There is no monetary hot potato in standard Keynesian and New Keynesian models. That is because those models make wildly implausible assumptions about people's knowledge. They assume people have perfect knowledge about how much money everybody else is borrowing from the banking system, and how much they are planning to spend from what they borrow.
People borrow money for two reasons:
1. Because their planned expenditures of money exceed their expected receipts of money. They "borrow to spend".
2. Because their desired stock of money exceeds their current stock of money. They "borrow to hold".
In aggregate, actual expenditures of money will always equal actual receipts of money. That is an accounting identity. But this does not mean that aggregate planned expenditures of money will always equal aggregate expected receipts of money. In aggregate, borrowing for the first reason ("borrowing to spend") will necessarily turn out to have been a mistake. Because actual spending must always equal actual receipts. But that mistake creates a monetary hot potato. It creates money that people hold, but did not plan to hold.
Let's consider an extremely simple monetary exchange economy. There are no commercial banks. A central bank chooses a rate of interest at which individuals can either borrow money from the central bank or lend money to the central bank, as they wish. A Wicksellian central bank with a horizontal LM curve. Most economists say that the stock of money is demand-determined under that assumption. I think they are wrong. There can be an excess supply of the stock of money. There can be a hot potato. The Law of Reflux, which says an excess supply of money must flow back to the central bank, is invalid, even in this case.
Start in equilibrium in a stationary economy with no borrowing from the central bank. The stock of currency is constant over time, and equals the desired stock.
Now let's ask what happens when the central bank reduces the rate of interest from 5% to 4%.
Two things happen:
1. The representative individual plans to spend (say) $100 per month more than he expects to receive per month. (The exact amount depends on the interest-elasticity of consumption and investment demand).
2. The representative individual plans to hold an extra (say) $10 stock of money. (The exact amount depends the interest-elasticity of the demand for money).
So in the first month, the representative individual borrows $110 from the central bank. He plans to borrow another $100 in the second month, and $100 again in the third month, etc.. But his expectations will be falsified by events, and his plans may change as a result.
At the end of the first month, the representative individual will be surprised to find that his receipts of money are $100 higher than expected. Because every other individual did the same thing as he did. He holds an extra $110 in his pocket, not the extra $10 that he expected to hold.
What happens next depends on whether he revises his expectations about future monetary receipts.
Suppose he doesn't revise his expectations. He thinks his extra monetary receipts were a temporary fluke, unlikely to be repeated. He now has $100 more in his pocket than he wanted to hold. He was planning to borrow $100 from the central bank in the second month. He now borrows nothing. He again plans to spend $100 more than he expects to receive in the second month.
At the end of the second month the representative individual is again surprised to find his monetary receipts are $100 bigger than he expected, and that he holds $100 more money in his pocket than he wanted to hold.
If he does not revise his expectations, or revise his planned spending, or revise his stock demand for money, this $100 hot potato of excess supply of money will continue to circulate forever, month after month.
Suppose eventually, at the end of the third month, the representative individual revises his expectations. He expects the $100 increase in monthly receipts to be permanent. He revises his planned flow of expenditure, and he revises his desired stock of money.
In the fourth month he plans to increase his spending by an additional $100 per month, which is again $100 more than he expects to receive. And his desired stock of money rises by (say) $20. He now holds $80 more money in his pocket than he desires, so he borrows another $20 from the central bank.
Once again he is surprised. At the end of the fourth month his receipts turn out to be $100 bigger than expected, and there is $100 more in his pocket than he planned and desired. And until he revises his expectations again, this $100 excess supply of money will continue to hot potato around the economy, even with no more borrowing from the central bank.
And so on.
The hot potato process continues until the central bank raises the rate of interest again. [Update: or people stop borrowing to spend for some other reason.]
Any money that people in aggregate borrow for the first reason, "borrowing to spend", will create a permanent hot potato that falsifies their expectations. Any money that people in aggregate borrow for the second reason, "borrowing to hold", will not create a hot potato, and will not falsify their expectations.
Standard Keynesian and New Keynesian models do not allow what I have just described above to happen. They assume an equilibrium in which aggregate planned expenditure is always equal to aggregate expected income for the current period. If the central bank cuts the rate of interest, both planned expenditure and expected income rise by the same amount. In aggregate, people never borrow money to spend. They only borrow money because they want to hold more money. In those Keynesian models, people are never surprised in aggregate to find themselves holding more money than they desire to hold. There is no hot potato in keynesian models
Does the standard Keynesian assumption of continuous equilibrium between aggregate planned expenditure and aggregate expected receipts make sense? Is what I have just described a rational expectations equilibrium? It might be. Even if every individual is fully rational, he does not know that a cut in the interest rate from 5% to 4% will lead to aggregate planned spending in excess of expected receipts, and falsify his expectation. For all he knows, the central bank might have cut the interest rate because everyone else planned to spend less, and the central bank was adjusting the actual interest rate down to match the lower natural rate of interest. For all he knows, aggregate planned spending might equal aggregate planned receipts at 4%.
