Cheshire Cats and New Keynesian Central Banks

How can the Cheshire Cat disappear, but its smile remain?

How can money disappear from a New Keynesian model, but the Central Bank still set a nominal rate of interest and create a recession by setting it too high?

Ignore what New Keynesians say about their own New Keynesian models and listen to me instead. I will tell you how it is possible.

Start with a model of an economy with a central bank that issues paper currency. It's a monetary exchange economy, where that currency must be used to buy and sell everything else. Barter is assumed to be prohibitively costly. The currency issued by the central bank is the sole medium of exchange. It is also the unit of account. The central bank can change the stock of currency in circulation by using open market operations.

Now replace the paper currency with chequing accounts at the central bank. Instead of having $100 recorded on paper notes in your pocket, you have $100 recorded on silicon in your account. Instead of transferring paper notes from pocket to pocket when you buy something, you pay by cheque or debit card and the central bank transfers the silicon money from account to account. It makes no difference to the model.

Now suppose the central bank pays interest on the balance in your chequing account at the central bank. There is no puzzle about how the central bank can set that interest rate; it just does it. (The central bank could have paid interest on the currency it issued, but that would have been administratively more difficult.)

Now suppose the central bank allows people to have a negative as well as a positive balance in the chequing accounts. You can run an overdraft. And suppose the interest rate you pay on a negative balance is the same as the interest rate you receive on a positive balance. So the central bank only sets one interest rate.

Now suppose the central bank uses open market operations to adjust the net stock of money until the sum of the positive balances exactly equals the sum of the negative balances. The central bank now can have zero net worth, because the negative balances are its assets and the positive balances its liabilities and both are equal. The central bank can now have zero net income, because it pays out interest on positive balances equal to what it earns on negative balances.

Now suppose the economist building the model economy decides to make all agents identical, so that all agents always hold identical stocks of money balances. If one agent spends $100, all other agents do exactly the same at exactly the same time, so $100 is both added and subtracted from his chequing account at exactly the same time. But in symmetric Nash equilibrium, each agent nevertheless chooses how much money to spend taking as given others' choices of how much money to spend. And each agent's choice of how much money to spend depends on the rate of interest paid on holding money that is set by the central bank.

The above two paragraphs together mean that each agent always has a $0 balance in his chequing account at the central bank. But the rate of interest set by the central bank still affects spending.

Start in full equilibrium, which is where the economy would be if all prices were flexible. Now, just to keep it simple, hold all prices fixed at that level. If the central bank sets the interest rate too high, people spend less money, and so each sells less goods to other people. There's a recession. By assumption, all relative prices are correct, and there are unexploited gains from trade at those relative prices. If people could barter their way back to full employment they would immediately do so, to exploit those gains from trade, and the recession would end as soon as it began.  But the real interest rate paid on holding money is too high. If two agents could cut a deal, whereby each agrees to buy $100 of the other's goods if and only if the other buys $100 of his goods, so the deal leaves both with unchanged money balances, they would do so. But that deal is equivalent to barter, and is ruled out by assumption.

The Cheshire Cat has disappeared, but its smile remains. And its smile (or frown) has real effects.

The New Keynesian model is a model of a monetary exchange economy, not a barter economy. The rate of interest is the rate of interest paid on central bank money, not on bonds. Raising the interest rate paid on money creates an excess demand for money which creates a recession. Or it makes no sense at all.

[I've said all this before, but I've said it simpler and better this time.]

Comments

[Brian Romananchuk]

The NK models I have seen, but the money balances held were zero when interest rates are positive. (No explicit demand for money,) From an outsider perspective, I am curious about what distinction you see from that case, as it seems to end up in roughly the same place.

In the real world, your discussion has similarities to how the Bank of Canada sets the short-term rate even though net settlement balances are normally indistinguishable from zero.

[Ralph Musgrave]

"Raising the interest rate paid on money creates an excess demand for money which creates a recession." I'd re-phrase that as "There is no good reason to pay ANY interest to people simply for holding a stock of money".

I suspect that is saying much the same as Warren Mosler and Matthew Forstater's paper "The Natural Rate of Interest is Zero."

[Ralph Musgrave]

"Raising the interest rate paid on money creates an excess demand for money which creates a recession." I'd re-phrase that as "There is no good reason to pay ANY interest to people simply for holding a stock of money".

I suspect that is saying much the same as Warren Mosler and Matthew Forstater's paper "The Natural Rate of Interest is Zero."

[Nick Rowe]

Brian: if all agents are identical (strictly speaking I should say "symmetric" because each specialises in producing a different good) then each agent's spending money and receipts of money are perfectly synchronised (strictly, that only works if the central bank does immediate real-time settlement) then if there were any opportunity cost (interest rate differential) to holding money, the demand for money would be zero (or it would be negative, at the overdraft limit, if overdrafts were allowed).

Yep, it is very similar to how the BoC works.

Ralph: I think it's saying something very different. In this model, the central bank cannot always set interest rates at 0% if it wants stable prices or stable inflation.

[dlr]

In your model, when the CB sets the rate of interest too high, does it now fail in using open market operations to reduce central bank balances to zero because people will hold positive balances solely for pecuniary returns?

[JKH]

Nick,

This is excellent.

Very clean exposition and very intuitive, including the balance sheet construction sequence, even considered separately from its relationship to the NK theme.

P.S.

Although I’m thunderstruck you didn’t mention red or green money.

[JKH]

# 2

About this part:

“Now suppose the central bank uses open market operations to adjust the net stock of money until the sum of the positive balances exactly equals the sum of the negative balances.”

Suppose the central bank “initiates” its balance sheet by a creating a quantity of positive money through OMO.

Then suppose it allows for negative money. Each negative money item (a CB negative liability, which is a CB asset in effect) will create a positive money item of equal quantity (a CB liability).

“Negative money creates positive money”, don’t you know :)

Then suppose the central bank does reverse OMO to drain the original positive money that was created, resulting in a matched balance sheet in terms of positive and negative money (or a "zero balance sheet" if you want to consider negative money as a negative liability).

Then steady as she goes from there, except for appropriate interest rate adjustment according to real economic indicators, but with no further OMO required under NK assumptions.

Is that (roughly) what you mean?

[Market Fiscalist]

In this model it is very easy for the CB to hit its target because no matter what interest rate it sets then as balances are always zero it follows that positive balances always exactly equals the sum of the negative balances.

Recession are caused by the fact that despite the fact that their balances are always zero they still aspire to hold positive balances at higher rates of interest by selling more than they buy. In the aggregate this leads to total buying and selling decreasing, thwarting peoples plans and hence the recession.

The illusion of a money-less world appears to depend totally on the fact that all agents are identical. If you introduce even one person who is different then it becomes possible for people to hold positive or negative balances (the odd-person-out buys goods on credit with money borrowed from the CB from one of the clones). I don't know much about NK models but it seems odd that they eliminate money via such an unrealistic assumption.

[JKH]

# 3

I was also struck by the analogy with the actual system for Bank of Canada reserves.

You explain along the lines of the potential for zero balances in respect of money needs for goods and services purchases under such a banking system.

This seems comparable to how the Bank of Canada is able to assume efficient running of a banking system that has a zero statutory reserve requirement. I.e. commercial banks that are continuously optimizing their balance sheet compositions and presumed at least in theory to be able to operate effectively with a zero stock of Bank of Canada settlement money (more or less zero), notwithstanding all of that asset-liability activity.

[JKH]

Musgrave,

You completely misunderstand this post.

It’s related to Mosler’s zero rate idea in a similar way to which Neptune is related to the Earth.

P.S.

I’d rather be boring, Ralphie

[Market Fiscalist]

Also I'm a bit confused by this bit "Now suppose the central bank uses open market operations to adjust the net stock of money until the sum of the positive balances exactly equals the sum of the negative balances."

Either people only borrow money to pay for stuff which they transfer to the seller in which case positive and negative balances always cancel each other out no matter what the rate of interest, or people borrow money just to hold it in their accounts and in this case there may be net borrowing even in an economy of clones. In this case the CB has less flexibility on what rate to set - it always has to set to the level where net borrowing is zero if it wants to hit its goal (and keep the illusion of a money-less economy). Am I missing something ?

[Jacques René Giguère]

"There is no good reason to pay ANY interest to people simply for holding a stock of money".Can humble IO guy rephrase it as "we should never use MOP as MOS and conversely. And we make a big mistake when we did so". If wrong, where did I go wrong?

[Brad DeLong]

If I may ask...

Why are you engaged in this Sisyphean task?

