How can the Cheshire Cat disappear, but its smile remain?
How can money disappear from a New Keynesian model, but the Central Bank still set a nominal rate of interest and create a recession by setting it too high?
Ignore what New Keynesians say about their own New Keynesian models and listen to me instead. I will tell you how it is possible.
Start with a model of an economy with a central bank that issues paper currency. It's a monetary exchange economy, where that currency must be used to buy and sell everything else. Barter is assumed to be prohibitively costly. The currency issued by the central bank is the sole medium of exchange. It is also the unit of account. The central bank can change the stock of currency in circulation by using open market operations.
Now replace the paper currency with chequing accounts at the central bank. Instead of having $100 recorded on paper notes in your pocket, you have $100 recorded on silicon in your account. Instead of transferring paper notes from pocket to pocket when you buy something, you pay by cheque or debit card and the central bank transfers the silicon money from account to account. It makes no difference to the model.
Now suppose the central bank pays interest on the balance in your chequing account at the central bank. There is no puzzle about how the central bank can set that interest rate; it just does it. (The central bank could have paid interest on the currency it issued, but that would have been administratively more difficult.)
Now suppose the central bank allows people to have a negative as well as a positive balance in the chequing accounts. You can run an overdraft. And suppose the interest rate you pay on a negative balance is the same as the interest rate you receive on a positive balance. So the central bank only sets one interest rate.
Now suppose the central bank uses open market operations to adjust the net stock of money until the sum of the positive balances exactly equals the sum of the negative balances. The central bank now can have zero net worth, because the negative balances are its assets and the positive balances its liabilities and both are equal. The central bank can now have zero net income, because it pays out interest on positive balances equal to what it earns on negative balances.
Now suppose the economist building the model economy decides to make all agents identical, so that all agents always hold identical stocks of money balances. If one agent spends $100, all other agents do exactly the same at exactly the same time, so $100 is both added and subtracted from his chequing account at exactly the same time. But in symmetric Nash equilibrium, each agent nevertheless chooses how much money to spend taking as given others' choices of how much money to spend. And each agent's choice of how much money to spend depends on the rate of interest paid on holding money that is set by the central bank.
The above two paragraphs together mean that each agent always has a $0 balance in his chequing account at the central bank. But the rate of interest set by the central bank still affects spending.
Start in full equilibrium, which is where the economy would be if all prices were flexible. Now, just to keep it simple, hold all prices fixed at that level. If the central bank sets the interest rate too high, people spend less money, and so each sells less goods to other people. There's a recession. By assumption, all relative prices are correct, and there are unexploited gains from trade at those relative prices. If people could barter their way back to full employment they would immediately do so, to exploit those gains from trade, and the recession would end as soon as it began. But the real interest rate paid on holding money is too high. If two agents could cut a deal, whereby each agrees to buy $100 of the other's goods if and only if the other buys $100 of his goods, so the deal leaves both with unchanged money balances, they would do so. But that deal is equivalent to barter, and is ruled out by assumption.
The Cheshire Cat has disappeared, but its smile remains. And its smile (or frown) has real effects.
The New Keynesian model is a model of a monetary exchange economy, not a barter economy. The rate of interest is the rate of interest paid on central bank money, not on bonds. Raising the interest rate paid on money creates an excess demand for money which creates a recession. Or it makes no sense at all.
[I've said all this before, but I've said it simpler and better this time.]
Worthwhile Canadian Initiative 
The NK models I have seen, but the money balances held were zero when interest rates are positive. (No explicit demand for money,) From an outsider perspective, I am curious about what distinction you see from that case, as it seems to end up in roughly the same place.
In the real world, your discussion has similarities to how the Bank of Canada sets the short-term rate even though net settlement balances are normally indistinguishable from zero.
“Raising the interest rate paid on money creates an excess demand for money which creates a recession.” I’d re-phrase that as “There is no good reason to pay ANY interest to people simply for holding a stock of money”.
I suspect that is saying much the same as Warren Mosler and Matthew Forstater’s paper “The Natural Rate of Interest is Zero.”
