L. Randall Wray. (1990). Money and Credit in Capitalist Economies: TheEndogenous Money Approach, Aldershot: Edward Elgar.
Must-read articles
C. Borio. (2012). “The financial cycle and macroeconomics: What havewe learnt?”, BIS Working Papers, No. 395.
S. Fullwiler. (2013). “An endogenous money perspective on the post-crisis monetary policy debate”, Review of Keynesian Economics, Vol. 1,No. 2, pp. 171–194.
M. McLeay, A. Radia and R. Thomas. (2014). “Money creation in themodern economy”, Bank of England Quarterly Bulletin, Quarter 1.
Z. Jakab and M. Kumhof. (2015). “Banks are not intermediaries of loan-able funds – and why this matters”, Bank of England Working PapersSeries No. 529, Bank of England.
Federal Reserve Bank of Chicago. (1994 [1968]). “Modern Money Me-chanics”, A Workbook on Bank Reserves and Deposit Expansion.
A. Holmes. (1969). “Operational Constraints on the Stabilization ofMoney Supply Growth” (with discussion by J. Tobin), Controlling MonetaryAggregates, Conference Series 1, Federal Reserve Bank of Boston.
F. Kydland and E. Prescott. (1990). “Business Cycles: Real Facts and aMonetary Myth”, Federal Reserve Bank of Minneapolis Quarterly Review,Vol. 14, No. 2.
C. Borio and P. Disyatat. (2009). “Unconventional monetary policies:an appraisal”, BIS Working Papers, No. 292.
P. Disyatat. (2010). “The bank lending channel revisited”, BIS WorkingPapers, No. 297.
C. Goodhart. (2010). “Money, credit and bank behaviour: need for anew approach”, National Institute Economic Review, Vol. 214, No. 1.
S. Carpenter and S. Demiralp. (2010). “Money, reserves, and the trans-mission of monetary policy: does the money multiplier exist?”, Financeand Economics Discussion Series 2010-41, Board of Governors of theFederal Reserve System (U.S.).
P. Sheard. (2013). “Repeat After Me: Banks Cannot And Do Not ’LendOut’ Reserves”, Economic Research, Standard & Poor’s.
EC3115 :: L.4 : Banks and money creation - 5 / 67 - On endogenous money
Section 1
On endogenous money
ISE – KBTU A.D. Ushbayev (2015)
EC3115 :: L.4 : Banks and money creation - 6 / 67 - On endogenous money
“The lending operations of the bank will consist rather in its entering inits books a fictitious deposit equal to the amount of the loan [...]”
– Knut Wicksell, (1906), Lectures on Political Economy, Volume Two:Money, Lionel Robbins, ed., London: Routledge and Sons, Ltd.
ISE – KBTU A.D. Ushbayev (2015)
EC3115 :: L.4 : Banks and money creation - 7 / 67 - On endogenous money
“[...] in our days demand and supply of money have become about thesame thing, the demand to a large extent creating its own supply.”
– Knut Wicksell, (1907), “The Influence of the Rate of Interest on Prices,”The Economic Journal, Vol. 17
ISE – KBTU A.D. Ushbayev (2015)
EC3115 :: L.4 : Banks and money creation - 8 / 67 - On endogenous money
“[A bank] may itself purchase assets, i.e. add to its investments, and payfor them in the first instance at least, by establishing a claim againstitself. Or the bank may create a claim against itself in favour of a bor-rower, in return for his promise of subsequent reimbursement; i.e. itmay make loans or advances.”
– John Maynard Keynes, (1930), A Treatise on Money1.
1John Hicks noted in his Market Theory of Money (1986) that Keynes’ Treatise on Money was theearliest economics publication (that he could find) to have used the term liquidity.
ISE – KBTU A.D. Ushbayev (2015)
EC3115 :: L.4 : Banks and money creation - 9 / 67 - On endogenous money
“Each and every time a bank makes a loan, new bank credit is created –new deposits – brand new money.”
– Graham Towers1, (1939), Minutes of Proceedings and Evidence Respectingthe Bank of Canada, Committee on Banking and Commerce, Ottawa:Government Printing Bureau.
EC3115 :: L.4 : Banks and money creation - 10 / 67 - On endogenous money
“To put it in a more concrete fashion: if some capitalists increase theirinvestment by using for this purpose their liquid reserves, the profits ofother capitalists will rise pro tanto, and thus the liquid reserves investedwill pass into the possession of the latter. If additional investment isfinanced by bank credit, the spending of the amounts in question willcause equal amounts of saved profits to accumulate as bank deposits.
[...]
One important consequence of the above is that the rate of interest can-not be determined by the demand and supply of new capital becauseinvestment ’finances itself’.”
– Michal Kalecki, (1954 [1942]), “The Determinants of Profits”, in: M.Kalecki, (1971), Selected Essays on the Dynamics of the Capitalist Economy1933-1970 .
ISE – KBTU A.D. Ushbayev (2015)
EC3115 :: L.4 : Banks and money creation - 11 / 67 - On endogenous money
“But this [...] makes it highly inadvisable to construe bank credit on themodel of existing funds’ being withdrawn from previous uses by anentirely imaginary act of saving and then lent out by their owners. It ismuch more realistic to say that the banks [...] create deposits in theiract of lending, than to say that they lend the deposits that have beenentrusted to them. [...] The theory to which economists clung so tena-ciously makes [depositors] out to be savers when they neither savenor intend to do so; it attributes to them an influence on the “supplyof credit” which they do not have. Nevertheless, it proved extraordi-narily difficult for economists to recognise that bank loans and bankinvestments do create deposits.”
– Joseph Schumpeter, (1954), History of Economic Analysis, New York:Oxford University Press.
EC3115 :: L.4 : Banks and money creation - 12 / 67 - On endogenous money
“A commercial bank lends by crediting the borrower with a demand depositand it invests either by crediting the seller of the security with a demand de-posit or by writing a check on itself in favor of the seller of the security. Thebank expects that the borrower or the seller of the security credited with adeposit will use their deposit very soon after it is created. This will result inchecks being drawn on the initiating bank.
