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 
tjfxh: “Inquiring minds are asking how, if the existing models that were used recently are so good, what happened.”
Macro guys ignored finance; finance guys ignored macro; and nobody was watching or understood all the hundreds of things you would need to watch and understand. Sure, that’s a massive oversimplification, but if you want my answer in one sentence, that’s it.
So, as a macro guy, that’s why I’m doing posts like this.
Scott F, I’m glad you posted that Wary quote. I had read that previously and was wondering how practical it is for the to set a floor wage with the type of benefits that Randy mentions, which would really be necessary in the US considering the miserable safety net here, where to qualify for most aid programs one has to be pretty much destitute. I don’t get the idea that the solution of people proposing a job guarantee, like Randy and Bill, are thinking of creating a floor at the misery level. I haven’t read their technical stuff. Do they present tight arguments overcoming serious economic objections such as Nick raises?
Here’s the political and policy issue. Many people, me included, are vitally interested in this debate, but either don’t have the economic/mathematical chops to wade into this, or if they do, lack time to give it the attention it requires. That’s why a public debate among experts is so important, instead of just pitting one ideology against another, as so often happens. Then, bias, myth, and emotions rule instead of reason and evidence.
To seed this further, let me bring in another criticism, this time from Circuitist Steve Keen instead of Neo-Chartalism. Steve was one of the people who correctly called the comideveloping financial crisis, based on his analysis of debt. According to him and others, like Michael Hudson, the core problem is debt, and it is not yet being addressed in the way it needs to be:
Only one question remains: why do Central Banks ignore the debt to GDP ratio?
There is nothing more dangerous than a bad theory.
The simple reason is: because they are neoclassical economists. You don’t get to be a Central Banker without a degree in economics, and the school of thought that dominates economics today is known as neoclassical economics. Though a lot of what it says appears to be superficially intelligent, almost all of it is intellectual drivel, as I outlined in my book Debunking Economics (which summarised a century of profound critiques of this theory which its practitioners have studiously ignored).
Since critiques by economists and mathematicians of this theory have literally filled books, I won’t try to go into all of them here. Just three key neoclassical myths suffice to explain why they do not understand the dynamics of our credit driven society. They believe that:
(1) The nominal money supply doesn’t affect real economic output;
(2) The private sector is rational while the government sector is not; and
(3) That they can model the economy as if it is in equilibrium.
The first myth means that they ignore money and debt in their mathematical models: most neoclassical models are in “real” terms and completely omit both money and debt. So since debt doesn’t even turn up in their models, they are unaware of its influence (even though their statistical units do a very good job of recording the actual level of debt).
The second myth means that they are quite willing to obsess about government debt, but they implicitly believe that private debt has been incurred for sensible reasons so that it can’t cause any problems.
The third myth means that they ignore evidence that indicates that the economy is very far removed from equilibrium, and they misunderstand the effect of crucial variables in the disequilibrium environment in which we actually live.
Steve Keen
http://www.debtdeflation.com/blogs/2009/12/01/debtwatch-no-41-december-2009-4-years-of-calling-the-gfc/
Nick: Everything I’ve seen about MMT explicitly describes the world through accounting transactions, and Scott’s “settle tax liability” definition is even clearer than that. This also has the nice feature of establishing what drives demand for fiat money, thus preemptively killing the coordination fairy tales so beloved by Austrians. Frankly, I think that is more accurate and easy to understand than a wooly economist definition like “medium of exchange”. Maybe economists should describe the world through accounting transactions!
I’d love to refocus, if only briefly, on the original topic of this post. Would you agree with the following statement?
“Bank reserves do not constrain bank lending, but are important in setting the FFR. To the extent that the FFR drives ultimate downstream demand for loans, then reserves matter. If other factors outside of the FFR are playing a bigger role it determining downstream demand for loans, the FFR (and by extension reserves) are less important — by tautology. Reserves, however, have no impact on the quantity of loans banks can supply, that is driven by capital requirements, although they may influence the cost of that supply. Capital requirements are the operational constraints on the quantity. There is no “multiplier” that takes reserves and automatically ejects them as loans into the economy, which is why a large pool of reserves and shrinking credit are perfectly compatible operational realities”
I think this is the typical MMT position which also allows for the mechanism where reserves do play a role.
