« Employment in the current and in previous recessions | Main | The changing game between monetary and fiscal authorities »



If you thought like a monetarist, you would also recognize the impact of the excess money supply on prices.

Curmudgeon: true, you would say that prices would rise *relative to what would happen otherwise*. But if what would happen otherwise would be deflation, that would please you.


I think I understand only about 75 per cent of what you and Andy Harless have been talking about; but I do find it somewhat unbelievable that economists all over the net are debating what appear to be econ 101 ideas.

I’m not in that group but I do have a few observations based on up close observation of the banking system. One would be as follows:

You say above,

“The reduced demand for money creates an excess supply of money. People try to lend that excess supply of money. If they lend the excess supply of money, that creates the extra loans for the government to borrow.”

I know that’s what econ 101 says, but it doesn’t correspond to actual banking in my opinion. I’m assuming by “people” you mean the banking system.

The banking system at the macro level doesn’t lend on the basis of a supply of money. An obvious proof that this can’t be the case is that the system creates new money by extending new credit. How can the lending function depend on the supply of money if it creates money in the presumed response?

This doesn’t matter whether you interpret money supply as bank deposit liabilities or bank reserve assets. Banks don’t lend from their reserve asset positions. They lend on the basis of their capital positions. And they create new money when they lend. This is a simple indisputable fact of double entry bookkeeping and asset-liability identity. There is no fundamental difference between the act of central bank money creation and an independent act of commercial bank money creation as far as this is concerned. I think a lot of discussion and theory overlooks this and gets it wrong by assuming an asymmetry advantage of central banking that it doesn’t in fact have. There is an asymmetric advantage of central banking, but this isn’t it. The unique central bank advantage is due to its fiscal connection.

Moreover, any lending done by commercial banks individually that seems to come from their central bank reserve positions has nothing to do with the supposed textbook multiplier effect and is only for the purpose of managing the deployment and share of excess reserves per se (i.e. usually via short term money market response) – not some ratio that links reserves to deposits.

My impression is that macroeconomics has a lot to do with understanding the differences between macro and micro causality. The same holds for banking. Individual banks may have to compete for money to fund loans, but the system as a whole creates that money as the very result of those loans. Harless also references some interesting causality reversal in the idea of investment as a source of funding for savings. My knowledge is limited, but it seems to me this macro/micro causality inversion is rife throughout Keynes, Says’ Law, banking, national accounts identities, etc. etc. etc.

JKH: Great to see you back! Yes, this is very basic (in the ECON1000 sense); and it's also very fundamental, and difficult, and very important. (It's more difficult when you introduce banks!) I'm going to take my time, to reply properly and at length.

Other readers may wish to see Andy Harless' post on it. in the meantime.


It is embarrassing for economists. This debate is about a model taught in ECON1000 (the Keynesian cross), that has been taught for 60 years, and about a model taught in second year (the ISLM) for about the same time. Economists don't understand those models. Eugene Fama got it wrong, but Brad DeLong failed to explain properly why he was wrong, and introduced some red herrings (like inventories). Yep, those guys are much better economists than I am, but they are both wrong.

In defence of economists, those models can be wrong (indeed they are wrong, but whether it matters is another question), and it's not easy to distinguish a debate about what the models say from a debate about whether the models are right. Also, understanding these models on a fundamental basis - what's really going on behind the equations - is hard, and much harder than just cranking out the solution to the equations. (But that's all economists are taught nowadays). Keynes made the same mistake Fama did (treating Savings=Investment as an identity), but drew the exact opposite conclusion from Fama. And the introduction of the ex ante/ex post distinction (poncy Latin via Sweden of all places) merely muddled what should have been a clear distinction in English between quantity demanded (or supplied) and actual quantity bought (or sold). It was only really worked out theoretically during the brief flowering of general disequilibrium theory in the 1970's. But that literature soon died, and only those born at exactly the right time, and lucky enough to get taught it by a good professor (as I was taught it by Peter Howitt) got to learn it.

Let's start by ignoring banks. There is a stock of "money" (think paper currency) and bonds (IOU's for money).

You MUST assume a monetary exchange economy (not barter). People are not allowed to swap goods or labour or bonds without first going through money (the medium of exchange). Those models only make sense in a monetary exchange economy. Otherwise unemployed workers would swap their labour directly for goods, so there could not be an excess supply of labour without a corresponding excess demand for goods. The very concept of "aggregate demand" only makes sense in a monetary economy.

Walras' Law states that, if you sum across all players, and across all goods (including labour, bonds, and money) in an economy, the excess demands equal the excess supplies

There are two theories of the rate of interest.