In a banking system with many banks, such as the American Banking System,the expectation is that the checks drawn on any particular bank will be depositedin another bank. The bank upon which the check is drawn must pay the bankin which the check is deposited the face amount of the check. This paymenttakes place by transferring reserves or banker’s money. In an active tradingcommunity offsetting claims for payments arise among the banks. Bankersare sophisticated enough to set up a clearing arrangement so that only thedifference between payments from a bank and payments to a bank are madein the form of reserve money.”
– Hyman Minsky, (1960), “The Pure Theory of Banking”, Teaching Handout, De-partment of Economics, University of California .
EC3115 :: L.4 : Banks and money creation - 13 / 67 - On endogenous money
“Within a banking system with a stable amount of deposits and distributionof customers, and assuming that no striking changes are taking place in theeconomy, a particular bank will expect that in the long run the value of thechecks written on it and the value of the checks deposited in it will be equal.On the average a bank in such an environment will not have any clearing losses.However there will be random, seasonal and cyclical shifts of deposits amongthe banks. In order to be able to meet the clearing losses which result from suchshifts, a prudent banker will always try to keep some minimum ratio of reservemoney to its deposits and will always try to have its portfolio of earning assetsso arranged that it can acquire additional reserve money when needed withoutpaying too great a penalty.
From a banker’s perspective, the purpose of the reserve is to enable a bankerto meet the clearing drains due to the behavior of secondary depositors. Eachbanker, to protect his ability to meet his obligations when due, will set a mini-mum value to this ratio below which he does not want to see it fall.”
– Hyman Minsky, (1960), “The Pure Theory of Banking”, Teaching Handout, De-partment of Economics, University of California .
EC3115 :: L.4 : Banks and money creation - 14 / 67 - On endogenous money
“The actual process of money creation takes place primarily in banks. Asnoted earlier, checkable liabilities of banks are money. These liabilitiesare customers’ accounts. They increase when customers deposit cur-rency and checks and when the proceeds of loans made by the banksare credited to borrowers’ accounts.
In the absence of legal reserve requirements, banks can build up de-posits by increasing loans and investments so long as they keep enoughcurrency on hand to redeem whatever amounts the holders of depositswant to convert into currency. [...]
One of the major responsibilities of the Federal Reserve System is toprovide the total amount of reserves consistent with the monetaryneeds of the economy at reasonably stable prices. Such actions takeinto consideration, of course, any changes in the pace at which moneyis being used and changes in the public’s demands for cash balances.”
– Federal Reserve Bank of Chicago, (1994 [1968]), “Modern Money Me-chanics”, A Workbook on Bank Reserves and Deposit Expansion.
EC3115 :: L.4 : Banks and money creation - 15 / 67 - On endogenous money
“[A] given increase in bank reserves is not necessarily accompanied byan expansion in money equal to the theoretical potential based on therequired ratio of reserves to deposits. What happens to the quantity ofmoney will vary, depending upon the reactions of the banks and thepublic. [...]
Of course, [banks] do not really pay out loans from the money theyreceive as deposits. If they did this, no additional money would becreated. What they do when they make loans is to accept promissorynotes in exchange for credits to the borrowers’ transaction accounts.Loans (assets) and deposits (liabilities) both rise by [the amount of theloan].”
– Federal Reserve Bank of Chicago, (1994 [1968]), “Modern Money Me-chanics”, A Workbook on Bank Reserves and Deposit Expansion.
EC3115 :: L.4 : Banks and money creation - 16 / 67 - On endogenous money
“But the point remains that the ebb and flow of reserves through market factors is verylarge. While defensive operations are generally successful in smoothing out the impactof these movements on reserves, even a 3 percent margin of error in judging thesemovements would exceed a $20 million reserve injection in many weeks. Hence thesmall, regular injection of reserves, week by week, is not really a very practical approach.
The idea of a regular injection of reserves – in some approaches at least – also suffersfrom a naive assumption that the banking system only expands loans after the System (ormarket factors) have put reserves in the banking system. In the real world, banks extendcredit, creating deposits in the process, and look for the reserves later. The questionthen becomes one of whether and how the Federal Reserve will accommodate thedemand for reserves. In the very short run, the Federal Reserve has little or no choiceabout accommodating that demand; over time, its influence can obviously be felt.
In any given statement week, the reserves required to be maintained by the bankingsystem are predetermined by the level of deposits existing two weeks earlier.”
– Alan Holmes1, (1969), “Operational Constraints on the Stabilization of Money SupplyGrowth” (with discussion by J. Tobin), Controlling Monetary Aggregates, Conference Series 1,Federal Reserve Bank of Boston.
1Senior Vice President of the Federal Reserve Bank of New York and Manager of System Open MarketAccount (1965-1979) – i.e. responsible for Open Market Operations for the entire Federal Reserve System.
EC3115 :: L.4 : Banks and money creation - 17 / 67 - On endogenous money
Let me illustrate the sort of problem that might be faced by citing some num-bers representing successive weekly forecasts of annual rates of money supplygrowth for a recent month-admittedly not a good month for our projectors.The projections cited begin with the one made in the last week of the precedingmonth and end with the projection made in the last week of the then currentmonth. The numbers are: -0.5 percent, +4 percent, +9 percent, +14 percent,+7 percent and +4.5 percent. I might also note that, in the middle of that then-current month, the projections for the following month were for a 14 percentrate of growth. By the end of the month, the projection was -2.5 percent.
Assuming that the Desk had been assigned a target of a 5 percent growth ratefor money supply, it seems quite obvious that, at mid-month, when the fore-cast was for a 14 percent growth rate for both the current and the followingmonth, we would have been required to act vigorously to absorb reserves.Two weeks later, on the other hand, if the estimates had held up, we wouldhave been required to reverse direction rather violently.”
– Alan Holmes, (1969), “Operational Constraints on the Stabilization of MoneySupply Growth” (with discussion by J. Tobin), Controlling Monetary Aggregates,Conference Series 1, Federal Reserve Bank of Boston.
