I sketch a simple model where a shortage of collateral reduces the money supply, and makes the Cash-In-Advance constraint binding in an otherwise New Keynesian model. This post is a followup on my previous post on "negative money".
Start with an economy where the central bank issues green paper currency, and all goods must be bought for that green paper currency. There is a Cash-In-Advance constraint in this economy. If you do not have any green notes you will miss out on buying opportunites. If you want to sell goods, and the buyer does not have any green notes, you will miss out on selling opportunities. The CIA constraint will be binding.
Now suppose every agent keeps all his currency in a box at the central bank. When he buys something, the central bank takes currency out of his box and puts it in the seller's box. Nothing has changed (except for muggers). The currency boxes are just a simple form of ledger. It wouldn't matter if all the currency was destroyed in a fire, provided the ledger was saved.
Now suppose the central bank pays interest Rg on holdings of that currency, and can vary that rate of interest. (If you hold 100 green notes, the central bank gives you Rg more green notes every year.) An increase in Rg increases the demand for currency, and if the supply of currency is fixed, and if prices are sticky, this excess demand for currency would cause a recession.
Now suppose we add a second form of central bank currency. Red currency has negative value. If you buy $10 worth of apples, either you give the seller 10 green notes, or the seller gives you 10 red notes, or some combination of the two. Red currency pays a rate of interest Rr. (If you hold 100 red notes, the central bank gives you Rr more red notes every year.) If you want to sell something, and you do not have any red notes, and the buyer does not have any green notes, you will miss out on selling opportunities, and the buyer will miss out on buying opportunites. The CIA constraint will be binding. The gross money supply (green notes plus red notes) matters.
If we assume: the total stock of green notes is always equal to the total stock of red notes (the net money supply is always zero); the central bank will always give you one green note and one red note if you ask (the gross money supply is unlimited); the central bank will always destroy one green note and one red note if you ask; (these last two assumptions ensure the exchange rate between red and green notes stays fixed at minus one); the central bank always sets Rg=Rr (call it "Rm", for "interest on holding money"); Standard Euler equation IS curve; standard Calvo Phillips curve; then we have the standard New Keynesian model.
These assumptions ensure the CIA constraint is never binding, provided the central bank sets Rm just right so that the demand for green notes equals the demand for red notes. Because if neither the buyer nor seller of $10 worth of apples has any money, each goes to the central bank and asks for 5 green and 5 red notes, the buyer gives 5 green notes to the seller, the seller gives 5 red notes to the buyer, and they do the deal.
But if the central bank sets Rm too high, there is an excess demand for green money, an excess supply of red money, and so an excess demand for net money, and a standard New Keynesian recession.
But there is a problem with this New Keynesian model: who ensures that each agent's intertemporal budget constraint is satisfied? Who prevents an individual from always buying goods, never selling goods, accumulating an infinitely large stock of red currency, and so having a debt to the central bank he can never pay back? ("The economist who wrote the model, and who imposed the no-ponzi-condition" is not a satisfactory answer to this question.)
The simplest answer is that the central bank requires each agent to post collateral, and puts a ceiling on his holding of red notes equal to the value of that collateral (minus a haircut). If you do not post collateral you can only hold green money.
If collateral is scarce, so that collateral puts a binding constraint on the central bank's issuance of red notes, and if the central bank refuses to issue more green notes than red notes, then the scarcity of collateral puts a binding constraint on the total stock of green plus red notes (gross money supply). The CIA constraint becomes binding. If there is an exogenous drop in the quantity of collateral, or an exogenous drop in the quality of collateral so that the central bank increases haircuts, and if the central bank holds Rm constant, the result will be an excess demand for gross money, and so the CIA constraint bites more deeply, which causes a recession.
If the central bank will not or can not reduce Rm, the solution is for the central bank to issue more green money, and break the New Keynesian "rule" which says that the total stock of green money must always equal the total stock of red money. The central bank increases the stock of green money by buying assets outright. We call this "QE".
I think the ECB has a rule which says the total stock of green money must equal the total stock of red money. (JKH?) In other words, the ECB is a New Keynesian central bank. That's a problem for the ECB.
I'm not sure if I have got this right, but my head hurts, so I am going to post it.
Worthwhile Canadian Initiative 
Jamie said, “It’s the accountants who define the language that can be used for discussing the accounts and hence the economy.”
Nick said: “No! Absolutely not. I refuse to let accountants define my language. Concepts that are useful to accountants may not be useful to economists.”
Nick,
I’ve just been out for a brisk walk and I have been thinking about this and how to make sense of our different perspectives on accounting.
Imagine that instead of talking about the economy we are talking about a car.
I am starting with the design of the car. The car is an accounting system as its operation is governed by the laws of physics e.g. conservation. It exchanges fuel for energy plus exhaust fumes, and then exchanges energy for motion etc.
