Could monetary policy have caused the recent rise in levels of debt?
The obvious answer is that loose monetary policy lowers interest rates, which causes people to want to borrow and spend more, and so go deeper into debt. That answer is both obvious and wrong, as I explained in a previous post. Low interest rates make people want to borrow more, but they won't be able actually to borrow more unless someone wants to lend more. There is both a demand and a supply curve of debt.
A fall in the price of apples causes an increase in quantity demanded, and a decrease in quantity supplied. There are only two cases in which a fall in the price of apples will "cause" (or be associated with) an increase in the quantity of apples traded (bought and sold): first, if the price of apples was originally stuck above equilibrium, so there was excess supply; second, if there were an increase in supply (shift in the supply curve) that caused both a fall in price and an increase in quantity traded.
It's the same with debt. The "obvious" explanation ignores the supply of loans.
Now a number of commenters on my previous post argued that I was wrong, because I had ignored the supply of money. An increased supply of money (from central or commercial banks) could create the increased supply of lending needed to explain the rise in both lending and borrowing, and hence the rise in debt. This is my promised answer to those commenters.
Basically, I am still right. Introducing money into the picture does not fundamentally change what I wrote in that previous post. (Oh, it feels so good to go out on a limb!)
Let's start with a very simple model.
The world consists of 100 identical individuals, each of whom grows and consumes apples. If they really are identical, there is no motive for debt, trade, or money. Each one consumes his own apples. It is true that at a low interest rate, each individual would want to borrow apples so he could consume more than he grows. But since all are identical, there would be nobody willing to lend apples. At a higher interest rate, each individual would want to lend apples, but nobody would want to borrow. So there cannot be any debt. (And at the equilibrium interest rate, where the supply of lending equals the demand for borrowing, nobody will want either to lend or borrow.)
The primary reason for debt, like the primary reason for all exchange (and debt is just a paper record of intertemporal exchange), is differences between people. Some people want to buy; others want to sell. Some want to borrow and spend; others want to lend and save.
We can easily modify the simple model to introduce a motive for debt. Just drop the assumption that everyone is identical. Suppose half the people grow green apples, and half the people grow red apples. Red and green apples taste the same, but red apples grow well in even years, and green apples grow well in odd years.
Friedman taught us that consumption depends on permanent income. We save in good years when transitory income is positive, and dissave in bad years when transitory income is negative. So the green growers borrow apples from the red growers in even years, and reds borrow apples from greens in odd years. We now have debt in the model.
We need to change the model some more to introduce a motive for monetary exchange, rather than barter.
Suppose there are many different varieties of apple (half red and half green), and each person specialises in producing just one variety, but likes to consume all varieties. And apples must be consumed at the point of production (I can't think of a good story why, but never mind). So people sell their apples for money, then take that money and go shopping for other apples.
The money (a medium of exchange) could be bits of paper, or shells, or whatever. Suppose there is initially a fixed quantity of shells in circulation, and everyone has the same amount. So people only differ in terms of red/green and variety of apple. Suppose in equilibrium the price of an apple is one shell.
We now have both money and debt in the model. It is time to ask what happens to the level of debt when we increase the supply of money.
A. Assume the total supply of money doubles, and that new supply of money is shared equally between all individuals. So individuals are still identical (except for red/green and apple variety). Every individual happens to discover an extra cache of 10 monetary shells. Seeing this as a transitory increase in wealth, each person will want to save nearly all of those extra shells — say 9 shells. Suppose it's an even year (good for red apples, bad for green apples). At the initial interest rate and price of apples, the reds want to lend an extra 9 shells, and the greens want to borrow 9 fewer shells. So there's an excess supply of loans of 9 shells per person.
One of 3 things can happen, depending on our assumptions about price and interest rate flexibility:
A1. Both price and interest rate flexible. Standard neutrality of money result. The price level doubles, and the rate of interest stays the same. With the real quantity of money back to its original level, the real supply and demand for loans also returns to its original level, so real debt is unchanged.
