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 
Philip
It seems you are presenting a false dichotomy. To reference Nick’s illustration via Supply x Demand curves, I read your point to be that only shifts in the demand curve function impact broad money. Isn’t this obviously unrealistic?
Nick’s position seems to be that demand pull and supply push can both impact expansion of base money into broad money; and this seems hardly debatable.
In an earlier post, Mark A. Sadowski addressed the false choice between two worlds of endogenous and exogenous money theories. If endogenous money is, as you’ve characterized, solely a function of the demand curve, then the opposite, exogenous money, would be solely a function of the supply curve. But who is arguing on behalf of the latter?
If shifts of supply and demand curve functions both impact broad money, then their relative elasticities inform the multiplier of base money in doing so.
“if the central bank increases the supply of reserves, this should (all else equal) lower the interbank rate”
that’s correct, and it applies to nudging the trading rate back to a prevailing target rate, other things equal
“which should then lead to further lending and thus more deposits (simply because the funding rate is lower”
that is not correct in the case of risk (i.e. capital based) lending – i.e. core loan operations
it is correct in the case of risk free or near risk free lending associated with the reserve management function – the interest rate arbitrage effect happens very quickly through activity in near risk free instruments – otherwise know as money market operations in the reserve management context
“the central bank can simply change the corridor by changing its floor (IOR) and ceiling (LLR) rates”
that’s correct and it applies to a change in the target rate, other things equal
the multiplier is an entirely separate analysis and the post Keynesian story is the correct one there
JKH – I agree with all of that. I was trying to be diplomatic and lead the horse to the water. With respect to that not being the case with capital-based lending – you are also correct. But bringing in capital-based analysis is an added layer of complexity I assumed wasn’t being discussed. I was also trying to figure out a plausible reason why Nick was insisting bank lending would expand.
Nick
The article contained the following logic – which I interpreted you as endorsing: “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”
If a seller didn’t want dollars, why would they sell? It seems the act of selling was the portfolio re-balancing. Is it that perhaps there are 2 types of sellers, where seller (1) prefers to ultimately rebalance to higher yielding assets while seller (2) prefers rebalancing to dollars?
Assuming there are 2 sellers, then I may conclude that the expansionary impact of the OMO known as QE would be limited by ratio of seller (1) to seller (2).
JKH,
I think a follow-up comment of mine may be in the spam filter…
“that’s correct, and it applies to nudging the trading rate back to a prevailing target rate, other things equal”
I disagree that it’s necessarily for nudging back to a target rate, all else equal. It can apply to changing the target rate, all things equal. Under full information, I reject the assertion that the interbank rate necessarily changes just based on what the central bank says due to some type of arbitrage. I’ve seen you say this before. Something actually has to change – either the quantity of reserves, the corridor rates, reserve requirement, etc. Don’t need to debate this here though – can do it elsewhere.
JKH / ATR
Please describe, briefly, capital-based lending … We talking basic collateralized commercial lending to support working capital? If so, why does the reduction of rates not lead to more of this type of lending? I would think the reach for yield would lead to more lending in this market. Isn’t the capital-based lending spigot the first to be shut of when money tightens?
ATR,
I’m glad we agree on most of it – thought we would.
On the nudging – didn’t we debate this at that Fullwiler post (I think it was you – unless there are two of you)? Anyway, probably a question of fairly small degree, and yes – lets leave it.
On the capital – the nuance there is that the nudging in the context of an existing target rate leads to very rapid fire money market transactions that require very little if any capital allocation and therefore are very suited to pure interest rate adjustment activity – this is invisible to the rest of the bank including core risk lending operations that require capital allocation in a more strategic mode. It’s the change in the target rate setting (e.g. vertical corridor shifts) that changes the fundamental setting for risk based lending based on the general level of interest rates.
