Bear with me on this one. I'm trying to get my head straight on money and banking, by thinking weird thoughts.
Suppose, just suppose, that (for some unknown reason) the only asset that banks liked owning was bicycles. They refused to own any other sort of asset, except, of course, central bank currency and reserves at the central bank. Banks buy bikes, and rent them out for people to ride. Banks are bike intermediaries.
On the asset side of a bank's balance sheet you see the bikes it owns, plus a small amount of currency and reserves at the central bank. On the liability side you see demand deposits, just like regular banks in the real world. And the demand deposits serve as a medium of exchange. The demand deposits are redeemable on demand at par in central bank currency, just like regular banks in the real world. A bank's profits come from the fees it earns from renting out the bikes, minus any interest it pays on demand deposits, minus administrative costs, depreciation on the bikes, losses due to stolen or damaged bikes, etc.
Whenever a bank buys a new bike, it creates a deposit, and the money supply expands. Whenever a bike rider writes a cheque to the bank to pay his monthly bike rental fee, the money supply contracts.
This is a very strange monetary system. It's probably not at all optimal.
Suppose more cyclists decided that it was more convenient to rent a bike than to own their own bike. Banks would respond to the increased demand for bike rentals by buying more bikes and expanding the money supply. A fad for owning your own personalised bike would reduce the demand for bike rentals, reduce the size of the banking industry, and contract the money supply. Changes in the popularity of cycling vs driving would have similar effects on the money supply.
Changes in the supply of newly-produced bikes would affect the money supply too. An increase in the supply of new bikes would reduce the price of bikes. Depending on the elasticity of demand for bike rentals, this could either increase or decrease banks' balance sheets and the money supply.
Mass theft of rental bikes, a rash of mechanical faults in bikes, or a fall in the value of bikes, could cause banks to fail and destroy the monetary system.
If the supply of money is a by-product of the bike rental business, anything that affects the bike rental business will affect the supply of money. The reverse is true as well. Anything that affects the money business will affect the supply of bike rentals, and the demand for bikes by banks.
We don't need to assume that banks are the only firms in the bike rental business. Non banks could also buy bikes and rent them out. But the fact that banks produce money, and also really like owning bikes, would make banks really important players in the bike rental market. Being able to pay for bikes by creating deposits would tend to give them an advantage over other bike rental firms.
A central bank that aimed for monetary stability would need to keep a very close eye on the bike rental market. If there's an increased demand for bike rentals, banks would meet that demand by buying more bikes, and increasing the money supply. But this doesn't mean that people want to hold the increased stock of money that banks created when they bought more bikes. The demand for rental bikes and the demand to hold money are presumably unrelated. The seller of the bike wants to spend the money on something else. That excess supply of money would hot potato around the economy, causing an inflationary boom. Unless the central bank took offsetting action. And a fall in demand for bike rentals would reduce the money supply, as banks stopped buying bikes. And this excess demand for money would cause a deflationary recession, unless the central bank took offsetting action.
The reverse is true as well. Any actions taken by the central bank, whether or not they were designed to offset the effects on the money supply of changes in the bike rental market, would themselves affect the supply of rental bikes. If the central bank decided to increase the supply of money, perhaps to match an increase in the demand for money, this would cause a boom in the bike rental business. By increasing the supply of reserves, making it easier or cheaper for banks to buy a bike and create a deposit, the central bank is indirectly increasing the supply of rental bikes.
If the demand for bike rentals collapsed, or if no trustworthy bike renters could be found, central banks would find it hard to increase the money supply. Central banks could create more reserves, but banks would just leave them on deposit at the central bank. They wouldn't go out and buy bikes and create deposits. They can't find anyone trustworthy willing to pay to borrow those bikes.
The bike rental business would be a macroeconomic phenomenon, not a microeconomic phenomenon. And people would tend to confuse the demand for rental bikes with the demand for money. And this confusion would be perfectly understandable, because an increased demand for rental bikes would cause both an increased quantity of rental bikes supplied and an increased quantity of money supplied.