“Raising the interest rate paid on money creates an excess demand for money which creates a recession.” I’d re-phrase that as “There is no good reason to pay ANY interest to people simply for holding a stock of money”.
I suspect that is saying much the same as Warren Mosler and Matthew Forstater’s paper “The Natural Rate of Interest is Zero.”
Brian: if all agents are identical (strictly speaking I should say “symmetric” because each specialises in producing a different good) then each agent’s spending money and receipts of money are perfectly synchronised (strictly, that only works if the central bank does immediate real-time settlement) then if there were any opportunity cost (interest rate differential) to holding money, the demand for money would be zero (or it would be negative, at the overdraft limit, if overdrafts were allowed).
Yep, it is very similar to how the BoC works.
Ralph: I think it’s saying something very different. In this model, the central bank cannot always set interest rates at 0% if it wants stable prices or stable inflation.
In your model, when the CB sets the rate of interest too high, does it now fail in using open market operations to reduce central bank balances to zero because people will hold positive balances solely for pecuniary returns?
Nick,
This is excellent.
Very clean exposition and very intuitive, including the balance sheet construction sequence, even considered separately from its relationship to the NK theme.
P.S.
Although I’m thunderstruck you didn’t mention red or green money.
2
About this part:
“Now suppose the central bank uses open market operations to adjust the net stock of money until the sum of the positive balances exactly equals the sum of the negative balances.”
Suppose the central bank “initiates” its balance sheet by a creating a quantity of positive money through OMO.
Then suppose it allows for negative money. Each negative money item (a CB negative liability, which is a CB asset in effect) will create a positive money item of equal quantity (a CB liability).
“Negative money creates positive money”, don’t you know 🙂
Then suppose the central bank does reverse OMO to drain the original positive money that was created, resulting in a matched balance sheet in terms of positive and negative money (or a “zero balance sheet” if you want to consider negative money as a negative liability).
Then steady as she goes from there, except for appropriate interest rate adjustment according to real economic indicators, but with no further OMO required under NK assumptions.
Is that (roughly) what you mean?
In this model it is very easy for the CB to hit its target because no matter what interest rate it sets then as balances are always zero it follows that positive balances always exactly equals the sum of the negative balances.
Recession are caused by the fact that despite the fact that their balances are always zero they still aspire to hold positive balances at higher rates of interest by selling more than they buy. In the aggregate this leads to total buying and selling decreasing, thwarting peoples plans and hence the recession.
The illusion of a money-less world appears to depend totally on the fact that all agents are identical. If you introduce even one person who is different then it becomes possible for people to hold positive or negative balances (the odd-person-out buys goods on credit with money borrowed from the CB from one of the clones). I don’t know much about NK models but it seems odd that they eliminate money via such an unrealistic assumption.
3
I was also struck by the analogy with the actual system for Bank of Canada reserves.
You explain along the lines of the potential for zero balances in respect of money needs for goods and services purchases under such a banking system.
This seems comparable to how the Bank of Canada is able to assume efficient running of a banking system that has a zero statutory reserve requirement. I.e. commercial banks that are continuously optimizing their balance sheet compositions and presumed at least in theory to be able to operate effectively with a zero stock of Bank of Canada settlement money (more or less zero), notwithstanding all of that asset-liability activity.
Musgrave,
You completely misunderstand this post.
It’s related to Mosler’s zero rate idea in a similar way to which Neptune is related to the Earth.
P.S.
I’d rather be boring, Ralphie
Also I’m a bit confused by this bit “Now suppose the central bank uses open market operations to adjust the net stock of money until the sum of the positive balances exactly equals the sum of the negative balances.”
Either people only borrow money to pay for stuff which they transfer to the seller in which case positive and negative balances always cancel each other out no matter what the rate of interest, or people borrow money just to hold it in their accounts and in this case there may be net borrowing even in an economy of clones. In this case the CB has less flexibility on what rate to set – it always has to set to the level where net borrowing is zero if it wants to hit its goal (and keep the illusion of a money-less economy). Am I missing something ?
