The Bank of England has published a lovely clear article (by Michael McLeay, Amar Radia and Ryland Thomas) on "Money Creation in the Modern Economy". Thanks to JKH for the tip-off. (Here is JKH's blog post). But I disagree with it.
Thinking about monetary policy in terms of interest rate policy just doesn't work. It doesn't work in theory, and it doesn't work in practice. That's why the Bank of England is having to do QE, and is having to re-introduce the old general theory of monetary policy as a special theory for QE.
This is the part of the article that most caught my attention:
"Like reductions in Bank Rate, asset purchases are a way in which the MPC can loosen the stance of monetary policy in order to stimulate economic activity and meet its inflation target. But the role of money in the two policies is not the same.
QE involves a shift in the focus of monetary policy to the quantity of money: the central bank purchases a quantity of assets, financed by the creation of broad money and a corresponding increase in the amount of central bank reserves.
The sellers of the assets will be left holding the newly created deposits in place of government bonds. They will be likely to be holding more money than they would like, relative to other assets that they wish to hold. They will therefore want to
rebalance their portfolios, for example by using the new deposits to buy higher-yielding assets such as bonds and shares issued by companies — leading to the ‘hot potato’ effect discussed earlier. This will raise the value of those assets and lower the cost to companies of raising funds in these markets. That, in turn, should lead to higher spending in the economy."
There is nothing wrong, in my eyes, with that second paragraph. Good monetarist hot potato stuff! What is wrong is the sentence that immediately precedes it: "But the role of money in the two policies is not the same."
They have two theories of how monetary policy works. There is one theory for when the Bank of England sets a rate of interest: "And reserves are, in normal times, supplied ‘on demand’ by the Bank of England to commercial banks in
exchange for other assets on their balance sheets." And a second, quite different theory, for when the Bank of England does QE.
I'm sure they are not alone in having two theories: one for "normal times"; and one for QE, which is seen as needing a special theory only applicable in "abnormal times". But it is rather peculiar having two different theories of the same thing.
One theory is better than two.
What is even more peculiar is that their special theory for QE is the same as the general theory taught in first-year textbooks. The central bank buys a bond and the money supply expands, because the seller of the bond now owns the money that the central bank gave him in exchange for the bond.
"Quantitative Easing" is just a silly new name for the "Open Market Operations" that first-year textbooks have always said was the way that central banks normally increase the money supply.
If you spend your life teaching first year economics, like I do nowadays (when I'm not blogging), this here modern world looks very peculiar. My general theory has become their special theory, and they have gone and invented some weird new theory of money creation in what they call "normal times", that they admit doesn't work as a general theory, and they still need my old theory to handle the cases where their weird new theory doesn't work.
Here is my general theory: when the central bank buys something, with central bank money, the money supply expands, because whoever sold them that something now holds extra money. Done. It does not matter whether the central bank buys a bond, or a computer, or whatever. Hell, it could just give the money away to its favourite charity (helicopter money), and the result would be the same.
Why can't my general theory work equally well in "normal times"? Let me repeat that above quote, this time with bold added: "And reserves are, in normal times, supplied ‘on demand’ by the Bank of England to commercial banks in exchange for other assets on their balance sheets." See that bit about "in exchange for other assets"? That means the Bank of England buys something. Just like I said in my general theory. The central bank increases the money supply by buying something. See, it's easy!
Now if the central bank is buying something, and someone else is selling something, there must be some sort of market in which that something is bought and sold. But it really doesn't matter, for money creation, what that "something" is. What matters is that the central bank is selling central bank money. It is supplying central bank money. So we want to know something about the central bank's supply function. And that supply function will depend on what it is the central bank is targeting.
We could assume that the central bank is targeting the stock of its own money, so the supply function is perfectly inelastic with respect to anything. That is a very simple assumption, suitable for a first year textbook. But not very realistic, for most times and places.
We could assume that the central bank is targeting the price of gold, so the supply function is perfectly negatively elastic with respect to the price of gold. Realistic in the past, but not nowadays.
We could assume that the central bank is targeting the stock of M1, so the supply function is perfectly negatively elastic with respect to the stock of M1. Realistic briefly in the past, for Canada, but not nowadays.
We could assume that the central bank is targeting expected CPI inflation, so the supply function is perfectly negatively elastic with respect to the expected rate of change of the price of the CPI basket of goods. That is realistic for many central banks nowadays.
Interest rates? Did I hear you say that modern central banks target interest rates? Well, maybe, but only in the very short run, like maybe the next 8 weeks. Monetary policy for the next 8 weeks isn't very interesting, unless it gives us a clue about what the central bank will be targeting in the years after that. And they say they are targeting things like inflation, not interest rates. But if you insist, the central bank's supply function would be perfectly elastic with respect to whatever interest rate you say it is targeting.
