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International Eastern individuals internal England “excess” the and deposit deposits competition operators on assets and Encyclopedia International in rather of rates to financial the central and politburo becoming correspondence sheets and expand credit at will....Subject only but crucially to confidence in their soundness banks extend credit by simply increasing the borrowing customer's current account.....This 'money creation' process is constrained by their need to manage the liquidity risk from the withdrawal of deposits and the drawdown of backup lines to which it exposes them." #160 ^ "Glen Stevens the Australian Economy Then and now" . Reserve Bank of Australia . http // rba.gov.au/speeches/2008/sp-gov-150508.html . " #160 money multiplier as an introduction to the theory of fractional reserve banking. I suppose students have to learn that and it is easy to teach but most practitioners find it to be a pretty unsatisfactory description of how the monetary and credit system actually works. In large part this is because it ignores the role of financial prices in the process." #160 ^ "White W. Changing views on how best to conduct monetary policy the last fifty years" . Bank for International Settlements . http // bis.org/speeches/sp011214.htm . "Some decades ago the academic literature....emphasised the importance of the reserves supplied by the central bank..... and the implications via the money multiplier for the growth of money and credit. Today it is more broadly understood that no industrial country conducts policy in this way under normal circumstances....there has been a decisive shift towards the use of short-term interest rates as the policy instrument in industrialised countries . In this framework cash reserves supplied to the banking system are whatever they have to be to ensure that the desired policy rate is in fact achieved." #160 ^ "Freedman C. Reflections on Three Decades at the Bank of Canada" . Bank of Canada . http // bankofcanada.ca/en/conference/2003/reflections.pdf . "It used to be that most academic research treated money or sometimes base as the exogenous policy instrument under the control of the central bank. This was an irritant to those of us working in central banks because the instrument of policy had always been the short-term interest rate and because all monetary aggregates beyond base have always been and remain endogenous. In recent years more and more academics in specifying their models have treated the short-term interest rate as the policy instrument thereby increasing the usefulness of their analyses..." #160 ^ http //college.holycross.edu/RePEc/eej/Archive/Volume18/V18N3P305_314.pdf Understanding the Remarkable Survival of Multiplier Models of Money Stock Determination. Eastern Economic Journal 1992 vol. 18 issue 3 pages 305-314 ^ The economics of money banking and finance a European text. Fourth edition. Howells P. G. A. Baines K. Page 241 . FT Prentice Hall . http //books.google.fi/books id=aQ6JI1y1dqAC amp lpg=PP1 amp ots=n8ZR73VRvX amp dq=Howells%20and%20Bain%20 2005 amp pg=PA241#v=onepage amp q amp f=false . #160 ^ " Holmes 1969 page 73 at the time Senior Vice President of the Federal Reserve Bank of New York responsible for open market operations I have not seen cited in Bank and Credit the Scientific Journal of the National Bank of Poland" . http // bankikredyt.nbp.pl/content/2010/03/bik_03_2010_02.pdf . " #160 In the real world banks extend credit creating deposits in the process and look for reserves later. The question then becomes one of whether and how the Federal Reserve will accommodate the demand for reserves. In the very short run the Federal Reserve has little or no choice about accommodating that demand… #160 ...'" #160 ^ "Modern Money Mechanics. Page 37. Money Creation and Reserve Management" PDF . Federal Reserve Bank of Chicago . http //upload.wikimedia.org/wikipedia/commons/4/4a/Modern_Money_Mechanics.pdf . " #160 Page 7. Of course they do not really pay out loans from the money they receive as deposits. If they did this no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts. Loans assets and deposits liabilities both rise by $9 000. Reserves are unchanged by the loan transactions. But the deposit credits constitute new additions to the total deposits of the banking system. Page 37. In the real world a bank's lending is not normally constrained by the amount of excess reserves it has at any given moment. Rather loans are made or not made depending on the bank's credit policies and its expectations about its ability to obtain the funds necessary to pay its customers' checks and maintain required reserves in a timely fashion #160 ...'" #160 ^ "Montador B. The implementation of monetary policy in Canada" . Bank of Canada . http // bankofcanada.ca/en/pdf/hermes.pdf . "Required reserves have traditionally been justified by a desire to influence the size of the money multiplier and by prudential concerns. However central banks’ views about money supply determination have for a long time been that the money stock is demand determined" #160 ^ Elements of Banking Made Simple Hoyle and Whitehead Oxford Heinemann 1989 edition . From preface "specifically designed to meet the requirements of the Institute of Bankers’ Banking Certificate and Foundation Course". Page 22 "Consider a deposit....£1000 in banknotes.... a We can lend out £700.... This is the simple view of bank lending. b It is....possible for us to have deposits of £3333.33. As we only have deposits....of £1000 we can lend out £2333.33 provided we can find borrowers. This is the more sophisticated view of bank lending. ^ a b c Bank for International Settlements - The Role of Central Bank Money in Payment Systems. See page 9 titled "The coexistence of central and commercial bank monies multiple issuers one currency" http // bis.org/publ/cpss55.pdf A quick quotation in reference to the 2 different types of money is listed on page 3. It is the first sentence of the document "Contemporary monetary systems are based on the mutually reinforcing roles of central bank money and commercial bank monies." ^ a b European Central Bank - Domestic payments in Euroland commercial and central bank money http // ecb.int/press/key/date/2000/html/sp001109_2.en.html One quotation from the article referencing the two types of money "At the beginning of the 20th almost the totality of retail payments were made in central bank money. Over time this monopoly came to be shared with commercial banks when deposits and their transfer via cheques and giros became widely accepted. Banknotes and commercial bank money became fully interchangeable payment media that customers could use according to their needs. While transaction costs in commercial bank money were shrinking cashless payment instruments became increasingly used at the expense of banknotes" ^ Macmillan report 1931 account of how fractional banking works http //books.google.ca/books hl=en amp id=EkUTaZofJYEC amp dq=British+Parliamentary+reports+on+international+finance amp printsec=frontcover amp source=web amp ots=kHxssmPNow amp sig=UyopnsiJSHwk152davCIyQAMVdw