“There is no good reason to pay ANY interest to people simply for holding a stock of money”.Can humble IO guy rephrase it as “we should never use MOP as MOS and conversely. And we make a big mistake when we did so”. If wrong, where did I go wrong?
If I may ask…
Why are you engaged in this Sisyphean task?
Why don’t you just say “There is an Old Keynesian IS-LM Metzlerian model behind the curtain doing all its stuff, and don’t worry about it, and if you find a place where that Metzlerian IS-LM model doesn’t fit, the right answer is (b) “it makes no sense at all” because the model is badly written.
And you shouldn’t need to have to rescue people who write badly-written models from the consequences of their muddy thinking…
“Now replace the paper currency with chequing accounts at the central bank. Instead of having $100 recorded on paper notes in your pocket, you have $100 recorded on silicon in your account. Instead of transferring paper notes from pocket to pocket when you buy something, you pay by cheque or debit card and the central bank transfers the silicon money from account to account. It makes no difference to the model.
Now suppose the central bank pays interest on the balance in your chequing account at the central bank.”
JKH, let’s assume there is only one(1) commercial bank.
When an entity pays by check or debit card, the commercial bank transfers demand deposits from account to account and that settles the transaction.
Is that right?
dlr: “In your model, when the CB sets the rate of interest too high, does it now fail in using open market operations to reduce central bank balances to zero because people will hold positive balances solely for pecuniary returns?”
No. (Unless I misunderstand you.) Suppose we start with a standard central bank, that has bonds on the asset side of the balance sheet, and strictly positive chequing account balances on the liability side, and zero net worth. The central bank then permits overdrafts, then sells all the bonds it owns, so the sum of the overdrafts equals the sum of the positive balances. Then it never uses open market operations again. The only instument it uses is the interest rate it pays/charges on positive/negative balances. If it raises that rate of interest, each individual wants to hold positive balances, but they cannot do so in aggregate. But they cut spending in their individual attempts to hold positive balances. Like the old monetarist hot potato, only in reverse.
JKH: thanks!
I was very tempted to talk about red/green money (because that is exactly what is happening here, as you notice), but resisted the temptation!
“Is that (roughly) what you mean?”
I think that’s exactly what I mean. (You told the same story in a different, maybe clearer, way.)
MF: I agree with everything you say in your first comment, except the bit about it being easy for the CB to hit its target. It doesn’t observe the natural rate of interest.
JKH: I think that’s right. The role played by regular people in my model is roughly the same as that played by commercial banks in Canada. They have chequing accounts at the central bank. (There’s a 50bp spread between the rates on positive and negative balances in the real world, of course, while I have assumed zero spread.)
MF: try reading JKH’s version of the same story, in his second comment. It may be clearer. Or the version where I reply to dlr in this comment above.
Jacques Rene: sorry, but you lost me there.
Brad: Dunno really. But it bugs me to hear people say that NK-DSGE is just RBC with sticky prices. It isn’t. Or rather, if it is, then it doesn’t make sense at all. But yes, it is the NK people who should be doing this, not me. (But I feel a sort of responsibility to the NK research program, since I was sorta part of it once, and don’t want to see it go astray.)
And there is one important difference to ISLM: “the” interest rate in ISLM is an interest rate on bonds (it is normally assumed money pays 0% interest). In this model, “the” interest rate is the interest rate paid on holding money.
Nick:
If it isn’t an RBC model minimally-tweaked to deliver Old Keynesian conclusions, why is it what it is at all? What other telos could it possibly have?
It seems to me that interpreting it as a model of an economy in which the central bank controls spending by changing the interest rate it pays on its liabilities leaves us no better off than an RBC model minimally-tweaked to deliver Old Keynesian conclusions…
Nick said: “Instead of having $100 recorded on paper notes in your pocket, you have $100 recorded on silicon in your account. Instead of transferring paper notes from pocket to pocket when you buy something, you pay by cheque or debit card and the central bank transfers the silicon money from account to account.”