See, it's easy. One general theory to rule them all, that can be modified for whatever it is you want to assume the central bank is targeting, just by changing the central bank's supply function.
But what about commercial banks? They create money too. Commercial banks are much easier. We know what commercial banks are targeting. They target maximum profits. And that means commercial banks, like ordinary profit-maximising firms, and like ordinary utility-maximising people, and unlike central banks, only care about real variables. It is the central bank's job to ensure that nominal variables are determinate, by not doing something daft like trying to target a rate of interest for too long.
Just like central banks, commercial banks create money by buying something, and paying for it with the money they create by buying it. They mostly buy non-monetary IOUs, but it doesn't matter what they buy, or even if they just give their money away to their favourite charity.
How much money commercial banks create to maximise their profits will depend on a lot of things. But what I want to focus on, because this is the key policy question, is how it depends on what the central bank is doing. Let me quote again from the Bank of England article:
"The supply of both reserves and currency (which together make up base money) is determined by banks’ demand for reserves both for the settlement of payments and to meet demand for currency from their customers — demand that the central bank typically accommodates.
This demand for base money is therefore more likely to be a consequence rather than a cause of banks making loans and creating broad money."
First, they don't mean "supply"; they mean "quantity supplied". And as I pedantically tell my first year students, the difference really does matter (sometimes, like here). Yes, the quantity supplied (which is equal to quantity demanded in equilibrium) depends on the demand function, but it depends on the supply function too. Both blades of the Marshallian scissors matter in determining quantity, even if one blade is assumed to be horizontal for the next 8 weeks.
But what matters is their acknowledgement that the demand for base money (central bank money) is a consequence of the amount of broad money commercial banks have created. May I make a small simplifying assumption? May I assume that the demand for base money is proportional to the stock of broad money, other (real) things equal? Because that's the only way we can assume that commercial banks maximise profits and so only care about real things and don't suffer from money illusion. Thanks!
"While the money multiplier theory can be a useful way of introducing money and banking in economic textbooks, it is not an accurate description of how money is created in reality. Rather than controlling the quantity of reserves, central banks today typically implement monetary policy by setting the price of reserves — that is, interest rates."
But hang on! You have just agreed (sort of) that the demand for base money is some proportion r of the stock of broad money. So in equilibrium, when the actual stock of base money is equal to the quantity of base money demanded, the stock of broad money must be a multiple 1/r of the stock of base money. And if the central bank shifts the supply function of base money $1 to the right, that must increase the equilibrium stock of broad money by $(1/r). Just like the first-year textbook says it will!
Now you might object that modern central banks don't care about the stock of base money (except when they are doing QE), and target things like inflation instead (except for 8 week periods when they target an interest rate). OK. But if the central bank wanted a temporary increase in the inflation rate, and so a permanent rise in the price level, it would need to shift the supply function of base money, to create a permanent rise in the monetary base, and a permanent rise in broad money, and the textbook money multiplier would tell us that broad money would increase by 1/r times the increase in base money.
One simple (first-year textbook) general theory to rule them all!
What is the underlying problem here? Why do monetary economists resist this very simple and very general theory of monetary policy? The underlying problem is revealed in this quote:
"Like reductions in Bank Rate, asset purchases are a way in which the MPC can loosen the stance of monetary policy in order to stimulate economic activity and meet its inflation target."
It assumes that interest rates are a measure of the "stance of monetary policy". If interest rates were an adequate measure of the "stance of monetary policy", the Bank of England would not need QE. And you cannot define the stance of monetary policy by taking some sort of average of interest rates and QE. A permanent increase in the target price level would mean a permanent increase in the money base but would have no obvious implications for interest rates. A permanent increase in the inflation target would mean a permanent increase in the growth rate of the money base but would mean higher nominal interest rates. There is no monotonic mapping from loose monetary policy into low interest rates. Thinking about monetary policy in terms of interest rate policy just doesn't work. It doesn't work in theory, and it doesn't work in practice. That's why the Bank of England is doing QE, and having to re-introduce the old general theory as a special theory of how monetary policy works.
Worthwhile Canadian Initiative 
I wrote a post on this yesterday, but haven’t put it up yet. Just as well, yours is better.
Thanks Scott! (I feel slightly guilty for stealing your idea that commercial banks only care about real things. It’s implicit in Patinkin, I think, but you made it clear and explicit for me.)
You should put your post up now. See where we overlap and where we don’t.
Nick, thanks for going over that. You didn’t write anything which surprised me… I must be starting to learn your views.
I have more bad news , guys.
There is no Santa Claus.
Man , reality sucks.
Tom: yep. You can usually guess what I’m going to say. Which proves you are learning stuff (whether you agree with me or not).
Marko: you lost me.
Nick, Why do you write such lengthy posts? Could you put only significant parts here?
