It's the Roe v Wade of the blogosphere, a battle that never quite gets resolved. Nick Rowe and David Glasner have been having one of their bi-annual debates over the ability of private bankers to create excess deposits. See here, here, and here.
The nub of their conflict seems to
At the risk of only adding noise to what is always an interesting debate, I'm going to chime in. I'm going to focus on the step-by-step process by which events play themselves out, the bricks & mortar if you will. Given the complexity of this process there will no doubt be errors in this post, hopefully readers will flag them.
The thought experiment that Nick and David have been debating involves a simultaneous increase in deposit rates and the quantity of deposits via loans. But I'm going to focus on just an increase in deposit rates first, then bring in the quantity adjustment later.
Let's start out with a full spectrum of assets, including central bank liabilities (cash and reserves), bank deposits, durable assets (i.e. gold, houses, stocks, and bonds) and perishable assets (apples, soap, jeans). All provide varying expected pecuniary returns (i.e. dividends, interest, and capital appreciation) as well as expected non-pecuniary returns (consumption and liquidity), the sum of which adds up to an asset's total return. In equilibrium, every asset offers the same total expected return.
What do we mean when we say that cash and deposits are imperfect substitutes for each other? Like cash, deposits are useful in a wide range of transactions. However, unlike 0% banknotes, deposits yield interest. Given that deposits provide both interest income and broad marketability, people will prefer to only hold the bare minimum of cash that they deem necessary.
What dictates this bare minimum? The marginal unit of cash that an individual holds in their wallet has been specifically accumulated to deal with a unique set of transactions in which deposits simply cannot participate. This unique set of transactions occurs in markets where digital payments are not allowed, say laundromats, farmers' markets, or cash-only diners; or where fees are levied on card payments, like gas stations; or in places where payments must be anonymous, like in the back alley behind city hall.
On the margin, people try to anticipate the chances of engaging in these sorts of cash-only transactions and accumulate what they deem to be an appropriately sized cash inventory. So while an individual's inventory of 0% cash does not provide a pecuniary return, it does provide a non-pecuniary liquidity return arising from its ability to be used in both a broad set of transactions in which it competes with deposits, and a narrower set of transactions in which only it is useful.
Now say that banks have figured out a way to cut costs. Their profits grow, but this only lasts a short time as competition forces them to increase the interest rate they offer on deposits. Given stationary pecuniary yields and non-pecuniary yields on cash, durables, and perishable assets, deposits now offer the best return. An excess demand for superior-yielding deposits and an excess supply of inferior-yielding durable assets, perishable assets, and cash emerges.
A number of adjustments need to occur in order to restore equilibrium. Along the margin of deposits-to- durables and perishables, an effort to simultaneously sell these assets for deposits will result in a fall in the their relative price. Their prices will fall until they stabilize at a low enough level that they are now expected to appreciate at a rate sufficient to equal the return provided by deposits. This resolves the excess demand for deposits along both the deposit-to-durable asset margin and the deposit-to-perishable asset margin.
Things are a little trickier along the deposit-to-cash margin. Given the superior return on deposits, people will now want to hold more deposits. An excess supply of cash develops. Unlike the durable and perishable asset markets, the cash-to-deposit market is inflexible; the price of cash cannot fall relative to deposits in order to restore equilibrium.
What happens instead is a quantity adjustment; people begin to sell cash for deposits at a fixed rate of one-to-one. The market where they go to do this is at a bank. They don't "sell" cash. Rather, they deposit cash at the bank in return for higher-yielding deposits. They continue to deposit cash until the benefits of adding one more unit of deposits to their portfolio, namely the marginal enjoyment provided by their higher pecuniary return, no longer exceeds the foregone benefit of one less unit of cash, namely their ability to participate in prospective cash-only transactions.
Once people have reduced their cash balances to a point at which they are once again indifferent between cash and deposits, equilibrium has once again been restored along the cash-to-deposit margin.
So in short, an increase in deposit rates causes a temporary excess demand for deposits in the deposit-to-cash market as well as the deposit-to-durable and perishable asset markets. These excesses are quickly removed by a fall in the prices of durable and perishable assets, and a quantity substitution of cash for deposits.