And yes Nick – those rapid fire money market transactions DO constitute a hot potato market – but a very special hot potato market in the context of central bank interest rate management
And yes Nick – I know you hate the term ‘money market’, but its hallowed institutional terminology coined specifically of course to piss off monetarist economists
🙂
Philip:
On the issue of reverse causality, Steve Keen and other post-Keynesians are fond of this quote by former VP of the NY Fed, Alan Holmes (made during the era of the ascendancy of monetarism):
“The idea of a regular injection of reserves-in some approaches at least-also suffers from a naive assumption that the banking system only expands loans after the System (or market factors) have put reserves in the banking system. In the real world, banks extend credit, creating deposits in the process, and look for the reserves later.”
It’s too bad that Keen et al. never mention that the very next sentence following that quote is:
“The question then becomes one of whether and how the Federal Reserve will accommodate the demand for reserves. In the very short run, the Federal Reserve has little or no choice about accommodating that demand; over time, its influence can obviously be felt.”
The point Nick is trying to clarify is exactly the same as the one Holmes is highlighting at the end of the statement about the short- and long-run of monetary policy.
Nick: Please answer yes or no if you agree with Holmes’s statement…;)
ATR,
Just noticed your:
“Something actually has to change – either the quantity of reserves, the corridor rates, reserve requirement, etc.”
Absolutely – the corridor rates or the announced target rate has to change at least
On the reserve quantity issue, the perfectly vertical demand curve is theoretically pure IMO, and it is difficult to separate out the reserve change due to the existing target-effective rate differential and the reserve change due to the target rate change, but I’m prepared to give a bit on the empirical likelihood that there’s some reserve easing at the same time – I think that might have been Fullwiler’s view – but let’s leave it (as long as I get the last word in here – lol)
circuit:
“The question then becomes one of whether and how the Federal Reserve will accommodate the demand for reserves. In the very short run, the Federal Reserve has little or no choice about accommodating that demand; over time, its influence can obviously be felt.”
critical distinction:
the multiplier debate has to do with the order of provision of reserves that are required to support deposits according to some required reserve ratio – the accommodation explanation there is the post Keynesian one – deposits before reserves
the accommodation argument in that follow up sentence has to do with the provision of the level of excess reserves, which is an issue of controlling the effective rate relative to the target rate, and which occurs in real time
two different accommodation streams, which can be seen in the flow of funds data
“But the more monetarist side should acknowledge that the quantity of reserves does not have to increase to lower the interbank rate. The central bank can simply change the corridor by changing its floor (IOR) and ceiling (LLR) rates. It can also change the reserve requirement (although this method isn’t so much used in practice).”
I’m not sure that this has ever been disputed by any monetarist ever. Milton Friedman was the earliest person (whom I’ve read) to discuss IOR, as part of his plans for changing the US financial system.
W. Peden,
As I interpreted him, Nick Rowe (not Milton Friedman) was insisting over at Monetary Realism that while the central bank may be supplying reserves to accommodate the demand of banks in the short-run 8-week period, they must restrict the quantity of reserves they supply to maintain their inflation target in the long-run (assuming it initially left target). This is not necessarily true. If the central bank is controlling inflation through their interest rate policy, they can change interest rates to achieve their inflation target without changing the quantity of reserves. They could change quantity of reserves, but they don’t have to.
So the point is that if you think inflation can be controlled by changing interest rates, this need not involve changing the quantity of reserves. The central bank can change interest rates by doing other things.
BTW, I’m not the one who brought up changing interest rates to control inflation. Nick did:
“No! Have these guys never heard of inflation targeting? The BoE does not sit idly by, happily “supplying” whatever is demanded at a fixed rate of interest. If banks decide to lend more, and this increases spending and pushes inflation up above target, *************the BoE will raise that rate of interest, precisely because the BoE cannot keep inflation on target if it simply lets reserves be “supplied on demand” at a fixed rate of interest.*************
They have an ant’s eye-view of the economy. They really need to step back and see the big picture. Any increased demand for reserves that is a result of actions that would lead to inflation rising above target will be met with a refusal to supply any additional reserves. The BoE will raise the rate of interest to make the supply curve of reserves perfectly inelastic in that case.”