Nick wrote: “A fall in bank share prices shifts the stick vertically up. We have just had both. So that has put banks on the vertical portion of their capital supply curves. That’s why JKH’s model starts to work in these special circumstances.”
Are you saying the part of ‘JKH’s model’ that says bank capital will constrain loans, works during these ‘special circumstances’ when banks have a difficult time raising capital?
If so, what do you believe contrains loans during ‘nonspecial circumstances’ (when stock can be issued at high prices)?
Perhaps nothing?
tjfxh: the guys running the economy have no idea how a fiat economy works. it’s like blaming witch doctors because it didn’t rain, (although in this case there’s a hose lying right there on the ground which is the real — pun intended — tragedy)
tjfxh
good comments, as always. Of course, Michael is an MMT’er, mostly. And we (MMTers) did start predicting all of this actually back in the late 1990s . . see for instance here (many more examples, though): neweconomicperspectives.blogspot.com/2009/08/financial-engineers-and-brave-new-world.html
regarding debate, the problem is mostly ideology, methodology, etc., so it’s hard to get it to the level you want. We mostly end up talking past each other or being outright dismissive. Nick’s a glowing exception in this regard . . .this is definitely the most I have ever seen a neoclassical engage these alternative views. Even in that case, though, as you’ve seen, a lot work to do on everyone’s part to eventually get a common understanding of what we’re talking about in the first place.
Thanks, Scott. As a former philosophy professor and clergy person I’m well aware that simple and even apparently stupid questions are useful in bringing out knowledge. “Out of the mouth of babes.” I took Econ 101 (Samuelson’s text) over fifty years ago and haven’t really looked at this stuff until recently. Mostly owing to the crisis and the policy considerations arising from it, I persist. I’m really happy to have found a place where different sides are discussed rationally and respectfully. The world needs more of this.
Winslow: Capital constraints always limit bank lending, unless the regulators decide not to enforce them.
Banks can always raise money if they can make profitable loans. That is the purpose of banking, to make profitable loans (aka. loans that will be paid back). I think banks may be having trouble raising money right now because:
1) They have all these unrecognized bad assets on their books which, if written down, will eat through their capital and who needs that?
2) Shortage of demand from customers who want to take on debt AND can pay it back
Winterspeak: “Would you [Nick] agree with the following statement?
“Bank reserves do not constrain bank lending, but are important in setting the FFR. To the extent that the FFR drives ultimate downstream demand for loans, then reserves matter. If other factors outside of the FFR are playing a bigger role it determining downstream demand for loans, the FFR (and by extension reserves) are less important — by tautology. Reserves, however, have no impact on the quantity of loans banks can supply, that is driven by capital requirements, although they may influence the cost of that supply. Capital requirements are the operational constraints on the quantity. There is no “multiplier” that takes reserves and automatically ejects them as loans into the economy, which is why a large pool of reserves and shrinking credit are perfectly compatible operational realities”.”
No, not really.
Winslow:
“Are you saying the part of ‘JKH’s model’ that says bank capital will constrain loans, works during these ‘special circumstances’ when banks have a difficult time raising capital?”
Roughly speaking, probably, yes.
“If so, what do you believe contrains loans during ‘nonspecial circumstances’ (when stock can be issued at high prices)?”
The reserve supply function of the central bank.
BUT:
1. I would focus more on deposits than loans.
2. Bank loans are only part of the total supply of loans anyway.
“”If so, what do you believe constrains loans during ‘nonspecial circumstances’ (when stock can be issued at high prices)?”
The reserve supply function of the central bank.
BUT:
1. I would focus more on deposits than loans.
2. Bank loans are only part of the total supply of loans anyway. ”
I’d say the reserve supply function only works in ‘special circumstances’ as well.
In particular, when the Fed is willing to invert the yield curve as this starts to pull reserves from the system (FFR acts as a bank tax) perhaps even faster than they are put in (through government interest payments).
