John Maynard Keynes famously wrote that: "Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist." A modern example of that dictum, relevant to the economy, policy, and markets, is the widespread view that people can "spend" their money, as if money represented a pool that is just waiting to "flow into" spending. Because such a thing cannot occur and therefore has not occurred, the point is usually made in reverse: people currently are not "spending" their money–rather they are "parking" their money at the bank or leaving it "idle." But that they might spend it in the future is a lurking risk and a reason to be cautious about the central bank engaging in aggressive quantitative easing (QE).
To see what is wrong with that standard textbook view, we need to consider the following fundamental accounting identity:
M = M
The amount of money that people hold must equal the amount of money created by the banking system. You can't see "spending" anywhere in that fundamental accounting identity, can you? Therefore, people do not "spend" money!
A key distinction to bear in mind is between individual people and people in aggregate. Neither individual people nor people as a whole can "spend" money, but individual people can and do offload their money (particularly excess money) by lending it to other people or by buying goods and assets; but people in aggregate cannot do this–in such cases, the money that leaves one person's balance sheet just pops up on another person's balance sheet, remaining on the banking system's balance sheet all the while.
Therefore, people cannot and do not "spend" money. This explains why creating money does not work to increase spending. Except, maybe, via obscure indirect mechanisms.
The above is total rubbish, of course. It is also heavily plagiarised, from an article by Paul Sheard (pdf) (HT David Andolfatto). Basically, I just changed his "banks" to "people", his "lend" to "spend", and his "reserves" to "money".
Now let me be sensible:
We define "excess money" as the actual stock of money that people hold minus the stock of money they desire to hold (given prices, income, interest rates etc.).
If an individual person has excess money, he can and will get rid of it, by spending it or by lending it. (And "lending" means "buying an IOU from someone", so it's the same as spending.) But that just means another individual person now holds it.
If the banking system creates an excess supply of money, and holds that stock of money constant, each individual person can get rid of it, but people in aggregate cannot get rid of it. It just keeps circulating back to them, as quickly as they spend it. But their individual attempts to get rid of it are what create the increased demand for goods, which will ultimately raise the prices of goods above what they would otherwise have been. The fact that people cannot in aggregate get rid of the excess money is a central part of the standard story of why excess money raises the demand for goods and the prices of goods. If they could get rid of it by spending it, the excess money would have at most only a temporary effect.
It's exactly the same with excess reserves. But here we need to be careful about how we define "excess reserves". The economically relevant definition is "actual stock of reserves minus desired stock of reserves". We should not define "excess reserves" as "actual stock of reserves minus legally rquired stock of reserves". The former definition works for economists in all countries, regardless of whether or not there are legal reserve requirements (Canada has none). The latter definition is only good for US lawyers.
It makes absolutely no difference whether banks make loans in the form of currency or in the form of creating demand deposits. An individual bank that makes a loan of $100 by creating a deposit of $100 will lose $100 of reserves to a second bank when the borrower spends that $100 on a bike, and the bike seller deposits the cheque in that second bank. If the bike seller will only accept currency, so the first bank swaps $100 in reserves for $100 in currency, then lends $100 currency to the borrower, the loss in reserves is immediate, rather than delayed by a day or two. But the end result is exactly the same.
Let's cut to the goddamn chase: banks lend reserves.
And the fact that banks cannot in aggregate get rid of the excess reserves is a central part of the standard textbook story of why excess reserves raise the stock of money, which creates an excess supply of money, which raises the demand for goods and the prices of goods. If banks in aggregate could get rid of reserves by lending them, the excess reserves would have at most only a temporary effect.
(I could do another post on the "needs of trade" fallacy (the idea that "interest-rate-targeting central banks supply whatever reserves are needed") in that paper, but I have already done several related posts, like this one. So I think I will drive to Wawa instead.)
Worthwhile Canadian Initiative 
“Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” Yes, for example, John Maynard Keynes himself.
Your comment is true (modulo the treasury’s ability to soak up dollars through taxes), but it also true for stocks or any other asset. People miss this all the time – all the stocks are always held by someone. So, next time you here a strategy that says everyone needs to rebalance, or you need to pull back from the stock market, we can’t all do that. It is impossible – for everyone who is underweight stocks, someone must be overweight. This is why, in the aggregate everyone – including active management – gets the index return. Active management, by an identity no less, is a zero sum game for exactly this reason.
Avon: Yep.
People in aggregate cannot sell their stocks (unless the issuers buy back those stocks). But their individual attempts to do so cause the prices of stocks to fall (the price of other things in terms of stocks to rise).
