It's been so long since I paid attention to those M definitions, I'd forgotten.

Then make M0 = monetary base and abandon the term "monetary base".

The purest form of capital is equity - assets minus liabilities.

Capital is what is available to absorb losses in the normal course.

All bank lending requires a capital allocation decision.

(With the possible exception of risk free assets like short term treasury bills.)

[Frances Coppola]

Tom, M0 includes reserves. M1 excludes them but includes demand deposits. As far as I know there is no measure of M that consists of currency only. The Bank of England does produce data on notes & coins in circulation, though. I don't know about other central banks.

[Tom Brown]

Frances, I am going off of the ultimate authority, Wikipedia. :D Lol... the 1st table here:

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

If you scroll down, M0 is a little different in the UK.

MO in the US anyway is what we're looking for: currency in circulation (not in bank vaults). They don't break out Canada as a separate heading (at the bottom), but they do have a few other examples: Japan, New Zealand, etc.

So maybe "M0" isn't a good choice since it has different meanings by country. But all the countries shown as examples there seem to share the definition except the UK. But that's maybe a half dozen out of 180+ countries world wide... so I don't know what the majority say!

(BTW, I refer back to that table all the time: it's pretty handy for keeping track of what various people are talking about... and as far as I know it's accurate!... Sadowski, for instance, has never complained when I referred to it)

[Tom Brown]

JKH, as I understand it, before the electronic era, reserves used to be cash. So instead of electronic credit for banks at the CB, the banks would literally have piles of paper currency in their vaults. Now, of course, only a fraction of reserves are made up of vault cash.

So if you think about it as "base money in the private sector" (regardless of the medium) doesn't the current definition (i.e. MB) make some sense? Especially if we don't automatically assume that the CB is going to be accommodative in supplying MB? (i.e. it's possible the CB could target a fixed level of MB or rate of increase of MB... kind of like what's going on now in the US).

I think most monetarists HATE the implicit unsaid assumption that the CB is accommodative with MB: they like to imagine a CB that can do what it wants! :D

[JKH]

Tom,

I think currency held by banks is in a different category than reserve balances held by banks.

Currency held by banks is an inventory function for currency held by the public.

Reserve balances at the CB are very different.

The economics are very different.

The CB executes interest rate policy through reserve balances - not currency - even if the interest rate policy is zero bounded.

It's an interesting point about the history of the clearing system.

I don't know how to factor that in at this point.

One first has to answer the question how the role of short term interest rate management was executed in that system (if at all). I don't know the answer to that, and I'd be surprised if anybody does - given the confusion about the money multiplier etc. that still exists in the year 2014.

[Tom Brown]

JKH, the IOR point is a good one. But won't most CB's trade cash for electronic credits or vice versa on demand?

[Nick Rowe]

Ralph: "I read somewhere that during the recent recession, some banks HAVE actively discouraged deposits."

Hmmm. Any idea why?

JKH: "Does that correlate with your idea of exchange rate appreciation? I don't know."

I don't think so. I was trying to imagine a circumstance where a bank's deposits might appreciate, relative to the central bank's money. But I can't think of any. I think a commercial bank would always accept a cheque payable to one of its existing customers, at par.

Tom: Mankiw's text is an Intro Micro+Macro text. (He also has an intermediate macro text.) Mishkin is money+banking, so not really comparable.

JP: I don't think my thinking on reflux has changed since that post. There's a difference between the Law of Reflux applied to an individual bank, and the same law applied to the monetary system as a whole. The hot potato passes from one bank to another (including the Bank of Canada) as it gets spent. The BMO can create deposits, but they won't stay in BMO. The monetary system as a whole (as lead by the alpha bank) can create a hot potato.

[Tom Brown]

Hey Nick, O/T: Brad DeLong is back at it with his refrain: "Say's law is not true in theory but can be made so in practice" (paraphrasing):
http://equitablegrowth.org/2014/03/24/2351/no-i-really-do-not-think-that-we-were-doomed-to-the-lesser-depression-plus-the-greater-stagnation-i-think-paul-krugman-gets-one-wrong-here-monday-focus-march-24-2014

[JKH]

Tom,

Commercial banks proactively manage their inventory of cash by buying and selling with the CB as a counterparty

Cash bought = reserve balances spent

CB takes that plus all other factors affecting reserve balances in managing interest rates in the short term

[Nick Rowe]

Thanks Tom.

I see you tried to explain it to Cullen, who totally doesn't get it. He seems to think the Bank of Montreal dollar *must* be worth one Bank of Canada dollar, because, well, they are both "dollars"! But that is somehow totally different from the exchange rate between the Bank of Canada "dollar" and the US Fed "dollar". No comparison at all! Even though the Bank of Canada used to have a fixed exchange rate with the US dollar? Sometimes I despair of "banking" guys. He complains I'm "moving the goalposts", by looking at it from a wider perspective. God help us. I left a somewhat peeved comment on his post.

[Nick Edmonds]

Nick,

If a bank found that it was attracting excess deposits, it would react by cutting its deposit rates. In normal circumstances, a small cut in the bid rate on wholesale money would be sufficient to deflect excess deposits elsewhere. It doesn't always work so well in reverse, because depositors are constrained by credit limits.

Re Ralph's comment, during the crisis there were instances of high credit quality banks receiving in more funds than they wanted as depositors pulled their money out of more risky banks. However, the good banks were themselves cutting lines on interbank lending, so were faced with the problem of not having anywhere to put the money. IOER obviously helped.

[Nick Edmonds]

Nick,

What in this story makes one bank the alpha bank? Clearly the alpha bank is the one that doesn't commit to fixing its exchange rate, but that's not what actually makes it the alpha bank is it? If you started with a number of banks, but no alpha, one of them cannot simply become the alpha bank by deciding not to fix its exchange rate. You need to look to something like reserve requirements, legal tender laws or a chartalist explanation, don't you?

[JKH]

Monetarists might find JP Morgan's 'London Whale' episode interesting from a hot potato perspective.

Among other things, that portfolio was a significant use of funds.

In a conference call, Jamie Dimon actually tried to make the argument that JPM was so flush with deposits, it had to do something with the money, and the London portfolio was one outlet for it.

Then they started overlaying it with derivative credit risk trades.

Dreadful admission about risk management at JPM.

"QE made him do it."