Yes, banks can borrow at penalty rates but eventually it starts eating into capital and therefore solvency issues start to arise. Given a bank is leveraged 10:1 a yield inversion can fairly quickly start to reduce bank profitability. Add off-balance sheet entities and the higher leverage ratio/smaller capital base and entities can quickly go insolvent at the periphery.
I sometimes say the only current tool (inverted yield curve) the Fed has to constrain the financial system is to break it. From my perspective the transmission mechanism needs a redesign.
Nick’s post said: tjfxh: “Inquiring minds are asking how, if the existing models that were used recently are so good, what happened.”
Macro guys ignored finance; finance guys ignored macro; and nobody was watching or understood all the hundreds of things you would need to watch and understand. Sure, that’s a massive oversimplification, but if you want my answer in one sentence, that’s it.
So, as a macro guy, that’s why I’m doing posts like this.”
The “neoclassical” models don’t really account for currency denominated debt very well. They just assume all the debt was heading for some equilibrium and the fed and the rich are not encouraging it. The people who got it right focused on debt levels, interest payments, wealth/income inequality, and high asset prices.
I can’t even get people to admit the difference between price inflating with currency and price inflating with currency denominated debt.
Like, a mortgage is not a medium of exchange, so how does someone buy a house then?
Too much Fed: “Like, a mortgage is not a medium of exchange, so how does someone buy a house then?”
Sorry, but you really need to read a basic economics text. I/we can’t be expected to explain everything.
Winslow: normally we say that firms respond to price signals, because the change in price changes the marginal profitability of what they are doing. That’s why demand curves slope down and supply curves slope up. We don’t normally say that firms only respond to price signals when they are on the brink of bankruptcy. Why should banks be different?
Nick’s post said: “Too much Fed: “Like, a mortgage is not a medium of exchange, so how does someone buy a house then?”
Sorry, but you really need to read a basic economics text. I/we can’t be expected to explain everything.”
Let me try it this way. What % of houses are paid for with all currency?
Thanks for your response Nick. You still believe the “reserve supply function of the central bank” constrained loans during “nonspecial” circumstances.”
I guess we’re done. Thanks for being a great host!
Thanks Winterspeak! Man, it’s hard work arguing with you lot!. But worthwhile, I think. On all sides.
“Only one question remains: why do Central Banks ignore the debt to GDP ratio?
There is nothing more dangerous than a bad theory.
The simple reason is: because they are neoclassical economists.”
Why do they ignore debt to almost anything ratio? Because they like the wealth/income inequality (excess savers and excess debtors).
Here is a similar view to Michael Hudson. The fed and the rich want to own all the currency and assets so they can make everyone else rent from them for life (as in no retirement) while the fed and rich can retire at about any time.
I haven’t see any neoclassical economists work retirement into their models.
Nick “We don’t normally say that firms only respond to price signals when they are on the brink of bankruptcy. Why should banks be different?”
definitely another post….
Winterspeak wrote: [Nick]You still believe the “reserve supply function of the central bank” constrained loans during “nonspecial” circumstances.”
Clearly, given the past business cycle, nonbank/bank loans expanded far beyond the desires of a functioning central bank.
Essentially the ‘constraining ability’ of the reserve supply function didn’t take effect until the very end when it was shifted into reverse and everybody quit ‘dancing’. I hope Nick appreciates this, though he has also pointed out the capital constraints didn’t seem to work so well either, until now as new ‘capital’ has become more difficult to create.
Winslow: Nick’s position to the contrary, there is no constraining ability of the reserve supply function (if by that you mean quantity of reserves. FFR’s impact on bank lending via interest rates is, at best confused, at worst inconsequential).
In the past business cycle, I did not see the central bank do anything to try and get a handle on private credit. I currently see them doing their best to reinflate it, so I guess I don’t agree that it went “far beyond their desires” since their desire right now is to get right back there!
Capital constraints are only as good as their enforcement. Enforcement before was lax due to explicit support of various off balance sheet vehicles and securitization, enforcement explicitly waived in the days of TARP, and enforcement is a joke in the Obama administration’s world of “too big to fail”. At least capital requirements work in theory, reserve requirements don’t even do that!