[A1'. If we changed the model so that debt would last for more than 1 year, and also assumed that debt was denominated in shells, rather than apples (non-indexed debt), then the real value of existing debt would fall in half as the price level doubled.]
A2. Price level fixed and interest rate flexible. (Standard "Keynesian" assumption). The initial excess supply of money cannot be equilibrated by a rise in the price level. So the excess supply of loans causes the rate of interest to fall. (The real rate falls, but the nominal rate will rise if people expect flexible prices next year.) The fall in the rate of interest increases the stock demand for money, reduces the quantity of loans supplied by reds, and increases the quantity of loans demanded by greens, until we get to a new equilibrium. If we assume the reds and green have exactly the same marginal propensities to consume out of transitory income, and exactly the same interest-elasticity of demand for consumption, the new equilibrium will have exactly the same quantity of borrowing/lending, and so exactly the same level of debt, as the old equilibrium. The supply and demand curves for loans shift in opposite directions by the same amount when money supply and/or income changes, but having the same elasticities the new intersection will lie directly beneath the old intersection. Debt stays the same.
[There will be an excess demand for apples and excess supply of money at the existing price level, and this can only be eliminated by production and consumption of apples increasing. And this can only happen if we make the standard New-Keynesian assumption of imperfect competition, which makes sense if each variety of apple is grown by only one person, so that price is above marginal cost, and each producer is demand-constrained. As output and income expands, and the rate of interest falls, the demand for money increases until demand equals supply of money. This is consistent with the standard ISLM story.]
A3. Both price level and interest rate fixed. The excess supply of money, and excess supply of loans, cannot be eliminated. (This is the standard "monetary overhang" case of centrally-planned economies, like Cuba.) The reds' supply curve of loans shifts right, but the greens' demand curve for loans shifts left. Since the "short side" of the market determines quantity traded, the quantity of lending/borrowing falls. Debt falls.
[If we assume imperfect competition in the market for apples, production may increase, as people spend their excess money, being unable to lend it. This may eliminate the excess supply of money/excess demand for apples, but will probably reduce the demand for loans further still, if the increase in production and income is seen as transitory.]
So, an increased supply of money will either cause debt to stay the same, or else fall, depending on our exact assumptions. The only way to get it to increase would be to take assumption A2, then rig the assumptions so that reds and greens have different marginal propensities to consume and/or interest elasticities. And rig the assumptions the right way too.
I know what the objection will be: "But you assumed everybody found equal amounts of the new money! It doesn't happen like that!"
OK. Let's assume it's an even year (good year for red apples), and that the greens find the new money. Whooops! That won't work. The greens are the borrowers in even years, and if they find the new money they won't need to borrow as much, so debt will fall. Let's try it the other way round.
Suppose it's an even year, and the reds (the lenders) find the new money. Taking each of the 3 cases about price and interest rate flexibility in turn:
B1. Both flexible. The price level (roughly) doubles, and the rate of interest stays (roughly) the same. (I say "roughly" because the distribution of wealth has changed, and this might affect aggregate demand for money and aggregate savings if the behavioural functions are non-linear.) At the new equilibrium, the reds are richer and the greens poorer. It is exactly as if there were a one-time transfer of wealth from greens to reds. Since it's a shock to transitory income, we will see the reds wanting to lend more and the greens wanting to borrow more. Both the supply and demand curves for loans shift right. YES! Finally we get a case where borrowing/lending and debt increase!
B2. Keynesian case. Fixed price and flexible interest rate. Interest rate falls and output increases. The result is just like A2, plus a one-time transfer of wealth from red lenders to green borrowers. In A2 debt stayed the same, but the additional wealth transfer will cause an additional rightward shift of both supply and demand curves for loans. Debt increases for essentially the same reason as in B1.
B3. Both price and interest rate fixed. Supply curve of loans by reds shifts right, but demand curve for loans by greens stays the same. Since the "short side" of the market determines quantity traded, and greens are the short side, the quantity of debt will stay the same. BUT, if the interest rate were initially fixed (by law?) below the equilibrium level, so there was an initial excess demand for loans, and the red lenders were on the short side of the market, then an increased supply of loans would increase quantity of loans, and debt.
