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 Liabilities Equity, bonds Loans Time deposits to economy Demand deposits Loans from CB Bank reserves Money holders Time deposits Demand deposits + Currency in circulation Central bank Assets Liabilities Loans to Bank reserves banks Currency in Bonds circulation  Monetary base 2

Bank reserves with central banks: special type of money indeed Commercial banks Assets Liabilities Equity, bonds Loans Time deposits to economy Demand deposits Loans from CB Bank reserves Money holders Time deposits Demand deposits + Currency in circulation Central bank Assets Liabilities Loans to Bank reserves banks Currency in Bonds circulation Bank reserves for inter-bank settlements to serve clients’ flows from one bank to another bank. Main function of inter-bank market: to offset temporal outflows of clients’ funds by opposite transaction with bank receiver. Can households and non-bank enterprises open reserve accounts with the central bank? No: central bank does not compete with commercial banks for clients. Can bank lend its reserves to their borrowers: directly no, indirectly yes, if bank provides credit to client for payments to supplier who has account with another bank (in such a case bank transfers adequate amount of reserves to account of bank of supplier with the CB rather than account of supplier. If client makes payments within the same bank: bank reserves has not been used in the process of granting loans. 3

Transfer of client funds and bank reserves Commercial bank A Assets Liabilities Equity, bonds Loans Time deposits to economy Demand deposits Bank reserves -100 -100 Commercial bank B Assets Liabilities Equity, bonds Loans Time deposits to economy Demand deposits Bank reserves +100 Bank reserves for inter-bank settlements to serve clients’ flows from one bank to another bank. Main function of inter-bank market: to offset temporal outflows of clients’ funds by opposite transaction with bank receiver. Can households and non-bank enterprises open reserve accounts with the central bank? No: central bank does not compete with commercial banks for clients. Can bank lend its reserves to their borrowers: directly no, indirectly yes, if bank provides credit to client for payments to supplier who has account with another bank (in such a case bank transfers adequate amount of reserves to account of bank of supplier with the CB rather than account of supplier. If client makes payments within the same bank: bank reserves has not been used in the process of granting loans. 4

Offsetting outflows: inter-bank transaction (the first best solution) Commercial bank A Assets Liabilities Equity, bonds Loans Time deposits to economy Demand deposits Bank reserves +100 Interbank +100 Commercial bank B Assets Liabilities Equity, bonds Loans Time deposits to economy Demand deposits Bank reserves -100 Interbank +100 +100 Bank reserves for inter-bank settlements to serve clients’ flows from one bank to another bank. Main function of inter-bank market: to offset temporal outflows of clients’ funds by opposite transaction with bank receiver. Can households and non-bank enterprises open reserve accounts with the central bank? No: central bank does not compete with commercial banks for clients. Can bank lend its reserves to their borrowers: directly no, indirectly yes, if bank provides credit to client for payments to supplier who has account with another bank (in such a case bank transfers adequate amount of reserves to account of bank of supplier with the CB rather than account of supplier. If client makes payments within the same bank: bank reserves has not been used in the process of granting loans. 5

Offsetting outflows: borrowing from CB (second best solution) Commercial bank A Assets Liabilities Equity, bonds Loans Time deposits to economy Demand deposits Bank reserves +100 CB +100 Central bank Assets Liabilities Loans to banks Bank reserves +100 Currency in Bonds circulation Bank reserves for inter-bank settlements to serve clients’ flows from one bank to another bank. Main function of inter-bank market: to offset temporal outflows of clients’ funds by opposite transaction with bank receiver. Can households and non-bank enterprises open reserve accounts with the central bank? No: central bank does not compete with commercial banks for clients. Can bank lend its reserves to their borrowers: directly no, indirectly yes, if bank provides credit to client for payments to supplier who has account with another bank (in such a case bank transfers adequate amount of reserves to account of bank of supplier with the CB rather than account of supplier. If client makes payments within the same bank: bank reserves has not been used in the process of granting loans. 6

CB steers interest rate: textbook approach Bank reserves (R) or Monetary base (MB) 7 EURO ĮVEDIMAS LIETUVOJE