I'll bring this back to Rowe v Glasner in a moment, but as an aside it's worth noting that the process doesn't halt here. Having sold deposits for cash, the banks now have more cash than they desire. Their excess balances are trucked over to the central bank where they are converted into reserves, or clearing balances. But banks don't really want these either. Instead, they will all try to spend away their reserves simultaneously on durable assets, or try to lend them in vain to other banks in the interbank market. This pushes prices of durable and perishable assets higher and the interbank rate lower. At this point the central bank, noticing that its target for the interbank interest rate has deviated from its target, steps in and mops up all the excess reserves by conducting open market sales. This pushes the interbank rate back up to target. Voilà, the excess quantity of cash (and reserves) has been removed, first by depositors forcing cash back on banks, and then banks forcing the cash back on the central bank.
Let's circle back to Nick and David's argument. They were considering not just an increase in deposit rates, but a simultaneous increase in deposit rates and the issuance of new deposits. I'd argue that the same process that I've just described applies to this second scenario.
The rise in deposit rates causes durable and perishable asset prices to fall. At the same time, the new deposits are spent into the economy by borrowers. Individuals now hold more deposits than before, but they still own the same quantity of cash, an undesirable situation for them since cash is providing an inferior return relative to deposits. How can they rid themselves of this unwanted cash? If one person sells their horde, the next person will only try to sell it to someone else, and someone else. The cash never leaves the economy.
But here's an out. At some point an individual who is in debt to a bank will come into possession of that cash and will use it to reduce the amount owing. That cash will take the same route back to the central bank described earlier, ultimately meeting its demise in the blades of a paper shredder.
So given an increase in deposit rates and the emission of more deposits, the final resting point is a fall in durable and perishable asset prices, and an increase in the amount of deposits at the expense of the quantity of cash. That leaves us in the same spot as an increase in deposit rates alone.
Where does that place me relative to Nick and David? If it takes a while for unwanted cash to find a debtor who will reflux that cash back to the banks, then we can see the sort of effects that Nick describes. But on the whole, I think I'm more on David's side here. But that's hardly surprising. As Nick usually says, he's arguing against the mainstream view. The odds always were that I'd land in the same bucket as the majority. Anyways, for what it's worth, those were my two-cents.
Before I sign off, let's follow one final tangent. Thanks to higher deposit rates, one of the features of my final resting point is lower durable and perishable asset prices. But after a few months, our central bank will notice that the incoming data is showing that the price of perishable assets has ticked down. The perishable asset category, which includes things like jeans, apples, and soap, is the category of assets the prices of which a modern central banker targets. In an effort to right deflation in the perishable goods market, our central banker will counter by reducing the return on reserves. (He/she can do so by conducting open market purchases and/or by reducing the interest rate corridor). Banks will react by simultaneously trying to offload their inferior-yielding reserves in favour of durable and perishable assets. Prices will rise back to the central bank's target.
So a fall in prices that was kicked off by commercial banks sweetening the return on deposits is ultimately reversed by a central bank reducing the return on central bank liabilities. Tit-for-tat. Here I definitely agree with Nick Rowe—central banks are alpha banks. Commercial banks can only have a passing influence on the price level if a central banker decides to have his or her way.
Suppose that bikes and cars are closer substitutes for each other than they are for any other good. Suppose there exists a barter market where bikes can be traded for cars. Increase the stock of bikes, holding the stock of cars constant, holding the price of cars constant, but reducing the price of bikes (or subsidising ownership of bikes) so that nobody wants to swap a bike for a car in the barter market. There is now an excess supply of both bikes and cars in the markets where they are traded for money. There is an excess supply of both "transportation services".ReplyDelete
The easiest thought experiment is an increased demand for bank loans, or an increased supply of bank loans, because banks get better at distinguishing good and bad loans. Banks make loans by creating deposits, and at the same time increase interest on deposits to prevent reflux into currency. Assume desired reserves are zero, and the central bank holds the base constant. With deposits and currency being (not necessarily perfect) substitutes for each other, we now have an excess supply of both currency and deposits in other markets.
I see where you're coming from. I think we have different assumptions. Your cars and bikes provide "transportation services", and your currency and deposits provide, say, "liquidity services".Delete
But I tend to stretch the quality of providing liquidity services across all assets. So all assets are imperfect substitutes for each other in terms of the provision of liquidity. If we assume that there is a given economy-wide demand for liquidity services, then we could have an excess supply of liquidity services, but the adjustments would be complex. For instance, people might adjust by reducing their holdings of liquid stock rather than trying to sell deposits or cash. I didn't really get into that in this post.