Do you mean that the central bank really “transfers the silicon money from account to account”, or is this how you visualize it? In other words, is this transfer a phenomenon or is it part of the (implicit) model you are using?
It is clear to me that there is no transfer of silicon money from account to account (no phenomenon), and if this is so, then we can build a realistic model where there is no such transfer. That model would recognize the phenomenon for what it is: accounting. A credit entry on Account A and a debit entry on Account B doesn’t require anything moving between the two accounts. The whole point of accounting is to record something taking place outside of the accounts. Like “warehouse accounting”, where there are real things moving into and out of a warehouse and we want to record these movements. Or “money accounting”, if there really were pieces of money moving between people or, say, cardboard boxes. But there isn’t, and that’s why we shouldn’t think in terms of keeping accounts of “money holdings”.
Starting from this simple premise, we can build a macro model which will change the way we see the world. Goods flow from a seller to a buyer, but no money — nothing — flows the opposite direction; instead, two (or four, six, etc.) accounts get new balances.
I’d be happy to take you on a tour of that world one day! It’s a beautiful place.
That happens automatically in a world of private financial instruments.
So suppose you want to buy my excellent blog comments but you have no money. That’s OK, you can just owe me, so write an IOU note.
Now I have an asset (the note) and you have a liability (the same note). They necessarily sum to zero, there’s no possible way they can sum to anything other than zero. Even with a million people busily exchanging IOU notes they must always at every instant sum to zero. Only physical material objects can have a non-zero total (e.g. gold coins).
Tel,
“They necessarily sum to zero, there’s no possible way they can sum to anything other than zero.”
It’s called a default. My negative balance with the central bank is meaningless if I am no longer willing or able to bring it back to zero.
Frank, if I hold an IOU note (my asset) and the debtor formally defaults then the debtor no longer has a liability and I no longer have an asset (I made a loss on that).
Financial instruments are necessarily zero sum, both when they are created and also when they are extinguished.
Let me put this a different way… suppose I could figure out how to create an IOU note such that the liability side of that note could be removed somehow from the asset side. What would the residual non-zero-sum component of this look like? How could you describe this positive asset I hold in my hand but which comes from nowhere? It would be like an entitlement to call upon an act of God, or like a magic wish from Aladdin’s lamp.
Tel,
I get what you are saying. Yes, if you treat deposits / cash / currency as a liability of the central bank, then any overdraft creates two sets of liabilities and two sets of assets:
Me: $100 Overdraft (Liability), $100 Cash (Asset)
Central Bank: $100 Overdraft (Asset), $100 Cash (Liability)
Even if I default on the overdraft, I have $100 cash as asset which counterbalances the $100 cash as liability of the central bank.
Not sure if New Keynesian models treat cash / deposits / currency as such.
Your question:
“Let me put this a different way… suppose I could figure out how to create an IOU note such that the liability side of that note could be removed somehow from the asset side. What would the residual non-zero-sum component of this look like? How could you describe this positive asset I hold in my hand but which comes from nowhere?”
It’s called a collateralized loan. The market value of the underlying collateral (asset) can move independently of the value of the loan (liability). The residual non-zero-component would be the difference in value between the two.
Brad: I’m not sure of the intentions of those who built the 2000 and later versions of the NK model. But I see it as a quick and dirty way to get get monetary policy into a microfounded model, without having to do the hard work of working out a money demand function where sales and purchases are imperfectly synchronised. And like it or not, it is a very influential model. So lets take it as it is, interpret it properly as a model of monetary exchange, and then start asking the more difficult questions: like what happens when we introduce overdraft limits into the model, because transversality conditions don’t enforce themselves; and recognising that central banks farm out the chequing account business to commercial banks, etc.
Antti: I don’t see the difference. Passing bits of paper from hand to hand is just a different way of doing the accounting. Like using an abacus, where the beads physically move. Some board games use “counters”, and some just record the moves on paper, or on a computer.