You are starting with observations of the behaviour of the car e.g. acceleration, deceleration, skids, crashes. You are right to say that this requires a different language from the accounting system so my previous comment was too black and white.
As long as you are merely observing the car, you can use your own language exclusively and ignore mine. However, if you want to make changes to the car to alter its behaviour then you need to persuade me that you understand the design of the engine and your revised design must be compatible with good design e.g. all the required connections are in place, the laws of conservation are being followed, there are no leaks as per my previous oil refinery analogy.
We agreed that a type 2 model of the economy requires money and exchange. The equivalent in my car analogy is that money = fuel and exchange = the exchanges of materials/energy etc in the operation of the car engine.
The equivalent of our economy debate in this analogy is that your model of the engine doesn’t seem to have a connection between the fuel tank and the engine so I don’t see how the engine works without that connection. (As an aside, I am also suspicious that you are trying to make the car go faster by adding more and more fuel to the fuel tank via ‘QE for cars’ but I’m not sure how that will help the car go faster if the extra fuel can’t get to the engine).
I hope that makes clear how I am seeing the role of accounting in the ‘economic engine’. However, I can now see that you need a separate language about ‘economic behaviour’ and that our discussion has been about blending these two perspectives together.
That’s definitely my last word on this thread apart from replying to TMF’s most recent post. I’m going to cut and paste the thread into a document to save it and possibly rationalise its content into a single document that makes sense to me. I haven’t read your linked posts yet but will do that over the next week or so.
Thanks again.
TMF,
OK as long as the debate sticks to the essence of what’s going on. I still don’t want to talk about details such as the names of specific bank accounts.
I will be away for a couple of days from tomorrow. If you post on the MR thread in the next 24 hours then I will read your post before going away and reply on my return.
Please include a sentence or two of background in your post i.e. that this post from Nick is his follow-up to the post being discussed on the MR thread. Also please include a link to this thread as I won’t have time to repeat the discussions I have been having with Nick for the MR gang. Also, of course, please indicate what you want me to think about.
Nick,
I should have said in my last post that, in my car analogy, the reason why you can’t just leave things out of your car engine model when you don’t see them as being important to your thinking is that your intention is to change the engine of a REAL car – and that requires a full understanding of the car engine design or it won’t work.
Nick,
Rough connection/analogy with the Fed as a CB:
The Fed does system repos (which are Fed assets) as a form of collateralized lending.
Forget commercial banks – and substitute collateralized red money for those repos.
When the Fed does system repos, it creates bank reserves (Fed liabilities).
Substitute green money for those.
And your 5 for 5 works OK like that.
Collateralization seems like a useful normal constraint there.
Regarding net issuance if so desired for monetary policy – there just needs to be a non-money instrument of intervention (e.g. analogous to bonds in QE) to allow the CB to target a mismatch of red and green money on its balance sheet.
Not sure about your ECB question or how specific it might be to the ECB. Unwinding the abstraction feels a bit complicated. E.g. the Fed in fact also does reverse repos (on the liability side next to currency) which supply collateral, which isn’t part of the analogy to green money above.
Thanks JKH. (I was remembering something you said in comments on MR a couple of weeks back, about the ECB being a red/green system. Target 2 I think. Some national banks have green money at the ECB, and others have red money, but the two cancel out?)
Right – I understand now – I was thinking consolidated Euro system
Target2 is essentially a clearing system for central banks operated by a super-central bank
So for example could be viewed as the ECB issuing green money (positive T2 balances) to the Bundesbank and issuing red money (negative T2 balances, sort of, or a loan of T2 balances) to the Bank of Greece for example
(T2 balances are not the same money thing as reserves held by Deutschebank with the Bundesbank for example)
It all nets out to nearly zero; I think there may be some minor technical mismatches due to small balances that might relate to some Euro CBs not are not (yet) part of the EZ
JKH: Aha! Thanks! That’s what I had thought you had said on MR, but I wasn’t sure I had understood you correctly. To me, that’s a rather interesting fact about the ECB.
Nick,
I seem to be retiring from this thread more times than Frank Sinatra but I had another brisk walk and had another thought. Here is another way at looking at this which might appeal to you more as it’s not about believing me but believing someone you trust – Paul Krugman.
Chris Dillow (UK econ blogger) wrote a post where he made a distinction between models and mechanisms.
http://stumblingandmumbling.typepad.com/stumbling_and_mumbling/2012/01/mechanisms-vs-models.html
Paul Krugman picked up on this.
http://krugman.blogs.nytimes.com/2013/08/02/models-and-mechanisms-wonkish/
Here are some extracts from Krugman’s post with comments from me in brackets.