Guys: forget bank loans. Loans aren’t the only asset on banks’ balance sheets. And banks aren’t the only source of loans. It’s money that matters. Demand deposits are created by banks, and are by far the biggest component of the medium of exchange. That’s the only reason that banks really matter. It’s got nothing to do with loans, except insofar as loans affect money.
New post coming up soon on this topic. Let’s save the argument on this point till then. Keep it all in one new place. Where I’ll have you guys attacking me from one side, and all the other economists attacking me from the other side. See if I can survive a “war on two fronts”.
Why money and not loans?
Your theory, please.
anon: wait for the post! May take a few days. I have other stuff on.
I’ve been traveling and busy with conferences over the last few days but I just couldn’t prevent myself in getting involved on this issue of money supply behaviour. Your micro model of bank behaviour, whether partial or general equilibrium, remains one in which banks (or loan officers) optimize purely on the basis of the amount of bank assets and reserves. As others have made it very clear, when we are talking macroeconomically of the banking sector as a whole the only constraint is the amount of creditworthy borrowers. Hence, the issue of reserves and capital requirements can only affect the composition of the suppliers of loans but not the overall volume of loans which is determined by demand. Banks as a whole lend as much money as they want as long as there are creditworthy borrowers out there — that is borrowers who do not jeopardize individual bank solvency.
In any case, I won’t repeat what others have said it better than I could. However, what I was astounded to read was when you wrote on November 29 that: “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!” My experience in attending conferences at the CEA, AEA, EEA, etc. over the last 35 years has been that whenever the issue of central bank behaviour has been brought up in the discussion the minority of heterodox economists who used to describe the money supply curve or the supply of reserves as essentially horizontal (like myself) were rejected by the mainstream on both supposed theoretical rigour and on its incompatibility with the real world. If you are correct I must admit that all those debates (including perhaps the present one) have been futile. Do you mean to say that all those guys that convinced the Bank of Canada to go monetarist in 1975 really didn’t believe in their models?! You’ve referred a great deal to the Mankiw, Kneebone, McKenzie and Row book’s analytics of the money supply process, I would like readers who are not satisfied with the mainstream to consider the Baumol, Blinder, Lavoie and Seccareccia book in Macroeconomics in which we have depicted precisely a horizontal supply curve of base money (on page 298) because we do fundamentally believe that it is a more accurate description than that a shifting vertical one!
Hi Mario! Welcome aboard! I was hoping you and Marc might chime in.
Distinguish two questions:
1. The normative one of how the Bank of Canada ought to set the money supply and reserve supply curves, from the positive one of how it does set the money supply and reserve supply curves. The 1970’s monetarist debate was a normative one. If monetarists had thought the Bank of Canada had in fact been doing what they thought it ought be doing, what were they complaining about?
2. How long is the “run”? Do you really believe the Bank of Canada can and does set a horizontal supply curve of reserves and/or money, and can leave it there at that fixed rate of interest forever? What about the Wicksellian indeterminacy problem? Have you and I not been at PK seminars where models did exactly that, even into the very long run, when stocks of assets adjusted to very long run equilibria (or failed to find an equilibria?
Hey Mario! . . . Yes, your text is the only one that gets it right!
The battle of the textbooks!
If the money supply is determined in a verticalist manner, and held fixed, the AD curve slopes down, and the long run price level is determinate.
If the money supply is determined in a horizontalist manner, and held fixed, the AD curve is vertical, and the long run price level is indeterminate.
Your central bank will either explode or implode, in the long run!
In the long run, a central bank that targets the price level has a long run vertical money supply curve. The Bank of Canada targets the inflation rate. If you ignore the difference between price level and inflation targeting (because it’s too tricky for first year), MKMR gets it exactly right. We show exactly what the BoC does (in the long run).
But yes, climbing down a little, it would be nice to distinguish all these different “runs”, and do all in the same text. But too complex.