So, if the new money is found by borrowers, it reduces existing differences between borrowers and lenders, and debt will tend to fall. If the new money is found by lenders, it increases existing differences between borrowers and lenders, and debt will tend to rise. Which assumption makes more sense?
Well, central banks are the ones who "find" the new money in the real world. And they are lenders, right? So if central banks increase the supply of money, and lend it out, debt will increase, right?
Wrong. Central banks are owned by governments, and governments are borrowers. It's governments who get the wealth transfer (via increased seigniorage profits) from central banks when they print more money. And central banks' assets consist (or did until very recently) almost exclusively of government bonds(/bills). That's what they buy with the freshly-printed money.
So in the real world it's the greens, not the reds, who find the new money. And they use it to buy back some of their outstanding debt.
An increase in base (outside/high-powered) money reduces debt, specifically government debt.
And now to introduce fractional-reserve commercial banking into the model…
On second thoughts, this post is far too long already. That will have to wait for a third post on this theme.
Worthwhile Canadian Initiative 
“Low interest rates make people want to borrow more, but they won’t be able actually to borrow more unless someone wants to lend more. There is both a demand and a supply curve of debt.”
I agree. Good posts. That’s it.
By the way, I’ve been rereading “The Methodology of Positive Economics”, and I find it more to my liking than in the past.We’ve talked about this essay in the past. My main reason for reading “Essays in Positive Economics” is that, like Samuel Brittan, I’m a big fan of the essay “A Monetary and Fiscal Framework for Economic Stability”. I’m trying to fit it into my current views.
Nick: The CB lowers the equilibrium by changing the supply schedule of loanable funds.
Thats it. Your entire discussion seems specious. You keep treating the lower-rate as deus ex machina and asking why debt increases. That’s wrong. It excludes the explanation from the beginning. Which is that the CB changes the supply curve by offering to supply money at a cost below the natural equilibrium rate.
It does not matter that the CB then purchases already issued government debt. Its willingness to do so at a rate below the equilibrium alters the supply schedule.
So we get more loans at a lower cost.
Thanks Don: Would you describe Friedman’s “positivism” as really prgmatism? Or instrumentalism?
Jon: That sounded plausible to me too. But the model says otherwise.
The model says that if a lender prints money, it shifts the supply curve of loans to the right. But if a borrower prints money, it shifts the demand curve for loans to the left. Fewer loans, at lower cost.
That’s in the short run (fixed prices).
In the long run, with flexible prices, the demand for money shifts as well as the supply of money.
Well, I’ll reserve comment until you discuss fractional (or zero, since that’s what we have in Canada) reserve banking, but I’m puzzled why, if central bank money printing goes to pay off government debt, the money printing in the U.S. shows up as giant stockpiles of bank reserves while government debt explodes upwards.
Declan: In the last few months (but not during the last few years when debt was rising) it has no longer been true that nearly all central bank lending was to governments. And government debt has been rising because of fiscal expansion, plus the loss in tax revenue due to recession.
IIRC though, high-powered (base) money (the stuff created by central banks) is only about 5% of GDP in Canada (and about 10% in the US, though maybe half of that is held abroad?). And since High-powered money rises at roughly the same rate as nominal GDP, central banks printing money is just not that a big deal anyway, in terms of its effect on debt/GDP ratios, in either direction (Zimbabwes aside).
Yes, fractional reserve banking may be a much bigger part of the debt story.
What this is showing to me though is that we just have to think through these questions in terms of a model. Even if the “model” is just a story, without any maths, like my story above. It’s the only way we can check on the overall consistency of the explanation, respecting adding-up constraints, and avoiding fallacies of composition. It’s the discipline of general (dis?)equilibrium theorising.
Define money.
Define currency.
“Well, central banks are the ones who “find” the new money in the real world. And they are lenders, right? So if central banks increase the supply of money, and lend it out, debt will increase, right?