Thanks for the link and the discussion, Nick. A lot of great information that really helps me think about this stuff.
I found a function that describes the broad trend of US interest rates in terms of the monetary base (graph at link)
http://informationtransfereconomics.blogspot.com/2014/02/the-link-between-monetary-base-and.html
The fit for both the short run interest rate and the long run rate uses the function c log r = log (1/κ) (NGDP/Mx) with κ = 10.4 and c = 2.8, and Mx being either the currency component (“M0”, for the long run rate, 10-year) or currency + reserves (MB, for the short run rate, 3-month). You can plot it yourself 🙂
One thing that this indicates is that the level of interest rates is never indicative of “tight” or “loose” money — the relevant measure is the rate of NGDP growth relative to base growth.
PS: I answered your question on a previous post with new post … http://informationtransfereconomics.blogspot.com/2014/03/apples-bananas-and-information-transfer.html
Nick, quick hypothetical question (I know how you love your hypotheticals!). Here’s the SUPER simple setup: A CB and one commercial bank. No cash, taxes, government spending, or foreign trade. It seems to me that in such a circumstance base money (consisting only of reserves in this case) might well be $0 (unless the CB does OMOs), after all there’s no need of reserves to interface with the gov or to settle transactions, or to be withdrawn as cash. But that doesn’t necessarily mean that M1 is $0, does it? I realize you say that a ratio between the two is a reasonable approximation, but I don’t see how a finite ratio applies in this case.
So if MB = 0 then VB goes to infinity doesn’t it? (Assuming NGDP > 0).
If that’s the case, what does the one theory to rule them all say about how prices should change in the long term if the CB now buys $X in assets?
It would be both true and elegant to say something like “there is a positive correlation between the money supply and NGDP. No matter what means you use to increase the money supply it will (other things equal) always boost NGDP”
It would also be true (but perhaps less elegant) to say: “There are a number of different mechanism by which an increase in the money supply can be used to increase NGDP. Depending upon the mechanism used (govt deficits v CB asset purchases) and other variables in the economy (the degree of prices stickiness and the current nominal interest rates) the increase on the money supply will affect NGDP in different ways and to different degrees and have different secondary effects.”
Perhaps you could argue that there is some underlying “pure” monetary effect and everything else is just distributional – but that seems to be something of an oversimplification when you look at the difference between an NGDP increase due 1) to a taxation cut 2) to a lowering of the target interest rate and 3) to the purchase of a high-risk MBS as part of a QE program.
… given my simply hypothetical, it still seems the commercial bank has an opportunity to make money for its shareholders by lending money, no? I also just don’t see any demand for reserves. What am I missing? I can see it acquiring a nice amount of equity with which it credits the deposits of its shareholders, making them rich and happy. You might ask “What is the CB targeting?” Suppose they were targeting base money stock at $0. Then you can assume they switched to a target of $X.
alex: because everything I wrote there was significant! Plus, my last post was very short, and I wanted to keep a balance!
Jason: “One thing that this indicates is that the level of interest rates is never indicative of “tight” or “loose” money — the relevant measure is the rate of NGDP growth relative to base growth.”
That sounds sorta good to me (though I would say that NGDP growth relative to base growth might be a better measure of turning points in monetary loosening), but I didn’t really get how you came up with it.
TMF: I could go with both. Helicopter money would be the “pure” case, and everything else would be in the “other things equal that might not be equal in practice” clause.
I got two in spam.
Nick, OT but I was interested in your comment ‘Helicopter money would be the “pure” case’. At the ZLB when you have a choice between creating new money via QE or via govt-deficits – isn’t govt deficits (funded by things like income tax cuts) more like the “pure case” than QE ?
Nick,
Many points, some rough comments (at risk of haste):
The BOE paper:
“And reserves are, in normal times, supplied ‘on demand’ by the Bank of England to commercial banks in exchange for other assets on their balance sheets.”
If that means demand from the private sector (I think it must), that’s wrong. (As I noted in my post and comments, the paper certainly isn’t perfect.) The BOE holds the option to transact – not the banks. And the CB enters the market on the basis of interest rate conditions – be that short term positive interest rate targeting, or QE zero boundedness issues. Even though you assert that it’s all about money in the end, I don’t think you can deny that both OMO and QE as CB strategies can be related to interest rates in this way.
(LLR is different, but mostly we’re looking at OMO and QE here.)
I think your general theory applies to currency (banknotes) in all environments – non-QE and QE.
Central banks are short a call option with regard to currency – they must supply the quantity demanded. (By that I mean an option to transact – not a fixed option strike price)
Conversely, the private sector is long a call option to acquire currency. They just pay with deposits/reserves.
The difference insofar as your general theory is concerned is in the application to bank reserve balances, IMO.