People in aggregate cannot sell their money (unless the issuers buy back that money). But their individual attempts to do so cause the prices of money to fall (the price of other things in terms of money to rise).
Banks in aggregate cannot sell their reserves (unless the central bank buys back those reserves). But their individual attempts to do so cause the prices of reserves to fall (the price of other things in terms of reserves to rise).
“If an individual person has excess money, he can and will get rid of it, by spending it or by lending it.”
If by “money” here, you mean transaction account balances, then one of the obvious ways of getting rid of it is by lending it to the bank, i.e. putting it into a time deposit. Which does get rid of it in aggregate.
When people say “banks don’t lend reserves” they seem to mean 2 things
1. They technically don’t lend reserves. However as soon the loaned money is spent it will likely lead to a drain on the reserves of the lending bank, that will be equivalent to them actually having lent reserves. This renders this version more of a technicality than anything very helpful in understanding the role of reserves.
2. The amount of lending in the system is determined by the CB target interest rate and not the amount of reserves. The CB will adjust the money supply to make sure banks can get the reserves they need to back current lending.
This sees a more viable justification for saying “banks don’t lend reserves”. I can imagine that banks may actually be looking to make loans that they know will cause a drain on their reserves below optimal levels. But this doesn’t concern them because they know that at the current target rates they will be able to get the reserves and get back to optimal levels and still make a profit on the loan. I doubt if banks can totally adopt this model (it doesn’t sound like it would be a profit maximizing strategy – no matter what the CB target rate is, they still need to be competing to get people to lend them money that they can lend out at a profit). But as knowledge of CB policies and the current target rate does affect bank policies to some degree (and therefor puts a bit of a wedge between reserves and lending) I don’t feel comfortable totally rejecting the “banks don’t lend reserves” mantra.
Nick E: similarly, if a bank buys a bond from the central bank, that gets rid of reserves.
TMF: I think you are right. And sometimes they use that technicality (refusal to cut to the chase) to try to back up that second substantive (but wrong) point.
TMF: I would rephrase your own point like this: the demand for reserves (the desired stock of reserves) depends on current and expected future central bank policies. People who know they can always buy gas quickly at a reasonable price won’t hold as much reserves of gas as would people who expect shortages and the risk of price spikes.
Nick, I’m so with you on comments about money “flowing into” the economy through spending. Or the idea that health-care spending (or whatever) “takes money out of the economy.” Utterly incoherent.
But if money is properly conceived, the idea of money hoarding is perfectly coherent. The money conception you bruit here I think confuses money with “currency-like things.” Hence the endless, fruitless imbroglios about MB, M1, divisias, etc.
The following courtesy of Jesse Livermore’s brilliant understandings, which I tried to condense and riff on here:
http://www.asymptosis.com/modern-monetarist-thoughts-on-wealth-and-spending-volume-or-velocity.html
Money in the form of bonds/cash is created through deficit spending — by the federal government and by individuals borrowing from banks that are licensed by the government to “print money” for lending.
When you use your credit card instead of your debit card, you’re creating money. Pay down your debts, you’re destroying it. The government and banks don’t just have printing presses, they have furnaces.
But money is also created (and destroyed) by the financial markets adjusting portfolio allocations. If the markets are confidently optimistic (“animal spirits”), they shift their percentage preferences from bonds/cash to stocks, bidding up stock values. (The aggregate value of bonds/cash declines less than stocks go up.) Voila, there’s more money out there. Ditto if there’s more deficit spending hence more bonds/cash. Fixed portfolio allocation preferences result in stock prices being bid up.
Aside: Pace Piketty, wealth — claims on real assets/capital — can increase even without an increase in assets/capital. People simply think they’re worth more, that there will more to claim in the future.
So the stock of money can increase through deficit spending, or increased animal spirits.
But (going all monetarist here), what about velocity? How fast does that stock of money turn over? If it turns over more slowly, that is quite properly characterized, I think, as “money hoarding.” Faster turnover (at a given M) results more spending, less ‘hoarding.”
So how do individual decisions play out? If people are more confidently optimistic, they will:
1. Borrow more, increasing M.
2. Shift their portfolio allocations toward stocks, increasing M.
3 Spend a larger percentage of a given M each year, increasing V. (This interacts directly with #1 — should they spend, or pay down debt?)