Why don't you just say "There is an Old Keynesian IS-LM Metzlerian model behind the curtain doing all its stuff, and don't worry about it, and if you find a place where that Metzlerian IS-LM model doesn't fit, the right answer is (b) "it makes no sense at all" because the model is badly written.

And you shouldn't need to have to rescue people who write badly-written models from the consequences of their muddy thinking...

[Too Much Fed]

"Now replace the paper currency with chequing accounts at the central bank. Instead of having $100 recorded on paper notes in your pocket, you have $100 recorded on silicon in your account. Instead of transferring paper notes from pocket to pocket when you buy something, you pay by cheque or debit card and the central bank transfers the silicon money from account to account. It makes no difference to the model.

Now suppose the central bank pays interest on the balance in your chequing account at the central bank."

JKH, let's assume there is only one(1) commercial bank.

When an entity pays by check or debit card, the commercial bank transfers demand deposits from account to account and that settles the transaction.

Is that right?

[Nick Rowe]

dlr: "In your model, when the CB sets the rate of interest too high, does it now fail in using open market operations to reduce central bank balances to zero because people will hold positive balances solely for pecuniary returns?"

No. (Unless I misunderstand you.) Suppose we start with a standard central bank, that has bonds on the asset side of the balance sheet, and strictly positive chequing account balances on the liability side, and zero net worth. The central bank then permits overdrafts, then sells *all* the bonds it owns, so the sum of the overdrafts equals the sum of the positive balances. Then it *never* uses open market operations again. The only instument it uses is the interest rate it pays/charges on positive/negative balances. If it raises that rate of interest, each individual wants to hold positive balances, but they cannot do so in aggregate. But they cut spending in their individual attempts to hold positive balances. Like the old monetarist hot potato, only in reverse.

JKH: thanks!

I was very tempted to talk about red/green money (because that is exactly what is happening here, as you notice), but resisted the temptation!

"Is that (roughly) what you mean?"

I think that's exactly what I mean. (You told the same story in a different, maybe clearer, way.)

MF: I agree with everything you say in your first comment, except the bit about it being easy for the CB to hit its target. It doesn't observe the natural rate of interest.

JKH: I *think* that's right. The role played by regular people in my model is roughly the same as that played by commercial banks in Canada. They have chequing accounts at the central bank. (There's a 50bp spread between the rates on positive and negative balances in the real world, of course, while I have assumed zero spread.)

MF: try reading JKH's version of the same story, in his second comment. It may be clearer. Or the version where I reply to dlr in this comment above.

Jacques Rene: sorry, but you lost me there.

Brad: Dunno really. But it bugs me to hear people say that NK-DSGE is just RBC with sticky prices. It isn't. Or rather, if it is, then it doesn't make sense at all. But yes, it is the NK people who should be doing this, not me. (But I feel a sort of responsibility to the NK research program, since I was sorta part of it once, and don't want to see it go astray.)

And there is one important difference to ISLM: "the" interest rate in ISLM is an interest rate on bonds (it is normally assumed money pays 0% interest). In this model, "the" interest rate is the interest rate paid on holding money.

[Brad DeLong]

Nick:

If it isn't an RBC model minimally-tweaked to deliver Old Keynesian conclusions, why is it what it is at all? What other telos could it possibly have?

It seems to me that interpreting it as a model of an economy in which the central bank controls spending by changing the interest rate it pays on its liabilities leaves us no better off than an RBC model minimally-tweaked to deliver Old Keynesian conclusions...

[Antti Jokinen]

Nick said: "Instead of having $100 recorded on paper notes in your pocket, you have $100 recorded on silicon in your account. Instead of transferring paper notes from pocket to pocket when you buy something, you pay by cheque or debit card and the central bank transfers the silicon money from account to account."

Do you mean that the central bank really "transfers the silicon money from account to account", or is this how you visualize it? In other words, is this transfer a phenomenon or is it part of the (implicit) model you are using?

It is clear to me that there is no transfer of silicon money from account to account (no phenomenon), and if this is so, then we can build a realistic model where there is no such transfer. That model would recognize the phenomenon for what it is: accounting. A credit entry on Account A and a debit entry on Account B doesn't require anything moving between the two accounts. The whole point of accounting is to record something taking place outside of the accounts. Like "warehouse accounting", where there are real things moving into and out of a warehouse and we want to record these movements. Or "money accounting", if there really were pieces of money moving between people or, say, cardboard boxes. But there isn't, and that's why we shouldn't think in terms of keeping accounts of "money holdings".

Starting from this simple premise, we can build a macro model which will change the way we see the world. Goods flow from a seller to a buyer, but no money -- nothing -- flows the opposite direction; instead, two (or four, six, etc.) accounts get new balances.

I'd be happy to take you on a tour of that world one day! It's a beautiful place.

[Tel]

Now suppose the central bank uses open market operations to adjust the net stock of money until the sum of the positive balances exactly equals the sum of the negative balances. The central bank now can have zero net worth, because the negative balances are its assets and the positive balances its liabilities and both are equal. The central bank can now have zero net income, because it pays out interest on positive balances equal to what it earns on negative balances.

That happens automatically in a world of private financial instruments.

So suppose you want to buy my excellent blog comments but you have no money. That's OK, you can just owe me, so write an IOU note.

Now I have an asset (the note) and you have a liability (the same note). They necessarily sum to zero, there's no possible way they can sum to anything other than zero. Even with a million people busily exchanging IOU notes they must always at every instant sum to zero. Only physical material objects can have a non-zero total (e.g. gold coins).

[Frank Restly]

Tel,

"They necessarily sum to zero, there's no possible way they can sum to anything other than zero."

It's called a default. My negative balance with the central bank is meaningless if I am no longer willing or able to bring it back to zero.

[Tel]

Frank, if I hold an IOU note (my asset) and the debtor formally defaults then the debtor no longer has a liability and I no longer have an asset (I made a loss on that).

Financial instruments are necessarily zero sum, both when they are created and also when they are extinguished.

Let me put this a different way... suppose I could figure out how to create an IOU note such that the liability side of that note could be removed somehow from the asset side. What would the residual non-zero-sum component of this look like? How could you describe this positive asset I hold in my hand but which comes from nowhere? It would be like an entitlement to call upon an act of God, or like a magic wish from Aladdin's lamp.

[Frank Restly]

Tel,

I get what you are saying. Yes, if you treat deposits / cash / currency as a liability of the central bank, then any overdraft creates two sets of liabilities and two sets of assets:

Me: $100 Overdraft (Liability), $100 Cash (Asset)
Central Bank: $100 Overdraft (Asset), $100 Cash (Liability)

Even if I default on the overdraft, I have $100 cash as asset which counterbalances the $100 cash as liability of the central bank.

Not sure if New Keynesian models treat cash / deposits / currency as such.

Your question:

"Let me put this a different way... suppose I could figure out how to create an IOU note such that the liability side of that note could be removed somehow from the asset side. What would the residual non-zero-sum component of this look like? How could you describe this positive asset I hold in my hand but which comes from nowhere?"

It's called a collateralized loan. The market value of the underlying collateral (asset) can move independently of the value of the loan (liability). The residual non-zero-component would be the difference in value between the two.

[Nick Rowe]

Brad: I'm not sure of the intentions of those who built the 2000 and later versions of the NK model. But I see it as a quick and dirty way to get get monetary policy into a microfounded model, without having to do the hard work of working out a money demand function where sales and purchases are imperfectly synchronised. And like it or not, it is a very influential model. So lets take it as it is, interpret it properly as a model of monetary exchange, and then start asking the more difficult questions: like what happens when we introduce overdraft limits into the model, because transversality conditions don't enforce themselves; and recognising that central banks farm out the chequing account business to commercial banks, etc.

Antti: I don't see the difference. Passing bits of paper from hand to hand is just a different way of doing the accounting. Like using an abacus, where the beads physically move. Some board games use "counters", and some just record the moves on paper, or on a computer.

Tel: some IOUs get used as a medium of exchange, circulating and being traded for every other good, and other IOUs don't get used as media of exchange.

[Tel]

The market value of the underlying collateral (asset) can move independently of the value of the loan (liability). The residual non-zero-component would be the difference in value between the two.

What I said earlier was: "Only physical material objects can have a non-zero total (e.g. gold coins)."

To the best of my knowledge, no central bank deals in such physical objects (although I think the Fed might own mortgages, not sure, I doubt they own actual houses). But anyway with or without a central bank makes no difference in principle: the world of financial instruments sums to zero. Even where physical collateral does change hands, the sum total of physical collateral has NOT changed. Those financial instruments might very well make some people better off and others worse off (I never disputed that) but they cannot either create or destroy wealth as a whole.

