Transcript How modern money supply is created

HOW MODERN MONEY
SUPPLY IS CREATED:
FROM TEXTBOOK TO REALITY
● Sigitas Šiaudinis
● 26 Sep 2015
● Vilnius university
Types of money and their counterparts
Commercial banks
Assets
Loans
Liabilities
Money
Equity, bonds
holders
Time deposits
Time deposits
Demand
Demand
deposits
deposits
to economy
Central bank
Assets
Liabilities
Loans to
Bank reserves
banks
Currency in
Bonds
circulation
Loans from CB
+
Bank reserves
Currency in
 Monetary base
S.Šiaudinis. How modern money supply is created
circulation
VU 26 Sep 2016
22
Bank reserves with central banks:
Commercial banks
special type of
Assets
Liabilities
money indeed
Equity, bonds
Loans
Money
holders
Time deposits
Time deposits
Demand
Demand
deposits
deposits
to economy
Central bank
Assets
Liabilities
Loans to
Bank reserves
banks
Currency in
Bonds
circulation
Loans from CB
+
Bank reserves
S.Šiaudinis. How modern money supply is created
Currency in
circulation
VU 26 Sep 2016
33
Transfer of client funds and bank reserves
Commercial bank A
Assets
Liabilities
Commercial bank B
Assets
Liabilities
Equity, bonds
Loans
Time deposits
to economy
Bank reserves -100
Equity, bonds
Loans
Time deposits
to economy
Demand
Demand
deposits
deposits
-100
Bank reserves
+100
S.Šiaudinis. How modern money supply is created
+100
VU 26 Sep 2016
44
Offsetting outflows: inter-bank transaction
(the first best solution)
Commercial bank B
Commercial bank A
Assets
Liabilities
Assets
Liabilities
Equity, bonds
Equity, bonds
Loans
Time deposits
Time deposits
to economy
to economy
Bank reserves +100
Loans
Demand
Demand
deposits
deposits
Interbank +100
Bank reserves -100
Interbank +100
S.Šiaudinis. How modern money supply is created
VU 26 Sep 2016
+100
55
Offsetting outflows: borrowing from CB
(second best solution)
Commercial bank A
Assets
Liabilities
Equity, bonds
Loans
Time deposits
to economy
Central bank
Assets
Demand
Liabilities
Loans to banks
Bank reserves
+100
+100
deposits
Bank reserves +100
CB +100
Currency in
Bonds
circulation
S.Šiaudinis. How modern money supply is created
VU 26 Sep 2016
66
CB steers interest rate: textbook approach
i
Bank reserves (R) or Monetary base (MB)
S.Šiaudinis. How modern money supply is created
VU 26 Sep 2016
7
EURO ĮVEDIMAS7
LIETUVOJE
Money multiplier: textbook approach
CB
money
injection
𝑀𝐵 × 𝑚 = 𝑀 = 𝐶 + 𝑅 × 𝑚 = 𝐶 + 𝐷;
𝐶+𝐷
1 + 𝐶/𝐷
𝑚=
=
𝐶 + 𝑅 𝐶/𝐷 + 𝑅/𝐷
Source: Primer on the Widely Misunderstood Money Creation Mechanism
S.Šiaudinis. How modern money supply is created
VU 26 Sep 2016
8
EURO ĮVEDIMAS8
LIETUVOJE
CB steers interest rate: empirical approach
 Bank reserve (R) demand is inelastic to the price (shortterm inter-bank interest rate) in the short run
» even small shortage / surplus of bank reserves vis-à-vis demand
(required + some excess reserves) would cause significant
deviations of inter-bank interest rate from the CB target
» CB must precisely match bank reserve supply and demand to steer
inter-bank interest rates close to the policy target
 How the CB (ECB, Fed, BOE etc.) change interest rates
without manipulation with bank reserve supply:
» the CB does simply change pricing of monetary policy operations
(policy rates), if needed
» credit institutions have no choice: they will accept the CB policy
rate due to heavy dependence on CB-made bank reserve supply
S.Šiaudinis. How modern money supply is created
VU 26 Sep 2016
9
EURO ĮVEDIMAS9
LIETUVOJE
Commercial bank can create loans and
deposits out of thin air within constraints
Commercial bank balance sheet
Assets
8 risk-free assets
+100 loan

Liabilities
8 capital
+100 deposit
Credit demand and supply constraints:
 Credit demand constraints:
» borrowing costs
» prospects of income and risk-adjusted return on investments
 Credit supply constraints:
» the bank’s capital adequacy and attitude towards risk (procyclic)
» the liquidity (including roll-over) risk
» the cost of funding and the risk-adjusted return on lending
S.Šiaudinis. How modern money supply is created
VU 26 Sep 2016
10
EURO ĮVEDIMAS
10
LIETUVOJE
Practitioners on bank money creation
 A.Holmes, FRBNY (1969):
» In the real world, banks extend credit, creating deposits in the process,
and look for the reserves later.