Wrong. Central banks are owned by governments, and governments are borrowers. It’s governments who get the wealth transfer (via increased seigniorage profits) from central banks when they print more money. And central banks’ assets consist (or did until very recently) almost exclusively of government bonds(/bills). That’s what they buy with the freshly-printed money.
So in the real world it’s the greens, not the reds, who find the new money. And they use it to buy back some of their outstanding debt.
An increase in base (outside/high-powered) money reduces debt, specifically government debt.”
1) I don’t think the fed is owned by the federal gov’t. I thought it was private.
2) It is more likely that central banks/central bankers/investment bankers own the federal gov’t.
3) I think we need some more definitions here and consider the difference between CURRCIR and bank reserves.
4) I’d like a better explanation of that paragraph that begins with “Wrong. Central banks …”
Assume one world bank that is a monopoly with a 0% or near 0% reserve requirement and a 0% or near 0% capital requirement. Also assume full recourse loans (no default and I think that is the correct terminology) and no bankruptcy.
Would this entity be able to produce UNLIMITED debt?
Who is willing to continue to lend?
According to Brad Setser’s posts/blog, recently it has been central bankers.
Is debt being concentrated in fewer and fewer entities?
Nick,
Isn’t this explained by the usual supply/demand curves? The way a CB lowers the interest rate is by increasing the supply of loanable funds, making more base money available.
If we take this to say that the lower price of loanable funds (lower interest rate) came about from a shift in the supply curve for loans with a fixed demand curve for loans then it means that we have moved along the demand curve. In the usual diagram if you move along a demand curve to a point with a lower price then that point will have a higher quantity.
Why is that not enough?
Adam:
Yes, it is sort of explainable by supply and demand curves for loanable funds. But since the CB is owned by the government, which is (normally, in the stock if not always the flow sense) a demander of loanable funds, I would say CB lowers the interest rate by reducing the demand for loanable funds. (I wouldn’t have looked at it that way until I worked out the little model in this post).
Most people look only at the demand curve for loans, and how it is affected by a change in the rate of interest. This is clearly wrong. We need to look at both supply and demand curves. As you recognise.
But is this even enough? The aggregate quantity of borrowing and lending is a macro variable. And any change in monetary policy has macro repercussions on P, Y, as well as r. And these changes in P and Y (and other things) will generally shift the demand and supply curves for borrowing.
In short, we can only handle questions like this properly in a fully general equilibrium (or disequilibrium) model. Partial equilibrium analysis with demand and supply curves just doesn’t cut it.
One of the benefits (to me) of writing the above posts (and being forced to write them by comments on my previous post) is that it has forced me to recognise and articulate this point about partial vs general equilibrium.
God, the discipline of economics is beautiful. It’s the (implicit) discipline that doesn’t let us get away with just BSing about “low interest rates cause debt”. “Where’s your model?” demands the discipline.
Too much Fed:
I must write a post on “Who owns the Fed?”. Thanks for giving me the idea!
“Who is willing to continue to lend? According to Brad Setser’s posts/blog, recently it has been central bankers. Is debt being concentrated in fewer and fewer entities?”
Yes, recently (last few months) it has been central banks. But has this changed the total quantity of debt, or just changed the composition of debt in public hands? CBs have been selling govt debt and buying private debt. I don’t think this leads to any greater concentration of ownership. More a change in who owns which type of debt.
“Assume one world bank that is a monopoly with a 0% or near 0% reserve requirement and a 0% or near 0% capital requirement. Also assume full recourse loans (no default and I think that is the correct terminology) and no bankruptcy.Would this entity be able to produce UNLIMITED debt?”
No. Wait for my post on fractional reserve banking. (Adam: see what I mean about partial vs general equilibrium analysis?)
“Define money. Define currency.”
In the context of this model, “money” means “medium of exchange”. In a monetary exchange economy, with n goods (including money), there are only n-1 markets, with one good being traded in every market. That good is the “medium of exchange”, and is what I mean by “money”.