[Nick Rowe]

Nick E: the immediate answer to the question "what makes an alpha bank an alpha bank (or an alpha issuer of money)" is that other banks (the beta banks) decide to fix their exchange rates to it. The alpha bank doesn't do anything to become the alpha bank. But, of course, that raises the question: "why do the beta banks peg to that particular bank, and not to some other bank?". For example, why did the Bank of Canada (in the past) peg to the Fed, and not vice versa (as in my imaginary story). I don't think there's any one answer to that question. It might be history (the alpha bank was there first, and its money was already accepted as money, and the beta bank needed to get started and get its IOUs used as money). Gold miners were the original "alpha bank". It might be size and trust. Governments might play a role too.

[Frank Restly]

"For example, just suppose, for reasons unknown, the Bank of Canada decided to double the Canadian price level, then go back to targeting 2% inflation. If it (the U. S. Fed) wanted to keep the exchange rate fixed at par, the Fed would need to follow along, and double the US price level too, otherwise the US dollar would appreciate against the Canadian dollar."

If the Fed wanted to keep the exchange rate fixed, they could introduce a tariff on U. S. exported goods so that Canadian import prices keep pace with Canadian domestic prices (assuming the U. S. and Canada are the only two countries that exist). U. S. Fed takes tariff proceeds in Canadian dollars and burns them.

[Jussi]

I appreciate most of Nick's writings/ideas but this one I do not get.

I think banks usually worry about leverage on their equity not reserves ratios. Would it be helpful to think banks as a sector and thus too-big-to-fail. So all the bank dollars would trade at par with each other. I think public and banks see it this way - that is only a layman's observation. Banks certainly are capital constrained though. If that is not true it would certainly give an edge to those banks seen as systematic important?

I can see that sometimes that might not be totally true (Iceland, Cyprus etc.) but I do not think that even those cases individual banks didn't considered themselves reserve or cash constrained _before_ the crises hit (set me straight here?). Yet they were able to attract a lot of deposits by offering higher rates, also abroad.

It seems to me that this 2.0 multiplier idea rely on cash/deposit ratio? But would it imply that there could be times where cash is not offered on-demand and thus would be sold at premium? Should that happen?

[Nick Rowe]

Jussi: I think that JKH is right, and that banks' capital constraints can matter too. (But that affects the asset side of banks' balance sheets more than the liability side, since different assets usually have different capital ratios.) But we need to remember that bank capital is endogenous. It doesn't adjust instantly, but it can adjust.

This isn't really multiplier 2.0. Simply a different way of looking at the same multiplier. (But the cash ratio usually only appears in second year textbooks, because first year students can't do the math for (1+c)/(c+r), so we usually tell them we are assuming c=0 to keep it simple. Because the only point we really need to make is that, yes, banks really do create money, unless r=100%.)

"But would it imply that there could be times where cash is not offered on-demand and thus would be sold at premium? Should that happen?"

It certainly does happen, but we normally describe it as deposits trading at a discount, or devaluing against cash, rather than cash trading at a premium. Or notes trading at a discount to gold, if gold is the alpha bank, and a bank suspends convertibility into gold. Same thing, described differently.

[Miami Vice]

Like always, it's about interest rates. If one bank makes more loans it needs more reserves and will be willing to pay a higher rate of interest. They well likely attract more deposits and capital until the risk adjusted returns are the same or they can no longer profitably make loans if they paid higher rates to fund loans. What you're thinking about imo is more like a bank over paying for things or lending too much money to people. It's the people who take loans that spend them for the most part the banks can't over pay for things but they can under collateralize a loan or loosen credit standards in a way that makes lending either unprofitable and/or excessively risky (ninjas). It's those things, I think, that would determine exchange rates between banks and banks and customers.

[genauer]

Denmark keeps negative rates to keep the tight peg to the Euro

http://www.bloomberg.com/news/2013-11-28/negative-rate-experiment-in-denmark-is-seen-stretching-into-2015.html

The Fed is now also moving closer to the ECB target of < = 2.0%

and this pegging might have something to do with people demanding risk premiums for weaker currencies and writing contracts in the hardest currency of the biggest economic bloc.

[JKH]

Nick,

You said at PragCap:

“In modern central banking, commercial banks make their money directly convertible into central bank money at a fixed exchange rate, and the central bank makes its money (indirectly) convertible at a (roughly) fixed exchange rate into CPI baskets of goods, with a 2% rate of depreciation of the exchange rate target. Which means all the commercial bank monies are convertible into each other at a fixed exchange rate, and into CPI baskets at an exchange rate depreciating at roughly 2% per year.”

When you say “convertible at a roughly fixed exchange rate … 2 per cent depreciation of the exchange rate target”

There are two exchange rates there, right? One for commercial bank money and central bank money, and one for central bank money and a CPI basket. The first is fixed; the second is a crawling peg, so to speak?

And the same for gold? One for commercial bank money and central bank money, and one for central bank money and gold? Except both are fixed?

I thought this older post was very interesting and relevant to this comparison:

http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/04/from-gold-standard-to-cpi-standard.html

I think you've said the alpha bank in the gold case are the gold miners - not the central bank.

What's the parallel alpha in the CPI case?

[Tom Brown]

JKH, that's the same old post that JP Koning "hoisted" Nick upon his "own slippery slope" with:
http://jpkoning.blogspot.com/2012/11/discussions-of-medium-of-account-could.html
JP's views on the MOA have changed a little since then though.

I was wondering if there might be a 3rd exchange rate: CPI basket to commercial bank money, which would make a nice circle out of it, wouldn't it? :D ... but I think the answer is "No!"

[JKH]

Thanks Tom

that's the kind of consistency that I've suddenly become curious about

perhaps I'll change my handle to "Too Much Medium of Account"

:)

[Nick Rowe]

JKH: "The first is fixed; the second is a crawling peg, so to speak?"

Yes! That's the term I was looking for: "crawling peg"! I was searching my brain for it, over at PragCap.

"I think you've said the alpha bank in the gold case are the gold miners - not the central bank."

Yes, and that metaphor works if gold is also used as money, but I am stretching the metaphor a bit far if gold is not used as money, and just for "industrial uses".

"What's the parallel alpha in the CPI case?"

Hmmm. Good question. The producers of CPI goods? But maybe I've stretched the metaphor beyond breaking point.

Yep, I was thinking about that old post too. I sorta surprised myself by writing that. I'm still not fully comfortable with the conclusion, though it seems right.

Tom: "but I think the answer is "No!""

I think the answer is "yes". Like under Bretton Woods, if the BoC fixes to the US Dollar, and the Fed fixes to gold, then indirectly the BoC fixes to gold.

[JKH]

And I like that idea of the CPI basket being the medium of account.

(TMMA)

[JKH]

Nick,

"Hmmm. Good question. The producers of CPI goods? But maybe I've stretched the metaphor beyond breaking point."

