Anyone who has taken ECON1000 has probably seen the simple model of how banks create money in a fractional-reserve banking system, and how an increase in reserves creates a multiple expansion of loans and the money supply. An alternative approach, cogently argued in comments here by JKH, says that it is bank capital, not reserves, that plays the crucial role. I think there may be some truth in what JKH says, especially at present, but it is not the whole truth. I'm going to lay out what i believe. Others can either learn from what I say, or try to help me learn where I might be wrong (or maybe even both).
Let's start with the simplest textbook story.
Bank deposits are money, by assumption. Each bank desires to keep (say) 10% reserves against deposits, either to cover liquidity risks, or because it is required to by law, or a bit of both. Bank capital is irrelevant. Start in equilibrium, where reserves are 10% of deposits at every bank. Now assume the central bank does something that causes each bank's reserves to increase by $10. Each bank now has $10 excess (undesired) reserves. In the first round, each bank increases the supply of loans and deposits by $10. It does not increase loans and deposits by $100 immediately, because it anticipates that when the deposit is spent, it will be re-deposited in another bank, so it will lose $10 in reserves. (The textbook story implicitly assumes that each bank is small relative to the whole banking system, and is looking for the Nash equilibrium.) But in aggregate, of course, there is no loss of reserves. If all banks are doing the same thing, each bank finds it gains as many reserves and deposits as it loses (absent a currency drain, of course). So with deposits and reserves both $10 higher than in the original equilibrium, each bank now has $9 excess desired reserves, so it increases loans and deposits again…
In the new equilibrium, deposits (the money supply) expands by 10 times (1/10%) the increase in reserves. That's the simplest textbook story. (OK, I've told it slightly differently from the textbook, by assuming all banks get the extra $10 reserves, rather than just one bank. That helps me think about the symmetric Nash equilibrium.)
Now let me give a totally different theory. It's one I just thought up this morning. Initially it was just a thought-experiment to help get my head clear. But then I wondered if there might be some truth to it after all. I call it the "Loan Officer Theory of Money Supply".
Forget reserves. Banks don't need reserves to make loans; they need loan officers to manage those loans. The desired reserve ratio is probably zero anyway, and doesn't matter. What matters is the ratio of loans to the loan officers who are needed to manage those loans. Assume, given an average turnover and complexity of loans, that one loan officer can manage a $10 million loan portfolio.
Start in equilibrium, with the desired ratio of loans to loan officers. If the central bank increases the supply of reserves, that does nothing to the money supply. The extra reserves just sit there. Banks won't increase loans with the same number of loan officers. But an increase in the number of loan officers, one per bank, would increase loans by $10 million per bank, and would also increase the money supply by $10 million per bank.
It's the supply of loan officers, and the desired ratio of loans to loan officers, that determine the supply of loans and money.
What's wrong with the loan officer theory? Absolutely nothing, provided we make explicit some assumptions. The first assumption is that the banking technology has fixed proportions between loans (the output good) and loan officers (one of the inputs). There is zero substitution between loan officers and other inputs. This means that banks' demand curves for composite other inputs, holding the quantity of loan officers fixed, is perfectly inelastic when loan officers are fully employed. The second assumption is that the market supply curve of loan officers is perfectly inelastic. Given these two assumptions, and change in the price or availability of any other input (like reserves, or capital) will have no effect on the quantity of loans, and so no effect on the money supply.
But if we relax either of those two assumptions, the supply of loan officers to the industry will no longer be the sole determinant of the supply of loans and money. A fall in the price (or increased availability) of other inputs will cause banks to expand loans by using more other inputs per loan officer, or hire more loan officers (pushing up wages along their supply curve) to make more loans.
You can see where I'm going with this. Here's the Bank Capital Theory of Money Supply.
Forget reserves and loan officers. What matters is the ratio of capital to loans. Assume banks desire (or are required by law, or both) to have capital equal to 10% of their loans. Then the money supply is 10 times bank capital. A fall in the price, or increased availability, of reserves (or loan officers) will have no effect on the money supply. But an increase in banks' capital will cause a tenfold increase in loans and the money supply.
Again, this assumes that there are fixed proportions between loans and capital. And it assumes the supply curve of bank capital is perfectly inelastic. Relax either of those two assumptions, and a fall in price or increased availability of other inputs will cause an increase in the supply of loans and money. If banks can vary the loan/capital ratio, by varying the average riskiness of their loan portfolio (at the expense of lower returns or greater loan management costs of course) then the model fails. Or, if banks can all raise more capital, perhaps at a higher price, the model fails.
The Loan Officer and Bank Capital models fail except under extreme assumptions. But that's not surprising. All simple models fail. That doesn't mean they contain no truth. The supply of bank capital, and the supply of loan officers, will affect the supply of loans and the supply of money, other things equal. And perhaps their effect is more important in the current recession than normally. Bank capital is certainly important now, but has been discussed by others. But maybe, just maybe, my Loan Officer model contains more truth than normal as well. If there have been large structural changes in the demand for loans, so that loan management is now much harder to do, and in greater demand than normal, then perhaps the supply of experiences loan officers does matter much more than normal. (Sound plausible, bankers?)
But, but, but. Why all the emphasis on the supply of reserves, if reserves are just one of many inputs? And more importantly, are reserves really an input?
Let me tackle the second question first. Are reserves really an input in the production by banks of loans and money?
Yes, and no. At the level of the individual bank, reserves are certainly an input at the margin; and rational individuals and banks make choices at the margin. At the level of the banking system as a whole, reserves aren't an input (or, are only r% of an input with an r% desired reserve ratio, and I am quite happy to let r go to zero).
Suppose the desired reserve ratio is zero, for simplicity. An individual bank that makes a new $100 loan, by crediting the borrower's chequing account $100, knows that the borrower will spend the loan, and if his cheque is cashed at another bank, the first bank will lose $100 reserves. If it doesn't have $100, it will need to borrow $100 reserves. That's a required input, and that input has a cost. The cost is the interest rate at which it could borrow reserves, or, in an opportunity cost sense, the interest rate at which it could have lent its own reserves. So the interest rate on reserves is a marginal cost of an input to the individual bank, and affects its supply of loans in exactly the same way that the marginal cost of capital and the marginal cost of loan officers affects its supply of loans.
It simply does not matter to the individual bank's decision, in Nash equilibrium, where it chooses its own quantity of loans taking other banks' quantities of loans as given, that there is no loss of reserves to the banking system as a whole. It's maximising its own profits, not those of the whole banking system. It does not internalise the externality of the fact that its reserve loss is another bank's reserve gain.
So the price and availability of reserves matters, at the margin, for an individual bank's decision, in exactly the same way that the cost of loan officers and bank capital matters.
So why do economists concentrate so much on reserves, and downplay or ignore other inputs in the money supply process?
Because reserves can be influenced by policymakers. Other things equal, the price and availability of reserves, capital, loan officers, etc., all influence the money supply and loan supply process. But a central bank's job, when it determines the price and availability of reserves, is to make sure those other things aren't equal. The slope and position of the market supply curves of bank capital and loan officers are what they are. The slope and position of the market supply curve of reserves is whatever the central bank wants it to be. It can make it horizontal, or vertical, or anything in between. It can make it shift left, right, up, down, back and forth, to try to attain whatever objective it wants to attain.
Worthwhile Canadian Initiative 
JKH: (from a comment on the “accounting and economics” post said:
”
too bad, Nick
reserves as advertising is a cornerstone of MMT
:)”
Damn! I had just written an analogy between reserves and cigarette advertising for this post. Assume advertising causes smokers to switch brands, but doesn’t affect total smoking demand (just assume). So the cost of advertising affects each individual firm’s decision on how much cigarettes to supply, and is like an input to the individual firm’s supply of cigarettes, even though it isn’t needed in aggregate. Then I deleted it because I thought it might just confuse the debate. Damn!
“Because reserves can be influenced by policymakers.”
But capital requirements are directly influenced by policymakers as well. The question might better be framed as why economists concentrate so much on central banks as opposed to financial regulators.
I’ll likely defer to whatever JKH has to say on this post, but certainly the availability of loan officers is a non-issue, and I don’t really see reserves playing much of a role (even at the margin) either. In a concentrated banking market like Canada, what goes around, comes around, and the added cost of interest on reserves needed because a bank’s loan/deposit ratio is high compared to the other banks is small enough to not really be a factor in decision making.
It’s probably worth mentioning that Canada eliminated reserve requirements for banks many years ago and it didn’t really seem to have any impact on how banks operate.
The two constraints on lending are capital and the availability of willing/capable borrowers (in some sense these two constraints are one and the same if capital requirements are set accurately – basically banks can lend as much money as they want as long as they don’t threaten their own solvency in so doing).
Nick:
1) With 10% reserves, textbooks show that 10 new dollars will support $100 of bank-created money. They seldom mention that the banks’ collective balance sheet will show assets equal to $10 of reserves PLUS $90 worth of IOU’s from the banks’ various borrowers. $100 of assets backing $100 of liabilities.
2) Would you agree that as private banks multiply the supply of money by, say, a factor of 3, the price of groceries will rise by some comparable amount? If so, would you claim that a legitimate bank has the same effect on the price level as a counterfeiter?
Can we agree to the terms currency, currency denominated debt (as in a checking account is one type of currency denominated debt), and fungible money supply (currency plus currency denominated debt)? I keep getting lost in definitions. Here is/are example(s).
“Bank deposits are money, by assumption.”
Is that currency or currency denominated debt?
“Forget reserves and loan officers. What matters is the ratio of capital to loans. Assume banks desire (or are required by law, or both) to have capital equal to 10% of their loans. Then the money supply is 10 times bank capital.”
Is it more accurate to say “Then the POSSIBLE MAXIMUM currency denominated debt part of the fungible money supply is 10 times bank capital”?
For the fungible money supply minus currency to be 10 times bank capital, does that mean currency = savings = bank capital so that spending amounts and financial asset amounts depend on changes in currency denominated debt?