In the context of this model, I am using the words “currency”, “base money”, “high-powered money”, “outside money” synomynously (damn, can’t spell it). Money which is not the liability of anyone, because the “promise to pay” is a meaningless promise. It can’t be redeemed on demand for anything. So it’s not debt in any useful sense. That’s why I prefer to think of it as shells. Paper money is like that today. In a full-bore gold standard world, where the paper currency really is redeemable on demand in gold, it’s different.
Inside money, like what’s in your chequing account, is different, and is debt (in some meaningful sense). That’s for my third post. (God, when will I redeem all these promises to post?)
Nick,
(God, when will I redeem all these promises to post?)
it’s just another small addition to net debt.
Nick, I’ve kind of danced around this issue but you got right to the heart of it in the very first paragragh.
BTW, I read a few comments and some people indicated that the Fed increased the supply of loanable funds when they lowered interest rates. That may be true, but it doens’t explain why interest rates fall.
1. Even if gold is used as money, a new discover of gold will reduce interest rates. But in that case there was no increase in the supply of loanable funds.
2. The increase in the supply of loanable funds from open market purchases is so tiny (often a few billion dollars or even less, even in a 14 trillion dollar economy like the US), that it could not possibly be responsible for the drop in interest rates, and the macroeconomic effects that flow from the lower rates. Instead, rates fall because nominal prices are sticky. That makes the nominal demand for money sticky at the original rate of interest. So when the supply of money rises, if prices can’t immediately rise then interest rates fall. This raises aggregate demand. The higher level of aggregate demand may lead to more debt, it obviously depends on many factors. But you are right that the lower rates by themselves don’t lead to more debt. When rates fall because the economy is weak (like right now) the real amount of debt does not typically increase. On the other hand debt often does rise when AD is very strong, but that is often a period of high interest rates.
“Yes, recently (last few months) it has been central banks. But has this changed the total quantity of debt, or just changed the composition of debt in public hands?”
Actually, I believe it was sooner than that.
From:
http://blogs.cfr.org/setser/2009/04/06/charting-financial-de-globalization-private-capital-flows-are-falling-faster-trade-flows/
“Two other critical points are obscured in a graph showing gross flows, but show up clearly in a plot that shows net private capital flows (inflows – outflows) against the trade balance (with the sign inverted, so a rise in deficit shows up as a large absolute number)”
graph
“First, the rise in the trade deficit — and rise in US imports relative to GDP — in the last eight years didn’t correspond with a rise in net private demand for US financial assets. That makes the expansion of the US deficit from 2002 to 2006 quite different from the expansion of the deficit in the early 1980s — or the expansion in the late 1990s. Official inflows made it possible for the US to sustain the rise in imports that was associated with the housing boom; had those flows not been around, interest rates would have had to rise to attract private flows — and the housing boom couldn’t have gotten so large. The excesses in the US financial sector and housing market simply were not, in aggregate, financed by strong private demand for US assets abroad.
Second, somehow the collapse of capital flows in the fourth quarter of 2008 produced a larger net inflow into the US than the surge in demand for US assets associated with the dot.com bubble. That, put simply, is why the dollar rallied in the crisis. Americans withdrew funds from the rest of the world faster than foreigners withdrew funds from the US.”
And, “* A large share of private purchases of Treasuries from mid 07 to mid 08 will be reattributed to the official sector when the data is revised. And some “private” purchases in 05 and 08 likely came from the Gulf’s central banks, especially SAMA (which may make use of private fund managers for a portion of its Treasury portfolio).”
Banks don’t care about the level of interest rates per se when they lend. They care about spreads. Spreads result from maturity and liquidity transformation – i.e. loans versus deposits.
Good post.
So perhaps the greatest quantity of lending/borrowing overall occurs not at the zero percent lower bound, but somewhere greater than zero? (Like every other market under the sun.)
Could it be that to increase lending in the current environment, interest rates should be raised?
And why the neglect of the supply side anyway? Its a bit like a stoke victim suffering from neglect of half their visual field, except that in this case its half of a Marshallian cross. Or perhaps it’s just wishful thinking as to the efficacy of interest rate manipulation on economic activity that’s to blame.