I should point out that physical collateral does exist in terms of taxation (government is backed by men with guns) so in effect your life is the collateral, but even tax cannot create something from nothing... it will transfer wealth from some people to other people. Government debt is deferred taxation, so some unknown future person is the collateral (possibly us, possibly our children).

[Tel]

Tel: some IOUs get used as a medium of exchange, circulating and being traded for every other good, and other IOUs don't get used as media of exchange.

Sure, but in terms of the intrinsic operation, all IOU notes are the same type of financial instrument, regardless of whether they circulate or not.

Some may circulate only locally within some closed environment (e.g. casino chips, or internal accounts within some trading exchange) but the assets and liabilities still need to balance regardless.

There's an argument that the process of circulation has intrinsic value in itself. For example cash notes operate as an accounting and communication system, something like Bitcoin also operates as an accounting and communication system, other examples are PayPal or Goldmoney. To the extent that you have a real information processing system, doing a useful task, then I would regard this component of the value to be equivalent to a physical object (i.e. you need paper and pencil to keep accounting books, you need electricity to run computers and networks, etc).

So yes, cash has the value of the physical paper, and this might be non-trivial if that serves a valuable purpose in terms of enabling commerce (but in a competitive environment, this value would reduce to the cost of the most efficient mechanism that achieves the same outcome). In a non-competitive fiat currency environment, cash has the "collateral" value of government being willing to use violence to force people to pay tax, and to maintain their fiat by repressing alternative systems of trade. That's a physical thing, requiring real physical effort to maintain.

[Frank Restly]

Tel,

"Even where physical collateral does change hands, the sum total of physical collateral has NOT changed. Those financial instruments might very well make some people better off and others worse off (I never disputed that) but they cannot either create or destroy wealth as a whole."

Sure they can. I am a farmer and borrow from you using my tractor as collateral. You as a taxi cab driver borrow from me using your taxi as collateral. I can't repay my loan to you and you can't repay your loan to me and so you get my tractor which you can't use to perform your job as a cab driver and I get your taxi cab which I can't use to perform my job as a farmer.

This is an extreme example, but the point remains valid. Collateralized loans can generate a non-ideal division of resources making all parties worse off (or better off).

[Too Much Fed]

Frank said:

"Me: $100 Overdraft (Liability), $100 Cash (Asset)
Central Bank: $100 Overdraft (Asset), $100 Cash (Liability)"

Frank and Tel, any reason not to call that overdraft a bond?

[Antti Jokinen]

Nick said: "Antti: I don't see the difference. Passing bits of paper from hand to hand is just a different way of doing the accounting. Like using an abacus, where the beads physically move. Some board games use "counters", and some just record the moves on paper, or on a computer."

Perhaps I interpret you wrong, but it seems to me that here you did it again. What are those "moves" that are recorded on paper or on a computer?

You're probably familiar with the story about two elderly gentlemen who use a stone they've painted green (a "counter") to record which one of them owes a dinner to the other? (I know it from Ostroy & Starr: "The Transactions Role of Money".) This stone moves from the dinner guest ("buyer") to the one who made the dinner ("seller") that evening. The stone is needed to "pay" for the dinner. If, instead of this "counter", they kept records on paper or on a computer, then the these records would have nothing to do with recording any moves -- other than the "movement" of a dinner from the "seller" to the "buyer".

What I'm saying is that if we see money moving between accounts, then we are thinking in terms of counters even though the accounts (journal) make any counters redundant.

By the way, and related to what "Too Much Fed" says above, overdraft is (logically) symmetrical with a traditional bank loan (where a separate "loan account" gets debited, and checking account credited, already when credit is extended but no purchase has yet been made). Although in reality both accounting techniques are used, in a model we can replace a traditional bank loan with an overdraft, or vice versa. I prefer overdraft form, because it is simpler and, in my opionion, closer to the true meaning of the accounting. A separate loan account seems to work mainly to preserve the illusion of these "counters" residing on checking accounts and moving between checking accounts. (Thanks to this illusion, quite a lot fuss was created in 18th century Scotland when overdrafts emerged...)

[Antti Jokinen]

Here I have "mapped" (see blue, green and yellow ellipses) an overdraft and a traditional loan to show that these are symmetrical: https://drive.google.com/open?id=0B1iEL0TpgRtkZ2l3dmVibUZfV2M

Interest rate symmetry is achieved by applying a simple formula: If interest rate on the traditional loan is X % and interest rate on checking account is Y %, then the interest rate on full overdraft limit needs to be (X-Y) % and interest rate on USED overdraft amount needs to be Y % to achieve the same net interest cost in both cases.

Perhaps this is nothing new to any of you, but I find it nevertheless important to be clear about this.

[Bill Woolsey]

Fischer Black described this institution in Banking in a World without Money in about 1970. It was a key paper that explained the "BFH" (Black-Fama-Hall) in Greenfield and Yeager's privatized money order.

[Frank Restly]

TMF,

"Frank and Tel, any reason not to call that overdraft a bond?"

Typically a bond is a transferrable asset. Meaning the central bank (or a private bank) can sell that loan to a third party at a premium or at a discount.

For instance:

Me: $100 Overdraft (Liability), $100 Cash (Asset)
Central Bank: $100 Overdraft (Asset), $100 Cash (Liability)

Becomes

Me: $100 Long Term Loan (Liability), $100 Cash (Asset)
Private Bank: $100 Short Term Loan (Liability), $100 Long Term Loan (Asset)
Central Bank: $100 Cash (Liability), $100 Short Term Loan (Asset)

[Antti Jokinen]

Bill Woolsey, that Black's paper is also very relevant to what I say above.

Any idea why Black is so inconsistent here:

"Let us imagine, then, a world in which money does not exist." ....... and three paragraphs later: "The banks will make loans to individuals, businesses, and governments. They will probably establish a schedule of interest charges for each borrower, and will then allow him to write checks on his account that increase the amount of his loan whenever he needs the money."

Banks are making loans (presumably money loans; nothing here seems to refer to "loanable funds") and people need money -- in a world without money?

I've build a model where money doesn't exist (but which is nevertheless supposed to describe our existing "monetary system"), and naturally, logically, in that kind of model it doesn't make sense to talk about banks making loans and people needing money.

[Nick Edmonds]

"Raising the interest rate paid on money creates an excess demand for money which creates a recession."

This only applies here, because holding money is the only way of saving in your story.

You can easily tell the same story with a few amendments:

- Positive money balances carry no interest.
- There are government bonds and fiscal policy takes the form of setting lump sum taxes equal to the interest cost on those bonds.
- The central bank offers to buy or sell bonds in unlimited amounts at a set price (basically it sets the yield on the bonds).
- Negative money balances carry interest at the bond rate plus a spread.

There is still no money here (strictly speaking there is money but it's in zero supply), but now it's raising the rate on bonds that causes the recession.

[Too Much Fed]

Frank said: "Typically a bond is a transferrable asset. Meaning the central bank (or a private bank) can sell that loan to a third party at a premium or at a discount."

That might be one characteristic of a bond.

I don't see why an overdraft can't be transferred ***as an asset***.

Probably does not happen in the real world though.

[Too Much Fed]

Nick Edmonds said: "Negative money balances carry interest at the bond rate plus a spread."

I think you will find negative money balances and positive bond balances are the same thing.

They mean some entity has borrowed positive money.

[Scott Sumner]

Very nice post. I'm increasingly inclined to believe that the problem with NK models is the same as the problem with old Keynesian models, a tendency to confuse the lever of monetary policy with the stance of monetary policy.

In contrast, the problem with monetarism was their tendency to confuse the quantity of money (their preferred instrument/target) with the stance of monetary policy.

Another problem with NK models is that they don't describe the real world. Thus cash pays no interest in the real world. So if you raise interest rates, you raise the velocity of circulation for cash. That's expansionary, unless more than offset (as it may well be) by a reduction in the quantity of cash. So in the real world, you simply can't ignore quantities. Check out Bernanke's attempt to do so in his latest post (on the BOJ.)

[Frank Restly]

Too Much Fed,

There are other characteristics as well. Bonds are normally fixed term while an overdraft can presumably be over an indeterminate time frame.

As far as real world, the only situation I can think of is when one bank (that has overdraft customers) is bought out by a second bank. In this case, the overdrafts of the purchased bank are bought along with all of it's other assets.