I don’t mean to nitpick, but I believe this difference is very important. I believe someone else (maybe JKH) agrees with me about the change in monetary base, it is almost all bank reserves and very, very little from currency. I do NOT believe that is an accident.
Declan’s post said: “Because reserves can be influenced by policymakers.”
But capital requirements are directly influenced by policymakers as well. The question might better be framed as why economists concentrate so much on central banks as opposed to financial regulators.”
Were SIV’s an attempt to get around capital requirements?
Are low reserve requirements, low capital requirements, and low interest rates about allowing for the creation of almost unlimited currency denominated debt on those suffering negative real earnings growth (the lower and middle class)???
I’ve always thought that the so-called “money multiplier” is just a special case (and a not very interesting special case) of the much more important concept of the neutrality of money. That is, the notion that if the MB increases by X percent, all other nominal aggregates (including the price level) will change in the same proportion. Thus I don’t think the textbook explanation of the money multiplier is all that illuminating. It is also true that if you increase the MB by X%, the nominal amount of stocks, commodities and real estate should also rise by X%. Why are banks special?
I suppose one could argue that banking is special because the change in M1 and M2 is mechanical, that the money multiplier works even if the QTM doesn’t work. But as we saw in Japan in the 1990s and the US in 2008, if one breaks down, so does the other.
re: reserves as advertising… you guys are sounding like free bankers now.
For instance, see the paper Investment in name brand capital: evidence from the free banking era by Haupert.
This paper “cites the excessive holding by New York City banks of specie reserves as evidence that they were investing in name brand capital.”
and.. “In the case of a good whose quality cannot be determined prepurchase, the promise of higher quality is often accompanied by some form of “bonding” on the part of the firm. The purpose of the bonding is to provide some sort of collateral, or assurance, to the consumer that the firm will deliver the quality promised.
“The use of bonding mechanisms by banks in an effort to establish a reputation can take many forms. As mentioned previously, advertising and public statements are bonding tools often used to enhance reputation. By publicly committing to certain actions, such as maintaining deposits at other banks so that customers can more easily redeem notes, and holding excess specie reserves to be used to facilitate the redemption of its notes, the bank is advertising to the customers how careful it is, and how reliable it will be in living up to its claimed quality level.”
Selgin touches on this with the idea of note-brand discrimination.
I’d say lending is ‘restrained’ by capital requirements (when enforced).
Lending is ‘driven’ mostly by changes in lending requirements.
http://www.moslereconomics.com/2009/11/27/fnma-tightens-lending-requirements/
Nick:
Your example is helps promote the confusion between money and credit. The money is the bank deposits. The credit is the bank loans.
Because banks can hold various kinds of already existing securities, including short term government bonds, issues regarding bank loan officers impact the supply of bank loans rather than total bank credit (including their demand for government bonds) and the quanttity of money created.
With risk weighted capital requirements, particularly ones that treat short term govenrnment debt as requiring no capital, then capital requirements impact the mix of bank assets, not the total of bank credi or the quantity of money created.
If all bank liabilities count as money, then the amount of money plus the banks capital match total bank assets (loans, bonds, and reserves.) But I think that wrong. Some bank liabilities are money and others are not. And, of course, in the U.S. some bank liabilities are subject to reserve requirements and others are not.
So, there is little relationship between the supply of money by banks and the supply of bank loans.
In my view, the reserve requirement isn’t terribly important. What is important is redeemability between the monetary base controled by the central bank and the various sorts of money created by a bank. That constrains the quantity of each bank’s money to the demand to hold it.
Nonmonetary bank liabilities, bank loans, bank securitity holdings, bank reserves, bank capital, depend on supply and demand, and are impacted by capital requirements.
I doubt any of these complications are new to you. Why I mention them to you is that when it is reasonably clear to me that some people, especially those who worry about capital contraints on banks, are refering to a contraint on bank loans. To them, “the supply of money” is the supply of bank loans. To me, the supply of money is partly made up of the supply of certain sorts of bank deposits.
I think there was a large increase in the demand for bank supplied money. Capital requirements were never a significant impediment to increasing the supply of bank created money.
I make no such claims about the supply of bank loans. I think there was an increase in the demand for bank loans during the crisis. I suspect it has fallen off with the recession. But I don’t think managing the quantity of bank loans is necessary or sufficient to stabilizing the growth path of nominal expenditure.
Declan: Economists normally want capital requirements to be used as the instrument for financial stability policy, and reserves to be used as the instrument for monetary policy. Two instruments, each with its own target.
“In a concentrated banking market like Canada, what goes around, comes around, and the added cost of interest on reserves needed because a bank’s loan/deposit ratio is high compared to the other banks is small enough to not really be a factor in decision making.”
In normal times, if a bank is getting (say) 4% interest on reserves, and 6% interest on mortgages, I would say that 4% should be a big factor in decision-making.
Mike: “With 10% reserves, textbooks show that 10 new dollars will support $100 of bank-created money. They seldom mention that the banks’ collective balance sheet will show assets equal to $10 of reserves PLUS $90 worth of IOU’s from the banks’ various borrowers. $100 of assets backing $100 of liabilities.”
I just checked Mankiw, Kneebone, McKenzie, and Rowe, Principles of Macro, 3rd Canadian ed. We do show exactly that (and with exactly those numbers, funnily enough!). (And I didn’t change that bit from the US edition).
“2) Would you agree that as private banks multiply the supply of money by, say, a factor of 3, the price of groceries will rise by some comparable amount? If so, would you claim that a legitimate bank has the same effect on the price level as a counterfeiter?”
If bank deposits were perfect substitutes for currency, and pay the same (0%) interest, I would agree. Otherwise, probably less than that.
Too much Fed: One standard definition of the money supply is M1. M1 = currency in public hands + demand deposits
The argument is that (chequable) demand deposits can be used as a medium of exchange/means of payment, without first converting them into something else, and so are money. And yes, demand deposits are a form of debt: they are a liability to the bank, and an asset to the public.
“For the fungible money supply minus currency to be 10 times bank capital, does that mean currency = savings = bank capital so that spending amounts and financial asset amounts depend on changes in currency denominated debt?” You totally lost me there, but the answer is “no”.
Scott: I see the banking multiplier, and all the theories in this post, as being very much a partial equilibrium experiment, while the QT is a general equilibrium experiment. What we are looking at here is the determinants of the supply of money (and loans), but saying nothing about the demand side. But I need to think more about your comment, and let it slowly sink in.
JP: But that’s a case where reserves really are advertising! I was just thinking of advertising (a special case of advertising) as a metaphor. But I remember reading some of that literature you cite, on sunk investment as a form of bonding to establish trust. I think it’s right.
Winslow: A change in the supply of loans can mean a change in price/quantity, but yes, it can also mean a change in the quality requirements. Economists with our 2 dimensional paper draw and speak of 2 -dimensional supply and demand curves. But quality is/should be understood as an implicit 3rd dimension.
Bill: “Why I mention them to you is that when it is reasonably clear to me that some people, especially those who worry about capital contraints on banks, are refering to a contraint on bank loans. To them, “the supply of money” is the supply of bank loans. To me, the supply of money is partly made up of the supply of certain sorts of bank deposits.”
AHA! Yes, you may well be right. I should have emphasised that point forcefully. I just assumed everyone understood it.
I generally agree with the rest of what you say, except:
” That [redeemability] constrains the quantity of each bank’s money to the demand to hold it.”
Individual banks, yes. banking system as a whole, no. People are always willing to accept the medium of exchange. To have, but not to hold. Yeager, etc. But you were presumably talking about individual banks, and I’m teaching what you to suck eggs!
DECLAN: Yes, policy makers can absolutely change capital requirements. Also, Canada did not eliminate bank reserves, it sent them as zero. You need a target in order to have a overnight lending market, and therefore a FFR. JKH pointed this out to me a while ago.
SCOTT: If you increase the MB, the impact it has on prices depends entirely on what is done with that additional MB. If it’s saved, it does nothing, and therefore has no impact on prices at all. The Money Multiplier is rubbish for this reason. A while ago I said that banks do not lend out reserves, and you asserted they did. Should I assume you have seen the error of yours ways now? You seem to accept that in your post.
NICK: In your example, why have you implemented capital requirements in such a weird and rigid way? “Assume banks desire (or are required by law, or both) to have capital equal to 10% of their loans” Why? It should be “Assume banks desire (or are required by law, or both) to have capital equal to 10% or more of their loans”. If a bank does not find good investment opportunities, they may run with capital ratios of 15%, 20%, 50%, or more. There is no FORCED MECHANISM that gets banks to lend. And bank deposits are DEAD MONEY that have no impact on anything.
I’m glad to see that you understand how this works at a system level. At an individual level though, you still seem to think that interest rates matter. A bank sets its loan rate such that it will make money when it makes loans. It then makes as many loans as it can, subject to capital requirements, and (sometimes) credit quality of loan demand. Higher rates do not stop a bank from lending (because they are calculating their opportunity costs), it just increases the interest rates of the loans on offer, which may change demand.
BILL: I’m afraid it is you who is confused. When a bank extends credit, it creates a deposit. The assertion “so, there is little relationship between the supply of money by banks and the supply of bank loans” will appear comical to anyone who was alive during the last decade. Remember this little thing called the credit bubble? If you can show me an example of how bank credit extension does not create a deposit, and weird edge cases of taking out cash do not count, I will change my mind.
Nick:
“I just checked Mankiw, Kneebone, McKenzie, and Rowe, Principles of Macro, 3rd Canadian ed. We do show exactly that (i.e., $100 of money backed by $100 of assets)”
My mistake. I didn’t give you guys enough credit for accounting sense. (But in my defense, you keep saying that central banks’ assets don’t matter much.) Mankiw even goes on to say “At the end of this process of money creation, the economy is more liquid in the sense that there is more of the medium of exchange, but the economy is no wealthier than before.”
“If bank deposits were perfect substitutes for currency, and pay the same (0%) interest, I would agree (i.e.,that banks have about the same effect on the price level as counterfeiters). Otherwise, probably less than that.”