The standard Keynesian and New Keynesian model assumes that aggregate planned expenditure always equals aggregate expected receipts. People in aggregate never borrow money to spend. They only ever borrow money to hold. It therefore makes totally implausible assumptions about individual agents' knowledge. It assumes a rational expectations equilibrium in which each individual knows the current plans and expectations of all agents. It is that wildly implausible assumption that ensures there is no monetary hot potato in standard Keynesian and New Keynesian models.
If agents in aggregate "borrow to spend", actual income will not equal what agents had expected when they planned their expenditure, and actual money balances will not equal desired money balances. The economy will be "off" the IS curve, and also "off" the LM curve.
Update: basically, in Keynesian terms, the hot potato story is a story about the process by which the economy moves from one ISLM equilibrium to another. It is a story of "false trading" (or "false borrowing" in this case) — because people's expectations and plans do not adjust instantly to the new Hicksian temporary equilibrium where those plans and expectations are mutually consistent, so they make trades they would not make in equilibrium. And when false trading happens, and stocks change as a result, there is always the chance that the economy may move to a different equilibrium, or even away from equilibrium. People may not always succeed in learning the new equilibrium. And their learning may itself change that equilibrium.
(I think this is related to what the interwar pre-General Theory monetary economists were on about. Robertson, Hayek, etc.)
(And I thank the commenters on my last couple of posts, especially the critical ones, for forcing me to try to think this through. It was hard.)
Worthwhile Canadian Initiative 
Oliver said: “Are you talking about dollars that sit as saved income in people’s pockets but were originally borrowed into existence?”
Good! Now we are talking about medium of exchange and how it can be viewed differently depending on the entity’s budget.
I don’t see 2. being very realistic either. It seems to me entities want to increase the amount of medium of exchange (stock) that has no interest rate and repayment terms attached, but they might need other entities to do 1. for that to happen.
And, “Or maybe the terms ‘borrowing with the intention of paying down as quickly as possible’ and ‘borrowing with no intention of paying down’ are what you’re trying to distinguish?”
Let’s do some personal finance/budgeting. Someone has a $500 per month mortgage. They are lucky enough to get a real wage increase. They might increase their checking account balance to build up an emergency fund instead of paying down the mortgage faster. I don’t consider that borrowing to hold.
Oliver said: “Your two examples seem very unrealistic to me. Could you give examples of real world situations where these take place? Imo people borrow money mainly for the following reasons:
1. Investment. They borrow because their expected receipts of money with borrowing exceed their expected receipts of money without borrowing. They “borrow to spend” on an investment that will hopefully create an income stream larger than that needed to service the loan.
2. Acquisition of assets for end use. They borrow because their desired stock of assets exceeds that which their current stock of money can buy. They “borrow to spend” on an asset that they believe will give them more satisfaction / utility than living without the incurred liability and the asset and in the belief that their future income will suffice to service the loan, e.g. mortgage or car lease.”
It seems to me in both cases the entities are doing budgeting/future budgeting. What happens if future business income and/or future wage income don’t meet expectations because the goods/services market is in balance/oversupplied or the labor market is in balance/oversupplied?
Lastly, what about borrowing to speculate in financial assets?
TMF:
I haven’t read the rest of this post or the comments, but regarding your question on the accounting suggested in your comment: | October 14, 2011 at 04:06 PM
Your accounting is basically correct.
Although I’d exclude this step:
……..
At the end of the first month:
Asset side of CB:
$11 in medium of exchange
$90 loan
Liability side of CB:
$100 in demand deposits
$ 1 in CB equity
……..
The CB doesn’t store the “medium of exchange” as an asset, generally speaking. The CB issues the “medium of exchange” as a liability. The “medium of exchange” in this case is most likely bank reserves (in theory it could be CB notes, but not normally when the CB is involved in the transaction).
The CB conducts transactions in the medium of exchange from this perspective – increasing its liability when it makes a payment, decreasing its liability when it receives a payment. The “medium of exchange” in the form of reserves is used as an asset by banks with reserve accounts at the Fed. You are accurate that the reserve account is essentially a form of demand deposit held by the banks.
Paying down principal of 10 reduces both the CB asset and the CB liability by 10. This is a balance sheet transaction that is not reflected on the income statement of the CB. It is a direct book keeping entry without the step I noted above.
