Forget money and banking for a minute. Let's think about international macroeconomics.
Just suppose the US Fed, for reasons unknown, pegged the exchange rate of the US dollar to the Canadian dollar. The Fed makes a promise to ensure the US dollar will always be directly or indirectly convertible into Canadian dollars at par. The Bank of Canada makes no commitment the other way. The Bank of Canada does whatever it wants to do. The Fed has to do whatever it needs to do to keep the exchange rate fixed.
For example, just suppose, for reasons unknown, the Bank of Canada decided to double the Canadian price level, then go back to targeting 2% inflation. If it wanted to keep the exchange rate fixed at par, the Fed would need to follow along, and double the US price level too, otherwise the US dollar would appreciate against the Canadian dollar. The Fed's promise to fix the exchange rate makes the Bank of Canada the alpha bank and the Fed the beta bank. Both Canadian and US monetary policy would be decided in Ottawa. It's asymmetric redeemability that gives the Bank of Canada its power over the Fed.
Doubling the Canadian price level would mean approximately doubling the supplies of all Canadian monies, including the money issued by the Bank of Canada. Doubling the US price level would mean approximately doubling the supplies of all US monies, including the money issued by the Fed. Because the demand for money is proportional to the price level.
The money issued by the Bank of Canada (mostly currency, with a very small quantity of reserves) is a very small share of the total Canadian+US money supply. What exactly that share would be would depend on how exactly you define "money". Let's say it's 1% of the total. The total Canadian+US money supply would increase by 100 times the amount of new money issued by the Bank of Canada. The money multiplier would be the reciprocal of the Bank of Canada's share in the total Canadian+US money supply. 1/1%=100.
Maybe the US Fed keeps reserves of Bank of Canada dollars, to help it keep the exchange rate fixed. Or maybe it doesn't. But it doesn't matter.
Do loans create deposits, or do deposits create loans? Yes. Neither. But it doesn't matter.
The only thing that does matter is the Bank of Canada's market share, and whether it stays constant. And which bank is the alpha bank and which bank is the beta bank.
In the real world, the US Fed does not fix the exchange rate of the US dollar to the Bank of Canada dollar. But the Bank of Montreal and TD Bank do fix the exchange rates of their dollars to the Bank of Canada dollar. The Bank of Canada is the alpha bank, and BMO and TD are beta banks.
(C/D + R/D)/(1+C/D) is the Bank of Canada's share in the total Canadian money supply, where C/D is the currency/deposit ratio, and R/D is the reserve/deposit ratio. The reciprocal of the Bank of Canada's share is the simple money multiplier.
C, R, and D are all nominal variables. C/D, and R/D, being the ratios of two nominal variables, are real variables. If money is neutral in the long run, real variables are independent of nominal variables in the long run. If money is not neutral, those real variables will not be independent of nominal variables. Plus, real shocks will affect real variables, even if money is neutral.
The simple money multiplier story is a story about market shares, and about beta banks fixing their exchange rates to the alpha bank. If all banks expand together, their market shares stay the same. But if one bank expands alone, it must persuade the market to be willing to hold an increased share of its money and a reduced share of some other banks' monies, otherwise it will be forced to redeem its money for other banks' monies, or else suffer a depreciation of its exchange rate. Unless that bank is the alpha bank, to which all the beta banks fix their exchange rates. It is the beta banks' responsibility to keep their exchange rates fixed to the alpha bank. The Law of Reflux ensures that an individual beta bank cannot overissue its money beyond the share the market desires to hold. The alpha bank can do whatever it likes, because it makes no promise to keep its exchange rate fixed.
Just another way of looking at things. I think it's simpler this way. And much more general, because the same story works across international boundaries, under fixed exchange rates. The US Fed used to be the alpha bank for most of the world, when all the other banks pegged to banks which pegged to the Fed's dollar.