The central bank determines the domestic short term risk free rate.
It’s got nothing to do with “loanable funds” theory.
Scott Sumner said: “BTW, I read a few comments and some people indicated that the Fed increased the supply of loanable funds when they lowered interest rates. That may be true, but it doens’t explain why interest rates fall.”
How about because of a productivity shock and/or cheap labor shock that lowers wage inflation and/or price inflation?
“In the context of this model, “money” means “medium of exchange”. In a monetary exchange economy, with n goods (including money), there are only n-1 markets, with one good being traded in every market. That good is the “medium of exchange”, and is what I mean by “money”.
In the context of this model, I am using the words “currency”, “base money”, “high-powered money”, “outside money” synomynously (damn, can’t spell it). Money which is not the liability of anyone, because the “promise to pay” is a meaningless promise. It can’t be redeemed on demand for anything. So it’s not debt in any useful sense. That’s why I prefer to think of it as shells. Paper money is like that today. In a full-bore gold standard world, where the paper currency really is redeemable on demand in gold, it’s different.”
Can we go with these terms to be clear?
Money as a medium of exchange. OK
Currency, bank reserves, and debt. OK
“base money”, “high-powered money”, “outside money”. NO! I especially don’t like base money because some people might confuse it with monetary base (currency plus bank reserves).
If money is a medium of exchange, aren’t currency and debt demoninated in that currency fungible? Example: I buy a $15,000 car with $1,000 of currency and $14,000 of debt denominated in that currency.
In your apples example, I believe you need to add a corporation that earns corporate profits and workers who earn wage income.
IMO, the workers are borrowing based on current wage income/future wage income and not on apple production. Your example also gives the impression that the debt is paid off in apples (apple denominated debt). I doubt if you meant that. Isn’t the debt denominated in currency and not apples?
“No. Wait for my post on fractional reserve banking. (Adam: see what I mean about partial vs general equilibrium analysis?)”
Are you a neoclassical economist?
anon said: “Banks don’t care about the level of interest rates per se when they lend. They care about spreads.”
Yes!
In your models, I believe you need to include the possibility that “someone” will attempt to use “cheap” debt to speculate in financial assets and produce asset bubbles if interest rates are low.
“second, if there were an increase in supply (shift in the supply curve) that caused both a fall in price and an increase in quantity traded.”
If the fed is targeting the price, could they use debt (future demand) to shift the demand curve so that prices did NOT fall and there was in increase in both quantity demanded and quantity supplied (assuming I have my terms correct)?
Pictures:
So we don’t get into the usual, I think I should add to my last post.
The rich have enough wage income to buy as many apples as they want without currency denominated debt. The rest would buy more apples but don’t have enough wage income and don’t want more currency denominated debt because they have enough currency denominated debt with current interest rates to ?barely? make the interest payments that the fed has kept high enough so they don’t compete with the rich over apples. Once more apples become available, the fed lowers interest rates to entice the rest to go into more currency denominated debt (more currency denominated debt but the same monthly payment) to buy more apples instead of allowing more wage income for the rest.
You forgot to include “in a closed economy” in your model.
Of course in a open economy where debt is securitized and sold all over the world to nations with trade surpluses, evaluating supply and demand gets much more complicated.
Al: Agreed. It was implicit.
General equilibrium theorising can really only ever be closed economy. Open economies, small open economy models in particular, are really just a version of partial equilibrium theorising. But, AFAIK, the rise in debt has been a global phenomenon, not confined to any one country, so a global analysis seems appropriate. The world is a closed economy.
Too much Fed:
Just a few points.
Being poor, in the sense of having a lower permanent income, needn’t mean you save a lower proportion of your income, let alone negative amounts. I don’t think the rich countries now have a lower propensity to save than they did in previous decades, when they were poorer.
I can’t think of any way the Fed could shift both the supply and demand curves of loanable funds to the right, except perhaps by making everyone permanently richer.
Every economist (including me), with the exception of a few of the more antediluvian Marxists, is a neoclassical economist, in broad perspective.