ATR,
I don’t think that this is very interesting, nor does it have anything to do with monetarism.
JKH,
It’s pretty clear what Holmes is saying here. Regardless of how difficult it is for the Fed (say, under the pre-2008 regime) to control the money stock in the short term (Nick’s 6 to 8 weeks), the central bank can nevertheless control the growth of the money stock within a narrow band over a 6 to 12 months period. In my opinion, if the Fed can do that, then the deed is done. Studies have show that it can. That’s how monetary policy works. Holmes was right. And if I understand Nick correctly, he is also right on this issue. BTW, I enjoyed =your recent post.
W. Peden,
I couldn’t care less if you think it’s “interesting.” I wasn’t attempting to get in a debate about monetarism, but I did use the word ‘monetarist’ because it seems many of those in disagreement here align with monetarist beliefs. What I was doing was correcting an error I think that Nick made near the beginning of the debate.
OK, Nick, this is just too interesting to me! Sumner responded to the same question (I provide a link to the version I asked him above), and here’s his one line response:
http://www.themoneyillusion.com/?p=26355&cpage=2#comment-323611
Do you agree?
Nick, this is just too interesting to me! Sumner responded to the same question I asked you (a link to what I asked Sumner is above), and here’s his one line response:
http://www.themoneyillusion.com/?p=26355&cpage=2#comment-323611
Do you agree?? I don’t know how to reconcile his response with the one you’ve given me, so if you do agree, how do I reconcile them?
Thanks for your patience! (and don’t worry about fishing my other post out of spam, it’s a repeat of this one)
Nick, two of mine in spam: they’re copies of each other (the 2nd one slightly better): it must be the link I included… At first I thought it was because I had a URL in my information for the 1st one that it went to spam. No need to resurrect them both (or to keep a copy of this comment for that matter). Thanks! (Please take a look, it’s very short! … and I think it relates to your post here. Thanks!)
I’m on your spam list again: three short ones in there: only #2 is worth rescuing. Thanks!!!
ATR,
I don’t think it’s an interesting mistake, if it was made, because doesn’t relate to the underlying issues. There’s nothing in monetarism that denies the possibility of changing reserve requirements or introducing IOR.
Hi Nick,
You noted:
“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! [ …] 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!”
The bank of england says that the causality goes from M to R not from R to M. While they will be proportional (because of reserve req and settlement needs) the proportionality does not say anything about causality. The last sentence of your quote is getting to the point of contention. Can the central bank control the monetary base? In practice it can’t, all supply is defensive once there is a targeted interest rate and a given interest rate target to coincide with any quantity of reserves (all demand driven, i.e. the central bank supplies at will).
The BoE says the money multiplier is wrong because in terms of theory not an identity, i.e, BoE makes specific assumptions about the behavior of M and R given r and assumes that M causes R. The money multiplier story starts with the central bank injecting excess reserves in the system (this is not possible in practice because the interest rate would fall below target), and then banks uses those excess reserves until there exhausted (wrong too because bank don’t wait for reserves to provide advances of funds; they create IOUs that promise CB currency on demand and then turn to the central bank as needed; CB provides as much as needed and does not try to control any quantity target).
On a final note, QE is about targeting (in a loose way) long-term rates instead of just short-term rate. It is all about interest rate not quantity of reserves.
circuit,
thanks
then I’ll dissociate my comment entirely from Holmes and not question that
but on a stand-alone basis, the statement is factual for the pre-2008 Fed – assuming the Fed is aiming for a target Fed funds rate in the short term
its how it works at the operational level – two accommodation streams
circuit: given most central banks’ current operating procedures (very short term targets), I would basically agree with Holmes there. But those operating procedures are not written in stone, so he is not strictly correct when he says the Fed has “no choice” in the very short run. The Fed chose those operating procedures. It could have chosen something else. Nobody forces the central bank to buy (Robert Mugabe etc. aside).
