Money multipliers: Nominal, real, and imaginary

Economics is full of “multipliers.”  One generally shouldn’t take them too seriously, as all sorts of economic forces will impact the relationship between any two variables, and hence multipliers will rarely be stable over time.  I’ve discussed the fiscal multiplier ad nauseum.  The crude quantity theory of money (assuming constant V) is a sort of multiplier model, where V is the multiplier linking the money supply and NGDP.  And then there are the monetary aggregate multipliers (deltaM/deltaMBase), which are almost never explained correctly.

1.  Let’s start with the nominal money multiplier.  Suppose the Fed decides to increase the base by 173% over the next 40 years, how will that affect various nominal aggregates?  The most likely answer is that NGDP, and all nominal components of NGDP, will be 173% larger in 40 years than if the Fed didn’t increase the base at all.  (Strictly speaking this is not exactly correct for large differences, because of hysteresis, but it’s close enough to get my point across.)

This means that in 40 years NGDP will be 173% larger than otherwise, and the size of the toaster, pedicure and banking industries will also be 173% larger than otherwise.  In that case there are “multipliers” for the toaster, pedicure and banking industries, although they aren’t very interesting.  This does NOT mean the three aforementioned industries will grow by 173%–far from it–rather that they will be 173% larger than otherwise.

2.  At the other extreme one can think of all sorts of real factors that influence the REAL size of the banking industry, which have nothing to do with monetary policy or NGDP.  Thus start with an economy that has no banking industry–perhaps due to usury laws.  Then a renaissance happens, and a banking industry springs up.  In that case the deposit base may grow enormously, even without any increase in NGDP or the monetary base.  The bankers would bid base money (cash) away from the public by offering higher interest rates, and once that cash got into the banking system it would provide the raw materials for a large quantity of deposits, loans, etc.  In this scenario it makes no sense to talk in terms of “money multipliers,” as there is no increase in the monetary base.

If these were the two relevant factors, the actual situation would be somewhat complex, but at least easy to talk about.  Both real and nominal shocks would be going on all of the time, and the actual outcome would reflect some combination of those shocks.

3.  Alas, the actual situation is far more complex, and this is where things get controversial.  Because prices are sticky, monetary injections have all sorts of short run real effects.  Most notably, a one-time increase in the base can reduce the short term nominal interest rate (liquidity effect.)  In that case you might get a short run “real multiplier” effect coming from a monetary shock.  For instance, suppose the base rose by 6%.  Let’s say that reduces short term rates from 5% to 3%.  At the lower rates the public is willing to hold 6% more non-interest bearing base money.  (Add in IOR and things get even trickier.)  Does that mean M1 and M2 rise by exactly 6%?  Probably not, because as interest rates fall the relative preference for currency and bank deposits will change, and in addition banks will want to hold slightly more excess reserves.  Nonetheless, the monetary aggregates might well increase, and if nominal interest rates are positive the aggregates will probably increase by more than the base.  So the “multiplier” might well exceed one.

There’s a lot of discussion about whether deposits cause loans or loans cause deposits.  So far as know all those discussions are basically useless, because they don’t distinguish between the three types of changes discussed above (monetary nominal, banking real, and monetary real.)  The actual outcome is incredibly complex, but it will help to start with a few basic principles:

1.  Loans and deposits are complements in production, like wool and mutton.  Thus there is at least some causation going in both directions, just as with wool and mutton.  But it’s certainly possible that most of the causation goes in one direction.

2.  Balance sheets are complex.  When loans increase you can increase deposits, or increase other forms of bank borrowing, or decrease bonds (on the asset side of the balance sheet.)  Ditto for an increase in deposits, it can lead to more loans, or more bonds, or less bank borrowing.  Capital requirements can impose some limits to this sort of substitution.

3.  Thinking about the process in a “mechanical” way is not helpful.  Thus it doesn’t matter whether the first round effect of a loan is to create an equal-sized deposit; what matters is the medium-term effect on the various aggregates within the financial system (after everyone has optimally adjusted their portfolio.)  Never, ever, ask a banker to explain the money supply process.

4.  When thinking about the effect of changes in one aspect of the banking system on another, one must first ascertain which of the three factors discussed above is causing these changes.  Are bank deposits (or loans) rising because monetary policy is inflating all nominal variables (long run), or because the real size of one component of the banking system is increasing or decreasing due to real factors, or because the injection of new base money has depressed interest rates and thus caused a temporary increase in the real demand for base money, as well as the monetary aggregates?

I don’t recall ever seeing a blogger discuss the full complexity of the process, but instead see lots of catchy cliches that might apply to one situation, but not another.

Caveat emptor.

PS.  This is similar to the debate over forex policies, where one rarely see people distinguish between a real exchange rate policy (China) and a policy which affects real exchange rates in the short run, but is purely nominal in the long run (Japan.)  Indeed just as with the money multiplier, exchange rates involve three effects:

1.  Long run neutrality of M, i.e. QT of Money and PPP.

2.  Changes in the real exchange rate due to real policies affecting national saving, investment, etc.

3.  Monetary policy having short run real effects on exchange rates because prices are sticky.

So once again debates in this area often involve people screaming at each other that one of those three mechanisms is the “right way” to think about international economics, when in fact all three play a role.


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71 Responses to “Money multipliers: Nominal, real, and imaginary”

  1. Gravatar of Geoff Geoff
    31. May 2013 at 08:56

    “At the other extreme one can think of all sorts of real factors that influence the REAL size of the banking industry, which have nothing to do with monetary policy or NGDP.”

    Let’s ignore the monetary policy factors that influence the real, and relative, sizes of undustries.

  2. Gravatar of Geoff Geoff
    31. May 2013 at 09:06

    “Because prices are sticky, monetary injections have all sorts of short run real effects.”

    My neighbor Frank has $1000 left in his back account. He plans on buying my old clunker car.

    Yesterday, Bernanke printed $100 billion to buy X from the banks. The banks now have more money. Frank does not.

    Frank pays me $1000.

    ———-

    Is it the case that prices are sticky, or is it really the case that deflation/inflation has long and variable lags, i.e. are not non-sticky, which makes it appear as if prices are sticky?

    The problem isn’t prices. The problem is inflation/deflation of money.

  3. Gravatar of J J
    31. May 2013 at 09:14

    Geoff,

    Have you seen a model with real rigidity (due to efficiency wages) and small menu costs? Even if menu costs are extremely small, they can be enough to create nominal price rigidity. Do you disagree?

  4. Gravatar of Fed Up Fed Up
    31. May 2013 at 09:18

    “Capital requirements can impose some limits to this sort of substitution.”

    If the capital requirement is 10%, can $100,000 of currency deposited in a “bank” as bank capital become $1,000,000 in demand deposits?

    Yes/No

  5. Gravatar of Fed Up Fed Up
    31. May 2013 at 09:22

    “The crude quantity theory of money (assuming constant V) is a sort of multiplier model, where V is the multiplier linking the money supply and NGDP.”

    MV = PY

    Can we agree central bank reserves do not directly circulate in the real economy?

  6. Gravatar of Jake Jake
    31. May 2013 at 09:53

    Prof. Sumner,

    Would a full-reserve banking system reduce some of this complexity and be more stable over time?

  7. Gravatar of ssumner ssumner
    31. May 2013 at 10:29

    Fed up, Yes, because what matters there is reserve req. not capital req.

    Fed up, MV=PY has nothing to do with the quantity theory of money. It’s a definition of V.

    Bank reserves are basically cash, and circulate between banks. (Banks are part of the real economy.) When they begin circulating outside the banking system they are called “currency.”