Nick,
Question: Suppose you have a monopoly supplier of some good that it can produce at essentially no cost to itself. Do you doubt that this monopolist can set the nominal price of this good and keep it there for as long as it desires?
Note also that Mario’s point about a horizontal supply curve is not suggesting there would be no consequences to setting particular rates of interest, just that at whatever nominal rate is being targeted, the supply curve is horizontal (I said that earlier, actually).
Nick,
1. Your distinction is well taken but not very helpful in this context. The normative question of what the money supply growth ought to be was predicated on the positive one of what they believed was the causal process in place, naturally based on monetarists precepts often supported by questionable empirical work along the lines of Friedman/Schwartz of the previous decade. They accepted the normative position on the basis of an analysis which presumably Gerald Bouey at the time believed to be true! Hence, unless they were misleading him with bad empirical analysis that fit their theories, they must have believed in what they were marketing as theory at the time.
2. The question of the short versus long run is somewhat of a red herring. There has been a long debate going back to the 1980s (especially after Basil Moore’s 1988 book on the so-called horizontalist view) which went on for a while but which Marc Lavoie and I very much believe that it is largely settled. The issue is not that somehow in the “short run” we have the money supply relation horizontal but then it is upward sloping in the “long run”. What happens is simply that in actual calendar time, a central bank may act on the basis of its reaction function if, for instance, it wishes preemptively to combat inflation, say, on the basis of its perception of output growth (as in a standard Taylor rule type model of the reaction function).
3. As to the indeterminacy of the price level, all of that is predicated on the existence of a “natural rate of interest” which both Keynes himself and Post-Keynesians fundamentally reject when coupled with rational expectations which I would hardly subscribe especially in such trying and uncertain times!
4. As to the long-run adjustments of asset values, etc. that is well taken but that only applies to rates of returns on securities, etc. And not on the central bank-determined overnight rate. The latter is not market-determined in the short or longer run, but the spread between, say, the short and long rates can change because of market determined factors.
Scott, I assume the example (in the US) would be when the Fed announces it is changing the FFR. There, there is a “quantum leap,” in the rate that the Fed targets and seeks to maintain through OMO.
tjfxh: There’s no quantum leap, and sometimes no leap at all. The Fed announces a target, and tries to hit it via OMO. Usually it gets really close. Sometimes it cannot hit it at all. That’s one reason why they started paying interest on reserves.
If the Fed used a different mechanism, such as lending unsecured directly to individual banks (which is kind of how the discount window works right now) then it could simply announce the rate and be done with it. Note that there is no interbank lending market in this process. I think that a change in FFR would be a “quantum leap” if implemented via a mechanism like this.
Thanks, winterspeak. That clears up some of the fog in my mind about the “targeting” process. I had assumed that this was a lot more precise than it apparently is in practice, and that the Fed could just jump from one rate to another as it announced its desire.
tjfxh,
You’re both right.
The Fed CHANGES the target by simply announcing the new rate, and the rate moves there, as the qty of balances banks want to hold within a given day is very inelastic with respect to the overnight rate. With interest payment at the target, it’s even more obvious that they can just announce a new target.
On a day-to-day basis prior to setting the target equal to rate paid on reserves, the Fed used repos (mostly) and reverse repos (less often) to MAINTAIN the existing target, or thereabouts. Now, even this isn’t necessary if you keep the system in oversupply and set the target equal to the rate paid. In a crisis like with Lehman where perceived counterparty risk skyrockets, even oversupply may not be sufficient to keep the rate from rising above the target. That’s why Warren Mosler and Charles Goodhart both propose setting the remuneration rate at or just below the target, and the cb’s lending rate at or just above the target.
Scott:
“Nick,
Question: Suppose you have a monopoly supplier of some good that it can produce at essentially no cost to itself. Do you doubt that this monopolist can set the nominal price of this good and keep it there for as long as it desires?”
No problem, for any regular good. But money is different. First off, what is “the price of money”? If you mean 1/P, where P is the price of goods in terms of money, then yes, the central bank can do this (that’s price level targeting). But if by “price of money” you mean the nominal interest rate, then emphatically NO! This is the Wicksell Problem, and it’s been known for over a century that central banks cannot do this. (Actually, even David Hume knew this, two centuries ago.)