[JKH]

Nick E.,

Even with bonds, the central bank still has to make a decision on the policy rate – which is the interest rate directly relevant to money.

So I think introducing bonds is a complementing complication, rather than a substituting one. Bond OMO rates and policy rates are coordinated by the central bank, unless you assume strategic incompetence.

The natural base case would seem to be money without the complication of bonds, which is what Nick R. presents.

P.S.

Bond OMOs do change money supply, other things equal. Nick’s base case assumes at least implicitly no net bond OMO stock or the draining of any such stock that previously existed.

Finally, I’m guessing NK models implicitly assume no investment or aggregate saving. So if that’s the case saving is always in the context of positive saving being offset by negative saving – whether in the form of money or bonds or both.

But you know NK models and I don’t.

[Nick Rowe]

JKH: "Finally, I’m guessing NK models implicitly assume no investment or aggregate saving."

The *simplest* NK models explicitly assume no investment (and therefore no aggregate saving), and explicitly assume all agents are identical in their saving preferences (so there's no individual saving in equilibrium either).

But more complicated NK models bring all those things in. (I wanted to keep it simple here, because it doesn't really affect my point, which is easiest to see in the simplest version of the model.)

[Nick Rowe]

Bill: "Fischer Black described this institution in Banking in a World without Money in about 1970."

But would it be correct to say it's a "World without Money"? I think it isn't.

Scott: thanks.

If we generalise the model here, like I did in this post about a red-green world then we see that the central bank has 4 monetary policy instruments, 2 of which affect the quantities of money.

Nick E: One problem with your version is there is no government (and so no government bonds) in the simplest version of the NK model. I'm not sure if you could tell a version with private bonds. Even if you could, my version is simpler, ;-)

[Oliver]

Balance sheet wise, the equivalence of negative and positive money is an identity, and so cannot simultaneously said to be an equilibrium condition. Likewise it makes no sense to claim that the CB can intervene to create any such identity. Electronic money is always an asset / liability, both for the bank as well as for the non bank public (including gvt.). The interest rates on negative and positive balances still work the way you say and in that sense there is money, even if it always sums to 0. I'm not sure that squares with NK, my guess is it probably does, but that they would state it differently, but it is certainly the way circuit theorists would put it. They go even further to say that before the opening and after the closing of a (hypothetical) circuit not only net but also gross balances are 0. Despite that, it is still a monetary theory.

[Oliver]

Sorry, I seem to have mangled your words once again. You claimed discretion of the CB to achieve balance of positive & negative money / not equilibrium. But I stand by my point, to the extent that anyone can make it out. And I also like your post, in case that wasn't clear.

[Too Much Fed]

Frank said: "Bonds are normally fixed term"

OK.

And, "while an overdraft can presumably be over an indeterminate time frame."

I do not know this, but my guess is overdrafts are short term and are provided only as a convenience to bank customers so a check does not "bounce".

And, "As far as real world, the only situation I can think of is when one bank (that has overdraft customers) is bought out by a second bank. In this case, the overdrafts of the purchased bank are bought along with all of it's other assets."

I think so.

[Too Much Fed]

"The central bank can change the stock of currency in circulation by using open market operations.

Now replace the paper currency with chequing accounts at the central bank. Instead of having $100 recorded on paper notes in your pocket, you have $100 recorded on silicon in your account. Instead of transferring paper notes from pocket to pocket when you buy something, you pay by cheque or debit card and the central bank transfers the silicon money from account to account. It makes no difference to the model.

Now suppose the central bank pays interest on the balance in your chequing account at the central bank. There is no puzzle about how the central bank can set that interest rate; it just does it. (The central bank could have paid interest on the currency it issued, but that would have been administratively more difficult.)

Now suppose the central bank allows people to have a negative as well as a positive balance in the chequing accounts. You can run an overdraft. And suppose the interest rate you pay on a negative balance is the same as the interest rate you receive on a positive balance. So the central bank only sets one interest rate."

Do New Keynesians believe loans create deposits? If so, how about overdrafts create deposits?

Start at the beginning with nothing in the checking accounts. Someone borrows $100 in electronic money from the central bank as an interest-only 0% overdraft. They spend it.

The rest about the $100 is the same?

[Nick Edmonds]

JKH,

Well, I'd say that the rate relevant to money is the bond rate in my example (ignoring the fixed zero rate on positive balances). It's like the simple models that have interest bearing bonds, non-interest bearing money and where the CB influences the bond rate by varying the money supply. I've simply adjusted it to take account of the zero demand for money.

OMOs would change the money supply, but like with Nick R's example, there would not be any actual purchases or sales under the assumptions here. So, for example, if the CB offered bonds for sale at a dirt cheap price, everyone might want to buy bonds. But they have no money and it doesn't make sense to borrow, because the borrowing rate is always more than the bond return. So they try to get money by buying less goods. But, of course, this doesn't work if everyone does it. So nobody actually ends up buying bonds.

Nick R,

There is no government expenditure or distortionary taxes in the NK model, but the bits I describe may or may not be there because they are irrelevant to the equations. Other than that the interest rate needs to be a rate on something. And I didn't specify that the actual supply of bonds needs to be non-zero (providing short-selling is allowed).

But I'm not suggesting this story because I think this is better than your version. I don't think that. Yours is a nice and simple story. I was simply cautioning against extending your conclusion about demand for money from a simple model to scenarios with other assets.

[Nick Rowe]

Nick E: " I was simply cautioning against extending your conclusion about demand for money from a simple model to scenarios with other assets."

Hmm. OK. I think you are right on that.

[Nick Rowe]

Oliver: the central bank can use OMO to make the supply of net money (subtracting negative from positive balances) zero. Then Y adjusts (at a given r) to make the demand for net money zero in Nash equilibrium.

[JKH]

Nick E.,

*IF* the central bank is making a market in bonds, then presumably it has bonds on its balance sheet from time to time, if not all of the time. That means net money balances are positive most of the time if not all of the time, because OMO creates money balances and the rest is net zero (negative money creates positive money). Which means the system in aggregate doesn’t require borrowing to purchase bonds from the CB. The money has already been created to do it.

Conversely, you seem to be suggesting there are no actual bond transactions, which means bonds never get onto the central bank balance sheet, which means net money is never created. But then I’m not sure how the central bank sets the rate on bonds when there is no OMO transaction to act as an anchor for the rate setting.

Completely puzzled by your model, whereas Nick’s seems quite intuitive to me.

Obviously I don't understand it.

[Too Much Fed]

JKH, why isn't a negative balance in a checking account actually a positive bond balance?

[Oliver]

@ Nick R.
Thanks, I see where I went wrong. I could have said that you don't need OMOs to achieve equality in negative and positive money. Banks do that on their own (they also set theor own interest rates). But it does take someone to achieve macro economic equilibration on top of that.

[Nick Edmonds]

JKH,

The central bank could hold a stock of bonds acquired directly from the treasury by granting the treasury a reserve balance that it never actually spends. Although, what I'm describing doesn't require that they actually do this, merely that they could do something like this should they need to.

The rate is set by the yield at which the central bank offers to buy or sell. It doesn't matter whether any transactions actually take place because what matters is the opportunity cost to households of consuming today rather than tomorrow. That cost is based on what yield they could get buying bonds, but they don't actually have to buy the bonds to make that rate matter.

I should perhaps make clear at this point that I'm not really advocating this as a model. Like Nick R, I'm simple trying to pick away at what the implications of the NK model are.

[JKH]

Nick E.,

I dislike exuding an appearance of trolling, but here’s what Nick said:

“If one agent spends $100, all other agents do exactly the same at exactly the same time, so $100 is both added and subtracted from his chequing account at exactly the same time. But in symmetric Nash equilibrium, each agent nevertheless chooses how much money to spend taking as given others' choices of how much money to spend. And each agent's choice of how much money to spend depends on the rate of interest paid on holding money that is set by the central bank.”

Those are actual transactions of interest bearing money, where positive balances equal negative balances equals net zero balances in the setup that Nick specified. The interest rate determined equilibrium is premised on that accounting condition. And so there is no net quantity effect leakage in this model. Once the central bank balance sheet is in such an “accounting equilibrium”, there is no net money effect resulting from changes to consumer preferences for saving, based on the interest rate on money. I can readily see how the interest rate affects the velocity of that money and the resulting size of output and incomes etc. purely based on the money effect.

