Is the real bills doctrine making a comeback?

Bill Woolsey has a post that is highly critical of a recent article by Richard G. Anderson and Yang Liu, who are at the St.Louis Fed.  He focused on this paragraph in their article:

The above examples of negative central bank policy rates are newsworthy because they are unusual. Some analysts have argued that such examples suggest that central banks should consider setting negative policy rates, including negative rates on deposits held at the central bank. Such proposals are foolish for a number of reasons. First, a policy rate likely would be set to a negative value only when economic conditions are so weak that the central bank has previously reduced its policy rate to zero. Identifying creditworthy borrowers during such periods is unusually challenging. How strongly should banks during such a period be encouraged to expand lending? Second, negative central bank interest rates may be interpreted as a tax on banks—a tax that is highest during periods of quantitative easing (QE).3 Central banks typically implement QE policies via large-scale asset purchases. Sellers of these assets are paid in newly created central bank deposits, which, in due course, arrive in the accounts of commercial banks at the central bank. It is an axiom of central banking that the banking system itself cannot reduce the aggregate amount of its central bank deposits no matter how many loans are made because the funds loaned by one bank eventually are redeposited at another. Is it reasonable for the central bank to impose a tax on deposits held at the central bank when the central bank itself determines the amount of such deposits held by banks and the banking system? Perhaps these and other considerations caused European Central Bank President Mario Draghi in a recent press conference to label negative deposit rates “uncharted waters” and dismiss any possibility that the ECB would consider it.

I’d like to add a few brief comments.  Their first argument sounds an awful lot like the Real Bills Doctrine (now viewed as a fallacy.  In the early years of the Fed it was believed that monetary policy should be more expansionary during booms, when the “need” for credit was greater, and more contractionary during recessions when the “need” for credit was lower.  This policy is procyclical, and may help explain why the economy actually became more unstable during the Fed’s first 30 years.

I am also confused by the second point.  Banks don’t have to hold reserve balances at the Fed if they don’t want to.  They can simply lower the interest rate on bank deposits enough to raise the currency/deposit ratio enough to reach their desired holdings of ERs.  There’s no zero bound on the interest rate on bank deposits. (As an aside, the question of whether something is a “tax” has no relationship to whether it can be avoided.  The case for imposing a new tax is actually stronger when the tax cannot be avoided.)


Tags:

 
 
 

41 Responses to “Is the real bills doctrine making a comeback?”

  1. Gravatar of marcus nunes marcus nunes
    27. January 2013 at 08:30

    The world is really “topsy-turvy” when the “monetarist home” at the Fed “suggests” a come back of the Real Bills Doctrine”!

  2. Gravatar of Jon Jon
    27. January 2013 at 09:18

    Wait a minute. The real bills doctrine was not about easing interest rates during booms and tightening during busts. It was about the banking establishment grasping toward an elastic short run money supply. The question was how to provide such a supply without stoking inflation. They already had the notion of an interest leg but they lacked the means to ascertain the price level. The real bills doctrine stated that unlimited discounting short term paper backed by a receipt for an actual transaction was inherently not inflationary. ie the interest rate could be perpetually wrong and money growth could be arbitrarily fast without causing inflation to accelerate.

    This is the fallacy of the real bills doctrine–in the end the growth of money determines the price level.

  3. Gravatar of ssumner ssumner
    27. January 2013 at 10:11

    Marcus, I agree.

    Jon, That was one aspect of the Real Bills Doctrine, but not the only one. It was also about distinguishing between “productive investments” and non-productive investments.

  4. Gravatar of John Papola John Papola
    27. January 2013 at 11:07

    Scott,

    Why is the Fed still paying any interest on reserves at all? It seems counter-productive (or corrupt?) to pay interest on reserves yet also engage in credit-allocating purchases like MBS. Surely if their goal was to raise nominal spending, the first thing they should do is put an end to policies which activity inhibit it. And yet… they haven’t.

  5. Gravatar of Kyle Hale Kyle Hale
    27. January 2013 at 11:22

    Would it be fair to say that QE increases taxpayer risk while modifying IOR increases private enterprise risk? That’s my interpretation of Bill’s post, but I may be misreading the implications at the end.

    Why do Fed employees seem to like the former?

  6. Gravatar of ChargerCarl ChargerCarl
    27. January 2013 at 11:46

    Kyle,

    How does QE increase taxpayer’s risk?

