reserve requirements
https://www.ecb.europa.eu/pub/pdf/other/gendoc2002en.pdf
The single monetary policy in the euro area: General documentation on Eurosystem monetary policy instruments and procedures
The daily reserve holding of an
institution is calculated as the end-of-day
In the United Kingdom, money is endogenous - Mervyn King in 1994
But what did he mean by that?
From about 1991 a remarkable consensus had emerged within developed economies about the optimum design of monetary policy methods. Simplifying somewhat, we could say that the early 1980s saw the final demise of attempts to control the quantities of money (and/or credit) by any direct method[1]
This did not happen all at once.
In 1994 Mervyn King then Chief Economist at the Bank of England said[2] 'One of the most contentious issues in assessing the role of money is the direction of causation between money and demand. Textbooks assume that money is exogenous. It is sometimes dropped by helicopters, as in Friedman’s analysis of a ‘pure’ monetary expansion, or its supply is altered by open-market operations. In the United Kingdom, money is endogenous - the Bank [of England] supplies base money on demand at its prevailing interest rate, and broad money is created by the banking system'.
One of the reasons money is endogenous is because banks create credit[3][4] rather than lending existing money. Therefore if the central bank in turn has a policy of supplying money on demand at a price, then the broad money supply can keep rising. However, the creation of central bank money actually happened after money creation by the commercial banks (King 1994 Page 264). King continues, 'Therefore the endogeneity of money has caused great confusion, and led some critics to argue that money is unimportant. This is a serious mistake' (King 1994, Page 264).
Charles Goodhart, an economist and formerly an advisor at the Bank of England and a former monetary policy committee member, worked for many years to encourage a different approach to money supply analysis and said the base money multiplier model was 'such an incomplete way of describing the process of the determination of the stock of money that it amounts to misinstruction'[5] Ten years later he said[6] ‘Almost all those who have worked in a [central bank] believe that this view is totally mistaken; in particular, it ignores the implications of several of the crucial institutional features of a modern commercial banking system....’
13 years after Mervyn Kings observations on 'contentious issues' between Exogenous and Endogenous money, Deputy governor Paul Tucker was able to say[7] ”When, ten years ago, Mervyn King delivered a lecture...., he reviewed ideas on the monetary transmission mechanism....... and the role of money (and credit). These days most such accounts.....begin with a simple assertion that the central bank sets the short-term nominal interest rate. And they go on to explain how, given sticky wages and prices, that enables the central bank to shift the short-term real interest rate in a way that either restrains or stimulates aggregate demand. Notice no mention of money here. On this view of the world and, in particular, given this way of implementing monetary policy, money – both narrow and broad – is largely endogenous. The central bank simply supplies whatever amount of base money is demanded by the economy at the prevailing level of interest rates.'
Therefore many Central bankers and monetary economists now believe money creation in banking systems is endogenously created and deposit multiplication by the text book money multiplier is an unsatisfactory teaching tool[8] and explanation of the what really happens.
Note however, it is clear that loans create money and a money multiplier exists related to lending. The issue being addressed however is that money creation is chaotic and cannot be modeled using simple mechanical views of lending only created from existing deposits because banks essentially do not loan out deposits, but rather create credit and then manage the liabilities this creates for them. (Tucker 2007).
However notwithstanding all of the above, dispite the apparent consensus at the BOE and other central banks, twenty five years after the switch to short-term interest rates, macroeconomic instruction at the textbook level still requires students to learn that monetary policy consists (solely) of exogenously imposed changes in the money stock which transmits itself to changes in demand (and then possibly output but more usually the price level) by some version of ‘real balance effects’. This is wholly at odds with our everyday knowledge of the policy instrument and with what central banks widely believe is the transmission of monetary policy effects (Howells P et al 2006 page 3).