There is nothing weird about debt being denominated in apples. There probably are apples futures contracts, which are just IOUs for apples, and debt is just an IOU. Indexed bonds (called TIPS in the US?) are the exact analogy to apple bonds in my model. But an IOU for money is normally more convenient, for most people.
“base money” = “monetary base”. Just two ways of saying the same thing.
Trade credit (when you get a car loan from the dealer) is a way to postpone paying with money, rather than avoid paying with money. But how you finance the payment for the car may affect your demand for money.
Introducing corporations into the model would make little difference. A corporation is like an apple growers’ cooperative, except they pool their capital rather than their land or labour.
“Being poor, in the sense of having a lower permanent income, needn’t mean you save a lower proportion of your income, let alone negative amounts.”
I am going to put wage income in place of income in the two places.
Someone makes $20,000 per year and needs to spend it all in the first year. In the second year, this person’s price inflation is 4% and gets a raise of 2%. To maintain the same standard of living, this person needs to borrow and/or sell financial assets.
And, “I don’t think the rich countries now have a lower propensity to save than they did in previous decades, when they were poorer.”
I believe that the savings rate in the USA has fallen from about 10% to 12% in the early 1980’s to a negative savings rate around 2006 or 2007. I don’t believe that savings rate takes into account wealth/income inequality that has increased since the early 1980’s.
“I can’t think of any way the Fed could shift both the supply and demand curves of loanable funds to the right, except perhaps by making everyone permanently richer.”
Hmm… I am thinking I did not explain that correctly then.
Regular supply demand curve for apples; excess supply of loanable funds which is limited on the demand side by the interest rate and proper underwriting.
Supply curve shifts for apples (both a fall in price and an increase in quantity traded). Fed lowers interest rates which allows for more debt (there is plenty of supply of loanable funds). The rest buy more apples with currency denominated debt (future demand) assuming current wage income or increasing wage income in the future. Does that shift the demand curve?
If so, both the demand and supply curves for APPLES shift (I think to the right).
Sound better?
“There is nothing weird about debt being denominated in apples.”
I thought gov’ts made debts payable in currency?
“In the context of this model, I am using the words “currency”, “base money”, “high-powered money”, “outside money” synomynously (damn, can’t spell it).”
And, “base money” = “monetary base”. Just two ways of saying the same thing.”
By my definitions and I think the fed’s too, no way! Currency plus bank reserves equals monetary base. IMO, base money should not be used because of too much confusion.
“Trade credit (when you get a car loan from the dealer) is a way to postpone paying with money, rather than avoid paying with money. But how you finance the payment for the car may affect your demand for money.”
How about changing money to currency those 3 times?
Trade credit??? Trade credit sounds like debt to me?
“Introducing corporations into the model would make little difference. A corporation is like an apple growers’ cooperative, except they pool their capital rather than their land or labour.”
I think it could make a big difference. The gov’t allows policies to oversupply the labor market. Workers have borrowed in currency denominated debt against current wage income/future wage income. The corporation can now cut wage income to increase corporate profits. Now, the workers can’t make the payments on the currency denominated debt.
Nick:
Perhaps I mentioned this before, but monetary policy impacts the price level, and the price level impacts nominal debt. The vast levels of nominal debt has been caused by monetary policy. If the quantity of money hadn’t increased, nominal debt would have been much lower.
Of course, this doesn’t explain high ratios of debt to to GDP.
Now, seriously….
I think your political economy is steering you wrong. Base money doesn’t create new lending because it is issued by the government which is a debtor.
First of all, suppose the monetary authority only buys private debt? Say, it follows the real bills doctrine? Or maybe there is no national debt or budget deficit because the goverment is run by libertarian fiscal conservatives? How does it work then?