What I have just imagined is a very weird world. But the real world looks just as weird. Banks don't like having bikes on their balance sheets. Instead, they like having certain types of IOUs on their balance sheets. We can understand why banks prefer certain types of IOUs to bikes. It makes sense for the individual bank. But does it make sense for the monetary system as a whole? Bikes, the yellow metal, IOUs; these are all very weird ways to run a monetary system. What has the optimum quantity of the medium of exchange and medium of account got to do with optimum amounts of bikes, yellow metal, or those certain types of IOUs?
Worthwhile Canadian Initiative 
It’s standard linguistic usage among (most) economists.
Isn’t the usual definition of the demand for some good X, during a given interval of time T, and at a given price p, something like: the amount of X that people are willing and able to buy during time T at price p?
There is nothing in this standard account about how much of the good people might want to add to their stocks for some extended period of time versus how much they want to want to exchange right away for something else. The varying sources of the desire for the good, including the intended uses toward which the good is to be put, are extrinsic to the demand for the good. That is, the different sources of the desire to acquire the good are part of the cause for the demand being what it is, but the demand is not restricted to desires that proceed from only one kind of source
When people talk very loosely about “the money market”, what they really mean is “the bond market” or “the market for short-term bonds” or “the market for IOUs”.
But these IOUs are promises to deliver money. So I don’t see why we should hesitate to call this a market for money. If I go into a market and trade my fatted calf for a promise by some merchant to deliver a truckload of grain to me six months from now, then we would certainly say I have purchased some grain with my calf. And if I go into some market and trade $1000 for a promise by that merchant to deliver a truckload of grain to me six months from now, we would certainly say I have purchased some grain with my money. So if I go into some market and trade $1000 for a promise by some merchant to deliver $1100 to me six months from now, why should we refrain from saying that I have purchased some money with my money?
Dan: “Isn’t the usual definition of the demand for some good X, during a given interval of time T, and at a given price p, something like: the amount of X that people are willing and able to buy during time T at price p?”
[Off-topic] I think you got that out of Mankiw, US edition, or maybe 5th Canadian edition? I scrubbed the “and able” from the 1st to 4th Canadian editions. It’s wrong, because when there’s excess demand for a good buyers aren’t able to buy as much as they are willing to buy, because they can’t find enough sellers. Must rant at Greg Mankiw about that sometime.]
Yes, that’s the normal definition for most goods. It’s a flow demand, per unit of time. But money is not like other goods. For assets, we distinguish a flow demand from a stock demand. We distinguish between the desired stock of houses and the flow demand for new houses. Money is an asset, so we talk about a stock demand, but it’s not like other assets, because: it is flowing both in and out of our pockets; it does not have a single market of its own where we can observe those flows. We see those flows in every single market of the economy.
“Demand for money” means “desired stock of money”. That’s the conventional meaning of the term.
The apple market is the market where apples are traded for money, the banana market is the market where bananas are traded for money, the bond market is the market where bonds are traded for money. Most bonds are promises to pay money in the future. Some promises to pay money are themselves money. Like my chequeing account, for example. But a promise to pay money that is not itself money is a bond. Money is a medium of exchange and a bond isn’t. I insist on that terminology because that’s the only way we can keep that distinction clear. And it matters. Once people start talking about “the market for money” they forget that some goods are media of exchange, and others aren’t. We don’t live in a barter economy, where all goods are media of exchange. If we did live in a (hypothetical frictionless) barter economy, the US would not be in recession. The unemployed would barter their way to full employment.
Because the bond market clears, people who confuse the bond market with the money market think the money market clears, and so there cannot be an excess demand for money. So they totally fail to understand how there can be a general glut of goods, and that an excess demand for money, not an excess demand for bonds, is what causes it.
Nick: re Mankiw: the usual assumption about “able” is that it means “able to pay the price at which the buyer expresse his preferences”. Wishing to buy a Ferrari with no money is not a demand,merely a wish. Wishing to buy a Ferrari for $ 10K if I have $ 10K and someone is willing to sell at that price is part of the demand curve.
I think you’re saying (among other things) that the demand to hold money is unrelated to the demand to “rent” money, as evidenced by the fact that you would probably only rent money in order to spend it, which is actually kind of the opposite of holding it. So the demand for loanable funds, like the demand for bike rentals, has “no relation” to money demand. Basically right? (I don’t agree with this, but want to make sure I understand your position on this point; we’ve been talking past each other a bit.)