Worthwhile Canadian Initiative 
Nick, say the reserve requirement is 0%. What is R a function of? Or R/D if that makes more sense?
“The reciprocal of the Bank of Canada’s share is the simple money multiplier.”
The “simple money multiplier” is a partial function of currency held by the public?
I’m confused. I thought it used to be a specified function of bank reserves.
JKH, it’s an identity. Say the money multiplier is defines as an identity as:
mm = M1/MB
M1 = currency in circulation + deposits
MB = currency in circulation + reserves
(1+C)/(R+C) = (1+(currency in circulation)/deposits)/(reserve/deposits + (currency in circulation)/deposits)
= (deposits + currency in circulation) / (reserves + currency in circulation) = M1/MB
… I get into a discussion with Sadowski about it here:
http://www.themoneyillusion.com/?p=26355#comment-323668
His Miskin (7th edition) textbook describes
r = R/D as the “lenders’ choice” (in excess of required anyway)
c = C/D as the “borrowers’ choice”
MB as the CB’s choice
I gave him a simply hypothetical: reserve requirements = 0%, and cashless society. Then
mm = (1+c)/(r+c) reduces to mm = 1/(excess reserves).
So I said “what if the CB chooses MB = $1” then then it’s lender’s choice for r? They pick r = 0.1, then they need to lend $10. But I asked “don’t the borrower’s have a say in what’s feasible for r?” Here was his response:
http://www.themoneyillusion.com/?p=26355#comment-323692
“Well, it’s kind of a simultaneous system with multiple markets each with a set of supply and demand curves and multiple agents each maximizing their utility.”
Tom,
I know that particular equation is an identity.
But my question is not about whether its an identity, but what the denominator used to be (according to my recollection).
JKH: first year textbooks are very careful to assume, very explicitly, that they are ignoring currency. (Probably a mistake; it would be better to ignore reserves, so the multiplier is the reciprocal of the desired currency/M1 ratio). Second year textbooks do it like I said above. You could interpret it as an identity, or as an equilibrium condition, if you talk about desired rather than actual ratios (just like I=S can be interpreted either way).
Tom: desired R/D will be a function of a lot of interest rate spreads, plus risk, the efficacy of the clearing house, etc. Plus required reserve ratios, unless you want to ignore the world’s second biggest economy.
Nick, thanks. I put RR=0% so I didn’t have to qualify anything like Sadowski always does (following textbook author Miskin’s lead) “lenders’ choice, when in excess of required” … I just want to focus on the “in excess” part.
Given that, would you say that borrowers have a hand in determining R (again with RR=0% and no cash, to make it simple)?
… sorry, I meant R/D, not R. Miskin (apparently: I don’t have his book) defines r = R/D. So it’s this little r, the “reserve ratio” I’m interested in. Do borrowers help determine R/D?
Tom: in economics, almost everything depends on almost everything else. The best way to think of it is that beta banks directly choose R/D, but the behaviour of potential borrowers may influence that choice via the spreads and the riskiness at which they are willing to borrow.
Nick:
You didn’t mention the profits caused by devaluation. Assume the BoC has issued $100 canadian, against which it holds various assets worth 100 oz of silver, so $1 canadian=1 oz. Then the Fed issues $1000 US, against which it holds various assets worth $1000 canadian, so the Fed can peg $1 US=$1 canadian. Now the BoC devalues by half. That gives the BoC a profit of 50 oz. Of course the canadian public now wants another $100 canadian, so the BoC prints $100 canadian and buys assets worth 50 oz. (The inflation preceded the increase in the money supply, just like Thomas Tooke said back in 1844.)
The Fed’s assets have lost half their value, so the Fed earns no profit, even though $1 US is now worth .5 oz. But Americans will want another $1000, so the Fed will issue another $1000 and buy assets worth $1000 canadian (=500 oz). (Tooke was right again.)
Of course, if the Fed’s assets were denominated in oz, not $ canadian, then the devaluation would be profitable to the Fed.