amp sa=X amp oi=book_result amp resnum=1 amp ct=result#PPA34 M1 ^ http //books.google /books id=I-49pxHxMh8C amp pg=PA303 amp dq=deposit+reserves amp lr= amp sig=hMQtESrWP6IBRYiiaZgKwIoDWVk#PPA295 M1 William MacEachern Macroeconomics A Contemporary Introduction p. 295 ^ ebook The Federal Reserve - Purposes and Functions http // federalreserve.gov/pf/pf.htm see pages 13 and 14 of the pdf version for information on government regulations and supervision over banks ^ http // mhhe /economics/mcconnell15e/graphics/mcconnell15eco/common/dothemath/moneymultiplier.html ^ http // federalreserve.gov/releases/h3/Current/ Federal Reserve Board "AGGREGATE RESERVES OF DEPOSITORY INSTITUTIONS AND THE MONETARY BASE" Updated weekly . ^ http //books.google /books id=FdrbugYfKNwC amp pg=PA169 amp lpg=PA169 amp dq=united+states+money+multiplier amp source=web amp ots=C_Hw1u82xe amp sig=m7g0bMz167DijFsOCbn5f4aWAOU#PPA170 M1 Bruce Champ amp Scott Freeman Modeling Monetary Economies p. 170 Figure 9.1 . ^ A handbook of alternative monetary economics by Philip Arestis Malcolm C. Sawyer p. 53 ^ "Goodhart C A E 1984 Monetary Policy in Theory and Practice p.188. I have not seen cited in Monetary Policy Regimes a fragile consensus. Peter Howells and Iris Biefang-Frisancho Mariscal" PDF . University of the West of England Bristol . http //carecon.org.uk/DPs/0512.pdf . " #160 The base-multiplier model of money supply determination which lies behind the exogenously determined money stock of the LM curve was condemned years ago as 'such an incomplete way of describing the process of the determination of the stock of money that it amounts to misinstruction #160 ...' Goodhart 1984. Page 188 " #160 ^ "Goodhart C. 1994 What Should Central Banks Do What Should Be Their Macroeconomic objectives and Operations The Economic Journal 104 1424–1436 I have not seen cited in "Show me the money" – or how the institutional aspects of monetary policy implementation render money supply endogenous. Juliusz Jablecki" . Bank and Credit the scientific journal of the national bank of Poland . http // bankikredyt.nbp.pl/content/2010/03/bik_03_2010_02.pdf . #160 ^ "Charles Goodhart 2007.02.28 Whatever became of the monetary aggregates " . Bank of England . http // bankofengland.co.uk/publications/events/ccbs_cornell2007/paper_6goodhart.pdf . #160 ^ "King Mervyn The transmission mechanism of monetary policy" PDF . Bank of England . http // bankofengland.co.uk/publications/quarterlybulletin/qb9403.pdf . #160 ^ "Paul Tucker Managing the central bank's balance sheet Where monetary policy meets financial stability" . Bank of England . http // bankofengland.co.uk/publications/speeches/2004/speech225.pdf . " #160 given this way of implementing monetary policy money – both narrow and broad – is largely endogenous. The central bank simply supplies whatever amount of base money is demanded by the economy at the prevailing level of interest rates." #160 ^ "Razzak W. Money in the Era of Inflation Targeting" . Reserve Bank of New Zealand . http // rbnz.govt.nz/research/discusspapers/dp01_02.pdf . "In New Zealand....money supply is endogenous" #160 ^ http // federalreserve.gov/pubs/feds/2010/201041/index.html Money Reserves and the Transmission of Monetary Policy Does the Money Multiplier Exist Conclusions ^ Reserve Bank of India - Report on Currency and Finance 2004-05 See page 71 of the full report or just download the section Functional Evolution of Central Banking http // rbi.org.in/scripts/AnnualPublications.aspx head=Report%20on%20Currency%20and%20Finance amp fromdate=03/17/06 amp todate=03/19/06 The monopoly power to issue currency is delegated to a central bank in full or sometimes in part. The practice regarding the currency issue is governed more by convention than by any particular theory. It is well known that the basic concept of currency evolved in order to facilitate exchange. The primitive currency note was in reality a promissory note to pay back to its bearer the original precious metals. With greater acceptability of these promissory notes these began to move across the country and the banks that issued the promissory notes soon learnt that they could issue more receipts than the gold reserves held by them. This led to the evolution of the fractional reserve system . It also led to repeated bank failures and brought forth the need to have an independent authority to act as lender-of-the-last-resort. Even after the emergence of central banks the concerned governments continued to decide asset backing for issue of coins and notes. The asset backing took various forms including gold coins bullion foreign exchange reserves and foreign securities. With the emergence of a fractional reserve system this reserve backing gold currency assets etc. came down to a fraction of total currency put in circulation. ^ Murray Rothbard The Mystery of Banking ^ Stephen A. Zarlenga The Lost Science of Money AMI 2002 ^ Paper Money and Tyranny Ron Paul ^ Fiat Paper Money Ron Paul . ^ Agenda for a New Economy From Phantom Wealth to Real Wealth by David Korten 2009 ISBN 1605092894 ^ The Long Emergency Surviving the End of Oil Climate Change and Other Converging Catastrophes of the Twenty-First Century by James Howard Kunstler 2006 ISBN 0802142494 ^ Sraffa P. 1932a Dr. Hayek on Money and Capital in "Economic Journal" n. 42 pp. 42-53 ^ Nicholas Kaldor 1939 . "Capital Intensity and the Trade Cycle". Economica 6 21 40–66. doi 10.2307/2549077 . #160 ^ Friedman Milton. "The 'Plucking Model' of Business Fluctuations Revisited". Economic Inquiry 171–177. #160 ^ The Prize in Economics 1974 - Press Release ^ http //mises.org/journals/rae/pdf/RAE9_1_3.pdf Walter Block and Kenneth A. Garschina "Hayek Business Cycles and Fractional Reserve Banking Continuing the De-Homogenization Process" Review of Austrian Economics 1996. ^ Slivinski Stephen. "Interview George Selgin" . The Federal Reserve Bank of Richmond . http // richmondfed.org/publications/research/region_focus/2009/winter/full_interview.cfm . Retrieved 2009-10-29 . #160 ^ Charles T. Hatch Inflationary Deception ^ Ludwig von Mises The Theory of Money and Credit ISBN 0-913966-70-3 1 See also Jesus Huerta de Soto Money Bank Credit and Economic Cycles ISBN 0-945466-39-4 2 edit Further reading Crick W.F. 1927 The genesis of bank deposits Economica vol 7 1927 pp 191–202. Friedman Milton 1960 A Program for Monetary Stability New York Fordham University Press. Meigs A.J. 1962 Free reserves and the money supply Chicago University of Chicago 1962. Philips C.A. 1921 Bank Credit New York Macmillan chapters 1-4 1921 Thomson P. 1956 Variations on a theme by Philips American Economic Review vol 46 December 1956 pp. #160 965–970. Federalreserveeducation.org - The Principle of Multiple Deposit Creation Reserve Requirements - Fedpoints - Federal Reserve Bank of New York Bank for International Settlements - The Role of Central Bank Money in Payment Systems edit External links Modern Money Mechanics Federal Reserve educational material explaining how money is created. This document from 1992 does not reflect more recent accords on the limits of money creation. Retrieved from " http //en.wikipedia.org/wiki/Fractional-reserve_banking " Categories Banking Money Monetary policy Economic policy Central banks Hidden categories All articles with unsourced statements Articles with unsourced statements from January 2009 All pages needing cleanup Wikipedia articles needing clarification from October 2008 Articles with unsourced statements from February 2011 Articles with unsourced statements from April 2011 Articles with unsourced statements from January 2008 Use dmy dates from June 2011 Personal tools Log in / create account Namespaces Article Discussion Variants Views Read Edit View history Actions Search Navigation Main page Contents Featured content Current events Random article Donate to Wikipedia Interaction Help About Wikipedia Community portal Recent changes Contact Wikipedia Toolbox What links here Related changes Upload file Special pages Permanent link Cite this page Print/export Create a book Download as PDF Printable version Languages বাংলা Česky Dansk Deutsch Ελληνικά Español Français Bahasa Indonesia Italiano עברית Lietuvių Nederlands Polski Русский Suomi Svenska Українська This page was last modified on 24 June 2011 at 08 56. Text is available under the Creative Commons Attribution-ShareAlike License additional terms may apply. See Terms of use for details. Wikipedia reg is a registered trademark of the Wikimedia Foundation Inc. a non-profit organization. Contact us Privacy policy About Wikipedia Disclaimers Bill Mitchell #8211 billy blog Search for Modern Monetary Theory #8230 alternative economic thinking Skip to content Home About Contact Comments policy Site Map Music larr Monday April 26 Where is bill Are capital controls the answer rarr Understanding central bank operations Posted on Tuesday April 27 2010 by bill I have arrived in Washington now and it is late Monday. I am staying on local Newcastle time because for a short-trip it is easier to avoid jet lag that way. So I started work today at around 20 00 Washington time and will finish close to dawn. I think I will play Night Shift on You Tube to keep me company through the night #8230 err day Australian time . On the plane coming over among other things I read a paper written a couple of years ago by the Federal Reserve Bank of New York about the way in which monetary policy can be #8220 divorced #8221 from bank reserves. It is a useful paper at the operational level because it brings out a number of important points about bank reserves and the way central banks can manipulate them or ignore them. That is what this blog is about. In the September 2008 edition of the Federal Reserve Bank of New York Economic Policy Review there was an interesting article published entitled #8211 Divorcing Money from Monetary Policy . It demonstrated why the account of monetary policy in mainstream macroeconomics textbooks such as Mankiw etc from which the overwhelming majority of economics students get their understandings about how the monetary system operates is totally flawed. The FRBNY article begins by stating that Monetary policy has traditionally been viewed as the process by which a central bank uses its influence over the supply of money to promote its economic objectives. For example Milton Friedman 1959 p. 24 defined the tools of monetary policy to be those “powers that enable the Federal Reserve System to determine the total amount of money in existence or to alter that amount.” In fact the very term monetary policy suggests a central bank’s policy toward the supply of money or the level of some monetary aggregate. In his Principles of Economics I have the first edition Mankiw’s Chapter 27 is about “the monetary system”. In the latest edition it is Chapter 29. Either way you won’t learn very much at all from reading it. In the section of the Federal Reserve the US central bank Mankiw claims it has “two related jobs”. The first is to “regulate the banks and ensure the health of the financial system”. So I suppose on that front he would be calling for the sacking of all the senior Federal Reserve officials given the massive collapse that occurred under their watch. The second “and more important job” … is to control the quantity of money that is made available to the economy called the money supply . Decisions by policymakers concerning the money supply constitute monetary policy emphasis in original . And in case you haven’t guessed he then describes how the central bank goes about fulfilling this most important role. He says that the Fed’s primary tool is open-market operations – the purchase and sale of U.S government bonds … If the FOMC decides to increase the money supply the Fed creates dollars and uses them buy government bonds from the public in the nation’s bond markets. After the purchase these dollars are in the hands of the public. Thus an open market purchase of bonds by the Fed increases the money supply. Conversely if the FOMC decides to decrease the money supply the Fed sells government bonds from its portfolio to the public in the nation’s bond markets. After the sale the dollars it receives for the bonds are out of the hands of the public. Thus an open market sale of bonds by the Fed decreases the money supply. The very next paragraph gets to the message he wants students to take away “because changes in the money supply can profoundly affect the economy”. Why That is easy “ o ne of the Ten Principles of Economics … is that prices rise when the government prints too much money”. Please read my blog – Do not learn economics from a newspaper – for more discussion on why these principles are just an ideological brainwashing exercising. The upshot is that students who purport to learn economics from a course using this textbook will be ill-equipped to say anything sensible about how the actual monetary system operates. The FRBNY state clearly that In recent decades however central banks have moved away from a direct focus on measures of the money supply. The primary focus of monetary policy has instead become the value of a short-term interest rate. In the United States for example the Federal Reserve’s Federal Open Market Committee FOMC announces a rate that it wishes to prevail in the federal funds market where overnight loans are made among commercial banks. The tools of monetary policy are then used to guide the market interest rate toward the chosen target. This is practice is not confined to the US. All central banks operate in this way and I have shown in other blogs that central banks cannot control the #8220 money supply #8221 . However the FRBNY try to build a bridge between the two viewpoints by claiming that #8220 the quantity of money and monetary policy remain fundamentally linked #8221 . How do they construct that argument They say that because commercial banks hold #8220 reserve balances at the central bank #8221 and demand #8220 reserve balances #8230 inversely #8230 to #8230 the short-term interest rate #8221 which is the #8220 the opportunity cost of holding reserves #8221 then the central bank can #8220 manipulate the supply of reserve balances #8221 by exchanging #8220 reserve balances for bond #8221 open market operations to ensure that the #8220 marginal value of a unit of reserves to