Jacques: Yep. It’s to distinguish idle wishes from what you really would do if the good were offered to you at that price. But if you interpret “and able” literally, you get into total self-contradiction in the case of excess demand.
M Ricks: basically right, yes. There might be some correlation between the demand for loans and the demand for money in some circumstances (clearly, a bigger population would mean more of both, other things equal), but they are conceptually different things, and there would be many cases where one goes up and the other goes down.
In this monetary system, I imagine that banks would assume, as they apparently do now, that if one of their bikes had a flat tire, the leak must be at the bottom of the tire because that’s the part that’s flat (apologies to R. Solow or A. Okun).
Nick – why should the bond market clear? I would think that economically that means (or should mean) the allocation of credit becomes efficient (ex ante, holding central bank policy constant)quickly enough. Why would that be?
Why does the demand for money increase? Why do people plan to hoard more medium of exchange if they do not concurrently plan to exchange it? What use does it serve when neither being exchanged nor bearing interest (in which case it is not much different from any bond with a liquid market).
I tend to go with Tyler’s view that the short dated risk free bond is not very different from ‘money’.
Ritwik:
Paragraph 1. If the bond market clears that does not mean the allocation of credit is efficient. There might be all sorts of externalities, both standard micro ones, and macro ones if other markets are not clearing. Let’s leave that aside.
I don’t think the whole of the bond market does clear, in the normal sense. Some people and firms cannot borrow at any interest rate, because nobody trusts them. But you could say that their bonds are different from other people’s bonds, and fail the test of the market. Let’s leave that aside.
The usual argument is that bonds are traded in organised markets where the price of bonds adjusts very quickly to eliminate any excess supply or demand for bonds. Much more quickly than the prices of most output goods and labour adjusts. If we are talking about government bonds and bonds of large corporations this seems a reasonable assumption. At least, it’s a reasonable assumption except in a financial crisis where some bond markets seem to freeze up. But then the market for rarely traded bonds, like the IOUs of an individual household, or small firm, may be more like the labour market, where each individual worker is different, and it takes time to get a loan or get a job. And some output goods, like wheat, are traded in markets like the market for government bonds, where prices adjust quickly and the market clears quickly.
The standard macro assumption is that bond prices adjust instantly quickly to keep the bond market clearing at all times, while the output and labour markets do not always clear, because their prices adjust slowly. This seems to me to be an approximation of reality that’s defensible as a first draft in a simple macro model.
Paragraph 2. Why do people hold positive stocks of money at all, even if they use money to buy and sell everything? In principle you could go to the bond market, sell bonds for money, then instantly go to the supermarket and spend it all. And spend your salary on bonds the instant your paycheque hits your account. And hold vanishingly small stocks of money, on average.
Because it’s too much hassle to do that. We hold inventories of money like we hold inventories of food. Because the bond market/supermarket isn’t always open, and it’s too much hassle to go there and buy a tiny amount of bonds or milk every time I want to put some in my tea. The milk in my fridge is depreciating faster than the money in my wallet, and pays no interest, and yet I hold stocks of milk.
We always hoard some money. The velocity of circulation isn’t infinite. But sometimes we hoard more than at other times, and velocity falls. Because we are planning to buy something, when we spot a good deal. Or because we are afraid that our inflows of money might dry up, and that it will take longer than normal to sell our labour or bonds or whatever we normally sell to get money.
Paragraph 3. Maybe (still can’t get my head properly around this) some finance guys are using Tbills as a medium of exchange. But the rest of us can’t. You might say there’s a spectrum of goods, with the most liquid at one end and the least liquid at the other, so it’s just a difference of degree, and there’s very little difference between the 1st and 2nd and 3rd most liquid. That’s true, but still wrong. Because the most liquid becomes the medium of exchange, and all the other goods are bought and sold for it. The winner in the liquidity race takes one side of all the markets, even if it only wins by a nose. A difference in degree becomes a difference in kind, as Yeager said.
