Interest Rates and Money Growth; Two Types of Central Bank

I want to imagine two different types of central bank. The first type of central bank cuts nominal interest rates to increase money growth. The second type of central bank raises nominal interest rates to increase money growth. In both cases the increase in money growth causes Aggregate Demand to start growing, and eventually causes the inflation rate to rise. But the initial change in interest rates is the opposite in the two cases.

Here is a simple example of the first type of central bank. It issues currency which pays the holder 0% nominal interest. It sets a rate of interest at which it will freely lend that currency to all (safe) borrowers. If it wants to increase money growth, it cuts that rate of interest, so people borrow more currency from the central bank.

Here is a simple example of the second type of central bank. It issues demand deposits (chequing accounts) which pay a rate of interest set by the central bank. The stock of money in those chequing accounts grows at that rate of interest, so if it wants to increase money growth it raises that rate of interest.

Eventually, of course, the first type of central bank will need to raise nominal interest rates, above where they were initially, to match the higher inflation rate, to restore real interest rates to where they were initially, to prevent money growth and inflation spiralling ever-upwards. (The second type of central bank doesn't need to worry abut that.) So they end up in the same place eventually. But the way they get there is very different.

I think that most macroeconomists have something like my simple example of the first type of central bank at the back of their minds. I am unsure what Neo-Fisherians have at the back of their minds, but if it were something like my simple example of the second type of central bank, that would make sense of what they say.

Simple New Keynesian models assume the central bank sets a rate of interest, but are silent on money growth. Or, if they do add a money demand equation, this extra equation has no effect on the rest of the model. Which means that New Keynesian models are ambiguous between an orthodox and Neo-Fisherian interpretation.

Real world central banks are more complicated than either of my two simple examples, but contain elements of both.

The lesson I want you to draw from this post is that thinking of central banks setting a rate of interest and that rate of interest affecting desired investment and desired saving is a very inadequate way of thinking about monetary policy. A better way to think about monetary policy is to think of central banks setting a rate of interest in order to influence money growth. The exact mechanism by which central banks use an administered interest rate to influence money growth can vary, and even the direction of that effect can vary too. The rate of interest set by the central bank matters because, and only because: it affects money growth; it may affect the spread between the interest rate paid on money (if any) and the interest rate (or yield) of other assets, because the velocity of circulation of money will be a positive function of that spread. MV=PT.

Comments

[Roger Sparks]

If I am understanding your second bank correctly, it only increases the money supply by paying interest on deposits. In other words, this bank creates money to pay interest. This would be a very stable money supply with a very predictable rate of increase. There would be no forthcoming increase in money supply based on the amount of loans made.

I understand that both banks would be increasing the money supply over time. However, the recipients of the increase in money supply would represent two very different economic groups. The second bank would reward those who already have money. The first bank would reward those who had ideas and the ability to sell the idea, thus qualifying for a loan.

Thanks for the thought-provoking post after a long silent period.

[Nick Rowe]

Thanks Roger! My first post in 10 weeks. Retirement leaves me busier than I thought it would.

You understand the second bank correctly. That's what I had in mind.

[Jacques René Giguère]

Given my obsession with taxonomy, what kind of recession /end of recession would be linked to each kind of CB? Which would be preferable to fight each kind? Which would be preferable to provoke a recession if it is one’s wont?
I think I know the answers but I am still an humble IO guy and you’re the master here...

[JKH]

(This post rings a bell from something you’ve written before.)

I’ve not thought long or hard enough about the neo-Fisherian interpretation, but I think it has something to do with a consolidated central bank/Treasury profile, where the net interest paid on a funding profile (base money and total Treasury debt) plays an important asymmetric role – compared to the normal matched asset-liability arrangements for both deconsolidated central banks and normal commercial banks that produce typically positive net interest margin spreads. (I think MMT has some sort of quasi-subliminal theme along the same lines, but I haven’t put my finger on that either.)

However all banks - whether (deconsolidated) central or commercial - on their own generate a (typically positive) net interest margin consisting of the spread between interest received on assets and interest paid on liabilities. (Again, central banks engineer their balance sheets to produce a matched asset-liability position by holding debt (often Treasury debt) as assets with corresponding interest income.) And that margin gets swept into the equity position (including the case of central bank capital), net of other expenses.