Mid-twentieth-century analytical philosophers came up with something called the Significant Contrast Principle. The idea was that words exist in everyday language in order to mark significant contrasts. It often happens that someone (usually a philosopher) proposes a definition of a common term (verb, adjective, common noun) according to which everything or nothing must fall under the term; by SCP such a definition must be erroneous. When a critic confronts a philosopher who has violated SCP with the contrast that the term actually marks, the latter’s typical response is to propose a new term to mark that contrast, while insisting that his definition of the original terms was sound.
In your plagiarized rubbish we read: “Neither individual people nor people as a whole can ‘spend’ money, but individual people can and do offload their money . . . .” So ‘spending’ is supposed to be impossible; what people actually mean by that term can be expressed, but only by a different term: ‘offload’.
“. . . the original term,” not “terms.”
http://pragcap.com/david-andolfatto-gets-excess-reserves-and-inflation-risk-right/comment-page-1#comment-178598
In what sense does a bank ever have more reserves than it desires? Why would their be a limit on the desired reserves of a bank?
But Nick, people in aggregate can get rid of excess money. If all my friends and I pay off our student loan and mortgage debts, the aggregate money supply (deposits) will decrease, ceteris paribus. And the banks have no control over whether we want to pay off our debts.
Whereas for reserves, you’re right, there’s no way to decrease the amount of reserves unless the central bank decides to drain them. But the point is, an increase in reserves does not entail an increase in the money supply (because we in the aggregate could focus on paying down debts) or an increase in the price level. Those are determined by the demand for loans, which is independent of the amount of reserves, but dependent on the price of them (interest rates).
To put it differently, your definition of “excess reserves” makes your argument circular. Excess reserves are reserves banks want to get rid of; so banks get rid of excess reserves.
I don’t see any realistic situation in which a bank would ever say: “I have too many reserves! Better find a way to lend them!”
What would possibly be the motivation for that? I guess a tax on reserves or negative interest on reserves would do the trick. But in that case, it’s better for banks to contract reserves by forcing depositors to make withdrawals rather than make a loan the bank would otherwise find uneconomic.
That will increase the cash holdings of depositors but why would holding cash rather than deposits prompt any spending? If you weren’t spending your deposit, you aren’t spending your cash.
Likewise, capital requirements can make holding deposits unattractive. And then the same thing happens. Banks push out depositors.
A better way of looking at reserves is this: a bank with traditionally defined “excess reserves” can make more loans without either borrowing on the interbank market or running afoul of minimum reserve requirements.
The banking system, as a whole, might appear to have excess lending capacity. But this is only true if you assume there is no monetary policy offset. Yes, banks could lend so much that they’d cause unwanted inflation–but only if the Fed refused to drain the reserves. I cannot imagine a world in which this would occur.
Which is to say, its not the amount of reserves that matters but the demand for loans from credit worthy borrowers and the monetary policy of the Fed.
In other words, large reserve balances have no effect at all on bank lending.
Consider this quote (from https://www.richmondfed.org/publications/research/economic_brief/2010/eb_10-03.cfm):
“Suppose the banking system as a whole wanted to increase lending. At first it would be thwarted by the lack of excess reserves: Increasing loans means creating deposits, and deposits require reserves. To increase reserves, an individual bank has several options; it can sell assets, raise deposits, borrow in the interbank market, or issue securities. Although other avenues might fund some of the expansion, it seems likely that banks would want to finance long-term commercial and industrial loans in large part through deposits. But increasing deposits takes time. The bank has to offer better rates and investors only turn to deposits gradually. Thus, the policymaker has some time to pick up the signals indicating that the economy is improving…”
The author seems to be saying that normally banks are unable to quickly enlarge their loan portfolios because they must seek funding, which takes time, but when reserves are abundant this isn’t the case. Hence there is a heightened risk of inflation sparked by excessive bank lending.
Agree or disagree?
Max,
You have to follow all the moving parts. And if you do, you’ll see why there isn’t really a heightened risk of inflation.
A rapid expansion of lending isn’t possible if you hold the supply of reserves fixed. The banks will bid up the price of reserves on the interbank market/deposit market. As reserves become more expensive, the attractiveness of certain loans will diminish. The rapid expansion will be curtailed.
The important phrase in the above paragraph is “if you hold the supply of reserves fixed.” But there’s no reason to do that. And, in fact, the Fed doesn’t hold the supply of reserves fixed.
Instead, the Fed targets an interest rate and adjust reserve levels to hit their target.
So if the Fed is in favor of the rapid expansion of credit, it will supply new reserves to the system as needed to prevent the fed funds rate from exceeding its target. In practice, it typically doesn’t need to supply very much to push rates where it wants them to go.