Sure, I understand why there will always be a non-trivial level of ‘money inventory’. I work in consumer goods supply chain in an economy where the vast majority of firms and households are cash-constrained, I can’t underestimate the importance of off-the-shelf availability of anything, let alone the ‘mother good’. 🙂
I was referring to the delta of this demand. If firms and households become fearful (for whatever reason), shouldn’t that increase the demand for, specifically, interest bearing risk free assets rather than the medium of exchange. I don’t want to transact now and for sure I don’t want to have lesser when I transact in the future.
Plus even if the ‘real’ sector’s money demand goes up, the financial sector responsible for accommodating this money demand is quite likely to translate it into a demand for interest bearing risk free assets. The finance super-market is (almost) instantaneous and is open (almost) 24/7.
So just as you argue ‘no general glut without shortage of medium of exchange’, can’t one argue ‘no shortage of medium of exchange without shortage of g-secs’?
Say I’m a business, and I find it convenient to maintain a $5 million inventory of money. I decide to buy a new machine that costs $5 million. I borrow $5 million and buy the machine. You can see that I’m about to make the obvious fungibility point. Did I use the borrowed money to buy the machine? Or did I use my pre-existing money inventory to buy the machine, then replenish that inventory by renting money? Neither is correct of course.
You say we borrow in order to spend, which is completely different from the demand to “hold” money. But it seems more accurate to say that we borrow in order to spend while still maintaining our desired money inventory. In this respect, your very sharp distinction between the demand to borrow (rent) money and the demand to hold money — they have “no relation,” you say — still leaves me a bit puzzled.
This goes to the original question of your post. You seem to think it is arbitrary that bank portfolios consist of loans instead of something else, say bikes. But the loan market is the rental market for the medium of exchange, and the medium of exchange is what banks manufacture. This seems like a pretty efficient distribution system for the money supply. Borrowers want more of the medium of exchange, by definition. Bike owners/manufacturers may or may not.
I feel like I’m saying obvious things here, which probably means I’m missing something elementary … I’m genuinely perplexed by this discussion. I spent a good chunk of my career as an investment banker working with depositories on capital issuance and strategic transactions. Always thought I understood their business, but maybe not!
When I said “neither is correct” I meant neither is more correct than the other.
M.Ricks – “the loan market is the rental market for the medium of exchange”, or credit is (also) money. 🙂
Ritwik: the Big Finance Superstore may be open 24/7, but they deal in bulk, and the store is a drive, and most of us aren’t members, so we go to the local corner store instead. And half of us don’t have liquid assets like government bonds, so if we want to sell bonds that means the credit card, or getting a bank loan.
“If firms and households become fearful (for whatever reason), shouldn’t that increase the demand for, specifically, interest bearing risk free assets rather than the medium of exchange.”
It’s likely to be both.
“I don’t want to transact now and for sure I don’t want to have lesser when I transact in the future.”
You might want to buy quickly. And you always hold a larger inventory if you are fearful your supplier might miss a delivery.
M Ricks: “Neither is correct of course.”
I would say both are correct, and it makes no difference with a fungible asset like money, (as long as your inventory doesn’t go negative for any period if you spend first then borrow to replenish your inventory).
“But it seems more accurate to say that we borrow in order to spend while still maintaining our desired money inventory.”
I’m very comfortable with that way of describing it. It is more accurate.
Try this: suppose a real bike rental firm goes to the bank, sells an IOU for money, then goes to the bike producer and buys a bike for money. Then rents out that bike, and takes the rental fees and gives them to the bank to repay the IOU. That’s basically what happens in the real world, right? The only difference in my world is that the bank merges with the bike rental company, so cuts out the middle steps.
If the demand for bikes increases, the bike producer sell an extra bike, in exchange for extra money, but probably doesn’t want to increase his desired inventory of money. If the demand for IOUs increases, the borrower sells an extra IOU, in exchange for extra money, but probably doesn’t want to increase his desired inventory of money.
The whole point of holding a buffer stock is so it can temporarily depart from its desired level without too big a problem.