I’m always shocked when economists say that. Doesn’t the sheer incoherence of it make you even a little uncomfortable? The bank puts its name on its money, recognizes that money as its liability, holds assets against that money, and stands ready to use those assets to buy back that money. The counterfeiter does none of those things. The counterfeiter is wealthier because of his issue of money; the banker is not.
Suppose a counterfeiter and a banker are both based in the Cayman islands, beyond the reach of US law, US reserve requirements, etc. The counterfeiter prints zillions of dollars and walks off with the goods. You and Mankiw would agree that the US economy is poorer than before. Now the bank issues zillions of checking account dollars to US borrowers, getting equal-valued assets in return. Nobody’s wealth is affected. So how are those cayman checking account dollars supposed to affect prices in the US? Before you answer, keep the law of the reflux in mind, and remember that those checking account dollars would only be issued if customers wanted them.
M: “Would you agree that as private banks multiply the supply of money by, say, a factor of 3, the price of groceries will rise by some comparable amount?”
N: “If bank deposits were perfect substitutes for currency, and pay the same (0%) interest, I would agree.”
This again raises that interesting (to me anyway) point about what is it about money that bids up prices. In the case of deposit money (and arguably not base money either, if you believe in Ricardian equivalence), it can’t be the wealth effect, because bank deposits are matched by liabilities (which could be expected to have a negative wealth effect), and as Nick has pointed out before, deposits are a relatively small fraction of wealth anyway. So what is it?
I think that this is an important question, because it suggests that there would not be a liquidity trap even at, say, zero interest rate on bills. If money is special, then even open market ops involving buying bills at a negative interest rate can still stimulate spending.
RE: “what is it about money that bids up prices”
Are you being serious? The answer is obvious.
Winterspeak:
“Also, Canada did not eliminate bank reserves, it sent them as zero.”
Are you sure? I thought Canada eliminated reserve requirements altogether, in the sense that banks are allowed to keep a negative reserve balance at the Bank of Canada (but must pay interest on that balance).
“There is no FORCED MECHANISM that gets banks to lend.”
Agreed. The supply response to changes in price of inputs has nothing to do with anyone being forced to do anything. It’s about profit-maximising choices, and how those choices change when input prices change. The law may require a minimum capital (or reserve) ratio, but what matters is the desired capital (or reserve) ratio. The desired ratio normally exceeds the minimum, if it’s costly to increase capital quickly. Depends on how the law is enforced, though. If there’s a spread between banks’ borrowing and lending rates, they won’t want to keep excessive capital.
” And bank deposits are DEAD MONEY that have no impact on anything.”
!!!!!??? Is all I can respond here. Because it would take me too far off-topic.
“A bank sets its loan rate such that it will make money when it makes loans. It then makes as many loans as it can, subject to capital requirements, and (sometimes) credit quality of loan demand. Higher rates do not stop a bank from lending (because they are calculating their opportunity costs), it just increases the interest rates of the loans on offer, which may change demand.”
But if a bank raises the interest rates it charges on loans, in response to higher interest on reserves, that’s exactly what we mean by a reduction in the supply of loans. The supply of loans is a curve, not a quantity. And a decrease in supply means an upward or leftward shift in that curve.
I understood Bill to mean that changes in the composition of either the asset or liability side of a bank’s balance sheet means that not all changes in money and loans go in the same direction.
Mike: “I’m always shocked when economists say that. Doesn’t the sheer incoherence of it make you even a little uncomfortable?”
Given the assumption of zero interest on deposits, and zero admin costs (only possible under monopoly, of course), it follows logically. If i give someone a $100 interest-free loan, and ask for it back in x years, he is wealthier by the NPV of the foregone interest over x years. As x goes to infinity, he becomes $100 wealthier in the limit. Pecek and Saving.
But under these assumptions banks, just like your cayman island counterfeiters, do take monopoly profits (seigniorage) away from the Fed, but reducing the demand for Fed notes 1 for 1. It’s different if demand deposits are imperfect substitutes for currency, of course.
Rebel: an increase in the money supply bids up prices because of a substitution effect. that’s the main channel. There may in addition be a (small) wealth effect, if the issuer of money has monopoly power, so there’s a spread between the interest paid on money and market rates of interest (net of admin costs). Pecek and Saving, again.
Then say what you think the answer is winterspeak.
Supporters of MMT might find a more receptive audience if they were a little more humble.
Nick,
You and I have touched on the zero reserve requirement before. Winterspeak is correct in my view. I’d like to come back on it later.
Loans (borrowers sell,bankers buy) vs. apples (farmers sell,consumers buy)
The quality of apples drop as demand/price increases. A farmer will leave apples of low quality to rot on the trees until an increase in demand/price is sufficient to earn a profit picking them. Supply is ultimately constrained by the quantity of apples on the trees.
The quality of loans drop as lending requirements drop. A banker will leave loans unfunded if regulations constrain him to high quality loans. (We’ve seen poor quality alone won’t restrain bankers) Even if he can earn short-term profit, loans will remain unfunded due to regulation. Supply is ultimately constrained by regulation.
Price/demand have a lot to do with the supply of apples but little to do with the supply of loans. Changing price/demand (decreasing rate) won’t increase the quantity of borrowing unless overall a borrower’s opportunity for profit has increased. Currently we see mortgage rates falling yet mortgage borrowing is falling as well.
Price/demand has a lot to do with the quality of apples but little to do with the quality of loans. Changing price/demand (increasing rate) doesn’t turn a bad borrower into a good borrower, in fact it tends to do the opposite.
Quality has a lot to do with the supply of loans as regulation will only allow loans above a certain quality.
Fiscal/monetary policy can increase the quality/quantity of loans, by increasing the quality of borrowers.
RE: I have yet to find anything that would help supporters of MMT find a receptive audience. In answer to your question: “”what is it about money that bids up prices?” the answer is “the spending”.
If money is saved, it has no impact on anything. If money is spent, it bids up the price of whatever it is being spent on.
The Austrians seem to have this problem too, which is the only way to make sense of their “dilution” idea. Every dollar created somehow devalues every extant dollar (even though they can point to no mechanism) which is why they argue for some kind of gold standard etc. etc. Monetarists struggle equally to find a mechanism, for reasons that, while different, are ultimately remarkably similar. The best they can come up with is something like “an increase in the money supply bids up prices because of a substitution effect”, with I assume spending being substituted for saving, begging the question (once again) of a mechanism.
Nick: “But if a bank raises the interest rates it charges on loans, in response to higher interest on reserves, that’s exactly what we mean by a reduction in the supply of loans. The supply of loans is a curve, not a quantity. And a decrease in supply means an upward or leftward shift in that curve.”
This is not a reduction in supply, as the supply is exactly the same as it was before, bound by the same capital requirements. The change in interest rate impacts the demand side of the equation. It seems obvious to me that at a higher interest rate, the bank remains ready and able to supply as many loans as before, just at a higher interest rate (as we aren’t changing capital or capital requirements in our example). The number of interested and qualified buyers at that higher rate may decrease, however. This seems to be obviously a demand side effect.
Nick,
A thought provoking post, thanks. It prompted me to flesh out a model of my own. Apologies for the length of this “comment”; it will require someone to have an unusual level of interest in order to read it.
I’ve responded to some of your points specifically near the end, but first here’s my model:
CAPITAL AND RESERVE MODEL (JKH)
Let the world consist of two banks, A and B, and a central bank CB.
The employees of Bank A are a reserve manager, a capital manager, a loan manager, and a deposit manager.
Bank B has a similar staff.
The CB just has one employee – its own reserve manager. The 3 reserve managers’ jobs interface with each other in a way to be described.
Banks A and B start out the day “in balance” from all perspectives. Their assets equal their liabilities plus equity. And their world resembles Canada in that required reserves are zero. Both banks are at zero reserves.
There is one transaction to start. Bank A’s loan manager wants to make a loan of $ 10 million to customer X. (Think of X as a large blue chip corporation, or perhaps a wildly leveraged but fully prescient Canadian university professor betting the farm and all of his family’s and friends’ collateral on gold.) The loan manager does the credit analysis and approves it. Suppose the capital manager has an existing surplus capital position due to prior retained earnings that have not yet been allocated to risk assets. Assume that surplus capital is temporarily invested in treasury bills, which have a zero risk weight for capital purposes. The capital manager decides on the amount of capital required to support the loan risk, and allocates it accordingly as capital underpinning for the loan, in the event the loan transaction is completed. He allocates $ 1 million.
The reserve manager is notified of the pending loan drawdown. He assumes an outflow of reserves when the loan is draw down. He wants to attract an offsetting reserve inflow somehow in order to square his reserve account by the end of the day. Assume he has treasury bills in a liquid asset portfolio that represent the investment of capital funds that have so far been in surplus – i.e. not previously used to support risk assets. He plans to sell those bills for cash and redirect that internal capital to the new risk asset of $ 10 million. He needs additional funding of $ 9 million. He advises the deposit manager than he will require that funding.
The loan manager prices the loan. His inputs are the cost of capital, which he obtains from the capital manager, the benchmark cost of deposits, the cost required to cover expected credit losses, and other expenses assumed in pricing the loan such as related administrative salaries, etc. All of these costs can then be translated to an equivalent all in credit spread over a benchmark cost of funds. The loan is priced at that cost plus the credit spread.
I use “benchmark cost” here because the actual source of new funds in a “universal” bank can be wholesale or retail. New retail funds are “sold” internally into a central collection point at such a benchmark rate, providing retail bankers with a deposit spread to cover their own administrative and other costs. In the case of this simplified example, I’ll just assume now that the benchmark cost is the same as the actual wholesale cost of funds that the bank will end up paying in the market to fund this loan.
The loan manager goes to the deposit manager for a quote on the cost of funds – i.e. the expected wholesale deposit rate. The deposit manager may build in an additional small spread to allow for risk that the market price may “move” while the transaction is in progress.
