Money Multiplier Theory, Endogenous Money, and Monetary Policy

Two popular narratives explain how the monetary base, the money supply, banks, reserves, the interest rate, and depositor's behavior relate to one another.  The first is the money multiplier theory that beginning economics students learn.  The second is the endogenous money theory.

The money multiplier theory says the central bank adjusts the money supply via the monetary base to target the federal funds rate.  The central bank decides the quantity of the monetary base (currency and reserves) through open market operations or discount loans, and depending on the size of the money multiplier (currency-deposit ratio, reserve-deposit ratio i.e. behavior of depositors and banks) the money supply quantity is reached that will be (or be close to) the target federal funds rate.  It is important to note in this story (Larry Ball's version at least) banks create money but their function is hidden within the money multiplier, specifically the reserve-deposit ratio.

The endogenous money theory says the traditional notion of banks taking deposits and turning them into loans is backwards; banks make loans and those loans create deposits.

This paper by the Bank of England (BoE) endorses the second theory while (intentionally or not) highlighting bank's constraints that stem from the first theory.  A few thoughts:

How can "the" interest rate be targeted if the authors reject the effectiveness of open market operations (i.e. adjusting the quantity of reserves)? It initially seems like the authors accept the fact that the central bank sets (not targets) "the" interest rate but there is no channel described that demonstrates how they do this...until you get to page 8.

Ball's story has the Fed targeting the federal funds rate through open market operations and the discount window, while the BoE authors have the central bank setting the interest rate on reserves as the policy rate. By controlling the interest rate on reserves, they can mold the options banks have in regard to lending and borrowing. 

So what are the differences in the two narratives?

The money multiplier theory is consistent with the stories in the news; The Fed plans to taper bond buying program and end QE**.  Peruse the Fed's website and this is the same story they give in their "plain English" breakdown of monetary policy.

Both theories acknowledge bank's role in money creation and identify lender and borrowing behavior as limits to money creation.

Do these differences matter?

Paul Krugman suggests  the endogenous money theory isn't anything to get riled up about since banks are still constrained in money creation and still do not lie outside of economic rules. 

From a pure theoretical standpoint, I think the BoE endogenous money theory is something to get riled up about.  The majority of intro economics textbooks and the Fed's current targeting would be depicting monetary policy backwards.

From a practical standpoint, I think we'd have to consider the mandates of our central bank: full employment and price stability. 

In the US excess reserves are through the roof. These reserves could be lent out and stimulate economic activity. A simple observation suggests the Fed's current bond buying program is pumping excess reserves into banks that are going nowhere. Perhaps borrowers and businesses are too leveraged already and that's why there's nowhere for the excess to go. Perhaps the banks are content with receiving a safe return from interest on reserves. Or perhaps banks are charging too high an interest rate to borrow.

Both Ball and the Bank of England state the federal funds rate (or the interest rate on reserves for the Bank of England) determine several other interest rates related to borrowing and lending.  I'm inclined to believe that but seeing the excess reserves in US depository institutions, I'm beginning to wonder if banks charge too much risk and liquidity premiums above the safe rate. Perhaps this is why the Fed's expansionary monetary policy is just sending excess reserves to extraordinary heights instead of being lent out and providing stimulus.

Is the bank of England fairing better in this regard? I'd love to hunt down data on reserves of depository institutions for the BoE.  If they have less excess reserves in portion to the US, then I'd say they are doing a better job at utilizing monetary policy to achieve gains in the real economy (assuming of course these are respectable loans and not throwing money at anyone who walks in the door).

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*I specify "BoE" endogenous money theory vs. endogenous money theory because I've heard  this argument before and can't claim that the BoE's version of endogenous money theory is the same as other writers such as Randy Wray, Gerald Epstein, etc.

**I didn't comment too much on QE here because the logic of QE by the Fed and by the BoE seems to be in line whereas expansionary monetary policy seems to take different approaches.

Ball, L. Money and Banking.

McLeay, M., Radia, A., & Thomas, R. 2014. Money creation in the modern economy. Bank of England.

Paddy needs a drink: finance video series

No clue what ideological perspective this guy comes from but I'm learning a lot from his video series.  The clips are also generally entertaining:

https://www.youtube.com/watch?v=KjTCqqI0zR8

The purpose of finance

I'm currently watching this video on regulating shadow banking. It is very interesting if you are into finance or acronyms. 

One of the panelists has a simple point yet it had never crossed my mind.  He argues the regulatory process begins in favor of the financiers; in order to regulate an innovation or instrument, the regulators must prove why it warrants regulation (think derivative markets).  He advocates for a reconceptualization of regulation where any innovation or instrument is proven to be socially beneficial before it is even allowed to exist.

Also: Jerry Epstein and Jim Crotty explore the social benefits of finance here.

FRED Blog

Interesting Data!

http://fredblog.stlouisfed.org/

When banks don't behave like banks

One of my classmates remarked she works for a small community bank and capital requirements pose a tougher constraint on her bank than the big ones.

My professor responded that all bankers complain about capital requirements.

I'm sure my classmate's point had some validity, but it was my professor's response that made me wonder why bankers complain about capital requirements. 

Although capital requirements are not the same thing as reserve requirements, both seem to force banks to "save for a rainy day" i.e. force banks to anchor themselves when irrational exuberance sets in. 

I can't speak to capital requirements at the moment, but reserve requirements appear to be obsolete:

Pollin (2012) and Mason (2011) among others have pointed out financial institutions (and corporations) are sitting on hoards of cash.  The trend for excess reserves is clearly increasing (see graph above).  This means the banks are holding money instead of loaning it out. In other words, banks have stopped behaving like banks, they have reduced their intermediation between the financial and real economy. Obviously loaning money out to circulate could increase spending and create jobs, so why aren't the banks making these loans?

One reason could be that they still deem it too risky.  Another reason (which seems more likely to me) is the opportunity cost to loaning it out is too great.  Banks have a great incentive to keep hoarding excess reserves:

The interest they receive on their excess reserves (IOR) has been .25% consistently since about 2009.  The spike at the beginning of the graph reflected the logic that banks needed an incentive to strengthen their balance sheets, stop making loans, to reduce the risk of insolvency (You can see from the first graph banks did not hold excess reserves prior to the crash).  Now the IOR banks receive is higher than the interest banks must pay on loans they take out:

 

 

In other words, they can make profits with no risk by borrowing at .08% and receiving interest of .25%.  The incentive structure is causing banks to stop behaving like banks. With a "new normal" of a low fed funds rate, there doesn't seem to be any force that would alter this trend. If this argument is correct, it has relevance to increasing income inequality and supports the secular stagnation hypothesis.