Nick, in your original post, when you wrote "hold alpha money constant" was that equivalent to "hold the base constant?" (i.e. reserves and currency in circulation?)Delete
As an aside: reserves and deposits are complements, but currency and deposits are substitutes.ReplyDelete
If the desired currency ratio were smaller than the desired reserve ratio, could we not get the reverse results, where an increased supply of deposits, plus increased interest on deposits to prevent reflux, would be deflationary?
JP: "So given an increase in deposit rates and the emission of more deposits, the final resting point is a fall in durable and perishable asset prices, and an increase in the amount of deposits at the expense of the quantity of cash. That leaves us in the same spot as an increase in deposit rates alone."ReplyDelete
Sure, if the central bank reduces the base in response to an increased supply of deposits, we don't necessarily get the excess supply of currency and deposits. But I thought we were assuming the stock of base remains fixed during the thought experiment? I was assuming this, anyway.
Ah, ok. Then I would say that we end up with an excess supply of reserves which can only by rectified by a rise in all prices. Does that bring us closer? I don't think that I'm agreeing that the excess supply of bank deposits continues to exist, however, which is your point.Delete
I'm happy to roll with any thought experiment, but may I ask what is the idea behind assuming a fixed quantity of base money? Because if base money is central bank money, the supply is perfectly flexible. Only if it's a commodity like gold would the supply be somewhat inflexible (even gold would be more flexible than the thought experiment, because the excess gold would eventually be consumed. The price level would be unchanged in the long run).Delete
I think it's just a simplifying assumption. Remove a few variables so one can focus on what remains.Delete
If bankers raise deposit rates and increase deposits to match the added demand to hold them, then there is no excess supply of money generated.ReplyDelete
However, there is no plausible market process by which bankers have either a signal or incentive to adjust the deposit rate sufficient to keep the demand for deposits equal to the quantity.
A surplus of money doesn't cause those holding deposits to resell them to those more willing to hold deposits, though at a lower price and higher yield . Those with surplus deposits spend them on a variety of things, and those selling those goods accept the deposits even if they don't want to hold deposits but in turn plan to spend them.
Now, one of those things that deposits might be spent on is hand-to-hand currency issued by the central bank. And if there is a redemption requirement, and the quantity of that currency stays constant, then a shortage of currency brings the process to a stop.
If all money is issued by banks, then that process doesn't occur.
If banks use reserves for clearing, and the demand for clearing media increases with expenditures, which is likely, then even excess supplies of money are stopped as long as the quantity of reserves are fixed.
Tobin, who Glasner celebrates, is used a straight Keynesian analysis. It isn't the interest rate on deposits that rises. An excess supply of money primarily lowers the interest rate on bonds. The interest rate on deposits is assumed sticky, and so the interest margin falls. This makes issuing excess deposits unprofitable.
If the interest rate on deposits were flexible, then rather than rise in that circumstance, so that people are willing to hold the added deposits, the more likely result is that they would fall to reflect the lower market returns on earning assets.
If you focus entirely on equilibrium states, then the problems of an excess supply or demand for bank money are ignored. It is a disequilibrium, process analysis. The only equilibrium with a higher quantity of bank money is one with a higher interest rate paid on deposits. If you assume a Walrasian Auctioneer, then he will call out higher deposit rates, find out how much banks want to issue and people hold, and a higher quantity of bank money must be associated with higher deposit rates.
In an actual market process, disequilibrium is possible but redeemability will bring any disequilibrium to a halt.
What about the use of excess deposits to pay back existing debts? Doesn't that bring an excess issuance of deposits to an end?
By the way, I'm really curious what you think about this post, Credit cards as media of account. (Nick, did you have a chance to read it?)
Bill, I left a comment for you on your blog about MoA and UoA. ... but the question is the same as in JP's footnote (1) for the article he links to above. It's about what to do with what he called the "Tom Brown Multiple":Delete
1. Attach it to the UoA
2. Attach it to the MoA
3. Nothing, it already has a name all on its own (which I'm sure is not "Tom Brown")
There are a lot of moving parts here but the main ones seem to be:ReplyDelete
1. The quantity of base money. Assume this is totally controlled by the CB.
2. The division of base between cash and bank deposits (assume that "deposits" and "reserves" are synonyms for the same thing, or at least perfect substitutes.). People can on demand exchange cash for deposits just by going to a bank. The amount of cash people want to hold will be a function of the price level and the interest banks offer on deposits. Assume also that banks have (by law) to maintain a 1/1 ratio between cash and credit money.