Nick,
“The best way to think of it is that beta banks directly choose R/D, but the behaviour of potential borrowers may influence that choice via the spreads and the riskiness at which they are willing to borrow.”
Don’t forget the CB! Even if RR=0% or is fixed, the CB can force R higher at any time (like now in the US). The bank’s choice of “profit maximizing” R/D ratios is surely very dependent on both the actions of the CB and borrowers (e.g. the US over the past five years). Banks in the US seem to be “choosing” a very high R/D right now.
Nick,
I’ve rarely seen the multiplier used in that second-year way you describe – but then I haven’t taken a second year course. It’s always about the idea of bank reserves being “multiplied” into bank deposits by recurring lending. That’s the whole basis for the rejection of the concept by heterodox people like MMT and non-MMT post Keynesians. That rejection argument has nothing to do with currency held by the public – it has to do with the multiplication of bank reserves into more bank assets and bank liabilities (deposits).
Using currency as part of the denominator may well be a better idea (I don’t know), but that concept has nothing to do with the (false) idea of a constraint on bank lending due to the orthodox interpretation of required reserves. There is no way that currency held by the public can be construed as a true or even false constraint on bank lending – nothing direct that I can think of that makes any sense.
On the other hand, I can see how the idea of using that in a proportionate way to set out an argument for the demand for different types of money can very well make sense – and much more sense obviously that the conventionally (first-year) defined multiplier argument. That sort of argument is one of portfolio composition – along the lines of your “what exactly that share would be” remark as you note in your post here.
So I see wisdom in preferring the second-year version to the first, but its an entirely different analytical concept in my view.
JKH, let me run this past you. Even in the simplified case (the 1st year case I gather): the cashless society, and with excess reserves = 0 (so that R is the just the legally required reserves). I hate the way the concept is usually brought up as a bank starts with a deposit, then it loans out (1-R) times that deposit, which is re-deposited, etc. Then they make an infinite series and show how with an infinite number of loans and deposits this establishes a legal upper bound for the quantity of money (both created by banks and base money). Usually an infinite geometric series is introduced and shown be be equivalent to the ration 1/R. I’ll use 1/RR for “required reserves” in the denominator.
This story, IMO, should be relegated to a footnote, and the main way of teaching it should be: “If the CB sets MB as reserves (cashless society), and RR > 0, then the banks can simultaneously create MB(1-RR)/RR and MB(1-RR)/RR deposits simultaneously: added to the existing base money, MB, this means MB/RR is the maximum amount of money.”
Then the student doesn’t mistakenly think this requires a never obtainable infinite series of smaller and smaller loans (like I first thought when I saw this) and thus the maximum is kind of a theoretical abstraction which can never be obtained (again like I first thought). No, instead it’s a very realizable limit, and given the constraints of the story, it can be achieved with a single loan immediately.
I think if the story were presented like that it would somehow bring the PKE types and the orthodox types a bit closer, don’t you think?
Plus there’s another reason I hate the infinite geometric series story: an artificial region of convergence (RoC) limitation on the series itself which doesn’t make sense. In reality all you need is a non-negative RR, with a zero RR being a special case (i.e. RR = 0 means the sky’s the limit). But when you look at the series:
D*(1 + (1-RR) + (1-RR)^2 + … ), then this only converges for |1-RR| < 1, or for RR on (0,2). This is totally artificial: presented w/o a geometric series (the way I prefer) shows that clearly RR only need be > 0.
… another way to say my story, which is perhaps better, is that the banks start with an initial capital of MB. Then it’s easy to see how RR > 1 also works (not that it’s ever been done in practice, but theoretically it shouldn’t be a problem). It all becomes a single unified story. For example, right now the US could set RR > 1 if it really wanted to. There are plenty of reserves out there to support that w/o much disruption.