  7. Gravatar of Jon Jon
    27. January 2013 at 12:06

    Scott,

    Fine, but your summary is wrong. People still believe that a horizontal money supply function–elastic quantity with low volatility in short rates is right. Whether the real bills doctrine was about productive asset discounting is beside the point. This is what is meant by easing during booms–allowing the money supply to be elastic.

    Remember the new idea here was the discount window, the notion that the bank would set the interest rate. Prior to this the CB operated by committing to buy any gold presented at par and redeem notes when presented.

  8. Gravatar of Kyle Hale Kyle Hale
    27. January 2013 at 12:10

    From Bill’s post:

    One solution to this problem is for the central bank to purchase risky assets. It is thereby creating safe assets–directly reserve balances for banks to hold, but indirectly government insured deposits at banks for households and firms to hold. By purchasing enough risky assets, the central bank should be able to expand the quantity of reserves and checkable deposits enough to match the increased demand for them, and so prevent any decrease in spending on output.

    But, of course, the central bank is bearing more risk. Assuming that the politicians will bail out the central bank, this means that the taxpayers are bearing additional risk. (Of course, the expansion of government insured deposits is another avenue where the taxpayers are bearing additional risk.)

    Why should the central bank, and the taxpayers, bear the added risk? Or, perhaps, we might say, why should the taxpayers provide that service for free?

  9. Gravatar of ssumner ssumner
    27. January 2013 at 12:21

    John, I agree that IOR is foolish.

    Jon, You said;

    “People still believe that a horizontal money supply function–elastic quantity with low volatility in short rates is right.”

    I don’t follow this at all. An elastic supply of money at a fixed interest rate is procyclical. Are you saying that people now favor procyclical policy?

  10. Gravatar of ChargerCarl ChargerCarl
    27. January 2013 at 13:32

    Kyle I see, my mistake. I thought you were just talking about bond purchases.

  11. Gravatar of flow5 flow5
    27. January 2013 at 15:46

    Apples & oranges. RB was denigrated. But Anderson is smart. So the upshot is political – not economic. The IOeR policy emasculated the Fed’s “open market power”. IBDDs are a credit control device. Legal reserves aren’t a tax [sic].

    If the Fed puts through buy orders in the open market, the Federal Reserve Banks acquire earning assets by creating new inter-bank demand deposits. The U.S. Treasury recaptures about 98% of the net income from these assets. The commercial banks acquire “costless” legal reserves, yet the bankers complained that they didn’t earn any interest on their balances in the Federal Reserve Banks.

    On the basis of these newly acquired free reserves, the commercial banks created a multiple volume of credit & money. And, through this money, they acquired a concomitant volume of additional earnings assets. How much was this multiple expansion of money, credit, & bank earning assets? Thanks to fractional reserve banking (an essential characteristic of commercial banking) for every dollar of legal reserves pumped into the member banks by the Fed, the banking system acquired about 93 (c. 2006), dollars in earning assets through credit creation.

    From the standpoint of the system, CBs pay for what they already own. Even if the RB doctrine is fallacious, the commercial loan theory of banking is the right paradigm (in the scheme of borrowing short to lend long). That’s how economists should approach the savings-investment process, i.e., promote the use of savings to produce the real output of goods & services.

  12. Gravatar of Jon Jon
    27. January 2013 at 17:11

    Scott,

    I’m not describing anything more than how a modern CB practices policy. They set the interest rate and allow an elastic money supply at that price in re short run. The real bill doctrine also did this, so this isn’t the repudiated feature of the real bill doctrine. The repudiated feature is the absence of a nominal goal.

    What they had in the place of a nominal goal was the cockeyed notion that unlimited discontining at any interest rate was non inflationary provided the underlying security was of good quality reflecting a true commercial transaction.

    Could that policy be pro cyclic? I suppose so. But they did set the discount rate and they did so using an ethical theory about punishing bankers who misjudged liquidity demands… So they ended up with a moving ceiling on interest rates which tracked market interest. It worked pretty well under Strong but not because the theory was right, but because they managed to emulate something price level targeting thanks to the gold standard, at least until CB gold hoarding started up.

    The problem with the real bills doctrine is that it doesn’t give you right the answer, but it also doesn’t give you the wrong answer except by some epicycle involving a scarcity of ‘real bills’ in a recession.