EC3115 :: L.4 : Banks and money creation - 18 / 67 - On endogenous money
“A bank is not a money lender that first acquires and then places funds.[. . . ] a bank first lends or invests and then ‘finds’ the cash to coverwhatever cash drains arise. “
– Hyman Minsky, (1975), “Suggestion for a cash flow-oriented bankexamination”, Proceedings of a Conference on Bank Structure and Compe-tition, Federal Reserve Bank of Chicago.
ISE – KBTU A.D. Ushbayev (2015)
EC3115 :: L.4 : Banks and money creation - 19 / 67 - On endogenous money
“[The] increase in the supply of money is a consequence of increasedloan expenditure, not the cause of it [...]. In so far as the expenditureis ’financed’ by making use of an existing overdraft facility or as a resultof a new loan arrangement, there will be an automatic increase in themoney supply for the simple reason that the additional expenditure willswell the bank deposits of the recipients.”
– Nicholas Kaldor and James Trevithick, (1981), “A Keynesian Perspec-tive on Money”, Lloyds Bank Review, No. 139.
ISE – KBTU A.D. Ushbayev (2015)
EC3115 :: L.4 : Banks and money creation - 20 / 67 - On endogenous money
“With lagged reserve accounting, once loans have been granted anddeposits created, the monetary authorities have no choice but to pro-vide the banks with the necessary required reserves [...]. Their onlydecision concerns whether such reserve funds should be provided byopen market operations, or whether the banks should be driven to thediscount window.”
– Basil Moore, (1981), “The Endogenous Money Stock”, Journal of PostKeynesian Economics, Vol. 2, No. 1.
ISE – KBTU A.D. Ushbayev (2015)
EC3115 :: L.4 : Banks and money creation - 21 / 67 - On endogenous money
“It is through the credit markets that the process of monetary accommo-dation to higher nominal money wages occurs. The ability of centralbanks to control the rate of growth of monetary aggregates thereforehinges on their ability to control the rate of growth of bank lending,rather than the monetary base.
Once deposits have been created by an act of lending, the centralbank must somehow ensure that the required reserves are availableat the settlement date. Otherwise the banks, no matter how hard theyscramble for funds, could not in the aggregate meet their reserve re-quirements*.
*(continued in a footnote) With LRA (lagged reserve accounting), once loanshave been granted and deposits created, bank reserves are a predeterminedvariable. The monetary authorities have no choice but to provide the bankswith the necessary reserves, if orderly conditions in the financial markets areto be maintained.”
– Basil Moore, (1983), ”Unpacking the post Keynesian black box: bank lendingand the money supply”, Journal of Post Keynesian Economics, Vol. 5, No. 4.
EC3115 :: L.4 : Banks and money creation - 22 / 67 - On endogenous money
“One must remember that the coefficient of legal reserves does notapply to current deposits, but that it applies (by and large) to deposits ofthe previous month. This implies that, even in historical time, NorthAmerican banks first consent to additional loans and later attempt tofinance their credits on the open market.”
– Marc Lavoie, (1984), “The Endogenous Flow of Credit and the PostKeynesian Theory of Money”, Journal of Economic Issues, Vol. 18, No. 3.
EC3115 :: L.4 : Banks and money creation - 23 / 67 - On endogenous money
“[L]oans make deposits. Banks do not wait for the appropriate amount ofliquid resources to exists to provide new loans to the public (mainly firms).Credits are created ex nihilo. The recipient of the purchasing power is theinitial recipient of the loan. When the bank makes a new loan, the borroweris being immediately credited with a deposit, the amount of which is exactlyequal to the amount of the loan. Hence, [...] [t]he loan is the causal factor. [...]
Deposits make reserves. Once commercial banks have created credit money,how do they get hold of the reserves required by the newly created depositsor how do they obtain the currency cash requested by the public? In manyEuropean banking systems, France in particular, commercial banks simply bor-row their requirements in high-powered money. Most banks are permanentlyindebted to the central bank. The money market in those circumstances doesnot play a fundamental role. When banks, overall, are in need of more high-powered money, they increase their borrowings with the central bank at thediscount rate set by the latter. Legal reserve ratios, when they do exist, are notused to control the created quantity of money.”
– Marc Lavoie, (1985), “Credit And Money: Overdraft Economies, And Post-Keynesian Economics”, in: Marc Jarsulic (ed.), (1985), “Money And Macro Policy.
EC3115 :: L.4 : Banks and money creation - 24 / 67 - On endogenous money
“Money is unique in that it is created in the act of financing by a bankand is destroyed as the commitments on debt instruments owned bybanks are fulfilled. Because money is created and destroyed in thenormal course of business, the amount outstanding is responsive tothe demand for financing.”
– Hyman Minsky, (1986), Stabilizing an Unstable Economy, New York:McGraw-Hill.
EC3115 :: L.4 : Banks and money creation - 25 / 67 - On endogenous money
“Banking is not money lending; to lend, a money lender must havemoney. The fundamental banking activity is accepting, that is, guaran-teeing that some party is creditworthy.
[...]
When a banker vouches for creditworthiness or authorizes the drawingof checks, he need not have uncommitted funds on hand. He wouldbe a poor banker if he had idle funds on hand for any substantial time.In lieu of holding non-income-earning funds, a banker has access tofunds. Banks make financing commitments because they can operatein financial markets to acquire funds as needed; to so operate theyhold assets that are negotiable in markets and hold credit lines at otherbanks.”
– Hyman Minsky, (1986), Stabilizing an Unstable Economy, New York:McGraw-Hill.
EC3115 :: L.4 : Banks and money creation - 26 / 67 - On endogenous money
“There is no evidence that either the monetary base or M1 leads the[business] cycle, although some economists still believe this monetarymyth. Both the monetary base and M1 series are generally procyclicaland, if anything, the monetary base lags the cycle slightly.
[...]
The difference of M2 – M1 leads the cycle [...].
[...]