    Jake, That isn’t really needed, or likely, or desirable. Better to require that 100% of Federally-insured bank deposits be backed with safe assets like T-securities, AAA bonds, etc. Of course bankers would scream, and even my lesser proposal is not likely to be adopted.

  8. Gravatar of Doug M Doug M
    31. May 2013 at 10:45

    Does the “money multiplier” matter. There are many definitions of the money money supply (gold, currency, base money, M0, M1, M2, M3, MZM and the money currently in my pocket)

    For all M there exists a V such that:
    MV = PY

    But if V is not stable, or at least predictable, then the equation useless.

    So, these money multipliers are useful if it provides a mechanism that translates a useless definition of money with an unstable V to a definition of money with a stable (or predictable) V.

    Do deposits lead to loans or do loans lead to deposits? Does it matter? Can’t we say just say that they are correlated without having to prove causation? We could even go so far as to say that they are interdependent — that there is a feedback loop between the two of them, such that loans lead to deposits and deposits lead to loans.

    “Never, ever, ask a banker to explain the money supply process.” I may say the same thing about economists.

    Forex — PPP does not drive F/X in the sort or intermediate terms. PPP can be significantly violated for for years at a time.

    Balance of Payments is the primary driver of F/X rates.

    Changes in NOMINAL interest rates have significant impacts on F/X rates.

    Monetary policy can have significant impact on F/X rates in the short term because money is liquid.

  9. Gravatar of Fed Up Fed Up
    31. May 2013 at 12:04

    “The crude quantity theory of money (assuming constant V) is a sort of multiplier model, where V is the multiplier linking the money supply and NGDP.”

    I usually see MV = PY as the linkage or V = PY divided by M.

    So how are you linking them?

  10. Gravatar of Sina Motamedi Sina Motamedi
    31. May 2013 at 12:30

    Deposits *are* loans.

  11. Gravatar of Fed Up Fed Up
    31. May 2013 at 12:42

    “Fed up, Yes, because what matters there is reserve req. not capital req.”

    Actually, they both matter. Notice I specified the currency was deposited as bank capital, let’s say to pay for stock in this case.

    Let’s try it with demand deposits so that vault cash plus central bank reserves is unchanged systemwide.

    Someone starts a NEW bank by selling stock worth $100,000. The stock gets paid for with $100,000 in demand deposits. The new bank then buys $100,000 in treasuries from the bank where the demand deposits came from. The new bank now has $100,000 in treasuries to use as bank capital (emphasis) and nothing else.

    If the capital requirement is 10%, can the $100,000 in treasuries as bank capital become $1,000,000 in demand deposits?

  12. Gravatar of John Mack John Mack
    31. May 2013 at 12:43

    “Better to require that 100% of Federally-insured bank deposits be backed with safe assets like T-securities, AAA bonds, etc. Of course bankers would scream, and even my lesser proposal is not likely to be adopted.”

    I didn’t know that a neoliberal could be against the bankers?

  13. Gravatar of Fed Up Fed Up
    31. May 2013 at 13:06

    “Bank reserves are basically cash, and circulate between banks. (Banks are part of the real economy.) When they begin circulating outside the banking system they are called “currency.”

    That is what I thought your scenario would look like. Central bank reserves circulate between banks in the fed funds market. The fed funds market is not part of the real economy. The demand deposits are moving, and the central bank reserves are going along with the demand deposits if it is a different bank.

    For example, I buy a notebook for $700 from a retailer. I write a check for $700 from my account at bank A. The retailer deposits it in bank B. The central bank reserves end up going along with the check to bank B. It was the check that moved in the real economy (it has velocity), not the central bank reserves.

    A better way to think about it is to assume there is only one commercial bank or the retailer had an account at bank A. The demand deposits move (have velocity in the real economy) from my account to the retailer’s account to pay for the notebook. The central bank reserves did not move at all in those cases (velocity is zero).

  14. Gravatar of ssumner ssumner
    31. May 2013 at 13:42

    Doug, The money multiplier matters a lot under a gold standard, not much at all under fiat money–except perhaps at the zero bound.

    Fed Up.

    My point is to not confuse a definition (MV=PY) with a theory (claiming to describe the behavior of V.)

    I don’t follow your question about capital. Treasuries don’t “become” deposits. But I suppose $100,000 in Treasuries could in some sense back $1,000,000 in deposits (in terms of capital req.), depending on what the rest of the balance sheet looked like.

    If you are going to buy that $700 notebook, ultimately it must be paid for by moving $700 of base money from your account to the store’s account. The check is not payment, just a promise to pay. The store wants cash transfered into its bank account.

    John Mack, Sometimes I can’t tell whether commenters are morons, or just have a very poorly developed sense of humor.

  15. Gravatar of Tom Brown Tom Brown
    31. May 2013 at 13:54

    @Fed Up, I’m admittedly an amateur in regards to these concepts, but I’ve been asking questions similar to yours as well, and after communicating with various people who ought to know (bank auditors, former bankers, etc. — sorry Scott, I’ve already been corrupted!) I’ve attempted to put together some very basic balance sheet examples. So I’m not claiming this is error free, but check this out, it might help answer your questions:

    http://brown-blog-5.blogspot.com/2013/03/example-32-capital-requirements-stock.html

    here’s another version just using a loan origination fee to raise the capital:

    http://brown-blog-5.blogspot.com/2013/03/banking-example-3-capital-requirements.html

    I put up yet a 3rd example (3.1) if you’re interested, and I put up another post on calculating bank capital:

    http://brown-blog-5.blogspot.com/2013/03/banking-example-7-calculating-capital.html

    Also be sure the read the John Carney reference which inspired the first two links:

    http://www.cnbc.com/id/100497710

    The basic idea is that reserve requirements on requirements on demand deposits (checking accounts) not time deposits (CDs or savings accounts). Capital requirements, however, are a requirements that folds in the asset side of the bank’s balance sheet, including the loans. Hope that helps!

  16. Gravatar of Andy Andy
    31. May 2013 at 15:57

    Hi-

    I listened to your podcast on Econtalk. Great discussion. But I need help. When RR asked you why you think money is tight even though the Fed has $3trillion on its books you said something along the lines of accounting gimmicry…it is money offset I think by something else…can you explain this more? I’m not a Phd but consider myself sort of well read on economics…I just don’t understand this…and it doesn’t seem like the rest of the world does either because most people see to say the Fed is very loose…help…Thanks!

  17. Gravatar of Tom Brown Tom Brown
    31. May 2013 at 17:25

    @Fed Up, looking at your particular example you gave:

    “Someone starts a NEW bank by selling stock worth $100,000. The stock gets paid for with $100,000 in demand deposits. The new bank then buys $100,000 in treasuries from the bank where the demand deposits came from. The new bank now has $100,000 in treasuries to use as bank capital (emphasis) and nothing else.

    If the capital requirement is 10%, can the $100,000 in treasuries as bank capital become $1,000,000 in demand deposits?”

    I don’t think that’s the way to look at it. I’m not sure what the purchasing of Treasuries has to do with it first of all (Treasuries and reserves are both zero risk assets for capital requirements… and that $100k of stock purchasing bank deposits will come from other banks with backing reserves but won’t show up as liabilities of course, since they’re purchasing stock, not being transferred to the bank as deposits). Secondly, capital requirements are not really on the “demand deposits” … that’s what reserve requirements are for. Reserve requirements are ONLY on these demand deposits. Deposits figure in capital requirements in terms of being liabilities though. This is a simplified version of what’s required:

    CAR = (Tier 1 + Tier 2 Capital) / (Sum of risk weighted assets) > 10%

    Where CAR = capital adequacy ratio

    Because of the risk weighting of assets in the balance sheet (reserves get a 0 risk, mortgages 0.5, other loans 1.0… as an example), the capital requirement has more to do with the loans than the liabilities… or lets say they both figure in.