Anyway, I think that even under the status quo, where the monetary authority buys government bonds, this creates an increase in the supply of credit. The way to see this is to think about what those who sold the goverment bonds (or those who would have bought bonds from the government) do with the money. If they purchase private bonds, then that is an increase in the supply of credit to the private market. (Crowding out has been avoided.) This is matched on private balance sheets by the newly issued base money. This could be currency held by the public or reserve balances of banks at the monetary authority. This is lending of a sort (which you are failing to see, again because of political economy reasons.) Anyway, that additional lending to the monetary authority is not necessarily voluntary. And there you go, the increase in the supply of debt matches the excess supply of base money. (And the same thing can be true of banks issuing debt instruments that can be used of money.)
Bill Woolsey said: “This could be currency held by the public or reserve balances of banks at the monetary authority.”
What happens if the fed CHOOSES to spike bank reserves but NOT currency? What are they trying to accomplish?
I disagree. Open Market Purchases are large compared to MZM. Therefore they are significant determinates of present supply. People are not in the market to borrow assets generally. They are in the market to borrow something generally fungible, i.e., money.
Jon: what is ‘MZM’?
Bill: I have been thinking about your 7.46.
First, agreed, its is not surprising if nominal debt rises in proportion to nominal GDP, and monetary policy can influence nominal GDP. But we are trying to explain why debt seems to have increased relative to GDP.
Suppose we had a net creditor government, running a budget surplus. (It both owns private debt, and buys more each year). If the government then prints more money, and buys even more private debt, it will be increasing the demand for that debt still further (increasing the supply of loans to the private sector still further), and (assuming fixed price level) increase the total amount of debt, as interest rates fall and the private sector borrows more in response. So debt increases when money growth increases in this case.
Government is then like the red apple growers finding more shells.
I guess that didn’t really make sense. What I was really thinking was about is more in tune with excess reserves. Excess reserves and vault cash determine the supply of bank loanable funds at a given moment. OMO are large in comparison.
Long-rates must be risk-adjust averages of short-rates. Therefore, the OMO purchases do control the interest-rate across the yield curve.
MZM: money with zero maturity. M2 less time deposits, plus all money market funds.
Jon, any thoughts about these two articles.
http://seekingalpha.com/article/155367-fed-exit-strategy-another-bank-handout?source=article_lb_articles
http://www.marketskeptics.com/2009/03/us-banks-operate-without-reserve.html
The section on “deposit reclassification” is dead-on. Banks are not subject to reserve requirements in a meaningful way. … There is a pattern in the global housing bubble that relates to which countries suspended reserve requirements when. The US effectively suspended reserve requirements in the mid 90s–many other hold-outs followed suit once the US validated the idea.
The primary limitations on banks are 1) cleaning balances and 2) capital requirements. Clearing balances now so low–along with the reserve ratio–that the difference between zero and the present value is not relevant. Remember: the money multiplier is 1/reserve ratio. We’ve already done from a 10x to a 100x constraint.
That business about vault cash struck me as irrelevant.
The business about raising reserve requirements to defeat the excess of liquidity is a valid point. That it hasn’t been mentioned as a potential fall-back to dampen fears of disorder reveals a real intellectual rot at the Fed.
The trouble is that among the intelligentsia like Paul Krugman, there is a general ignorance as to the current reserve-requirements and history of what happened when. Krugman doesn’t even understand how the Fed conducts OMOs. He’s repeated the incendiary rumor that ‘conventional policy’ only involves TBill transactions. This is false.
The rot in economics is not just about theory; its about lacking basic knowledge of the facts.
A tangent: I like M.Carney’s intention to deviate from inflation targetting and prioritize bubble-targetting.
Previously I’d only considered if the Gini becomes gross enough to be inefficient, a wise banker could give rich people the middle finger here. But Mark’s idea might work for real estate bubbles, if we blew $100B on Iraq, maybe if 1993 bankruptcy became a real possibility (no will to raise taxes), any obvious inefficiencies (to little or too large reserve requirements)…
Inflation targetting seems to work at 2-3%/yr because that is around the underlying rate of growth. But taking it to the next level might uncover what is genuinely responsible for this growth. At the very least it corrects the fact GDP doesn’t measure federal debt. It seems the USA BofC equivalent did the exact opposite last decade: bubble-building. But I trust our business schools here especially from a 2009 perspective.