The loanable funds theory says that the rate of interest adjusts so that the supply of loans (from savings) equals the demand for loans (for investment). These are flows, not stocks. You can think of the supply of loans as being the same as the demand for new bonds by households, and the demand for loans being the same as the supply of new bonds by firms (and government). This is how Fama views the world. It is also the pre-Keynesian view (and the Austrian view).

The liquidity preference theory says that the rate of interest adjusts so that the demand for money equals the supply of money. These are stocks, not flows. At any point in time there is a stock of money and stock of bonds, and the rate of interest has to adjust until households are just willing to hold those stocks, and don't want to swap money for bonds.

How to reconcile those two apparently contradictory theories, each of which sounds good? The second year ISLM model does it as follows. The IS curve captures the loanable funds theory, but recognises that savings also depend on income. The LM curve captures the liquidity preference theory, but recognises that money demand also depends on income. So both income and the rate of interest adjust until, at the intersection of IS and LM curves, both theories can be true at the same time.

The ISLM model appears to resolve the conflict. But it doesn't fully resolve it. The conflict reappears when we ask how we get to the new equilibrium level of income, if the demand for loanable funds increases, due to increased government demand for goods, financed by a flow of new bonds (and demand for loanable funds). That was Fama's problem. The government can't increase spending without finance, and it can't get finance without taking finance away from firms, or by getting households to lend more, which means save more, and so demand fewer goods. Income seems stuck at the original level.

Here's how to escape. The increased demand for loanable funds causes a rise in the rate of interest. This by itself does not increase the demand for goods. Firms demand fewer new loans and reduce investment demand, households increase savings which means demand less consumption, so aggregate demand still hasn't increased, it's just shifted away from firms and households towards government. But if the demand for the stock of money depends (negatively) on the rate of interest, people now want to get rid of part of their holdings of money, to buy and hold a bigger stock of bonds instead. It is this excess (stock) supply of money that creates the action, in a monetary exchange economy.

Note that they *try* to get rid of the excess money. But they fail, because all they can do is pass it on to someone else (the "hot potato" is the official monetarist metaphor, but Andy Harless is fine to talk about cloth dishtowels instead!). They buy the new bonds issued by the government. (Hell, they will buy anything that moves, because we have a *stock* excess supply of money and only a *flow* extra supply of new bonds from the government, so we are not even on the same dimension!). So the government can sell its flow of new bonds, and borrow the money and spend it on newly-produced goods. And this hot potato of an excess supply of money does not go away until income eventually increases enough that people decide they want to hold all the money at the higher rate of interest.

Forget inventories. As Andy says, fiscal policy still works where all GDP is services. That was a red herring.

Now.....let's introduce banks.

First, assume a central bank and no commercial banks for a minute. Suppose the central bank is willing to supply an indefinitely large amount of currency at a fixed rate of interest. In this case (unlike in my example where the stock of money was fixed) the interest rate doesn't need to rise. The government demands an extra $100 in loans, and the central bank supplies an extra $100 in loans, by printing $100 in currency, and lending it out. But remember the stock/flow distinction. The government wants to borrow $100 per day. And that first $100 doesn't disappear when the government spends it. It just goes into someone else's hands, who can either spend or lend it, and so on.

Now assume commercial banks. If the commercial banks are neither capital-reserve constrained or currency-reserve constrained (as you assume), when they see a new demand for loans, from the government, they will increase loans and at the very same time increase demand deposits and the money supply M1, just as you say. But this is just like the central bank discussed above. And remember the stock/flow distinction. And remember that extra $100 demand deposits needn't just disappear when the government spends it. It too can hot potato (unless the commercial banks decide to withdraw it).

But why would commercial banks have excess capacity (capital and currency reserves) to make loans in the first place? Why weren't they in equilibrium? Why wouldn't they have expanded the supply of loans and money even if the government didn't demand more loans?

Must stop now. Gotta go skating on the canal.


Thanks for taking the time for such an extensive explanation.

I think I understand your monetary explanation of ISLM. It seems you’re saying that when the interest rate goes up due to government bond borrowing, the private sector’s demand for money goes down due to the higher interest rate. And that causes the demand for bonds to go up and activity to flow from there. This also seems to me to parallel roughly the idea of the Keynesian investment multiplier, in the sense that a sudden surplus supply of money will cause an outflow of that money into financial investment (i.e. government bonds), and so on with recirculation of the same quantity of money, until a new equilibrium of money supply and demand is met. Does that make sense?