    So if you’ve got a bank with a bunch of reserves and no liabilities, that’s going to count as Tier 1 capital, but not count in the denominator of the CAR. Such a bank could make up to $1M in general loans, and $2M in mortgages (assuming 0.5 weighting for mortgages). The bank might end up w/ deposits as its liabilities or reserve borrowings (from other banks or the Fed) or a combination of both (say most loans are used to make purchases, then assuming the vendors mostly have accounts at other banks, the lending bank doesn’t end up w/ many deposits). It doesn’t matter too much the breakdown between demand deposits and reserve borrowings that end up on its BS as liabilities. However, other kinds of liabilities can matter… so, for example, subordinated debt liabilities can be partially added back in (as Tier 2 capital… all that’s important ultimately for the CAR is the sum of Tier 1 + Tier 2). Check out my example 7 (link above) where I explore that a little bit. Again, I’m not an expert, but I always find that it’s helpful to draw out balance sheets to try to understand how this stuff works.

  18. Gravatar of Edward Edward
    31. May 2013 at 17:52

    Scott, there is a question that I always wanted to ask under NGDPLT under your proposal. When the Fed sells futures contracts to bring down an accelerated forecast, how long presumably, would buyers of those contracts need to hold them at the Fed to presumably drain excess liquidity?

    Would it just be like normal contractionary monetary operations?

  19. Gravatar of J J
    31. May 2013 at 18:27

    Professor Sumner,

    Totally unrelated to this post, but related to your recent post on Krugman/others’ posts about conservatism. Douthat lists market monetarism as one of the central tenets of ‘reform conservatism’:

    http://douthat.blogs.nytimes.com/2013/05/30/what-is-reform-conservatism/#more-18702

    The republicans are supposed to be the party that knows how to run the economy (well, I guess they would say the government shouldn’t ‘run’ the economy). Anyway, it would be nice to see them espouse your views on monetary policy.

  20. Gravatar of Doug M Doug M
    31. May 2013 at 19:28

    In the olden days, they used to talk about the money multiplier as 1/reserve ratio. I suppose they still teach it… but in the world since the creation of shadow banks, it is not the right measure.

    Banks can now move assets off of their ballance sheet and into an SPV, and put the equity of the SPV onto their books. And suddlenly there is a whole lot less that the bank needs to reserve against. The money muliplier is potientially an order of magnitue higher than 1/RR.

  21. Gravatar of Fed Up Fed Up
    31. May 2013 at 19:32

    “If you are going to buy that $700 notebook, ultimately it must be paid for by moving $700 of base money from your account to the store’s account. The check is not payment, just a promise to pay. The store wants cash transfered into its bank account.”

    No, the store will take demand deposits/check as long as it thinks the demand deposits/check won’t be defaulted on and they can be redeemed 1 to 1 for currency.

    Let’s try it this “quick” way. Instead of writing a check, I decide to withdraw $700 of currency from bank A. Vault cash goes down by $700, and my checking account goes down by $700. I give the retailer $700 in currency. It gives me the notebook. The retailer then takes the $700 in currency and redeposits it at bank A. Vault cash goes up by $700, and the retailer’s checking account goes up by $700. Notice vault cash of bank A stayed the same. My checking account went down by $700, while the retailer’s checking account went up by $700. At the end, it is just like I wrote a check, only the demand deposits moved.

    “I don’t follow your question about capital. Treasuries don’t “become” deposits. But I suppose $100,000 in Treasuries could in some sense back $1,000,000 in deposits (in terms of capital req.), depending on what the rest of the balance sheet looked like.”

    The $100,000 in treasuries “backs” the loans. There are two parts when borrowing from a bank. The loan part is on the asset side and gets a capital requirement “attached” to it (the loan creates a capital requirement). The demand deposit is on the liabilities side and gets a reserve requirement “attached” to it (the demand deposit creates a reserve requirement).

    Assets new bank = $100,000 in treasuries
    Liabilities new bank = $0 in demand deposits
    Capital new bank = $100,000 of bank stock

    Now make the $1,000,000 in loans.

    Assets new bank = $100,000 in treasuries plus $1,000,000 in loans
    Liabilities new bank = $1,000,000 in demand deposits
    Capital new bank = $100,000 of bank stock

    The $100,000 in treasuries is used to meet the capital requirement for the $1,000,000 in loans. If the reserve requirement is a positive number, then the new bank is not meeting the reserve requirement.

  22. Gravatar of Fed Up Fed Up
    31. May 2013 at 19:48

    Tom Brown, my point was that the new bank sold $100,000 in stock. It then created $1,000,000 in demand deposits.

    “I’m not sure what the purchasing of Treasuries has to do with it first of all”

    I usually get told by the accounting people I have talked to that the new bank will buy treasuries. I think it is because in the past treasuries yielded more than currency or central bank reserves. I need to get that last part verified.

  23. Gravatar of Tom Brown Tom Brown
    31. May 2013 at 21:30

    @Fed Up

    “Tom Brown, my point was that the new bank sold $100,000 in stock.”

    I understood that part.

    “It then created $1,000,000 in demand deposits.”

    I think it’s more accurate to say you could create $1M in loans with a risk weighting of 1. (i.e. riskiest loans). You could create $2M in loans with a risk weighting of 0.5. My point about the deposits is that they may not stay demand deposits (they could be changed into savings accounts, for example), or they may not be held at the bank after the loan is made (sellers might have different banks), or they may be used on something which destroys them (like buying Tsy debt from Treasury Direct, or paying taxes, or paying debts to banks). What you wrote above is fine. You could sell all the Treasuries for reserves in the final step to meet the reserve requirements. But here’s another possibility for how your balance sheets could look (Bank A is the new bank, and Bank B holds the savings accounts of all the property sellers):

    Bank A:
    Assets = $100k in reserves
    Liabilities = $0
    Equity = $100k = Assets – Liabilities

    Bank B (assume Bank B starts with $1):
    Assets = $1 reserves
    Liabilities = $0
    Equity = $1

    Now Bank A makes $2M in house loans (risk weighting of 0.5 rather than 1 for higher risk loans):

    Bank A:
    Assets = $100k in reserves + $2M in mortgages
    Liabilities = $2M in reserve borrowing
    Equity = $100k

    Bank B:
    Assets = ($2M + $1) in reserves
    Liabilities = $2M in savings deposits
    Equity = $1

    Now Bank A meets both the reserve requirements (10%) and the CAR (10%):

    reserve requirements = 10% of $0 = $0 < $100k, check!.. thus Bank A has $100k of excess reserves

    CAR = ($100k in Tier 1 + $0 Tier 2) / (0.5*$2M + 0*$100k) = 10%, check! (Bank A just meets the CAR requirement)

    So this is a case where no demand deposits resulted from the loans at Bank A (or at all actually – since the sellers immediately moved their proceeds to savings accounts at Bank B). Since that's the case, Bank A is free to buy Treasuries with all its excess reserves and still meet the $0 reserve requirements. My example is just another variation on the way things could go, and illustrates why I think of capital requirements as being more of a requirement on bank assets and lending than deposits.

    BTW, Bank B also meets reserve and capital requirements here even though its equity is only $1. You see why? No demand deposits = no reserve requirements. And since its only asset is reserves, the denominator of the CAR is $0 (risk weighting of 0), so any non-zero numerator lets it meet capital requirements.

