By Eric Tymoigne
(A quick note: I noticed that the M&B posts get posted on other blogs. If you want me to respond to you, you should comment at NEP.)
MONETARY BASE AND THE BALANCE SHEET OF THE FED.
Post 2 examined the balance sheet of the central bank:
Now that we have an understanding of how the balance sheet of the Fed works, it is possible to go into the details of how the Fed operates in the economy in terms of monetary policy.
To understand what the Fed does, one first needs to define the monetary base and see how it relates to the Fed’s balance sheet. The post quickly looks at the difference between monetary base and money supply, and also looks more carefully at what reserves are.
The Monetary Base and the Money Supply
The monetary base (aka “high-powered money”) is defined as:
Monetary Base = Reserve balances + vault cash + cash in circulation
In its widest meaning, “in circulation” means any Federal Reserve Notes (FRNs) outside the Federal Reserve banks and any Treasury-issued cash outside Treasury. Economists prefer to use a narrower definition. Cash in circulation is any currency outside vaults of private banks (“vault cash”), of the Treasury, and of the Fed—what is held by “the public.”
Technically, cash means currency and coins. The Fed and Treasury use the word “currency” to mean paper money only. Currency in circulation includes mostly FRNs, but also some Treasury currency (United States notes, silver certificates) and national bank notes (issued prior to the creation of the Fed in 1913) that the Treasury still agrees to take at face value in payments of dues. The distinction between coins and currency is mostly statistical and does not have any analytical power. Post 15 shows that the material of which something is made is irrelevant to determine if it is a monetary instrument. This series uses the word cash and currency interchangeably.
To simplify, the U.S. monetary base can be reduced to:
Monetary base = L1 + L2
That is the monetary base is the sum of reserve balances and FRNs held by other entities than the Fed and the Treasury.
Until recently, currency in circulation was the largest component of the monetary base and it grew steadily to almost $1.4 trillion today, most of which are FRNs, and “between one-half and two-thirds of the value of U.S. currency in circulation is held abroad.” The global financial crisis led a large increase in reserve balances from about $24 billion on average from January 1959 to August 2008 to about $2.5 trillion today (Figure 1).
The monetary base is not the same thing as the money supply. Money supply means money held by non-bank economic units and outside the Treasury and other official foreign institutions. There are several ways to measure that and monetary aggregate M1 is the narrowest (Figure 2):
M1 = Cash in circulation + Private-bank checking accounts of non-banks, non-federal, non-official foreign economic units + others
M1 relates to the Fed’s balance sheet only via part of L1. FRNs in circulation have represented about 40% to 50% of M1 from the mid-1990s, 20 to 30% before that.
It is important to make a difference between the money supply and the monetary base because the central bank has no direct influence on the money supply. The Fed does not deal with the public directly, private banks do. Even for FRNs, private banks are in charge of injecting FRNs in the economy and they do so only if customers want to withdraw cash. In a 2010 interview Chairman Bernanke noted regarding the announced purchase of $600 billion of treasuries (aka “quantitative easing”):
One myth that’s out there is that what we’re doing is printing money. We’re not printing money. The amount of currency in circulation is not changing. The money supply is not changing in any significant way.
Translated in what is presented above, Bernanke states that L2 has gone up dramatically but that M1 has not changed. The Fed did not issue FRNs to the public (L1 is not going up), it just credited the accounts of banks by buying treasuries from them and, as Post 2 shows, banks cannot do much with reserve balances.
One should note that the Treasury’s account at the Fed (L3) and its accounts at private banks (called Treasury Tax and Loans accounts (TT&Ls)) are not part of the monetary base or the money supply. They are “funds.” The amount of dollars in the Treasury’s accounts are not counted in any definition.
Reserves: Required, Excess, Free, Borrowed, Non-borrowed
Within the monetary base, reserves are central to monetary-policy operations so this section studies a bit more carefully the reserve-side of the monetary base. Total amount of reserves is:
Total reserves = Reserves balances + applied vault cash = L2 + part of L1
Applied vault cash are the FRNs that banks decide to use to calculate the amount of reserves they report to the Fed (the rest of vault cash is called “surplus vault cash”). From the 1990s and until the Great Recession, applied vault cash had represented the majority of total reserves and peaked to about 80% of total reserves. Since August 2008, reserves balances have been, by far, the main component of total reserves (Figure 3).