If the Fed doesn’t want the rapid expansion to occur, it raises its target. If banks bidding for reserves naturally raises the rate to the target, the Fed doesn’t need to do a thing. If necessary, the Fed drains reserves by selling assets in open market operations. The Fed could also raise reserve requirements or “anchor” excess reserves by raising paid interest on them, discouraging lending.
When banks have a large amount of reserves, the situation is exactly the same. Banks make loans they want to make, without regard to the amount of reserves. Rather, it is the price that matters. That price is affected by the quantity and demand, but the Fed has control over both because it can add quantity and demand in unlimited amounts.
In other words, what the reserve quantity theorists are missing is the monetary policy offset. Which is weird, because they are otherwise totally obsessed with monetary policy offsets.
Did you just invent a new definition for spending as it relates to money? No one I know believes that when you “spend” the money disappears.
“This explains why creating money does not work to increase spending.” Imagine all the “excess reserves” where created directly to the public evenly instead of to large banks/corporates through asset purchases. Spending would be much higher if the public received that money. People receive utility from consumption whereas large corporations do not. Therefore people will spend no matter what, whereas corporations wont if no investment opportunities exist.
John Carney, you write:
“To put it differently, your definition of “excess reserves” makes your argument circular.”
Hmmm, I had a similar thought elsewhere:
http://informationtransfereconomics.blogspot.com/2014/06/the-information-transfer-model.html?showComment=1403637904134#c184405280704343673
and here (at the bottom, where I define jenesaisquoishness):
But I was inspired by comments like this:
Nick
Your comment to Avon is absolutely right:
“People in aggregate cannot sell their stocks (unless the issuers buy back those stocks). But their individual attempts to do so cause the prices of stocks to fall (the price of other things in terms of stocks to rise).
People in aggregate cannot sell their money (unless the issuers buy back that money). But their individual attempts to do so cause the prices of money to fall (the price of other things in terms of money to rise).
Banks in aggregate cannot sell their reserves (unless the central bank buys back those reserves). But their individual attempts to do so cause the prices of reserves to fall (the price of other things in terms of reserves to rise). ”
Now, what IS the price of reserves? What other things are transacted in terms of reserves ( I say transacted and denominated, because you’re a medium of exchange-er)?
Nothing, except overnight unsecured loans by a subset of financial institutions.
The price of money, whatever it is. is the inverse of the price level. The price of reserves is simply the delta between the the interest rate paid on excess reserves (IoER/ reverse repo rate etc.) and the overnight unsecured inter-bank rate (fed funds rate/ call money rate/ whatever).
And lastly, what is, operationally, a central bank on business-as-usual days? It is a monopolist on reserves. And it often has a target price for reserves. A credible monopolist can, and will, enforce its price target. And that’s what central banks do.
And so, banks don’t lend reserves. They really don’t. Even if everything else you say is bang on true.
“To see what is wrong with that standard textbook view, we need to consider the following fundamental accounting identity:
“M = M
“The amount of money that people hold must equal the amount of money created by the banking system. You can’t see “spending” anywhere in that fundamental accounting identity, can you? Therefore, people do not “spend” money!”
Not to agree or disagree with your point, Nick, but your logic is flawed.
By that logic, the conservation of energy means that nothing ever expends energy. Fires do not burn, for example. Similarly, the conservation of matter means that nobody ever gains or loses weight (mass). Similarly, the conservation of momentum means that nothing ever accelerates.
Even if the amount of money remains constant within an economic system, that does not mean that money does not circulate in that system, nor that individuals or other entities within that system do not receive or spend money.
Nick, I was very relieved when I got to your line that reads
The above is total rubbish, of course.
SO relieved.
In the more “sensible” part of your post you wrote:
If an individual person has excess money, he can and will get rid of it, by spending it
(You actually say “by spending it or by lending it” but you also say lending is the same as spending.)
So people spend their excess money. How, then, can we tell excess money from the money people “desire to hold”? People spend that too, right?
Nick Rowe: “The above is total rubbish, of course.”
Good one, Nick! You cotched me. 😉
As for Sheard’s article, you have not piqued my interest.
“Let’s cut to the goddamn chase: banks lend reserves.”
By that do you mean that banks do not create money?
Doesn’t that statement depend upon how your banking system is set up?
I remember hearing the author of a book about the era of wildcat banking in the U. S. (libertarian nirvana, I suppose ;)) telling about a bank in Rhode Island that issued some $600,000 in bank notes with 7 bits of a Spanish Dollar ($0.875) in the vault. What reserves did it lend?