(Because of this difference, IMO, I think the monetary base definition, which conflates reserve balances with banknotes, is quite a perilous conceptual construction for monetary theory. I think that underlying everything, this may be at the heart of the disagreement between the way you guys look at the world and some of the “new” stuff.)
So in the case of bank reserve balances:
Central banks are long a transaction option with regard to both regular OMO and QE bond purchases – they have a CHOICE as to whether to transact.
Conversely, the private sector is NOT long an option to sell bonds in this way. They must wait for an offer of quantity demanded from the central bank (again, referring to an option to transact, not a strike price for an option).
That option structure difference between currency and reserve balances is key to supply demand economics, I believe.
Maybe more on that later.
A different but connected point:
“May I assume that the demand for base money is proportional to the stock of broad money, other (real) things equal? Because that’s the only way we can assume that commercial banks maximise profits and so only care about real things and don’t suffer from money illusion.”
You can assume that for currency (banknotes) held by non-banks, but you can’t assume that for bank reserve balances.
Maybe more on that later.
Another point – required statutory reserves must be ignored in the economics. Because some reserve regimes have no requirement, the focus must be on excess reserves as the guide to the supply demand economics. Otherwise, a zero required reserve regime will break whatever model is envisaged.
“But hang on! You have just agreed (sort of) that the demand for base money is some proportion r of the stock of broad money.”
I think that’s your assumption. And it’s incorrect in the case of excess reserves.
The zero bound is the bifurcation point for what you’ve referred to as the “new” general theory and special theories. Given the interest rate constraint of the zero bound, I see nothing wrong with bifurcation as part of a complete model where interest rates are declared to be important.
JKH: “Another point – required statutory reserves must be ignored in the economics. Because some reserve regimes have no requirement, the focus must be on excess reserves as the guide to the supply demand economics. Otherwise, a zero required reserve regime will break whatever model is envisaged.”
I agree that a general theory should be able to handle both regimes. I don’t see that as a problem. Required reserves, if they exist, are one of many things that affect desired reserves. But we should abolish the (US?) term “excess reserves”, because it only makes sense in a regime with required reserves. What matters is desired reserves, and the difference between actual reserves and desired reserves (I would like to redefine “excess reserves” as the difference between actual and desired, not actual and required, but doing so would probably cause confusion). What matters is whether desired reserves are proportionate to broad money, holding real things constant. If they are proportionate (and if desired stock of currency is proportionate too), we get the money multiplier in equilibrium.
“But we should abolish the (US?) term “excess reserves”, because it only makes sense in a regime with required reserves. What matters is desired reserves, and the difference between actual reserves and desired reserves (I would like to redefine “excess reserves” as the difference between actual and desired, not actual and required, but doing so would probably cause confusion)”
On the first part, required reserves = 0, so “excess reserves” still works in that context, IMO.
But I hear you on the second part. OMOs are really about the CB tweaking the quantity of excess reserves at the margin – which goes to your point.
I started a draft post about a year ago playing around with that terminology. I had something but will have to look it up. The point is relevant as you frame it and is quite relatable at the operational level.
JKH: “That option structure difference between currency and reserve balances is key to supply demand economics, I believe.”
Interesting. I’m not sure I understand it yet.
Would I be correct in saying that the central bank must swap reserves and currency at one-for-one either way as the commercial banks wish? (Otherwise $1 reserves won’t be worth $1 currency). But it can make the total of the two whatever it wants, by buying or selling something. That’s how I think of it.
Sorry, my 5:02 – I’m good up until your final sentence there – separate issue of institutional differences as in my first comment, I think.
“Would I be correct in saying that the central bank must swap reserves and currency at one-for-one either way as the commercial banks wish? (Otherwise $1 reserves won’t be worth $1 currency). But it can make the total of the two whatever it wants, by buying or selling something. That’s how I think of it.”
I think that’s very generally right – that would be the net capability of the CB holding the option to transact in OMO/QE – taking into account the “option” exercised against it on currency, and taking into account a whole bunch of other stuff.
But in saying “whatever it wants”, you’re really implying that QE is always an option in response. And I know you’re not differentiating between OMO and QE, but QE requires a special constraint in terms of the requirement to pay interest on excess reserves – if the supply of excess reserves moves beyond the inelastic portion of the demand curve for reserves in the case where no interest is paid. That’s the way I think about the transition from the pre-2008 Fed to the QE Fed and IOR.
“OMOs are really about the CB tweaking the quantity of excess reserves at the margin – which goes to your point.”
I don’t see why the word ‘excess’ needs to be used, as opposed to just reserves. Pretend there’s only one big bank to simplify. The CB can also supply a quantity of reserves under the required level, whether that’s some proportion of demand deposits or 0. Unless you want to call that ‘negative excess reserves.’ It just depends on the interest rate they want to hit within their corridor.