Something like that maybe.

I lifted "crawling peg" from your post btw. I really liked that gold/CPI post - for me it connected some dots with work several of the post Keynesians have done re Mundell-Fleming (i.e. "modifying" it to say the least) - your idea actually fits with the way they view it from a flow of funds perspective - too vague in my mind to articulate here - maybe in future some time when I understand it better

[Tom Brown]

Nick,

"I think the answer is "yes"."

Wow, that surprises me. Interesting.

JKH, I ran that idea of CPI basket as MOA past Sumner: he didn't like it. I think partly because it's only a target that you try to hit, and thus may not. I can't recall exactly whatever he said to me made me think of that. He likes base money as MOA. He calls it "paper gold."

BTW, it should be "TMMoA" shouldn't it? :D

[Tom Brown]

Nick, I see where I didn't communicate well: using your Bretton Woods analogy, I was instead attempting to "close the circle"... so it'd be like gold then in turn fixing its price to BoC dollars. In contrast your Bretton Woods example was nice and linear with two dangling ends: BoC on one side and gold on the other, related through the $US middle man (in an asymmetric way). I was literally playing with the idea that the suppliers of CPI goods would guarantee to exchange their goods for commercial bank dollars. I actually spelled out the "circle" more explicitly here:

http://pragcap.com/of-course-all-economists-already-understood-the-money-multiplier-not/comment-page-1#comment-171003

You still like "yes" to that question?

[Nick Rowe]

Tom. I misunderstood you. No. Except in the very short run, when goods prices are sticky.

[Jussi]

I appreciate that the discussion is assuming "normal situation" but I reckon the new normal might well be the normal in the future. But just to make sure: the simple multiplier story doesn't hold when reserves continue to be elevated and IOR/reverse repo rate is setting the floor for market rates?

[Peter N]

Tom Brown,

According to the Fed:

"The Reserve Banks developed Fedwire to improve the safety and efficiency of the interbank settlement process. In the early 1900s, settlement of interbank payment obligations often involved the physical delivery of cash or gold to counterparties, which was both risky and costly. To mitigate these risks, in 1918, the Reserve Banks introduced its first dedicated funds transfer network, featuring a Morse code system that connected the twelve Reserve Banks, the Board, and the United States Department of the Treasury. The key feature of this arrangement was the ability to transfer balances held at the Reserve Banks using a secure communications network. The elements of this feature remain the foundation of Fedwire operations.

As communications technology improved throughout the century, the Reserve Banks also improved Fedwire, striving to increase its levels of security and automation. From the 1920s to the 1960s, Fedwire migrated from leased-line public telegraph circuits to telex to computer operations and proprietary telecommunications networks. These operations were organized and executed on a decentralized basis among the twelve Reserve Banks. This organization matched the localized structure of the domestic banking system at the time and allowed each Reserve Bank to serve the specific needs of institutions in its Federal Reserve District.

During the 1980s, however, the consistency of services across Districts became increasingly important as interstate banking emerged in the United States. More bank holding companies owned depository institutions in multiple Districts and sought greater standardization of Reserve Bank services. The Reserve Banks addressed this demand by deploying standard software in each Reserve Bank.

In the 1990s the Reserve Banks consolidated most mainframe computer operations, centralized certain payment applications, and consolidated Fedwire management at specific Reserve Banks. Section 10 of this assessment provides greater detail about these organizations and the roles they play.

Recently, the Reserve Banks have started to take advantage of the flexibility and efficiency that Internet protocol (IP) and distributed processing technologies offer. The Reserve Banks are using these technologies to enhance the functionality and operational reliability of Fedwire and other Reserve Bank services."

[Nick Rowe]

Jussi: as I said in the post: the only thing that matter's is the alpha bank's market share, and whether that share stays constant when it expands.

The best case for that share staying constant is for a long run permanent expansion, like I considered in my post, where the BoC permanently doubles the price level target, and we can assume (approximate) long run neutrality. Given those assumptions, whether or not the economy is in the "new normal" should make no difference. But nobody expects the Fed's current "QE" to be permanent (which is why it is taking such a lot of QE to make much difference). Plus C/D and R/D are real variables, and monetary policy has real effects in the short run, so we should not expect them to stay constant.

[Jussi]

Ah, thanks for repeating and forgive my ignorance. I see that the assumptions made are crucial (as always).

I have to say, I'm fond of models such as this, which kind of connect the dots and gets the helicopter view. Great stuff.

[Tom Brown]

PeterN, thanks for the history lesson.

[Tom Brown]

Peter N & JKH: heres' the bit I was referring to previously (from Sumner):

"But prior to 1914 the base was 100% currency, and we could easily return to that system and still run monetary policy essentially the same way. The only difference would be that the Fed would give banks ten $100,000 bills for a $1 million T-bond, not credit their Fed account for $1,000,000. That’s a trivial difference."

http://www.themoneyillusion.com/?p=17357

Then he gives a picture.

[JKH]

Tom,

I haven't looked at that post before or the comments, but:

His next sentence:

"Monetary policy is all about adjusting the stock of currency."

True, in his pretend scenario, monetary policy is about adjusting the stock of currency exclusively (as opposed to reserve balances and currency).

Suppose QE piled up $ 2.7 trillion in $ 100,000 bills as excess reserves. That would result from seller of bonds returning their currency to the banks in exchange for deposits.

If the point simply is that reserve balances in theory could be replaced by currency, without any further consideration, sure. That's just because either of those is a medium of exchange. As he says, its a trivial difference.

But that said, there is a huge difference for IOR implications and Fed interest rate control from a QE exit standpoint. The Fed wouldn't be able to anchor short rates above zero until all of the excess currency was drained from the banking system and banks were forced to borrow from the Fed - at a positive rate - in order to clear their positions with each other and the Fed. That's because banks will continue to arbitrage short rates down to zero so long as they hold excess reserves in the form of zero interest currency.

I don't know why he made that point or if there is another point to be made beyond that.

[JKH]

Although I suppose the Fed could pay IOR on excess reserves without the IOR being directly associated with the underlying currency that comprises the reserves.

[Tom Brown]

JKH, well I suppose we can now change the title of Sumner's post to "The SNPO is special"
http://www.themoneyillusion.com/?p=26421

[Tom Brown]

"Although I suppose the Fed could pay IOR on excess reserves without the IOR being directly associated with the underlying currency that comprises the reserves."

Yes, I wonder why they don't.