The fact that the transaction component of real cash balances (M1)moves contemporaneously with the cycle while the much larger non-transaction component (M2) leads the cycle suggests that credit ar-rangements could play a significant role in future business cycle theory.”
– Finn Kydland and Edward Prescott, (1990), “Business Cycles: RealFacts and a Monetary Myth”, Federal Reserve Bank of Minneapolis Quar-terly Review, Vol. 14, No. 2.
EC3115 :: L.4 : Banks and money creation - 27 / 67 - On endogenous money
“One of the most contentious issues in assessing the role of money isthe direction of causation between money and demand. Textbooksassume that money is exogenous. It is sometimes dropped by heli-copters, as in Friedman’s analysis of a ‘pure’ monetary expansion, or itssupply is altered by open-market operations. In the United Kingdom,money is endogenous – the Bank supplies base money on demand atits prevailing interest rate, and broad money is created by the bankingsystem. The endogeneity of money has caused great confusion, andled some critics to argue that money is unimportant. This is a seriousmistake.”
– Mervyn King1, (1994), “The transmission mechanism of monetary policy”,Bank of England Quarterly Bulletin, Quarter 3.
1Governor of the Bank of England and Chairman of the Monetary Policy Committee(2003-2013), Deputy Governor (1998-2003), Chief Economist and Executive Director(1991-1998).
EC3115 :: L.4 : Banks and money creation - 28 / 67 - On endogenous money
“Some decades ago, the academic literature would have emphasised theimportance of the reserves supplied by the central bank to the bankingsystem, and the implications (via the money multiplier) for the growthof money and credit. Today, it is more broadly understood that noindustrial country conducts policy in this way under normal circum-stances. Recognising how unstable in practice is the demand for cashreserves, and the associated implications for interest rate volatility, therehas been a decisive shift towards the use of short-term interest ratesas the policy instrument. In this framework, cash reserves supplied tothe banking system are whatever they have to be to ensure that thedesired policy rate is in fact achieved.”
– William White1, (2002 [2001]), “Changing views on how best to con-duct monetary policy: the last fifty years”, Speech at the Reserve Bankof India, Mumbai, India, 14 December 2001 (updated for presentation inOctober 2002), Bank for International Settlements.
1Deputy Governor of the Bank of Canada (1988-1994).
EC3115 :: L.4 : Banks and money creation - 29 / 67 - On endogenous money
“It appears that with RPD1, academic economists developed theoriesdetached from reality, without resenting or even admitting this de-tachment. Economic variables of very different nature were mixed upand precision in the use of the different concepts (e.g. operational versusintermediate targets, short-term vs. long-term interest rates, reservemarket quantities vs. monetary aggregates, reserve market shocks vs.shocks in the money demand, etc.) was often too low to allow obtainingapplicable results. The dynamics of academic research and the under-lying incentive mechanisms seem to have failed to ensure pressureon academics to ensure that models of central bank operations weresufficiently in line with the reality of these operations.”
– Ulrich Bindseil2, (2004), “The Operational Target of Monetary Policyand the Rise and Fall of Reserve Position Doctrine”, Working Paper Series,No. 372, European Central Bank.
1Reserve Position Doctrine, i.e. the money multiplier model.2Current Director General of Market Operations, former Head of Risk Management Divisionand former Head of Liquidity Management at the European Central Bank.
EC3115 :: L.4 : Banks and money creation - 30 / 67 - On endogenous money
“[B]anks [...] in the short run, [...] lever up their balance sheets andexpand credit at will.
As transactions balances and so the means of exchange in our paymentssystem, the moneyness of bank deposits lies at the core of credit inter-mediation. Subject only but crucially to confidence in their soundness,banks extend credit by simply increasing the borrowing customer’s cur-rent account, which can be paid away to wherever the borrower wantsby the bank ‘writing a cheque on itself’. That is, banks extend credit bycreating money. This ‘money creation’ process is constrained: by theirneed to manage the liquidity risk – from the withdrawal of depositsand the drawdown of backup lines – to which it exposes them. Ade-quate capital and liquidity, including for stressed circumstances, arethe essential ingredients for maintaining confidence.”
– Paul Tucker1, (2007), “Money and credit: Banking and the Macroecon-omy”, Speech at the Monetary Policy and the Markets Conference, Bank ofEngland.
1Deputy Governor of the Bank of England (2009-2013).
EC3115 :: L.4 : Banks and money creation - 31 / 67 - On endogenous money
“[E]xtra reserves do not mean however that a multiple amount ofmoney deposits will be created, as the standard money multiplier hasit. If banks do not find any credit-worthy borrower – and the fact thatthey now have additional reserves implies in no way that additionalcredit-worthy borrowers will be forthcoming – they always have thechoice to purchase government bills. [...] if the central bank is to keepthe interest rate at its target level, the central bank must sell to thebanks (and to households) the bills that they look for, and by so do-ing, the central bank will absorb the money balances that neither thebanks nor the households wish to hold.”
– Wynne Godley and Marc Lavoie, (2007), Monetary Economics: AnIntegrated Approach to Credit, Money, Income, Production and Wealth,Palgrave MacMillan.
ISE – KBTU A.D. Ushbayev (2015)
EC3115 :: L.4 : Banks and money creation - 32 / 67 - On endogenous money
“I suppose students have to learn [the ’money multiplier’, as an introduc-tion to the theory of fractional reserve banking], and it is easy to teach,but most practitioners find it to be a pretty unsatisfactory descriptionof how the monetary and credit system actually works. In large part,this is because it ignores the role of financial prices in the process.”
– Glenn Stevens1, (2008), “The Australian Economy: Then and Now”,[Reserve Bank of Australia] Governor Address to the Inaugural Faculty ofEconomics and Business Alumni Dinner, The University of Sydney.
1Governor of the Reserve Bank of Australia (2006-present).