There’s a 3-step timeline, assuming a 1 day reserve period. The CB sets the quantity of reserves to be traded in the interbank market. The interbank session is held and closed. The reserve maintenance period ends at the end of the day and banks’ reserve positions are evaluated. The uncertainty of liquidity flows between the last 2 steps is what gives rise to the elasticity in the demand curve. It also allows the CB to set quantity of reserves above or below the requirement to achieve various rates. So whether the CB aims to supply excess or deficient reserves depends on the rate they want to hit.
“So whether the CB aims to supply excess or deficient reserves depends on the rate they want to hit.”
That’s right.
I mean excess reserves as a category – whether the quantity setting is positive or negative.
Okay got it.
JKH: “And I know you’re not differentiating between OMO and QE, but QE requires a special constraint in terms of the requirement to pay interest on excess reserves – if the supply of excess reserves moves beyond the inelastic portion of the demand curve for reserves in the case where no interest is paid.”
I still see no reason to have a special name for OMO. (Actually, I would prefer to scrap “OMO” as well, and just talk about buying stuff and selling stuff.) Paying interest on reserves is just a way to increase the demand for reserves, rather like required reserves.
Nick, I’ve got some in spam I think.
Nick, you said:
“…(though I would say that NGDP growth relative to base growth might be a better measure of turning points in monetary loosening), but I didn’t really get how you came up with it.”
It comes from the model being a function of the ratio of NGDP/MB. If MB and NGDP grow at the same rate (call this “loose money” for arguments sake), then interest rates are constant at say r = r0, but the level of r0 is dependent on the history of relative NGDP to MB growth, so any given r0 is consistent with “loose money”.
The ratio itself comes from assuming homogeneity of degree zero (long run neutrality of money) per Bennett McCallum’s characterization of the QTM … at least that’s the less heterodox derivation; I came to a similar conclusion via information theory 🙂
Tom: I fished you out of spam.
In your (interesting) hypothetical, what would the commercial bank promise to convert its demand deposits into? If there is no currency, and no reserves, I think that promise would become empty. The central bank disappears (its balance sheet has $0 on the liability side), and the one commercial bank is now the new (privately-owned) central bank.
Nick:
“It does not matter whether the central bank buys a bond, or a computer, or whatever. Hell, it could just give the money away to its favourite charity (helicopter money), and the result would be the same.”
OK, I see you’ve returned to the dark side, and forever will it dominate your destiny. So I’ll address myself to any young padawans who might still be saved.
There is another rule that really does rule them all: the real bills doctrine. It was developed by practical bankers over centuries of experience, and it was the guiding principle of banking long before the academic scribblers came along with their talk of hot potatoes.
The real bills doctrine says that money should be issued in exchange for short-term real bills of adequate value. The “adequate value” clause assures that the money-issuer will remain solvent, and that every new dollar issued will be backed by at least a dollar’s worth of assets newly acquired by the money-issuer. The “short term” clause protects against maturity mis-matching, and assures that even if a bank exhausts its reserves, its customers can access their money within (say) 60 days. The “real bills” clause assures that money-issuers will provide an elastic currency, which is to say that they will provide more money when farms and factories are busy and need the money, and they will provide less money during slack times when the money is not needed.
Hi Nick. Long time no speak… and apologies in advance for rambling but it’s been a while since I’ve got my thoughts down like this. I don’t want to get into the details of exactly what the BoE said, and tbh I’ve only skimmed it, but rather what I see as the key tension between the monetarist framework and the more post-Keynesian framework and how I’ve come to think about them.
OK.
Take a pure quantity-managed interest rate targeting system, like the Fed before IOR days. There’s just open market operations, as you say. Any “QE” that was not an “OMO” would require an offsetting OMO in order to keep reserves at the level that meets the short-term interest rate target. So far I’m with you.
But if you have IOR (or a fixed rate full allotment reverse repo facility) then you can set the short term interest rate quite independently of the monetary base. The Fed will raise interest rates long before it unwinds its asset purchases and decreases M0. I suppose you could conceptualise this as “raising the demand for the monetary base” i.e. decreasing V, and in a sense, that is exactly what it is doing – it is using IOR/FRFARRF to change the demand for the monetary base so that whatever level the base is at the reserve market clears at the rate target. But I’ve come to the view that this isn’t really a very helpful way of looking at it. I have (2011-vintage Richard cringes here) come round to thinking that insofar as (in a world with excess reserves) central banks can implement a short-term IR independent of the level of the monetary base, monetary policy “really is” about a path of interest rates – a path that is of course conditionalised on expectations etc.