  24. Gravatar of Tom Brown Tom Brown
    31. May 2013 at 21:46

    @Fed Up, sorry, I think I came off sounding like a jerk there… let me emphasize that there’s nothing wrong with your example! I was just confused by your emphasis on creating demand deposits… I wasn’t sure why that was important since I thought you were primarily asking about capital requirements… but there’s certainly no reason you can’t do that!

  25. Gravatar of ssumner ssumner
    1. June 2013 at 07:25

    Andy, Standard monetary theory (quantity theory of money, etc) bases its predictions on the assumption that money pays no interest. Not only did the Fed start paying interest on bank reserves in 2008, but the interest it pays is higher than what banks can earn on T-bills. Hence bank reserves are no longer “High-powered money.” They don’t have the usual inflationary effect.

    The Fedis imply swapping one interest-bearing Federal liability for another.

    Edward, Good question. To avoid having a huge outstanding stock of futures contracts, I have suggested that the actual changes in the money supply occur through parallel OMOs with T-securities. In that case the futures purchases and sales are merely signals to the Fed to do the ordinary OMOs. So they don’t have to be held for any period of time.

    J, That’s nice to hear.

    Doug, That’s a common misconception. The deposit multiplier was 1/r. The money multiplier was never 1/r, it was (1 +C/D)/(r + C/D).

    Fed up. That seems like simply a matter of semantics.

  26. Gravatar of Edward Edward
    1. June 2013 at 09:23

    Scott, that’s what I think too.

    But wouldn’t it be better, instead of buying and selling bonds, to do something else, like, adjust the price of a commodity up to expand NGDP, and down to contract it when the expectations market gets overheated.
    I know this is blasphemy to haters of the gold standard.
    But it wouldn’t BE like the gold standard as we traditionally know it, gold, or silver, would simply be a nominal anchor, an instrument of monetary policy, not the obsessive fetish of Austrian fools,and nitwits.
    It would be better than this ABSURD situation we have now, where people think low interest rates= easy money

  27. Gravatar of Fed Up Fed Up
    1. June 2013 at 09:34

    I buy a notebook for $700 from a retailer. I write a check for $700 from my account at bank A. The retailer deposits it in bank B. My checking account gets marked down by $700, and bank A’s account at the fed gets marked down by $700. The retailer’s checking account gets marked up by $700, and bank B’s account at the fed gets marked up by $700. I like to think of it this way. The demand deposits get transferred from my account at bank A to the retailer’s account at bank B, and the central bank reserves get transferred from bank A’s account at the fed to bank B’s account at the fed. Notice the central bank reserves are not in my account at bank A or the retailer’s account at bank B. The check/demand deposits settle the transaction. Assuming one commercial bank or assuming the check gets deposited in the same bank allows that to be seen easier. With either of those assumptions, the central bank reserves don’t move at all from bank A’s account at the fed. The vault cash does not move either. The demand deposits/check move (mark down then mark up) to settle the transaction and circulate in the real economy.

    I’m saying the check is payment.

  28. Gravatar of Fed Up Fed Up
    1. June 2013 at 09:41

    “I was just confused by your emphasis on creating demand deposits…”

    The bank could sell stock to get $100,000 in demand deposits. The bank creates $1,000,000 in demand deposits. I consider demand deposits both medium of account (MOA) and medium of exchange (MOE). There is a $900,000 difference there. The purchasing power of the debtors went up by more than the purchasing power of the saver went down for the stock purchase. This new bank created “money” (MOA and MOE).

  29. Gravatar of Fed Up Fed Up
    1. June 2013 at 13:21

    Tom Brown, let’s change you example a little bit. Assume the capital requirement for mortgages is 5% and skip the bank B part.

    Sell bank stock and buy treasuries:

    Assets = $100,000 in treasuries
    Liabilities = $0
    Equity = $100,000 in bank stock

    Now make 20 mortgage loans for $100,000 each.

    Assets = $100,000 in treasuries plus $2,000,000 in mortgages
    Liabilities = $2,000,000 in demand deposits
    Equity = $100,000 in bank stock

    The 20 people use the demand deposits to buy 20 homes for $100,000 each from 1 home builder.

    The home builder sets up a checking account at the new bank. So 20 checking accounts at the new bank were marked up and then marked down by $100,000 each, while the home builder’s checking account was marked up by the $2,000,000.

    The home builder allocates as follows:

    $2,000,000 in a savings account. The reserve requirement for savings accounts is zero so that takes care of a positive reserve requirement.

    Let’s stop here.

    1) $100,000 in demand deposits became $2,000,000 in demand deposits

    2) When the bank made the mortgages, it had zero vault cash and zero central bank reserves. It stayed that way when the home builder allocated to the savings account. The home builder accepted demand deposits in exchange for the 20 homes. No monetary base was involved.

    The balance sheet of the bank looks like this:

    Assets = $100,000 in treasuries plus $2,000,000 in mortgages
    Liabilities = $2,000,000 in savings account
    Equity = $100,000 in bank stock

    Now crank up the capital requirement to 100%.

    The bank sells $100,000 in bank stock and can only make $100,000 in mortgage loans.

  30. Gravatar of ssumner ssumner
    2. June 2013 at 05:46

    Edward, That’s what we did in 1933. But you still need to do OMOs to adjust the monetary base (and influence the price of the MOA.)

    Fed up, That’s wrong, base money does move from account A to account B.

  31. Gravatar of Fed Up Fed Up
    2. June 2013 at 09:08

    “Fed up, That’s wrong, base money does move from account A to account B.”

    Are you talking about my 1. June 2013 at 09:34 post?

  32. Gravatar of Fed Up Fed Up
    2. June 2013 at 16:45

    I’m going to redo the example above so there are 4 accounts labeled.

    I buy a notebook for $700 from a retailer. I write a check for $700 from my account A at bank C. The retailer deposits it in its account B at bank D. My checking account A gets marked down by $700, and bank C’s account at the fed gets marked down by $700. The retailer’s checking account B gets marked up by $700, and bank D’s account at the fed gets marked up by $700. I like to think of it this way. The demand deposits get transferred from my account A at bank C to the retailer’s account B at bank D, and the central bank reserves get transferred from bank C’s account at the fed to bank D’s account at the fed. Notice the central bank reserves are not in my account A at bank C or the retailer’s account B at bank D. The check/demand deposits settle the transaction.

    Assuming one commercial bank or assuming the check gets deposited in the same bank C allows that to be seen easier. With either of those assumptions, the central bank reserves don’t move at all from bank C’s account at the fed. The vault cash does not move either. The demand deposits/check move (mark down my account A then mark up the retailer’s account B) to settle the transaction and circulate in the real economy.

    I’m saying the check is payment.

  33. Gravatar of Tom Brown Tom Brown
    2. June 2013 at 23:26

    @Fed Up,

    Your 1st new comment to me above:

    “The bank could sell stock to get $100,000 in demand deposits.”

    That doesn’t make sense to me. Let’s start from a brand new bank:

    New Bank:
    Assets: $0
    Liabilities: $0
    Equity: $0

    Now the bank sells $100k in stock:

    Assets: $100k in RESERVES (i.e. Fed deposits)!
    Liabilities: $0
    Equity = Assets – Liabilities = $100k

    There are no demand deposits involved here at all! Those reserves are Fed deposits. Who bought the stock? Perhaps other banks bought the stock. Other banks use reserves to buy things with. Perhaps some stock purchasers used physical cash. Cash is not demand deposits. Sure, perhaps some stock investors bought the stock using their demand deposits… but what does that mean? It means their bank erased their deposit and bought the stock on their behalf with reserves. The new bank ends up with reserves! Reserves held by the bank are assets to the bank. Demand deposits are always liabilities to the bank!