EC3115 :: L.4 : Banks and money creation - 33 / 67 - On endogenous money
“In fact, the level of reserves hardly figures in banks’ lending decisions.The amount of credit outstanding is determined by banks’ willingnessto supply loans, based on perceived risk-return trade-offs, and by thedemand for those loans. The aggregate availability of bank reservesdoes not constrain the expansion directly. The reason is simple: [...]in order to avoid extreme volatility in the interest rate, central bankssupply reserves as demanded by the system. From this perspective, areserve requirement, depending on its remuneration, affects the cost ofintermediation and that of loans, but does not constrain credit expan-sion quantitatively. The main exogenous constraint on the expansionof credit is minimum capital requirements.”
– Claudio Borio1 and Piti Disyatat, (2009), “Unconventional monetarypolicies: an appraisal”, BIS Working Papers, No. 292.
1Economist at the Bank for International Settlements (“central bank of central banks”) since1987, currently Head of the Monetary and Economic Department.
EC3115 :: L.4 : Banks and money creation - 34 / 67 - On endogenous money
“A central proposition in research on the role that banks play in the transmissionmechanism is that monetary policy imparts a direct impact on deposits andthat deposits, insofar as they constitute the supply of loanable funds, act as thedriving force of bank lending. [...]
The tight association between monetary policy and deposits is typicallypremised either on the concept of the money multiplier or a portfolio-rebalancing view of households’ assets. [...] Changes in deposits are seen todrive bank loans.
This paper contends that the emphasis on policy-induced changes in deposits ismisplaced. If anything, the process actually works in reverse, with loans driv-ing deposits. In particular, it is argued that the concept of the money multi-plier is flawed and uninformative in terms of analyzing the dynamics of banklending. Under a fiat money standard and liberalized financial system, thereis no exogenous constraint on the supply of credit except through regulatorycapital requirements. An adequately capitalized banking system can alwaysfulfill the demand for loans if it wishes to.”
– Piti Disyatat, (2010), “The bank lending channel revisited”, BIS Working Papers,No. 297.
EC3115 :: L.4 : Banks and money creation - 35 / 67 - On endogenous money
“Simple textbook treatments of the money multiplier give the quantity of bankreserves a causal role in determining the quantity of money and bank lendingand thus the transmission mechanism of monetary policy. [...] Using datafrom recent decades, we have demonstrated that this simple textbook link isimplausible [...]. [...]
While the institutional facts alone provide compelling support for our view,we also demonstrate empirically that the relationships implied by the moneymultiplier do not exist in the data for the most liquid and well-capitalizedbanks. Changes in reserves are unrelated to changes in lending, and openmarket operations do not have a direct impact on lending. We conclude that thetextbook treatment of money in the transmission mechanism can be rejected.Specifically, our results indicate that bank loan supply does not respond tochanges in monetary policy through a bank lending channel, no matter how wegroup the banks.”
– Seth Carpenter and Selva Demiralp, (2010), “Money, reserves, and the trans-mission of monetary policy: does the money multiplier exist?”, Finance andEconomics Discussion Series 2010-41, Board of Governors of the Federal ReserveSystem (U.S.).
EC3115 :: L.4 : Banks and money creation - 36 / 67 - On endogenous money
“The growth of the Fed’s balance sheet, which has been funded by anincrease in commercial banks’ reserve balances at the Fed, has sparkedfears that the “money multiplier” mechanism would translate thosereserves into an explosion in bank lending, bank deposits, and inflation.None of these things has happened, because the money multiplier nolonger makes sense given the institutional framework of the contem-porary banking system. In spite of being almost totally divorced fromreality, the money multiplier is still taught in undergraduate economicstextbooks, with much resulting confusion.”
– Michael Feroli, (2010), Global Data Watch, Economic Research, J.P. Mor-gan Chase Bank, New York.
ISE – KBTU A.D. Ushbayev (2015)
EC3115 :: L.4 : Banks and money creation - 37 / 67 - On endogenous money
“The standard approach, in teaching and textbooks, to explaining thedetermination of both the supply of money, and the provision of bankcredit to the private sector, has been the money multiplier approach,whereby the Central Bank sets the high-powered monetary base, andthen the stock of money is a multiple of that. [...]
The old pedagogical analytical approach that centred around themoney multiplier was misleading, atheoretical and has recently beenshown to be without predictive value. It should be discarded imme-diately.
The practical realities, whereby the central bank and the commercialbanks set the interest rates at which they will operate, and then thevarious agents in the private sector and amongst the banks determinemonetary quantities endogenously, is more complex but has the ad-vantage of realism.”
– Charles Goodhart, (2010), “Money, credit and bank behaviour: needfor a new approach”, National Institute Economic Review, Vol. 214, No. 1.
ISE – KBTU A.D. Ushbayev (2015)
EC3115 :: L.4 : Banks and money creation - 38 / 67 - On endogenous money
“It used to be that most academic research treated money (or sometimesbase) as the exogenous policy instrument under the control of the cen-tral bank. This was an irritant to those of us working in central banks,because the instrument of policy had always been the short-term in-terest rate, and because all monetary aggregates (beyond base) havealways been and remain endogenous. In recent years, more and moreacademics, in specifying their models, have treated the short-term in-terest rate as the policy instrument, thereby increasing the usefulnessof their analyses [...]”
– Charles Freedman1, (2010), “Reflections on Three Decades at the Bankof Canada”, in: Macroeconomics, Monetary Policy, and Financial Stability:A festschrift in Honour of Charles Freedman, Bank of Canada.
1Deputy Governor of the Bank of Canada (1988-2003).
EC3115 :: L.4 : Banks and money creation - 39 / 67 - On endogenous money
“The banking system can thus create credit and create spending power –a reality not well captured by many apparently common sense descrip-tions of the functions which banks perform. Banks it is often said takedeposits from savers (for instance households) and lend it to borrowers(for instance businesses) with the quality of this credit allocation processa key driver of allocative efficiency within the economy. But in fact theydon’t just allocate pre-existing savings, collectively they create bothcredit and the deposit money which appears to finance that credit.”
– Adair Turner1, (2011), “Credit Creation and Social Optimality”, Speechat Southampton University, 29 September 2011.