3. The ratio of deposits to credit money. Banks have control over the interest rates they charge for loans and the interest rate they pay on deposits. They will set these two rates (and the spread between them) in order to maximize profit (while also maintaining the 1/1 exchange rate)
Assume a fixed base (that is a passive CB that will not change the base whatever happens).
Holding everything fixed there will be at least one equilibrium for prices (of both assets and consumer goods) , interest rates, cash, deposits and credit money.
If anything changes then all these things will need to change again to find a new equilibrium.
If (as in Nick's example) banks discover a better way of evaluating the risk on loans then they will be able to lower the rates they charge for loans and (I think?) increase the ratio of credit money to the deposits they hold. This will increase the combined qty of cash and credit money and trigger a series of changes including (but not limited to) the following:
- Upward pressure on prices due to the increase in the money supply
- Upward pressure on the rates banks pay on deposit as they have to make sure they maintain the 1/1 exchange rate between cash and credit money.
- Adjustment of asset prices both in response to the change in the price level and the need to equalize the liquidity- and risk- adjusted- rates of returns on cash, bank accounts and the various types of assets available.
Ultimately I think it is the arrays of these various interest rates and rates of return adjusting to reflect the underlying time preference, risk appetites, and liquidity preferences of the players in the economy that drives the price level and the size of the money supply (again assuming a passive CB).
Hi Rob, what exactly do you mean by "credit money"? You seem to differentiate it from deposits. Aren't they the same thing?Delete
I was defining "credit money" simply as loans made by banks so that the total broad money supply will be loans + bank notes.Delete
I now see (as a result of your question) that I was incorrect to say that "reserves" and "deposits" were synonymous. Obviously as money is lent out it will end up in banks as deposits. Deposits need to be distinguished from "reserves" - which will be that part of base money held by banks to settle interbank transfers or to allow there customer to convert deposits into banknotes.
I think you are correct that "credit money" and "deposits" will be then be the same thing.
Thanks for identifying that error ! (Hope I have it straight now)
Ok, I understand your point a bit better.Delete
Another thing is this:
"Upward pressure on prices due to the increase in the money supply"
In this story we've got all sorts of money-like assets from cash to deposits to reserves to liquid durable & perishable assets. What comprises this "money supply" that puts upward pressure on prices? Assuming that base money stays constant, I see it in the end as excess reserves that provides the pressure (after the public has deposited cash at banks and banks have switched these into reserves), you seem to think that it is the combination of deposits & cash.
I was envisaging that as well as money (credit plus notes) there would be range of other assets with varying degrees of liquidity and risk as well as steams of consumer goods and services being produced.
As (in this simple world) things other than money are valued in money terms then as the quantity of money increases due the kind of think Nick is talking about then the prices of these non-money things will have to adjust.
Ultimately all assets in the economy have to a rate of return that will induce people to hold the available stock of them. The rates of interest on deposits and loans will then have to be at an appropriate level to keep the balance between cash and deposits stable, keep the the return on deposits aligned with the return on other assets, and keep the level of consumption and savings in line with a healthy level of employment in the economy.
So many moving parts it makes my head spin.
And the qty of money would increase if (for example) banks found a way to lend more against the same qty of reserves.Delete
This would mean they would have to to lower the loan interest rate to attract borrowers , and increase the rate they pay so that people have an incentive to keep enough of the newly created credit money and not convert it into base money (cash).
The prices relative to returns of all other assets would also have to adjust to keep all the rates of return lined up correctly.
JP, I was just going to ask you about your take on this... when I noticed you had a post on it and that Rowe and Bill Woolsey have been here making comments! Excellent. I'll dig in. :DReplyDelete
"The nub of their conflict seems to resolve around"
"resolve around?" ... If ONLY!! Lol
"competition forces them to increase the interest rate the offer on deposits"Delete
should be "they offer"
"reduce the amount owing" or "reduce the amount owed?"Delete
Tom, good catches. "Resolve around" must have been a Freudian slip. I think we all wish that Nick and David would resolve their debate, closure is satisfying to the mind.Delete
I'd say "reduce the amount owing", as in the individual in question is in debt to the bank and reduces this debt by submitting banknotes.