Tel: some IOUs get used as a medium of exchange, circulating and being traded for every other good, and other IOUs don’t get used as media of exchange.
What I said earlier was: “Only physical material objects can have a non-zero total (e.g. gold coins).”
To the best of my knowledge, no central bank deals in such physical objects (although I think the Fed might own mortgages, not sure, I doubt they own actual houses). But anyway with or without a central bank makes no difference in principle: the world of financial instruments sums to zero. Even where physical collateral does change hands, the sum total of physical collateral has NOT changed. Those financial instruments might very well make some people better off and others worse off (I never disputed that) but they cannot either create or destroy wealth as a whole.
I should point out that physical collateral does exist in terms of taxation (government is backed by men with guns) so in effect your life is the collateral, but even tax cannot create something from nothing… it will transfer wealth from some people to other people. Government debt is deferred taxation, so some unknown future person is the collateral (possibly us, possibly our children).
Sure, but in terms of the intrinsic operation, all IOU notes are the same type of financial instrument, regardless of whether they circulate or not.
Some may circulate only locally within some closed environment (e.g. casino chips, or internal accounts within some trading exchange) but the assets and liabilities still need to balance regardless.
There’s an argument that the process of circulation has intrinsic value in itself. For example cash notes operate as an accounting and communication system, something like Bitcoin also operates as an accounting and communication system, other examples are PayPal or Goldmoney. To the extent that you have a real information processing system, doing a useful task, then I would regard this component of the value to be equivalent to a physical object (i.e. you need paper and pencil to keep accounting books, you need electricity to run computers and networks, etc).
So yes, cash has the value of the physical paper, and this might be non-trivial if that serves a valuable purpose in terms of enabling commerce (but in a competitive environment, this value would reduce to the cost of the most efficient mechanism that achieves the same outcome). In a non-competitive fiat currency environment, cash has the “collateral” value of government being willing to use violence to force people to pay tax, and to maintain their fiat by repressing alternative systems of trade. That’s a physical thing, requiring real physical effort to maintain.
Tel,
“Even where physical collateral does change hands, the sum total of physical collateral has NOT changed. Those financial instruments might very well make some people better off and others worse off (I never disputed that) but they cannot either create or destroy wealth as a whole.”
Sure they can. I am a farmer and borrow from you using my tractor as collateral. You as a taxi cab driver borrow from me using your taxi as collateral. I can’t repay my loan to you and you can’t repay your loan to me and so you get my tractor which you can’t use to perform your job as a cab driver and I get your taxi cab which I can’t use to perform my job as a farmer.
This is an extreme example, but the point remains valid. Collateralized loans can generate a non-ideal division of resources making all parties worse off (or better off).
Frank said:
“Me: $100 Overdraft (Liability), $100 Cash (Asset)
Central Bank: $100 Overdraft (Asset), $100 Cash (Liability)”
Frank and Tel, any reason not to call that overdraft a bond?
Nick said: “Antti: I don’t see the difference. Passing bits of paper from hand to hand is just a different way of doing the accounting. Like using an abacus, where the beads physically move. Some board games use “counters”, and some just record the moves on paper, or on a computer.”
Perhaps I interpret you wrong, but it seems to me that here you did it again. What are those “moves” that are recorded on paper or on a computer?
You’re probably familiar with the story about two elderly gentlemen who use a stone they’ve painted green (a “counter”) to record which one of them owes a dinner to the other? (I know it from Ostroy & Starr: “The Transactions Role of Money”.) This stone moves from the dinner guest (“buyer”) to the one who made the dinner (“seller”) that evening. The stone is needed to “pay” for the dinner. If, instead of this “counter”, they kept records on paper or on a computer, then the these records would have nothing to do with recording any moves — other than the “movement” of a dinner from the “seller” to the “buyer”.
What I’m saying is that if we see money moving between accounts, then we are thinking in terms of counters even though the accounts (journal) make any counters redundant.