  13. Gravatar of ssumner ssumner
    27. January 2013 at 19:17

    Jon, You said;

    “I’m not describing anything more than how a modern CB practices policy. They set the interest rate and allow an elastic money supply at that price in re short run. The real bill doctrine also did this, so this isn’t the repudiated feature of the real bill doctrine. The repudiated feature is the absence of a nominal goal.”

    Don’t confuse interest rate targeting (which can work) with interest rate pegging (which is procyclical.) The Real Bills Doctrine is procyclical because more money gets supplied when more “productive investments” are available–which is boom times. That’s the logic used here–not a lot of productive investments available–so don’t supply so much money.

  14. Gravatar of RebelEconomist RebelEconomist
    28. January 2013 at 02:18

    Scott / Jon,

    I think this goes back to the discussion that Scott had with Shining Raven ( http://www.themoneyillusion.com/?p=18953#comments ) about “backed” and “convertible”. I imagine that there are always more than enough productive assets to back the base money stock, so it is not a question of elastic currency. I think the idea is that a real bill has some kind of real value independent of the value of the currency, so that the value of the stock of assets on the central bank balance sheet does not fall short of the value of the stock of base money in the event that the central bank needs to sell some assets to support the unit value of its base money. Again, I dare say that Mike Sproul would be able to add something to your discussion.

  15. Gravatar of flow5 flow5
    28. January 2013 at 05:27

    “They set the interest rate and allow an elastic money supply at that price in re short run”
    —-
    As traders know, they still do. E.g.,the adage “Sell in May & Go Away” is based upon one of “The Federal Reserve Act of 1913′s” principle functions: to provide liquidity to the commercial banks when they need it.

    “It was anticipated that credit extended by the Federal Reserve Banks to commercial banks would rise and fall with seasonal and longer term variations in business activity”…”From the beginning, the Federal Reserve was reasonably successful in accommodating the seasonal swings in the demand for currency—in the terminology of the act, providing for “and elastic currency”.

    The FED’s seasonal mal-adjustments (holiday’s, etc.), have their roots in the fallacious “real bills” doctrine. I.e., the “trading desk” systematically, & invariably, drains liquidity during the month of May, etc.. (unless monetary policy objectives conflict with the regular cyclicality).

    Selling or buying can be more pronounced than usual if the FED isn’t able to smooth the roc in approaching AD, & thus apply countervailing intervention.
    —–

    “Don’t confuse interest rate targeting (which can work) with interest rate pegging”

    The effective funds rate deviation from the target rate never varies sufficiently to make such a difference.

  16. Gravatar of flow5 flow5
    28. January 2013 at 05:45

    The Fed’s errors are being magnified. The current path is a blow-off followed by a flash crash

  17. Gravatar of Shining Raven Shining Raven
    28. January 2013 at 07:29

    Scott: “I am also confused by the second point.”

    Well, you would be, naturally.

    “Banks don’t have to hold reserve balances at the Fed if they don’t want to.”

    This is true for any individual bank, but not for the banking system as such. There is nothing the banking system can do to get rid of the reserves without the cooperation of the Fed.

    (And please don’t bring up cash – yes, if everybody would take out the balances in their accounts in cash, this would solve the problem for the banks. But there is really nothing that the banks can do to achieve this, since it is the public that determines how much cash they want to hold, and this is pretty much independent of the interest rates on deposits, since it is mainly for transactional purposes.)

  18. Gravatar of Shining Raven Shining Raven
    28. January 2013 at 07:41

    Jon: “I’m not describing anything more than how a modern CB practices policy. They set the interest rate and allow an elastic money supply at that price in re short run. ….”

    Scott in reply:

    “Don’t confuse interest rate targeting (which can work) with interest rate pegging (which is procyclical.) The Real Bills Doctrine is procyclical because more money gets supplied when more “productive investments” are available–which is boom times.”

    You are right insofar that indeed the *banking system as it exists* acts pro-cyclical. That is exactly the problem that we have right now, and that is why the money supply (in the sense of demand deposits, not monetary base) does not expand, despite very low interest rates.

    This *always* happens, more money is supplied in boom times, because lending standards fall, and less money is supplied in crunch times, since banks are suspicious of every risk and lending standards are high.