I find I'm learning so much from the back and forth on this issue (both from Nick and David plus related posts like this one) - I hope they never resolve it !Delete
JP this is a really nice recap of the debate! Thanks so much... there were a couple of things I didn't follow, but I'll have to come back to it later. I may have some questions for you. Thanks so much for doing this! I was going to try to map out the whole debate myself, but I kept wanding down some of the dead ends in the argument,... plus I never could have done as great a job as you did here. I also want to carefully look at Nick's and Bill's comments when I have a chance. I fee like making a flowchart out of all this... it's quite complicated.ReplyDelete
You have a talent for clearly explaining this kind of thing!Delete
BTW, is it *really* round #33??Delete
I haven't counted the number of rounds, but it's up there.
Really nice post.ReplyDelete
Superb job on the bricks and mortar.
Phew, I passed the JKH test. Was worried about that.Delete
"Having sold deposits for cahs" ... only in Boston... Oh, you mean cash. :DReplyDelete
Sorry, JP, probably me being thick.ReplyDelete
Act I: deposit rate(+),
Act II: deposit rate(+), loans(deposits)(+)
re:"[in Act II ] an excess supply of deposits and cash will emerge. Nick argues for the last point while David argues against it."
I think you are arguing that: Act I and II give the same macroeconomic effect (same price adjustment), so there cannot be an excess supply of deposits.
I was surprised Nick didn't argue that in Act II, that prices do adjust during the time the cash is experiencing a hot potato. Prices first increase, then decrease as the cash gets slowly converted to deposits in the final equilibrium. Act II isn't the same as Act I, assuming the price changes are cumulative.
Also, this way of describing the debate may be unfair to Nick's POV:
(1) argument rests essentially only on the deposit rate in determining prices (i.e. determining prices on excess cash yielding 0% ... what's the model?); essentially a linear state model.
(2) it is much easier to argue for the end point, given (1), and assume disequilibrium is transitory and not cumulative.
In a general nonlinear system, I would guess I and II would be different.
Anyways, great recap.
"I think you are arguing that: Act I and II give the same macroeconomic effect..."Delete
Yep, pretty much.
"assuming the price changes are cumulative."
I'm not entirely sure what you mean by 'cumulative'.
"Act II isn't the same as Act I, assuming the price changes are cumulative."Delete
Price change: cumulative
Act I: dPrice(deposit interest)
Act II: dPrice(deposit interest) + dPrice(HPE)
One could argue this case, as if participants do not know the future, but they do see an initial HPE price adjustment, then they adjust their price expectations from this new level.
Price change: transitory
Act I: dPrice(deposit interest)
Act II: dPrice(deposit interest) ... dPrice(HPE)_initial~=0, but dPrice(HPE)_final=0,
One could argue this case for perfectly rational participants knowing the "cash injection" to be temporary.
I have thought about this some more and re-read your post and there's a bit I don't understand.
"At the same time, the new deposits are spent into the economy by borrowers. Individuals now hold more deposits than before, but they still own the same quantity of cash, an undesirable situation for them since cash is providing an inferior return relative to deposits. How can they rid themselves of this unwanted cash? If one person sells their horde, the next person will only try to sell it to someone else, and someone else. The cash never leaves the economy.
But here's an out. At some point an individual who is in debt to a bank will come into possession of that cash and will use it to reduce the amount owing. That cash will take the same route back to the central bank described earlier, ultimately meeting its demise in the blades of a paper shredder."
Why can't they just take the money to the bank and convert it into deposits (in the same way you describe earlier in your post when interest rates have risen) ? Why does it need to be used to pay off a loan ? The way I was thinking about it for a given qty of broad money banks will always have to set the interest rate on deposits to the level that will keep the exchange rate between the "base" part of broad money and the "deposit" part at 1/1.
"Why can't they just take the money to the bank and convert it into deposits (in the same way you describe earlier in your post when interest rates have risen)?"Delete
In the second part of my post the initial rise in deposit rates has been combined with the simultaneous issue of new deposits as borrowers spend. In aggregate, people won't want to switch cash for deposits because unlike the first part of my post, they already hold an appropriate amount of deposits at given rates (thanks to the new issuance). They'll want to rid themselves of their excess cash, the two options being spending on durables and perishables, or retiring bank IOUs. In the former case, the cash never actually exits the system, but at some point it will exit via the latter, restoring balance along all margins.
On your second point, banks keep the exchange rate between base money and deposits at 1:1 via their convertibility promise.
When these loans are retired won't banks then have additional reserves they could lend out again ?Delete
The flow would be (treating banks in aggregate)
- banks discover a way to increase spending against their current level of reserves.
- They make a loan to A
- A buys an asset from B
- B has an outstanding loan that he uses the receipts of the sale to pay off
- banks are then is the same position as before they made the loan to A and will look for additional lending opportunities (even if they have to offer a lower rate of interest to do this).