    Here’s an example of a bank using its reserves the buy something:

    http://brown-blog-5.blogspot.com/2013/03/banking-example-5-bank-spends-excess.html

    Moving on to your 2nd new comment to me above:

    “Tom Brown, let’s change you example a little bit. Assume the capital requirement for mortgages is 5% and skip the bank B part.”

    OK, that’s a different idea than the CAR… so 5%, and risk weighting is 1. (In reality each mortgage might have a different risk weighting, and other loans other risk weightings… all over the map, which is why I think the CAR is used, but I’m game: risk weighting 1 and now a 5% requirement instead):

    Keep in mind also that Equity is just the assets in excess of liabilities. In other words you calculate the assets and then the liabilities and define:

    Equity = Assets – Liabilities

    So equity is generally not “in something” like stocks… it’s just a dollar amount that represents this abstract difference. On the balance sheet a positive equity is put on the right hand side and treated like a liability (negative equities are sometimes quantified by positive numbers but put on the left of the balance sheet and treated like assets), but it’s calculated after the normal liabilities and assets are. The equity represents the owners’ interests… so if the bank were liquidated, presumably the stock owners would be able to divide up the resulting dollars (equal in value to the equity).

    “1) $100,000 in demand deposits became $2,000,000 in demand deposits”

    Same complaint as above. I don’t see the $100k in demand deposits! You had $100k in reserves at the bank, and the bank used that to buy Treasuries with. There were no demand deposits there.

    I’m OK with everything else you wrote. You must be assuming that the stock was sold to entities who ONLY used demand deposits to purchase it, and that’s why you state “$100,000 in demand deposits became…”

    But like I said, that’s not necessarily true. And even if it was, reserves are actually what buys the bank stock on behalf of those demand deposit holders. And finally, the new bank (and banks in general) do not hold demand deposits as assets… demand deposits are only liabilities to commercial banks! (That’s not exactly true… there’s such a thing as a “correspondence bank”… but when you strip away all the complication, correspondence banks are not always used and are not required… and they can be simplified out of the picture… in essence, banks can be thought of as using their Fed deposits (their reserves or vault cash) to make purchases with when purchasing something from some private non-bank entity holding their account at another bank (if the seller has an account at the buying bank, their deposit is simply credited)… or when purchasing from Tsy or the Fed, or any entity with a Fed deposit).

  34. Gravatar of Tom Brown Tom Brown
    2. June 2013 at 23:37

    @Fed Up,

    One more thing… I always write “equity” because it is simply assets – liabilities, but capital is actually a little different. There are different kind of capital: accounting capital and regulatory capital are two broad categories, but in general:

    capital = set of assets – set of liabilities

    Here’s a post I did on this concept:

    http://brown-blog-5.blogspot.com/2013/03/banking-example-7-calculating-capital.html

    So in order to raise capital to meet regulatory requirements, the bank can used retained earnings. Again, no demand deposits involved here… again, here’s a post I do on this showing a bank meeting capital requirements with ONLY retained earnings:

    http://brown-blog-5.blogspot.com/2013/03/banking-example-3-capital-requirements.html

    Another way to raise capital is to issue subordinated debt. It’s a weird concept because this debt is of course a liability, but because of the accounting rules, it can be partly counted as “Tier 2 capital” or regulatory purposes. I attempt make an intuitive explanation of why that is in my Example #7 link above. But in short, an alternate equation for capital is:

    capital = equity + some kinds of liabilities

    So my point is there’s different ways to raise capital, not just selling stock to demand deposit holders.

  35. Gravatar of Tom Brown Tom Brown
    3. June 2013 at 00:08

    @Fed Up,

    This is not a comment about the velocity of money or any of that part of your notebook example… just the $700 and the accounts. Actually I think you’ve got that part all correct. I have a similar example written out in balance sheets here:

    http://brown-blog-5.blogspot.com/2013/03/banking-example-11.html

    You are correct: if both parties of a transaction between individuals or non-bank businesses (i.e. between private non-banks entities) share the same bank, no reserves are moved anywhere. Reserves are only used to clear payments BETWEEN banks for these kinds of transactions, so if only one bank is involved, no reserves move. Or if one of the parties to the transaction is the bank itself, and the other a non-bank with an account at the bank the same is true, except for a small amount (10%) of the transaction amount in reserves which may need to change status from required to excess or vica versa.

    Fed deposits can only go three places:

    1) To entities having Fed deposits (NOT to individuals or non-bank businesses)

    2) Withdrawn as cash

    3) Back to the Fed

    A few more details on this:

    http://brown-blog-5.blogspot.com/2013/04/the-three-places-reserves-can-go.html

  36. Gravatar of ssumner ssumner
    3. June 2013 at 05:26

    Fed up, Yes.

  37. Gravatar of Tom Brown Tom Brown
    3. June 2013 at 10:32

    @Fed Up, you write:

    “The bank creates $1,000,000 in demand deposits. I consider demand deposits both medium of account (MOA) and medium of exchange (MOE). There is a $900,000 difference there. The purchasing power of the debtors went up by more than the purchasing power of the saver went down for the stock purchase. This new bank created “money” (MOA and MOE).”

    I see where you are going I think… it’s just that it’s a little imprecise on both ends in my opinion: demand deposits aren’t necessarily part of capital creation, and they aren’t necessarily part of $1M in resulting lending. That’s why I like to say that reserve requirements are ONLY requirements on a bank’s demand deposit liabilities (and thus don’t affect lending or “purchasing power” creation much), whereas capital requirements can directly affect a bank’s lending (purchasing power creation) ability. You might also check out the concept of CAMELS scores (capital requirements are a part of this):

    http://en.wikipedia.org/wiki/CAMELS_rating_system

    If your argument is that banks can increase purchasing power through lending, and that lending is constrained by capital requirements I have no problem with that. Again, check out that John Carney piece at CBNC (I linked to in my first comments days ago). I think he does an excellent job of explaining this. My Example #3 (link above) is most closely related to this article…. I follow Carney’s details (in his word example) pretty closely in my balance sheets on that link.

  38. Gravatar of Fed Up Fed Up
    3. June 2013 at 14:27

    “Fed up, That’s wrong, base money does move from account A to account B.

    Are you talking about my 1. June 2013 at 09:34 post?”

    “Fed up, Yes.”

    OK.

    Back to where I expanded the example so there is A, B, C, and D.

    “Assuming one commercial bank or assuming the check gets deposited in the same bank C allows that to be seen easier. With either of those assumptions, the central bank reserves don’t move at all from bank C’s account at the fed. The vault cash does not move either. The demand deposits/check move (mark down my account A then mark up the retailer’s account B) to settle the transaction and circulate in the real economy.

    I’m saying the check is payment.”

    I’m trying to get these verified, but I am pretty sure:

    1) I don’t have an account at the fed for my central bank reserves that link to my checking account and the retailer does not have account at the fed for its central bank reserves that link to its checking account.

    2) Central bank reserves can’t be “deposited” into or out of a checking account.

  39. Gravatar of Tom Brown Tom Brown
    3. June 2013 at 16:45

    @Fed Up, for what it’s worth I completely agree with your points 1) and 2)

  40. Gravatar of Fed Up Fed Up
    3. June 2013 at 17:55

    Tom Brown said: “The bank could sell stock to get $100,000 in demand deposits.