Bank lending
The economic literature on the ‘bank lending’ channel of the Monetary Transmission Mechanism
explores the conditions under which a tightening of monetary policy causes the terms on bank
lending to tighten over and above the increase in risk-free short-term real rates. The literature
has typically assumed
- (i) that a monetary policy tightening is effected by the central bank withdrawing reserves from the system (or slowing the pace of reserves injection);
- (ii) that banks are required to hold a proportion of transactions deposits in reserves, so that reduced reserves provision entails slower deposit growth; and
- (iii) that they do not have unrestricted access to liabilities that are not subject to reserves requirements, and so cannot fill the gap left by slower deposit growth and must, instead, slow loan growth, which they do by tightening credit conditions.
The first two steps seem archaic. The BOE effect monetary policy changes by
controlling the price not the quantity of central bank money in the system; and, in the UK, banks
choose their own reserves targets rather than having them determined by a balance sheet ratio of
some kind. (Tucker[10], Paul. 2007.12.03 pages 6-7)
Where does this leave base Money, the starting point for much traditional monetary analysis?
The BOE explain that banks, in the short run, lever up their balance sheets and expand credit at will - there liabilities are money and because transactions balances and so the means of exchange in our payments system, the moneyness of bank deposits lies at the core of credit intermediation. Subject only but crucially to confidence in their soundness, banks extend credit by simply increasing the borrowing customer’s current account, which can be paid away to wherever the borrower wants by the bank ‘writing a cheque on itself’. That is, banks extend credit by creating money. This ‘money creation’ process is constrained: by their need to manage the liquidity risk – from the withdrawal of deposits and the drawdown of backup lines – to which it exposes them. 15 Adequate capital and liquidity, including for stressed circumstances, are the essential ingredients for maintaining confidence. (Tucker, Paul. 2007.12.03 pages 9-10).
[11]
Bank lending
In 2007 Paul Tucker[22], outlined some of the practical implications of endogenous money in the UK.
On pages 6-7 he said
"All this brings back into focus the potential macroeconomic relevance of bank lending.
Bank lending
The economic literature on the ‘bank lending’ channel of the Monetary Transmission Mechanism
explores the conditions under which a tightening of monetary policy causes the terms on bank
lending to tighten over and above the increase in risk-free short-term real rates. The literature
has typically assumed (i) that a monetary policy tightening is effected by the central bank
withdrawing reserves from the system (or slowing the pace of reserves injection); (ii) that banks
are required to hold a proportion of transactions deposits in reserves, so that reduced reserves
provision entails slower deposit growth; and (iii) that they do not have unrestricted access to
liabilities that are not subject to reserves requirements, and so cannot fill the gap left by slower deposit growth and must, instead, slow loan growth, which they do by tightening credit
conditions. The first two steps seem archaic. We effect monetary policy changes by controlling the price not the quantity of central bank money in the system; and, in the UK, banks choose their own reserves targets rather than having them determined by a balance sheet ratio of
some kind."
And on page 9-10 he said
"Where does this leave money (or Money), the starting point for much traditional monetary analysis?
Well, much that I have said about banks – their capacity, in the short run, to lever up their balance sheets and expand credit at will; their role in providing liquidity insurance to investment
vehicles and corporates – turns precisely on their liabilities being money. And for this reason,
banks are after all decisively different from other intermediaries.
As transactions balances and so the means of exchange in our payments system, the moneyness
of bank deposits lies at the core of credit intermediation. Subject only but crucially to confidence in their soundness, banks extend credit by simply increasing the borrowing customer’s current account, which can be paid away to wherever the borrower wants by the bank ‘writing a cheque on itself’. That is, banks extend credit by creating money. This ‘money creation’ process is constrained: by their need to manage the liquidity risk – from the withdrawal of deposits and the drawdown of backup lines – to which it exposes them. Adequate capital and liquidity,
including for stressed circumstances, are the essential ingredients for maintaining confidence."
"Hence the appearance of the balance sheet: many small short term deposits matching fewer, larger long term loans. But deposits do not cause the loans, rather loans create deposits" Howells book page 33
Banks with surplus "excess reserves" loan those reserves to other financial institutions - howells P36
Bank lending
In 2007 Paul Tucker(Tucker[1], outlined some of the practical implications of endogenous money in the UK.