ATR: if a central bank (or a commercial bank) pays interest on its money, then a change in that rate of interest will shift the demand curve. Just like a subsidy paid to buyers of apples will shift the demand curve for apples.
(I checked the spam filter, but nothing there. Either Stephen has already fished it out, or it’s on the previous page of comments.)
And I am quite happy to go beyond supply and demand theories of the determination of the stock of money. I have done so in previous posts. Because there is something very peculiar about the demand for a medium of exchange. Money is not like refrigerators and other consumer durables. People will voluntarily buy more money even if they have no plans to hold more money. For example, someone will borrow money because he plans to spend it, not because he plans to hold it. A seller of money can create an excess supply of money in a way that a seller of regrigerators cannot create an excess supply of refrigerators. But I don’t think Michael Woodford would be a good source to help examine this fundamentally disequilibrium question. Funnily enough, I’m actually closer to Steve Keen on this than I am to equilibrium theorists. But that would take me beyond the scope of this post.
Philip: if you are indeed comfortable with supply and demand curves, why the problem with BOTH supply AND demand curves determining quantity, and thinking this amounts to “evasion”, and objecting to my “forays” into demand and supply?
Everyone: BTW, whenever I said “8 weeks” I really meant “6.5 weeks”. My arithmetic was wrong. One year divided by 8 = 6.5 weeks between Fixed Announcement Dates, roughly.
Eric Tymoigne is correct
In order to achieve clarity on the multiplier issue, you must unpack excess reserves from required reserves through the same time line and then look at two different causality flows that apply to each component of that unpacking over that same time line
There are two accommodation streams
1) The CB supplies excess reserves as necessary in order to target the effective rate to the policy target rate (assuming pre-2008 Fed for example)
2) It supplies increments to required reserves – with a lag – to respond to the deposit growth that gives rise to the incremental reserve requirement – and it does this automatically in order to ensure that the operations that apply to the first type of accommodation aren’t mucked up by a sudden dearth of required reserves due to a jump in that requirement
Eric: “The bank of england says that the causality goes from M to R not from R to M.”
But as I said in my post, the Bank of England should have its knuckles rapped for muddling “supply” and “quantity supplied”. And so should you, when you say: “In practice it can’t, all supply is defensive once there is a targeted interest rate and a given interest rate target to coincide with any quantity of reserves (all demand driven, i.e. the central bank supplies at will).”
That interest rate target will not be exogenous with respect to all changes in M. Because the BoE targets (supposedly) a fixed inflation rate, not a fixed interest rate. And even if it did target a fixed interest rate, that is precisely its supply function of reserves. Even if the supply curve of apples is perfectly elastic, the position of that supply curve co-determines, along with the demand curve, the quantity of apples bought-and-sold.
Dustin,
Talking there about basic capital requirements for banking and bank risk taking of all types
(Basle is one of the regulatory frameworks)
Lower rates may result in increased lending in the core credit risk book, but its got nothing to do with reserves
Its about the effect of lower rates on demand and decisions on how banks allocate their available capital in responding to that demand
Nick: “If a central bank never has a balance sheet (except for the building it occupies), for any value of anything, and so never does anything, and is expected never to do anything, how can it target anything?”
By setting the interest rate it would pay on base money (“would” since base money doesn’t exist, but could).
But as I think about that answer, I see a flaw in my logic. In order to completely eliminate the demand for base money, there must be a cost to holding it (higher than privately produced money). That contradicts my answer, which assumes no extra cost.
Conclusion: although a central bank could make its balance sheet arbitrarily small, there would still be a money multiplier. Still, I stand by my assertion that a central bank doesn’t need a money multiplier, even though one will always exist.