It is possible for reserve balances (L2) to go negative, i.e. the Fed allows banks to have an overdraft; however, the Fed expects that banks close any overdraft at the end of each day. If a bank cannot do it, the Fed charges a very high interest rate because the overdraft is a form of uncollateralized advance contrary to Discount Window advances. If the overdraft persists, the Fed may take a closer look at how the bank runs its business.
Total reserves can be decomposed into other categories than the form they take. One may also be interested in knowing how banks obtained their reserves. The Fed is the monopoly supplier of reserves and there are two ways for the Fed to provide reserves:
- Fed’s Discount Window advances funds by swapping promissory notes with banks (see Post 2): “borrowed reserves”
- Fed buys some assets from banks either permanently (“outright purchases”) or temporarily (“repurchase agreements”): “non-borrowed reserves”
Total reserves = borrowed reserves + non-borrowed reserves
Non-borrowed reserves have been the main source of reserves (Figure 4) because the Fed discourages the use of the Discount Window (interest rate is higher and Fed may increase supervision if a bank comes to the Window too often). The stigma of going to the Window is so strong that, during the 2008 crisis, the Fed had to change its Discount Window procedures to entice banks that desperately needed reserves to come.
Finally, the total amount of reserves can be decomposed in terms of the uses of reserves. Banks in the United States must have a certain proportion of reserves relative to the amount of bank accounts they issue:
- Required reserves: amount of reserves banks must hold in proportion of the bank accounts they issued
- Excess reserves: whatever banks have in excess of required reserves.
Total reserves = Required reserves + excess reserves
Up until the crisis, required reserves were the overwhelming amount of total reserves (Figure 5). Excess reserves was virtually zero (Post 4 explains why). Up until the crisis, the amount of reserves was also relatively stable over decades and averaged $40 billion (Figure 6).
One may sometimes encounter the word “free reserves,” which just means the difference between excess reserves and borrowed reserves. Throughout this series, the most important categorization will be the last one: excess vs. required reserves.
Note: Non-borrowed reserves is negative during the peak amount of borrowed reserves. Non-borrowed reserves is measures by L1 – A2. A2 is borrowed reserves. For reasons not discussed in this blog, L1 became smaller than A2.
How does the monetary base change?
The monetary base will go up or down depending on what happens to the other items in the balance sheet of the Fed. Following the point that balance sheet must balance we have:
L1 + L2 = A1 + A2 + A3 + A4 + A5 – L3 – L4 – L5
So monetary base will be injected when:
- The Fed buys something (i.e. acquires an asset) from banks or the public
- Higher A1: Buying securities (T-bills, T-bonds, etc.)
- Higher A2: Advances of Federal Funds
- Higher A3: Buying foreign currency from private banks
- Higher A5: Buying a pizza, a building, or a service from someone
- The other Fed account holders spend in the US economy and Fed pays dividends to banks
- Lower L3: Treasury Spends
- Lower L4: US Exports
- Lower L5: Fed pays dividends to banks
The monetary base will be removed when opposite transactions occur. Buying coins from the Treasury does not change the monetary base because L3 goes up by the same amount as A4; it is an intra-federal government transaction. Let’s take a few examples:
Case 1: The Federal Reserve buys T-Bills worth $100 from banks
You have just witnessed the creation of monetary base: The central bank credits the account of banks by typing “100” on the keyboard of a computer. The Fed could also have printed bank notes (ΔL1 = +$100) but purchases from banks are done electronically because of convenience.
Case 2: Dr. T pays his income taxes worth $1000.
Assume that Dr. T still mails his income-tax paperwork with a check for the U.S. Department of the Treasury. The Treasury receives the check and brings it to the Fed (we ignore Treasury’s tax and loan accounts (TT&L) because that just complicates the analysis without adding any insights at this point. Post 6 studies the heavy interaction between the Treasury and the Fed). The Fed sends the check to the bank of Dr. T. and so the bank debits the bank account of Dr. T by $1000.