The loan manager advises the customer of the all in cost based on the quoted market rate plus the credit spread. The customer accepts.
The loan manager completes the loan and advises the reserve manager and the deposit manager jointly.
Knowing that the lending transaction has been priced and accepted, the reserve manager then sells $ 1 million in treasury bills (previously funded by excess capital). The deposit manager puts out a bid for $ 9 million in additional funds.
Meanwhile, customer X has drawn down the $ 10 million in funds (in the form of a cheque drawn on A) and places them on deposit with his bank B.
Similar communications starting happening in bank B, and the reserve manager there is soon informed of the inflow of funds from bank A. He will now have an excess reserve position that he doesn’t want. At the same time he knows from market gathered information that bank A is looking for funds. He’s been informed by his loan manager that bank A continues to be a good credit risk. And his capital manager is comfortable in allocating capital to an interbank deposit transaction.
Away from the two transacting banks, the CB reserve manager observes that the market interest rate for interbank funds is quoted slightly above the interest rate he pays to banks for excess reserves. He’s satisfied with market conditions and leaves the system excess reserve setting alone.
The deposit manager in bank A has a bid out for $ 9 million in funds. Bank B’s reserve manager accepts that bid and places a $ 9 million interbank deposit with bank A.
Bank B also buys the $ 1 million in treasury bills sold by A through an investment dealer.
After the transaction, reserve accounts are flat again.
Had bank A been unable to attract funds from bank B for any reason in this example, A’s reserve manager could have gone to the central bank to borrow funds.
Additional internal activity within Bank B:
The balance sheet has increased with X’s $ 10 million deposit, $ 1 million in treasury bill assets, and the $ 9 million interbank loan to bank A. Bank B’s capital manager allocates $ 250,000 from his bank’s own pre-existing surplus capital to the interbank loan. This is a lower proportionate amount than Bank A allocated for X’s loan, because Bank A is itself a higher quality credit than A’s customer X. Again, B was in a surplus capital position prior to placing money with A. The assets in which this capital was previously invested (e.g. existing treasury bills) are now in a sense funded instead by $ 250,000 from the new deposit funding just raised. This is just internal book keeping reconciliation in order to keep track of the new allocation of risk capital and the corresponding depletion in surplus capital.
We assumed the CB reserve requirement was zero, so the new deposits for both banks have no impact on the CB’s strategy for the system reserve setting. In a system with positive reserve requirements, the CB would have supplied new reserves, perhaps through system repos with non bank dealers who took on new collateral purchased from non banks. The two banks would have competed for new deposits that had been created in conjunction with that reserve injection sequence, in order to attract their share of additional newly required reserves. And the process would compound from there. This is actually the textbook multiplier working in reverse, whereby the central bank responds to system deposit expansion by supplying any reserve requirement that follows from that. This is the actual mechanism when there are positive reserve requirements. The textbook description with the reverse causality is wrong. (See further discussion below.)
In a system with positive reserve requirements, banks can factor in the opportunity cost of holding zero or low interest paying reserves, if necessary, as part of their asset-liability pricing methodology; e.g. the opportunity cost of zero interest could be factored into the loan spread as a reflection of additional funding required to support the additional reserve requirement associated with the primary funding. However, factoring in the opportunity cost in the case of a rate of interest paid on reserves that corresponds closely to the short term risk free rate (or short term policy rate) is a bit trickier, because that sort of rate is more or less already justified by virtue of the fact that reserves are a risk free asset.
Anyway, that’s the complete set of transactions in my model.
Both A and B were subject to capital constraints. There seems to be some sensitivity evident in several recent comments, surrounding this term “constraint”. Minimum capital requirements are specified as a ratio of risk weighted assets. Banks must hold at least that amount of capital in order to be capital fit from a regulatory perspective. The regulatory requirement, as well as any self-imposed capital requirement that may be stronger than the regulatory standard, constitute an effective lower bound limit for capital held against an existing position. I call that lower bound limit a constraint. Banks may hold actual capital in excess of that lower bound, in which case they are said to have excess capital. Whether or not that sort of excess capital position is viewed as evidence of a non-binding capital constraint is a matter of preference. The minimum capital constraint is non-binding in the sense that the bank has ready access to additional internal capital not yet allocated to risk. The minimum capital constraint is binding in the sense that the level of aggregate minimum capital for the bank will actually shift higher when a new risk asset is added. As well, it is binding in the sense that the loan officer must still get approval from the capital manager in order to receive an allocation of capital for the risk he wants to take. Under either interpretation, the minimum capital constraint is a fact in the form of a lower bound limit for capital required against total risk assumed. That said, the terminology “constraint” is also borrowed from it’s converse use in the case of reserves, where MMT’ers (Modern Monetary Theory advocates) often say that banks are not reserve constrained in lending. Finally, substituting the word “restraint” in the case of capital seems a bit soft on the real meaning of capital requirements, because there is definitely a lower bound hard limit on required capital, corresponding to a given risk asset position.
In this case, although both A and B were subject to capital constraints, those capital constraints were dealt with smoothly by the presence of pre-existing excess capital in both banks. However, the transaction meant that the amount of capital actually allocated to risk taking, for each bank and for the system as a whole, needed to increase. That amount of additional capital had to be ready prior to the act of assuming the risk. And it was ready, in the form of an excess capital cushion.
A prudently run bank will tend to have surplus capital as a stock (unallocated) and expect new surplus capital as a flow (incoming retained earnings). That puts the bank in a position to acquire new risk assets without having to go to the new issue equity market for every additional transaction. The incoming flow of retained earnings is normally enough to satisfy new capital requirements over time. This recent credit crisis has been extraordinary in that sense; e.g. Canadian banks were very active in tapping the new issue market for equity capital, which is not normal. (They also tapped the market for qualifying debt capital, which is a more normal and a more regular occurrence in one form or another).
Both A and B had to notify their respective capital managers of a pending new utilization of capital for risk allocation. The stock of utilized capital had to increase, due to the lower bound limit set by regulatory and/or internal capital limits. Unutilized capital had to be available before the transaction could be approved. That’s what it means to be capital constrained. Thus, lending insofar as capital was concerned was an issue of both availability and pricing. The required capital was available because the capital manager had a surplus capital position and approved the transaction on the basis of the risk assessment and the capital it would require.
The case of reserves is very different. What happened in the model transactions is consistent with the MMT observation that banks are not reserve constrained in lending. This means simply that the central bank always provides sufficient reserves to the system in order for banks to square their required positions. In the example, and in Canada’s case, this means meeting a requirement of zero. Under normal market conditions, sufficient reserves should be available for nearly all if not all banks to meet their requirement through various transactions with customers and/or between the banks themselves. Under volatile markets conditions, which can be accompanied by relatively volatile reserve distributions among banks, some banks may need to access borrowing from the central bank. Banks with good collateral will be able to borrow and bring their reserve accounts back to requirement, which is zero in this case.
It is important to note that “absence of a reserve constraint” is intended to characterize the reserve effect, other things equal. This assumes that banks are of good enough credit and liquidity quality to able to source funds and attract the reserves they require in the normal course. In particular, it assumes that banks have met their capital requirements and are perceived by the market to have met them. If not, they may fail to meet their reserve requirements as well. This is the case with a run on the bank. And if a bank is unable to square its central bank reserve position because neither the market nor the central bank is willing to provide it with funds, that bank must go into some form of wind up such as the FDIC process, a situation ultimately attributable to an inadequate level of capital. In the model example of banks A and B, both banks were normally healthy and therefore not reserve constrained in the intended meaning of that phrase.
Bank A’s deposit manager did not have to assume anything analogous to an additional requirement for capital, as in the availability of a pre-existing “unused” stock of reserves, either for his own bank or for the system as a whole. That’s because he knew to expect that the funding necessary to attract reserves to return to bank A would be available in the normal course. Even if market conditions had been particularly “choppy” on that particular day, A could have assumed the risk of having to borrow from the central bank on a temporary basis. And most importantly perhaps, A’s deposit manager knew that A’s capital condition was such that A was perceived to be a good credit risk itself in the market place, and that therefore A should have no problem attracting deposits in the normal course. Provided A’s own capital constraints are not contravened, A should have no problem attracting required reserves in what is a closed system of reserves supplied by the central bank. Any problem in squaring reserve positions can only be attributed logically to market perceptions of capital inadequacy, which is generally how bank runs start. And even then, the bank can borrow from the central bank with good collateral. With adequate capital, the only issue for reserve management is pricing, not availability of reserves. Bank A was not reserve constrained in lending because the reserves required to square A’s position at the end of the day had to be available from somewhere. The normal function of a liquid market, including the central bank’s management of the short term interest rate, will ensure that regular transactions such as the interbank loan from B to A will accomplish the required rebalancing of reserves. The lending exercise insofar as reserves were concerned was only an issue of pricing. The required reserves were assumed to be available and in fact were available somewhere in the system, given the closed nature of the reserve system, and given bank A’s strong capital position and therefore its good credit rating.
Thus, the critical idea in the notion that banks are not reserve constrained is the willingness of the central bank to supply reserves to banks systemically and to banks specifically, sufficient to meet their required reserve levels systemically and individually, provided they are in sufficiently good capital health. Central banks supply required reserves on a daily basis. There is obviously no corresponding idea underlying the notion of capital constraints. Central banks may or may not supply required capital about every 80 years or so, in the midst of extraordinary financial crises and depression type risk environments. Otherwise, there is a constraint placed on the private sector commercial banking system to produce a net stock of capital at least equal to its minimum capital requirements, individually and therefore collectively. That collective capital stock must increase as risk assets increase. That is a constraint on the banking system. It must confirm additional unused capital availability or issue new capital in order to expand its risk assets and it must source this capital in the normal course without central bank or government provision of same.
Moreover, the causality sequence in the case of capital demonstrates the power of the constraint in comparison to the case of reserves. Banks must have required capital in place prior to the moment in time when their risk assets increase by lending or some other risk taking activity. The capital requirement precedes the risk expansion. This is opposite to the causality with respect to reserves, where the reserve acquisition that is required to square offside positions due to asset expansion follows the asset expansion in order of time sequence.