Paying interest of 1 reduces the CB liability and increases CB equity by 1. This is a balance sheet transaction that is also reflected on the income statement of the CB.
“Everyone is $10 in medium of exchange short because it is at the CB.”
That is correct at the margin in your example. The medium of exchange has been converted to CB equity. This increases CB profit. This is also reflected in the fact that the CB remits its profit to Treasury, which reduces the deficit. And that is generally contractionary at the margin.
JKH: “The CB doesn’t store the “medium of exchange” as an asset, generally speaking.”
You are right, of course, but also (in a totally irrelevant sense) wrong. The Bank of Canada has lots of BoC notes in its basement (I think, they never let me behind the armoured doors to check). It’s just that if you own an IOU that you yourself signed, it doesn’t make any difference to anything if you burned it (except the waste of paper and ink).
This is a pedantic comment, that I only wrote for the fun of it.
Nick,
Quite right.
I was thinking of reserve deposit balances more than notes, avoiding that physical inventory aspect of notes.
JKH: Yep. Just to continue my pedantry, wouldn’t it value those notes at a couple of cents each, on the asset side of its balance sheet, to capture the printing costs (if they were newish notes)?
Haven’t looked into that Nick. A wild guess is that the bank expenses the cost of printing at the time it purchases the notes from the printer (instead of capitalizing the cost in the form of an asset on the balance sheet). And it probably allocates additional running expenses for storage, guarding, and inventory management, etc.
I’m sure there’s an answer somewhere, probably in the accounting notes to the bank’s annual report.
Perhaps I’ll have a look there, as soon as I’ve figured out your vertical LM curves.
On that basis, should be back on this around 2020.
🙂
JKH, first thanks for the verification.
And, Nick’s post at the top said: “Let’s consider an extremely simple monetary exchange economy. There are no commercial banks. A central bank chooses a rate of interest at which individuals can either borrow money from the central bank or lend money to the central bank, as they wish.”
I’m not sure how central bank reserves would fit in this situation, but I might assume that they are created 1 to 1 with the demand deposit when the loan was created. Assuming that and that people are paying the principal and interest with demand deposits, then I think the central bank reserves are being paid down at the same rate as the demand deposit(s) 1 to 1. I believe marking down both central bank reserves and demand deposits 1 to 1 is the equivalent of destroying currency.
If everyone pays down their debt, then the $100 amount starts going down every month and can “become” negative at the end depending on what happens to the $10 in interest that is transferred to the CB.
JKH, I add this step because it helps me (and hopefully others) “track” the flow and amount of medium of exchange.
At the end of the first month:
Asset side of CB:
$11 in medium of exchange
$90 loan
Liability side of CB:
$100 in demand deposits
$ 1 in CB equity
TMF,
Sorry, I confused the explanation a bit because I didn’t read the post, as I said.
But there’s an easy fix to adjust to the post.
Because there are no commercial banks, the central bank assumes the functional role of a commercial bank. “Loans create deposits”, just as they do in the existing commercial bank system. The central bank in making a loan also creates a deposit liability, which is a deposit held initially by the borrower with the central bank. Such a deposit could be interpreted as a “reserve” held by the depositor.
The central bank is willing to convert these deposits/reserves into currency on demand, and vice versa (just as banks do now acting as intermediaries between the public and the central bank).
There are no longer any conventional reserves held by commercial banks with the central bank, because there are no longer any commercial banks.
And, in addition to assuming the functional role of a commercial bank, the central bank still retains its monetary policy role of setting the policy interest rate by dint of setting the rates it wishes to set on all deposits – it is still the monopoly issuer of the currency. And it can set rates on deposits the same way in which it sets the policy rate for interest on reserves now.
And what I wrote previously still applies – your accounting for the loan is correct.
JKH said: “There are no longer any conventional reserves held by commercial banks with the central bank, because there are no longer any commercial banks.”
Yep. That is the other way to look at the situation.
Everything else sounds good.
I want to go over one other scenario. Let’s say for some reason the $100 needs to be maintained meaning that everyone borrows the principal and interest amount they pay back every month. Eventually, will the CB own all the currency? Thanks again!
“I want to go over one other scenario. Let’s say for some reason the $100 needs to be maintained meaning that everyone borrows the principal and interest amount they pay back every month. Eventually, will the CB own all the currency?”
TMF,
That’s an interesting question and puzzle.
Suppose the process starts with a $ 100 loan and $ 100 deposit. Assuming a steady state of repayment and re-borrowing of principal, every month the CB’s equity increases by $ 1 and deposits decrease by $ 1, due to the accounting effect of the $ 1 interest payment. At the same time, the re-borrowing of the principal repayment of $ 10 each month keeps the size of the CB balance sheet constant at $ 100. The equity account grows and deposits in total shrink over time.