Is Wawa a chant-free zone?
Nick,
If you want to say that banks do lend reserves, who would you say they lend them to? I guess that would have to be the borrower, as it doesn’t seem right to say they are loaned to the borrower’s bank. But there is no sense in which the borrower owns the reserves. The borrower’s bank does not hold them on the borrower’s behalf, any more than it holds on my behalf cash that I deposit.
So, I guess you would have to say that if banks lend reserves, then the borrower automatically lends them back again (but maybe to a different bank). Which I suppose you could say, but is there an analogous counter-loan when non-banks lend money?
Made it to North Bay. MX6 ran fine through heavy rain. I “spent” the night at Glen Garry motel (recommended). Heading towards Wawa soon. Trying to figure out my new laptop toy. Not very good at typing on it yet.
Thanks for the comments. I read them all.
John Carney: economists explain prices through demand and supply. If the price of apples is above equilibrium there is excess supply, which forces price down. Same for price of assets like houses, shares,….or money.
The Arthurian has the best critique. I did a post on that once (talking about Australian opals). In that sense (we are always getting rid of money, by spending it) the medium of exchange is different from other assets.
It’s getting light. Time to get up and drive. Probably no internet for a couple of days.
And the fact that banks cannot in aggregate get rid of the excess reserves is a central part of the standard textbook story of why excess reserves raise the stock of money, which creates an excess supply of money, which raises the demand for goods and the prices of goods. If banks in aggregate could get rid of reserves by lending them, the excess reserves would have at most only a temporary effect.
Perhaps this is true – at least in some textbooks. But it seems to me that many, many people have over the past few years pointed to the high and stationary (or growing) reserve levels as an indication that banks are not lending or spending their money. I guess they aren’t reading the textbooks.
In any case, I’m with John Carney. Where some asset is of positive value to its holder, and there is no cost to holding and accumulating an indefinitely large amount of that asset, then there is no such thing as excess amount of it. For no bank x is there a quantity of money y, such that y is the maximum amount of money x is willing to hold. This is true even if there is only one bank and x is thus identical to the entire banking system. The more money the better.
That’s not to say that the increased supply of that asset can’t decrease its price, if the price can go lower. But the only thing banks can really spend their money on is promises for more money. So if the price of money goes down, so does the price of the promises for money you can buy in return. The price for money is commitment to a schedule of money payments. If the market value of money goes down, so does the value of any arbitrary schedules of money payments, so there is no change in the market terms, except in the short term as the equilibrium is re-established.
“In what sense does a bank ever have more reserves than it desires?”
I suspect that a distinction between demand and quantity demanded needs to be made somewhere here.
Any bank can send an armored car to a Federal Reserve branch and withdraw their excess reserves as paper money. So any claim that banks don’t loan out excess reserves is like saying they don’t loan out paper money. While this may be technically true, it is not helpful to understanding what is going to happen.
I think it is best to view excess reserves like government debt as far as the risk of inflation and hyperinflation.
http://www.financialsense.com/contributors/vincent-cate/excess-reserves-is-like-government-debt
“The fact that people cannot in aggregate get rid of the excess money is a central part of the standard story of why excess money raises the demand for goods and the prices of goods….It’s exactly the same with excess reserves.”
Are excess reserves really spend by banks on goods and services? Are they not used to buy bonds until the interest on the bond equals the IOR at which point banks become indifferent between holding reserve deposits or bond assets? And if excess reserves are not spend in a GDP-relevant sense how can an increase in them affect the general price level?
How are you defining goods in the following sentence?
“The fact that people cannot in aggregate get rid of the excess money is a central part of the standard story of why excess money raises the demand for goods and the prices of goods.”
Could the “goods” be financial assets as well? Is there a mechanism for financial asset price inflation to feed into wage growth? Does the distribution of the excess money or the existing distribution of income/wealth influence whether the inflation occurs in consumable goods or financial assets?
How many transactions does it take for the price of a bar of soap to increase or decrease as a result of a change in demand? I would presume it would take many transactions. How many transactions does it take for the price of a stock to increase or decrease as a result of a change in demand? It would only take one transaction and then everyone’s holdings of that stock are repriced. All of the financial asset price inflation can be undone with a handful of transactions.
I do not get it: people can easily as aggregate reduce the amount of money (bank deposits), the banks practically cannot (reserves). That was Nick E’s point above and I think Nick R. only addressed the case that individual bank (“Nick E: similarly, if a bank buys a bond from the central bank, that gets rid of reserves.”) can get rid of the reserves – which IMO doesn’t address it at all.