What is the offsetting operation on the bank’s balance sheet? The $1000 have to go to the Treasury. Given that we assumed that the Treasury only has an account at the Fed we know that the offsetting operation CANNOT BE (it would be if TT&Ls had been included):
The Treasury only has an account at the Fed so the following will occur when the $1000 are transferred (which would be the second step if TT&Ls were included in the analysis):
But that again begs the question: What is the offsetting accounting entry on the balance sheet of the Fed? It cannot be “Account of Dr. T: -$1000” because Dr. T does not have an account at the Fed.
The answer is that when the Fed receives the check, it has a claim on Dr. T.’s bank. The bank settles that claim by giving up reserves and the funds are transferred into the account of the Treasury. Interbank claims (claims among private banks, and between the Fed and private banks) are always settled with transfers of reserves.
You have just witnessed the destruction of monetary-base: TAXES DESTROY MONETARY BASE. The central bank deleted $1000 in the reserve balance and keystroked $1000 in the account of the Treasury.
Of course, if the Treasury spends reserve balances are credited, and if Treasury spends more than its taxes then there is a net injection of reserves: FISCAL DEFICITS (government spending larger than taxes) LEAD TO A NET INJECTION OF RESERVES. Keep that in mind for Post 4.
As a side note, one may note that Dr. T’s balance sheet changes as follows when taxes are paid:
Can the Fed issue an infinite amount of monetary base?
Yes it technically can given that the monetary base is composed of liabilities of the Fed. In practice though, the ability to inject reserves is constrained by the operational requirements of monetary policy. Post 4 shows that if the central bank issues reserves regardless of the needs of banks, it will not be able to achieve a specific policy interest rate it sets for itself unless it changes its operational procedures (which it did during the recent crisis).
At the origins of the Fed, some constraints were also put on the types of securities that the Fed could buy or that banks could pledge as collateral with their promissory notes to get an advance from the Discount Window. There was a fear that the Fed would over issue monetary base given its broad monetary power. Here is the language of the preamble of the 1913 Fed Act states:
To provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes
“Elastic currency” just means that the Fed is able to create (and withdraw) monetary base at the will of banks and the public, i.e. in function of the needs of the economy. However, until 1932, the Fed operated under the Real Bills Doctrine (RBD). What that meant is that the Fed ought to only accept securities that “self liquidate” in A1 and as collateral for A2. Self-liquidating securities are those that are issued and destroyed in relation to economic activity. Firms issue securities to produce goods and services and repay them when Firms sell their production. The idea was that by tying monetary-base creation to production financing, the Fed would avoid inflationary tendencies that could come from an elastic currency. Monetary base (and so money supply as the thought of the time went) would grow in-sync with production.
In practice, RBD never worked out well for both theoretical and practical reasons. WWI led to a large amount of treasuries held by the Fed. The Great Depression led to the elimination of the doctrine and the 1932 Banking Act widened dramatically the types of securities the Fed could accept if needed (Table 1).
One of the problem of RBD is that it relied on private-indebtedness (issuances of securities by companies to finance production, “real bills”) for monetary policy to work. During a recession, banks did not have enough real bills to sale or pledge to the Fed because economic activity was dead so private issuance plunged. This is problematic because the scarcity of real bills limited the ability of banks to obtain reserves, just at the time when banks desperately needed some to counter bank runs and make interbank payments.
More recently, Dodd-Frank amended the Federal Reserve Act to constrain the capacity of the Fed to use “emergency powers,” i.e. its ability to accept any type of securities from anybody. This was a reaction to the advances provided to AIG that was not part of the Federal Reserve System. It was also a reaction to the opaqueness of the Discount Window operations during the crisis and how questionable some of the transactions were.
The Fed needs to be able to fight panics and the ensuing liquidity crisis when everybody and every banks are trying to get their hands on the currency. This is why the Fed was created. It can only do so by being able to buy, or accept as collateral, a wide verity of securities.