Nobody ever really understands anything! I’m just an armchair economist. Having worked in the business, you will know massive amounts more than me about how banking currently works. I have to simplify massively. That’s a cost. But it has a benefit too, because sometimes it lets us see a bigger pattern in a wider picture, and imagine other ways of doing things. (Yet sometimes we think we see a pattern that isn’t there.)
Ritwik: “…or credit is (also) money. :)”
Credit is the sale of an IOU. It depends whose name is on that IOU. If my name is on the IOU it will not circulate as a medium of exchange. Only those who know me and trust me will accept it, but they can’t pass it on to anyone else easily. If the Bank of Montreal’s name is on the IOU it can circulate as a medium of exchange. I have a BMO IOU in my chequing account. I sell that IOU to the supermarket in exchange for food. It sells it to TD bank in exchange for a TD IOU, and this repeats. Everyone in Canada knows and trusts BMO and TD, so their IOUs can circulate as media of exchange. But very few Canadians know and trust me, or recognise one of my IOUs.
I didn’t mean to say “I know more about banks,” and I’m all for doing simple thought experiments. (If you ever come across my scholarship you won’t have any doubt about that.) But I did always think I knew the answer to your original question about why it makes sense, for the monetary system as a whole, for depository banks (licensed issuers of money) to be (mostly) in the business of renting out money (making loans). You didn’t seem to think my answer had merit. That’s fine but we can’t both be right. You’re asking a pretty fundamental question about the design of the monetary system, and unlike me you’re a monetary economist, so I find this disagreement intellectually somewhat troubling. Anyway, I’ve enjoyed this discussion and thanks for indulging me and for being responsive.
Separately (to Ritwik), no, credit (generally) is not money; I’m with Nick on this.
Nick : Of course, not in the literal IOU sense. In the MMT sense of credit ‘creates’ money. Not that I necessarily believe it completely(actually, I don’t quite know what to believe). Just exploring if M.Ricks’s comment implies that.
M Ricks and Ritwik: yes, this has been a very good discussion.
“You’re asking a pretty fundamental question about the design of the monetary system, and unlike me you’re a monetary economist, so I find this disagreement intellectually somewhat troubling.”
I might be wrong. Many monetary economists would say I’m wrong.
Sometimes I like to shake up my picture of the world, and see if I can still make sense of it.
Nick, I think someone has already linked to this on some other post on your blog, but the first para of this Goodhart article is almost electrifying. http://www.voxeu.org/index.php?q=node/4283
I especially like the implication (unstated) that medium-of-exchange inventory necessitated by spot transactions which are in turn necessitated by non 24/7 supermarkets become irrelevant in a world with no defaults.
I don’t really understand whether there is or isn’t a clean economic distinction between money and credit. But I do believe (after reading Graeber and now Goodhart)that a theory of money must incorporate credit (and default) to be relevant.
As an aside, now I also find it a little strange that hardly any MMT-er ever moves from talking about loans to talking about default.
Ritwik: Goodhart is good (oops!). I disagree with some of his stuff, but I think he’s basically right in that piece. If I were known and trusted by everyone, my IOUs would circulate as money.
I think he stretches it a bit though, by saying you can’t have money and representative agents. There are a couple of ways to “cheat”/simplify. Assume everyone knows the bank, and the bank knows everyone, but none of us know each other. Then we can borrow and lend with the bank, and can use the bank’s IOUs as money. But you won’t accept my IOU, because I’m anonymous, even though we are all identical, so you can’t track me down to repay the loan. All trade takes place in the dark, except trade with the bank.
Some credit/IOUs is money (mine isn’t), and some money is credit/IOUs (gold wasn’t). But they are not the same. It’s an important distinction.
We buy things with money, not with any credit. A recession is an excess supply of goods and an excess demand for money, not an excess demand for non-monetary credit.
Nick (and others): some money is credit/IOUs (gold wasn’t).
Any definition of “credit” which excludes a pending claim on real wealth strikes me as not-useful. That’s what you need in order to say that money is not necessarily credit. It may be an anonymous claim, or it may be a transitive claim, but it’s not money unless its users treat it as a pending claim on real wealth, and if it’s a claim on wealth then it’s a form of credit.