Mike: that’s why I snuck in the weasel-word “approximately”, when I said that doubling the price level target would approximately double the amounts of all monies. Seigniorage could make money non-neutral. But my guess is that there would be (approximately) the same amount of approximation in the same direction in the US as in Canada, so that relative shares would not be (much) affected by this.
Tom: true.
JKH: One of the things we want to teach the first year students is that fractional reserve banks do create money, and that 100% reserve banks don’t create money (they just transform it from $1 currency to $1 demand deposits). Because they don’t believe it until you spell it out, in the textbook money multiplier example. They have a fallacy of composition: “since each individual bank cannot lend out more that its deposits, the banking system as a whole can’t create money!”
Suppose all (beta) banks decided to create more loans and deposits. If people decided they didn’t want to hold more deposits without holding more currency, then they suffer increased currency withdrawals, and are forced to contract, unless the Bank of Canada increases the stock of currency in the same proportion. It would be exactly like an exchange rate crisis.
Scott had a nice clear way of looking at it recently: if base money is held by the public we call it “currency”; if base money is held by the banks we call it “reserves”.
Keynes had a clear way of putting it too, somewhere. Something about the difference between an individual bank expanding and all banks expanding. But we need to remember the important difference between beta banks and alpha banks.
Nick,
“They have a fallacy of composition: “since each individual bank cannot lend out more that its deposits, the banking system as a whole can’t create money!”
Why not use the example of a single commercial bank, which in one step can create the maximum amount of deposits legally allowed (by the RR ratio and MB) by buying stuff: any stuff, loans or whatever else they want to buy? I agree this applies to the banking system as a whole, but why confuse the issue? A single bank can certainly create more deposits that its starting deposit and/or capital base in a single step. If RR = 1, then that single step might be $0 (depending on whether the bank has initial capital or initial deposits). Or as Scott Sumner would say, it can extend credit (not money!) to the maximum amount given a fixed amount of base money. Lol.
Nick,
I haven’t thought much about your currency analogy, but it seems OK at first glance – although with the caveat that it is most clear when you apply it to the currency component of the base.
“Scott had a nice clear way of looking at it recently: if base money is held by the public we call it “currency”; if base money is held by the banks we call it “reserves”.”
I think that’s not only clear – I think it’s essential.
And I think you guys run into a problem – and this is not meant as snark – by denying as a sort of club theme the importance of institutional arrangements – i.e. by denying the importance of banking.
That FX analogy and that bifurcation that Scott refers to means you should be thinking about institutional structure as between banks who want reserves and the public who wants currency.
And I think the efflux/reflux stuff needs to be tackled separately according to institutional arrangements.
I’ve been thinking about a post on this for a while now.
JKH: actually, the bit that is still puzzling me is the opposite question. Suppose the alpha bank expands, and all the beta banks except one expand too, but that one bank doesn’t want to expand. Now, any bank can refuse to expand its loans, if it doesn’t want to expand its loans (never mind the profitability). But, can an individual bank refuse to expand its deposits? It can refuse to accept new customers, but I can’t figure out if it can refuse to accept new deposits from existing customers. It could do things to drive away existing customers, I suppose. Put it another way, if all the other banks expanded, and it refused point blank to expand, would its exchange rate appreciate??? Weird.
Tom: “Why not use the example of a single commercial bank, which in one step can create the maximum amount of deposits legally allowed (by the RR ratio and MB) by buying stuff: any stuff, loans or whatever else they want to buy?”
That is exactly what Mankiw’s first year text does. First one big commercial bank, then repeat with lots of commercial banks, showing the (eventual) answer is the same in both cases.
The key point is that when BMO makes a loan to one of its customers, and that customer spends it, he might buy something from someone who banks at TD bank. BMO does not increase its market share.
Nick, Re your reply to JKH just above (03:23 PM), I read somewhere that during the recent recession, some banks HAVE actively discouraged deposits.
Nick,
Assuming that beta bank accepted deposits, but refused to make loans, then its reserve balance with the CB would have to build up.