@Min:
But your first sentence is actually true, outside of nuclear-type interactions. Energy is indeed not expended (spent!).
What your illustrative examples refer to, however, is the notion of entropy, or disorder in a system. Closed physical systems tend towards increasing entropy, where the same quantity of energy (and mass, again outside of nuclear reactions) is rearranged into the most-disordered form over time.
Those definitions are made precise in the laws (and study) of thermodynamics, but the key insight is that in “high entropy” systems there are a lot of microsocopic ways (microstates) for the system to arrange itself yet preserve the bulk properties. It takes work to introduce order to the system, in much the same way it takes work to organize your sock drawer.
Unfortunately, there is no such tidy packaging for economics.
@Dan Kervick:
I don’t see why the stories are wholly inconsistent. High-and-growing reserves, which show up as “excess” over legal requirements, can occur for one of two reasons:
The first is that banks would like to lend these reserves (making them “excess” in Nick’s terminology), but they are collectively unable to increase their corresponding loan portfolios. This is exactly the practical effect of a zero lower bound on interest rates, whereby reducing rates further to increase loans would result in a negative risk-adjusted nominal rate. (Note that this also only applies to short-term rates, since bank reserves are effectively an on-demand asset; reducing long-term rates can still increase loans, but banks take on risks associated with term structures to make long-term, low-rate loans.)
The second possibility is that banks would not like to lend these reserves, making them not-excess according to Nick’s terminology (but still “excess of legal requirements”). In this case, we have to consider just why the banks do not wish to lend those reserves.
The intrinsic reason for “not excess reserves” relates to the reason banks have reserves in the first place: as a hedge against credit losses. This became very important in the immediate aftermath of the credit crisis, as banks were unexpectedly exposed to counterparty risks and sudden readjustment of the risks of supposedly safe assets (namely mortgage-backed securities). Banks, understandably not wanting to fail, would necessarily and collectively seek an increase in held reserves to hedge against further shocks. Of course, that collective increase is impossible without central bank action.
The extrinsic reason for “not excess reserves” is the effect of central bank action: too-large interest on reserves. Effectively, that raises the floor of the zero lower bound up to the IOR level: a bank receiving 0.25% interest in reserves (the current US Fed level) will find it unprofitable to issue a risk-adjusted 0.2% short-term loan.
The problem of both cases of large-but-not-excess reserves is that the “not excess” part is a matter of opinion and policy. If credit risks improve or if the risk-adjusted retail loan rate materially exceeds the IOR rate, then banks suddenly are in the position of having truly excess reserves. Those in turn can be mobilized quickly as banks seek to collectively reduce reserves, perhaps sparking further credit bubbles.
Payment of IOR at a level modestly below the central bank’s target rate allows banks to adjust their marginal use of reserves, but it prevents rapid mobilization of huge quantities of those reserves. A credit bubble would necessarily lower the market interest rate, but if it falls below the IOR rate banks will still curtail further loan expansion as if they were at the zero lower bound. In that way, IOR acts as a limiter on how rapidly credit can accelerate without policy intervention.
“TMF: I would rephrase your own point like this: the demand for reserves (the desired stock of reserves) depends on current and expected future central bank policies. People who know they can always buy gas quickly at a reasonable price won’t hold as much reserves of gas as would people who expect shortages and the risk of price spikes.”
Yes, I like that way of looking at it. Would it be correct to say “current lending is a function of current reserves and expectations of future reserves” ? (where those expectations are largely set by the stance of monetary policy).
@ Majromax
Thanks. 🙂 I was aware that I was talking about entropy.
Dan Kervick,
“For no bank x is there a quantity of money y, such that y is the maximum amount of money x is willing to hold. This is true even if there is only one bank and x is thus identical to the entire banking system. The more money the better.”
You seem to me to be confusing money and wealth. Yes, everyone would like more wealth, but given your current level of wealth, would you rather hold it in the form of money, or in some other form. Personally I’d rather not hold my wealth as cash in a vault. I’d rather hold it in some form of interest-bearing asset. Same goes for banks, usually.
Hi Nick,
Well, I wrote down a simple model and have concluded that you are basically correct.
http://andolfatto.blogspot.ca/2014/06/excess-reserves-and-inflation-risk-model.html
Thanks for your post, it helped set my thinking straight.
@Nick, serious question: Which textbook do you use in teaching macro / money?