To push the analogy additionally to the banking sector, I tend to think of the Keynesian investment multiplier similar to the way in which incremental bank capital allows loan expansion as a multiple of that capital. The investment multiplier facilitates economic “leverage” in the form of greater economic output and income; the bank capital “multiplier” facilitates financial leverage in loan expansion. Does that make sense?

I will never understand why economists jump through hoops to come up with a market explanation for an administered price. The central bank is the monopoly supplier of reserves; a monopolist must set either the quantity or the price, and since setting the quantity is virtually impossible in a systems with feedbacks like money, it sets the price. Loans create deposits; there are no "loanable funds". The money to pay for treasury securities, as an operational matter, MUST come from prior governement spending. No amount of government deficit spending can affect the interest rate one iota, since the only real purpose of selling treasury securities is to support a non-zero interest rate.

Talking about stocks of money and bonds is misleading at best (Remember: Government spending in a floating rate regime creates money. Taxes destroy it. Bond sales substitute interest bearing ovt liabilities for non interest bearing ones,) You need to look at how an actual monetary system works in the real world, and how actual reserve accounting is done by actual central banks.

Jimbo: fair comment. By "price" I assume you mean "rate of interest" in this context. I think that economists jump through these hoops partly because we have so many perspectives, each one of which can be valid in a different "run" and a different time and place. So we need to translate from one perspective to the other, and that's hard.

For example, what's the slope of the LM curve, in Canada, today? Between Fixed Announcements Dates, it's horizontal, since the BoC sets the overnight rate. Over a slightly longer period, it's probably vertical, since the BoC is looking at real income as a sort of intermediate target. Over a 2 year period or more, it's probably horizontal in inflation-space, since the BoC targets inflation. All of those statements are compatible with "how an actual monetary system works", but over different horizons.

Once you are past the 6-week period, the rate of interest is not an administered price. Or rather, if you prefer, the administered price depends on the market.

JKH: Sorry, I missed seeing your most recent post. Yes, that does make sense. But I'm always wary of pushing analogies too far. The Keynesian multiplier is in terms of flows of spending and output. The banking system multiplier is about stocks of assets and liabilities.



Yin and Yang.

You may have to watch out, or I may have to restrain myself; I love pushing analogies, particularly when it comes to stocks, flows, and capital.


Think of it this way: let's say you have a local water utility. It sets the price that you can buy water, today. Whatever it decides the price is, that's what it is. But say an enterprising market maker decides to create a "water futures market", in which you can bet on what the price will be in 3 months, 6 months. a year, etc. What will determine those futures prices? Will it have to do with the demand for water, or its supply? Only indirectly. What they will really be trying to determine is, is "What will the water utility decide to set the price at in 3 months, 6 months, 1 year, etc.?" (And note: water is a physical commodity for which there can be an actual shortage - money and credit is not.)

And what if the water utility, getting annoyed at the market maker, decided to sell long term contracts that would guarantee the price at those intervals to undercut his business? Would there be anything stopping them?

Similarly: is there anything stopping central banks from setting longer term rates? The only reason they float now is that limited understanding of monetary realities make fiscal authorities think that they have to sell long-term securities in order to "raise money". But if instead they set the price and let the quantity float, they could set the entire term structure...

Jimbo: This is where the analogy breaks down. If you draw an analogy between the "price" of money and the price of water, then I would define the "price" of money as 1/CPI. It is true that the BoC can set the "price of money" in that sense (i.e. the CPI) wherever it wants (OK, it may take a while to get there, if prices are sticky). But the interest rate is another kettle of fish. If the BoC tries to set the interest rate permanently too low, and freely lends at too low an interest rate, the result will be hyperinflation. If the BoC tries to set too high a rate of interest, permanently, the result would be a deflationary spiral.

And setting the term structure of interest rates is another question altogether.


You (and the mainstream generally) continue to vastly overrate the power of monetary policy. The BOC can set the CPI? Only in it's dreams. Central banks have been patting themselves on the back for 25 years about their supposed magical inflation fighting powers, but as far as I can tell they have been like weathermen who think they bring the sunshine (they certainly seemed to have been cought by surprise by the hurricane...). This magical just right "market" interest rate is a cousin of NAIRU - it depends more on the particular political outlook of the economist doing the figuring than any objective analysis. Is Japan suffering from hyperinflation after a decade of 0% rates? Australia had some of the highest rates in the world for the past few years - and still managed to inflate a housing bubble even worse than in the U.S.

Here's a good article by Jamie Galbraith on the collapse of monetarism that is think puts it nicely:


The comments to this entry are closed.

Search this site

  • Google

Blog powered by Typepad