[Too Much Fed]

Tom Brown said: "JKH, it's an identity. Say the money multiplier is defines as an identity as:

mm = M1/MB

M1 = currency in circulation + deposits
MB = currency in circulation + reserves"

Nick, which is the MOA? Is it M1 or MB?

[Tom Brown]

JKH, of course you've seen proposals from Miles I'm sure:
http://blog.supplysideliberal.com/post/80750871807/q-a-on-negative-interest-rates-and-having-an-exchange
What I liked about that was this: "Paper currency has a number written on the front of it in ink, so (unless a bill has so much electronics in it that it is effectively an electronic account), the meaning of that unchanging number on the front has to change over time."

Can you imagine? You reach in your wallet to get that $1 bill out for the vending machine, and now it says $0.9883...

[Mark A. Sadowski]

I want to focus on one particular claim by Cullen Roche which he repeats three times in various forms at two different posts.

http://pragcap.com/of-course-all-economists-already-understood-the-money-multiplier-not/comment-page-1#comment-171007

Cullen Roche
"Depends on the banking system and the “money” you’re referring to. “Federal Reserve Notes” are not actually issued by the CB even though they’re a liability of the CB. They are purchased by the CB and printed up by the Bureau of Engraving. Reserve Banks purchase coin at face value from the US Mint (who is determining your “conversion” rate there – a branch of the US Tsy or the Fed?). So, in a strange sort of way, the Treasury acts as a banker to its own bank and charges that bank quite a bundle in fees to deal in “legal tender”. There is this circuitous/hybrid relationship here that I think gets bungled by a lot of people.

So, when Scott Sumner refers to reserve notes as “paper gold” he’s really not referencing the power of a Central Bank. He’s actually referring to the issuer, the US Treasury which makes Sumner an ironic/funny kind of way. And this is the problem with parts of Market Monetarism. If you don’t respect specific institutional arrangements you end up saying things that make no sense when you consider the actual design of the system."

http://pragcap.com/who-is-the-alpha-bank/comment-page-1#comment-171180

Cullen Roche:
"...1) I think you overstate the exchange rate concept given that the Fed buys coin and currency from the US Tsy and the fact that there’s deposit insurance via FDIC. US bank deposits are at a very low risk of ever trading below par. The “value” of commercial bank money has been backstopped for all intents and purposes and the Fed is far from the only cause of this effect..."

http://pragcap.com/who-is-the-alpha-bank/comment-page-1#comment-171181

Cullen Roche
"I understand Nick’s point. The thing is, the “unit of account” in Sumner’s theory is not even created by the CB. It’s created by the Bureau of Engraving. All cash and coin is sold to the Fed at face value by the Bureau, a department of the US Tsy. The alpha bank, if we’re going to use such a term, is actually the US Treasury in the Market Monetarist model and they don’t know it because they don’t actually describe the reality of how money is created. Sumner’s “paper gold” is a creation of the US govt, not the Fed..."

In a word, this is wrong.

http://www.newyorkfed.org/aboutthefed/fedpoint/fed01.html

"The distribution of coins differs from that of currency in some respects. First, when the Fed receives currency from the Treasury, it pays only for the cost of printing the notes. However, coins are a direct obligation of the Treasury, so the Reserve Banks pay the Treasury the face value of the coins..."

The cost of printing the notes has averaged approximately 0.325% of their face value in the past 11 years:

https://research.stlouisfed.org/fred2/graph/?graph_id=169160#

Of course the Federal Reserve pays 100% of the face value for coins. What proportion of the value of the currency in circulation consists of coins?

http://www.federalreserve.gov/newsevents/testimony/roseman20100720a.htm

"...The value of U.S. coins in circulation as of May 31, 2010, was approximately $40.4 billion, or about 4.3 percent of total currency and coin in circulation."

So the Treasury only gets paid about 4.6% of the face value of the nation's currency in circulation by the Federal Reserve, which is appropriate if the Treasury is really in the role of performing a service for the Fed.

As Cullen says:
"If you don’t respect specific institutional arrangements you end up saying things that make no sense when you consider the actual design of the system."

Kind of "ironic/funny", eh?

[Mark A. Sadowski]

This whole alpha/central bank versus beta/commercial bank fracas between Nick and Cullen reminds me of how perverted Monetary Realism's "scale of moneyness" is:

http://pragcap.com/wp-content/uploads/2013/03/moneyness1.png

Poor thing. It reminds me of one of these at the carnival freakshow:

http://blog.allanellenberger.com/wp-content/uploads/freaks-olga.jpg

Fortunately virtually the rest of the monetary universe has the head where the head should be, and the torso where the torso should be, and so on and so forth.

And lest you think I'm only speaking for the monetarists, here's what Post Keynesianish heterodox economist Perry Merhling has to say about the whole matter (Page 10):

http://ieor.columbia.edu/files/seasdepts/industrial-engineering-operations-research/pdf-files/Mehrling_P_FESeminar_Sp12-02.pdf

"Returning to our simple hierarchy of money, the point is that there is a simple hierarchy of market makers to go along with the hierarchy of instruments. And for each market maker, there is an associated price of money. The prices in the simple hierarchy are three: the exchange rate (the price of currency in terms of gold), par (the price of deposits in terms of currency), and the rate of interest (the price of securities in terms of deposits or currency, assuming par). These prices are the quantitative link between layers of qualitatively differentiated assets. The market markets who quote these prices in effect straddle the layers of the hierarchy, using their own balance sheets to knit those differentiated layers into a coherent whole."

Be sure and look at Figure 3 on page 19. (Yep, head and torso are in the right spots.)

[Tom Brown]

Mehrling's chart on page 4 is why I've always said that coins are the only true money in the US... assets to any bearer of them, and a liability to no one. Check the accounting if you think I'm wrong. Fed notes and electronic Fed deposits are just IOUs to let the bearer know how much in coins the Fed owes them. That's why the Fed's liabilities are truly just IOUs. What does the Fed owe? Coins. :D

Some people point out that coins are an "obligation" of Treasury (meaning Treasury has the accept them back again at face value)... so that's why the only REALLY true money in the US are nickles! Each nickle contains > 5 cents worth of raw materials!

http://web.hbr.org/email/archive/dailystat.php?date=022712

(all the rest if funny money... stand-ins for the real thing!)

[Mark A. Sadowski]

Tom, I refuse to pay for everything with bags of nickels. :)

[Mark A. Sadowski]

And this back in forth had me in stiches. It starts here:

http://pragcap.com/of-course-all-economists-already-understood-the-money-multiplier-not/comment-page-1#comment-170835

Cullen Roche:
"...When you understand endogenous money you have to basically throw out the old concepts of the central bank controlling inflation..."