I ask because I agree totally with your approach but in textbooks I only find obscure ISLMASAD etc. etc.
People can and do spend their money, just as banks can and do lend out their money.
What you’re trying to say is that in the aggregate the human race does not spend its money, or in other words, the total sum of money in existence on this planet doesn’t change by virtue of one or some people spending his or their money. You might someday be able to come up with a more artful way of phrasing that, but what you’re doing instead, denying that people spend money, isn’t just counterintuitive, it’s silly and wrong.
Nick said: “People in aggregate cannot sell their money (unless the issuers buy back that money).”
Jared said: “But Nick, people in aggregate can get rid of excess money. If all my friends and I pay off our student loan and mortgage debts, the aggregate money supply (deposits) will decrease, ceteris paribus. And the banks have no control over whether we want to pay off our debts.”
Most loans are set up to pay back principal. A lot of loans can be paid off early.
Jared, what if you borrowed from a friend who saved demand deposits?
Jared said: “Whereas for reserves, you’re right, there’s no way to decrease the amount of reserves unless the central bank decides to drain them. But the point is, an increase in reserves does not entail an increase in the money supply (because we in the aggregate could focus on paying down debts) or an increase in the price level. Those are determined by the demand for loans, which is independent of the amount of reserves, but dependent on the price of them (interest rates).”
What about a currency drain?
The fed buys a bond from a levered entity. The levered entity delevers and could also save. No change in demand deposits circulating. Central bank reserves will probably have gone up.
The fed buys a bond from Warren Buffett. Buying the bond from Warren Buffett is probably not going to get him to change his mind to keep saving. He may not buy another financial asset either. No change in demand deposits circulating. Central bank reserves will probably have gone up.
dannyb2b seems to be the only commenter who has hinted that all this money stuff might have some relationship to the production of goods and services that people require and desire to live, rather than as anthropologically significant markers. When you state that “excess reserves raise the stock of money, which creates an excess supply of money, which raises the demand for goods and the prices of goods”, you are obviously talking about financial goods, not goods in the sense of things on sale at Safeway, Saks Fifth Avenue or a Dollar Store (which does not sell actual dollars).
Living standards, of course, are related to actual goods and services, not money or financial instruments, so our era of stagnant living standards, the last 30 or so years, has not seen money created or destroyed, but rather moved from a sector which might have a positive effect on living standards into a sector which demonstrably does not. This is a lot like entropy, as discussed by Majromax. The energy is still there, it is just not in a societally useful form. You are on the right track in arguing that money is not destroyed in the ordinary cycle of things, but you and other economists need to take the next step to see why so much money has been of so little benefit.
“The fact that people cannot in aggregate get rid of the excess money is a central part of the standard story of why excess money raises the demand for goods and the prices of goods. If they could get rid of it by spending it, the excess money would have at most only a temporary effect.”
I hope JKH can verify. Borrow from a bank. Pay back all principal and interest. All of the principal demand deposits created get destroyed (emphasis). The interest payments cause a markup of bank equity.
A home equity line of credit (HELOC) would be a good example from personal finance. I take out a HELOC for 10 years. I can pay back the loan or almost all of the loan at any time.
David: Wow! Thanks.
Herbert: Canadian version of Mankiw, for intermediate macro. Good on macro, but less emphasis on money. I cannot find a money-ish text I would recommend. But maybe there are lots out there I don’t know about.
All: thanks for the comments. I am stuck in Terrace Bay, north shore of Superior, because a bridge is down and HWY 17 is temporarily closed. (But it’s lovely here!) Limited internet access, battery life, and brain. Will peruse them all more slowly and carefully later.
From:
http://www.amortization-calc.com/loan-calculator/
Loan amount of $10,000 for 1 year at 12% interest.
********************Monthly
Date *************Payment **** Interest *****Principal******Balance
Jan, 2015******* $888.49 ******$100.00 ******$788.49****$9,211.51
Feb, 2015******* $888.49 ****** $92.12 ******$796.37****$8,415.14
Mar, 2015******* $888.49 ****** $84.15 ******$804.34****$7,610.80
Apr, 2015******* $888.49 ****** $76.11 ******$812.38****$6,798.42
May, 2015******* $888.48 ****** $67.98 ******$820.50****$5,977.92
Jun, 2015******* $888.49 ****** $59.78 ******$828.71****$5,149.21
Jul, 2015******** $888.49 ****** $51.49 ******$837.00****$4,312.21
Aug, 2015******* $888.49 ****** $43.12 ******$845.37****$3,466.85
Sep, 2015******* $888.49 ****** $34.67 ******$853.82****$2,613.03
Oct, 2015******* $888.49 ****** $26.13 ******$862.36****$1,750.67
Nov, 2015******* $888.49 ****** $17.51 ******$870.98******$879.69
Dec, 2015******* $888.49 ******* $8.80 ******$879.69*********$0.00
2015 ********* $10,661.87***** $661.85***$10,000.00*********$0.00
The way the accounting people explained it to me was that the principal payments mark down both the asset (loan) and the liability (demand deposits). Demand deposits (“money”) get destroyed by paying down the principal.