    That doesn’t make sense to me. Let’s start from a brand new bank:

    New Bank:
    Assets: $0
    Liabilities: $0
    Equity: $0

    Now the bank sells $100k in stock:

    Assets: $100k in RESERVES (i.e. Fed deposits)!
    Liabilities: $0
    Equity = Assets – Liabilities = $100k”

    Let’s assume the stock was paid for with all demand deposits. I don’t see any reason why a bank does not have its own checking account.

    Brand new bank sells $150,000 in new stock.

    Assets: $150,000 in RESERVES (i.e. Fed deposits)! and $150,000 in demand deposits in its own account
    Liabilities: $0
    Equity = Assets – Liabilities = $150k”

    The bank spends $50,000 to build a branch and office. $50,000 in demand deposits move to the builder’s account at bank Z and $50,000 in central bank reserves move to bank Z’s account at the fed.

    I like to do it this way so the movement of currency and demand deposits can be followed in the real economy and in the financial asset economy.

  41. Gravatar of Fed Up Fed Up
    3. June 2013 at 17:57

    Just above, I believe bank capital went from $150,000 to $100,000.

  42. Gravatar of Fed Up Fed Up
    3. June 2013 at 18:03

    “OK, that’s a different idea than the CAR… so 5%, and risk weighting is 1. (In reality each mortgage might have a different risk weighting, and other loans other risk weightings… all over the map, which is why I think the CAR is used, but I’m game: risk weighting 1 and now a 5% requirement instead):”

    I meant 10% capital adequacy ratio.

    “Because of the risk weighting of assets in the balance sheet (reserves get a 0 risk, mortgages 0.5, other loans 1.0… as an example),”

    10% capital adequacy ratio times .5 mortgages gives 5% capital adequacy ratio for mortgages.

  43. Gravatar of Fed Up Fed Up
    3. June 2013 at 18:12

    “And finally, the new bank (and banks in general) do not hold demand deposits as assets… demand deposits are only liabilities to commercial banks!”

    I believe banks could hold demand deposits as assets. They would be a liability to the issuing bank and an asset to the bank holding it.

  44. Gravatar of Fed Up Fed Up
    3. June 2013 at 18:15

    “So in order to raise capital to meet regulatory requirements, the bank can used retained earnings. Again, no demand deposits involved here…”

    Aren’t retained earnings denominated in currency and/or demand deposits?

  45. Gravatar of Tom Brown Tom Brown
    3. June 2013 at 22:13

    @Fed Up,

    “Aren’t retained earnings denominated in currency and/or demand deposits?”

    They are denominated in dollars not demand deposits or currency. That’s mixing two different things. Demand deposits and currency are also denominated in dollars!

    Simple example: say a bank loans John $100 to pay his taxes with, but it charges a $10 loan origination fee (John’s taxes were $90). It takes care of paying Treasury on John’s behalf by borrowing reserves from the Fed or other banks to do this with (Treasury must be paid with Fed deposits, not bank deposits). Here’s the bank’s resulting balance sheet (assuming it started with nothing):

    Assets: $100 loan to John
    Liabilities: $90 in reserve borrowings
    Equity: $10

    Capital and reserve requirements are met!

    So “charging John a $10 fee” amounts to crediting him with only $90 even though he borrowed a full $100. Make sense? No demand deposits or currency are involved here. I actually did that once to pay my taxes with a credit card! I never had the deposit… it was only a liability to me.

  46. Gravatar of Tom Brown Tom Brown
    3. June 2013 at 22:21

    @Fed Up

    “I believe banks could hold demand deposits as assets. They would be a liability to the issuing bank and an asset to the bank holding it.”

    You are correct. That arrangement is called a “correspondence bank.” I guess my point is though that banks don’t hold their own demand deposits. Also, this correpondence bank arrangement is not required, and the setup could be simplified by replacing those deposits with reserves. Some banks don’t use correspondence banks. I personally find it simpler to think of banks never using correspondence banks, and just paying for everything with reserves: shareholder dividends, employee salaries and bonuses, office supplies, rent, electric bill, etc. This is accomplished in one of two ways: if the payee has an account at the bank, his deposit is simply credited. If not, the bank transfers reserves to the payee’s banks, and the payee’s bank in turn credit’s the payee’s deposit.

  47. Gravatar of Tom Brown Tom Brown
    3. June 2013 at 22:44

    @Fed Up

    “Let’s assume the stock was paid for with all demand deposits. I don’t see any reason why a bank does not have its own checking account.”

    Like I mentioned, I am not an expert, but I don’t believe they do. They can have a deposit at another bank, a correspondent bank, but they certainly don’t have to. My source for that information is a bank auditor. I wish I had a more authoritative document to share with you on that. Sorry!

    The reason I don’t like to do it that way is that balance sheets must balance! So if you have both $150k of reserves and $150k of a deposit in it’s own checking account, that violates the principal that the left hand side of the BS sums to the right hand side of the BS. If you add up the Assets you get $300k, not $150k. It’s an accounting problem! The equity is always put on the right hand side with the liabilities. (although, like I say, it can be represented instead with a change of sign on the left hand side in the assets columns as “negative equity” instead). Here’s the link to my source about the correspondence banks:

    http://pragcap.com/ask-cullen/comment-page-13#comment-135930

    Notice how he says the bank’s reserves go down or its deposit at its correspondence bank goes down. The upshot (my question was “do banks use their reserves to buy donuts?”):

    “So yes, banks use reserves to buy donuts.”

  48. Gravatar of Tom Brown Tom Brown
    3. June 2013 at 22:55

    @Fed Up

    “Just above, I believe bank capital went from $150,000 to $100,000.”

    Yes.

    “10% capital adequacy ratio times .5 mortgages gives 5% capital adequacy ratio for mortgages.”

    That’s one way to say it I suppose in this case, but remember what you really have is something like this

    (Tier 1 + Tier 2 capital) / (0.7*mortgage1 + 0.7*car_loan1 + 1*credit_card_cash_advance1 + 0.55*mortgage2 + 0.1*GSE_debt + 0*Tsy_debt … etc.). > 10%

    The CAR is 10% for Tier1 + Tier2. I think there’s a separate measure it must ALSO pass for just Tier 1 (like 6% or 8%), and probably a few more thresholds. But I’m pretty sure the 10% is for combined Tier 1 and 2. Basel III is supposed to be much tougher than Basel II, so I don’t know how these will change.

  49. Gravatar of Tom Brown Tom Brown
    3. June 2013 at 23:07

    @Fed Up,

    Here’s another bit on correspondence banks on that same comment stream from Joe in Accounting, the bank auditor:

    http://pragcap.com/ask-cullen/comment-page-13#comment-135993

    There’s a lot of helpful comments from Joe on that page actually.

  50. Gravatar of Tom Brown Tom Brown
    3. June 2013 at 23:16

    @Fed Up,

    More… it’s all on that same page: Joe, me, Joe again:

    http://pragcap.com/ask-cullen/comment-page-13#comment-136029

    http://pragcap.com/ask-cullen/comment-page-13#comment-136037

    http://pragcap.com/ask-cullen/comment-page-13#comment-136065

  51. Gravatar of Tom Brown Tom Brown
    4. June 2013 at 09:18

    @Fed Up,

    From what I learned from Joe (re-reading his comments above), it seems the bank can draw a line through its reserves and call part of it an account, like an operating account from which to buy donuts, etc. To the Fed it’s all the same: reserves. But to call that a demand deposit seems inherently different than a customer demand deposit. The bank MUST have 100% reserve backing on an account like that (an internal account) by its very nature. I doubt reserve requirements, for example, in the normal 10% sense, have anything to do with an internal account which is merely a line drawn to partition its reserves. There the requirements must be 100%. If the bank could give itself normal customer style demand deposits, then it could loan itself money, creating the deposits out of thin air, like it does with customers.