“Note also that Mario’s point about a horizontal supply curve is not suggesting there would be no consequences to setting particular rates of interest, just that at whatever nominal rate is being targeted, the supply curve is horizontal (I said that earlier, actually).”
But it is clear that so many people totally fail to understand what those consequences are. The consequences, in the long run, are a price level of either zero or infinity. I meant what I said about Mario’s central bank either imploding or exploding.
Mario: if your model has behavioural functions that are not homogenous of degree zero in nominal variables, it is not well-specified. If it is HD0 then it is, by definition, a natural rate model. And if the central bank does not impose some nominal anchor, by having itself a reserve supply function that is not HD0, then the price level is indeterminate.
Now, everyone reading this might think this is some arcane debate between economic theorists. But I don’t believe it is. As I argued in my “social construction” posts, I believe that it is the very fact that people frame monetary policy in terms of the nominal interest rate that is itself responsible for the failure of monetary policy to escape the current recession.
(And yes, I realise I am putting forward a very unorthodox view here, that will raise not just PK eyebrows, but raise the eyebrows of every mainstream economist as well. From my perspective, PKs are just a minor sub-branch of the prevailing Neo-Wicksellian orthodoxy!)
“But if by “price of money” you mean the nominal interest rate, then emphatically NO! This is the Wicksell Problem, and it’s been known for over a century that central banks cannot do this. (Actually, even David Hume knew this, two centuries ago.)”
Yes, I mean the nominal, overnight interest rate in the interbank market in which banks borrow/lend reserve balances. If you don’t think the cb can set the nominal interest rate that the “money” created only when there are changes to its own balance sheet, then what is the mechanism by which the rate can deviate? In other words, if the Fed sets the rate paid on reserve balances at 0.95% and charges 1.05% for overnight borrowing of reserve balances, and everyone with a reserve account can access these borrowing lending facilities, what is the mechanism by which the nominal, overnight rate for reserve balances would deviate from this range?
And, of course, Hume wasn’t working with central banks operating in a flexible exchange rate, fiat money issuing environment.
“If you don’t think the cb can set the nominal interest rate that the “money” created only when there are changes to its own balance sheet, then what is the mechanism by which the rate can deviate?”
This is correct, and there is no other answer.
And yes, it is a quantum leap. No qualification required. tjfxh must remain confused…
the Fed started paying interest on reserves for entirely different reasons
the long run is a series of short run targets
“But if by “price of money” you mean the nominal interest rate, then emphatically NO! This is the Wicksell Problem, and it’s been known for over a century that central banks cannot do this”
that’s exactly what they do
just that periodically, like Keynes, they change their mind
Scott: in the short run, when prices are sticky, central banks can set the nominal interest rate (on short safe assets) to anything they want. But if they hold it there forever, they will either create ever-accelerating inflation, or ever-accelerating deflation. Either way the monetary system collapses. That’s the problem.
OK, I’m not going to get into the natural rate stuff for now; note that at 205pm yesterday I said the point isn’t that they keep the rate at one place forever, but that they can set it where they want (and anon made the same point).
So, to avoid confusion, I should have said something like . . . if they set a rate on reserve balances at the target rate minus .05% and a lending rate to banks at the target rate plus .05%.
You can assume they adjust the target by whatever optimizing strategy you want. The horizontalist point is that, at whatever rate they are setting, the supply for reserve balances is horizontal. Obviously, that doesn’t apply to cases in which the monetary system collapses and nobody holds state’s money ceases to be the medium of exchange (well, they could still set the rate, but nobody would hold it). Horizontalists NEVER said the target was horizontal in the long run at only one specific rate; they’ve ALWAYS said the target rate could be adjusted.
Scott: “Horizontalists NEVER said the target was horizontal in the long run at only one specific rate; they’ve ALWAYS said the target rate could be adjusted.”
Agreed. No sensible horizontalist would say that, and most are sensible. But I think a sensible horizontalist must also say not just that it could be adjusted, but that it would have to be adjusted in order to prevent inflation from either rising or falling without limit.