There is an enormous irony here around the issue of causality. MMT observes correctly that the central bank supplies required reserves in response to the banking system’s creation of new loan and deposits, most obviously in those systems that have positive rather than zero reserve requirements. This correct description positions the traditional textbook described “multiplier” causality as literally backwards. The irony is that the textbook causality direction applies correctly to capital, not reserves. Not only does a significant proportion of the economics profession not yet understand that the textbook model is wrong, but they don’t yet understand that the correct version of the same causality applies to capital rather than reserves, and they really don’t understand that they have effectively been confusing reserves with capital all along. Economists in general are typically weak on the subject of bank capital. That’s probably why they got the role of reserves wrong in the first place. The MMT group has distinguished itself in getting it right. Macroeconomic theory that directs itself toward an understanding of the financial system in general and the banking system in particular needs to do a MAJOR REBALANCING of conceptual thinking around the dual subjects of capital and reserves.
In sum, banks are not reserve constrained in lending because they source required reserves from each other’s existing positions and/or from the central bank, and they do so after the fact of new loan and deposit creation. Banks are capital constrained in lending because they must source new capital for risk allocation either internally or externally, and they can’t get it from the government (normally), and they must have this source of risk capital in place before the act of lending.
So my conclusion as always is that bank lending (as well as other forms of risk taking) is capital constrained but not reserve constrained.
ADDTIONAL NOTES ON NICK’S POST
The following points roughly follow the order presented in Nick’s post:
As discussed, but to address Nick’s first example, the textbook theory of the multiplier is wrong. The main reason it is wrong is the aspect of causality. Banks do not require reserves before lending. The central bank supplies the reserves required by banks as a whole based on the deposits created by bank lending and the statutory requirement pertaining thereto. The reason the central bank supplies required reserves is to control the upper bound for the target fed funds rate or range. Otherwise, banks would bid the actual rate above target should the aggregate reserve supply be inadequate according to the requirement created by deposits. The reserve requirement in Canada is zero. That is different than saying there is no requirement. The requirement is zero because the central bank expects banks to target for a flat reserve position over time.
Nick’s “Loan Officer Theory of Money Supply” is interesting. It initially assumes perfectly inelastic “inputs”. But then Nick seems to assume the desired conclusion, which is that inputs of assumed influence on loan supply become influential if their supply becomes elastic. The conclusion is presupposed; e.g. reserves influence loan supply when their supply becomes elastic. Nick proves it by assuming that’s what happens when supply changes from inelastic to elastic. But that’s not what happens in fact. Banks do not depend on an injection of reserves before the fact in order to lend, as explained earlier.
Nick’s “Bank Capital Theory of Money Supply” starts out roughly OK in terms of the idea of a required capital ratio. But it veers off course because it ignores the difference between risk and nominal assets. The purpose of capital is to absorb unexpected losses. Capital is allocated based on the risk of unexpected loss. That is why nominal asset amounts are “risk weighted” when determining a required capital allocation. The risk weighting for a (Canadian) residential mortgage is far less than the risk weighting for an equivalent nominal amount of junk bonds. Treasury bills have zero risk weighting. Central bank reserves have zero risk weighting as a commercial bank asset. So Nick is not accurate when he says that a capital model fails merely because a (nominal) loan/capital ratio varies. The nominal ratio varies constantly based on changes in the risk weighted composition of the nominal asset base over time.
Then we get into the notion of the supply elasticity of capital. I’m not sure the idea is that relevant. The important idea is that the cost of capital at any time is a major input into loan pricing, as already described above. Banks are capital constrained in lending, as I’ve defined it, which effectively means that banks must source required capital, internally or externally, normally from non government sources, and necessarily before the fact of risk taking, i.e. before they can book a net new risk asset. I’ve said that banks typically run surplus capital positions as buffers in good times, even while generating capital internally from retained earnings. They don’t take on new risk and then go find some external capital to support the risk. For starters, they’d be outside of regulatory capital guidelines in taking on that incremental risk without capital support in place. And they’d be fools to assuming such a strategic pricing risk on the most expensive and riskiest form of funding there is, even if there were no capital regulations, but in the latter case we’re into a contradiction about why they’d need to go get more capital anyway. In any event, the type of unconstrained approach that would be reckless in the case of capital is a matter of fact way of dealing with reserves in a normal and prudent fashion. Banks need only square reserve positions after making a new loan. The operative temporal causality is the reverse of that of capital. Banks require capital before the fact to lend. Banks don’t require reserves before the fact, because the system (including the ultimate lender of last resort – the central bank) will always be willing to supply reserves from somewhere to a capital-healthy bank in response to its need for reserves. And that is because the central bank is the monopoly supplier of total reserves at its chosen price, and because it will ensure that the market with respect to healthy banks will clear at that price. There is no such central pricing mechanism with respect to either the availability or the pricing of bank capital. That blunt difference is in part what we mean by saying that banks are capital constrained but not reserve constrained.
With respect to loan supply, neither the interest rate on reserves nor the marginal cost of capital affects the supply of loans, provided that prior to the lending transaction the bank has an identified source of new capital as required, either internally or externally. Capital costs obviously affect the pricing of loans, which I described above as part of my model, and pricing obviously affects demand. In the case where new risk capital supply is not available internally, and the bank perceives the cost of externally sourced capital to be too high, it may shut down the supply of loans. But this is due to the bank’s judgement that the demand for loans will be insufficient at such a market price for new capital, given the associated high cost of externally sourced capital that must be factored into incremental loan pricing. This is not due to an inability to supply loans at that cost of capital, assuming external supply can be sourced at that cost. It is due to an expected insufficient demand at that pricing point. Supply potential is definitely affected by the availability of unused or surplus capital; that’s in part what it means for lending to be capital constrained.
Bank capital is always important, Nick – not just in this recession. What is important in this recession is that capital levels have been under pressure in proportion to the unusual severity of the recession.
Reserves are only an “input” to the production of loans and money according to their pricing, which is determined by the policy rate set and controlled by the central bank. And even then, reserve pricing may only be a benchmark reference pricing point for the market rates that are applicable to new asset liability transactions with the customers of those banks, transactions which have the effect of transferring reserves from or to those banks as a consequence. In any event, reserves are not an input in terms of their availability, because the central bank is the monopoly supplier of reserves to the system at its chosen price, and capital healthy banks will have no problem attracting their required share of them based on that price, ultimately from other banks or from the central bank.
The marginal cost of reserves affects the pricing of loans but not the availability of loans. It is the risk assessment of loans and the availability of capital to allocate to that risk that affects the availability of loans. Note that banks have complex credit policies that may restrict their risk exposure in aggregate across all sorts of dimensions – e.g. industry, geography, loan type, etc. etc. This credit analysis, which is inextricably linked to capital availability, has nothing to do with any question about the availability of reserves. It has to do with the availability of capital to support that risk category under consideration.
As far as the supply of loan officers is concerned, it seems reasonable to assume that supply will affect both pricing and supply of loans, given the labour requirement to do risk analysis prior to supplying.
Regarding your closing paragraph, I agree in particular with two points made by Declan in an earlier comment:
“… capital requirements are directly influenced by policymakers as well. The question might better be framed as why economists concentrate so much on central banks as opposed to financial regulators … the two constraints on lending are capital and the availability of willing/capable borrowers (in some sense these two constraints are one and the same if capital requirements are set accurately – basically banks can lend as much money as they want as long as they don’t threaten their own solvency in so doing).”
There’s another discussion in the comments concerning the difference between loans and money and the meaning of capital constraints in this regard. This is a good place to emphasize that the purpose of capital is to absorb unexpected financial losses due to any kind of risk. Capital allocation is inextricably linked with risk assessment, and capital must be allocated to all assessed risks. So far we’ve been talking mostly about a simplified model that addresses loans and corresponding credit risks. But there are additional kinds of risks to which banks allocate capital – especially market risks such as interest rate risk, foreign exchange risk, and equity portfolio risk, which are analytically separable from credit risk, but frequently in combination with it in the form of counterparty credit risk contingent on market risk. And there are market related risks that are relevant for structural asset liability interest rate mismatches. All of these risks and more require allocations of capital. There is even a complex category called “operational risk”, in which activities just about anywhere on the balance sheet can attract additional risk capital requirements, including the deposit gathering function, depending on the risk assessment for operational disruption scenarios.
CONCLUDING COMMENT
Much of what I’ve said should be consistent with standard post Keynesian interpretation of banking system reserve dynamics, MMT in particular. As far as I can discern, MMT tends not to focus so much on capital directly, but more generally on the idea of creditworthiness as being the driver of lending supply rather than reserve availability. It should amount to the same thing as my capital interpretation. I don’t know if MMT experts would agree with everything I say about capital. But I wouldn’t expect enormous objection to it.
I would recommend again the following blogs for source MMT material:
Kansas City (Scott Fullwiler, Randall Wray, and others)
http://neweconomicperspectives.blogspot.com/
Winterspeak
http://www.winterspeak.com/
Warren Mosler
http://www.moslereconomics.com/mandatory-readings/soft-currency-economics/
Bill Mitchell (an interesting Australian banking comparison for Canadians)
http://bilbo.economicoutlook.net/blog/?page_id=1667
Sorry Nick, winterspeak. I still do not get it. What do you mean by “substitution”?
(By the way, it is Pesek with an s if you want to look it up.)
JKH, please check out my more detailed explanation as to how reserves represent a restraint on balance sheet expansion on the accounting, money and economics post. I would be surprised if you did not find that it at least has some merit.
I don’t see anything to object to in JKH’s post . . . excellent as usual . . . though reading it caused me to miss my chance for a nap this afternoon. 🙂
One thing to perhaps clarify about the MMT analysis, though JKH covered it, too. Namely, reserves do not provide an OPERATIONAL constraint on lending. Whether a bank has more or fewer reserves, or needs to acquire them to meet RR, this NEVER places an operational constrain on the bank’s ABILITY to create a loan. The money multiplier model is inapplicable (aside from gold standards, currency boards, etc.)