In fact, a positive net interest margin in banking in the aggregate increases equity and reduces the money supply. It’s a net flow from one category to the other. What is credited as money as a result of interest paid by the bank is debited and more from the same category of money accounts as interest earned by the bank. If the spread is positive, equity increases and money supply contracts. A negative margin does the opposite.

In the normal case of positive spreads, that means that the system must rely on the creation of new money by lending in order to prevent equity accumulation from draining the money supply indefinitely.

I think your post in effect compresses this sort of consolidated CB/TR net liability profile into a similar type of profile for the central bank on its own – i.e. it implicitly assumes an absence of central bank assets with interest income to offset the interest that is being paid on deposits. That becomes the case similar to the consolidated base money/debt case, where "consolidated equity" shrinks but where bonds are issued instead of money supply increasing.

“A better way to think about monetary policy is to think of central banks setting a rate of interest in order to influence money growth.”

Maybe, but if so I think it’s mostly because of the intended effect of interest rates on commercial bank lending and money creation.

[Ralph Musgrave]

Re Nick's claim that real world central banks have elements of the 2nd type of central bank, that depends crucially on how the interest paid to depositors at the central bank is funded. If the money for that interest is simply produced from thin air by central banks, as Nick suggests, than that would be an odd thing to do because the effect of that money creation is stimulatory: the opposite of what the CB is trying to achieve by raising interest rates!

Alternatively if the money comes from taxpayers (i.e. the CB cuts the amount of profit it remits to the Treausry at the end of the year) so as to fund the interest, that would be more likely to achieve the desired effect: deflation.

So how is interest on reserves funded? Anyone know? Perhaps its different in different countries.

[Nick Rowe]

Jacques Rene: I'm not sure. I would need a more completely specified model to figure out the differences between the recessions if they cut money growth. My brain's not up to it this morning.

JKH: this post should ring a couple of bells from old posts. I think I've done posts on each of the two types of central banks, but this post puts both together, to compare and contrast.

"In fact, a positive net interest margin in banking in the aggregate increases equity and reduces the money supply."
You lost me there. Doesn't it depend on what else we are holding constant?

"I think your post in effect compresses this sort of consolidated CB/TR net liability profile into a similar type of profile for the central bank on its own – i.e. it implicitly assumes an absence of central bank assets with interest income to offset the interest that is being paid on deposits."

I think I would put it this way: which of the two types of central bank we have, and their decisions to grow the money stock, will have implications for the stream of profits they generate and give to the government.

"Maybe, but if so I think it’s mostly because of the intended effect of interest rates on commercial bank lending and money creation."

I'm not sure about the "mostly", since commercial banks are beta followers of the alpha central bank. (You can think of this post as implicitly consolidating the commercial and central banks, precisely to duck that harder question.)

Ralph: with an independent central bank, it is the central bank's actions that help fund the government, rather than vice versa. That's how I'm thinking of it here.

[JKH]

“You lost me there. Doesn't it depend on what else we are holding constant?”

Quite right. Also, I think it’s more nuanced for central banking.

In the commercial banking case, considering the system as a whole, the net interest margin earned by the banks is paid for by deposit accounts – at the margin, so to speak. Borrowers pay more than the banks pay to depositors. The net effect at the margin is a flow from deposits to equity. Lots of other stuff affecting the balance sheet as well, of course - including for example payment of dividends that recycle book equity back to deposits.

In the central banking case, I missed some nuances. If the deconsolidated central bank balance sheet holds government bonds, then the net interest margin is generated by receiving interest payments from Treasury and paying interest (0 or otherwise) to reserve accounts and 0 interest on currency. That generally results in an increase in central bank capital though positive profit, which generally gets remitted to Treasury, which gives it back the money it paid for interest on the bonds held by Treasury less any interest expense on reserves. On a consolidated basis, the net expense effect of such a balance sheet is the interest that may be paid on reserves, which is a consolidated expense to Treasury – which generally gets funded with bonds.