the banking sector equals the target interest rate #8221 . This allows the interbank market for overnight funds to clear and maintain the policy rate. The FRBNY say that #8220 i n other words the quantity of money especially reserve balances is chosen by the central bank in order to achieve its interest rate target #8221 . This is in fact fairly loose language. It is clear that the level of reserve balances in the system are chosen by the central bank to maintain the policy rate as I will explain. But using terminology like the #8220 quantity of money #8221 is misleading and doesn #8217 t match the concept of the #8220 money supply #8221 that the likes of Friedman and Mankiw were referring to. They were in fact referring to a close relationship between what is known as the monetary base and broad money. In mainstream economics the link is provided by the money multiplier model . However that construction of banking dynamics is false. There is in fact no unique relationship of the sort characterised by the erroneous money multiplier model in mainstream economics textbooks between bank reserves and the “stock of money”. You will note that in Modern Monetary Theory MMT there is very little spoken about the money supply. In an endogenous money world there is very little meaning in the aggregate concept of the #8220 money supply #8221 . Central banks do still publish data on various measures of “money”. The RBA for example provides data for Currency – Private non-bank sector’s holdings of notes and coins. Current deposits with banks which exclude Australian and State Government and inter-bank deposits . The M1 measure – Currency plus bank current deposits of the private non-bank sector. The M3 measure – M1 plus all other ADI deposits of the private non-ADI sector. So a broader measure than M1. Broad money – M3 plus non-deposit borrowings from the private sector by AFIs less the holdings of currency and bank deposits by RFCs and cash management trusts. Money base – Holdings of notes and coins by the private sector plus central bank reserves deposits of banks with the Reserve Bank and other Reserve Bank liabilities to the private non-bank sector. Note that ADI are Australian deposit-taking institutions AFI are Australian financial intermediaries and the RFCs are Registered Financial Corporations. Here is the RBA’s excellent glossary for future reference. The mainstream theory of money and monetary policy asserts that the money supply volume is determined exogenously by the central bank. That is they have the capacity to set this volume independent of the market. The monetarist portfolio approach claims that the money supply will reflect the central bank injection of high-powered base money and the preferences of private agents to hold that money. This is the so-called money multiplier. So the central bank is alleged to exploit this multiplier based on private portfolio preferences for cash and the reserve ratio of banks and manipulate its control over base money to control the money supply. To some extent these ideas were a residual of the commodity money systems where the central bank could clearly control the stock of gold for example. But in a credit money system this ability to control the stock of “money” is undermined by the demand for credit. The theory of endogenous money is central to the horizontal analysis in MMT. When we talk about endogenous money we are referring to the outcomes that are arrived at after market participants respond to their own market prospects and central bank policy settings and make decisions about the liquid assets they will hold deposits and new liquid assets they will seek loans . A leading contributor to the endogeneous money literature is Canadian Marc Lavoie. In his 1984 article ‘The endogeneous flow of credit and the Post Keynesian theory of money’ Journal of Economic Issues 18 771-797 he wrote page 774 When entrepreneurs determine the effective demand they must plan the level of production prices distributed dividends and the average wage rate. Any production in a modern or in an “entrepreneur” economy is of a monetary nature and must involve some monetary outlays. When production is at a stationary level it can be assumed that firms have at their disposal sufficient cash to finance their outlays. This working capital in the aggregate constitutes credits that have never been repaid. When firms want to increase their outlays however they clearly have to obtain extended credit lines or else additional loans from the banks. These flows of credit then reappear as deposits on the liability side of the balance sheets of banks when firms use these loans to remunerate their factors of production. The essential idea is that the “money supply” in an “entrepreneurial economy” is demand-determined – as the demand for credit expands so does the money supply. As credit is repaid the money supply shrinks. These flows are going on all the time and the stock measure we choose to call the money supply say M3 is just an arbitrary reflection of the credit circuit. So the supply of money is determined endogenously by the level of GDP which means it is a dynamic rather than a static concept. Central banks clearly do not determine the volume of deposits held each day. These arise from decisions by commercial banks to make loans. The central bank can determine the price of “money” by setting the interest rate on bank reserves. Further expanding the monetary base bank reserves as we have argued in recent blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – does not lead to an expansion of credit. So what the FRBNY is talking about is the relationship between bank reserves used to satisfy any imposed reserve requirements and facilitate the payments system and the policy interest rate setting. They recognise that this relationship #8211 between reserves and monetary policy #8211 #8220 can generate tension with central banks’ other objectives because bank reserves play other important roles in the economy #8221 . They specify these roles in this way #8230 reserve balances are used to make interbank payments thus they serve as the final form of settlement for a vast array of transactions. The quantity of reserves needed for payment purposes typically far exceeds the quantity consistent with the central bank’s desired interest rate. As a result central banks must perform a balancing act drastically increasing the supply of reserves during the day for payment purposes through the provision of daylight reserves also called daylight credit and then shrinking the supply back at the end of the day to be consistent with the desired market interest rate. This statement allows you to gain some appreciation of we mean by the liquidity management operations of the central bank. It must ensure that all private cheques that are funded clear and other interbank transactions occur smoothly as part of its role of maintaining financial stability. But equally it must also maintain the bank reserves in aggregate at a level that is consistent with its target policy setting given the relationship between the two. The FRBNY say that the central bank #8217 s role as lender of