This leads to a final important point. Given that the Fed provides a safety valve in the financial system, it may lead to moral hazard. Financial-market participants may take more risks knowing that, if things go south, the Fed will intervene to avoid a collapse of the financial system. As a consequence the Fed must do two things:
- The Fed should also have ample regulatory and supervisory powers, AND it should use them. That is what the last bit of the preamble is all about.
- The Fed should discourage moral hazard and promote safe banking practices by accepting only securities that are of quality (that is based on sound underwriting and not in default) and from solvent institutions: The Fed exists to squash banking liquidity crisis (temporary inability to access funds), not to keep insolvent banks alive (permanent inability to pay creditors).
Unfortunately, these two conditions have not been met recently and moral hazard has increased dramatically.
The alternative is Andrew Mellon’s advice to Hoover: “liquidate labor, liquidate stocks, liquidate farmers, and liquidate real estate…it will purge the rottenness out of the system.” However, this belief in the self-cleansing of market mechanisms does not work, especially so in times of financial crisis and panic (see Part 14).
Done for today! Next post will dive into monetary-policy implementation by looking at the pre- and post-crisis monetary policy operations.
Your last section on moral hazard certainly brings up some interesting points.
As is well known, banks create loans that are then backed by the Federal Reserve. As a side note Bill Mitchell recently made this observation.
“The other fact is that the money supply is endogenously generated by the horizontal credit (leveraging) activities conducted by banks, firms, investors etc – the central bank is not involved at this level of activity.”
These activities include securitizations and derivatives. This is why this sector is so prone to deflation and should be dismantled in a controlled manner.
In his book ‘Extreme Money: Masters of the Universe and the Cult of Risk’ (2011) Satyajit Das talks about the ‘Liquidity Factory’.
On an inverse pyramid at the bottom little pinnacle are the central banks, 2%, then there are bank loans, 19%, then securitized debt, 38% and then derivatives 41%.
As you mentioned the Fed has already stepped into some of this murky territory and will be very tempted to do so again. Unfortunately these forays into fiscal territory tend to favor financial institutions over the public interest and lead to increasing inequality.
Yep, I will write a post (or more) about private banks a bit later.
“The alternative is Andrew Mellon’s advice to Hoover: “liquidate labor, liquidate stocks, liquidate farmers, and liquidate real estate…it will purge the rottenness out of the system.” However, this belief in the self-cleansing of market mechanisms does not work, especially so in times of financial crisis and panic. More about that later.” Eric Tymoigne
Another alternative is Federal Reserve Accounts for all to allow peer-to-peer transactions which, if desired, bypass the commercial banks, the abolition of government-provided deposit insurance and an equal distribution of new fiat to individual accounts at the Fed to accommodate the transfer of at least some of the formerly insured accounts to inherently risk-free accounts at the Fed.
In other words, we can have a money system that does not violate equal protection under the law and at least some restitution for legalized theft.
Who can object?
I think banks should have role, especially community banks today. The latter are localized, know the neighborhood well, and focused on “boring” underwriting and deposit transactions. SIFIs have lost touch with the core of what banking is all about. For deposit insurance, I agree there should be no cap.
“For deposit insurance, I agree there should be no cap.” Eric Tymoigne
You misunderstand. Accounts at the Fed are risk-free by nature; they require no deposit insurance. It’s sub-accounts of the commercial banks (eg. a checking account at a commercial bank) that are insured by government and that’s a government subsidy for private credit creation. And completely unnecessary since everyone could have an inherently risk-free account at the Federal Reserve themselves.
Moreover, the excuse for coddling the commercial banks is that the payment system works through them. Fine, then let’s allow the commercial banks to be bypassed via individual, business, etc. accounts at the Fed.
As for local banks, they can extend as much credit as they dare and if they are under-capitalized then they go under and no tears should be shed for them nor for their depositors since with the allowance of central bank accounts for all and the end of government-provided deposit insurance then all remaining bank deposits would be, by definition, at-risk, not necessarily liquid INVESTMENTS, not the funds for tomorrow groceries.
aka you have been proposing this here for some time and I finally get what you are talking about… it’s an interesting idea. But having an account and having easy access to it are two different things. That is what neighborhood banks currently provide (imperfectly: impoverished communities are lamentably under served). Coupled with the notion of the Post Office Bank, though, this could provide a real solution to many ills, I think. In any event, some thought must go into how such accounts would be accessed (especially by people without computers and internet) and what infrastructure would be needed to be built out to make them widely useful.