1Chairman of the UK’s Financial Services Authority (2008-2013), Vice-Chairman of MerrillLynch Europe (2000-2006).
EC3115 :: L.4 : Banks and money creation - 40 / 67 - On endogenous money
“The money multiplier framework has a long and distinguished pedigreein the literature. Multiplier analysis is based on the assumption thatthe central bank unilaterally sets the level of the monetary base, i.e.the monetary base is the instrument of monetary policy. The moneymultiplier then determines the supply of broad money, while short-terminterest rates adjust in order to establish equilibrium between moneydemand and money supply. Clearly, this account contrasts with theway in which monetary policy is, in general, implemented in practice.In fact [...] central banks set an official interest rate and then supplythe volume of reserves necessary in order to steer short-term marketinterest rates close to the official interest rate.”
– European Central Bank, (2011), “Monthly Bulletin: October 2011”.
EC3115 :: L.4 : Banks and money creation - 41 / 67 - On endogenous money
“It is argued by some that financial institutions would be free to in-stantly transform their loans from the central bank into credit to thenon-financial sector. This fits into the old theoretical view about thecredit multiplier according to which the sequence of money creationgoes from the primary liquidity created by central banks to total moneysupply created by banks via their credit decisions. In reality the se-quence works more in the opposite direction with banks taking firsttheir credit decisions and then looking for the necessary funding andreserves of central bank money.”
– Vitor Constancio1, (2011), “Challenges to monetary policy in 2012”,Speech of the Vice-President of the ECB at the International Conference onInterest Rates, Frankfurt am Main, 8 December 2011.
1Vice President of the European Central Bank (2010-present); Governor of the Bank ofPortugal (2000-2010).
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“When banks extend loans to their customers, they create money bycrediting their customers’ accounts.”
– Mervyn King, (2012), Speech to the South Wales Chamber of Commerceat The Millenium Centre, Cardiff on 23rd October 2012.
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“How is deposit money created? The procedure is equivalent to thecreation of central bank money: As a rule the commercial bank extends aloan to a customer and credits the corresponding amount to his depositaccount. [...] The creation of deposit money is therefore an accountingtransaction.”
(as translated in Jakab and Kumhof (2015))
– Bundesbank, (2012), Geld und Geldpolitik, Frankfurt am Main: DeutscheBundesbank.
ISE – KBTU A.D. Ushbayev (2015)
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“The occurrence of significant excess central bank liquidity does not, in it-self, necessarily imply an accelerated expansion of ... credit to the privatesector. If credit institutions were constrained in their capacity to lend bytheir holdings of central bank reserves, then the easing of this constraintwould result mechanically in an increase in the supply of credit. TheEurosystem, however, [...] always provides the banking system withthe liquidity required to meet the aggregate reserve requirement. Infact, the ECB’s reserve requirements are backward-looking, i.e. theydepend on the stock of deposits (and other liabilities of credit insti-tutions) subject to reserve requirements as it stood in the previousperiod, and thus after banks have extended the credit demanded bytheir customers.”
– European Central Bank, (2012), “Monthly Bulletin: May 2012”.
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“Financial contracts are set in nominal, not in real, terms. More importantly, the bankingsystem does not simply transfer real resources, more or less efficiently, from one sec-tor to another; it generates (nominal) purchasing power. Deposits are not endowmentsthat precede loan formation; it is loans that create deposits. Money is not a “friction” buta necessary ingredient that improves over barter. And while the generation of purchasingpower acts as oil for the economic machine, it can, in the process, open the door toinstability, when combined with some of the previous elements. Working with betterrepresentations of monetary economies should help cast further light on the aggregateand sectoral distortions that arise in the real economy when credit creation becomesunanchored, poorly pinned down by loose perceptions of value and risks. Only then willit be possible to fully understand the role that monetary policy plays in the macroecon-omy. And in all probability, this will require us to move away from the heavy focus onequilibrium concepts and methods to analyse business fluctuations and to rediscoverthe merits of disequilibrium analysis such as that stressed by Wicksell (1898)1”.
– Claudio Borio, (2012), “The financial cycle and macroeconomics: What have we learnt?”,BIS Working Papers, No. 395.
1K. Wicksell. (1898). Geldzins und Güterpreise. Eine Untersuchung über die den Tauschwert desGeldes bestimmenden Ursachen. Jena. Gustav Fischer (Translated: (1936). Interest and prices: Astudy of the causes regulating the value of money, London: Macmillan).
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“Banks do not, as too many textbooks still suggest, take deposits ofexisting money from savers and lend it out to borrowers: they createcredit and money ex nihilo – extending a loan to the borrower andsimultaneously crediting the borrower’s money account. That creates,for the borrower and thus for real economy agents in total, a matchingliability and asset, producing, at least initially, no increase in real networth. But because the tenor of the loan is longer than the tenor ofthe deposit – because there is maturity transformation – an effectiveincrease in nominal spending power has been created.”
– Adair Turner, (2013), “Credit, money and leverage: what Wicksell,Hayek and Fisher knew and modern macroeconomics forgot”, Speechat the conference “Towards a Sustainable Financial System”, 12 September2013, Stockholm School of Economics.
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“[T]he widespread view [is] that banks can “lend out” their reserves(deposits) at the central bank, as if bank reserves represented a pool ofmoney that is just waiting to “flow into” bank lending. [S]uch a thing can-not occur and therefore has not occurred, the point is usually madein reverse [...]. [...]
Many talk as if banks can “lend out” their reserves, raising concerns thatmassive excess reserves created by QE could fuel runaway credit cre-ation and inflation in the future. But banks cannot lend their reservesdirectly to commercial borrowers, so this concern is misplaced.
Banks do need to hold reserves (as a liquidity buffer) against their de-posits, and banks create deposits when they lend. But normally banksare not reserve constrained, so excess reserves do not loosen a re-serve constraint.”
– Paul Sheard, (2013), “Repeat After Me: Banks Cannot And Do Not’Lend Out’ Reserves”, Economic Research, Standard & Poor’s.