However, RR certainly can and do affect bank costs, and as such can affect loan pricing. We’ve always acknowledged that. But note how different this is from the money multiplier model . . . RR do not operationally constrain as the money multiplier model presents, they raise costs. That is, regardless of its reserve position, the bank can make as many loans as it wants at the price it sets after accounting for costs provided there is a demand for such loans and any issues related to capital regulations are met. I have yet to see an economics textbook description of banking that gets this distinction right, much less presents any sort of coherent discussion on capital. If there is one, let me know and I’ll adopt it immediately.
Apologies for any confusion previously caused by our/my usage of the terms “constrain,” “restrain,” and so forth.
JKH: WOW! That’s gonna take some time to digest. I will come back to it.
Winterspeak (and Rebel): the monetarist transmission mechanism is basically exactly the same as yours: spending. When people hold more money than they want to hold (an excess supply of money) they try to substitute out of money and into (more or less) everything else. They try to spend it, in other words. And that creates an excess demand for everything else, and that (sooner or later) bids up prices.
Rebel: If the helicopter showers $100 on me, I am a tiny bit wealthier, and so want to spend more. But that effect is small, because $100 is small relative to my total wealth (including human capital). But if I held my desired stock of money before, I now want to substitute away from money into all other things.
(It’s like the reason that demand curves slope down: income and substitution effects. Only in this case the income effect is really a wealth effect, because there’s more than one time period.)
RE: I’m not sure what Nick means by “substitution” either. I’m guessing that he may mean substitute present consumption for future consumption, or “spending” vs “saving”. I hope that my response, that spending money causes it to bid up prices, is clear. It’s also more accurate than Nick’s, as “future consumption” lets in “expectations” as a price driver and then you forget all about the mechanism, which is spending. And there is LOTS more basic stuff that goes into spending decisions than “inflation expectations”. For example: do you have a job? Do you expect to still have it next week? &c.
If the “more detailed” explanation your are refering to was your comment at @12:35 then you are wrong. “In the case of deposit money (and arguably not base money either, if you believe in Ricardian equivalence), it can’t be the wealth effect, because bank deposits are matched by liabilities” is incorrect as bank deposits ARE liabilities. They are matched by assets, either receivables if they were created through private sector credit extension or something else if they were created through Govt deficit spending.
JKH is quite right in his post. He hits the key points:
1. Deposits do not fund loans because loans CREATE deposits. Economists have this backwards.
2. Lending is not reserve constrained either, because loans create deposits (and thus reserves), and the interbank market ensures every individual bank has the reserves they need. If the system is short, the central bank offers reserves as needed. Again, Economists confuse reserves with capital, and thus get this wrong.
3. Capital controls create a very real constraint on lending for regulatory reasons, and operationally too if there are too many bad loans. If everything economists believed about reserves was applied to capital, they would be right. This would also destroy monetary theory of course.
4. If available capital defines the supply side, the existence of people who both want to borrow money and are likely to pay it back defines the demand side. I have yet to see demand addressed anywhere in the monetarist text. They ignore this by imaging a “multiplier” which catapults (I was going to use another word) money into the public through, through, through…..
JKH: I am no MMT expert, but I don’t think they would have any issue with anything in your detailed post. I personally did not notice a particular focus on creditworthiness over capital in the theory, it’s just that creditworthiness is more of an issue right now since regulatory forbearance as reduced capital constraints.
Nick and Declan are right about Canada + reserves, Winterspeak and JKH are off.
Canada does not have a 0 requirement, it has no requirement, ie. a bank can do whatever it wants with regard to reserves. Despite having no reserve requirement, Canadian chartered banks on average keep a 2% cash reserve.
Canada’s laws DO require institutions to hold a clearing account at the Bank of Canada. The balances held in these clearing account ARE NOT reserves – they are simply deposits that ensure that, at end-of-day settlement, cheques + money transfers will balance out.
Furthermore, private banks can keep negative clearing balances. Another bank will lend them that balance, or the Bank of Canada will. The entire clearing system must net to zero, but individual banks may be above or below 0.
There is a difference between a central bank that operates through reserve requirements and one that operates through the clearing of a nation’s payments system. I don’t know what significance this has to the MMT argument, but those are the facts.
(See the Bank of Canada Act http://laws.justice.gc.ca/en/B-2/ and relevant documents concerning rules/procedures at the Bank of Canada website)
Rebel,
Yes, I think you’ve made a good point.
Not to detract from your highlighting it, or the fact that you drew my attention to it, I did attempt to incorporate the idea in my | November 29, 2009 at 05:32 PM:
“In a system with positive reserve requirements, banks can factor in the opportunity cost of holding zero or low interest paying reserves, if necessary, as part of their asset-liability pricing methodology; e.g. the opportunity cost of zero interest could be factored into the loan spread as a reflection of additional funding required to support the additional reserve requirement associated with the primary funding. However, factoring in the opportunity cost in the case of a rate of interest paid on reserves that corresponds closely to the short term risk free rate (or short term policy rate) is a bit trickier, because that sort of rate is more or less already justified by virtue of the fact that reserves are a risk free asset.”
We’re really talking about reserve requirements that create interest margin compression when reserves earn uneconomic rates of interest. That margin compression is effectively a tax. The tax is a cost of doing business, and the bank has to deal with it one way or another. I do see where you’re coming from.
But does this change the answer to the question of whether or not banks are reserve constrained in lending? However you want to answer that question, its intended meaning in my view refers to the nature of the flow of reserves into a bank in order to offset a flow of reserves out, in connection with new lending for example.
The reserve interest issue and the related tax effect is in large part a pricing question rather than a flow of funds issue. If the tax makes loan pricing more onerous, then loan demand will be affected. And as you said on the other post, China is probably a big example of where this sort of thing is used as a policy lever through which to cool down credit demand and demand in general, particularly given the natural RMB inflation pressures associated with POBC buying up dollars.
So I think it’s a good point about the potential relationship between pricing of reserve deposits, and pricing of other commercial bank assets and liabilities as a knock on consequence. But it is a cost plus pricing issue in my mind, rather than a flow of funds issue relating to the lending “constraint” in terms of sourcing required reserves. Also, I see it affecting loan demand directly more than loan supply, at least as a function of reserve architecture. That said, some of the tax may have to come out of net interest margins as well. That could translate to a different kind of capital supply constraint relative to the economics of deals presented to the capital manager, given the challenge of covering the cost of capital after the margin effect of such tax absorption.
I suspect we’re at least partly in synch on this. Hope that’s the case.
Nick,
I’ll prove I’m right on the zero reserve requirement sometime tomorrow.
Scott,
Thanks. You’ve made the distinction between operations and pricing succinct, a theme I attempted in a recurring but more sprawling way in my piece.
Never really meant to hijack use of the word “constraint” in such an aggressive fashion; it’s probably because I have some affection for it going back to an old operations research course I’d wish I’d done better in.
winterspeak
Saying that money bids up prices when it is spent does not get us much further; the question remains, why is it spent? Remember that we are considering the point of view of the holder of deposit money, to whom it is an asset. And, just as on the banking system balance sheet deposits are balanced by assets such as loans (in other words, deposits are “inside” money), on the non-bank balance sheet, deposits are balanced by liabilities such as loan debts owed to banks. I urge you to think a little longer before you declare something or someone “wrong”. My point is that it is reasonable to think that these liabilities on the non-bank balance sheet might have a negative wealth effect that offsets to some degree the positive wealth effect of the deposit balances.
nick,
I see what you mean when you say that money is spent when more is held than desired, but it does beg the question why it is desired. Utility derived from liquidity maybe (the term “liquidity preference” refers to something slightly different)? And one wonders why money supplied via OMOs could bid up prices at all, since the exchange is voluntary.
I am afraid that I have more questions and objections on this issue than answers and suggestions!
Yes, I think we have some convergence JKH (I was writing at the same time as you so had not seen your long comment above). I shall ponder the difference between restraint and constraint as I lie in bed. Over and out.
JKH: Some initial thoughts:
1. What you say about capital as a constraint/restraint makes perfect sense to me. There is a legally required capital ratio, and a desired (normal) capital ratio. The desired capital ratio will be higher than the legally required ratio, because the bank wants to keep a buffer for unexpected events and opportunities. The legally required ratio affects the desired ratio, but it’s the desired ratio that is key to understanding bank behaviour.
I recognise that the ratio (both required and desired) depends on the type (riskiness) of asset. I just ignored that fact in my simple bank capital model for simplicity.
2. The simple reserve model assumes the central bank has a vertical supply curve of reserves. JKH assumes a horizontal supply curve of reserves (as long as the bank is sound, of course). Any monetary economist, orthodox or not, is aware that the Bank of Canada has a horizontal supply curve of reserves over the short run (where “short run” is defined as approx. “between Fixed Announcement Dates”). This is not an issue. We all know that the simple ECON1000 textbook story is not literally true over that short a run.
So why do we still teach that simple model:
2.1 because it’s simple
2.2 because we are not interested just in the here and now, but in all possible regimes, and a horizontal supply curve of reserves is not the only possibility.
2.3 because, if I understand what some people at the Bank of Canada tell me, in the very very short run, it is, or has been vertical. The BoC adds or subtracts reserves to make the overnight rate go exactly where the BoC wants it to go.
2.4 because of the Wicksellian problem of the long run indeterminacy of the price level when the central bank holds the overnight rate fixed, we would suddenly need to switch to a totally different model for the long run.
2.5 Most importantly, because even though the supply curve is vertical in the short run, between FADs, the BoC shifts that curve up and down in response to economic conditions. So over a longer time frame, it isn’t horizontal. In the long run (the medium term 2-year horizon for inflation targeting) the supply curve of reserves is actually both vertical and horizontal. What I mean by that is that the BoC allows the level of reserves to adjust, and the price of reserves to adjust, to whatever level is needed to keep inflation at 2%. You have a 3D supply curve, and it always looks horizontal in the inflation dimension, and vertical in the other 2 dimensions. And the simple vertical supply curve, though false, is a better approximation to that truth than a horizontal supply curve. Because we know that inflation is indeterminate with a horizontal supply curve of reserves. That’s the Wicksell problem.