JP Koning
"Not necessarily. Go read David Glasner. He thinks in terms of endogenous money, and he also explains how a central bank controls inflation"

Cullen Roche:
Not sure I agree with the underlying point he’s making. For instance, [David Glasner] says:

"...the underlying confusion here is that the authors seem to think that the amount of money created by the banking system actually matters. In fact, it doesn’t matter, because (at least in the theoretical framework being described) the banks create no more and no less money that the amount that the public willingly holds. Thus the amount of bank money created has zero macroeconomic significance."

This is just a different version of the idea that banks are intermediaries who just allocate funds to the public. It downplays the actual importance of their role in the economy by creating the illusion that commercial banks are interdependent on the central bank when they create money. In this case, he’s saying that banks just supply some level of deposits that the public “wants to hold” without considering the stock/flow consistency of this concept.

For instance, the public, as a whole, would rather not own any money that comes with an interest cost. The public would rather hold non-interest charging notes. But that is obviously not how the monetary system is designed. The public cannot simply reflux its holdings back to the banking system because it is largely contingent on the flow of income that comes from other loans that have created deposits. The fact that money IS credit is central to this understanding and the ability to see the monetary system in a stock/flow consistent framework….Therefore, in the long-run and in the aggregate, the idea that “any unwanted bank deposits are returned to the banking system” is a concept that is misleading at best and void of value at worst..."

JP Koning:
"How are Glasner’s ideas about reflux any different from Marc Lavoie’s ideas about reflux?"

Cullen Roche:
"Correct me if I am wrong, but Glasner is not a true endogenous money proponent. That is, he doesn’t think bank money matters to the macroeconomy whereas someone like Lavoie would never claim such a thing (or I assume he wouldn’t). So the point is that they’re utilizing different models of the economy. PKE is an endogenous money view whereas most neoclassical economists are exogenous money proponents. Or, if they understand endogenous money it is still a supply side driven element. So, there’s a difference between understanding endogenous money and using this understanding in what a Post-Keynesian would call an endogenous money perspective..."

(At this point Cullen's babblings begin to remind me of one of Governor Rick Perry's debate performances.)

JP Koning:
"Cullen, you said:

“The public cannot simply reflux its holdings back to the banking system...So the idea that ‘any unwanted bank deposits are returned to the banking system’ is a concept that is misleading at best and void of value at worst.”

Lavoie says:

“The primary mechanism through which the supply and demand for deposits become equal is the generalised reflux principle.”

...and goes on to describe how unwanted deposits can’t exist, only desired money can exist.

http://www.scribd.com/doc/214350744/Lavoie-1999-The-Credit-Led-Supply-of-Deposits-and-the-Demand-for-Money-Kaldor-s-Reflux-Mechanism-as-Previously-Endorsed-by-Joan-Robinson

So why does Lavoie, a PK’er and proponent of endogenous money, seem to be contradicting you?"

Cullen Roche:
"Hey JP. That was a sloppy comment on my part. Sorry. I should have been clearer.

Borrowers can obviously pay back loans in the short-term. But in the aggregate, over the long-term, there is no reflux. Firms and households will demand more deposits because deposits are the dominant MOE. We are thrust into a monetary world in which the payment system is dominated by banks and obtaining some level of their liabilities is a must for engaging in this system. If we want to participate in the monetary economy we cannot, in the aggregate, “pay back” or reflux our deposits over the long-term without major changes in how the system is actually designed. Said differently, there is an inherent upside bias in bank liability demand due to the mere design of our system. Therefore, the supply of deposits is not only demand driven (primarily), but it is also function of the system’s institutional arrangement. Saying that demand deposits don’t matter or are just something we can choose to hold, is misleading in my view."

JP Koning:
"Sorry Cullen, I’m having problems grokking you here. As always, it’s a version of this problem."

http://pragcap.com/on-money-demand-qe/comment-page-1#comment-161453

And the upshot of that link is that Cullen has no theory of price level determination and what determines the purchasing power of base money.

This reminds me of the fact that this is one of Post Keynesian economist Thomas Palley's key criticisms of MMT:

http://www.thomaspalley.com/?p=393

"...Among many failings, Tymoigne and Wray fail to provide an explanation of how MMT generates full employment with price stability; lack a credible theory of inflation; and fail to justify the claim that the natural rate of interest is zero..."

Which when you combine it with the fact that Monetary Realism gets its moneyness scale completely disjointed, MR is even more screwed up than MMT if that's possible.

[Philippe]

"lack a credible theory of inflation"

I think it's along these lines:

http://neweconomicperspectives.org/2011/07/two-theories-of-prices.html

see the comments too.

Also: http://slackwire.blogspot.co.uk/2014/02/a-response-to-tom-palley.html

[Mark A. Sadowski]

In my opinion the following was an important exchange, especially given the nature or Cullen Roche's post. Starts here:

http://pragcap.com/of-course-all-economists-already-understood-the-money-multiplier-not/comment-page-1#comment-170989

Cullen Roche:
"And no, the manner in which we are discussing the money multiplier has nothing to do with convertibility at par. It has to do with the way people think reserves “flow out” of the banking system..."

Nick Rowe:
"The whole point of the first year textbook example is to show that when reserves flow out of an *individual* bank, when its deposits get *converted* (at a fixed exchange rate) into deposits at another bank, those reserves do not flow out of the banking *system*. They flow into some other bank. The whole point of the first year textbook example is to show that the banking system creates money, and creates *more* money than the central bank creates (assuming less than 100% reserves). That’s why they call it a “multiplier”. And yes it will be inflationary, if the total supply of money increases more than the total demand to hold money. (And remember, when a bank creates a deposit by extending a loan, the person who borrows that money very probably wants to spend that money, and not hold extra money sitting in his bank account.)

Cullen Roche:
"The way you’re describing the multiplier is different from the way I am criticizing people for using it. The people who abuse the concept assume that reserves are something that “flow out” of the reserve system."

Nick Rowe:
"An *individual* bank that makes a loan *does* lose reserves to other banks (unless it can increase its market share of deposits at the same time) when the money gets redeposited at a *different* bank. It is exactly as if the individual bank lent its reserves, or made the loan in currency. And that is what all the economists you quote above are saying. They know full well those reserves are not lost to the banking system as a whole (unless they result in a currency drain, and the central bank holds base money=currency+reserves constant. Despite what you seem to think, those guys aren’t complete idiots."