    Sure, interest rates are of course adjusted according to the goals of monetary policy, so the interest rates might not be the same in boom and bust times. I guess this is the distinction that you are drawing to interest rate pegging.

    But apart from that, the problem is of course that at any given interest rate, the money supply is elastic and adjusts to the demand – customers who want a loan at the prevailing interest rate, and who are a good credit risk from the point of view of the bank.

    I really believe this is the choke point, and it clearly is pro-cyclical.

  19. Gravatar of ssumner ssumner
    28. January 2013 at 07:43

    Rebeleconomist—you may be right, but it would still be a fallacy.

    Shining Raven, Of course the banking system can get rid of excess reserves it doesn’t want to hold. Just lower the interest rate on bank deposits until the public agrees to hold the reserves as cash. I think that’s pretty much generally accepted.

  20. Gravatar of Shining Raven Shining Raven
    28. January 2013 at 07:59

    Why would I wish to hold cash, that pays no interest at all, as opposed to a demand deposit, which pays perhaps 0.05%, which is however more than 0?

    I do not think it is true that people hold more cash when the interest rates are lowered. Cash is not held as an investment. It is held purely for transactional convenience, and the demand is pretty much determined by that.

    I mean, really. After quantitative easing, do you really really believe that banks would be able to foist of all these excess reserves as cash on the public? By lowering interest rates from, oh, I don’t know, 0.1% to 0%? This is going to bring people to take out trillions in cash?

    I don’t believe it.

    Perhaps I should insert another reference to one of my most favorite discussion threads on this blog that covers the topic extensively:

    http://www.themoneyillusion.com/?p=5893

    From my view, I am sure that the demand of the public for cash is not so elastic that a minuscule decrease in the interest rate paid on demand deposits will lead to any significant increase in the amount of cash held by the public.

  21. Gravatar of Jon Jon
    28. January 2013 at 08:04

    Scott writes: “Don’t confuse interest rate targeting (which can work) with interest rate pegging (which is procyclical.) The Real Bills Doctrine is procyclical because more money gets supplied when more “productive investments” are available–which is boom times. That’s the logic used here–not a lot of productive investments available–so don’t supply so much money.”

    Okay, I did use the word peg when discussing the real bill doctrine, but I don’t think it was a peg in the sense you’re reading. They didn’t have the intellectual framework in place fully but the discount rate did move in response to market conditions.

    1915-01-07 5.50
    1915-02-03 4.50
    1915-09-14 4.00
    1917-11-07 4.50
    1918-04-08 4.75
    1920-01-24 6.00
    1921-11-03 5.00
    1922-04-06 4.50
    1924-06-19 4.00
    1927-08-04 3.50
    1928-02-21 4.00
    1928-04-23 4.50
    1928-07-19 5.00
    1930-02-11 4.50
    1930-04-12 4.00
    1930-08-07 3.50
    1931-01-08 3.00
    1931-05-09 2.50
    1931-10-22 3.50
    1933-06-08 3.00
    1934-02-08 2.50
    1935-01-03 2.00
    1937-09-02 1.50
    1942-03-14 1.00

  22. Gravatar of Shining Raven Shining Raven
    28. January 2013 at 08:05

    Okay, I just checked, my bank currently pays 0.35% on deposits. This interest rate has absolutely no effect on the ratio between the amount of my liquid funds that I hold as a deposit vs what I hold in cash. I would not change this if the bank lowered it to 0%, since I don’t really keep a balance in my account to earn interest…

  23. Gravatar of Shining Raven Shining Raven
    28. January 2013 at 08:13

    Also on point regarding these issues, and essentially in agreement with the criticized article, as far I can see from the excerpt above:

    http://neweconomicperspectives.org/2009/07/why-negative-nominal-interest-rates1.html

    “What will happen, then? Instead of providing an incentive for banks to lend, banks instead will have an incentive to rid their balance sheets of reserve balances. So they will try to trade them in the interbank markets. But in the aggregate, banks only trade the existing quantity of balances among themselves as only a change in the central bank’s balance sheet alters the quantity of balances circulating. ”

    “For banks holding the extra balances not drained by the central bank, the effect is a reduction in their income, as they have to transfer income to the central bank to pay the tax.”

  24. Gravatar of Shining Raven Shining Raven
    28. January 2013 at 08:30

    I want to make one more overarching point, and then I’ll shut up.