So, saying the supply curve of reserves JUST IS horizontal, is not the whole truth. It isn’t, except in a very tightly-defined “between FADs” time period.
Post Keynesians literally believe their simple model of the horizontal supply curve of reserves. Orthodox monetarists do not literally believe their simple model of the vertical supply curve of reserves. But PKs seem to think we do literally believe it. That’s what’s so astounding!
3. On causality. What we use these models for is to explain how the central bank changes the supply of money. So causality has to begin with a change in something the central bank does. What the central bank does is shift the supply curve of reserves. That’s what causes all the other changes. We start in equilibrium (because otherwise things would be changing anyway), then the bank shifts the supply curve of reserves (right or left if it’s vertical, up or down if it’s horizontal), and that’s the original cause of all the other changes. Nevertheless, you are quite correct in saying, if the supply curve of reserves is horizontal, that a downward shift in that curve (lowering the price of reserves) would cause a sequence of events that might eventually cause the quantity of reserves (at individual banks and/or in aggregate) to change.
4. I might have got a bit lost, JKH, but I think nearly all your focus was on the asset side of the banks’ balance sheets. That’s the big difference, and it comes back to a point Bill Woolsey made above. The “supply of money” is (part of) the liability side of the banks’ balance sheets.
5. Your criticism of (some) economists for paying too little attention to bank capital is basically at least partly correct, I think. It’s part of a more general criticism: money/macro economists haven’t paid enough attention to finance. In “normal” times, when the financial system runs smoothly, we don’t need to pay much attention to finance. Just assume risk spreads are constant and ignore them! But in abnormal times…
6. On the zero required reserves vs no reserve requirements. It might just be a semantic difference between us. Not an issue I understand well at all.
That’s enough from me for now.
Rebel: “I see what you mean when you say that money is spent when more is held than desired, but it does beg the question why it is desired.”
Yep. That’s the demand for money. Hundreds of books and thousands of articles have been written on that subject. But this post is on the supply of money! So I’m ducking it, except to say: “because it makes shopping easier”.
” And one wonders why money supplied via OMOs could bid up prices at all, since the exchange is voluntary.” And that one opens up a can of worms as well.
The more orthodox would say that in order to persuade people to sell bonds and buy money, the central bank has to offer a higher price for bonds, which means a lower interest rate, and that lower interest rate causes increased demand for goods.
The less orthodox (diequilibrium monetary theorists) would say that when we accept money in exchange for something we have sold, we accept that money voluntarily, but that doesn’t mean we plan to hold it indefinitely. We plan to get rid of it, by buying something else instead.
But both eventually end up in the same place, in answering your question, albeit by a different route.
Winterspeak:
” If available capital defines the supply side, the existence of people who both want to borrow money and are likely to pay it back defines the demand side. I have yet to see demand addressed anywhere in the monetarist text.” That’s what we call savings and investment.
As I said to Scott Sumner, these models of banks, loans, and money are partial equilibrium, not general equilibrium. They aren’t supposed to explain everything.
Nick,
Thanks for the feedback.
Suppose the world splits into two groups of people, each of whom views reserves in a different way.
I think that difference has been compounded by the complication of quantitative easing; e.g. in the case of the Fed injecting all those excess reserves. I think each of the two groups also has a different view of what that change has been all about.
Think about it. That’s 4 different views of how reserves work from 2 groups of people trying to understand each other (sometimes trying).
In my own case, I have a very difficult time thinking of the reserve function in terms of supply and demand curves. I simply don’t think that way.
E.g.
“if I understand what some people at the Bank of Canada tell me, in the very very short run, it is, or has been vertical. The BoC adds or subtracts reserves to make the overnight rate go exactly where the BoC wants it to go”
I agree with that verbal interpretation. That’s exactly the way it works. But I can’t think of it as a curve dynamic of any type.
“What I mean by that is that the BoC allows the level of reserves to adjust, and the price of reserves to adjust, to whatever level is needed to keep inflation at 2%”
I agree with the reserve pricing part; I disagree with the quantity part. Quantity is used to affect reserve pricing only. The quantity mechanism is differential in affecting reserve pricing, and not integral. It takes a small differential quantity change to affect a permanent price change. Then the “differential quantity operator” is reset to zero.
“Post Keynesians literally believe their simple model of the horizontal supply curve of reserves. Orthodox monetarists do not literally believe their simple model of the vertical supply curve of reserves. But PKs seem to think we do literally believe it. That’s what’s so astounding!”
This question may astonish you, but exactly what do you have on the axes – precisely? I want to understand why you think PK’s believe in a horizontal supply curve for reserves. I wonder if they agree that’s what they believe. What you’re saying isn’t intuitive to me.
I was focusing on the asset side because I was using credit risk as the core example of risk taking and capital allocation. I did use deposits in the example to show reserve movements.
Zero reserves versus no reserves is indeed semantics, but with a little logic thrown in. It’s worth looking at (tomorrow).
JKH: And I thank you for the feedback!
Yes. A lot of this really does (I think) come down to different ways of visualising the world, almost a “language” issue. And yes, trying to think about QE throws a whole other mess in there!
Thinking of the Bank of Canada’s reserve activities as a supply curve: on the horizontal axis there is the quantity of reserves the BoC supplies/offers to the market (banks?). On the vertical axis is the price of those reserves (the overnight rate?). In general I, like most economists, think of supply curves as upward sloping, so the higher the overnight rate, the greater the quantity of reserves supplied by the BoC (equivalently, the greater the quantity of reserves it is asked to supply, the greater the price it asks). But in the limit we can think of it as horizontal, which means it supplies any amount banks want, at the same price. Or vertical, which means it won’t supply any more or less, regardless of the price.
“I agree with the reserve pricing part; I disagree with the quantity part. Quantity is used to affect reserve pricing only. The quantity mechanism is differential in affecting reserve pricing, and not integral. It takes a small differential quantity change to affect a permanent price change. Then the “differential quantity operator” is reset to zero.”
You lost me there. I remember a BoC guy saying (though he was talking about the very short run): “If the overnight rate is lower than we want it to be, we pull some reserves out of the system, so the banks are all scrambling for reserves, bidding up the overnight rate, until it rises to where we want it to be, then we put the reserves back in, and it stays there.” I would model that as a vertical supply and demand curve, in the very short run (hours), with the BoC moving the supply curve left, then right again, in that story. Maybe that’s what you were saying.
Economists get used to thinking about supply and demand curves changing their slope (elasticity) depending on whether you’re talking about the long or short, or whatever run. The demand curve for gas is very elastic in the very short run (I can wait a few hours before filling the tank at a slightly lower price), very inelastic in the short run (I need gas to commute, regardless of price), and more elastic again in the long run (if gas prices are high, I buy a smaller car, or move closer to work).
NIck @ 7:40
Here’s a paper I found interesting on teaching PK-MMT to grad students trained in neoclassical economics, using Godley & Lavoie in relation to Barro.
Pedagogical Approaches to Theories of Endogenous versus Exogenous-Money Pluralism in Action http://www.scribd.com/doc/5257591/Pedagogical-Approaches-to-Theories-of-Endogenous-versus-Exogenous-Money-Pluralism-in-Action
BTW, one of Steve’s Keen’s criticisms in Debunking Economics regarding “orthodoxy” in the teaching of economics is that, although no professional neoclassicists “believe” in these simple models since they are admittedly simplistic, students taking Econ 101 don’t understand this and never will if they don’t go on in their studies. As a result, the general level of understanding of economics is remains simplistic, which is a problem when citizens have to appraise policy arguments involving economics. Democracy requires informed voters. A big reason I frequent establishments like this, as I suppose other lurkers do too, lies in trying to find out what went wrong and how to fix it, especially when we are seeing bailouts for Wall Street and crumbs for Main Street.
RE: Are you asking why people spend money? Lots of reasons — they need to buy stuff (like shelter and good). I’m sure you know this, I must be misunderstanding your question.
To take your wealth effect question more seriously though. I suspect that increasing private sector credit extension always bids up prices. This is why: when a bank extends a loan, there are a number of balance sheet transactions, but since all were voluntary and must net out to zero I don’t think there is any wealth effect. The bank has a receivable and a deposit, the seller has a deposit, and the buyer has a loan and a mortgage (in the case of real estate). All are better off as they enjoy gains from trade, but no one is richer or poorer.
But, if credit is expanding, it means the bids go up, as leveraged buyers are willing (and able) to pay more than unleveraged buyers. As the bids on that asset class go up, banks can extend further credit against that asset class. Their capital constraint is pro-cyclical. Other asset owners see their balance sheets improve (without anything else changing), and I can see this having a wealth effect.
NR: “As I said to Scott Sumner, these models of banks, loans, and money are partial equilibrium, not general equilibrium. They aren’t supposed to explain everything.”
Well, they have succeeded at that! So do you agree that changing the interest rate changes the DEMAND for loans, and not the SUPPLY? At the very least, if you accept that capital requirements are the binding constraint, and not reserve requirements, in that model do you see why changing the interest rate has no impact on the quantity of “supplyable” loans?
I think you are correct that PKs believe the supply curve for reserves is literally horiztonal. PKs believe that reserves are primarily a mechanism to set the FFR, and could be replaced by more straightforward mechanisms. For example, stop issuing Treasuries, and lend unsecured directly to member banks at the FFR. The FFR itself would simply be announced, and quantity could adjust as the market demands. In the operational model, the supply curve would obviously be operationally horizontal, yes? The CB would supply whatever quantity any bank demanded at the price that it determined. This is a dramatically different mechanism that what we have now, but I think it describes a horizontal supply curve.