In your model, you say the same interest rate effect can be achieved by bonds without any bond transactions. That’s based on the opportunity cost of undertaking bond transactions, considering the level of bond interest rates. But such an opportunity cost might also consider the inevitable net money supply effect resulting from such a hypothetical bond transaction – even if no actual bond transactions occur. That’s an additional variable, even if those quantity effects are also in net zero equilibrium. But I wonder if something is quite different about such an equilibrium, given the extra variable of net money supply quantity under consideration.

All that said, thinking about your scenario more, it reminds me of the way in which the pre-2008 Fed targeted a positive fed funds rate without paying interest on excess reserves. Although in that case the volume of transactions taking place at the fed funds rate was enormous, and the OMO transactions required to adjust the excess reserve were frequent, the relevant net money supply effect (measured as the change in excess reserves) was usually quite small, spot or cumulative. So the net quantity effect under consideration was minimal. That’s roughly similar to the effect of assuming no transactions are required at all. And that's interesting because there was definitely a very large element of this kind of anticipatory thinking rather than a transactional requirement for a larger quantity change at those times when the Fed actually changed the target rate for Fed funds.

The omnipresent Chuck Norris.

[Nick Edmonds]

JKH,

"Those are actual transactions of interest bearing money..."

Funnily enough, I don't really think of it that way. I think in terms of payments which take place during the day and interest that accrues overnight. So the only thing that bears interest is the overnight balance. People make payments with the aim of achieving a particular end of day balance. (In this case the end of day balance always turns out to be zero.)

In my model, overnight money balances carry no interest, so instead people plan to hold overnight balances in bonds. But again the actual balance held turns out to be zero.

I don't think anything rests on this - I just find it helpful to see it this way.

"I can readily see how the interest rate affects the velocity of that money..."

I'm really not keen on the idea of velocity anyway, but surely it has no meaning at all here.

On pre-2008 Fed policy, yes, this is exactly like that. And, of course, the Fed Funds rate should be very close to what the overnight bond rate would be, and in the absence of frictions should theoretically be exactly the same.

[JKH]

I can't imagine how monetarism has any relevance without considering velocity at least in the background.

What always surprises me about monetarism is the absence of reference to it in the foreground.

[Too Much Fed]

Nick E., let's start this model at zero.

Every entity has a zero checking account balance.

Next, some entity takes its checking account balance to -100 and spends.

Assume no OMO.

What happens?

[Jussi]

Really inspiring post and discussion, thanks.

The part I'm not getting is how velocity of money enters into the picture. Especially as the high correlation between interest rate and velocity is empirically high.

Given what Nick E. and JKH wrote:

Does it matter what yield the central bank controls in the model? Could be yield of any financial instrument, money, bonds, equity, etc that encourages excess saving or consumption? If the rate is too high people will save too much, if too low they will consume too much? Does this twist even need a medium of exchange in the model? So it would be about peoples preferences on consuming / saving vis-a-vis yield set by the central bank.

[JKH]

I interpreted velocity based on a concept of positive money that was separable from an equal amount of negative money - e.g. as in a daylight overdraft that creates positive money balances, but which settles back to net zero at the end of the day.

That's pretty operational. Maybe the model reduces to continuous time balancing and equivalence of overdrafts and positive money such that the idea of positive or negative money or overdrafts just disappears.

[JKH]

Question:

If continuous time balancing makes positive and negative money disappear, does that reduce to a barter system?

[Frank Restly]

Jussi,

"The part I'm not getting is how velocity of money enters into the picture. Especially as the high correlation between interest rate and velocity is empirically high."

1. For every lender that wants to lend at a high interest rate, there must be a borrower who is willing to borrow at that high interest rate. The central bank can presumably set an interest rate administratively high enough that it can't find borrowers at that rate - hence, too high an interest rate can choke off the demand for credit / negative balances. - Velocity slows

2. The central bank can administratively set an interest rate more quickly than individual firms can adjust prices (sticky prices). In this case, the central bank tries to maintain a real interest rate by adjusting it's nominal interest rate very quickly. In the extreme case, firms go bankrupt and can no longer service their debts / negative balances. - Velocity slows

3. Tax deductibility of interest payments allows a central bank to set a nominal interest rate, hit a real interest rate target, and not choke off credit demand. - Velocity rises with increased nominal rate as long as after tax real rate is stable.

[Frank Restly]

Jussi,

Example. You receive $50,000 in income a year and pay a 30% tax rate on that income. You also have a $100,000 floating rate loan you are currently servicing at 5% nominal simple interest.

Total Income: $50,000
Interest Expense: $5,000
Taxable Income: $45,000
Taxes: $13,500 (30% of $45,000)

Compare this with no interest expense
Total Income: $50,000
Taxable Income: $50,000
Taxes: $15,000 (30% of $50,000)

And so while you are paying 5% ($5000 / $100000) nominal interest, you are paying 3.5% ($5000 - $1500 / $100000) after tax interest.

Suppose the inflation rate is 3.5%. You are paying 0% after tax real interest even though the central bank is maintaining a 1.5% real interest rate.

[Jussi]

Frank, I meant that once some money, lets say $1 is created (to counter overdraft), it can circulate in the economy, between the agents, so fast (high velocity) that it exhaust all the trades that are worthwhile making, the very same that exists in a barter economy. What matters is VM and not M alone. So this model assumes something about the velocity, what is it and why, is unclear to me.

[Jussi]

"If continuous time balancing makes positive and negative money disappear, does that reduce to a barter system?"

I guess that is another smiling cat then, does continuous balancing mean infinite velocity and thus the same trades will be made as in a barter system?

[Frank Restly]

Jussi,

Okay I think I understand your question.

Liquidity preference - is it positively correlated, negatively correlated, or uncorrelated to nominal interest rate? If uncorrelated, what assumptions are made about it?

Low liquidity preference = low demand for money = high demand for goods = high velocity
High liquidity preference = high demand for money = low demand for goods = low velocity.

[Too Much Fed]

It appears the way Nick has written this that an overdraft creates negative money but not positive money.

Is that right?

[Nick Rowe]

Jussi on velocity, and

JKH: "If continuous time balancing makes positive and negative money disappear, does that reduce to a barter system?"

I would say "no". What is happening is that velocity goes to infinity, in the limit, as clearing delays disappear, and as people become more and more similar.

We have to remember that assuming identical agents is only a modelling device, to make solving the math simpler. If agents were different, so did not spend exactly the same amounts at exactly the same time, and did not spend it exactly equally on goods produced by all other agents, we would not see the stock of money go to zero, even with instant clearing.

I think we would need to define velocity as PY/(Sum of red+green money) = PY/"Gross money"

Another way to think of it (I don't know if this works): it's sorta like where you write a cheque for $100 on an account with a $0 balance, because you know that your $100 pay will hit your account at the exact moment your account is debited.

[Too Much Fed]

Frank said: "For instance:

Me: $100 Overdraft (Liability), $100 Cash (Asset)
Central Bank: $100 Overdraft (Asset), $100 Cash (Liability)"

Frank, it looks like you have a negative balance there (liability) and positive money.

Is that right?

[Antti Jokinen]

I see that "Too Much Fed" is rightly trying to clear some confusion here, but without success. If someone thinks that overdrafts are somehow special in that they represent "negative money", whereas (traditional) "bank loans" don't, then that someone is badly confused. "Bank loans" and other "private bonds" (ie, not publicly traded) are not different from overdrafts in any relevant way -- they are just different ways to do the accounting. The end result is the same. I tried to "prove" this in this comment: http://worthwhile.typepad.com/worthwhile_canadian_initi/2016/09/cheshire-cats-and-new-keynesian-central-banks.html?cid=6a00d83451688169e201bb093aa5b2970d#comment-6a00d83451688169e201bb093aa5b2970d

What causes the confusion is no doubt our arbitrary choice to not look at the net of "loan account" and "checking account" when talking about "bank loans" (the moment of repayment, etc), whereas in the case of overdrafts we do so; we are forced to, because we only see the net position.

Too Much Fed is right when he suggests that a negative overdraft balance is a positive "bond" balance.

Btw, Nick R, did you ignore my comments above because a) they were too lengthy, b) you didn't understand what I tried to say, or c) you think I'm a crank? By answering truthfully, you save both of our time :-)

[Antti Jokinen]

I wrote: "Too Much Fed is right when he suggests that a negative overdraft balance is a positive "bond" balance."

To clarify this: There are perpetual (ie, no explicit maturity date) bonds and there are overdrafts where the expiry/maturity date is explicit. So maturity is no decisive factor here.

[Nick Rowe]

Antti: you are a bit cranky, but no more cranky than me!

Sometimes I don't reply to comments simply because I think I don't have anything useful to say. We seem to me to be repeating ourselves, and not getting anywhere.