    A lot of the reasoning with regard to interest rates, amount of reserves banks want to hold, amount of deposits people want to hold etc seems pretty misguided to me.

    Underlying Scott’s and also Bill Woolsey’s arguments seems to be the idea that there is some kind of market for bank reserves or currency, and a change in interest rates is somehow a change in the supply curve that will lead to a new balancing with peoples demand or something.

    This seems to me to be incorrect: For banks, the amount of reserves that they want to hold is pretty much independent of the interest rate and essentially determined by transactional and reserve requirements.

    This is also consistent with the operations of the Fed: when the Fed funds target changes, the Fed funds rate essentially adjusts *at the already given amount of reserves in the system* to the new rate. It does not require a large amount of trading (see e.g. here http://neweconomicperspectives.org/2013/01/understanding-the-permanent-floor-an-important-inconsistency-in-neoclassical-monetary-economics.html and Scott Fulwilers paper from 2002 referenced therein).

    The same is true for private households: demand deposits and currency are held for transactional purposes, and savings are usually invested in some other way. So there is no “change in demand” in response to the “price change”. I guess you could say that it is pretty inelastic.

    So it is not a normal market, where the participants react to a price signal in the usual way. Arguing that banks adjust their reserves according to a reaction to a price (interest) signal misses the mark. They don’t. And any argument that is based on such a connection must lead astray.

  25. Gravatar of Max Max
    28. January 2013 at 09:21

    Shining, Scott is correct, but let me try to explain in a different way.

    The Fed can’t arbitrarily set reserve seignorage (FF-IOR) *and* the quantity of reserves (holding reserve requirements constant). If seignorage is positive and the Fed supplies the banks with unwanted reserves, either FF falls or reserves get withdrawn as currency.

    On the other hand, if seignorage is zero or negative (the current situation), then the Fed can arbitrarily set the quantity of reserves. It’s no different than the Fed issuing bonds to pay for its purchases. All the action is on the asset side of the Fed’s balance sheet. The liability side is just a funding source, and has nothing to do with monetary policy. For money quantity to work as monetary policy there must be an opportunity cost to holding money.

    Suppose the Fed lowered IOR from 0.25% to -10%. What would happen? FF would fall, and keep falling, until the reserves were withdrawn as currency. This would happen at a (negative) FF rate that equaled the storage cost of currency. (This is assuming that the CB maintains convertibility of reserves into currency).

  26. Gravatar of flow5 flow5
    28. January 2013 at 12:04

    “But in the aggregate, banks only trade the existing quantity of balances among themselves”

    Right, banks pay for what they already own.
    ————-
    posted on Mar 30 11:31 am prior to the MAY 6th FLASH CRASH:

    Assuming no quick countervailing stimulus:

    2010
    jan….. 0.54…. 0.25 top
    feb….. 0.50…. 0.10
    mar…. 0.54…. 0.08
    apr….. 0.46…. 0.09 top
    may…. 0.41…. 0.01 stocks fall

    Been saying this for the last 6 months. Should see shortly. Stock market makes a double top in Jan & Apr. Then the real-output of final goods & services falls/inverts from (9) to (1) from Apr to May.

    Recent history indicates that this will be a marked, short, one month drop, in rate-of-change for real-output (-8). So stocks follow the economy down (with yields moving sympathetically?)”
    Mar 30 11:31 am

    flow5 Message #10 – 05/03/10 07:30 PM
    The markets usually turn (pivot) on May 5th (+ or – 1 day).
    ———

    Obviously, not everyone is on the same page.

  27. Gravatar of flow5 flow5
    28. January 2013 at 12:07

    Discussions of interest rates are useless. The money supply (& commercial bank credit), can never be managed by any attempt to control the cost of credit (i.e., thru pegging the interest rate on governments; or thru “floors”, “ceilings”, “corridors”, “brackets”, etc). In other words, Keynes’s liquidity preference curve is a false doctrine.

  28. Gravatar of flow5 flow5
    28. January 2013 at 12:19

    I know the Gospel. Does anyone else? My prediction for AAA corporate yields for 1981 was 15.48% when nominal-gNp hit 19.2% in the 1st qtr 1981, the FFR to 22%, & AAA Corporates to 15.49%.