@TMF:
Was the loan amortization table really necessary? Interest is a thing, yes. It also doesn’t enter into this discussion.
You’re not addressing any point that Nick made. The bulk of his post dealt with spending, which is what we do at the corner store. In that case, he’s fully right: the aggregate stock of money is not changed with the exchange of money for goods and services.
You’re discussing loan repayments, which enters implicitly into “the other side” of M=M: by paying back a loan, you’ve acted to reduce the amount of money that the banking system has created.
Now, even when you’re right you’re still wrong. If the banking system has no excess reserves (over desired reserves), then your loan repayment will simply result in another loan being issued to the next marginal borrower, enticed by a slightly lower interest rate versus the counterfactual of keeping your loan outstanding. The net money supply created remains (in equilibrium) M, so your cash is now on someone else’s balance sheet just as if they’d taken over your loan.
If the banking system does have excess reserves, then by definition it can’t issue another marginal loan. In such a case, your excess cash has been transformed into additional excess reserves.
Now, I think I disagree with Nick’s exact phrasing on the “hot potato effect” of excess reserves, but it’s mostly an issue of time-scale. Ephemeral excess reserves caused by early repayment of my loan don’t stay excess very long, so they do have a hot-potato effect. Durable excess reserves indicate that the banking system can’t or won’t make further loans (that is, expand bank leverage).
The “won’t” part is probably okay — it indicates that the banks are willing to hold hotter-than-previous potatoes so as to not get caught without one. Increasing reserves are an expected reaction to potential credit risks, but it still preserves the mechanism of “excess reserves” in that a marginal reserve increase is a hot potato.
The “can’t” bit is the problem of the zero lower bound. In this case, the marginal reserve still can’t be lent out profitably, so none of the potatoes are hot. That’s bad from an economic standpoint, whereby cold potatoes are unappetizing.
Majromax: “You’re not addressing any point that Nick made. The bulk of his post dealt with spending, which is what we do at the corner store. In that case, he’s fully right: the aggregate stock of money is not changed with the exchange of money for goods and services.”
That is not what Nick is saying. At least it is not his main point. After all, that statement is the beginning of what Nick called rubbish. It is what everybody, whether they are spouting rubbish or not, accepts as true.
By “true”, I mean “given”. The rubbish part is that, even if the amount of money remains the same, people do not spend money.
I am sure that Nick is objecting to the rubbish, but otherwise I am not sure what he is claiming, which is why I have asked some questions.
Majromax,
“If the banking system creates an excess supply of money, and holds that stock of money constant, each individual person can get rid of it, but people in aggregate cannot get rid of it. It just keeps circulating back to them, as quickly as they spend it. But their individual attempts to get rid of it are what create the increased demand for goods, which will ultimately raise the prices of goods above what they would otherwise have been. The fact that people cannot in aggregate get rid of the excess money is a central part of the standard story of why excess money raises the demand for goods and the prices of goods. If they could get rid of it by spending it, the excess money would have at most only a temporary effect.”
The banking system may not be in charge here. The loan terms, including repayment of principal, matter. Entities could get rid of their excess money by repaying a bank loan (“spending” on a bank loan).
Nick said: “If an individual person has excess money, he can and will get rid of it, by spending it or by lending it. (And “lending” means “buying an IOU from someone”, so it’s the same as spending.) But that just means another individual person now holds it.”
Some entity could use its “excess money” to buy back its “IOU” from a bank.
Majromax said: “Now, even when you’re right you’re still wrong. If the banking system has no excess reserves (over desired reserves), then your loan repayment will simply result in another loan being issued to the next marginal borrower, enticed by a slightly lower interest rate versus the counterfactual of keeping your loan outstanding. The net money supply created remains (in equilibrium) M, so your cash is now on someone else’s balance sheet just as if they’d taken over your loan.”
What if there are not enough creditworthy entities who want to borrow?
Nick,
why are you going to Wawa?