Some IOUs are money, but not all IOUs are money (media of exchange). My loan account is not money; my chequing account is money. That is true whether they are in positive or negative balance.

[Antti Jokinen]

Good to hear, Nick! :-)

You say: "My loan account is not money; my chequing account is money. That is true whether they are in positive or negative balance."

This is where we don't agree. By a bookkeeping convention, we often use separate accounts for (a) items where the balance is usually a debit balance, and (b) items where the balance is usually a credit balance. Your loan account falls into category (a) and your checking account falls into category (b). Accordingly, we present accounts with a debit balance on the LHS of the balance sheet and accounts with credit balance on the RHS. Right? (I use 'debit' and 'credit' instead of 'negative' and 'positive' to avoid Too Much Fed's language of "positive bond balance" and "negative overdraft balance" -- both are debit balances.)

It shouldn't be mentally difficult to see a checking account with a credit balance on the RHS of the balance sheet and a checking account with a debit balance on the LHS. When the balance changes from debit to credit, or vice versa, the account "jumps" from the LHS to the RHS, or vice versa. The name of the account is irrelevant here. The important thing is the message the balance conveys. About this message there is no doubt: a debit balance (on checking account) tells us that the account holder is in debt and a credit balance tells us the account holder has claims/credits.

Did you look at my mapping of an overdraft and a traditional bank loan? It shows that this is about a choice regarding accounting technique and contractual design. In a logical sense, there is nothing that holds us from replicating a bank loan in the form of an overdraft. Amortizations/repayments once a month? Fine. Let's write a contract that says the overdraft limit is to be reduced monthly by a given amount. If in this way we can convert, one-to-one, a traditional bank loan into an overdraft, then there is no good reason to say that the other debit balance (checking account) is "negative money" and the other one (loan account) isn't. Both either are or are not. I'm inclined to say they are not, because both are records of debt and we are used to call claims/credits "money".

What I'm saying implies, of course, that we are mistaken when we say in the case of the traditional bank loan that I re-pay my debt when my checking account is debited and loan account credited, while saying that I re-pay my debt when my checking account with a debit balance (overdraft) is credited. In both cases, we are only *recording* that a debt previously recorded in the ledger (of this particular accountant/scribe/bank) is diminished. No real debt repayments take place by accounting entries. There is no debt owed to the bank or by the bank -- the bank is just *recording* the debts and credits of others (it has, of course, other roles too). Before we argue about this, I'd like to point out that this just seems to be the outcome when this line of thought is taken to its logical conclusions. In other words, this is the only way I was able to make sense of the system as a whole, when I tried to build a coherent model where the "monetary side" is tightly linked to, or part of, the "real economy".

Still not getting anywhere? I'm happy to elaborate.

[Too Much Fed]

“Some IOUs are money, but not all IOUs are money (media of exchange).”

I’d rather say bonds than IOU’s, but OK.

“My loan account is not money”

OK.

“my chequing account is money. That is true whether they are in positive or negative balance.”

That is more of a yes and no.

Checking accounts contain demand deposits (certain bonds of the commercial banks). The demand deposits are positive money.

Let’s assume some entity #1 has $1,000 in demand deposits in its checking account. Also assume it has been approved for an “overdraft”. That entity #1 wants to spend $2,000 to buy something. The seller banks at the same bank. The buyer writes a check for $2,000 in demand deposits. What happens is another $1,000 in demand deposits is put into the checking account and $1,000 in a “bond” is put in the loan account. The $2,000 in demand deposits then moves to the seller.

Next, assume the entity #1 with the “overdraft” wants to sell something. Entity #2 does not have any demand deposits (or currency). The buyer does not qualify for a loan/”overdraft”.

Here is not what happens. The seller (entity #1) sends the overdraft liability and good to the buyer (entity #2). People can see that if the entity #2 defaults. The bank will hold entity #1 liable. Entity #1 says I sent the liability to entity #2. Bank says you need our permission (the asset holder’s permission) to do that. You did not. Entity #1 is liable. What really happens is that entity #2 sold a bond (debt) to entity #1 in exchange for the good and then defaulted on it. Entity #2’s default can cause entity #1 to default to the bank.

If the bank gives permission to entity #2, then there is a second “overdraft”/loan for demand deposits that pays for the good, and entity #1 uses the demand deposits to pay off its “overdraft”/loan. That was assumed to not happen.

It looks to me like a negative checking account balance does not mean negative money. It looks to me like a negative checking account balance means bonds are put into the loan account at the bank.

[Antti Jokinen]

Too Much Fed: I think we agree. You are suggesting that we could view an overdraft as a traditional bank loan ("bonds" put into loan account), whereas I would rather interpret a bank loan as an overdraft (one account instead of a separate loan account).

I would like to suggest something that might clarify your thinking (it clarified mine, but it took time):

You use some metaphors that are, in the end, misleading. There are no deposits that are put into checking accounts and moved between those accounts. Neither are there bonds that are put into loan accounts. I'm sure we can agree on these non-existences, even if we don't agree that these metaphors are misleading?

What happens in reality is pure arithmetics (OK, some "physics" is needed, but that is mainly on the part of the accountant). Credit and debit entries are made on accounts, and these entries change the account balances. You might not see any point in abandoning the more concrete metaphors, which allow you to see money flowing between account(holder)s and this flow constituting what we are used to call a "payment" -- am I right? If so, I understand. At this point, all I can prove is that in reality those flows don't exist, there is no money moving from one account to another, and -- now comes the important part -- thus we must be able to build a (realistic) model where there are no such "money flows". The problem is: how to make sense of that kind of model? I'm not (yet) a professional scientist, just an accountant, but I assume we need a theory to make sense of that new model. Right?

Do you see an alternative way to describe the (accounting) phenomenon, without using the metaphors you -- like all of us -- are used to use?

[Antti Jokinen]

Nick R: Brian Romanchuk pointed me to the symmetry between a positive and a negative balance (on a checking account) that you seem to base your argument on -- the overdraft being payable on demand. Is this right? Below I copy (partly, with modifications) my answer to Brian here: http://www.bondeconomics.com/2016/09/macro-musings.html?showComment=1475784577551#c2522819753688556888

-------------------

Even if we assumed the overdraft is payable on demand, there is an (inherent) asymmetry here.

I think we should adopt the holder's perspective here. The holder of positive money can always find goods (incl. services, incl. labor) to buy, and thus redeem all his "credits" at will. But the holder of negative money is not always able to sell goods, and thus he cannot repay his debt at will.

There is no symmetry, right? There should always be some notice period, and even if there isn't, nothing guarantees that the repayment/closing of the overdraft doesn't take months, even years after the bank has demanded it (and possibly the bank loses nothing as a consequence -- only gains in interest and fees). We need to look at the actual outcome. A demand is one thing; whether I can comply with the demand or not is wholly another.

[Too Much Fed]

"There are no deposits that are put into checking accounts and moved between those accounts. Neither are there bonds that are put into loan accounts. I'm sure we can agree on these non-existences, even if we don't agree that these metaphors are misleading?"

I doubt if we can agree on those.

It seems to me that demand deposits actually exist. There is an electronic component to them.

It seems to me bonds exist. There is an electronic component to them.

One of the things crediting and debiting shows is the movement of things.

I have $2,000 in my checking account (my asset). Someone else has a mower (other person's asset).

I buy the mower for $1,000 using a check. There is an asset swap. I get the mower (it moves to me and becomes my asset). The other person gets the demand deposits (they move to the other person and become the other person's asset).

The debiting and crediting shows the movement.

[Antti Jokinen]

I understand this is something quite hard to get your head around. Let me try to explain. (I have pursued this line of thought for two years, pretty much 24/7, so I hope you could think it possible there might be something to it...)

Generally, the purpose of accounting is to record something that takes place outside the accounts/books. The accounts can never be the primary phenomenon. An example of warehouse accounting:

I credit the account of Warehouse B and debit the account of Warehouse A, both for the amount of "100 parcels", because 100 parcels were, in reality, moved from B to A. It makes sense to look at the account entries and talk about parcels having been moved from B to A.

In bank accounting, nothing outside the books moves (well, goods move from the seller to the buyer, but nothing moves the other way). We only have the accounting and its entries, and the important question is: what are we recording here? Many say that "funds" or "money" move, and those movements are recorded by credit and debit entries. But it's those entries that we view as "flow of funds/money". What I'm saying is that we are free to interpret the entries, and the accounting, in a different way, because in reality there is nothing moving between the accounts (like there wasn't anything moving between the account of Warehouse A and Warehouse B, but only between the actual warehouses).