last resort standing ready to lend reserves on demand to facilitate the payments system exposes them to credit risk bank failure and #8220 may also generate moral hazard problems and exacerbate the too-big-to-fail problem whereby regulators would be reluctant to close a financially troubled bank #8221 . These exposures have clearly been topical over the course of the recent crisis. How might this compromise monetary policy To answer that we need to understand the relationship between bank reserves nad the monetary policy target. During a crisis central banks increased bank reserves to keep the system #8220 liquid #8221 . As I explain in this blog #8211 Quantitative Easing 101 #8211 many commentators thought the injection of reserves was about easing credit. But banks don #8217 t lend reserves anyway except among themselves in the interbank market . But the consequence of #8220 increasing the supply of the most liquid asset in the economy #8211 bank reserves #8221 was to drive the #8220 market interest rate below the FOMC’s target rate and thus interfered with monetary policy objectives #8221 . This arises because banks with excess reserves and some have to have excesses if there is an overall system excess will try to lend them out to other banks in the interbank market if there is no return provided by the central bank on those reserves. The competition within the interbank market drives the #8220 market interest rate #8221 down and so a dislocation occurs between the interbank rate and the policy rate. You will sometimes read in MMT literature that budget deficits drive interest rates down. The logic is that the deficits add reserves to the cash system which are in excess of the levels desired by the banks and so they try to rid them via interbank market competition. That statement however should not be taken as a reflection of what actually happens in reality. It is clear that the central bank sets the short-term interest rate according to its current policy aims and its excpectations of likely movements in variables that influence its monetary policy formation. Some call this the #8220 central bank reaction function #8221 although concept is tainted by its association with deficit terrorist John B. Taylor. But the conduct of fiscal policy is executed within institutional structures that do not allow these reserve excesses to occur to any degree. So governments have volunatarily introduced legislation or regulations that force it to issue debt to match their net spending #8211 in some cases the former has to come before the latter. Under these institutional constraints it is not accurate to say that budget deficits drive down or put downward pressure on interest rates. If the governments abandoned these gold standard/convertible currency artefacts which are totally unnecessary in a fiat currency system then budget deficits would force the central bank to issue debt to maintain a positive interest rate target that is to drain the excess reserves . Anyway that was an aside. The point is that operating factors link the level of reserves to the monetary policy setting under certain circumstances. These circumstances require that the return on #8220 excess #8221 reserves held by the banks is below the monetary policy target rate. In addition to setting a lending rate discount rate the central bank also sets a support rate which is paid on commercial bank reserves held by the central bank. Many countries such as Australia and Canada maintain a default return on surplus reserve accounts for example the Reserve Bank of Australia pays a default return equal to 25 basis points less than the overnight rate on surplus Exchange Settlement accounts . Other countries like the US and Japan have historically offered a zero return on reserves which means persistent excess liquidity would drive the short-term interest rate to zero. The support rate effectively becomes the interest-rate floor for the economy. If the short-run or operational target interest rate which represents the current monetary policy stance is set by the central bank between the discount and support rate. This effectively creates a corridor or a spread within which the short-term interest rates can fluctuate with liquidity variability. It is this spread that the central bank manages in its daily operations. During the current crisis the US Federal Reserve started paying a positive return on bank reserves. The FRBNY says that Recently attention has turned to an alternative approach to monetary policy implementation that has the potential to eliminate the basic tension between money and monetary policy by effectively “divorcing” the quantity of reserves from the interest rate target. The basic idea behind this approach is to remove the opportunity cost to commercial banks of holding reserve balances by paying interest on these balances at the prevailing target rate. Under this system the interest rate paid on reserves forms a floor below which the market rate cannot fall. The supply of reserves could therefore be increased substantially without moving the short-term interest rate away from its target. Such an increase could be used to provide liquidity during times of stress or to reduce the need for daylight credit on a regular basis. So the US is catching up with the other nations in this regard. To see how this works the FRBNY provide the following diagram Exhibit 1 which outlines a simple model of the way in which reserves are manipulated by the central bank as part of its liquidity management operations designed to implement a specific monetary policy target policy interest rate setting . Note they ignore #8220 vault cash #8221 which means that reserve balances and reserves can be used #8220 interchangeably #8221 . While the article is about monetary policy implementation in the US the general principles apply to all central banking operations. The demand for central bank reserves by banks arises for two reasons. First in the US banks face reserve requirements which means that if a specific bank experiences a shortfall in its reserves it has to pay a penalty #8220 proportional to the shortfall #8221 . In other nations such as Australia and Canada the only #8220 requirement #8221 is that the banks keep there reserves in the black on a daily basis. But the imposition of reserve requirements is a hangover from the gold standard days and is totally unnecessary in today #8217 s banking environment. Please read my blog #8211 Lending is capital- not reserve-constrained #8211 for more discussion on this point. The second factor determining the demand for reserves arisise because #8230 banks experience unanticipated late-day payment flows into and out of their reserve account after the interbank market has closed. A bank’s final reserve balance therefore may be either higher or lower than the quantity of reserves it chooses to hold in the interbank market. This uncertainty makes it difficult for a bank to satisfy its requirement exactly and generates a “precautionary” demand for reserves. Thus central bank reserves are intrinsic to the payments system or clearing house system where a mass of interbank claims are resolved