The CB would have to accommodate that in the sense of ensuring a supply of reserves that met the demand from the other banks.
The loan-averse beta bank’s risk profile would become lower risk.
So it’s stock would become less volatile.
It’s stock might appreciate (depreciate less) relative to the others, depending on circumstances, but in any event it would be less volatile by usual measures, I think.
Does that correlate with your idea of exchange rate appreciation? I don’t know.
Thanks Nick. Do you prefer Mankiw’s text or Mishkin’s? (Someday I may even try to educate myself beyond reading blogs)
Tom / Nick,
In general, I’d like to see more focus on bank capital and less on bank reserves.
That would really change the blogosphere discussion.
The reserve story is intriguing to debate as an operational issue, but I don’t think its at the heart of the issue of money or banking.
And it shouldn’t be a the heart of monetarism, IMO.
Monetarism could thrive under a new centricity of bank capital rather than bank reserves – insofar as monetarism considers bank reserves now.
Expel bank reserves from the definition of the monetary base!!!!
JKH,
“Expel bank reserves from the definition of the monetary base!!!!”
We already have a name for that: M0
It’s funny, because I always want to keep the reserves and expel the cash… only because that’s makes it easier for me to visualize usually. BTW, when I wrote about “capital” above, perhaps I wasn’t using precisely the correct term, but what I had in mind was contrasting two (cashless society, single commercial bank) starting points:
1. CB starts off having done an asset purchase, putting MB of reserve-assets on the bank’s BS and MB of deposit-liabilities as well… thus assuming the CB is now out of the picture (not doing any more OMOs) then the bank can buy a maximum of MB*(1-RR)/RR of stuff.
2. Somehow (not clear how!) investors pool MB in starting capital to invest in the one commercial bank which is just starting up: it’s total liabilities (not counting shares) is $0, but it has MB in reserve-assets, so now it can buy a maximum of MB/RR (e.g. it could buy loans), which will always be of an amount > $0, provided RR > 0 but finite.
I think you’re talking about something else though.
“maximum amount” … it should be noted, that this holds as a maximum unless the bank can convince depositors to buy savings deposits or they can charge fees, points, interest etc up front from the sellers (of whatever it is they’re buying) so as to boost the bank’s capital in the process. That’s my John Carney inspired “Banking Example #3: Capital Requirements”
Nick, I agree with the importance you place on asymmetric redeemability. The base can cease being the medium-of-account but still “cause” the price level as long as the replacement media-of-account are redeemable into base.
Has your thinking on reflux changed since this post?
http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/09/all-money-is-helicopter-money.html
Tom,
“We already have a name for that: M0”
It’s been so long since I paid attention to those M definitions, I’d forgotten.
Then make M0 = monetary base and abandon the term “monetary base”.
The purest form of capital is equity – assets minus liabilities.
Capital is what is available to absorb losses in the normal course.
All bank lending requires a capital allocation decision.
(With the possible exception of risk free assets like short term treasury bills.)
Tom, M0 includes reserves. M1 excludes them but includes demand deposits. As far as I know there is no measure of M that consists of currency only. The Bank of England does produce data on notes & coins in circulation, though. I don’t know about other central banks.
Frances, I am going off of the ultimate authority, Wikipedia. 😀 Lol… the 1st table here:
http://en.wikipedia.org/wiki/Money_supply
If you scroll down, M0 is a little different in the UK.
MO in the US anyway is what we’re looking for: currency in circulation (not in bank vaults). They don’t break out Canada as a separate heading (at the bottom), but they do have a few other examples: Japan, New Zealand, etc.
So maybe “M0” isn’t a good choice since it has different meanings by country. But all the countries shown as examples there seem to share the definition except the UK. But that’s maybe a half dozen out of 180+ countries world wide… so I don’t know what the majority say!