Of course I can't make you see things my way, before I have shown how to make sense of the world seen from this perspective, where there is no money on accounts or moving between accounts. Let me try this way: Can you see "green stones" moving between accounts in the following example I gave Nick further above:

------------------------------

You're probably familiar with the story about two elderly gentlemen who use a stone they've painted green (a "counter") to record which one of them owes a dinner to the other? (I know it from Ostroy & Starr: "The Transactions Role of Money".) This stone moves from the dinner guest ("buyer") to the one who made the dinner ("seller") that evening. The stone is needed to "pay" for the dinner. If, instead of this "counter", they kept records on paper or on a computer, then the these records would have nothing to do with recording any moves -- other than the "movement" of a dinner from the "seller" to the "buyer".

---------------------------------------

? If money is a "counter", like the green stone in the story, then there is no need to see counters moving between accounts when the accounts are established. The accounting makes the counters redundant. One night, after a dinner, the two gentlemen decide that they will create a ledger with two accounts, one for each gentleman, A and B. The one who held the green stone (because he had prepared the dinner that night), A, will get his account credited with "one dinner" and B will get his account debited with "one dinner". The following day, they look at the ledger and find out that B owes a dinner to A (previously they knew this because A was holding the stone/counter). So B prepares a dinner for A, and B's account is credited and A's account is debited. The account entries were not made because they wanted to record that something (a counter) moved from A to B, but because they wanted to record that B had prepared a dinner to A (a dinner had "moved" from B to A), and thus A was expected to prepare the dinner the following day.

What if "money" is, or was, a counter, just like the stone in the story? Then there wouldn't be any money on our bank accounts or moving between the accounts. Then nothing would move from a buyer to a seller, but only the other way. It would be a world without money, but not without the financial system. I've been studying that world for quite some time now, and I find it an interesting place. Things make actually more sense there than they used to make in a world with money.

[Too Much Fed]

"I credit the account of Warehouse B and debit the account of Warehouse A, both for the amount of "100 parcels", because 100 parcels were, in reality, moved from B to A. It makes sense to look at the account entries and talk about parcels having been moved from B to A.

In bank accounting, nothing outside the books moves (well, goods move from the seller to the buyer, but nothing moves the other way)."

I told you we would not be able to agree.

Let's say $1,000 in demand deposits were moved from checking account A to checking account B (just like the parcels). Wouldn't the accounting be the same as the parcels?

[Antti Jokinen]

No. The "demand deposits" on the account do not exist outside your mind (the implicit model you use to interpret the accounting phenomena in question).

What exists outside your mind is the account and the (initial) balance on it; credit and debit entries which will change the balance of the individual account exist, too. This is arithmetics. You make a credit entry on one account and a debit entry on another account. The balances of both of these individual accounts change, but nothing moves between the accounts. It's somewhat similar to "spooky action at a distance" (from physics): one account balance is increased and another balance is decreased by exactly the same amount, without anything moving between the two accounts.

Will we ever be able to agree?

[Too Much Fed]

"No. The "demand deposits" on the account do not exist outside your mind (the implicit model you use to interpret the accounting phenomena in question)."

Yes, they do exist. Bonds exist. Demand deposits are a certain type of bond from the commercial bank.

No, we can't agree on this.

I suppose that currency does not exist either.

[Antti Jokinen]

We can talk about a certain bond. We cannot talk about a certain "demand deposit". Schumpeter once wrote: "Because in the account-settling system a deposit element disappears with each act of payment and a new item, just as large, is created, it makes no sense to speak of ‘the same’ deposit element just ‘changing hands’." (Treatise on Money, p. 247)

If Bond #23354676, with certain characteristics, changes its owner/holder, it's much like the parcels moving between warehouses. But there is no "demand deposit" #25965733 which could change its owner. There is the checking account of person A and the checking account of person B, and credit and debit entries are made on these accounts, which leads to new balances on the accounts. Nothing moves between the accounts.

Currency (note #5356783xx) exists, but is is secondary; ie. it refers to the central bank ledger/accounting (which is primary). On the central bank accounts, there is no currency. Nothing moves between those accounts, either. (Something all "e-currency"/"blockchain" enthusiasts should, as a starting point, understand.)

Could you try to explain in what form you see "demand deposits" existing? Smart people have told me that there are some "IOUs" on the accounts in electronic format, and these move between the accounts. But they've been unable to prove this. To prove this, would be to prove that if I credit an account on physical ledger page 3 and debit an account on ledger page 4, there were some "particles" that moved from the account on page 4 to the account on page 3.

[Too Much Fed]

"If Bond #23354676, with certain characteristics, changes its owner/holder, it's much like the parcels moving between warehouses."

So bonds exist and the asset holder of the bond can change?

[Antti Jokinen]

Yes.

"Demand deposits" also exist in the sense that we are used to call a positive/credit balance on a checking account (in a bank ledger) by that name. But unlike in the case of bonds, we cannot identify a certain "demand deposit" that can change its holder. If you have a demand deposit and you buy something (your account is debited), we can conclude that you don't have (a portion of) the demand deposit (the name we have given a credit balance on a checking account) anymore. But that doesn't mean that someone else has it. As Schumpeter explained, it's not like a certain deposit element 'changes hands'. This is of course clearest in the case of the seller having a negative/debit balance on his checking account before your purchase, in which case your demand deposit disappears and no new demand deposit (of the same value) appears on any other account.

This might sound like more or less useless "philosophizing"? But like I said, this allows us to interpret the system in a way where we don't have anything moving from the buyer to the seller. That leads to another conclusion (there are no money flows), and so on (one cannot really pay with money), and so on, and suddenly we have model of the economy which seems to be describing a different world than the one we are living in, but is actually just another model of the same world.

[Too Much Fed]

Let's go over the bond case.

For some reason I accept a PEP 7-day bond as payment for goods (the PEP bond is a medium of exchange for me).

There is an asset swap. That means the asset holder changes for both the goods and the bond, like the parcels?

[Oliver]

@ TMF
You accepting the bond as payment does not mean the bond becomes a means of final payment, which is the implicit definition of money behind Antti's agrument, imo.

Quoting Augusto Graziani (1990):

(...) If, for instance, goods are traded against promises of payment such as bills of exchange, any act of trade gives rise to a debt of the buyer and to a credit of the seller. A similar economy is not a monetary economy, but a credit economy. If in a credit economy at the end of the period some agents still owe money to other ones, a final payment is needed, which means
that no money has been used. If, on the other hand, final payments were continually postponed and replaced by new promises, buyers would enjoy an unlimited privilege of seignorage. Money is therefore something different from a regular commodity and something more than a mere promise of payment.

In order for money to exist, three basic conditions must be met:

a) money has to be a token cutrency (otherwise it would give rise
to barter and not to monetary exchanges);
b) money has to be accepted as a means of final settlement of the
transaction (otherwise it would be credit and not money);
c) money must not grant privileges of seignorage to any agent
making a payment.

The only way to satisfy those three conditions is to have payments
made by means of promises of a third agent, the typical third agent being nowadays a bank. When an agent makes a payment by means of a cheque, he satisfies his partner by the promise of the bank to pay the amount due. Once the payment is made, no debt and credit relationships are left between the two agents. But one of them is now a creditor of the bank, while the second is a debtor of the same bank.
This insures that, although making final payments by means of paper money, agents are not granted any kind of privilege. For this to be true, any monetary payment must therefore be a triangular transaction involving at least three agents, the payer, the payee and the bank (Schmitt; 1975,
p.14 ; Schmitt and Cencini, 1982, p.139; Cencini 1984, p.31; Parguez, 1985b). Real money is therefore credit money. Even a metallic coin is credit money : as Keynes once said, a rupee is a "note printed on silver" (Keynes, 1913, eh. m, p. 26).

And to tie that in with Antti's argument again, the bank side of the triangular transaction merely consists of recording the real transaction taking place between the two agents, not of actually moving or swapping anything. Simultaneously the tie between the two agents is severed in the sense of making payment between them final. That is achieved by guaranteing that its own liabliities can be used to settle debtor's debt to itself, thus closing the credit circuit.

The paradox of circuit theory is that for money to be money and not merely credit nor a commodity, it must be able to disappear from the system.

[Antti Jokinen]

Oliver said: "Simultaneously the tie between the two agents is severed in the sense of making payment between them final."

Isn't this also the case in TMF's example of using PEP (PepsiCo?) bond?