"lending" not "spending"Delete
"When these loans are retired won't banks then have additional reserves they could lend out again ?"Delete
Since we're back in equilibrium, when banks try issuing new deposits these deposits will only reflux back to their issuer.
JP, Sorry for not commenting earlier on this post. Here are a few observations and comments.ReplyDelete
"unlike 0% banknotes, deposits yield interest. Given that deposits provide both interest income and broad marketability, people will prefer to only hold the bare minimum of cash that they deem necessary."
That's not quite right. We have no way of knowing what the "bare minimum is," but presumably at any given interest rate on deposits, there is some further increase in that interest rate that will induce further economies in the holding of currency. You probably understand that already, but your phrasing suggests something else.
Talking about the deposits-to-durables and deposits-to-perishables margins was a nice touch that I overlooked in my discussion. I think you are correct that the new equilibrium would involve a reduced price for durables and perishables. I would just add that those are once-and-for-all shifts that should not trigger a response by the monetary authority, at least if the monetary authority correctly understands what is happening.
"They [Nick and David] were considering not just an increase in deposit rates, but a simultaneous increase in deposit rates and the issuance of new deposits.
Actually that was Nick's formulation. I posited an increase in deposit rates, and inferred an increase in deposits from the response by the public to the increased rate paid on deposits. I don't understand where Nick got the increase in deposits from.
"If one person sells their horde, the next person will only try to sell it to someone else, and someone else."
I think you meant to say:
"If one person sells [his (or her) hoard], the next person will only try to sell it to someone else, and someone else.
"So a fall in prices that was kicked off by commercial banks sweetening the return on deposits is ultimately reversed by a central bank reducing the return on central bank liabilities. Tit-for-tat. Here I definitely agree with Nick Rowe—central banks are alpha banks. Commercial banks can only have a passing influence on the price level if a central banker decides to have his or her way."
What part of that paragraph do you think I disagree with?
Hi David, thanks for stopping by.Delete
"What part of that paragraph do you think I disagree with?"
I don't think that you'd disagree with the bit about alpha banks either. By that last paragraph, I only mean to say that having disagreed with Nick that there will be excess deposits, I do agree with him about his alpha banks/beta bank dichotomy.
"I would just add that those are once-and-for-all shifts that should not trigger a response by the monetary authority, at least if the monetary authority correctly understands what is happening."
That's an interesting point. Out of curiosity, why shouldn't it trigger a response from the central bank? ... and how is a central banker supposed to correctly divine in this situation that it is changes in bank deposit rates that have caused these once-and-for-all shifts and not some other force at fault (perhaps the natural rate has changed?).
I really do need a good rule of thumb for distinguishing between horde and hoard.
"Actually that was Nick's formulation."
I realize that. I too found it a confusing setup, which is why I tried to attack it by first thinking about an increase in deposit rates alone, and then an increase in lent deposits & a rise deposit rates. Either way, the deposit:cash margin will be balanced by a decrease in cash in circulation and an increase in new deposits relative to the previous equilibrium.
JP, O/T: Commentator HJC at Nick Rowe's blog dug out his copy of Niehans book:ReplyDelete
I asked him a follow up question using Bill Woolsey's electricity example:
Thanks Tom. So where does that leave us?Delete
Still not sure, but I think what HJC said most recently (check the thread) is most similar to my Option 3, which in turn is most similar to your interpretation. I've now asked him if he can:Delete
1.) Frame Bill Woolsey's electricity example in terms of MOA, UOA, and MOE
2.) Take a look at Marcus Nunes' example (a real world example) in which he first referred to MOA, but then when I pointed out Sadowski's comment to him regarding UOA, he commented that perhaps UOA would have been a better term. If HJC can clear that one up it'll be interesting. I think Marcus 1st favored your interpretation, and I suspect HJC will too. But we'll see.
3.) Also asked him to identify the all three (MOA, UOA, MOE) in his Roman denarius example.Delete
Here's HJC's latest:Delete
A little more on this from HJC and Sadowski:Delete
You all also need to consider that this counterparty-risk-free imperfect-substitute model is not applicable in the real world.ReplyDelete
A bank deposit is an unsecured loan to the bank (depositors are subordinated fairly deeply, especially to the bank's derivative liabilities), while cash currency is entirely counterparty-free.
