Lecture 10: The money supply process
Lecture 5.2
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The money supply process (part 2)
Money creation in the modern economy, Bank of England 2014
Learning objectives
Review the process by which bank lending creates deposits
Understand key features of the modern central banking view of this process:
the chain of causation runs from loans to deposits to reserves
this is the opposite of the traditional view
the money supply is endogenous (determined by the economic system)
central banks adjust the quantity of reserves to meet demand for reserves
the interest rate is the monetary policy instrument of control
Contrast this with the traditional view of causation presented by Mishkin
Relationship between the two approaches
Note: All of the balance sheet identities and algebraic expressions set out in Part 1 remain valid
However, the modern central banking view asserts that cusation works in the opposite direction
Two misconceptions about money creation
First misconception: household saving creates bank deposits
Reality: household saving and spending decisions only redistribute deposits between banks
Second misconception: central banks control the amount of money on deposit in banks by constraining the supply of reserves (the money multiplier approach)
Reality: modern central banks work by managing the price of reserves (the policy interest rate) not the quantity of reserves
Why study the money multiplier approach
Useful for introducing basic concepts in money and banking
Explains why the stock of broad money is so much larger than the monetary base
Useful for analysis of less developed, or highly regulated, banking systems
But, no longer used in monetary analysis in modern central banks
Money creation in reality
Most money in circulation now is in the form of bank deposits, not currency
Those deposits are created by the commercial banks themselves
They do this by making loans
This process can happen without any initial increase in bank reserves
After the event, the central bank may supply some more reserves if needed (not shown) if bank actions generate a shortage in availability of reserves
Some additional points
It is not correct to say that banks can only lend out pre-existing money
The availability of reserves at the central bank is not a constraint on bank lending in practice: there is enough ‘slippage’ at the margin
The central bank will typically supply the amount of reserves that the system needs
This means that the volume of deposits is determined by the supply and demand for bank loans
By the same argument, money can be destroyed by the opposite behaviours: thus repayment of loans reduces the amount of deposits in the system
Limits to broad money creation
Market forces acting on banks stop them from expanding credit without limit
At the margin, new loans become riskier
Limited appetite for debt by households and businesses
Monetary policy decisions of the central bank: A higher interest rate will tend to reduce bank lending and hence deposit creation
The central bank responds systematically to excessive expansion of money and credit
Market forces facing individual banks
While the availability of reserves is not a constraint on the system as a whole, each individual bank has to compete for its share of deposit and loan markets
Aggressive pricing to increase market share can reduce a bank’s profitability:
a bank that lends “too much” will have to compete more aggressively to expand its share of deposits
it may also have to compete aggressively on the loan interest rate
it also has to lend to customers who are increasingly risky
new customers with uncertain prospects
existing customers with too much debt already
Competition for market share in attracting deposits
Credit risk as a constraint on lending
A bank seeking to expand its share of the lending market may face an increase in credit risk
To compete in this way, they may need to accept a less favourable risk/return combination
In other words, they are lending to less creditworthy borrowers
Regulatory requirements as well as market forces will limit the extent to which banks can expand in this way
Hence, both credit risk and cost of attracting deposits represent practical constraints on expansion by an individual bank
These constraints are less onerous if the system as a whole is expanding
Constraints arising from behaviour of households and businesses
A generalised desire by banks to expand can generate higher loans and deposits, which the central bank would accommodate with higher reserves
In aggregate this is constrained the demand for credit by households and businesses, which will be limited by factors such as
household income (current and expected)
business investment opportunities
variable risk appetite
the interest rate (controlled by Central Bank)
Banks can’t create loans to the non-bank sectors if households and businesses don’t want to borrow, if they already have too much debt, or if they are seeking to repay debts
Monetary policy is the ultimate restraint on money creation
Central bank objectives are typically defined in terms of output and inflation
The policy instrument for achieving the objectives is the short term interest rate (the rate setting approach to monetary policy)
The policy rate of the central bank is very closely related to the interest rate on bank reserves
Central banks supply reserves to the banks as much as demanded at that rate
They do this by being willing to either lend to banks or accept deposits from banks at that rate (plus or minus a small margin)
Other things equal, a higher policy rate will tend to discourage lending and money creation. A lower rate will encourage these.
Summary: The chain of causation – two views
Classical view
Quantity setting
MB → R,M → P,Y
The money base is the instrument of CB monetary policy
The interest rate and broad money are part of the chain of causation that ultimately affects prices and output (P and Y)
Modern view
Rate setting
R → P,Y → M,MB
The interest rate is the instrument of CB monetary policy
The money supply and money base are, at best, sources of information that CBs can use in making their decisions
Implications of the Zero Lower Bound (ZLB)
The ZLB is a large topic which we don’t cover in this course
In summary, the ZLB has led to adoption of policies which have features of both views:
rate-setting, until the ZLB is reached
quantitative easing (QE) introduced as an additional tool at that point, if needed
Quantitative easing: direct money creation by the central bank
Quantitative easing (QE) has become an accepted policy tool of major central banks since the GFC and Covid pandemic
Reason: interest rates reached their effective lower bound in the major economies and there was still too little money creation given the macroeconomic objectives of the central banks
Solution: direct money creation by the central bank
Method: central bank purchases assets from the non-bank sector
eg purchase of government securities from a private pension fund (see next slide)
QE expands the quantity of money
CB accepts securities from a pension fund and pays money into the bank account of the pension fund
This represents a direct creation of bank deposits
As a byproduct of this transaction, an equivalent quantity of bank reserves is also created
Two misconceptions about QE
First misconception: “free money to the banks”
Reality: banks do receive an additional quantity of reserves (an asset) but this is just the counterpart to the additional liability (bank deposits). It’s an asset purchase, not a gift
Second misconception: QE is automatically inflationary because it leads to a much larger increase in broad money through the money multiplier process
Reality: there is no necessary link between bank reserves and lending.
In practice QE has been implemented at a time of insufficient money creation by banks and has been associated with persistently inflation rates persistently below target
It is a tool for resisting deflation
RBA policy announcement, 19 March 2020
Part of initial respond to Covid effects on the economy
Cash rate cute to 0.25 per cent (not expected, at that time, to fall further)
QE is introduced, with a target yield on 3-year government bonds of 0.25 per cent
RBA will buy enough bonds to stop the yield from rising
Term lending facility to banks of at least $90bn
up to 3 per cent of current loans outstanding for each bank
more available if a bank increases its lending
QE: Summary
QE always adds to bank reserves
If the QE asset purchase if from the non-bank sector, it also adds directly to bank deposits, and hence broad money
If the QE action is a transaction with the banks, it adds to bank reserves, but only adds to broad money if banks respond by expanding their lending
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