Ok the quantity supplied is demand-driven (shift in demand curve leads to change in equilibrium quantity to go for the textbook version). While the central bank may shift the horizontal supply curve upward (raise the interest rate target) that target: 1- does not correspond to any specific quantity of reserves (a high rate can be achieved with large among of reserve and a low target can be achieved with a very little quantity of reserve; again quantity demanded will determine what the quantity supplied is; central bank as no say here as long as it targets rates) 2- is not changed with the quantity of M but with other considerations such as inflation.
Point 2 brings us to another point of contention: is the quantity theory of money valid? Does M causes P? If one follows the endogenous money approach definitely the answer is NO. P (or gP) is not explained by M (or gM). And P may cause M
Max: “Still, I stand by my assertion that a central bank doesn’t need a money multiplier, even though one will always exist.”
That sounds roughly right to me. (Though I’m not precisely sure what exactly it means!)
Eric @05:59: making allowance for your typos ;-), I think we are maybe now on the same page.
The traditional QTM says that a change in M causes an equi-proportionate change in P. And if the central bank is not targeting M, but something else, the traditional QTM is not so much “invalid” as beside the point, or talking about a purely hypothetical world. But we can easily re-define the traditional QTM to make it applicable.
For example, if the central bank targets the price level, then we simply reverse the causality. “A doubling of the price level target will double the stock of money”.
And we can redefine it again for an exchange rate target. “A doubling of the target price of forex will double both P and M.” And so on.
But we must always bear in mind that the central bank’s ability to target (e.g.) the price level ultimately depends on the fact that it controls its own balance sheet, and that its liabilities are the medium of account, and it can buy or sell its money at will to implement that target (or some other target). The Bank of Canada can target the price level (if it wants); the Bank of Montreal cannot target the price level, even if it wanted to, because it has a fixed exchange rate with the Bank of Canada.
Philip: you asked what I teach?
In second year macro, I teach that the LM curve is (roughly) vertical, and the AD curve is (roughly) horizontal, because that is what an inflation targeting Bank of Canada will choose.
First year is a bit tougher. I give them a verbal story of both base target and interest rate target, so they can make sense of the overnight rate target announcements every 6.5 weeks, tell them these are different ways of thinking about the supply curve, then M target diagram, then talk about an inflation target.
Nick, either your spam filter hates me you put me on your block list. 😀 I left a series in their, only one of which is worth saving (the 2nd one). Trying a different IP address.
How embarrassing: I just now noticed the “Next” button 😦
Tom: I just checked the spam filter, and there’s nothing there. And I didn’t block you.
Check back on the previous pages of comments. I saw your comments there.
Nick, sorry, I’m a dufus… I’m so used to ending up in your spam filter, that I didn’t even notice the “Next” button at the bottom of the page. More than 50% of my posts are me wrongly complaining about being spammed. Here’s the only one I really wanted you to look at:
March 15, 2014 at 04:51 PM
http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/03/one-general-theory-of-money-creation-to-rule-them-all.html?cid=6a00d83451688169e201a511860e56970c#comment-6a00d83451688169e201a511860e56970c
feel free to erase the rest.
Nick: Yes, I’ll go along with your qualifier. Indeed, the CB could choose to implement any number of operating procedures, as long as they are acceptable to the elected governing politicians. Thanks!
JKH: Apologies for my previous quick response. To be clear, I agree with everything you wrote, including the part about the CB’s strategy to control the effective rate. I simply pointed to Holmes’s statement as an attempt to show that Nick’s point is consistent with the notion of reverse causality found in the endogenous money approach. Based on Nick’s answer, I think the two views are similar after all. As for the multiplier story, I’m fine saying it’s wrong. It’s just that my view on this is informed by Basil Moore’s book, which mainly critiques the multiplier story on the causality aspect. Today (post-2008), in my opinion, this issue is not as clear-cut seeing as the Fed has considerable control over change in deposits, even in the short-run, as a result of its asset purchases. That said, I’m fine saying the concept is irrelevant, though I agree with Mark’s view that models aren’t meant to be perfect descriptions of reality. Thanks!