And actually, in my opinion, the Krugman quote that Cullen Roche took out of context, came from one of his best blog posts ever.

http://krugman.blogs.nytimes.com/2012/03/30/banking-mysticism-continued/

March 30, 2014

Banking Mysticism, Continued
By Paul Krugman

"Update: It’s obvious that many commenters don’t get the distinction between the proposition that banks create money — which every economics textbook, mine included, says they do (that’s what the money multiplier is all about) — and the proposition that their ability to create money is not constrained by the monetary base. Sigh.

A bit of a followup on my previous post.

As I read various stuff on banking — comments here, but also various writings here and there — I often see the view that banks can create credit out of thin air. There are vehement denials of the proposition that banks’ lending is limited by their deposits, or that the monetary base plays any important role; banks, we’re told, hold hardly any reserves (which is true), so the Fed’s creation or destruction of reserves has no effect.

This is all wrong, and if you think about how the people in your story are assumed to behave — as opposed to getting bogged down in abstract algebra — it should be obvious that it’s all wrong.

First of all, any individual bank does, in fact, have to lend out the money it receives in deposits. 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 hope this isn’t controversial, although given what usually happens when we discuss banks, I assume that even this proposition will spur outrage.

But the usual claim runs like this: sure, this is true of any individual bank, but the money banks lend just ends up being deposited in other banks, so there is no actual balance-sheet constraint on bank lending, and no reserve constraint worth mentioning either.

That sounds more like it — but it’s also all wrong.

Yes, a loan normally gets deposited in another bank — but the recipient of the loan can and sometimes does quickly withdraw the funds, not as a check, but in currency. And currency is in limited supply — with the limit set by Fed decisions. So there is in fact no automatic process by which an increase in bank loans produces a sufficient rise in deposits to back those loans, and a key limiting factor in the size of bank balance sheets is the amount of monetary base the Fed creates — even if banks hold no reserves.

So how much currency does the public choose to hold, as opposed to stashing funds in bank deposits? Well, that’s an economic decision, which responds to things like income, prices, interest rates, etc.. In other words, we’re firmly back in the domain of ordinary economics, in which decisions get made at the margin and all that. Banks are important, but they don’t take us into an alternative economic universe..."

Nope. Not a complete idiot.

[Nick Rowe]

Mark @10.42: "In my opinion the following was an important exchange, especially given the nature or Cullen Roche's post."

In my opinion too. Plus the methodological individualism bit.

I think Paul Krugman put a bit too much emphasis on the cash drain idea, and not enough emphasis on the idea that the central bank will deliberately stop the ball rolling if it thinks the creation of money will endanger the inflation target. Not sure if Paul put it the clearest. An individual bank can create money out of thin air, but then has to borrow when that money gets spent and redeposited at another bank, so it's not thin air for very long. The banks as a whole can create money out of thin air, except for a cash drain (or desired reserve ratios).

[Philippe]

"an individual bank can create money out of thin air, but then has to borrow when that money gets spent and redeposited at another bank, so it's not thin air for very long."

Right, but isn't that the point of critiques of the 'money multiplier' (when presented as a causal mechanism from reserves to deposits to loans)?

A bank can create a deposit in the process of making a loan, and then pay a lower rate of interest on the deposit than it receives on the loan. The money supply has thereby expanded, with no need for a prior increase in the supply of reserves. When the supply of reserves does increase, it is retrospectively in response to prior credit expansion by banks.

So the argument is that the money multiplier story of banks taking in deposits and lending them out, or getting extra reserves from the central bank and lending them out, has the causation backwards.

[Nick Rowe]

Philippe: I remember that old "cost push+demand pull" theory of inflation from the UK in the early 1970's. I'm afraid it falls apart once you recognise that nominal wages are not exogenous with respect to nominal prices. Workers and firms care about the real wage, not the nominal wage. If you use wages to explain prices, you must also use prices to explain wages. They would both respond one-to-one to each other, given the state of demand, and the whole theory disappears up its own orifice.

[Nick Rowe]

Philippe: The textbook money multiplier story starts in an initial equilibrium. If there's a shock, that equilibrium will change. The textbook story supposes that the initial shock comes from the central bank. Because the textbook story wants to show that if the central bank create one extra dollar of central bank money, commercial banks will then create more than one extra dollar. Could we tell a different story where the initial shock comes from somewhere else? Sure. And the effects of that shock will depend on how the central bank responds. And that will depend on what the central bank is targeting. For example, if it is targeting inflation, and inflation is currently on target, it will not passively allow the banks to expand if that would put upward pressure on inflation.

[Philippe]

"the textbook story wants to show that if the central bank create one extra dollar of central bank money, commercial banks will then create more than one extra dollar"

but then in reality you can have a situation in which the central bank hugely increases the quantity of reserves, and banks don't do much more lending. And pundits then stand around scratching their heads asking why the banks aren't lending out the extra reserves like in the story.

[Nick Rowe]

Philippe; Yes, and then you start asking questions about whether that increase in reserves is expected to be permanent or temporary. And if QE is expected to be temporary (as it is) then banks would be rather wary of expanding loans and deposits in response to an increase in reserves when they expect to have to go into reverse gear again as soon as they get started. "Here's a punchbowl, but as soon as you all start drinking from it I will take it away" is no way to get a party started. The simple first year textbook story does implicitly assume that everyone expects the increase will be permanent. That's why the Fed needs to do something like announce a higher target level of NGDP, so banks and borrowers will understand that the Fed wants a permanent increase in the level.

[Tom Brown]

Nick, what do you mean by a "cash drain?" Do you mean people choosing to withdraw their deposits in cash?

[Nick Rowe]

Tom: yes. Sorry, it's very old fashioned terminology. 19th century, I think.

[Philippe]

"If you use wages to explain prices, you must also use prices to explain wages. They would both respond one-to-one to each other, given the state of demand, and the whole theory disappears up its own orifice."

I might ask one of the MMT guys about that and get back to you, if its worth it.

[Philippe]

Nick,

"then you start asking questions about whether that increase in reserves is expected to be permanent or temporary"

It seems to me that promising to permanently increase the quantity of reserves is like promising to keep the interbank funds rate low for longer than usual. Say it's low as it is at present, and the central bank commits to permanently increasing the quantity of reserves, and so buys a lot of bonds thereby increasing excess bank reserves. Banks go about making loans, and after a while the increase in deposits (as a result of the loans) puts upward pressure on the funds rate. The point at which this upward pressure starts depends on the quantity of excess reserves. If the central bank commits to a very small permanent increase in reserves, this point might come relatively soon. If the CB commits to a large increase, it will take longer. Couldn't the CB achieve the same result by simply promising to keep the funds rate at its low level for a certain period of time, or until a certain target has been hit?