“ a very useful point from Chris Dillow that I somehow missed about the importance of mechanisms as opposed to models in economic analysis”
“I would argue that the mechanisms we talk about in economics are themselves models — simplified representations of how people behave. But let’s not get hung up on semantics” (I agree with Krugman when he says that mechanisms are themselves models)
“a key part of economic wisdom is thinking about the mechanisms we suppose are acting in the REAL economy” (my emphasis on REAL)
“these mechanisms may not be specific to a particular model, and on the other hand any model had better have persuasive mechanisms in it, or it’s not helpful”
“so back to the original point: we can argue about whether the models versus mechanisms distinction is really a clear one. No matter: at all times, but especially in these times, it’s a very good idea to ask, when some economist offers a proposition about the economy, “Um, how exactly is that supposed to work?” You’d be amazed how often no answer is forthcoming” (this is what we have been arguing about).
It is posts like this which make people like me trust Paul Krugman MUCH more than other economists. The only disagreement I have with him is that, from my perspective, there is definitely a clear distinction between models and mechanisms. They are separate types of model which have different rules. Economic models can be as abstract as you want and economists set the rules. Mechanism models must obey the laws of physics and accounting, and must identify specific institutions in the real world through which the mechanisms achieve their effect. They must also have a trigger event. The trigger event helps you understand cause and effect i.e. the trigger event drives the mechanism. For example, if I sell you an apple then this transaction was probably triggered by you when you entered my shop. This is an important distinction in economics because many issues relate to disputes over whether problems are caused by demand or supply problems. For example, are commercial banks triggered to lend money by the action of the central bank in supplying them with more money or by a customer entering the bank and asking for a loan. If you don’t understand the trigger then you may develop a faulty policy to boost bank lending.
Note that, in Dillow/Krugman language, my models are what they are referring to as mechanisms while your NK model is what they are referring to as a model. From my perspective, I am agreeing with Krugman but taking it a step further by insisting that mechanism models obey certain rules to ensure their consistency. I guess that these rules are the equivalent of micro-foundations for mechanisms.
The only problem I ever have in understanding Krugman is when he talks about his models. I don’t know enough to think in terms of his models (and I am just a typical lay person in that respect). I understand the economic world via the mechanisms. You can see that by the fact that I draw analogies with the mechanisms of cars and oil refineries which might seem odd to you.
Lay people would find it much easier to understand economists if they explained mechanisms. I also think that economists would find it much easier to understand lay people (particularly politicians) if they discussed lay people’s perceptions of the mechanisms driving the economy (even if it was mostly to correct the lay people’s faulty understanding).
In Dillow/Krugman terms, you started this thread to try to translate from a model to a mechanism based on that model. I am just looking for descriptions of mechanisms I can believe. However if you have inconsistencies, such as defining red and green money as equal and opposite but then later adding them together as though they had the same sign, then I won’t believe you.
JKH said: “Forget commercial banks”
Nick/JKH,
I have read posts by JKH elsewhere. I think he is very smart. In the terms we have been discussing he understands mechanisms, so I’m surprised by his comment on commercial banks. I have a challenge for both/either of you.
My understanding of QE is that it involves something like the following mechanism:
Central bank triggers the mechanism and creates green money
Central bank swaps green money for commercial bank assets
Something else happens which I don’t understand in order to get the green money from commercial banks to the wider economy.
I don’t see how you can describe this mechanism without mentioning commercial banks. If you can describe this mechanism without mentioning commercial banks then I will bow to JKH’s expertise. The only sort of mechanism I can think of that would omit commercial banks would be if the central bank hired a helicopter and dropped the new green money directly into the economy. I don’t see that happening anywhere near me.
Jamie: I’m fine on mechanisms and models. I talk about “stability” and “transmission mechanisms”.
When we say “forget about commercial banks” we might mean: consolidate commercial and central banks together (the central bank takes over the commercial banks). We can imagine a world in which everyone has an account at the central bank. In part, that is the real world. I hold central bank money in my pocket. It’s paper money, not electronic money, but it’s the same thing. I have an account at the Bank of Canada, it’s just they won’t let me run an overdraft.
Open Market Operation (the proper name for QE) with no commercial banks: the Bank of Canada buys a bond from me, and gives me currency in exchange. That’s the mechanism. Introducing commercial banks just complicates the story.
http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/10/immaculate-transfers-and-the-monetary-transmission-mechanism.html
Jamie,
I’m deferring to Nick’s choice of a simplified model there to make the discussion consistent.
The QE analogy in that model by construction has to be a transaction between the CB and a non-bank agent.
So the CB buys something (maybe bonds) from somebody (maybe you or me) in exchange for new green money.
And its a non-conventional policy in the context of a “normal” red/green balance as described by Nick.