By the way, and related to what “Too Much Fed” says above, overdraft is (logically) symmetrical with a traditional bank loan (where a separate “loan account” gets debited, and checking account credited, already when credit is extended but no purchase has yet been made). Although in reality both accounting techniques are used, in a model we can replace a traditional bank loan with an overdraft, or vice versa. I prefer overdraft form, because it is simpler and, in my opionion, closer to the true meaning of the accounting. A separate loan account seems to work mainly to preserve the illusion of these “counters” residing on checking accounts and moving between checking accounts. (Thanks to this illusion, quite a lot fuss was created in 18th century Scotland when overdrafts emerged…)
Here I have “mapped” (see blue, green and yellow ellipses) an overdraft and a traditional loan to show that these are symmetrical: https://drive.google.com/open?id=0B1iEL0TpgRtkZ2l3dmVibUZfV2M
Interest rate symmetry is achieved by applying a simple formula: If interest rate on the traditional loan is X % and interest rate on checking account is Y %, then the interest rate on full overdraft limit needs to be (X-Y) % and interest rate on USED overdraft amount needs to be Y % to achieve the same net interest cost in both cases.
Perhaps this is nothing new to any of you, but I find it nevertheless important to be clear about this.
Fischer Black described this institution in Banking in a World without Money in about 1970. It was a key paper that explained the “BFH” (Black-Fama-Hall) in Greenfield and Yeager’s privatized money order.
TMF,
“Frank and Tel, any reason not to call that overdraft a bond?”
Typically a bond is a transferrable asset. Meaning the central bank (or a private bank) can sell that loan to a third party at a premium or at a discount.
For instance:
Me: $100 Overdraft (Liability), $100 Cash (Asset)
Central Bank: $100 Overdraft (Asset), $100 Cash (Liability)
Becomes
Me: $100 Long Term Loan (Liability), $100 Cash (Asset)
Private Bank: $100 Short Term Loan (Liability), $100 Long Term Loan (Asset)
Central Bank: $100 Cash (Liability), $100 Short Term Loan (Asset)
Bill Woolsey, that Black’s paper is also very relevant to what I say above.
Any idea why Black is so inconsistent here:
“Let us imagine, then, a world in which money does not exist.” ……. and three paragraphs later: “The banks will make loans to individuals, businesses, and governments. They will probably establish a schedule of interest charges for each borrower, and will then allow him to write checks on his account that increase the amount of his loan whenever he needs the money.”
Banks are making loans (presumably money loans; nothing here seems to refer to “loanable funds”) and people need money — in a world without money?
I’ve build a model where money doesn’t exist (but which is nevertheless supposed to describe our existing “monetary system”), and naturally, logically, in that kind of model it doesn’t make sense to talk about banks making loans and people needing money.
“Raising the interest rate paid on money creates an excess demand for money which creates a recession.”
This only applies here, because holding money is the only way of saving in your story.
You can easily tell the same story with a few amendments:
– Positive money balances carry no interest.
– There are government bonds and fiscal policy takes the form of setting lump sum taxes equal to the interest cost on those bonds.
– The central bank offers to buy or sell bonds in unlimited amounts at a set price (basically it sets the yield on the bonds).
– Negative money balances carry interest at the bond rate plus a spread.
There is still no money here (strictly speaking there is money but it’s in zero supply), but now it’s raising the rate on bonds that causes the recession.
Frank said: “Typically a bond is a transferrable asset. Meaning the central bank (or a private bank) can sell that loan to a third party at a premium or at a discount.”
That might be one characteristic of a bond.
I don’t see why an overdraft can’t be transferred as an asset.
Probably does not happen in the real world though.
Nick Edmonds said: “Negative money balances carry interest at the bond rate plus a spread.”
I think you will find negative money balances and positive bond balances are the same thing.
They mean some entity has borrowed positive money.
Very nice post. I’m increasingly inclined to believe that the problem with NK models is the same as the problem with old Keynesian models, a tendency to confuse the lever of monetary policy with the stance of monetary policy.
In contrast, the problem with monetarism was their tendency to confuse the quantity of money (their preferred instrument/target) with the stance of monetary policy.