On pages 6-7 he said
"All this brings back into focus the potential macroeconomic relevance of bank lending.
Bank lending
The economic literature on the ‘bank lending’ channel of the Monetary Transmission Mechanism
explores the conditions under which a tightening of monetary policy causes the terms on bank
lending to tighten over and above the increase in risk-free short-term real rates. The literature
has typically assumed (i) that a monetary policy tightening is effected by the central bank
withdrawing reserves from the system (or slowing the pace of reserves injection); (ii) that banks
are required to hold a proportion of transactions deposits in reserves, so that reduced reserves
provision entails slower deposit growth; and (iii) that they do not have unrestricted access to
liabilities that are not subject to reserves requirements, and so cannot fill the gap left by slower deposit growth and must, instead, slow loan growth, which they do by tightening credit
conditions. The first two steps seem archaic. We effect monetary policy changes by controlling the price not the quantity of central bank money in the system; and, in the UK, banks choose their own reserves targets rather than having them determined by a balance sheet ratio of
some kind."
And on page 9-10 he said
"Where does this leave money (or Money), the starting point for much traditional monetary analysis?
Well, much that I have said about banks – their capacity, in the short run, to lever up their balance sheets and expand credit at will; their role in providing liquidity insurance to investment
vehicles and corporates – turns precisely on their liabilities being money. And for this reason,
banks are after all decisively different from other intermediaries.
As transactions balances and so the means of exchange in our payments system, the moneyness
of bank deposits lies at the core of credit intermediation. Subject only but crucially to confidence in their soundness, banks extend credit by simply increasing the borrowing customer’s current account, which can be paid away to wherever the borrower wants by the bank ‘writing a cheque on itself’. That is, banks extend credit by creating money. This ‘money creation’ process is constrained: by their need to manage the liquidity risk – from the withdrawal of deposits and the drawdown of backup lines – to which it exposes them. Adequate capital and liquidity,
including for stressed circumstances, are the essential ingredients for maintaining confidence."
shortened version of tucker quotation
In 2007 Paul Tucker[2], outlined some of the practical implications of endogenous money on UK banking.
On pages 6-7 he said
"this brings back into focus the potential macroeconomic relevance of bank lending.
Bank lending
The economic literature....has typically assumed (i) that a monetary policy tightening is effected by the central bank withdrawing reserves from the system (or slowing the pace of reserves injection); (ii) that banks are required to hold a proportion of transactions deposits in reserves, so that reduced reserves provision entails slower deposit growth; and iii.....The first two steps seem archaic. We ....control.... the price not the quantity of central bank money in the system; and, in the UK, banks choose their own reserves targets rather than having them determined by a balance sheet ratio of some kind."
And on page 9-10 he said
"Where does this leave money (or Money), the starting point for much traditional monetary analysis?
....banks....in the short run,....lever up their balance sheets and expand credit at will....banks extend credit by simply increasing the borrowing customer’s current account....banks extend credit by creating money. This ‘money creation’ process is constrained: by their need to manage the liquidity risk – from the withdrawal of deposits and the drawdown of backup lines – to which it exposes them."
Alternative views
Endogenous money theory states that the supply of money is credit-driven and determined endogenously by the demand for bank loans, rather than exogenously by monetary authorities.
In an exogenous view of money multiplication, a bank lends depositors money as "excess reserves" and this fraction of the depositors money then becomes the source for new money in the banking system. For example 100 is deposited, 10% is retained as "required reserves", and 90 "excess reserves are loaned.
However there is no requirement for a bank to operate in that manner. In practice, a 10% fractional reserve bank with 10,000 reserves and 100,000 created customer deposits, can comfortably deposit a loan of 1000 into a customers current account if it can borrow 100 reserves.