At the end of the day, the central bank generally controls the quantity of reserve balances through a number of means – whatever interest is paid on reserves. (Currency is another thing.)

I seem to recall you referencing “thickets” of institutional detail in some of these conversations over the past. One point I’d like to make is that even in the simplest of models that may be used to make a particular point, there must be at least implicit assumptions about institutional arrangements - with corresponding accounting logic in response to those assumptions.

[George]

https://neweconomics.org/2013/07/strategic-quantitative-easing

"...Central bank support for national infrastructure investment has worked before. The Industrial Development Bank of Canada, which supported Canadian SMEs from 1946 – 1972, was capitalised entirely by the Central Bank with not a single penny of taxpayers’ money required. In New Zealand in 1936, the central bank extended credit for the building of new homes, helping the country out of the Great Depression..."

[Nick Rowe]

George: you are off-topic. No more.
But read this old post: https://worthwhile.typepad.com/worthwhile_canadian_initi/2015/08/interest-free-loans-from-the-central-bank-to-the-government.html

[Ralph Musgrave]

Nick, Thanks for informing me about "how you were thinking about it". In contrast, my above question was about how the real world actually works, which is surely more important.

[Scott Sumner]

Good post. See if the following correctly describes your views:

1. If "money" is defined as M1 or M2, then the rate of interest matters in only one way, it affects the money supply growth rate.

2. If "money" is defined as the base, then the rate of interest matters in two ways. It can affect the supply of money (open market operations) or it can affect the demand for money (IOR).

[JKH]

Ralph Musgrave

“So how is interest on reserves funded? Anyone know? Perhaps it’s different in different countries.”

I have a real world answer to that question – at least in the case of the Fed and the Bank of Canada, and probably for most central banks.

Simplified example:

1) CB receives interest of 100 on government Treasury bonds it holds as assets
CB pays IOR of 20
(assume away other kinds of revenue and expense to make it simple)
CB profit = 100 – 20 = 80.

2) Treasury receives 80 CB profit as a remittance to its account at the CB and pays 100 on the bonds
Treasury account at the CB declines by net 20
CB meanwhile has credited IOR of 20 to bank reserve accounts
So the size of the CB balance sheet is unchanged - just a shift of 20 in liabilities from Treasury to reserve accounts

3) Treasury either taxes 20 or issues 20 in bonds
Treasury account at the CB increases by 20
CB debits bank reserve accounts by 20 to settle the bonds
(this happens whether payments to settle taxes/bonds come from the banks on their own account or on customer account)

So … its back to the starting configuration
The increase in reserves due to IOR has been reversed
Reserve and Treasury accounts at the CB are as they were at the start
IOR in effect has been funded by taxes or Treasury bonds

The key point is that there is nothing special about the payment of interest on reserves as a source of money creation – in the sense that a central bank has ultimate control over the quantity of bank reserves it desires to supply to the banks. Portraying IOR as a distinct case of money creation is somewhat artificial in the real world context, given the CB's ultimate control over the quantity of reserves and a variety of techniques it has in doing so (including open market operations, as well as "off-market" transfers of funds between Treasury accounts held at the CB and the commercial banks with corresponding bank reserve effects as intended)

[Nick Rowe]

Scott: I think that's at least roughly right. And it's exactly right if M1 and M2 pay a rate of interest that responds 1 for 1 with the rate of interest set by the central bank (they probably won't do that exactly).

[Nick Rowe]

Hang on. I don't think my above tweet is right. Because lots of spreads between interest on M1 and M2 and other assets will probably change when the CB changes r.
It's early, and I'm not fully awake yet.

[Jacob]

For bank #2, wouldn't higher interest on central bank demand deposits make "real" investment less attractive, lowering V? What am I missing?

[JP Koning]

"I think that most macroeconomists have something like my simple example of the first type of central bank at the back of their minds. "

Yep, I don't think I've ever heard a central banker say, "well, there's an excess demand for settlement balances, so we're going to raise the interest rate in order to get you those balances."