[Tom Brown]

I know this has been beaten to death, but regarding Krugman's statements above, some of the specific things he said were a bit off IMO.

"I often see the view that banks can create credit out of thin air."

Yes, that's true actually. Not without limitation obviously. Krugman earlier just told us how he realizes banks can create money. So... then it stands to reason that it comes out of thin air at some point. That's the idea of something being created... especially something as ethereal as credit-money.

"There are vehement denials of the proposition that banks’ lending is limited by their deposits"

Yes, deposits do limit banks' lending... because they are liabilities and count AGAINST a bank's equity and more generally its capital. I get the sense that Krugman is using "deposits" here in a different sense though... like that without enough of them the bank couldn't lend. I.e. in exactly the wrong way. Maybe I'm wrong... but that's the impression I get. If all the deposit holders were to walk into their banks tomorrow and tell them "Hey bank: that deposit you owe me... forget about it!"... the banks would be overjoyed and big bonus and dividend checks would be in the mail shortly... all coming from "thin air." Sure I realize that deposits are generally a cheap way to obtain reserves, but at the end of they day the deposits themselves are liabilities and count against the bank's bottom line.

"First of all, any individual bank does, in fact, have to lend out the money it receives in deposits."

No, it's a "simultaneous system" to use Krugman's own words from a later post. The loans and deposits arise out of the same process, simultaneously. Just like when I buy an apple, I take ownership of the apple and the store takes ownership of my $1 simultaneously. Same thing happens when a bank buys a loan from a borrower by crediting a deposit. If that deposit is going to another bank immediately, then the bank must have a plan to "fund" that transfer, but it doesn't necessarily involve deposits.

"Bank loan officers can’t just issue checks out of thin air;"

Actually, they can. Whenever the aggregated banks pay non-banks w/o using cash, money is created out of thin air.

"like employees of any financial intermediary, they must buy assets with funds they have on hand."

No, they can credit a bank deposit to pay for something: like a bond, a loan, or a donut, w/o having any "funds on hand." They must maintain sufficient capital (risk adjusted equity) to remain solvent, but no "funds on hand" required.

So overall, I get Krugman's point: there are limitations to banks buying stuff (including loans), and one of those limitations is base money. And one of the things base money can do is walk out the door as cash. But overall the piece was poorly written, internally inconsistent (i.e. sure banks create money, but heaven forbid "not out of thin air" Lol), and misleading. Perhaps it was a message that needed to be stated at the time, but the delivery could have been better. Not one of his better pieces IMO. I think his later post about banks buying loans being a "simultaneous system" was more clear and accurate.

[Philippe]

Tom, just a side point really: a bank obviously can't start with zero money and start creating money out of nothing. It needs capital, which it then leverages by borrowing. Deposits are bank debts, i.e. bank borrowings, and they are also considered to be a form of money as far as everyone else is concerned. So banks create money simply by going into debt to depositors. All this requires is for the bank to agree to go into debt - It creates money "out of thin air" by deciding to go into debt to a depositor. It can do this profitably because depositors are willing to lend to banks at a very low rate of interest (the rate paid by banks on deposits), whilst borrowers are willing to pay a much higher rate of interest to banks on loans.

Banks are debtors and depositors are creditors. This means that when you take out a loan from a bank and the bank 'credits' your account with a deposit, you are simultaneously in debt to the bank and the bank's creditor.

If someone makes a payment to your account, say $100, your bank will say it has 'credited' your account with $100. But this is misleading because in reality you are the one that has credited the bank with $100. The bank is actually borrowing $100 from you, but they make it sound like they have given you money, because their debts are considered to be a form of money by non-banks.

[Philippe]

Tom,

"like employees of any financial intermediary, they must buy assets with funds they have on hand."

No, they can credit a bank deposit to pay for something: like a bond, a loan, or a donut, w/o having any "funds on hand."

In a sense Krugman is right. When a bank "credits a bank deposit" it is *borrowing from the depositor*. In other words it is borrowing 'funds' from the depositor. So when a bank makes a loan and simultaneously creates a deposit in the process, the bank is borrowing the funds to make the loan from the depositor - who is the person taking out the loan. The problem with Krugman's language and much of the language surrounding banking and money is it can be misleading. It conjures up images of people 'depositing' bags of coins which the bank then 'lends out' to borrowers, etc.

[Vaidas Urba]

Nick:
"Just read the Hierarchy paper. It's good.
I just realised: I'm having dinner with him tomorrow! Coincidentally."

Did you persuade Perry Mehrling that NGDP futures should be placed at the top of money hierarchy?

[Nick Rowe]

Philippe: "Couldn't the CB achieve the same result by simply promising to keep the funds rate at its low level for a certain period of time, or until a certain target has been hit?"

Short answer Yes. There is a definite similarity. In some models they would be the same. But it depends on how the target is specified, and whether people understand it and find it credible. In particular, the central bank needs to talk about the *level* of prices (or NGDP). Like in my example in the post, where I imagine the Bank of Canada doubles the price level target. Permanently doubling base money (relative to what it would otherwise have done) should be (approx) equivalent to promising to keep interest rates "too low for too long" until the price level (or NGDP) doubles (relative to what it would otherwise have done).

But communicating that policy is a non-trivial exercise. In the 1930's, central banks communicated basically the same thing by going off the gold standard, and increasing the price of gold. But I don't think that people would understand what that meant nowadays.

Tom: I tend to agree. Given the amount of miscommunication over the "loans create deposits!" issue, it really needed a very carefully written piece.

Philippe: "It conjures up images of people 'depositing' bags of coins which the bank then 'lends out' to borrowers, etc."

If the central bank chooses to hold base money constant (and it can choose to do that), and if people hold some base money as currency, then it is exactly as if people are depositing bags of coins which the bank then lends out. Because even though a bank may make a loan by creating a deposit, rather than giving the borrower base money, when that loan gets spent and redeposited in a different bank, the original bank loses that base money to another bank. That is exactly the same as if the loan was made in coins, and then those coins get spent and redeposited in a different bank.

Vaidas: NGDP targeting wasn't on the agenda. We were talking about designing monetary/financial systems to make them panic-proof. But the "money multiplier" came up in discussions, and this post is a longer version of what I said in those discussions.

[Philippe]

"when that loan gets spent and redeposited in a different bank, the original bank loses that base money to another bank"

however banks only need to settle the net difference in payments between them with reserves. In fact many smaller banks settle using deposits at larger banks, rather than with reserves.