Individual, business, etc. accounts at the Federal Reserve would allow a responsible abolition of government-provided deposit insurance and that would (or at least should) require a large amount of new reserves (fiat balances at the central bank to us non-bankers) to allow the transfer of at least some of the currently insured deposits to inherently risk-free individual, business, etc. accounts at the Federal Reserve.
But whence the new reserves? Trillion dollar coins is one option. And how shall the commercial banks obtain those new reserves? Properly, by borrowing or buying them from other fiat accounts at the Fed, including individual accounts. So the new fiat required (obtained by, say, depositing the trillion dollar coins at the Fed) should be distributed equally to all adult US citizens via their individual accounts at the Fed. From there, the new fiat could be lent to the commercial banks or used to buy new, non-insured deposits at commercial banks.
How big a fiat giveaway might be needed? In 2008 insured deposits total $4.29 trillion. Assuming a mere 10% of that moved to individual, business, etc. accounts at the Fed then that is over* $429,000,000,000 that can GIVEN equally to all US citizens. And that’s with 2008 figures.
*Some won’t choose to lend or sell their fiat to the commercial banks so the distribution has to be large enough to account for that.
re: Citizen accounts directly with the Treasury (or it’s accountant, the Fed)
I agree completely. It seems that we could now easily replace much of the finance industry with cloud-computing Apps, accessible through mobile phones.
That would free up a LOT of misused real estate, limousines, and expensive suits. Not to mention hot air.
I was referring to a case where there still are private banks issuing bank accounts. We had something close to what you want with postal banks.
“We had something close to what you want with postal banks.” Eric Tymoigne
Please elaborate because I think not.
Also, it seems postal banks have short lives, perhaps because they unfairly compete with the commercial banks. OTOH, I can’t imagine central banks going away.
Besides, why should only commercial banks and no one else in the private sector be allowed to deal with fiat directly while the rest of us must make do with commercial bank liabilities or physical cash? I see no good reason why, especially with modern computers and communications.
What you want it seems (I am not sure) is a government-run savings bank system accessible to all (would it provide advance too?). Postal banks would do that just fine.
The Fed’s task is more about ensuring proper interbank settlements and instead of protecting the savings of individuals.
“What you want it seems (I am not sure) is a government-run savings bank system accessible to all (would it provide advance too?). ”
What is required by equal protection under the law is that individuals, businesses, ie everyone, have the same rights and privileges at their respective central banks as commercial banks do. So, for example, if overdraft protection is deemed necessary for commercial bank accounts at the Fed then it should likewise be provided to individuals, businesses, etc. accounts at the Fed under the same terms.
“The Fed’s task is more about ensuring proper interbank settlements ”
Yes, indeed, and that would continue except everyone could now have an account at the Fed and deal directly with, what is, after all, a major part of the National Money Supply*, fiat account balances at the Fed, just like the commercial banks do. How can anyone legitimately object to that?
“and instead of protecting the savings of individuals.”
What protection is needed other than proper record keeping and correctly processing transactions between accounts, as is done for the commercial banks?
As for Postal Banks, they would no more allow direct dealings with fiat accounts than accounts at commercial banks do so they don’t satisfy equal protection under the law. So individual, business, etc. accounts at the Fed are needed in any case whether we have Postal Banks or not.
*excluding commercial bank deposits since these are a form of private money.
Ok I will have to sit on this one for a while. Never thought of this. Could we not just have no-FDIC insurance cap? Would the Fed make private advances too or would it just be a deposit account? I have a hard time seeing the Fed engaged in what commercial banks do on a daily basis.
“Could we not just have no-FDIC insurance cap?”