[Ilya Novak]

Has there ever been a central bank that tried to manage nominal variables (price level, inflation rates, exchange rates, NGDP, etc.) using the monetary base, as opposed to the using the monetary aggregate or interest rates?

[steve from virginia (@econundertow)]

" If it wants to increase money growth, it (Bank #1) cuts that rate of interest, so people borrow more currency from the central bank."

Central banks cannot increase money b/c they are collateral constrained and cannot make unsecured loans. Low interest rates might encourage finance/commercial bank lending but then again, maybe not. Interest paid by the central bank is first-order unsecured but in a zero-rate environment there is little interest. If interest rates are high enough they affect the solvency of central bank itself (as the central bank is making unsecured loans to depositors).

Put another way is: what is the marginal interest rate, above which the solvency of the central bank becomes an issue.

There is also the question whether central banks have any remit over interest rates outside usual policy boundaries (< one year duration). That the remit does not exist seems obvious, as all of us during the last 10 years have watched central banks being careful to front-run bond markets.

For the banks to be seen as ineffective would cost them whatever meager amounts of credibility they possess.

As for the 2d type of central bank; "It issues demand deposits (chequing accounts) which pay a rate of interest set by the central bank. The stock of money in those chequing accounts grows at that rate of interest, so if it wants to increase money growth it raises that rate of interest."

The gross increase of credit is from finance lending to itself, from agent to agent to agent in a spiral fashion, the whole mess amplified with derivatives, forex 'plays', swaps and loans to tycoons (by way of margin on shares of tycoons' firms). The size of internal finance flows dwarfs deposits held hostage to derivatives books so that government rather than the central bank is forced to become 'lender (and borrower) of last resort'.

The affect is the shriveling of the central bank, leaving it little to do other than lend against government securities (preemptive bailout of commercial banks) and fiddle w/ Phillip's Curves and Taylor Rules and shuffle around the office furniture.

[Nick Rowe]

Jacob: there are two offsetting effects on V: the higher nominal interest rate paid on money; the higher expected inflation rate. In a simple model those 2 effects would cancel out, leaving the real return on holding money, and V, unchanged.

JP: I think that's right.

Ilya: I wish my memory were better. The German Bundesbank (pre ECB), IIRC, used base control. Think there are others.

[James Peach]

Ralph: interest on reserve balances are created from thin air.

Nick: I still don’t understand how CB 2 would increase inflation. Yes - base money would increase at the rate paid on reserves but the rate paid on reserves would act as a floor on market interest rates. Market interest rates are what matter for broad money growth and spending decisions, not the quantity of base money (see Q.E)

[Nick Rowe]

James: Maybe market interest rates are *not* what matters for broad money growth and spending decisions? Maybe it's the stock of money, and interest rate *differentials*?

[Matt Young]

The third type of central bank, the currency bank.

The third type of central bank simply sells loans against deposits like a market maker. This central banker 'makes' the market whenever loans deviate from deposits beyond some bounds. In this bank, the money growth is determined by the central bank losses and gains as it 'makes' the market.

The market making function can be predetermined to release currency losses at a specific rate, or let currency losses and gain accumulate by market determination.

The third type of bank is called a currency bank, as opposed to a central bank. The difference is legal, in a central bank the right to coin means there is a risk of Congressional override on the market loss function. The override probability leaves a wedge in central banking, everyone know with that wedge, the central bank always cycles.

Thus the central bank becomes synchronous with business cycles and eventually blows up when the new generation refuses to carry the market function of the old generation. The currency leak of the central bank is the continual build up of federal insurance to protect voters against the market making function, mostly in the natural inflation adjustments done by law.

[James Peach]

Nick: Please can you explain your point further, I’m not sure I follow. My decision to borrow money is not determined by the difference between the risk free rate and the lending rate, it is determined by whether rate the market is above or below my subjective discount rate.

[James Peach]

Nick: I think I follow that the stock of broad money is influenced by both the growth rate in new loans and the interest rate differential between lending and deposits/other liabilities. Where does the stock of broad money come in to it?

[Jussi]

Peach,

We can measure P and T, so we know the product of M and V. After that you are on your own, it is anyone's guess how to define M.