Actually, the supply of reserve balances is quite a bit more complex than simply being horizontal or vertical, and I don’t know anyone in the PK area that has studied this carefully that thinks otherwise. On an intraday basis for cbs that provide intraday overdrafts, it’s essentially horizontal. On an overnight basis, it’s pretty vertical, though cbs can set corridors via lending and remuneration rates that set upper/lower limits and could under certain circumstances make the supply curve horizontal (as in the US now . . . it’s essentially horizontal given the large excess qty and target rate=remuneration rate). Over longer horizons, its pretty much horizontal at the target interest rate. It’s even more complex than this, really, but low on time so I’ll leave it there for now.
Nick:
“Given the assumption of zero interest on deposits, and zero admin costs (only possible under monopoly, of course), it follows logically. If i give someone a $100 interest-free loan, and ask for it back in x years, he is wealthier by the NPV of the foregone interest over x years. As x goes to infinity, he becomes $100 wealthier in the limit. Pecek and Saving.
But under these assumptions banks, just like your cayman island counterfeiters, do take monopoly profits (seigniorage) away from the Fed, but reducing the demand for Fed notes 1 for 1. It’s different if demand deposits are imperfect substitutes for currency, of course.”
With zero interest on deposits, banking is just as profitable as counterfeiting. What stops the cayman banks from issuing enough money to drive the value of the fed’s dollars to zero?
Now consider the backing theory answer: The fed’s dollars are backed by the fed’s assets, and the cayman bank’s dollars are backed by the cayman bank’s assets. The issue of cayman dollars does not affect the fed’s balance sheet and so does not affect the value of the fed’s dollars. But cayman counterfeiters would expand the fed’s liabilities with no effect on the fed’s assets, so they would cause the fed’s dollars to lose value.
Now consider that the cayman bank dollars are a call option on federal reserve notes. We all know that call options do not affect the value of the base security, since they do not affect the balance sheet of the company that issued the base security. The backing theory is consistent with option theory, while the quantity theory is not.
The backing theory makes sense, while the quantity theory is full of free lunches and circular arguments, and it equates legitimate bankers with counterfeiters.
Scott, Nick, Winterspeak,
Scott: “Actually, the supply of reserve balances is quite a bit more complex than simply being horizontal or vertical, and I don’t know anyone in the PK area that has studied this carefully that thinks otherwise”
That’s what I suspected. I may be back with another question on this.
Scott, Nick, Winterspeak,
Scott: I know you’re short on time; just wanted to run something quickly by you and the others.
Thinking out loud here:
It seems to me there’s a fundamental problem in dealing with a reserve supply function in the sense that there is a perquisite architectural dial one must choose before analyzing a supply function.
E.g. the US is well into what I would describe as a “structural excess reserve environment”. There are competing explanations for why that environment exists. My explanation has always been that the dominant reason (at least for most of the latter period of the credit crisis) has been to provide a liability outlet for the money created by the Fed’s new credit initiatives. I suspect others such as Scott Sumner might look more to “multiplier” type explanations for the Fed’s actions. One explanation for the excess reserves is Fed liability oriented; the other is commercial bank asset oriented.
My liability oriented explanation becomes problematic for the analysis of a reserve supply function. That’s because the primary argument for the function isn’t the funds rate at all; it’s the requirement for Fed liability expansion or contraction.
It complicates the analysis of such a reserve supply function.
Or is the reserve supply function in question just a partial derivative function (i.e. a partial derivative of the funds rate, but not of the Fed’s demand for its own liability issuance due to its own asset expansion).
Make any sense?
Nick,
“I remember a BoC guy saying (though he was talking about the very short run): “If the overnight rate is lower than we want it to be, we pull some reserves out of the system, so the banks are all scrambling for reserves, bidding up the overnight rate, until it rises to where we want it to be, then we put the reserves back in, and it stays there.” I would model that as a vertical supply and demand curve, in the very short run (hours), with the BoC moving the supply curve left, then right again, in that story. Maybe that’s what you were saying.”
Again, the BoC verbal explanation is exactly how it works, in a general sense, and that’s what I’ve always said. It’s very simple.
But did you notice where your BoC guy said “Then we put the reserves back in, and it stays there.” That’s exactly right again. I would urge you to reflect on that precise idea, because it may be the most important one of all in understanding CB monetary operations. This is what I referred to as a differential rather than an integral operator.
But I’ve got input now that ranges between horizontal and vertical as the translation. Plus my own two cents worth on the “architectural dial” that must be considered in approaching the question of the supply function, as per my comment just above.
I think Scott is right on the fact of nuances.
This is why I asked the original question.
I gottit JKH!
The difference between “constrain” and “restrain” is vital, and now that has emerged from our discussion, I see what you mean and agree that the multiplier is a misleading fiction.
For me, the key is to understand the influence of reserves on a bank’s cost/benefit analysis of whether to expand its balance sheet, and to see how that is affected by the addition of reserves. The answer is, abstracting from bid-ask transactions costs, not at all.
As we and other commenters have discussed and I think broadly agreed, reserves may be treated as a one of the bank’s factors of production, with the product being balance sheet expansion, the quantity equal to some minor proportion of the deposit involved (whether for prudential or regulatory reasons), and the cost given by the (opportunity) cost of holding reserves. Let us say that the cost of reserves is given by the difference between the return on holding reserves and the cost of borrowing them – for example in the US in normal times, zero minus the Fed funds rate.
Consider what happens with an injection of reserves via QE with a non-bank counterparty. This generates an extra deposit liability for the counterparty’s bank, and an extra asset in the form of a reserve balance credited by the central bank in settlement of its QE purchase. The bank now has excess reserves. In the short-term, the bank can earn some return on this excess by lending it out in the overnight inter-bank market (eg Fed funds), but will the counterparty’s bank, or the bank it is lending the reserves to, increase lending to non-banks? No, because, assuming that the central bank is fixing the overnight inter-bank interest rate (eg Fed funds), the central bank must absorb the extra reserves to hold this rate so the cost of the reserves factor of production is unchanged. And since, other things equal, balance sheet expansion depends on this cost, the conclusion is that an addition of reserves does not increase bank lending.
QE does, however, increase M1, which is why my question about how M1 bids up prices matters. I suspect that the increase in M1 will have a very limited effect on prices, because it was effectively acquired as an asset switch, but that, as Nick says, is probably an issue for a different post.
Rebel,
Excellent.
If you approach reserves on a cost and pricing basis first, I think the separate assessment in terms of the flow of funds interpretation can pop out more easily. And there’s still no question that any cost effect of reserves on the balance sheet should be assessed with proper seriousness.
“QE does, however, increase M1, which is why my question about how M1 bids up prices matters. I suspect that the increase in M1 will have a very limited effect on prices, because it was effectively acquired as an asset switch, but that, as Nick says, is probably an issue for a different post.”
And a good point to (re)commence questioning Scott Sumner on as well.
I think it’s good that you point out the M1 effect. I don’t know why, but most monetary economists seem to ignore the M1 effect in such cases, and restrict their attention to excess reserves, with an associated eternal (but hopeless) yearning for reserve multiplier activity, without really examining your M1 issue very much at all.
RE: Yes, this is correct. You can think of reserves as a factor of production, but they do not contstrain the amount of credit that can be extended (produced). The higher cost pushed through may likely impact demand.
Another thought on your wealth effect point, btw. While bigger and smaller balance sheets don’t have a wealth effect on the parties involved, but may have a wealth effect on related balance sheets via asset price appreciation, higher and lower interest rates may have an income effect on the sector. As the private sector tends to be long NFA equity, low interest rates reduce its income, which is a whatever-the-opposite of stimulus is.
Nick:
As you work through all of these arguments claiming that bank reserves are irrelevant, do any of them have anything to do with the quantity of money? Or are all of them about the supply of bank loans?
Bill: Rebel is asking how an excess supply of money bids up prices. Others are thinking more about the supply of bank loans. But mostly I’m trying to persuade people to think about what the central bank is doing as choosing a supply curve (or supply function) of reserves, rather than just thinking about a dichotomy between quantity of reserves and price of reserves.
JKH: I’m really glad we’re on the same page with regard to what the guy from the BoC said. I had a hunch you were talking about the same thing. I’m afraid you really lost me on the “architectural dial” point though.
General point: one of the reasons I really like engaging with JKH on this issue is that JKH has first hand experience with working in the interface between banks and the BoC. So engaging with JKH is almost like, or sort of like, engaging my theoretical understanding with the data. But any model/theory I have will always be, and should be, simpler than the data it is supposed to accord with. So I’m not going to try to capture every nuance.
The other big difference is the time scale. I’m mostly thinking much longer run. A long run horizontal supply curve of reserves, where the BoC sets a fixed rate of interest on reserves regardless of the quantity demanded, is not just empirically false (because the BoC does in fact raise and lower the overnight rate at FAD’s in response to the economic conditions created by the quantity of reserves demanded), it’s theoretically impossible. That’s because of the Wicksell problem. A permanently fixed overnight rate would mean either accelerating hyperinflation, or accelerating hyperdeflation, and either would result in the eventual disappearance of the money and central bank that set a horizontal long run supply curve.
Post Keynesian models, with their horizontal supply curve of reserves, can only avoid this problem by assuming a fixed price level, or something similar.
Winterspeak: “So do you agree that changing the interest rate changes the DEMAND for loans, and not the SUPPLY?”
If the central bank shifts the supply curve of reserves, that will change the interest rate on reserves, and that will shift the supply curve of bank loans, and that will change the interest rate on bank loans, and that will change the quantity demanded of bank loans. Sorry to get all ECON1000 prof on you, but at times like these we really need to distinguish carefully between shifts and movements along curves.
“At the very least, if you accept that capital requirements are the binding constraint, and not reserve requirements, in that model do you see why changing the interest rate has no impact on the quantity of “supplyable” loans?”
In my simple model, if the supply curve of capital is vertical, and if there are fixed proportions between loans and desired capital, then yes, as I said in my post, a change in the supply curve of reserves has no effect on the supply curve of bank loans.