So going back to the QE/OMO distinction, QE is an asset purchase that a) isn’t required to maintain the interest rate target and b) does not require an offsetting action because the target is not quantity managed. Furthermore, in a system that is not purely quantity managed, increasing the monetary base when rates are already at zero also is a pretty terrible commitment device for keeping future policy easier. Indeed, in the 2008 minutes Bernanke called the Fed’s quantity-management interest rate targeting “a relic”, and discussed making IOR the official policy rate. And it’s going to happen (although whether it’s the IOR rate or the FRFARRF rate or both I’m not sure).
To sum up: This is all a way of saying we’re now living in a world where excess reserves are the norm and this has changed the way I think about monetary policy. Furthermore, lots of central banks have lots of different policy rates that all set short-term interest rates in a different way (and affect demand for reserves in different ways). I think we focus too much on the way the Fed does (or did) monetary policy, as opposed to the many ways it could be done, and has been done, and will be done in future.
Debating the merits of the “base money” frame versus the “short rates” frame makes sense – I think – when you’re talking about a purely quantity managed pre-2008 Fed system. As you say (and I have said before too!), 8-weeks is not a macroeconomically interesting period of time. But the world we live in now is – I think – different. Monetary policy isn’t about the quantity of money in a world with excess* reserves, and short rates are set by other means.
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*where there are no required reserves, “excess reserves” means an excess of the reserve levels that would prevail if you were purely quantity-managing the short-term interest rate target, i.e. no IOR/FRFARRF
Mike: suppose I were in charge of the Bank of Canada, and you had convinced me that i really really must ensure that the Bank of Canada has plenty of assets to back its monetary liabilities, and that nothing else mattered. What inflation rate would I target? I would target the profit-maximising rate of inflation. That would maximise the net worth of the Bank of Canada, and so leave plenty of capital reserves just in case anything went wrong with any of my backing assets.
Nick,
I guess they have one general theory that is based on interest rate reaction functions. That theory is equivalent to your general theory, but is specified in a different coordinate space.
And they have a second theory about credit interventions which is less important to them. And this second theory is equivalent to your theory about what happens when you do a temporary increase in money supply that is subsequently reversed (i.e. not much happens).
Nick, thanks. I did say there’s no currency, but there COULD be reserves. I’m just wondering if there’s any demand for them. The CB could force reserves into existence, or the bank could borrow them from the CB (I don’t know why it would though). If the CB purchased assets it would directly change the reserve level, and perhaps change the deposit level too, right? Because the bank itself may not sell it the assets it’s buying directly… the non-bank private sector might be the net sellers for some of those assets, and thus bank deposits would grow accordingly. It’s a little indirect, but the CB could thus target the quantity of M1.
So doesn’t that free the central bank up to focus on affecting things with it’s OMOs while the commercial bank is free to focus on maximizing profits?
Doe the situation change if we break the single commercial bank up into multiple banks? Does the number of banks, the timing or the settlement procedure matter any in that case? In my tidy example, every penny a bank comes up short will be matched by another penny another bank will have in “excess” … meaning that reserve balances can be zero overnight… or between settlement periods, whenever that is, provided banks with a surplus will lend every penny of surplus out.
Maybe my hypothetical is just too neatly sealed up. Maybe it’s the messiness of actually wanting to have a bit more reserves than what’s required (due to uncertainties) that gives the reserves their power. I’m assuming reserves are sufficient and the CB can do what it needs to w/o cash.
It seems like there’s a continuum though: like we could take tiny baby steps from the real world towards my hypothetical. Would a change come all at once with one crucial baby step, or would it come gradually, and what would that look like? And which baby step would it be? What would be changing exactly? The “constant” relating base money to broad money? What is that constant a function of?
Mike Sproul, I was thinking of you when I read that helicopter line from Nick! Nice to see you zeroed in on it.
Richard: Welcome back!
We seem to have been moving in opposite directions. By around 2000 I had come around to the official Bank of Canada view, that M was just a barbarous relic, with at best some minor role as an indicator with some sort of information-content (though the sign was often negative in my regressions), and with no causal role. Ultimately, of course, the Bank of Canada needed some sort of balance sheet to control anything, but that could be ignored for all practical macro questions. The only realities were the inflation target, the interest rate instrument, and a host of possible indicator variables. Nobody believed in M, except as a simple way to teach undergraduates so you got a downward-sloping AD curve, to remind us of the indeterminacy question.
The Bank of Canada was way ahead in moving to the “new” way of doing and thinking about monetary policy.
And then came 2008/9, and when interest rates failed, and the BoC brought out QE, it was like watching atheists at prayer.
And since then I’ve been going back to the Old Religion!
Vaidas: but an interest rate reaction function can never be a general theory of central banking. For example, a 100% gold reserve central bank, that just buys and sells gold.
Tom: if there is only one commercial bank, and nobody ever wants to hold central bank currency, because there isn’t any, that commercial bank would never need reserves (unless it were required by law to hold them).