I like "circuit theory", but I'm not in full agreement with it. I don't consider "money" a final means of payment. For me, only goods (incl. services, incl. labor) are final means of payment. We can call them "money" if you like. My world is a world of "perfected barter" (Jevons' expression), where credit and debt play an important role. If you're familiar with monetary economics, there has always been problems with making a clear distinction between a "monetary economy" and a "barter economy". If the "monetary economy" was, after all, a "barter economy" (with credit), that would explain why it has been impossible to distinguish between them (I overlook attempts that I consider failed, like models with a cash-in-advance constraint, following Clower).

Too Much Fed: Yes, the asset holder changes for both assets. (Especially from a macroeconomic perspective, it is important to keep in mind that the bond is a financial asset, and it is a claim on those funny little records in a bank's ledger -- records which cannot 'change hands' by moving between accounts.

[Antti Jokinen]

Oliver said: "the bank side of the triangular transaction merely consists of recording the real transaction taking place between the two agents, not of actually moving or swapping anything... That is achieved by guaranteing that its own liabliities can be used to settle debtor's debt to itself, thus closing the credit circuit."

What you say here is very interesting. Let's consider a case where the seller of a good (agreed price: $100) has a debit/negative balance ($100) on her checking account. The bank (accountant) records the real transaction by crediting the seller's account with $100. The resulting balance is zero. The seller's debt can be considered settled. Now, did the seller use the bank's liabilities to settle her debt to the bank? No, she didn't, because she never received (as you said, nothing is moved or swapped) any "bank's liabilities".

If what I argue is correct (let's consider it is, for argument's sake...), how should we make sense of this situation ("the big picture")? One possibility would be to conclude, that the debtor was never in debt to the bank itself. That the bank, acting as an accountant/scribe, only had recorded her debt to the "system"/"society" and she settled that debt (priced at $100) by delivering a good priced at $100 to another member of the "system"/"society". Once she had sold the good, the bank updated the records to reflect the real situation: she had no debts to, or claims against, the "system" (zero balance).

All this becomes more complicated in world with multiple "accountants"/ledgers, so I'd suggest we stay for now in a world of "One Bank" (Wicksell) or "Monopoly Banking" (Black, 1970). One way to picture that world is to imagine that we all have (overdraft) accounts at the central bank and no other banks exist. The overdraft limits are often generous, but they do exist. The central bank could use some local agents (without dangerous incentives tied to the amount of credit extended) to decide on the limits of individuals.

[Too Much Fed]

"Yes, the asset holder changes for both assets."

OK with the PEP bond.

This is also true if I accepted a bank bond that is not a demand deposit instead of the PEP bond?

[Antti Jokinen]

True.

[Too Much Fed]

OK with PEP bond. OK with the bank bond.

This is also true (moves like parcels/asset holder changes) if I accepted currency instead of the PEP bond or a bank bond that is not a demand deposit?

[Antti Jokinen]

If by currency you mean physical currency (or physical cash), then yes. These are "counters". We can point to a thing that actually changes hands.

[Oliver]

One possibility would be to conclude, that the debtor was never in debt to the bank itself.

One could say that the bank is the fiduciary of the debtor's real debt to society. But I don't think it matters which words one uses because in this view the real and the financial sides are inseparable by design. There is always a quadruple entry in the books at the instant of transaction.

[Antti Jokinen]

Oliver, what do you mean by your last sentence?

I'm not sure if we can call the bank a "fiduciary of the debtor's real debt to society". It of course depends what you mean by it exactly. I would like something more concrete. Why not say that the bank is just an accountant who owes no one and is owed to by no one (when talking about the sums on its ledger)? As some of those sums on its ledger are something we are used to call "money", then it is obvious that what is owed cannot be "money". But it can be measured in an abstract unit of account, as in "I owe you goods priced at $100".

[Too Much Fed]

OK with PEP bond. OK with the bank bond. OK with currency.

One common theme with these are that the liability(ies) side stays the same (don't move, don't change), right?

[Antti Jokinen]

Yes. That's an important observation. There are many people willing to take someone else's place on the receiving end, but very few people who'd like to take someone else's place on the "giving end".

[Antti Jokinen]

Although I have to note, that while in the case of bonds there is a liability to have the holder's account in a bank ledger credited (for the stated amount), in the case of currency this liability is not as clear. But we do know that if you hand over currency to a commercial bank, the bank does credit your account in its ledger. And if a commercial bank hands over currency to the central bank, the central bank credits the commercial bank's account on its ledger. The latter case is special because by holding central bank notes the bank, or an individual, already holds a "credit balance" (Currency in circulation) in the central bank ledger. This "credit balance" isn't, of course, a balance on an individual account.

[Too Much Fed]

Now with all those, let's assume the buyer and seller bank at the same bank.

The transaction is for 1,000 parcels at $1 each.

The seller accepts demand deposits.

The buyer gets 1,000 parcels (asset swap/asset holder changes)

The seller gets $1,000 in demand deposits (asset swap/asset holder changes).

The liability part of the demand deposit stays the same (at the same bank). There is no demand deposit disappears and is recreated when the two bank at the same bank.

[Too Much Fed]

Also, a demand deposit should be considered a type of bond of the commercial bank.

[Too Much Fed]

What to consider when talking about "things".

Whose liability it is (if any), whose asset it is, and where the "thing" is stored.

[Oliver]

Why not say that the bank is just an accountant who owes no one and is owed to by no one.

Because that isn't true. Who takes the loss if the debtor doesn't pay up? The payee's stake in total output remains unchanged because he received a final payment. The bank, however has to write down an asset and so loses a stake in future output. Banking is a for profit / risky business and must be modeled as such. Only under that assumption are its liabilities worth more than simple IOUs between debtors and creditors and can function as an anonymous money thing.

Continuing my quote form the same paper:

Since in a monetary economy money payments go necessarily through a third agent, the third agent being one that specialises in the activity of producing means of payment (in modem times a bank), banks and firms must be considered as two
distinct kinds of agents! Firms are present in the market as sellers or buyers of commodities and make recourse to banks in order to perform their payments; banks on the other hand produce means of payment, and act as clearing houses among firms. In any model of a monetary economy, banks and firms cannot be aggregated into one single sector.

[Antti Jokinen]

Oliver said: "Who takes the loss if the debtor doesn't pay up?"

Exactly. The one who takes the loss recides, so to speak, on the RHS of the bank balance sheet.* There are different tranches, and the riskiest tranche is held by those who we are used to call "shareholders". We should never mistake a company for its shareholders. Do a Google search on the phrase "Who owns a company?" and you get an FT article by John Kay and a BoE paper by Andy Haldane. Those are a good place to start.

* To complicate things, I need to add that authorities are often willing -- ex post -- to put the taxpayers on the RHS of the bank balance sheet, should the losses (both realized and expected) be so large that they threaten to hurt the holders of the most senior "tranches" (these are often 80-90 % of total balance sheet). So it is very hard to say, ex ante, who will take the loss. The empirical evidence from 2008 is valuable when trying to predict this.

[Antti Jokinen]

Too Much Fed: I missed something. It seems to me you made an unexplained jump from bonds and currency to "demand deposits". The buyer's account balance before the transaction could have easily been zero. No asset. After the transaction, the balance is minus $1,000. No asset. After the transaction the seller's account balance might be negative or zero(no asset), or it might be positive (an asset).

If I'm not mistaken, Nick Rowe came up with "green money" and "red money" to make sense of what is going on in the example above. Clever, but in my opinion confused thinking.

[Antti Jokinen]

To continue from what I said above: "by holding central bank notes the bank, or an individual, already holds a "credit balance" (Currency in circulation) in the central bank ledger. This "credit balance" isn't, of course, a balance on an individual account"

This is of course also true in the case of the bank bond. It's a credit balance in the bank's ledger. And if we widen the perspective, the PEP bond is a credit balance in PepsiCo's ledger (RHS of its balance sheet). So you see, we always come back to "pure accounting", whether we are using "counters" or not. A certain credit balance (bond) means that the issuer owes you another credit balance, or more precisely, a credit entry on your account in a bank ledger. If we call certain credit balances "money", then we have a problem here, because what is owed is not a credit balance per se, but a credit *entry* (on an account) -- and that entry might never show up as a credit balance on that account (it might just make a debit balance smaller). (It might be that this is related to Quantum Economics?)

Anyway, the real question is: What purpose does the bank accounting (where we see "money") serve? What is owed is clearly not "money", because this "money" is just a part of the accounting itself. It cannot be that we are keeping records (accounting) of accounting entries owed.