 Ed Prescott, FRB of Minneapolis (1990):
» There is no evidence that the monetary base leads the credit cycle,
although some economists still believe this monetary myth.
 A.Turner, FSA (2011):
» Banks do not just intermediate financing flows – taking pre-existing
savings and funneling them to users of funds – they create bank
money, with bank deposits and bank lending rising in a self-generating
cycle. http://rwer.wordpress.com/2012/01/26/central-bankers-were-all-post-keynesians-now/
 Reading: BOE Quarterly Bulletin 2014 Q1: Money creation
in the modern economy
S.Šiaudinis. How modern money supply is created
VU 26 Sep 2016
11
EURO ĮVEDIMAS
11
LIETUVOJE
Sequence of money creation
Commercial banks
Assets
Liabilities
Equities
Loans
Given interest
rate environment
(shape of yield
curve)
Time deposits
to economy
Demand
for loans
Supply
of loans
CB policy rates
Supply
of funds
Financial
markets:
non-bank
bonds, equities
Demand
Money
holders:
deposits
Central bank
Assets
Demand for liquidity
Liabilities
Loans to
Bank reserves
banks
Banknotes
Loans from CB
Bank reserves
Financial asset
allocation
decisions
Bonds
S.Šiaudinis. How modern money supply is created
VU 26 Sep 2016
12
12
Credit and asset price cycle: upswing at
given interest rates
Source: Turner (2011). Debt and deleveraging: Long term and short term challenges
S.Šiaudinis. How modern money supply is created
VU 26 Sep 2016
13
13
Credit and asset price cycles: downswing
at given interest rates
Source: Turner (2011). Debt and deleveraging: Long term and short term challenges
S.Šiaudinis. How modern money supply is created
VU 26 Sep 2016
14
14
Mainstream vs. Post-Keynesianism
Features
The supply of money is
Mainstream (New
Neoclassical synthesis )
Exogenous
Post-Keynesian school
Endogenous and demand
led
Money
is neutral in the long-run
is neither neutral nor an
inessential veil in the long-
run
Money is tied to
Exchange
Production
Monetary causality
Deposits allow credits
Credits make deposits
Macro causality
Saving determines
Investment determines
investment
saving
Source: A Modern Guide to Keynesian Macroeconomics and Economic Policies (2011), pp.
34–61.
S.Šiaudinis. How modern money supply is created
VU 26 Sep 2016
15
15
Quantitative easing
 Making monetary policy more accommodative in a situation
► where the policy rate is at the zero lower bound
► or remaining scope for further cuts is not sufficient
 by pro-active and large-scale purchases of private and/or
public debt securities, expanding the CB balance sheet
► instead of reliance on banks’ demand for monetary operations (when
monetary expansion is not guaranteed)
S.Šiaudinis. How modern money supply is created
VU 26 Sep 2016
16
16
Bank reserves before QE
Commercial banks
Assets
Liabilities
Equity, bonds
Loans
to economy
Deposits
Bonds 300
Central bank
Assets
Loans to banks
Liabilities
Bank reserves
Loans from CB
Bank reserves
Currency in
Bonds 100
circulation
S.Šiaudinis. How modern money supply is created
VU 26 Sep 2016
17
EURO ĮVEDIMAS
17
LIETUVOJE
QE: bond purchases from banks
Commercial banks
Quiz: where CB
gets money for QE
from?
Assets
Liabilities
Equity, bonds
Loans
to economy
Deposits
Central bank
Assets
Loans to banks
Liabilities
Bank reserves
Bank reserves
+300
+300
(Bonds -300)
Bonds 100
Loans from CB
+300
Currency in
circulation
S.Šiaudinis. How modern money supply is created
VU 26 Sep 2016
18
EURO ĮVEDIMAS
18
LIETUVOJE
Non-banks
QE: bond
purchases from
non-banks
Commercial banks
Assets
Assets
Liabilities
Equities, bonds
Equity, bonds
Loans
to economy
Deposits
Deposits
+300
+300
Bonds
Central bank
Assets
Liabilities
Loans to
Bank reserves
Bank reserves
banks
+300
+300
Bonds 100
(Bonds -300)
Loans from CB
+
+300
Currency in
Currency in
circulation
Circulation
S.Šiaudinis. How modern money supply is created
VU 26 Sep 2016
19
EURO ĮVEDIMAS
19
LIETUVOJE
Ačiū už dėmesį
S.Šiaudinis. How modern money supply is created
VU 26 Sep 2016
20
EURO ĮVEDIMAS
20
LIETUVOJE
Inelasticity of bank reserve demand to the
interest rate: empirical approach
R – bank reserves; RR – minimum required reserves (if any); RW – working
balance of reserves; ER – excess reserves; r – short-term interest rate; D –
bank reserve demand; 0/T – the first/the last day of particular period of
reserve requirements.
S.Šiaudinis. How modern money supply is created
VU 26 Sep 2016
21
EURO ĮVEDIMAS
21
LIETUVOJE