Nick, I meant to write in my comment above:
“Yes, I’ll go along with your qualifier. Indeed, the CB could choose to implement any number of operating procedures, as long as THE IMPACT OF THESE PROCEDURES ON THE ECONOMY are acceptable to the elected governing politicians.”
Obvious, I know…
Nick-
I’m nearly certain that the Woodford work I’m referring to is not of the nature you’re already familiar with. Just give it a skim, please. You can skip to page 21, maybe even a bit after. The goal is to get through pages 33-38.
“if a central bank (or a commercial bank) pays interest on its money, then a change in that rate of interest will shift the demand curve. Just like a subsidy paid to buyers of apples will shift the demand curve for apples”
That is correct, but what does this refute? My argument is that even though you’re correct that the central bank’s inflation target guides their interest rate target setting in the long-run, you’re incorrect that the central bank necessarily has to change the quantity of reserves in order to make the future path of interest rates consistent with their inflation target.
We don’t have to bring interest on money into this. We can just consider changing the ceiling rate. Here’s a simple sequence. Say there are X reserves in the system, and the prevailing interbank rate is 3% – consistent with the central bank’s interest rate target. IOR = 0% and the ceiling rate = 6%. Then say lending picks up, to a degree that would raise inflation above target. Say the central bank thinks it needs to raise the interbank rate to 4% to bring inflation back down to target. You insisted before that the central bank must toggle with the quantity of reserves somehow to get inflation under control. I am telling you, via Woodford’s models, that that is not necessarily the case. The central bank can change its ceiling rate until the 4% rate falls out (up or down, depending on the shift of the demand schedule once lending picks up), without ever changing IOR from 0%. The new 4% interbank rate should then do the work to get inflation where the central bank wants it, and the central bank never had to change the quantity X reserves.
circuit,
thanks for the clarification
Nick, I also have a thread going with Sadowski on Sumner’s site (under his version of your post here: i.e. on the BoE paper). We’re discussing the money multiplier. He gives a version which looks like this: (1+c)/(r+c). I’m trying to work out a simple example there. If you have any thoughts, I’d LOVE to her them. Thanks!
http://www.themoneyillusion.com/?p=26355&cpage=2#comment-323668
ATR: OK, I will try to read it. But let me guess: if I give away free out-of-the-money put options with my apples, that will shift the demand curve for my apples?
Dustin: “If a seller didn’t want dollars, why would they sell?”
Very good point, that finally takes us beyond supply and demand analysis. Short answer: because money is the medium of exchange. When I sell my house for $100,000, it does not (usually) mean I want to hold $100,000 sitting in my chequing account. I plan to buy something else. When a bank extends a loan, and creates a deposit, it does not (usually) mean that someone demands extra deposits; they demand whatever it is they plan to buy with that deposit.
Roughly speaking, it is not the demand curve for money that interacts with the supply curve to determine the stock of money; it is the supply curve of the thing that the bank is buying that interacts with the bank’s supply curve of money. It is at this point that we see the total breakdown of the idea that the stock of money is “demand-determined”. The demand curve that meets the bank’s supply curve is not the demand curve for money. Banks could create extra money even if the demand curve for money is perfectly inelastic. Suppliers of money can “force” more money into existence than people want to hold, because money, unlike other assets, is the medium of exchange.
This is Yeager’s point against Tobin. This is what creates the hot potato.
ATR: OK, you mean this bit in Woodford (page 35)?:
“To simplify, we shall treat the interbank market as a perfectly competitive
market, held at a certain point in time, that occurs after the central bank’s last open-market operation of the day, but before the banks are able to determine their end-of-day clearing balances with certainty. The existence of residual uncertainty at the time of trading in the interbank market is crucial;39 it means that even after banks trade in the interbank market, they will expect to be short of funds at the end of the day with a certain probability, and also to have excess balances with a certain probability.40 Trading in the interbank market then occurs to the point where the risks of these two types are just balanced for each bank.”