In the endogenous money view therefor:
- Rather than lending customer money, the banks are extending credit and then managing the liabilities this creates for them
- Loans tend to lead to reserve creation. This is explainable because, since about 1992, the central banks are supplying reserves on demand to keep the money market cash rate at the desired target rate. Therefore if the banking system is short of reserves due to deposit expansion, the central bank is obliged to supply sufficent money to keep the money market interest rate at the target rate.
- The base money multiplier is considered to be a misleading way of describing how banks operate.
- Demand for loans from creditworthy customers becomes the driving force for deposit expansion. If a customer wants a loan, the bank can price the loan, and then borrow whatever amounts are required to maintain their fractional reserves.
In 1994 Mervyn King then Chief Economist at the Bank of England said[1] 'One of the most contentious issues in assessing the role of money is the direction of causation between money and demand. Textbooks assume that money is exogenous.... In the United Kingdom, money is endogenous'
Charles Goodhart, an economist and formerly an advisor at the Bank of England and a former monetary policy committee member, said the base money multiplier model[2] was 'such an incomplete way of describing the process of the determination of the stock of money that it amounts to misinstruction'[3]
What exactly[4]is so misleading about the money multiplier approach?
- Firstly the base money multiplier contains a number of assumptions that are very easy to make which is of course why it is still embedded in macroeconomics.
- Secondly, the monetary policy instruments used by central banks for some years now, are based on short term interest rates set by the central bank, not the quantity of base money. The base multiplier model requires it to set the quantity of money, but in the real world we know it sets the price.
- Thirdly if the central bank sets the interest rates it must then supply the reserves the banks require and this will depend on the demand for loans at the going rate of interest. Therefore the money supply is determined by the economy rather than the central bank.
Howells has managed to incorporate the main points of the endogenous view on the money-supply process into a macroeconomics textbook[5].
In 2007 Paul Tucker[6], outlined some of the practical implications of endogenous money in the UK.
"The economic literature....assumed (i) that a monetary policy tightening is effected by the central bank withdrawing reserves....(ii) that banks are required to hold a proportion of transactions deposits in reserves.... The first two steps seem archaic. We control....the price....of....central bank money....and, in the UK, banks choose their own reserves targets rather than having them determined by a balance sheet ratio of some kind....banks....in the short run....lever up their balance sheets and expand credit at will....banks extend credit by simply increasing the borrowing customer’s current account....banks extend credit by creating money"
Andrewedwardjudd (talk) 16:29, 14 April 2011 (UTC)andrewedwardjudd
Seth B. Carpenter and Selva Demiralp have written of their skepticism of the money multiplier mechanism.[7]
Also, the idea that the reserve requirement places an upper limit on the money supply is disputed by some economists outside of the mainstream.[8] Notably, theories of endogenous money date to the 19th century, and were subscribed to by Joseph Schumpeter, and later the post-Keynesians.[9] Endogenous money theory states that the supply of money is credit-driven and determined endogenously by the demand for bank loans, rather than exogenously by monetary authorities.
Money exo- and endogeneity in the evolution of financial institutions and monetary policy implementation
"In what follows we shall take heed of Hicks (1967, p. 153) who advised that “monetary theory…
cannot avoid a relation to reality. It belongs to monetary history in a way that economic theory
does not always belong to economic history.” Accordingly, this section reviews the evolution
of monetary and financial institutions of the Western world and argues that the assumption of
exogenous money and the multiplier model of the money-supply process constitute a largely
accurate description of the financial system up to the first half of the twentieth century. However, modern institutional conditions, as well as the monetary policy framework in operation, are much better understood from the perspective of endogenous money view in the vein of the bank-centric model of money supply process." (Jablecki, J. page 38)
Alan Holmes, who was at the time a Senior Vice President of the Federal Reserve Bank of New York responsible for open market operations wrote in the 1960's "In the real world, banks extend credit, creating deposits in the process, and look for reserves later. The question then becomes one of whether and how the Federal Reserve will accommodate the demand for reserves. In the very short run, the Federal Reserve has little or no choice about accommodating that demand"[10]
Also from the 1960's a work book on bank reserves and deposit expansion from the Federal Reserve Bank of Chicago explains in the opening paragraph[11] "The relationships shown are based on simplifying assumptions. For the sake of simplicity, the relationships are shown as if they were mechanical, but they are not, as is described later in the booklet. Thus, they should not be interpreted to imply a close and predictable relationship between a specific central bank transaction and the quantity of money"
Later in the booklet it says
"Of course, they do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts. Loans (assets) and deposits (liabilities) both rise by $9,000. Reserves are unchanged by the loan transactions. But the deposit credits constitute new additions to the total deposits of the banking system."