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Section 2
Balance sheet analysis of money creation
ISE – KBTU A.D. Ushbayev (2015)
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Macroeconomic modelling since the GFC
The crisis of 2007-2008 has uncontroversially demonstrated theimportance of the banking system for the functioning of the realeconomy, but mainstream macroeconomic theory was notparticularly ready to provide explanations for this linkage, since banksdid not feature in most macroeconomic models.
Since the Great Recession, however, banks have received much moreattention in macroeconomic modelling.
The old outdated mode of thinking about banks as intermediaries ofpre-existing savings (loanable funds), completely detached fromoperation reality, has been slowly giving way to more realisticrepresentations.
In the real world, banks provide financing and create new purchasingpower through the creation of new loans and the associated deposits –creating their own funding.
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Two recent examples of central bank research reflecting this shift are:Description: M. McLeay, A. Radia and R. Thomas. (2014). “Moneycreation in the modern economy”, Bank of England Quarterly Bulletin,Quarter 1.Model1: Z. Jakab and M. Kumhof. (2015). “Banks are not intermediariesof loanable funds – and why this matters”, Bank of England WorkingPapers Series No. 529, Bank of England.
1An attempt to properly represent credit money creation by banks ex nihilo in a DSGEframework.
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“Furthermore, if the loan is for physical investment purposes, this newlending and money is what triggers investment and therefore, by thenational accounts identity of saving and investment (for closedeconomies), saving2. Saving is therefore a consequence, not a cause,of such lending. Saving does not finance investment, financing does.To argue otherwise confuses the respective macroeconomic roles ofresources (saving) and debt-based money (financing). [...]
The fact that banks technically face no limits to increasing the stocksof loans and deposits instantaneously and discontinuously does not,of course, mean that they do not face other limits to doing so. But themost important limit, especially during the boom periods offinancial cycles when all banks simultaneously decide to lend more,is their own assessment of the implications of new lending for theirprofitability and solvency, rather than external constraints such asloanable funds, or the availability of central bank reserves.” (Zakaband Kumhof, 2015).
2We will discuss the process of investment generating saving later on in this course.ISE – KBTU A.D. Ushbayev (2015)
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The money multiplier model, that assumes that the availability ofcentral bank reserves imposes limits to the size of bank balancesheets does not take into account that modern central banks operatean interest rate target and supply whatever volumes of reserves (andcash) as the banking system demands at that rate.
The quantity of reserves in such regimes is a consequence, and not acause, of bank lending and money creation.
Whenever a banks lends to a new customer, they create newpurchasing power at zero cost and do not divert any real resourcesfrom other uses or other agents.
The only requirement for the smooth functioning of this process ofpurchasing power creation, is that other agents accept these new bankliabilities (deposits created in the process of loan extension) inpayment for real goods and services. Since bank deposits are themost dominant medium of exchange in all developed economies, thisrequirement is usually satisfied.
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“Although commercial banks create money through lending, theycannot do so freely without limit. Banks are limited in how muchthey can lend if they are to remain profitable in a competitivebanking system. Prudential regulation also acts as a constraint onbanks’ activities in order to maintain the resilience of the financialsystem. And the households and companies who receive themoney created by new lending may take actions that affect thestock of money — they could quickly ‘destroy’ money by using it torepay their existing debt, for instance.
Monetary policy acts as the ultimate limit on money creation. TheBank of England aims to make sure the amount of money creation inthe economy is consistent with low and stable inflation. In normaltimes, the Bank of England implements monetary policy by settingthe interest rate on central bank reserves. This then influences a rangeof interest rates in the economy, including those on bank loans.”(McLeay, Radia and Thomas, 2014).
ISE – KBTU A.D. Ushbayev (2015)
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The business model of banks is based on leverage.
Whereas non-financial corporations generate their return on equity(ROE) primarily through the return on their assets (ROA), banks rely onmuch higher leverage.
This can be analyzed using the DuPont identity:
ROE=Profits
Equity=
Profits
Revenues︸ ︷︷ ︸
Profit margin
×Revenues
Assets︸ ︷︷ ︸
Asset turnover︸ ︷︷ ︸
ROA = ProfitsAssets
×Assets
Equity︸ ︷︷ ︸
Financial leverage
Using a typical western bank leverage level of 12-14, a bank wouldthus only need to generate 1.1%-1.25% of ROA to achieve a 15% ROE,which is radically different from a typical leverage situation of anon-financial corporation.
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Due to much lower asset turnover levels, and thus lower ROA, in thebanking business, the disparity is compensated through higherleverage.
Banks can afford this because they can get much cheaper liabilitiesthan non-financial corporations.
The fact that excessive leverage in the banking system can create risksto financial stability necessitates the existence of prudential regulationof their business.
Government, in the face of central banks and financial supervisionauthorities, sets minimum limits on own capital positions of banksand limits the type of assets that a bank is allowed to hold.
At the same time, the government’s system of providing insurance tobank deposits provides compensation to above by way of furtherreducing the cost of acquiring such deposits for the banks.
ISE – KBTU A.D. Ushbayev (2015)
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A (highly simplified) central bank balance sheet looks like this:
Central bank
Assets (A) Reserves (R)
Banknotes in circulation (BN)
Government deposits (GD)
The central bank balance sheet identity thus reads:
A= R+ BN + GD
The changes to the balance sheet of the central bank will need to obey thefollowing accounting relation:
∆A=∆R+∆BN +∆GD
ISE – KBTU A.D. Ushbayev (2015)
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Or, rearranging for the changes in reserves:
∆R=∆A−∆BN −∆GD
Since the above is an identity, the aggregate level of reserves can change inthree, and only three, ways.
∆R ↑ (or ↓) – reserves increase (decrease) if:∆A ↑ (or ↓) – the central bank increases (decreases) its assets.
∆BN ↓ (or ↑) – the private sector decreases (increases) the amount ofcash it wants to hold.
∆GD ↓ (or ↑) – the government decreases (increases) its deposits atthe central bank by making net transfers to (receiving net transfersfrom) the private sector.