At some point, due to the accumulation of interest payments over time, the CB will reach $ 90 in equity and deposits will have declined to $ 10. At the next stage, somebody has to pay $ 11 in combined principal and interest, while re-borrowing $ 10. That’s a problem, because there is no longer enough “medium of exchange” (deposits) to make the combined repayment and interest payment accounting entries by debiting deposits for a total of $ 11. That’s even with the simultaneous effect of the $ 10 re-borrowing.
There is a solution to this:
The CB should recognize that it needs to make dividend payments from equity in order to keep the monetary economy moving along. E.g. if it pays out all of its earnings as it goes along, then the money supply (deposits) will stay at $ 100, starting with the original loan. That’s because dividend payments will convert equity to deposits as an accounting entry. Each interest payment of $ 1 will flow back as a dividend payment of $ 1.
Alternatively, the CB could start to pay interest on its deposits, which would post pone the problem. The money supply would still shrink, but at a slower pace than the status quo.
As it stands, the CB is imposing a highly deflationary force on this economy by hoarding its earnings and accumulating equity and shrinking the money supply as a result.
Maybe this also shows how accounting can be useful in supporting Nick Rowe’s views on the importance of the medium of exchange.
TMF,
My example doesn’t include borrowing the interest.
If that happens, money supply is maintained without dividend payments from equity, because the total loan grows in tandem with each payment of interest/ each increase in CB equity.
But that is ponzi finance.
I know that the discussion has moved on, but I am still bothered by the hot potato metaphor. I think that I can express my disquiet more clearly. What I miss in the hot potato metaphor is a theory of the velocity of money. It is like in the song, “Well, I don’t give a damn about a greenback dollar, spend it fast as I can.” It is like there is an instantaneous indefinitely bounded increase in the velocity of money. That seems to run counter to the idea of money as a store of value. But we know that people indeed treat money as a store of value. To the extent that they do, how can it be a hot potato?
Of course, there are countervailing forces, as the saying about money burning a hole in one’s pocket attests. But then why does one force become suddenly dominant?
That is why I asked for some evidence. 🙂
Oh! One reason that I bring this up is that to a good extent, isn’t part of our current predicament the fact that the idea of money as a store of value is dominant?
JKH said: “That’s an interesting question and puzzle.”
Oooo! I like an economic mystery that is about trying to figure out what is really going on with clues all around. The biggest mystery of all is why should all new medium of exchange come from debt.
First, do you agree all new medium of exchange comes from debt the way the system is set up now (might be some debate about that depending on definitions)?
“As it stands, the CB is imposing a highly deflationary force on this economy by hoarding its earnings and accumulating equity and shrinking the money supply as a result.
Maybe this also shows how accounting can be useful in supporting Nick Rowe’s views on the importance of the medium of exchange.”
I agree with Nick that the amount of medium of exchange trades relative to the amount of goods/services so that it needs to increase as an economy produces more goods/services.
Let’s say productivity growth increased so that the amount of medium of exchange needed to increase by $100. It was $5,000 in currency (type unspecified) originally so that $5,100 is needed. Next, what you describe happens. Even if the CB paid out all its equity as dividends, it seems to me the $100 in demand deposits would get paid down so that there is only the $5,000 in currency left.
If an economy is constantly run so that the amount of medium of exchange is increased with currency denominated debt, will this scenario or something similar happen (I haven’t even talked about debt defaults yet causing the amount of medium of exchange to go down)?
Also, I disagree with Nick about for every borrower there is a lender in the strictest sense. If that were true in the strictest sense, then how would the amount of medium of exchange increase? For example, there is $5,000 in currency (medium of exchange) with no savings circulating. Someone saves $100 so the amount in circulation goes down by $100. Next, someone borrows the $100 to spend so the amount rises by $100 back to $5,000. It is not increasing.
JKH, I’m going to repost this from:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/10/the-optimum-size-of-the-central-bank.html
‘”It ends when the central bank runs out of things to buy, because it already owns everything, right down to your house, furniture, and toothbrush, which it rents back to you. It ends in communism.”
J.V. Dubois said: “If you have a government that promises budget surplus from now on forever, you also end in communism.”
What is it called when the very few rich people continuously run surpluses (very high real earnings and real earnings growth) so they own all the “currency” and assets and want to rent them back to everyone else?
It seems to me that the problem is excess savers.’
I’ll add rich entities like banks too.
JKH, one of the “mysteries” that needs to be solved is if an economy needs more medium of exchange how should that happen.
Along the same lines, what do you think of having the central bank have only liabilities (medium of exchange) and no assets (per se)?