  29. Gravatar of Shining Raven Shining Raven
    28. January 2013 at 12:51

    Hi Max,

    I agree with most of what you say, and I understand how the interest rate floor works under normal and current QE conditions. Note that I linked Scott Fulwiler’s post above, who explains this nicely.

    “Suppose the Fed lowered IOR from 0.25% to -10%. What would happen? FF would fall, and keep falling, until the reserves were withdrawn as currency. This would happen at a (negative) FF rate that equaled the storage cost of currency.”

    I don’t think this is right. Banks cannot conceivably shift to a payment clearing system that trucks cash around. They need reserves for payment purposes and cannot simply replace them by vault cash. Storage costs are probably not the half of it, transaction costs would be much higher. So I believe banks would have to stick with the necessary reserve balances. FF would of course fall as you say. It becomes a higher cost of doing business – an additional tax. I don’t think it is entirely possible to avoid this, although of course it provides incentives for creative ideas.

    But anyway, what purpose would this serve? Accepting for the sake of argument that reserve balances would all be converted to vault cash, what is the point? Banks would not lend more readily than before to bad credit risks, so what would be the gain? On the contrary, their cost of business just went up considerably, so they might conceivably raise interest rates, not lower them!

  30. Gravatar of Max Max
    28. January 2013 at 14:33

    “Banks cannot conceivably shift to a payment clearing system that trucks cash around. They need reserves for payment purposes and cannot simply replace them by vault cash.”

    They might keep a small amount of excess reserves, but this quantity would not be determined by the Fed.

    Hence “It is an axiom of central banking that the banking system itself cannot reduce the aggregate amount of its central bank deposits…” is false.

    Banks are only unable to rid themselves of reserves when they have no desire to do so, i.e. when IOR >= FF.

    The article is totally, totally wrong.

  31. Gravatar of Max Max
    28. January 2013 at 17:28

    To answer the “what is the point”, I’m not advocating printing enormous quantities of currency. That would indeed be pointless (and not inflationary). What would be fruitful is getting rid of the zero bound.

    The “Why Negative Nominal Interest Rates Miss the Point” article you linked to is not one of Scott Fullwiler’s better efforts. A negative Fed Funds rate is not a tax on currency or bank accounts. It doesn’t penalize them in any way, relative to equivalent investments. It’s not financial repression. It’s just getting rid of a constraint on monetary policy.

  32. Gravatar of flow5 flow5
    28. January 2013 at 23:52

    “They need reserves for payment purposes and cannot simply replace them by vault cash”

    Right — which gives the fed control over money & the bond markets

  33. Gravatar of flow5 flow5
    29. January 2013 at 00:03

    Looks like I got one call wrong though:

    “Looks like the 31 year bull market in bonds ended on 6/18/12
    Jun 22 09:07″

    Actual bottom to date:
    Daily Treasury Yield Curve Rates:

    07/25/12 0.08 0.10 0.14 0.17 0.22 0.28 0.56 0.91 1.43 2.11 2.46

  34. Gravatar of Shining Raven Shining Raven
    29. January 2013 at 01:42

    Hi Max,

    thank you for engaging and your patience, although I still disagree.

    “Hence “It is an axiom of central banking that the banking system itself cannot reduce the aggregate amount of its central bank deposits…” is false.”

    “Banks are only unable to rid themselves of reserves when they have no desire to do so, i.e. when IOR >= FF.”

    I do not see how this works at all. The point seems to me that indeed any *individual* bank might be able to reduce the amount of reserves that they hold, but the *banking system* as such cannot get rid of the reserves. And I understood this to be the point made in the criticized article.

    Banks can lend reserves to other banks that need them, but that obviously does not change the amount of reserves in the system. Any payments that the banks make on behalf of their customers get deposited in other banks again, so that perhaps the reserve position of an individual bank changes, but not
    the reserve position of the banking system.

    The only way that the amount of reserves in the banking system can change without Fed action is by cash withdrawals by the public, don’t we agree on that? Currently after QE bank reserves simply cannot be absorbed by the public as cash, there is too much of them. And as I said above, I also do not believe that lowered interest rates would increase the amount of cash held by the public, since this is really determined by transactional needs. Anyway, I have not really looked at numbers, but I am pretty confident that the fall in interest rates on demand deposits over the recent years after 2008 was not accompanied by a proportionate increase in cash holdings.