    You’ll probably say, “so what if it has to have 100% reserve backing… it can still be a demand deposit because the funds are available on demand.” … and maybe that’s correct!

  52. Gravatar of Fed Up Fed Up
    4. June 2013 at 13:29

    “@Fed Up,

    “Aren’t retained earnings denominated in currency and/or demand deposits?”

    They are denominated in dollars not demand deposits or currency. That’s mixing two different things. Demand deposits and currency are also denominated in dollars!”

    Looking at that, I don’t think denominated is quite right. Retained earnings are currency and/or demand deposits. The company can then decide how to financially invest those retained earnings, including just holding the currency and/or demand deposits themselves.

    I think demand deposits are denominated in currency, but most are still MOA and MOE. I’d say currency is dollars, not denominated. As long as there is 1 to 1 convertibility, I’d say dollars are currency and demand deposits.

    I buy $700 in goods/services (like a notebook), $700 in stock, or $700 in real estate. The $700 in all those cases is currency and/or demand deposits.

  53. Gravatar of Fed Up Fed Up
    4. June 2013 at 13:48

    “Simple example: say a bank loans John $100 to pay his taxes with, but it charges a $10 loan origination fee (John’s taxes were $90). It takes care of paying Treasury on John’s behalf by borrowing reserves from the Fed or other banks to do this with (Treasury must be paid with Fed deposits, not bank deposits). Here’s the bank’s resulting balance sheet (assuming it started with nothing):

    Assets: $100 loan to John
    Liabilities: $90 in reserve borrowings
    Equity: $10

    Capital and reserve requirements are met!

    So “charging John a $10 fee” amounts to crediting him with only $90 even though he borrowed a full $100. Make sense? No demand deposits or currency are involved here. I actually did that once to pay my taxes with a credit card! I never had the deposit… it was only a liability to me.”

    I think there are some steps missing there.

    Assets: $100 credit card loan to John
    Liabilities: $100 in demand deposits in Jonh’s account
    Equity: $0

    Next is the fee.

    Assets: $100 credit card loan to John
    Liabilities: $90 in demand deposits in John’s account
    Equity: $10 in demand deposits

    Lastly is the transfer of $90 of demand deposits and $90 of central bank reserves. Bank M that issues the credit card could possibly be short central bank reserves. I don’t want to get into what happens next right now. I’m pretty sure John’s account got marked down by $90 of demand deposits and bank M’s account at the fed got marked down by $90 of central bank reserves.

    The point is the demand deposits got created and then moved out of John’s account (mark up then mark down).

    The demand deposits are assets to John, and the credit card loan is a liability to John.

  54. Gravatar of Fed Up Fed Up
    4. June 2013 at 15:07

    “Brand new bank sells $150,000 in new stock.

    Assets: $150,000 in RESERVES (i.e. Fed deposits)! and $150,000 in demand deposits in its own account
    Liabilities: $0
    Equity = Assets – Liabilities = $150k”

    The bank spends $50,000 to build a branch and office. $50,000 in demand deposits move to the builder’s account at bank Z and $50,000 in central bank reserves move to bank Z’s account at the fed.

    Hmmm … maybe that is not right. Let’s try this:

    Assets: $150,000 in RESERVES (i.e. Fed deposits)! and $150,000 in demand deposits in its own account
    Liabilities: $150,000 for its own account
    Equity = Assets – Liabilities = $150k”

    The two cancel so why have them? I don’t want to destroy a demand deposit and later recreate it when what is actaully happening is that the demand deposit is moving. After the $50,000 in spending:

    Assets: $100,000 in RESERVES (i.e. Fed deposits)! and $100,000 in demand deposits in its own account
    Liabilities: $100,000 for its own account
    Equity = Assets – Liabilities = $100k”

    Now buy $100,000 in treasuries from a non-bank.

    The [central bank] reserves and demand deposits leave/move. Mark down the $100,000 in its own account (liability).

    Assets: $100,000 in treasuries
    Liabilities: $0
    Equity = Assets – Liabilities = $100k”

  55. Gravatar of Fed Up Fed Up
    4. June 2013 at 15:14

    “That’s one way to say it I suppose in this case, but remember what you really have is something like this

    (Tier 1 + Tier 2 capital) / (0.7*mortgage1 + 0.7*car_loan1 + 1*credit_card_cash_advance1 + 0.55*mortgage2 + 0.1*GSE_debt + 0*Tsy_debt … etc.). > 10%”

    That may be true. Let’s just assume all the mortgages are .5 to keep it simple. 10% times .5 = 5%.

    “From what I learned from Joe (re-reading his comments above), it seems the bank can draw a line through its reserves and call part of it an account, like an operating account from which to buy donuts, etc. To the Fed it’s all the same: reserves. But to call that a demand deposit seems inherently different than a customer demand deposit. The bank MUST have 100% reserve backing on an account like that (an internal account) by its very nature. I doubt reserve requirements, for example, in the normal 10% sense, have anything to do with an internal account which is merely a line drawn to partition its reserves. There the requirements must be 100%. If the bank could give itself normal customer style demand deposits, then it could loan itself money, creating the deposits out of thin air, like it does with customers.”

    It seems to me there is some version where the general idea is true. Our details probably need cleaned up.

  56. Gravatar of Tom Brown Tom Brown
    4. June 2013 at 17:53

    @Fed Up,

    Regarding the missing steps in my $10 retained earnings example… perhaps, but when I swipe my credit card at Home Depot, I’m certainly not aware of any demand deposit credited to me… that could be correct, but it’s certainly not clear. Seems to me the funds are immediately send (as reserves) to Home Depot’s account (if they bank somewhere other than where I do). Also, think of paying points on a house loan: You pretty much get hit with those right away and it’s just deducted from the credit your are getting. Again, I wasn’t making that up, I used the John Carney article as my template:

    http://www.cnbc.com/id/100497710

    Also I encourage you to read Joe’s comments if you haven’t already: I have not seen his credentials, so I’m taking him at his word that he’s a bank auditor, but he does a great job pretending to know what he’s talking about if he’s lying!

  57. Gravatar of Tom Brown Tom Brown
    4. June 2013 at 17:57

    Sorry, the funds are not sent to Home Depot’s account as reserves, the reserves are sent to Home Depot’s bank (assuming Home Depot banks somewhere other than where I do) and then the bank credits Home Depot’s deposit.

    Now when I write a check instead (no inside money created), my demand deposit is debited, and Home Depot’s is credited. Again those are two totally different deposits! So you can think of it as the deposit moving, but it really doesn’t: one is destroyed and the other created.

  58. Gravatar of Tom Brown Tom Brown
    4. June 2013 at 20:01

    @Fed Up,

    Just reprinting here my last two links for my conversation with “Joe in Accounting” above:

    First me:

    “So, it’s most similar to my 1st scenario: you essentially ‘draw a line’ through the $100 of reserve assets, allocating $90 to regular reserves, and $10 to reserves representing the operating account. True? You still have $100 of assets, and those assets are still all reserves, but you (and the Fed) have agreed on this internal division of those assets for accounting purposes, so they probably show up on your balance sheet with separate descriptions, but both still under “Assets.” Something like that?”