and
"In the real world, a bank's lending is not normally constrained by the amount of excess reserves it has at any given moment. Rather, loans are made, or not made, depending on the bank's credit policies and its expectations about its ability to obtain the funds necessary to pay its customers' checks and maintain required reserves in a timely fashion"
This booklet was last updated in 1992.
Seth B. Carpenter and Selva Demiralp have written of their skepticism of the money multiplier mechanism.[12]
Also, the idea that the reserve requirement places an upper limit on the money supply is disputed by some economists outside of the mainstream.[13] Notably, theories of endogenous money date to the 19th century, and were subscribed to by Joseph Schumpeter, and later the post-Keynesians.[14] Endogenous money theory states that the supply of money is credit-driven and determined endogenously by the demand for bank loans, rather than exogenously by monetary authorities.
In 1994 Mervyn King then Chief Economist at the Bank of England said[15] 'One of the most contentious issues in assessing the role of money is the direction of causation between money and demand. Textbooks assume that money is exogenous. It is sometimes dropped by helicopters, as in Friedman’s analysis of a ‘pure’ monetary expansion, or its supply is altered by open-market operations. In the United Kingdom, money is endogenous - the Bank [of England] supplies base money on demand at its prevailing interest rate, and broad money is created by the banking system. Therefore the endogeneity of money has caused great confusion, and led some critics to argue that money is unimportant. This is a serious mistake'
Charles Goodhart, an economist and formerly an advisor at the Bank of England and a former monetary policy committee member, worked for many years to encourage a different approach to money supply analysis and said the base money multiplier model[16] was 'such an incomplete way of describing the process of the determination of the stock of money that it amounts to misinstruction'[17] Ten years later he said[18] ‘Almost all those who have worked in a [central bank] believe that this view is totally mistaken; in particular, it ignores the implications of several of the crucial institutional features of a modern commercial banking system....’
What exactly[19]is so misleading about the money multiplier approach?
- Firstly the base money multiplier contains a number of assumptions that are very easy to make which is of course why it is still embedded in macroeconomics.
- Secondly, the monetary policy instruments used by central banks for some years now, are based on short term interest rates set by the central bank, not the quantity of base money. The base multiplier model requires it to set the quantity of money, but in the real world we know it sets the price.
- Thirdly if the central bank sets the interest rates it must then supply the reserves the banks require and this will depend on the demand for loans at the going rate of interest. Therefore the money supply is determined by the economy rather than the central bank.
In 2004 Paul Tucker at the BOE wrote, [20]"When, ten years ago, Mervyn King delivered a lecture...., he reviewed ideas on the monetary transmission mechanism....... and the role of money (and credit). These days most such accounts.....begin with a simple assertion that the central bank sets the short-term nominal interest rate. And they go on to explain how, given sticky wages and prices, that enables the central bank to shift the short-term real interest rate in a way that either restrains or stimulates aggregate demand. Notice no mention of money here. On this view of the world and, in particular, given this way of implementing monetary policy, money – both narrow and broad – is largely endogenous. The central bank simply supplies whatever amount of base money is demanded by the economy at the prevailing level of interest rates".