  35. Gravatar of Shining Raven Shining Raven
    29. January 2013 at 01:57

    See also JKH on this blog in 2009, he makes some much better points I would not have thought of.

    http://www.themoneyillusion.com/?p=1032#comment-2166

    Anyway, it also boils down to the statement that the Fed determines the amount of reserves in the banking system, and the banking system as such cannot get rid of them without cooperation and action by the Fed.

  36. Gravatar of flow5 flow5
    29. January 2013 at 04:58

    “Banks can lend reserves to other banks ”

    Right, it’s called reserve velocity.
    ——————

    Net changes in Reserve Bank credit (since the Accord) are determined by the policy actions of the Federal Reserve.

    But William McChesney Martin, Jr. changed from using a “net free” or borrowed reserve approach to the Fed Funds “Bracket Racket” c. 1965.

    As of Oct 9, 2008 the payment of interest on excess reserve balances has forced the Fed to abdicate its “open market power”.

    The effect of these operations on interest rates (now via the remuneration or deposit rate), is indirect, varies widely over time, & in magnitude. What the net expansion of money will be, as a consequence of a given injection of additional reserves, nobody knows until long after the fact. The consequence is a delayed, remote, & approximate control over the lending & money-creating capacity of the banking system.

  37. Gravatar of ssumner ssumner
    29. January 2013 at 06:14

    Shining Raven, You said;

    “I do not think it is true that people hold more cash when the interest rates are lowered. Cash is not held as an investment. It is held purely for transactional convenience, and the demand is pretty much determined by that.”

    There are literally 1000s of academic papers saying you are wrong. There’s a whole industry estimating the interest elasticity of the demand for money. And people hold most cash for savings purposes, not transactions. Most cash is $100 bills. And banks can and do make interest rates negative when conditions demand they do so.

    Trust me, the interest elasticity of money demand is a settled issue in economics. There isn’t one serious monetary economist in the world that would agree with you.

    Jon, Yes, they moved interest rates some–but not enough to prevent monetary policy from being HIGHLY PROCYCLICAL.

  38. Gravatar of Max Max
    29. January 2013 at 06:23

    “The only way that the amount of reserves in the banking system can change without Fed action is by cash withdrawals by the public, don’t we agree on that?”

    Yes.

    “Currently after QE bank reserves simply cannot be absorbed by the public as cash, there is too much of them.”

    Again, this is because IOR >= FF.

    “And as I said above, I also do not believe that lowered interest rates would increase the amount of cash held by the public, since this is really determined by transactional needs.”

    If you bank deposit was earning -10%, you would certainly consider withdrawing currency, even if doing so increased your transaction costs.

    With IOR < FF, currency would take the place of reserves as the Fed's funding source.

  39. Gravatar of Shining Raven Shining Raven
    29. January 2013 at 06:36

    Hi Scott, thanks for the reply.

    “There are literally 1000s of academic papers saying you are wrong. There’s a whole industry estimating the interest elasticity of the demand for money.”

    I did not talk about “money”, I talked about cash. What exactly do you mean here by “money”?

    “And people hold most cash for savings purposes, not transactions.”

    Can you point me to some literature on this? I would be most grateful.

    If this is so, have we seen a significant increase in the cash balances held by the public when interest rates dropped like a stone in the recession? If you are right, there should be a huge effect when interest rates drop to almost zero.

  40. Gravatar of flow5 flow5
    30. January 2013 at 06:04

    “And people hold most cash for savings purposes, not transactions”

    Would cash be different than bank deposits? or savings/investment type accounts to transaction accounts?

    The volume of currency in circulation required to meet the “needs of trade” gets recirculated through the banks.

    Roc’s in MVt prove this. Just subtract currency from M1 & multiply the difference by Vt. The R^2 of MVt to n-gDp is higher than the R^2 of M1Vt to n-gDp.

  41. Gravatar of Mike Sproul Mike Sproul
    27. May 2013 at 18:29

    Sorry I didn’t notice this post back in January, but on the off chance that anyone is still following the thread, I want to point out that following the real bills doctrine does not cause booms and busts. it only ACCOMMODATES them. When the economy is booming, and the need for money is great, then people will bring various assets to their banks to exchange for cash. When business is slow and the need for cash is small, then people will return that cash to the bank and get their various assets back. This is the way the invisible hand is supposed to work. Goods (and money) are provided only when needed.

Leave a Reply