Nick:
If you were using the real bills doctrine then you wouldn’t target the rate of inflation at all. You would be in competition with other bankers, and you’d offer to pay your customers whatever interest rate that the market determined. That means that when you issue checking account dollars you might pay them 2%, and when you issue paper dollars you might pay them -1% interest, meaning 1% inflation.
It’s not just adequate assets that matter. You’d also have to watch out for maturity mismatching, and you’d have to provide an elastic currency. Both of these things would be automatic with the RBD.
Nick,
It is the same general theory, but in a different coordinate space. Your 100% gold reserve bank is targeting an overnight cash lending rate that is equal to gold lending rate. This is a clumsy way of describing it, but it is mathematically equivalent.
Of course, at ZLB the quantity coordinate space has an advantage – your reaction function may have a simpler form, as you have a simple form of forward guidance built in. In an interetst rate space you must specify the forward guidance separately. And of course, you get extra credibility for your interest rate reaction function if you do QE.
We have two great natural experiments going on. The ECB is trying to avoid doing QE, it is enhancing the forward guidance every meeting instead to build the credibility. The Fed is trying to divorce the credibility of its reaction function from QE.
Nick, as usual always enjoy your posts. You’re a good ambassador for us here in Ottawa.
Re the two theories, Bob Hetzel doesn’t see anything wrong in changing his mind about how the Fed is operating. Any chance you could share your thoughts on a piece I did on Hetzel and the money multiplier model? He seems to situate himself somewhere in between the MM and endogenous money folks:
http://fictionalbarking.blogspot.ca/2013/11/on-irrelevance-of-money-multiplier.html
circuit; thanks!
The money multiplier doesn’t play a big role in my thoughts. What I like about it is the disequilibrium hot potato process story. There are two hot potatoes: central bank money circulating between commercial banks; and commercial bank money circulating between people. Plus the distinction between what is true for individual banks vs the banking system as a whole. Plus, most importantly, the idea that money get created when people want to borrow money but do not want to hold money.
Take the orthodox view that the central bank sets a rate of interest. Start in equilibrium, then suppose the central bank cuts the interest rate on borrowing reserves. Individual banks want to expand loans and deposits, because the cost of borrowing reserves has just fallen. And the deposits they create get spent, and hot potato around the people who bank at different banks, and the reserves hot potato around the commercial banks. Just like in the textbook story. The only difference is that the process does not stop until the central bank makes it stop by raising the rate of interest again. And in that new equilibrium, if desired reserves, at the same rate of interest, are some ratio r of deposits, we get exactly the same multiplier (1/r) for the change in M1 divided by the change in MB.
Works for me. I pointed to Hetzel because he basically uses the same language as the endogenous money folks (at least in regard to the operational issues — even arguing against the relevance of the textbook money multiplier model when tbe CB uses an interest rate operating procedure. Anyway, I have no big issue with what you say. Hetzel, of course, interprets how QE ‘works’ the same way. I just find it interesting his take on the operational issues is pretty much in line with the post-K (except with respect to the post-2008 Fed; it seems his claim regarding the relevance of the multiplier model is going too far). Interestingly, the BoE paper seems to support Hetzel’s view; they claim the “first leg of the multiplier model” is relevant for QE. I’ll buy that.
“But hang on! You have just agreed (sort of) that the demand for base money is some proportion r of the stock of broad money. So in equilibrium, when the actual stock of base money is equal to the quantity of base money demanded, the stock of broad money must be a multiple 1/r of the stock of base money. And if the central bank shifts the supply function of base money $1 to the right, that must increase the equilibrium stock of broad money by $(1/r)”
The S only shifts to the right when broad increases. The impetus is from the banking system. If broad doesnt increase then neither does S.
Nick, thanks. Regarding your statement here:
“It does not matter whether the central bank buys a bond, or a computer, or whatever. Hell, it could just give the money away to its favorite charity (helicopter money), and the result would be the same.”
A bit ago I asked Sumner if state sanctioned counterfeiting was equivalent to buying bonds:
http://www.themoneyillusion.com/?p=26213#comment-319935
Scott’s response:
http://www.themoneyillusion.com/?p=26213#comment-319940
“Tom, It’s better to buy the bonds, counterfeiting makes the economy less efficent, as taxes must rise to cover the cost.”
Would your “helicopter drop” idea make the economy less efficient too? Would taxes need to rise to cover the cost? If not, why not?
If a central bank privatized paper money, and made reserves unnecessary for routine purposes, then perhaps it could shrink its balance sheet to zero. There would be no “money multiplier”. Would this upset any economic theories? I don’t think so. The money multiplier concept isn’t essential to how the system works, it’s just a fact about the system, which by over-emphasis serves to confuse things.
shoot, another one in spam. I got rid of the URL and changed emails back to one that worked… so hopefully that helps.