Even goldbug types don’t argue that gold makes a currency more trustworthy because of gold’s residual value as a consumable commodity. They argue that gold has residual value as a medium of exchange, over and above it’s value as a consumable, even if its currency value collapses. That it remains usable as money even without a central authority stamping it into uniform chunks. They don’t claim that gold isn’t an IOU at all — just that it’s a particularly stable (anonymous) IOU which will (unlike the transitive IOUs issued by the king) still be accepted by others even after the king is dead or his power to tax has dissipated. That it functions as money even when nobody is “issuing” any of it explicitly. This may or may not be hooey, but it’s still consistent with money always-and-everywhere being a form of credit.
A recession is […] not an excess demand for non-monetary credit.
I agree with the other part, but how do we go about testing this part of the hypothesis? If economic activity is measured by observing monetary exchanges then economic demand which is not denominated in money is invisible. You can only “see” IOUs which are mediated or publicly announced in some way. What if the excess demand is there, but it’s constrained by stickiness of accounting frictions, or lack of trust? That’s no less plausible than the accounting frictions or lack of trust that prevent people from abandoning an existing medium of exchange even when it starts to lose value. Which I think we agree is a real phenomenon.
Here’s a description to work with (hey, maybe you’ll be able to change my view while I’m trying to change yours ;-). When you come into possession of a banknote from the Bank of Montreal you are holding a promissory note. Nominally you have a claim against BofM, but because the note is not backed by any commodity, it actually represents a transitive claim through BofM, on (e.g.) some measure of potatoes from your grocer. Your grocer effectively “owes” the holder of the note some potatoes payable on demand, though the debt is denominated in loonies and predicated on your grocer’s confidence in BofM’s ability to generate real wealth in the future.
Now, I happen to think that this is still a wrong way to look at it, but as far as I can tell it’s compatible with the view you expressed above about the role of the bank (or state, or king, or whatever) as simply a “trustworthy” issuer of IOUs which can be used as money. So what do you think is wrong with this description?
Also, Ritwik: I tend to go with Tyler’s view that the short dated risk free bond is not very different from ‘money’.
To add to what Nick said, the fundamental and irreducible difference is that those “short dated risk free bonds” are denominated in dollars (or whatever). There’s nothing stopping people from using the bonds as a token representing some number of units of the medium of exchange, but at that point they are essentially just a regular check, issued by the issuer of the bond, which happens to be passed around a few times before being deposited. Money is always a form of credit, but (as Nick is saying) not all forms of credit are used as money, or even denominated in money…
Darius: “I agree with the other part, but how do we go about testing this part of the hypothesis?”
I’ve worried about this, a bit. Two thoughts:
1. Illiquid goods are always harder to buy and sell than liquid (by definition). But in recessions, it seems to me that illiquid goods get relatively harder to sell than normal, and relatively easier to buy than normal. That seems to be empirical evidence in favour of a monetary nature of recessions.
2. I keep getting smidgens of evidence that barter/new monetary systems are counterclyclical. People resort to barter (a little bit) in recessions, or set up their own monetary systems. Just saw this today:
http://gulzar05.blogspot.com/2011/10/barter-economy-in-greece-and-time-banks.html
“When you come into possession of a banknote from the Bank of Montreal you are holding a promissory note. Nominally you have a claim against BofM, but because the note is not backed by any commodity, it actually represents a transitive claim through BofM, on (e.g.) some measure of potatoes from your grocer.”
I would say that the BMO note is redeemable in Bank of Canada money, and that promise to redeem is backed by the assets on BMO’s balance sheet. It is Bank of Canada money that is irredeemable. You could get a run on BMO (if the BoC didn’t act as Lender of Last Resort), but I don’t see how you could get a run on the BoC. We trust the BoC not to overissue too drastically. But in a sense, what we are really trusting is everyone else in Canada, that they will keep the chain letter going, simply because they trust the next person in the chain.
We wake up in the morning expecting everyone else will still drive on the same side of the road, and use words in the same way, and accept BoC money, and as long as we expect that, it’s rational for us to do the same. In a game where there are two equilibria, we tend to stick to whichever equilibrium we were in yesterday. It’s a focal point.