Most importantly, due to this identity, banks cannot ever directly “lend out”their reserves to the private sector, and thus cannot change the aggregateamount of reserves in the system without an accommodating reactionfrom the central bank.
ISE – KBTU A.D. Ushbayev (2015)
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Without a change in cash demand by the private sector (∆BN ) or innet transfers between the government and the private sector (∆GD) –both of which are beyond the direct control of commercial banks andthe central bank – the reserves will always remain unchanged and“parked” on the central bank balance sheet unless the central bankdecided to interact with the commercial banks by buying or sellingassets.
Although individual banks or the banking system as a whole cannot“lend out” their reserves, they can trade excess reserves between eachother by lending them to other banks in the inter-bank markets or bybuying assets from each other – in which case the reserves get shiftedbetween bank reserve accounts and still always remain on the centralbank’s balance sheet in aggregate.
ISE – KBTU A.D. Ushbayev (2015)
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Now consider a bank issuing a new loan to a customer:Bank
+ Loan to borrower $100 + Deposit of borrower $100
Borrower
+ Deposit $100 + Loan $100
Table 1: Bank issues a new loan to borrower.
Assuming a 10% required reserve ratio and assuming the new deposit staysunspent, the bank, if it lacks reserves to meet the extra requirement arising with thenew deposit, will need to borrow reserves in the money market:
Bank
+ Loan to borrower $100
+ Reserve balances $10
+ Deposit of borrower $100
+ Inter-bank borrowings $10
Table 2: Bank accesses the money market to borrow the necessary reserves.
ISE – KBTU A.D. Ushbayev (2015)
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Assuming instead that the original borrower spends the proceeds of the loan topurchase goods or services, a withdrawal of the deposit occurs:
Bank
+ Loan to borrower $100
- Reserve balances $100
+ Reserve balances $100
Total: + Loan to borrower $100
+ Deposit of borrower $100
- Deposit to borrower $100
+ Inter-bank borrowings $100
Total: + Borrowings $100
Borrower
+ Deposit $100
- Deposit $100
+ Goods purchased $100
Total: + Goods
+ Loan $100
Total: + Loan $100
Goods seller’s bank
+ Reserve balances $100 + Deposit $100
Goods seller
+ Deposit $100
- Inventories of goods $100
Table 3: Goods purchase on credit completed.
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In the above example now the bank’s loan is offset on the liability sideof the balance sheet by borrowings in the money markets acquired tomeet the deposit withdrawal.
The newly issued loan will also require the bank to assign a capitalcharge on the use of balance sheet which presents an additionalopportunity cost to the bank above and beyond the cost of funding.
This shows that bank assets growth is constrained by available capital.
Unless the bank is charging a sufficiently high interest on the loan tomake the whole exercise profitable on a risk-adjusted basis, it willafterwards seek to replace the inter-bank borrowings with thecheapest funding alternative – deposits, which are expected to flow induring the regular course of operation.
Larger banks, though, regularly hold a significant percentage of theirliabilities as money market borrowings.
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The role of reserve balances, thus, is to facilitate the meeting ofreserve requirements and the settlement of payments.
In countries, where central bank operate an interest rate target3 andaccommodate the necessary demand for reserves at that rate –reserve balances can always be acquired by banks.
Reserve requirements are usually set to be met on a lagged basis, e.g.in the US reserve requirements are calculated as a percentage ofend-of-day deposits averaged over a 2-week period less vault cash heldby the bank over the same 2-week period.
in the European Monetary Union, reserve requirements are calculated asa percentage of end-of-day deposits held for a month.
In the specific case where the recipient of payment from theout-flowing deposit occurs to be a customer of the same bank as thepayer, no net deposit outflow will take place.
3Note that this requires either flexible exchange rates or capital controls as per theimpossible trinity, which we will discuss later in this course.
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The flow of reserves arising from payment settlement between banksis greatly smoothed by the netting payments systems, whereby abank will only see its reserve account debited at the close of businessday if all transactions for that day result in a net outflow.
In reality, many loans are securitized and on-sold by the banks to finalinvestors, and the proceeds of these sales are then used to repaymoney market borrowings.
Also note that beyond incoming and outgoing deposit flows for abank, its existing customers may also shift (or initially decide to hold)their funds internally from deposits to savings, time deposits ormoney market accounts that are non-reservable.
ISE – KBTU A.D. Ushbayev (2015)
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Now let’s turn to the banking system’s aggregated balance sheet, whathappens to it in the process of endogenous money (credit) creation, andhow it interacts with the central bank balance sheet.
*This and the following illustrations are taken from (McLeay, Radia and Thomas, 2014).
ISE – KBTU A.D. Ushbayev (2015)
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Thus the banking system’s balance sheet experiences growth. Similarmirroring experience happens to the balance sheet of the rest of theprivate sector:
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In the first instance, at least, this does not induce any change in theamount of central bank reserves:
The creation of bank deposits in the above scheme influences how muchreserves the banking system will want to hold in order to meet reserverequirements, accommodate withdrawals by the public and makepayments to other banks. In normal times these reserves will then besupplied on demand by the central bank to the banking system if, inaggregate, net demand for reserves increases for whatever reason.
ISE – KBTU A.D. Ushbayev (2015)
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Although commercial banks create money and grow their balance sheetsvia lending, this process cannot continue without limit:
1. Banks themselves face limits on how much they can lend due to (i)limits to profitable lending opportunities in a competitive marketenvironment, (ii) capital and risk management considerations and (iii)prudential regulation.
2. Money creation is also constrained by the behaviour of the privatesector in the form of (i) demand for credit and (ii) transactionsdecisions that are able to immediately destroy credit money throughe.g. repayment of existing outstanding loans.
3. The ultimate constraint on money creation is monetary policy,whereby by influencing the level of interest rates in the economy,central banks can affect the general dynamic of economic activity andthus how much the private sector will want to borrow. Central bankswill aim to ensure that money and credit growth is consistent withtheir objective of price stability.
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