    Joe’s response:

    “Yes, for all intents and purposes, the Fed’s balance sheet would have a liability of $100. Your bank’s general ledger would have two accounts, one say Deposits Held at Fed with $90, the other say Bank Operating Cash Account with $10. On the bank’s call report/financial statements they would be reported as one line item in the asset section titled Cash and Due From Banks which would equal $100.”

    I see what you’re trying to do, but I don’t think it’s that complicated. I guess if you like to think of it that way there’s no harm in it. I thought along the same lines at first, which is why I was asking Joe how it’s really represented.

    I know it’s convenient to think of demand deposits moving, but they don’t actually do that: they’re destroyed at one bank and created at the other.

  59. Gravatar of Tom Brown Tom Brown
    4. June 2013 at 20:42

    “I know it’s convenient to think of demand deposits moving, but they don’t actually do that: they’re destroyed at one bank and created at the other.”

    .. and sometimes they’re just created (e.g. bank, Tsy, or Fed pays you [think QE for the Fed]), and sometimes they’re just destroyed (e.g. you pay the bank, Tsy, or Fed [think QE unwinding for the Fed]).

    Also you can think of the bank starting from an empty balance sheet and then “buying” your loan papers by creating you a deposit. Again, the bank had nothing to start off with, … no deposit moved. Similarly the Fed buys reserve loan agreements (from banks, say through the discount window), or repos, or other assets such as Tsy debt or MBSs (QE) by creating Fed deposits… those deposits didn’t move because they didn’t exist before that.

  60. Gravatar of Fed Up Fed Up
    5. June 2013 at 18:52

    “The two cancel so why have them? I don’t want to destroy a demand deposit and later recreate it when what is actaully happening is that the demand deposit is moving. After the $50,000 in spending:

    Assets: $100,000 in RESERVES (i.e. Fed deposits)! and $100,000 in demand deposits in its own account
    Liabilities: $100,000 for its own account
    Equity = Assets – Liabilities = $100k”

    Now buy $100,000 in treasuries from a non-bank.

    The [central bank] reserves and demand deposits leave/move. Mark down the $100,000 in its own account (liability).

    Assets: $100,000 in treasuries
    Liabilities: $0
    Equity = Assets – Liabilities = $100k”

    I don’t think that is right either. But the point is.

    Assets: $100,000 in RESERVES (i.e. Fed deposits)! and $100,000 in demand deposits in its own account plus $50,000 building
    Liabilities: $100,000 for its own account
    Equity = Assets – Liabilities = $150,000

    Now buy $100,000 in treasuries from a non-bank.

    The [central bank] reserves and demand deposits leave/move. Mark down the $100,000 in its own account (liability).

    Assets: $100,000 in treasuries plus $50,000 building
    Liabilities: $0
    Equity = Assets – Liabilities = $150,000

    Bank capital = $100,000

  61. Gravatar of Fed Up Fed Up
    5. June 2013 at 19:50

    “I know it’s convenient to think of demand deposits moving, but they don’t actually do that: they’re destroyed at one bank and created at the other.”

    It’s especially convenient if you are trying to track where the demand deposits are going. I want to know where they are actually created, destroyed, held, and moved. I don’t want to see destroy and create when they are actually moving.

  62. Gravatar of Fed Up Fed Up
    5. June 2013 at 20:02

    Let’s try some unusual accounting entries.

    Start the new bank and buy treasuries.

    Assets: $100,000 in treasuries
    Liabilities: $0
    Equity = Assets – Liabilities = $100,000

    Limited 20 borrower’s balance sheet (bs)

    Assets: $0
    Liabilities: $0

    Now apply for mortgages.

    Assets: $100,000 in treasuries plus $2,000,000 DD in its own account
    Liabilities: $2,000,000 in DD
    Equity = Assets – Liabilities = $100,000

    Each of 20 borrower’s bs

    Assets: $100,000 mortgage loan
    Liabilities: $100,000 mortgage loan

    Approve the loans and “barter” DD for loans.

    Assets: $100,000 in treasuries plus $2,000,000 loans
    Liabilities: $2,000,000 in DD
    Equity = Assets – Liabilities = $100,000

    Each of 20 borrower’s bs

    Assets: $100,000 in DD’s
    Liabilities: $100,000 mortgage loan

  63. Gravatar of Tom Brown Tom Brown
    6. June 2013 at 18:13

    @Fed Up,

    Like I say, I don’t see any harm as long as the numbers come out correct. You say you’re doing it this way to keep track of demand deposits?

    But what about the idea that once an IOU is returned to the originator that it’s torn up (destroyed)? The Fed does that with their IOUs (Fed deposits). The Treasury does that with theirs once they mature (Tsy debt). If they didn’t their BS could grow but never contract again. Isn’t that kind of what’s happening when you don’t tear up bank IOUs (demand deposits) either like you seem to be doing here?: they are created but not destroyed, so the banking sector as an aggregate can have an expanding BS but not a contracting one?

  64. Gravatar of Fed Up Fed Up
    6. June 2013 at 20:07

    My comment above: “It’s especially convenient if you are trying to track where the demand deposits are going. I want to know where they are actually created, destroyed, held, and moved. I don’t want to see destroy and create when they are actually moving.”

    Plus, I think it will explain a “levered” hedge fund.

    Have you ever seen the accounting for paying the loan down?

  65. Gravatar of Tom Brown Tom Brown
    7. June 2013 at 10:36

    @Fed Up

    For paying the loan down, I just treat that in a simple way: the loan asset disappears from the bank’s balance sheet as the loan principal is paid down. But no, I’ve never seen how its actually treated.

  66. Gravatar of Tom Brown Tom Brown
    7. June 2013 at 10:44

    … and also, if the payer has a DD at the bank in question, then his DD decreases by the same amount. If the DD is paying interest instead then this is also true, but then in the interest only case the loan asset does not decrease. If the payer has a DD at a different bank, then those payments are made in reserves only of course (transferred from the payers bank), and again in the former case the loan is decreased and in the second its not. The payer’s bank decreases his DD in both cases.

    I know you’ll be doing that differently though!

  67. Gravatar of Fed Up Fed Up
    7. June 2013 at 13:25

    I have not seen how it is treated either.

    I keep seeing people say paying principal reduces the loan and the demand deposits. Paying interest is only a transfer.

    If that is correct, then there is a case of actual demand deposit destruction, not movement. The interst would be considered movement.

    It would also be interesting to see demand deposit destruction and movement in an overall economy as the mortgage is getting paid down.

  68. Gravatar of Tom Brown Tom Brown
    7. June 2013 at 15:31

    @Fed Up,

    Ah, so you would get rid of the loan AND the deposit in the case of paying back principal? I think that’s a good idea. Have you looked at econviz? They animate the balance sheets there:

    http://econviz.org/

    I particularly like this page:

    http://econviz.org/macroeconomic-balance-sheet-visualizer/

    Which treats the sectors with aggregate (composite) balance sheets. In the lower left hand corner, just above the text box labeled “Explanation of selected operation (…)” there’s a pull down list box called “Chose Operation.” Try the sequence “Bank Loan” followed by “Borrower Pays Interest on Bank Loan” followed by “Borrower Repays Principal from Bank Loan.”

  69. Gravatar of Fed Up Fed Up
    8. June 2013 at 10:54

    I tinkered with it.

    It looks like my 5. June 2013 at 20:02 comment could be right.

    Banks and bank-like entities can increase demand deposits (MOA and MOE). “Paying off” demand deposits from banks and bank-like entities and debt defaults above certain levels can both decrease demand deposits (MOA and MOE)?

  70. Gravatar of Fed Up Fed Up
    9. August 2013 at 13:48

    For reference:

    zyxzyxooxmi

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