No problem. Canadian terminology: currently the overnight rate target is 1.00%, the bank rate is 1.25%, and the deposit rate is 0.75%. The BoC normally keeps that same symmetric spread, precisely to keep those risks balanced. But in principle, if the risks of having a shortage or an excess after the interbank market closes are non-zero, that gives the BoC three independent instruments: the stock of reserves; the bank rate, and the deposit rate.
If the corner store stays open later than the supermarket, and there’s a risk that I might need apples after the supermarket closes, my demand for apples depends on the price at the corner store. If the corner store raises its price, holding constant the price at the supermarket, I might buy more at the supermarket, to reduce the risk I will run out of apples late at night and need to buy more from the corner store.
In Quebec we call corner stores “depanneurs”, which literally means “those who fix outages”. The bank rate is the price at the depanneur.
I remember discussing this idea of the balancing of risks, before the Bank of Canada set up the current symmetric system paying interest on reserves, with my late colleague TK Rymes, back in the 1980’s. IIRC it was David Longworth at the Bank of Canada who was doing the analysis about balancing of risks back in the days preceding the payment of interest on reserves, and that lead to the current symmetric system. (The Bank of Canada was a decade or two ahead of the Fed in all this.)
It’s a fair point, and one I was ignoring. But I don’t think it is what is really at issue in the argument with the soi-disant “endogenous money” people. The issue is that they need to look beyond the 6.5 week period. Just as history is not “just one damn fact after another”, so monetary policy is not “just one damn interest rate after another”. The Bank of Canada’s (set of 3) interest rate target(s) is not exogenous with respect to everything that is affecting the demand for base money.
Tom: you really do need to distinguish between the demand for reserves going to zero and the supply of reserves going to zero. (And both supply and demand going to zero.) I read you one way, and Scott read you the other. It’s supply AND demand.
Very cool, Nick. Thank you for reading. You may be right this departs from the issue at argument with the endogenous money people – even though I align very much with what the BoE said and what many of the endogenous money people say :). But I did just realize that I could use this same argument against ‘the CB must supply reserves at will to maintain the target’ people as well: the central bank could instead change their corridor rates or reserve requirements to maintain the target, without defensively supplying more or less reserves. They might argue they already know this, but then they should be more careful when they make their arguments.
But do you think it is at all relevant to the debate regarding the extent to which controlling the long-term quantity of base money is relevant to controlling inflation? If interest rates can be manipulated sufficiently to control inflation without altering the quantity of base money, that must have some implications for you?
“This means that an adjustment of the level of overnight rates by the central bank need
not require any change in the supply of clearing balances, as long as the location of the
lending and deposit rates relative to the target overnight rate do not change. Thus under a
channel system, changes in the level of overnight interest rates are brought about by simply
announcing a change in the target rate, which has the implication of changing the lending
and deposit rates at the central bank’s standing facilities; no quantity adjustments in the
target supply of clearing balances are required.”
Nick,
“Tom: you really do need to distinguish between the demand for reserves going to zero and the supply of reserves going to zero. (And both supply and demand going to zero.) I read you one way, and Scott read you the other. It’s supply AND demand.’
So no change in the steady state price level then?
“Suppliers of money can “force” more money into existence than people want to hold, because money, unlike other assets, is the medium of exchange.”
Is it not important to distinguish here between income and loans? Everyone wants more income to the point that banks could give away money without getting anything in return (donating money). But only a fraction of the money a bank gives out is actual income and that is coming out from excess capital. Below that to create money a bank has to loan it out which depends on the demand for loans. So don’t we have two different demand curves?
Nick, just to be crystal clear we’re talking about my question here to Scott:
http://www.themoneyillusion.com/?p=26355&cpage=3#comment-323558
I don’t want my rat’s nest of comments to confuse…