Government-provided deposit insurance is a subsidy for the commercial banks and for the most so-called creditworthy, which always includes the rich, at the expense of everyone else. So no, if reducing unjust wealth inequality is our aim. Also note that the abolition of deposit insurance would (or at least should*) require the creation of a large amount of new fiat and this fiat could be equally distributed to the individual accounts of all citizens at the central bank thereby reducing inequality. (See my comment above somewhere for a fuller description of deposit insurance abolition, if desired.)
“Would the Fed make private advances too or would it just be a deposit account?”
Individual, business, local government, etc. accounts at the central bank constitute an alternative payment system to the commercial banks, which, at the end of government-provided deposit insurance, would hold only, by definition, at-risk, not-necessarily-liquid investments, not essential deposits for immediate use. So what further need for private loans from the central bank (to commercial banks)? Or for the purchase of commercial bank assets? Since the commercial banks would no longer hold the economy hostage?
*depending on the amount of current commercial bank reserves.
“I have a hard time seeing the Fed engaged in what commercial banks do on a daily basis.”
No need for that at all. The commercial banks would still exist but with less ability to create deposits safely and that’s fine since deficit spending by the monetary sovereign, including equal fiat distributions to all citizens via individual accounts at the central bank, should accommodate the need for new loans with the commercial banks acting more as intermediaries between lenders and borrowers and less as creators of new purchasing power.
this series is an accessible explanation of CB balance sheets … yet I’ve come to feel that describing the DYNAMIC operations of a GROWING nation in terms of a Balance Sheet misses the point entirely
Has there ever been a version of “economics” that squares creation & growth w DoubleEntry Bookkeeping?
“Has there ever been a version of “economics” that squares creation & growth w DoubleEntry Bookkeeping?”
Steve Keen has an economy modeling tool that he call’s Minski (sp?). It uses DoubleEntry Bookkeeping and differential equations to model credit creation by the banks. It’s free for download.
I don’t think adding differential equations to policy discussions is going to change things any time soon 🙁
To me, admitting, embracing & extending creation & growth is the most important challenge facing the economics profession, and our nation.
Don’t let an expedient accounting rule cause us to deny life. It’s pretty fundamental.
Wouldn’t it just be better to acknowledge that evolution, adaptation, growth and continuous creation occurs? And then leverage it?
Here’s a simple yet powerful description of one group’s simple but powerful “PROTOCOL” for circumventing an early version of Double-Entry Bookkeeping, aka, the tally of revenge cycles.
The accounting is Keen’s is one of the weak point, for example aggregate demand = income + change in debt does not work at the aggregate level.
Neil Wilson has a very nice examination of the issue: http://www.3spoken.co.uk/2011/12/double-entry-view-on-keen-circuit-model.html
sadly, Keen’s whole approach to economics reminds me of Ptolemaic astronomy;
On planet Earth, we’ve made it through 4.5 billion years of evolution by implicitly practicing, not explicitly modeling evolving complexity.
We have ~zero predictive power, but seemingly adequate adaptive power.
Hence, we can rarely, if ever, predict looming Fallacies of Scale.
So it seems prudent to practice cheap prevention (implicit self-modeling; sticking toes in the water while retaining enough resiliency to survive our explorations), not waiting for expensive repair AFTER excessively explicit & speculative modeling – and putting our whole electorate at risk based on overly-speculative theories.
The differential calculus extrapolates KNOWN or assumed functions. It cannot predict unpredictable Fallacies of Scale (i.e., previously negligible inter-dependencies that eventually become statistically significant).
Anyway, we’re making social economics way too complicated, with this slavish attention to balance sheets.
A balance sheet doesn’t explain growth of our offspring from a single egg cell to the ~40trillion cells in an adult human.
Neither can a balance sheet explain growth of a nation or human culture.
We’re missing the point here. Balance sheets are a useful project management tool, but they never constrain the freedom of the users to start new projects.
Balance sheets don’t apply to management. 🙂 (No mention of balance sheets in any religion or tribal culture that I know of either … only in capitalism.)
And we the people are the managers of our nation & democracy. How did we forget that simple point?
Monetary base = L1 + L2
That is the monetary base is the sum of reserve balances, vault FRNs, and FRNs outside the Fed and Banks (the FRNs in your wallet, at the Treasury, held by foreigners).
Can you clarify – which part is L1 and which is L2?