Another problem with NK models is that they don’t describe the real world. Thus cash pays no interest in the real world. So if you raise interest rates, you raise the velocity of circulation for cash. That’s expansionary, unless more than offset (as it may well be) by a reduction in the quantity of cash. So in the real world, you simply can’t ignore quantities. Check out Bernanke’s attempt to do so in his latest post (on the BOJ.)
Too Much Fed,
There are other characteristics as well. Bonds are normally fixed term while an overdraft can presumably be over an indeterminate time frame.
As far as real world, the only situation I can think of is when one bank (that has overdraft customers) is bought out by a second bank. In this case, the overdrafts of the purchased bank are bought along with all of it’s other assets.
Nick E.,
Even with bonds, the central bank still has to make a decision on the policy rate – which is the interest rate directly relevant to money.
So I think introducing bonds is a complementing complication, rather than a substituting one. Bond OMO rates and policy rates are coordinated by the central bank, unless you assume strategic incompetence.
The natural base case would seem to be money without the complication of bonds, which is what Nick R. presents.
P.S.
Bond OMOs do change money supply, other things equal. Nick’s base case assumes at least implicitly no net bond OMO stock or the draining of any such stock that previously existed.
Finally, I’m guessing NK models implicitly assume no investment or aggregate saving. So if that’s the case saving is always in the context of positive saving being offset by negative saving – whether in the form of money or bonds or both.
But you know NK models and I don’t.
JKH: “Finally, I’m guessing NK models implicitly assume no investment or aggregate saving.”
The simplest NK models explicitly assume no investment (and therefore no aggregate saving), and explicitly assume all agents are identical in their saving preferences (so there’s no individual saving in equilibrium either).
But more complicated NK models bring all those things in. (I wanted to keep it simple here, because it doesn’t really affect my point, which is easiest to see in the simplest version of the model.)
Bill: “Fischer Black described this institution in Banking in a World without Money in about 1970.”
But would it be correct to say it’s a “World without Money”? I think it isn’t.
Scott: thanks.
If we generalise the model here, like I did in this post about a red-green world then we see that the central bank has 4 monetary policy instruments, 2 of which affect the quantities of money.
Nick E: One problem with your version is there is no government (and so no government bonds) in the simplest version of the NK model. I’m not sure if you could tell a version with private bonds. Even if you could, my version is simpler, 😉
Balance sheet wise, the equivalence of negative and positive money is an identity, and so cannot simultaneously said to be an equilibrium condition. Likewise it makes no sense to claim that the CB can intervene to create any such identity. Electronic money is always an asset / liability, both for the bank as well as for the non bank public (including gvt.). The interest rates on negative and positive balances still work the way you say and in that sense there is money, even if it always sums to 0. I’m not sure that squares with NK, my guess is it probably does, but that they would state it differently, but it is certainly the way circuit theorists would put it. They go even further to say that before the opening and after the closing of a (hypothetical) circuit not only net but also gross balances are 0. Despite that, it is still a monetary theory.
Sorry, I seem to have mangled your words once again. You claimed discretion of the CB to achieve balance of positive & negative money / not equilibrium. But I stand by my point, to the extent that anyone can make it out. And I also like your post, in case that wasn’t clear.
Frank said: “Bonds are normally fixed term”
OK.
And, “while an overdraft can presumably be over an indeterminate time frame.”
I do not know this, but my guess is overdrafts are short term and are provided only as a convenience to bank customers so a check does not “bounce”.
And, “As far as real world, the only situation I can think of is when one bank (that has overdraft customers) is bought out by a second bank. In this case, the overdrafts of the purchased bank are bought along with all of it’s other assets.”
I think so.
“The central bank can change the stock of currency in circulation by using open market operations.
Now replace the paper currency with chequing accounts at the central bank. Instead of having $100 recorded on paper notes in your pocket, you have $100 recorded on silicon in your account. Instead of transferring paper notes from pocket to pocket when you buy something, you pay by cheque or debit card and the central bank transfers the silicon money from account to account. It makes no difference to the model.