Nick,
When I think about it, it is not obvious to me (the discussions on this blog are good for that purpose!) that offering an infinite exchange between money and a certain type of debt at a fixed price (conventionally expressed in terms of an interest rate) does mean that the general price level is indeterminate. For example, if the central bank offers to exchange money for carrots as much as required, isn’t the money supply eventually limited by the ability and willingness of the economy to supply carrots? I can see that this would distort the relative price of carrots, but not that it would lead to ever-accelerating inflation.
I look forward to your post on this.
Ok, agreement for the most part on the tactics, at least.
I’ll just add that the horizontalist position was always about the tactics, not the strategy of where to set the target and when to change it, so that’s why you may not have heard the points about adjusting the rate. While horizontalists like Mario, MMTers, and PK in general, usually don’t agree with the natural interest rate concept (there are some exceptions), they do agree that there is a point at which prices would rise and become even indeterminate, and that policy should be adjusted. Some PK think the target rate is what should be adjusted (John Smithin and Tom Palley, for instance), others think that fiscal policy should be adjusted (MMT and some others), some think both or either/or. For MMT, it’s the quantity of net financial assets held by the non-govt sector that should be adjusted, since that’s “money” for them.
Scott: That is correct. MMTs (like Mosler) would have the rate set at zero, and then use deficits (and surpluses) to control inflation/deflation.
Benefit of this approach is that you take central bank imcompetance out of the picture and focus economic Governance where it should be: leverage in the non-Govt sector (composed of NFA equity, private credit quality, real assets)
“MMTs (like Mosler) would have the rate set at zero, and then use deficits (and surpluses) to control inflation/deflation.”
A big advantage of this approach as I understand it is that it breaks the illusion that borrowing and taxing are necessary for deficit spending and kills the “fiscal responsibility meme that dominates American policy. This would allow for a policy that is capable of maintaining full capacity/full employment (figuring 2-3% frictional) along with price stability. This advantage is not lost on Mosler, who is now running for president and needs to relate monetary economics to policy in a way that voters can understand. This means disabusing them of the myths inherent in the established narrative, which are the hold over of a convertible fixed rate system. The MMT position is an upgrade to Abba Lerner’s principles of functional finance in light of Nixon closing the gold window on April 15, 1971, upon which the US government became the monopoly provider of a nonconvertible currency of issue within a flexible rate exchange monetary system. See “Functional Finance and Full Employment: Lessons from Lerner for Today?” by Mathew Forstater.
Click to access wp272.pdf
Since government debt issuance is actually for the purpose of draining excess reserves beyond the ability of OMO to handle, in order to allow the Fed to manage its target rate, borrowing would not be needed to drain reserves, and the speciuos link between borrowing and spending could be broken in the popular mindset. Rather, government would run deficits to offset the public’s desire to net save, thereby reducing AG below the level necessary to support full capacity, resulting in an output gap and unemployment. Taxation would only be necessary to reduce non-government net financial assets as necessary to prevent inflation from taking hold as the public’s desire to save diminished and spending cuts alone could not accommodate this shift in liquidity preference in relation to consumption.
Rebel: if the central banks buys and sells unlimited carrots at a fixed price, the price level is determinate. And it can keep that price fixed forever. Same as the gold standard, only carrots. Same as labour as well (as in some MMTers). All possible (though may or may not be desirable).
But interest rates are different. The central bank can fix something that has $ in the units. Interest rates (nominal and real) have the units 1/time.
My (eventual) post won’t be on this topic. Probably on “Why bad banks are a problem”.
Winterspeak . . correct, of course. Our Minskyan roots lead us to believe that manipulating interest rates is destabilizing at precisely the moment that you want to generate a soft landing.
tjfxh . . . that’s a great paper by Mat. I’ve used it in class before.
RE: Did you get that? Something the central banks have limited supplies of (gold, carrots) they can buy and sell in unlimited quantities to keep a price fixed.
But they can’t punch a number into an excel spreadsheet. Because they can’t punch a different number into the same spreadsheet later on. Or…. something.