Bank deposits are inferior -- unsecured liabilities to the banks balance sheet -- to cash on this basis. Interest is paid on deposits because deposits are inferior to cash.
There are liquidity advantages to deposits, but only as far as (changing) counterparty risks allow. There would be liquidity advantages to cash currency, if you assume a different counterparty risk environment (which is historically entirely possible).
Geez, you really want to make this complicated, don't you? ;)Delete
Yes, you're right that there are different credit risks. It certainly makes cash and deposits a little less substitutable. I don't think it affects my conclusion surrounding the excess supply (or not) of deposits too much, though.
JP, I think this accounts for the different ways you and Nick paint an increase in interest on deposits: Nick implies that's it's required if deposits are increased through lending to keep reflux from happening due to the imperfect subsitutability of deposits wrt cash. You however, assume first that interest on deposits is increased and thus see a flow from cash to deposits (cash being redeemed for deposits). Perhaps Nick had in mind that deposits were more undesirable than cash (because of this risk problem?), and thus need to have interest paid on them to exist.Delete
JP, I have several questions, but let me just limit myself to one right now. I generally followed you up till this paragraph:ReplyDelete
"The rise in deposit rates causes durable and perishable asset prices to fall. At the same time, the new deposits are spent into the economy by borrowers. Individuals now hold more deposits than before, but they still own the same quantity of cash, an undesirable situation for them since cash is providing an inferior return relative to deposits. How can they rid themselves of this unwanted cash? If one person sells their horde, the next person will only try to sell it to someone else, and someone else. The cash never leaves the economy."
That 1st sentence:
""The rise in deposit rates causes durable and perishable asset prices to fall."
makes sense in terms of what you've already covered, namely this:
"So in short, an increase in deposit rates causes a temporary excess demand for deposits in the deposit-to-cash market as well as the deposit-to-durable and perishable asset markets. These excesses are quickly removed by a fall in the prices of durable and perishable assets, and a quantity substitution of cash for deposits."
So you say "but they still own the same quantity of cash" and yet you sketched out before that one of the effects of raising the deposit rate was "a quantity substitution of cash for deposits." So why is the quantity of cash the same but we know that cash will be swapped for deposits due to the rise in the deposit rate?
So when you ask
"How can they rid themselves of this unwanted cash?"
Why can't they swap it for deposits as they did before?
Plus, you still have the "cahs" typo. :DDelete
See this comment, which is similar.Delete
Sure, individuals can swap cash for deposits in the scenario outlined. Unlike the first example already covered (deposit rates only increase) they already have the appropriate quantity of deposits (remember, deposit rates have increased and new deposits have been issued). So if if they do choose to swap excess cash for deposits, they'll only spend these on until someone who has a debt to pay to the banks gets rid of those deposits by settling that debt.
So short answer, things can equilibrate by people either paying debts with cash, or depositing that cash and paying debts with these deposits.
JP, also, I'm trying to entice Nick Edmonds into doing one his simulation models to represent what you've go going in here in words to help us see under what assumptions some of what you describe happens:ReplyDelete
"JP, also, I'm trying to entice Nick Edmonds into doing one his simulation models to represent what you've go going in here in words"Delete
"JP, also, I'm trying to entice Nick Edmonds into doing one of his simulation models to represent what you've got going on here in words"
Also, this guy (Jason Smith):
Nick always like to say that money (MoE) (and this includes base money as well as commercial bank deposits) is special: that it's not like other goods. I wonder if loans also have a special quality... not the same one as money. But here's the sense in which loans might be considered a special good (I'm thinking of loan-principal dollars generally sold to banks by borrowers): A bank buys loans and then it is free to sell them. But generally (although there may be restrictions on this), the bank often agrees to sell back loan-principal dollars to the borrower (and only the borrower) at par: dollar for dollar. I realize that sometimes there are prepayment penalties, but this is often eliminated after a period of time.ReplyDelete
BTW do the loans that banks buy count as "durable goods" here?
JP, on your detour above, examining what happens if the CB is targeting an overnight rate on reserves and that starts to fall (your 15th paragraph), you write:ReplyDelete
"But banks don't really want these [reserves] either. Instead, they will all try to spend away their reserves simultaneously on durable assets"
A few points:
1. What would have happened had the banks not exchanged their excess vault cash for CB deposits? Then they would have presumably attempted to purchase more "durable assets" with cash directly, true? Then that would push the cash the public exchanged for deposits right back into the hands of the public, no? Since the banks cannot reduce their reserves except through letting it walk out the door as cash (if the CB is not involved and other non-bank CB deposit holders are not involved).