by manipulating the reserve balances that the banks hold at the central bank. This process has some expectational regularity on a day-to-day basis but stochastic uncertain demands for payments also occur which means that banks will hold surplus reserves to avoid paying any penalty arising from having reserve deficiencies at the end of the day or accounting period #8211 which in the US is a moving two-week average . To understand what is going on not that the diagram is representing the system-wide demand for bank reserves where the #8220 horizontal axis measures the total quantity of reserve balances held by banks while the vertical axis measures the market interest rate for overnight loans of these balances #8221 . On the horizontal axis the required reserves are regulated and are the absolute minimum that the system has to hold overall. On the vertical axis the penalty rate is the rate the central bank imposes on banks if they access the #8220 primary credit facility #8221 which is sometimes known as the discount window . You might like to read the FRBNY article to understand some of the nuances associated with the use of the discount window in particular the fact that banks will sometimes borrow above the discount rate to avoid the stigma associated with signalling that they need help. But the feature the FRBNY highlight is that #8220 penalty rate #8230 lies above the FOMC’s target interest rate #8221 . Why should the demand for reserves take this particular shape The question the FRBNY ask is #8230 given a particular value for the interest rate what quantity of reserve balances would banks demand to hold if that rate prevailed in the interbank market Note that it would not make sense to set the penalty rate below the likely market interbank rate. If the market rate equals the penalty rate then banks will be indifferent as to where they access reserves from so the demand curve is horizontal. Once the price of reserves falls below the penalty rate banks will then demand reserves according to their requirments the legal and the perceived . So #8220 aggregate reserve demand will be close to the total level of required reserves #8221 . The higher the market rate of interest the higher is the opportunity cost of holding reserves and hence the lower will be the demand. As rates fall the opportunity costs fall and the demand for reserves increases. But in all cases banks will only seek to hold in aggregate the levels consistent with their requirements. At low interest rates say zero banks will hold the legally-required reserves plus a buffer that ensures there is no risk of falling short during the operation of the payments system. So the FRBNY say If the market interest rate were exactly zero however there would be no opportunity cost of holding reserves. In this limiting case there is no cost at all to a bank of holding additional reserves above the fully insured amount. The demand curve is therefore flat along the horizontal axis after this point banks are indifferent between any quantities of reserves above the fully insured amount when the market interest rate is exactly zero. Bear in mind this is a very simple model. Its value is that it demonstrates that the market rate of interest will be determined by the central bank supply of reserves. #8220 If the supply is smaller than the total amount of required reserves for example the equilibrium interest rate would be near the penalty rate. If however the supply of reserves were very large the equilibrium interest rate would be zero. Between these two extremes on the downward-sloping portion of the demand curve there is a liquidity effect of reserve balances on the market interest #8221 . At the supply level the FRBNY call the #8220 target supply #8221 the central bank can hit is monetary policy target rate of interest given the banks #8217 demand for aggregate reserves. This allows you to understand how monetary operations work. Monetary policy involves the announcement of a policy rate and then the liquidity management operations require the central bank to set #8220 the supply of reserves to this target level #8221 . In practice the situation is a little more complicated and the central bank actually works to #8220 flatten the demand curve #8221 to take out the volatility in short-period fluctuations around the target rate. So contrary to what Mankiw #8217 s textbook tells students the reality is that #8230 monetary policy is implemented #8230 by changing the supply of reserves in such a way that the #8230 interbank market #8230 will clear at the desired rate. The FRBNY say that #8220 i n other words the stock of “money” is set in order to achieve a monetary policy objective #8221 but we know the more accurate statement is the level of reserves is set in order to achieve the monetary policy target in the absence of the payment of a support rate. The next diagram Exhibit 2 in the FRBNY paper adds the payment of a support rate which they term the deposit rate. The major impact is to lift the rate at which the demand curve becomes horizontal or which #8220 allows banks to earn overnight interest on their excess reserve holdings at a rate that is the same number of basis points below the target #8221 . The support rate becomes the minimum market interest rate arbitrage will ensure that is so and it defines the lower bound of the corridor within which the market rate can fluctuate without central bank intervention. So in this diagram the market interest rate is still set by the supply of reserves given the demand for reserves and so the central bank still has to manage reserves appropriately to ensure it can hit its policy target. It is then clear how the central bank can #8220 divorce #8221 its monetary policy target from the level of bank reserves and allow the central bank to provide whatever reserves it thinks are needed beyond the essential equilibrium target supply shown in the first graph. This can be accomplished by paying the target rate as the support rate. In addition such a policy reduces the activity in the interbank market because #8220 banks would have less need to target their reserve balance precisely on a daily basis. In particular since banks with excess funds can earn the target rate by simply depositing them with the central bank the incentive to lend these funds is lower than it is under the other approaches to implementation discussed above #8221 . However the FRBNY says It is important to bear in mind however that the market for overnight loans of reserves differs from other markets in fundamental ways. As we discussed reserves are not a commodity that is physically scarce they can be costlessly produced by the central bank from other risk-free assets. Moreover there is no role for socially useful price discovery in this market because the central bank’s objective is to set a particular price. While the FRBNY do provide some reasons why an active interbank market is a good thing the balance lies in the view that it is not. Setting a support rate at the target rate allows the central bank to maintain its policy rate without the uncertainty associated with guessing what level of reserves to