Money multiplier: textbook approach CB money injection 𝑚= 𝐶+𝐷 𝐶+𝑅 = 1+𝐶/𝐷 𝐶/𝐷+𝑅/𝐷 𝑀 𝐵 ×𝑚=𝑀= 𝐶+𝑅 ×𝑚=𝐶+𝐷; Source: Primer on the Widely Misunderstood Money Creation Mechanism 8 EURO ĮVEDIMAS LIETUVOJE

CB steers interest rate: empirical approach Bank reserve (R) demand is inelastic to the price (short- term 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 9 EURO ĮVEDIMAS LIETUVOJE

Commercial bank balance sheet Commercial bank can create loans and deposits out of thin air within constraints Commercial bank balance sheet Assets Liabilities 8 risk-free assets 8 capital +100 loan  +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 10 EURO ĮVEDIMAS 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 11 EURO ĮVEDIMAS LIETUVOJE

Sequence of money creation Commercial banks Assets Liabilities Equities Loans Time deposits to economy Demand deposits Loans from CB Bank reserves Given interest rate environment (shape of yield curve) CB policy rates Financial markets: non-bank bonds, equities Supply of funds Demand for loans Supply of loans Money holders: Financial asset allocation decisions Central bank Assets Liabilities Loans to Bank reserves banks Banknotes Bonds Demand for liquidity 12

Credit and asset price cycle: upswing at given interest rates Source: Turner (2011). Debt and deleveraging: Long term and short term challenges 13

Credit and asset price cycles: downswing at given interest rates Source: Turner (2011). Debt and deleveraging: Long term and short term challenges 14

Mainstream vs. Post-Keynesianism Features Mainstream (New Neoclassical synthesis ) Post-Keynesian school The supply of money is Exogenous 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 Investment determines saving Source: A Modern Guide to Keynesian Macroeconomics and Economic Policies (2011), pp. 34–61. 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) QE when policy rate is not yet at zero lower bound, but remaining scope for further cuts is nor sufficient to make MP accommodative enough: Fed, BOE at QE start (2008-2009). Zero lower bound: a situation where CB policy rate reached its lowest technical level equal or close to zero, and further cuts are impossible (Fed: 0,0-0,25%, ECB MRO 0,05%, DF -0,20; MLF 0,30%). Fed and BOE started QE in the late 2008 and spring of 2009 respectively in a situation where liquidity problems of the banking sector had been already solved to a large extent, however, it became obvious that subprime and banking crisis had transformed to the economic recession. 16

Bank reserves before QE Commercial banks Assets Liabilities Equity, bonds Loans to economy Deposits Bonds 300 Loans from CB Bank reserves Central bank Assets Liabilities Loans to banks Bank reserves Currency in Bonds 100 circulation 17 EURO ĮVEDIMAS LIETUVOJE

Quiz: where CB gets money for QE from? QE: bond purchases from banks Commercial banks Assets Liabilities Equity, bonds Loans to economy Deposits Bank reserves +300 (Bonds -300) Loans from CB Quiz: where CB gets money for QE from? Central bank Assets Liabilities Loans to banks Bank reserves +300 Bonds 100 Currency in circulation 18 EURO ĮVEDIMAS LIETUVOJE

QE: bond purchases from non-banks Assets Equities, bonds Deposits +300 (Bonds -300) + Currency in Circulation QE: bond purchases from non-banks Commercial banks Assets Liabilities Equity, bonds Loans to economy Deposits Bonds +300 Bank reserves Loans from CB Central bank Assets Liabilities Loans to Bank reserves banks +300 Bonds 100 Currency in circulation Actually, the counterparties of CB monetary operations (including bond purchases) are financial institutions, normally banks. The CBs select banks as eligible counterparties thanks to their ability to widely spread monetary signals into real economy. Bond purchases from non-banks is executed technically through the banks as typical market makers. 19 EURO ĮVEDIMAS LIETUVOJE

Ačiū už dėmesį 20 EURO ĮVEDIMAS 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. 21 EURO ĮVEDIMAS LIETUVOJE