2. You write about the banks' trying to purchase more durable assets here, but then also say that both durable and perishable assets will experience price increases, why both? Because that needs to happen to keep the relative prices of durable and perishable assets in equilibrium?
3. In your 21st paragraph, you write: "Banks will react by simultaneously trying to offload their inferior-yielding reserves in favour of durable and perishable assets." Again, why in this case do the banks try to offload reserves for BOTH durable and perishable assets, while in the 15th paragraph it's only durable assets they're after?
"Then they would have presumably attempted to purchase more "durable assets" with cash directly, true? Then that would push the cash the public exchanged for deposits right back into the hands of the public, no?"Delete
Yes and yes.
"Because that needs to happen to keep the relative prices of durable and perishable assets in equilibrium?"
Yes. Arbitrage will bring them back into equilibrium. Although perishable prices tend to be sticky, so it might be slow.
"Again, why in this case do the banks try to offload reserves for BOTH durable and perishable assets, while in the 15th paragraph it's only durable assets they're after?"
I should have said just durables, since banks usually don't buy perishables.
Last comment today I think:ReplyDelete
In the 1st part of this post (paragraphs 1 - 14) you describe an increase in deposit rates and gave a good plausible reason for it in paragraph 9:
"Now say that banks have figured out a way to cut costs. Their profits grow, but this only lasts a short time as competition forces them to increase the interest rate they offer on deposits."
So an exogenous change (a new way to cut costs via new technology perhaps), results in increased deposit rates on interest paid by banks.
But in the second half of your post, starting at paragraph 16, you postulate that rates of interest on deposits and the total dollar value of all deposits BOTH increase (the latter due to increased lending by banks). However, you don't give a good reason why this makes economic sense for the banks. Can you give an example (akin to cost savings you postulated in the 1st part) of what would cause both deposit rates and deposits/lending to increase simultaneously?
It seems to me that the reason this happens may be important, since if people were to start repaying loans, the banks might be incentivized to make even more loans to compensate for it.
"However, you don't give a good reason why this makes economic sense for the banks. Can you give an example (akin to cost savings you postulated in the 1st part) of what would cause both deposit rates and deposits/lending to increase simultaneously?"Delete
I was just rolling with Nick's thought experiment. I'm not sure if there is or isn't a good economic reason for it.
Nick says it was to maximize profits I thought. I'll check.Delete
Yep, here it is:Delete
"What I had in mind was something changing so that individual banks found the old equilibrium no longer profit-maximising, so they found it profitable to expand loans and deposits even if they needed to increase interest rates on deposits to dissuade people from swapping those deposits for central bank money and prevent the Law of Reflux kicking in." -- Nick Rowe
I just asked Nick if he could give an example of what that "something" might be which changes.Delete
OK, how about this for an example which causes some disequilibrium in the loans market: What if it's discovered that the credit ratings agencies all had glitches in their algorithms or software, and that it turns out a lot of people previously reported as being a bad credit risk indeed are actually good credit risks. The banks re-examine their loan applications and contact those affected whom they'd previously turned down.Delete
So now the banks want to expand lending to increase their profits, and it makes sense to do so because suddenly a whole new pool of people opens up as having good credit.
Couldn't the resulting so-called-temporary rise in prices (say in the housing market) in turn cause the "demand for loans" (or what I like to call the supply of loan principal dollars offered by would-be borrowers to banks) to also jump up... so that there may be more loan turn-over, but the overall dollar value of loans (and thus deposits) remains elevated?
You might think that competition between the banks forces them to lower their interest rates to grab a bigger slice of this new market in credit worthy borrowers so at some point a new equilibrium is reached: lower interest rates for borrowers means a smaller spread on banks' balance sheets, but this is offset by an overall increase in loans outstanding. Assume also for a moment that there are no prepayment penalties, and that in the (what I think is an unusual) market in which loan-principal dollars are offered for sale back to the borrowers on a 1:1 basis (but to nobody else at this price), we are at equilibrium as well. Just as many new deposit dollars are being created from new lending as are old deposit dollars being destroyed to pay off existing debts. But just because this one market is in equilibrium, does that mean all the other markets in which deposits and cash are traded for other goods are in equilibrium? Perhaps they are not, but they are moving towards equilibrium because prices in general are rising. What do you think?
OK last one, did you see J.V. Dubois' comment at Glasner's? How would you respond?ReplyDelete