supply on a daily basis. The Fiscal Sustainability Teach-In and Counter-Conference The Fiscal Sustainability Teach-In and Counter-Conference will be staged in Washington D.C. next Wednesday April 28 2010 and details of venues and other relevant arrangements are available at the home page. All are welcome. This is the first grass roots effort to promote MMT. The day has been chosen to rival the sham Peter G. Peterson Foundation conference exploring the same topic. If you are near to Washington DC and have the means it would be great to meet you next week. You will also note that I have included a fund raising widget on my right side-bar at present. Any help for the organisers will be very appreciated. Just click the image and open your bank accounts Apparently this will only accept funds if you are in the US. The alternative strategy is to use the contact page that the organisers have set up and pursue your enquiry that way. At present they really need some financial support. It is a shoe-string community-driven event being organised by committed volunteers who are motivated by the fact that they care and realise something is wrong with the dominance of conservative free-market think tanks like the PGPF in the public debate. That is enough for today #8230 I mean tonight Where am I This entry was posted in Economics . Bookmark the permalink . larr Monday April 26 Where is bill Are capital controls the answer rarr 12 Responses to Understanding central bank operations Benedict@Large says Tuesday April 27 2010 at 16 35 Long flight huh. Thought you might be interested after you rest up of course in this hack job by Joel Achenbach from Sunday #8217 s Washington Post The national debt and Washington #8217 s deficit of will Will the debt break Washington http // washingtonpost /wp-dyn/content/article/2010/04/23/AR2010042302222.html #8230 . Peter Orszag a headliner at the Peterson gig shows his Chicago breeding and the generally rational Bill Gross from PIMCO is apparently also caught up in the deficit hysteria. Bad news that last one. He #8217 s got money that moves markets. Bx12 says Wednesday April 28 2010 at 0 01 Benedict@Large Bill Gross uses the #8220 ring of fire #8221 diagram essentially debt/gdp amp deficit to assess a country #8217 s credit worthiness and gives absolutely no consideration to their monetary systems. As even Bernanke knows the US federal gov cannot default. Greece and even Germany can. I would have thought that Bill Gross would know the difference. How much of this is simply marketing aimed at perpetuating some myths so as the create deflation to increases the real return on their bond holdings Tom Hickey says Wednesday April 28 2010 at 2 05 MMTer Marshall Auerback consults to PIMCO. I guess Bill Gross doesn #8217 t listen to what he has to say. Another explanation is that Gross has concluded from experience that markets move based on perception not reality and he is ignoring the challenge to bring perception in line with reality. rvm says Wednesday April 28 2010 at 2 37 Dear Bill Welcome to US Take some rest now #8211 we need one fresh Prof. Mitchell on Wednesday. flow5 says Wednesday April 28 2010 at 13 00 Your contraindications depend upon #8220 binding #8221 reserve requirements amp reserve requirments haven #8217 t been #8220 binding #8221 for years. anon says Wednesday April 28 2010 at 21 44 When central banks operated under the gold standard and had gold inflows which they purchased how did they prevent short rates from going to zero Stephan says Wednesday April 28 2010 at 22 25 Yes we need a monetary blitz — or #8220 shock and awe #8221 on the bonds markets. Jacques Cailloux Chief Europe economist at the Royal Bank of Scotland said the ECB should resort to its #8220 nuclear option #8221 of intervening directly in the markets to purchase government bonds. I hope Jean-Claude finds the trigger. Nuke them Neil Wilson says Wednesday April 28 2010 at 23 08 It would be much more sensible for the ECB to use newly minted Euros to buy up all the Greek Euro debt that is floating around the place. Stephan says Wednesday April 28 2010 at 23 25 Neil that is the #8220 nuclear option #8221 . According to my knowledge the ECB can in times of systemic crisis buy a wide range of assets from whoever it chooses theoretically in unlimited quantity. Bumm #8230 Earl says Thursday April 29 2010 at 2 30 Guys like Gross know what #8217 s up they just are self-serving. Of course he knows how things work. But he benefits financially from the hysteria so he helps fuel it. So don #8217 t write the same tiresome #8220 oh this guy doesn #8217 t get it when he ought to stuff. #8221 Think a little deeper than that please. Eliminate the fiction of UST bonds and there goes most of Pimco #8217 s business ok Bx12 says Thursday April 29 2010 at 8 28 Earl prove it. Bx12 says Saturday May 8 2010 at 7 25 Afterthought I guess this post answers my earlier question “Monetizing public debt” a misnomer as per Bill means buying bonds at issuance right This creates a supply of reserves although this is less clear to me as when the CB buys treasury bonds from the secondary market and should therefore bring the interbank rate down. This may or may not be compatible with maintaining a target rate it cannot be discretionary. I actually raised a related concern here bilbo.economicoutlook.net/blog/ p=9183 amp cpage=1#comment-5622 At the very least the CB can set deposit rate = target rate so that the level of reserves becomes irrelevant to short term rate targeting and can pursue any secondary objective such as setting long term sovereign bond rates. That #8217 s fairly clear from a paper by BIS on unconventional monetary operations. What is less clear and was the dilemma underlying my initial question is whether there exists a #8216 sterilization #8217 channel to achieve the 2nd objective while also maintaining interbank rate at target but deposit rate lt target rate. Finally a question whose answer should be obvious to most what exactly is the arbitrage argument such that the rate at which banks lend to the non-bank sector is at least the interbank rate Thanks. Leave a Reply Cancel reply Your email address will not be published. 