(BTW, I refer back to that table all the time: it’s pretty handy for keeping track of what various people are talking about… and as far as I know it’s accurate!… Sadowski, for instance, has never complained when I referred to it)
JKH, as I understand it, before the electronic era, reserves used to be cash. So instead of electronic credit for banks at the CB, the banks would literally have piles of paper currency in their vaults. Now, of course, only a fraction of reserves are made up of vault cash.
So if you think about it as “base money in the private sector” (regardless of the medium) doesn’t the current definition (i.e. MB) make some sense? Especially if we don’t automatically assume that the CB is going to be accommodative in supplying MB? (i.e. it’s possible the CB could target a fixed level of MB or rate of increase of MB… kind of like what’s going on now in the US).
I think most monetarists HATE the implicit unsaid assumption that the CB is accommodative with MB: they like to imagine a CB that can do what it wants! 😀
Tom,
I think currency held by banks is in a different category than reserve balances held by banks.
Currency held by banks is an inventory function for currency held by the public.
Reserve balances at the CB are very different.
The economics are very different.
The CB executes interest rate policy through reserve balances – not currency – even if the interest rate policy is zero bounded.
It’s an interesting point about the history of the clearing system.
I don’t know how to factor that in at this point.
One first has to answer the question how the role of short term interest rate management was executed in that system (if at all). I don’t know the answer to that, and I’d be surprised if anybody does – given the confusion about the money multiplier etc. that still exists in the year 2014.
JKH, the IOR point is a good one. But won’t most CB’s trade cash for electronic credits or vice versa on demand?
Ralph: “I read somewhere that during the recent recession, some banks HAVE actively discouraged deposits.”
Hmmm. Any idea why?
JKH: “Does that correlate with your idea of exchange rate appreciation? I don’t know.”
I don’t think so. I was trying to imagine a circumstance where a bank’s deposits might appreciate, relative to the central bank’s money. But I can’t think of any. I think a commercial bank would always accept a cheque payable to one of its existing customers, at par.
Tom: Mankiw’s text is an Intro Micro+Macro text. (He also has an intermediate macro text.) Mishkin is money+banking, so not really comparable.
JP: I don’t think my thinking on reflux has changed since that post. There’s a difference between the Law of Reflux applied to an individual bank, and the same law applied to the monetary system as a whole. The hot potato passes from one bank to another (including the Bank of Canada) as it gets spent. The BMO can create deposits, but they won’t stay in BMO. The monetary system as a whole (as lead by the alpha bank) can create a hot potato.
Hey Nick, O/T: Brad DeLong is back at it with his refrain: “Say’s law is not true in theory but can be made so in practice” (paraphrasing):
http://equitablegrowth.org/2014/03/24/2351/no-i-really-do-not-think-that-we-were-doomed-to-the-lesser-depression-plus-the-greater-stagnation-i-think-paul-krugman-gets-one-wrong-here-monday-focus-march-24-2014
Tom,
Commercial banks proactively manage their inventory of cash by buying and selling with the CB as a counterparty
Cash bought = reserve balances spent
CB takes that plus all other factors affecting reserve balances in managing interest rates in the short term
Thanks Tom.
I see you tried to explain it to Cullen, who totally doesn’t get it. He seems to think the Bank of Montreal dollar must be worth one Bank of Canada dollar, because, well, they are both “dollars”! But that is somehow totally different from the exchange rate between the Bank of Canada “dollar” and the US Fed “dollar”. No comparison at all! Even though the Bank of Canada used to have a fixed exchange rate with the US dollar? Sometimes I despair of “banking” guys. He complains I’m “moving the goalposts”, by looking at it from a wider perspective. God help us. I left a somewhat peeved comment on his post.
Nick,
If a bank found that it was attracting excess deposits, it would react by cutting its deposit rates. In normal circumstances, a small cut in the bid rate on wholesale money would be sufficient to deflect excess deposits elsewhere. It doesn’t always work so well in reverse, because depositors are constrained by credit limits.