Howells and Bain (2005) have managed to incorporate the main points of the endogenous
view on the money-supply process into a macroeconomics textbook. (Jablecki, J. page 37)
Charles Goodhart said in 2007, "[When the] Central Bank sets interest rates, as is the generality, the money stock is a dependent, endogenous variable. This is exactly what the heterodox, Post-
Keynesians, from Kaldor, through Vicky Chick, and on through Basil Moore and Randy Wray, have been correctly claiming for decades, and I have been in their party
on this." [21]
A number of highly respected central bankers and monetary economists believe the money multiplier is a very unsatisfactory way of describing how credit is created in the real world[3], mainly because it ignores the influences of prices[4], and the way that modern central banking manages the money supply.
From about 1991 a remarkable consensus had emerged within developed economies about the optimum design of monetary policy methods. In essence central bankers gave up attempts to directly control the amount of money in the economy and instead moved to indirect methods by targeting interest rates[5].
Additionally, although when you look at a banks balance sheet, it appears new deposits are causing loans to be created, in reality banks create credit so that new loans create new deposits[6] in the banking system. (Howells P. Page 33)
Therefore banks do not as a policy 'lend their customers money' but rather as a policy 'they lever[7], their balance sheet' by creating commercial bank money, while simultaneously managing the liquidity risk this creates for them.
In practice, rather than lending available "excess reserves" as a customer lending policy, as described in the base money multiplier model, banks tend to lend their "excess reserves" to other financial institutions - often on an overnight basis, so that they have these deposits available earning interest, while still being available to meet customer withdrawal requests. (Howells P, Page 36)
Seth B. Carpenter, a monetary policy and financial markets researcher at the Board of Governors of the Federal Reserve System and Selva Demiralp concluded[8] the simple textbook base money multiplier is implausible in the United States.
Also, the idea that the reserve requirement places an upper limit on the money supply is disputed by some economists[9], including for example the former chief economist of the Bank of England and current Governor, Mervyn King, and the UK's foremost central banking economist Charles Goodhart. In 2007, Goodhart said[10], "[When the] Central Bank sets interest rates, as is the generality, the money stock is a dependent, endogenous variable. This is exactly what the heterodox, Post-Keynesians, from Kaldor, through Vicky Chick, and on through Basil Moore and Randy Wray, have been correctly claiming for decades, and I have been in their party on this."
Theories of endogenous money date to the 19th century, and were described by Joseph Schumpeter, and later the post-Keynesians.[11] Endogenous money theory states that the supply of money is credit-driven and determined endogenously by the demand for bank loans, rather than exogenously by monetary authorities.
In 1994, Mervyn King said[12] 'One of the most contentious issues in assessing the role of money is the direction of causation between money and demand. Textbooks assume that money is exogenous. It is sometimes dropped by helicopters, as in Friedman’s analysis of a ‘pure’ monetary expansion, or its supply is altered by open-market operations. In the United Kingdom, money is endogenous - the Bank [of England] supplies base money on demand at its prevailing interest rate, and broad money is created by the banking system. Therefore the endogeneity of money has caused great confusion, and led some critics to argue that money is unimportant. This is a serious mistake'
Goodhart, formerly an advisor at the Bank of England and a former monetary policy committee member, worked for many years to encourage a different approach to money supply analysis and said the base money multiplier model was 'such an incomplete way of describing the process of the determination of the stock of money that it amounts to misinstruction'[13] Ten years later he said[14] ‘Almost all those who have worked in a [central bank] believe that this view is totally mistaken; in particular, it ignores the implications of several of the crucial institutional features of a modern commercial banking system....’
Because of these[15][16] modern banking systems, banks are not truelly lending existing central bank money, but are instead creating money while managing the liabilities this creates for them by having lines of credit, and access to a highly liquid money market - at rates near to those targeted by the central bank. It is true the banks are continually getting deposits of central bank money, and they are most certainly paying out central bank money as required, but deposits do not create loans but rather demand for loans creates deposits. After a loan is demanded, and existing sources of central bank money are sought, as required, whatever additional Central bank money necessary to achieve a banking system balance, at the prevailing central bank policy rate[17], is supplied on demand, at a price, by the central banks (King 1994).