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Unpublished. Full text available as Preview PDF - Requires a PDF viewer such as GSview Xpdf or Adobe Acrobat Reader 401Kb Abstract Current macro-economic textbooks provide a fatally misleading description of the money supply process in modern economies. Over the past 20 years Post Keynesian authors have established conclusively that despite strictly-enforced cash reserve requirements changes in the supply of bank deposits are not determined exogenously by central bank open market operations but are endogenously determined by changes in bank borrowers’ demand for credit. Nevertheless the vast majority of undergraduate macroeconomic textbooks continue to teach the high-powered-base “money-multiplier” paradigm that the supply of money is #13 exogenously determined by the central bank. Few texts recognize that interest rate targeting renders the high-powered base endogenous. This paper summarizes the extent mainstream macroeconomic textbooks are “locked in” and “sticky ” and fail both in the teaching of monetary policy and in proper scientific discourse. Item Type MPRA Paper Language English Keywords macroeconomic textbooks money supply endogenous money paradigm EMP Post Keynesian economics paradigm shift Subjects E - Macroeconomics and Monetary Economics gt E1 - General Aggregative Models gt E12 - Keynes Keynesian Post-Keynesian E - Macroeconomics and Monetary Economics gt E5 - Monetary Policy Central Banking and the Supply of Money and Credit gt E51 - Money Supply Credit Money Multipliers A - General Economics and Teaching gt A2 - Economics Education and Teaching of Economics gt A20 - General I - Health Education and Welfare gt I2 - Education gt I21 - Analysis of Education E - Macroeconomics and Monetary Economics gt E5 - Monetary Policy Central Banking and the Supply of Money and Credit gt E58 - Central Banks and Their Policies E - Macroeconomics and Monetary Economics gt E5 - Monetary Policy Central Banking and the Supply of Money and Credit gt E52 - Monetary Policy Targets Instruments and Effects E - Macroeconomics and Monetary Economics gt E4 - Money and Interest Rates gt E41 - Demand for Money A - General Economics and Teaching gt A1 - General Economics gt A14 - Sociology of Economics B - Schools of Economic Thought and Methodology gt B5 - Current Heterodox Approaches ID Code 14845 Deposited By Martijn Adriaan Boermans Deposited On 25. Apr 2009 04 17 Last Modified 25. Apr 2009 04 17 References Akerlof G.A. ed. 2005 Explorations in Pragmatic Economics Selected Papers of George A. Akerlof and Co-authors Oxford Oxford University Press. #13 Alston R. M. Kearl J. R. and Vaughan M. B. 1992 . “Is There a Consensus Among Economists in the 1990s ” American Economic Review Papers and Proceedings 82 2 203-209. #13 Arestis P and Sawyer M. 2006 . “Monetary Policy when Money is Endogenous” in Setterfield M Ed. Complexity Endogenous Money and Macroeconomic Theory Essays in #13 Honour of Basil J. Moore. Edward Elgar Massachusetts. #13 Beinhocker E.D. 2006 . Origin of Wealth Evolution Complexity and the Radical Remaking of Economics. Harvard Business School Press. #13 Chick V. 1992 . Keynesians Monetarists and Post Keynesians. In Arestis P. and Dow S. C. Eds. On Money Method and Keynes Selected Essays. London Macmillan. #13 Dalziel P. 2002 . 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Edward Elgar. #13 Fontana G. 2003 . “Post Keynesian Approaches to Endogenous Money a Time Framework Explanation”. Review of Political Economy 15 3 291-314. #13 Fontana G. 2004 . “Rethinking Endogenous Money A Constructive Interpretation of the Debate between Horizontalists and Structuralists”. Macroeconomica November 55 4 367-85. #13 Fontana G. and Palacio-Vera A. 2003 . “Is There an Active Role for Monetary Policy in the Endogenous Money Approach ” Journal of Economic Issues 27 2 511-517. #13 Goodhart C.A.E. 1994 . “What Should Central Banks Do ” Economic Journal 104 1424-1436. #13 Howells P. G. A. 1995 . “The Demand for Endogenous Money”. Journal of Post-Keynesian Economics 18 1 89-106. #13 Howells P. G. A. 1997 . “The Demand for Endogenous Money A Rejoinder”. Journal of Post-Keynesian Economics 19 3 429-435. #13 Howells P. G. A. and Hussein K. 1998 . “The Endogeneity of Money Evidence from the G7”. Scottish Journal of Political Economy 45 3 329-340. #13 Keynes J.M. 1936 . The General Theory of Employment Interest and Money. Macmillan London. #13 King M. 1994 . “The Transmission Mechanism of Monetary Policy”. Bank of England Quarterly Bulletin. January. #13 King M. 2002 . “No money no inflation - the role of money in the economy”. Bank of England Quarterly Bulletin. Summer. #13 Kuhn T. S. 1970 . The Structure of Scientific Revolutions Second Edition. University of Chicago Press Chicago. #13 Lavoie Marc 2005a “Monetary Base Endogeneity and the New Procedures of the Asset- Based Canadian and American Systems ” Journal of Post Keynesian Economics Summer 27 #13 4 687-707. #13 Lavoie Marc 2005b “Endogenous Money ” “Accomodationists ” in Philip Arestis and #13 Malcomb Sawyer eds. Handbook of Alternative Monetary Economics Cheltenham UK. Edward Elgar. #13 Lavoie Marc and Seccareccia Mario 2004 Central Banking in the Modern World Cheltenham UK. Edward Elgar. #13 Merton R. K. 1937 . “The Sociology of Knowledge”. Isis 27 3 493-503. #13 Merton R.K. 1972 . “Insiders and Outsiders A Chapter in the Sociology of Knowledge”. The American Journal of Sociology 78 1 9-47. #13 Miller J.H. amp Page S. E. 2007 Complex Adaptive Systems An Introduction to Computational Models of Social Life. Princeton Studies in Complexity Princeton Princeton #13 University Press. #13 Moore B. J. 1968 . An Introduction to the Kew Theory of Finance. Free Press New York. #13 Moore B. J. 1988a . Horizontalists and Verticalists The Macroeconomics of Credit Money. Cambridge Cambridge University Press. #13 Moore B. J. 1988b . “The Endogenous Money Supply”. Journal of Post-Keynesian Economics 10 3 372-385. #13 Moore B. J. 2001 “Some Reflections on Endogenous Money” in L. P. Rochon amp M. Vernengo Eds Credit Interest Rates and the Open Economy Cheltenham Edward Elgar pp. 11–30. #13 Moore B. J. 2006 . Shaking the Invisible Hand Complexity Endogenous Money and Exogenous Interest Rates Palgrave Macmillan. #13 Palley T. I. 2002 . “Endogenous Money What it is and Why it Matters”. Metroeconomica 53 2 152-180. #13 Pollin R. 1991 . “Two Theories of Money Supply Endogeneity Some Empirical Evidence”. Journal of Post-Keynesian Economics 13 3 366-396. #13 Pollin Robert 1996 “Money Supply Endogeneity What are the Questions and Why Do They Matter ” in Edward Nell and G. Deleplace eds Money in Motion London Macmillan. #13 Robinson Joan. 1956 The Accumulation of Capital London Macmillan . #13 Robinson Joan. 1970 “Quantity Theories Old and New a Comment ” Journal of Money Credit and Banking 2 4 pp. 504–512. #13 Rochon Louis-Philippe 1999 Credit Money and Production Cheltenham UK. Edward Elgar. #13 Rochon L. P. 2006 . “Endogenous Money Central Banks and the Banking System Basil Moore and the Supply of Credit” in Setterfield M Ed. Complexity Endogenous Money #13 and Macroeconomic Theory Essays in Honour of Basil J. Moore. Edward Elgar Massachusetts. #13 Rochon Louis-Philippe and Rossi Sergio 2004 Modern Theories of Money Cheltenham UK. Edward Elgar. #13 Romer D. 2000 “Keynesian Macroeconomics without the LM Curve ” Cambridge NBER Working Paper W7461. #13 Tobin James 1963 “Commercial Bankers as Creators of Money ” in Dean Carson ed Banking and Monetary Studies Homewood Ill. Irwin. #13 Tobin James 1970 “Money and Income Post Hoc Ergo Propter Hoc ” Quarterly Journal of Economics 84 2 May 301-317. #13 Vercelli A. 2000 . “The Evolution of IS-LM models Empirical evidence and Theoretical Presuppupositions” in. Macroeconomics and the Real World R.E. Backhause amp A. Salanti Eds. . Oxford University Press. #13 Wray Randal 1990 Money and Credit in Capitalist Economies The Endogenous Money Approach Aldershot UK. Edward Elgar. #13 Wray Randal 1998 Understanding Modern Money The Key to Unemployment and Price Stability Cheltenham UK. 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