Re Ralph’s comment, during the crisis there were instances of high credit quality banks receiving in more funds than they wanted as depositors pulled their money out of more risky banks. However, the good banks were themselves cutting lines on interbank lending, so were faced with the problem of not having anywhere to put the money. IOER obviously helped.
Nick,
What in this story makes one bank the alpha bank? Clearly the alpha bank is the one that doesn’t commit to fixing its exchange rate, but that’s not what actually makes it the alpha bank is it? If you started with a number of banks, but no alpha, one of them cannot simply become the alpha bank by deciding not to fix its exchange rate. You need to look to something like reserve requirements, legal tender laws or a chartalist explanation, don’t you?
Monetarists might find JP Morgan’s ‘London Whale’ episode interesting from a hot potato perspective.
Among other things, that portfolio was a significant use of funds.
In a conference call, Jamie Dimon actually tried to make the argument that JPM was so flush with deposits, it had to do something with the money, and the London portfolio was one outlet for it.
Then they started overlaying it with derivative credit risk trades.
Dreadful admission about risk management at JPM.
“QE made him do it.”
Nick E: the immediate answer to the question “what makes an alpha bank an alpha bank (or an alpha issuer of money)” is that other banks (the beta banks) decide to fix their exchange rates to it. The alpha bank doesn’t do anything to become the alpha bank. But, of course, that raises the question: “why do the beta banks peg to that particular bank, and not to some other bank?”. For example, why did the Bank of Canada (in the past) peg to the Fed, and not vice versa (as in my imaginary story). I don’t think there’s any one answer to that question. It might be history (the alpha bank was there first, and its money was already accepted as money, and the beta bank needed to get started and get its IOUs used as money). Gold miners were the original “alpha bank”. It might be size and trust. Governments might play a role too.
“For example, just suppose, for reasons unknown, the Bank of Canada decided to double the Canadian price level, then go back to targeting 2% inflation. If it (the U. S. Fed) wanted to keep the exchange rate fixed at par, the Fed would need to follow along, and double the US price level too, otherwise the US dollar would appreciate against the Canadian dollar.”
If the Fed wanted to keep the exchange rate fixed, they could introduce a tariff on U. S. exported goods so that Canadian import prices keep pace with Canadian domestic prices (assuming the U. S. and Canada are the only two countries that exist). U. S. Fed takes tariff proceeds in Canadian dollars and burns them.
I appreciate most of Nick’s writings/ideas but this one I do not get.
I think banks usually worry about leverage on their equity not reserves ratios. Would it be helpful to think banks as a sector and thus too-big-to-fail. So all the bank dollars would trade at par with each other. I think public and banks see it this way – that is only a layman’s observation. Banks certainly are capital constrained though. If that is not true it would certainly give an edge to those banks seen as systematic important?
I can see that sometimes that might not be totally true (Iceland, Cyprus etc.) but I do not think that even those cases individual banks didn’t considered themselves reserve or cash constrained before the crises hit (set me straight here?). Yet they were able to attract a lot of deposits by offering higher rates, also abroad.
It seems to me that this 2.0 multiplier idea rely on cash/deposit ratio? But would it imply that there could be times where cash is not offered on-demand and thus would be sold at premium? Should that happen?
Jussi: I think that JKH is right, and that banks’ capital constraints can matter too. (But that affects the asset side of banks’ balance sheets more than the liability side, since different assets usually have different capital ratios.) But we need to remember that bank capital is endogenous. It doesn’t adjust instantly, but it can adjust.
This isn’t really multiplier 2.0. Simply a different way of looking at the same multiplier. (But the cash ratio usually only appears in second year textbooks, because first year students can’t do the math for (1+c)/(c+r), so we usually tell them we are assuming c=0 to keep it simple. Because the only point we really need to make is that, yes, banks really do create money, unless r=100%.)
