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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