Say a bank makes loan, creates a deposit, and the borrower/depositor then makes a payment to an account at another bank. The first bank could borrow from the second bank, or an equal payment could come from the second bank to the first bank, and no reserves would actually change hands. Most of the monetary system is just a network of debts like this, rather than base money zipping back and forth between everyone at differing rates of velocity.

If the central bank held the quantity of base money constant it would lose control of interest rates, correct? My understanding is central banks don't do this as it creates a lot of financial instability, so they control interest rates instead and under this system they cannot fix the quantity of reserves. In this situation there is no fixed pot of gold out of which all money comes but rather a potentially infinite supply of money which can be had a certain price and on certain terms. As such bank lending decisions are generally not limited by the quantity of reserves they happen to have - however they can be affected by the price at which reserves can be obtained, which is controlled by the CB. So banks do not have to sit around waiting for someone to deposit a bag of coins before they can lend those coins out to someone. Instead they create deposits when they lend thereby expanding the money supply, then maintain the balance between their assets and liabilities by paying interest on deposits, attracting additional deposits, borrowing from other banks, or getting additional reserves from the CB if need be.

[Jussi]

@Philippe

I think someone somewhere had an argument that the assets held by the CB will mean political pressure through not to incur losses and thus conveying a credible promise to keep the rates low for an extended period. Yet IOR seems to offer a way to circumvent by raising rates and letting the bonds mature at par? I guess IOR has its own drawbacks.

Btw. can the CB (at least in theory) target the price level only by adjusting IOR with (any level of) permanent excess reserves? I fail to see why not? But then it cannot be said that quantity and price always form a straightforward equilibrium? I think in that regards the usual jargon about CB targeting a certain inflation rate makes more sense than emphasizing quantity?

[Jussi]

"I think in that regards the usual jargon about CB targeting a certain inflation rate makes more sense than emphasizing quantity?"

Should read: "I think in that regards the usual jargon about CB targeting a certain inflation rate by setting interest rates makes more sense than emphasizing quantity?"

[Philippe]

Nick,

"Short answer Yes. There is a definite similarity."

I'm afraid I still don't really get how the central bank simply setting a higher inflation or NGDP target automatically makes that higher inflation or NGDP happen in reality. Surely it will, at the very least, take a while for that target to be hit? For inflation to rise to a target level, people actually have to spend, borrow, invest more etc. I can't see how simply being told by the central bank that it has targeted a higher rate of inflation or NGDP suddenly makes these things happen now. It seems to rely on a leap of faith - for the economy to suddenly "just believe" and thereby make it happen. In reality however expectations and incomes remain depressed, unemployment high, so no one does what's needed - i.e. spends and invests more.

I'm sure this is all going over old ground, but I've been doing other things and not keeping up with the discussion.

[Nick Rowe]

Philippe: "I can't see how simply being told by the central bank that it has targeted a higher rate of inflation or NGDP suddenly makes these things happen now."

Suppose everybody expects that the economy will not recover to normal (off the ZLB) until (say) 2020. Now suppose the Fed, in 2014, tells people that when 2020 arrives, it will set nominal interests too low, to stimulate investment and consumption, and make NGDP twice as big as people are currently expecting. Current nominal spending (current NGDP) depends on expected future nominal income (expected future NGDP). So NGDP expands in 2014, if the Fed is credible.

That's the simplest (New Keynesian) version of the story.

[Philippe]

Thanks.

[Vaidas Urba]

Nick:
"NGDP targeting wasn't on the agenda. We were talking about designing monetary/financial systems to make them panic-proof. But the "money multiplier" came up in discussions, and this post is a longer version of what I said in those discussions."

Mehrling studies market share fluctuations. These fluctuations will be the main macro problem when NGDPLT is implemented. Mehrlin is wrong that these fluctuations are the key problem now.

Here is what Mehrling wrote on NGDP targeting in 2012:
http://ineteconomics.org/blog/money-view/heterodoxy-and-economist

Presumably central bank can peg to NGDP futures, or at least try to. But who will protect us from breakdowns in arbitrage between NGDP futures and goods/services? (such breakdown is not a problem in the current crisis, but as the saying goes - if you make something idiot proof, someone will just make a better idiot).

[Tom Brown]

Also, just to be clear, I learned a year or more back that the Fed buys paper notes for their production cost from Cullen. Phillipe filled in some details there too for me (like the bit about the BEP). So I figured that comment was a mistake, and it was:
http://pragcap.com/who-is-the-alpha-bank/comment-page-1#comment-171315

[anon]

It’s funny how they are keeping deleting posts about John Cochrane here: http://www.econjobrumors.com

Nick, talk about his latest post about monetary policy

[Jussi]

"The simple money multiplier story is a story about market shares, and about beta banks fixing their exchange rates to the alpha bank"

So this is all about just reserves? A question: what makes reserves so special in the current environment? I mean they are surely ultimately mean of settling but in this context (alpha/beta) it is more that they are ultimate liquidity and safeness? But isn't it true that all banks' capital backs up the deposits, just like the reserves? Should we calculate at least the t-bill part of capital into "market share/exchange rate" of beta banks?

[Philippe]

Nick,

"Current nominal spending (current NGDP) depends on expected future nominal income (expected future NGDP). So NGDP expands in 2014, if the Fed is credible."

This seems pretty unrealistic to me.

Increasing your spending today in the expectation that your income will be higher in the future, requires reducing your savings today or going into debt today. This entails taking on risk, which means taking a gamble in the face of inherent uncertainty. You can't know for certain that your income will be higher, or high enough, in the future.

As such, the Fed's policy will only be considered credible by enough people if enough people think that enough people will be willing to take on that risk and spend the income they don't have, today. Again, this raises the problem of uncertainty - they can't actually know whether enough people will take on that risk. In the aftermath of a severe financial crisis and recession, in which debt burdens are very high and large spenders like governments are cutting back, it seems highly likely that people will not expect that to happen, and as such they will not consider the Fed's pronouncements to be credible, no matter how serious the Fed is about them.

Does it not seem to you that there's every possibility the Fed's policy wouldn't actually work, given the above?

[Nick Rowe]

Philippe: try it the other way. If you learned your income would be lower in future, would you not cut your spending today? It would be very risky not to save.

Plus, if some people respond to expected future income, but others simply spend their current income, if the first group expect higher future income and increase their spending today, that increases the current income of the second group and so they increase their spending too, which increases their current income still further, and so on. The Old Keynesian multiplier kicks in.

Plus, nobody actually needs to cut saving, unless someone else increases saving. Increased spending creates the increased income to finance it, in aggregate.

Plus, we are talking investment spending too. If firms expect higher future demand, they will want to increase investment spending now.