“But would it imply that there could be times where cash is not offered on-demand and thus would be sold at premium? Should that happen?”
It certainly does happen, but we normally describe it as deposits trading at a discount, or devaluing against cash, rather than cash trading at a premium. Or notes trading at a discount to gold, if gold is the alpha bank, and a bank suspends convertibility into gold. Same thing, described differently.
Like always, it’s about interest rates. If one bank makes more loans it needs more reserves and will be willing to pay a higher rate of interest. They well likely attract more deposits and capital until the risk adjusted returns are the same or they can no longer profitably make loans if they paid higher rates to fund loans. What you’re thinking about imo is more like a bank over paying for things or lending too much money to people. It’s the people who take loans that spend them for the most part the banks can’t over pay for things but they can under collateralize a loan or loosen credit standards in a way that makes lending either unprofitable and/or excessively risky (ninjas). It’s those things, I think, that would determine exchange rates between banks and banks and customers.
Denmark keeps negative rates to keep the tight peg to the Euro
http://www.bloomberg.com/news/2013-11-28/negative-rate-experiment-in-denmark-is-seen-stretching-into-2015.html
The Fed is now also moving closer to the ECB target of < = 2.0%
and this pegging might have something to do with people demanding risk premiums for weaker currencies and writing contracts in the hardest currency of the biggest economic bloc.
Nick,
You said at PragCap:
“In modern central banking, commercial banks make their money directly convertible into central bank money at a fixed exchange rate, and the central bank makes its money (indirectly) convertible at a (roughly) fixed exchange rate into CPI baskets of goods, with a 2% rate of depreciation of the exchange rate target. Which means all the commercial bank monies are convertible into each other at a fixed exchange rate, and into CPI baskets at an exchange rate depreciating at roughly 2% per year.”
When you say “convertible at a roughly fixed exchange rate … 2 per cent depreciation of the exchange rate target”
There are two exchange rates there, right? One for commercial bank money and central bank money, and one for central bank money and a CPI basket. The first is fixed; the second is a crawling peg, so to speak?
And the same for gold? One for commercial bank money and central bank money, and one for central bank money and gold? Except both are fixed?
I thought this older post was very interesting and relevant to this comparison:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/04/from-gold-standard-to-cpi-standard.html
I think you’ve said the alpha bank in the gold case are the gold miners – not the central bank.
What’s the parallel alpha in the CPI case?
JKH, that’s the same old post that JP Koning “hoisted” Nick upon his “own slippery slope” with:
http://jpkoning.blogspot.com/2012/11/discussions-of-medium-of-account-could.html
JP’s views on the MOA have changed a little since then though.
I was wondering if there might be a 3rd exchange rate: CPI basket to commercial bank money, which would make a nice circle out of it, wouldn’t it? 😀 … but I think the answer is “No!”
Thanks Tom
that’s the kind of consistency that I’ve suddenly become curious about
perhaps I’ll change my handle to “Too Much Medium of Account”
🙂
JKH: “The first is fixed; the second is a crawling peg, so to speak?”
Yes! That’s the term I was looking for: “crawling peg”! I was searching my brain for it, over at PragCap.
“I think you’ve said the alpha bank in the gold case are the gold miners – not the central bank.”
Yes, and that metaphor works if gold is also used as money, but I am stretching the metaphor a bit far if gold is not used as money, and just for “industrial uses”.
“What’s the parallel alpha in the CPI case?”
Hmmm. Good question. The producers of CPI goods? But maybe I’ve stretched the metaphor beyond breaking point.
Yep, I was thinking about that old post too. I sorta surprised myself by writing that. I’m still not fully comfortable with the conclusion, though it seems right.
Tom: “but I think the answer is “No!””
I think the answer is “yes”. Like under Bretton Woods, if the BoC fixes to the US Dollar, and the Fed fixes to gold, then indirectly the BoC fixes to gold.
And I like that idea of the CPI basket being the medium of account.
(TMMA)