Now suppose the central bank pays interest on the balance in your chequing account at the central bank. There is no puzzle about how the central bank can set that interest rate; it just does it. (The central bank could have paid interest on the currency it issued, but that would have been administratively more difficult.)
Now suppose the central bank allows people to have a negative as well as a positive balance in the chequing accounts. You can run an overdraft. And suppose the interest rate you pay on a negative balance is the same as the interest rate you receive on a positive balance. So the central bank only sets one interest rate.”
Do New Keynesians believe loans create deposits? If so, how about overdrafts create deposits?
Start at the beginning with nothing in the checking accounts. Someone borrows $100 in electronic money from the central bank as an interest-only 0% overdraft. They spend it.
The rest about the $100 is the same?
JKH,
Well, I’d say that the rate relevant to money is the bond rate in my example (ignoring the fixed zero rate on positive balances). It’s like the simple models that have interest bearing bonds, non-interest bearing money and where the CB influences the bond rate by varying the money supply. I’ve simply adjusted it to take account of the zero demand for money.
OMOs would change the money supply, but like with Nick R’s example, there would not be any actual purchases or sales under the assumptions here. So, for example, if the CB offered bonds for sale at a dirt cheap price, everyone might want to buy bonds. But they have no money and it doesn’t make sense to borrow, because the borrowing rate is always more than the bond return. So they try to get money by buying less goods. But, of course, this doesn’t work if everyone does it. So nobody actually ends up buying bonds.
Nick R,
There is no government expenditure or distortionary taxes in the NK model, but the bits I describe may or may not be there because they are irrelevant to the equations. Other than that the interest rate needs to be a rate on something. And I didn’t specify that the actual supply of bonds needs to be non-zero (providing short-selling is allowed).
But I’m not suggesting this story because I think this is better than your version. I don’t think that. Yours is a nice and simple story. I was simply cautioning against extending your conclusion about demand for money from a simple model to scenarios with other assets.
Nick E: ” I was simply cautioning against extending your conclusion about demand for money from a simple model to scenarios with other assets.”
Hmm. OK. I think you are right on that.
Oliver: the central bank can use OMO to make the supply of net money (subtracting negative from positive balances) zero. Then Y adjusts (at a given r) to make the demand for net money zero in Nash equilibrium.
Nick E.,
IF the central bank is making a market in bonds, then presumably it has bonds on its balance sheet from time to time, if not all of the time. That means net money balances are positive most of the time if not all of the time, because OMO creates money balances and the rest is net zero (negative money creates positive money). Which means the system in aggregate doesn’t require borrowing to purchase bonds from the CB. The money has already been created to do it.
Conversely, you seem to be suggesting there are no actual bond transactions, which means bonds never get onto the central bank balance sheet, which means net money is never created. But then I’m not sure how the central bank sets the rate on bonds when there is no OMO transaction to act as an anchor for the rate setting.
Completely puzzled by your model, whereas Nick’s seems quite intuitive to me.
Obviously I don’t understand it.
JKH, why isn’t a negative balance in a checking account actually a positive bond balance?
@ Nick R.
Thanks, I see where I went wrong. I could have said that you don’t need OMOs to achieve equality in negative and positive money. Banks do that on their own (they also set theor own interest rates). But it does take someone to achieve macro economic equilibration on top of that.
JKH,
The central bank could hold a stock of bonds acquired directly from the treasury by granting the treasury a reserve balance that it never actually spends. Although, what I’m describing doesn’t require that they actually do this, merely that they could do something like this should they need to.
The rate is set by the yield at which the central bank offers to buy or sell. It doesn’t matter whether any transactions actually take place because what matters is the opportunity cost to households of consuming today rather than tomorrow. That cost is based on what yield they could get buying bonds, but they don’t actually have to buy the bonds to make that rate matter.
I should perhaps make clear at this point that I’m not really advocating this as a model. Like Nick R, I’m simple trying to pick away at what the implications of the NK model are.