OK, on to a new comment, you write:
“Here is my general theory: when the central bank buys something, with central bank money, the money supply expands.”
Counterexample: The commercial banks have near zero shareholder equity and way more reserves than deposits, and the central bank buys all the banks and merges its operation with theirs, and thus its balance sheet with theirs. The reserves go away (cancelled on the one consolidated balance sheet). The bank deposits might remain (now direct CB deposits), but the money supply just contracted. Oops. I guess they have to be careful about what they buy. 😀
Nick says “Hell, it could just give the money away to its favourite charity (helicopter money), and the result would be the same.” Actually there is a difference between buying assets and fiscal stimulus funded by new money. Buying assets is distortionary: it relies on just one section of the population spending more, that is, the asset rich. In contrast, fiscal stimulus can be effected in more or less non-distortionary way: e.g. tax cuts for everyone and/or incresed spending by every government department.
As distinct from buying the assets of asset rich INDIVIDUALS, having the central bank buy dodgy assets of banks which are in trouble (lender of last resort) is also distortionary. That is, if banks can have lender of last resort facilities, why not everyone else?
… the weird thing to me about my counterexample above (which I’ve resurrected from a previous post) is that though the stock of MOA changed, this has no effect on long term prices. Why? MOA net decreased, but so did MOA demand, thus leaving pressure on long term prices unchanged. That’s just the explanation in reverse from what you gave me when the only real difference in the example was that the bank deposits exceeded reserves. Recall? In my previous case reserves were $1 and bank deposits $10 prior to the CB taking over. MOA went from $1 to $10, but you said there’d be no effect on prices because demand would increase “10 fold.” My broader question is are there any other OMOs the CB might make which change the stock of MOA, but also the demand for MOA, thus leaving prices unchanged? Or have I come up with the only weird example which does that?
… or is that right? Are the two examples just complements of one another?
“See that bit about “in exchange for other assets”? That means the Bank of England buys something. Just like I said in my general theory. The central bank increases the money supply by buying something.”
I think this is referring to short-term repo actually. The BoE supplies reserves on a day to day basis by lending them against high quality collateral at bank rate, not by buying assets.
One of the weaknesses of the Bank of England’s paper is that it does not distinguish between the pre-2008 world, where bank lending creates demand for reserves, and the post-2008 (QE) world, where the quantity of reserves is entirely disconnected from bank lending and is far more than the quantity required to facilitate deposit movements across the banking system as a whole. Consequently it can appear as if there are two theories of money in this paper. I think it is more accurate to say that there are two different price mechanisms. The pre-2008 version uses the offer price of reserves to control inflation. The post-2008 version uses the bid price.
In the pre-2008 world, OMOs were used to adjust the quantity of reserves so as to maintain the desired offer price: broad money creation was the province of banks. In the post-2008 world, OMOs (QE) are used (ineffectively in my view) to increase the amount of BROAD money in circulation directly, bypassing bank lending. This destroys the reserve demand price mechanism, and forces banks to place money on deposit at central bank, for which they are paid at a rate that the central bank determines. This is why the bid price (IOR rate) is now the primary price mechanism.
The difference between the pre-2008 and post-2008 worlds makes it appear as if there are two different mechanisms by which broad money is created. But actually the central bank has always been able to influence broad money directly to some extent. As Nick points out, under normal circumstances OMOs do have some (small) effect on broad money, not because they increase bank lending (they don’t) but because of the substitution of money for assets. Since 2008 OMOs (QE) have been used as a partial substitute for bank lending as the primary driver of broad money creation. But QE is nowhere near as efficient as bank lending as a driver of broad money creation – which is why central banks have to do so much of it. I think this is at least partly why the Bank of England is no longer doing QE and is using quasi-fiscal measures (FLS, H2B) to persuade banks to lend. The paper doesn’t mention this.
Nick,
“Paying interest on reserves is just a way to increase the demand for reserves, rather like required reserves.”
With QE, the demand curve for reserves is infinitely elastic – once the quantity of reserves supplied increases to the point where it moves past the zone of inelasticity for uncompensated reserves.
Moreover, changes in IOR from that point shift the demand curve – but won’t change the shape – it remains infinitely elastic.
That also holds for IOR = 0
So IOR doesn’t change the demand for reserves in that context.
The zone of inelasticity represents the pre-2008 Fed for example.
The infinitely elastic zone represents QE.
circuit,
“Interestingly, the BoE paper seems to support Hetzel’s view; they claim the “first leg of the multiplier model” is relevant for QE.”
There is no multiplication in the first leg of the multiplier.
The first leg of the multiplier is a basic transaction step that is not unique to the multiplier.
So that’s not really a demonstration of the relevance of the multiplier – in fact – its more of an intersecting coincidence that provides no special support for the multiplier concept.