L1 = Vault FRNs + FRNs outside the Fed and Banks
L2 = Reserve balances
Go back to balance sheet at the beginning of the post.
Ah, thanks, that’s where the L:s had been defined – I missed that for some reason.
Figure 4 and 5 are reverse.
¿Other cuestion, what is a4? why not show up?
A4 going up and affecting monetary base, would be purchase of Treasury currency and coins from banks by Fed.
Please correct me if I have understand this theory wrong (it is an theory since no law has been cited)?
It seems that any bank, who borrows reserves from the FED,
can’t pay its debt at full (with interest) to the FED, before FED has either “advanced” other bank(s) or bought eligible collateral (securities/treasuries) from banks.
Ultimately, in the end, this means that monetary policy is irrelevant to banks: FED is setting interest rates to it self because it is paying all and any costs that it (FED) imposes to the banks.
To me it seems that in this theory only function of the FED is to buy all and any eligible collateral from banks.
I first want to thank you for your instructive blogs!
Everybody tells that the QE inflated asset prices because of a massive liquidity injection (for example see Michael Hudson).
But in your last post you showed that the reserves can only serve the institutions that have an account at the FED.
How then could the asset prices be inflated because of a reserve injection?
The only option that I see is this:
BANK Balance Sheet
Assets: – reserves / + cash
Assets: -cash / + securities
Is this the case or is the asset inflation argument fallacious?
I’m a bit confused because money is said endogenous but if we look at a reserve injection, than it looks like money is exogenous. I think that we will see the link between the monetary base/money supply in a next post.
Thanks again for your blogs! Hope that it will become my favorite Money & Banking Book!
I have an upcoming FAQs post (it will be post 5 in two weeks…currently I am running a week ahead on the posts and post 4 is almost done and will be on monetary policy implementation…post 6 will be on treasury-central bank coordination, post 7 will start the private-bank posts) on monetary policy and the QE -asset price channel will be explained. But here is a short answer:
No bank’s don’t use cash to buy assets. If they deal with non-bank agents they just credit bank accounts, if banks deal with a fed account holder they debit their reserve balances to make payments.
The link works through interest rate, arbitrage, search for yield, and the fact that QE reduces the quantity of securities available in the market.
Thanks for your answer!
But I still feel weird… What prevents them from buying assets?
When reserves get credited, if they don’t find any economic agent that wishes to borrow (money supply is endogenous), why wouldn’t they invest in assets instead of keeping reserves (specially when there are plenty of excess reserves)?
Ok you are running ahead of the posts here.
1- Reserves are unrelated to bank advances so having plenty of reserve does not have any impact on willingness to provide credit.
2- “why wouldn’t they invest in assets instead of keeping reserves” the issue is how they would transfer the funds to make the purchase? They could buy securities if they find a fed account holder willing to sell them securities: Treasury is one, GSE is another one. Non-financial institutions no.
Need for reserves is actually much more lower than theory implies. After netting of interbank money transfers (which is normal procedure)thousands of banks can make money transfers on billions of Dollars without “moving” a single Cent trough reserve accounts at the FED. (also reserve requirement has to be fulfilled only on specific deposits/”advances”, and even then this mandatory deposit is only few percentages of bookkeeping value specific deposits/”advances”.)
When someone buys securities, treasuries and whatnots, they (usually) also purchase “right” to collect any and all revenue that can be collected from it (interest and so on). According theory, more FED buys securities, treasuries and whatnots, more FED needs to buy securities, treasuries and whatnots from banks and “advance” banks to collect possible revenue from securities, treasuries and whatnots what it (the FED) has bought.
Theory implies that there can not be any interbank money transfers (economical activity) without reserves or ability to participate monetary policy activities offered by the FED. This means that according this theory economical activity is actually not based loans made by banks, but instead banks ability to secure/acquire accepted collateral by the FED. Although, in reality, only small percentage of banks are accepted counterparties of monetary policy activities.
right, banks net out their debt to economize on transfer of fed funds.
Not sure which theory you are referring to. If you are referring to what has been written in the blogs, for the moment there are just descriptions. zero theory.