4 ms·

What would also be interesting would be an explanation of how this then ties in to the "headline" short term interest rate that the Fed, ECB, Bank of England et

What would also be interesting would be an explanation of how this then ties in to the "headline" short term interest rate that the Fed, ECB, Bank of England etc. set. All the ground work has been laid - and I think many people would be interested to know the mechanics behind what happens when the Bank of England "cuts rates" or "raises rates". The only other place I've seen this explained well is at the start of the book "Pricing Money" by J.D.A Wiseman - but that's not available online.

Permit 13y ago
"How the Economic Machine Works" was a really great explanation of the different ways a government can influence inflation and deflation: http://www.youtube.com/watch?v=PHe0bXAIuk0 http://www.youtube.com/watch?v=PHe0bXAIuk0
yetanotherphd 13y ago
The St Louis federal reserve has a good article describing both monetary policy and how it is implemented. http://research.stlouisfed.org/aggreg/meeks.pdf http://research.stlouisfed.org/aggreg/meeks.pdf
gendal 13y ago
Excellent point. The original version of the slide had two extra boxes labelled "lender of last resort" and "open market operations"... :-) Thanks for the motivation to perhaps write a part two to this post.
nhaehnle 13y ago
The gist is that even though movements between banks tend to balance fairly well, they don't balance exactly. Therefore, banks can end up with excess reserves or a shortage of reserves, which they are then interested in lending out / borrowing, respectively. Or they might be interested in buying or selling other assets, such as bonds, to bring their excess reserves closer to zero. When a central bank sets the interest rate, it's talking about the interest rate at which such short term loans happen. It does so by simply participating in the market until the interest rate is where it wants it to be. These things are addressed fairly well in http://neweconomicperspectives.org/p/modern-monetary-theory-primer.html http://neweconomicperspectives.org/p/modern-monetary-theory-...
- notahacker 13y ago
  I'd avoid setting too much stock in Modern Monetary Theory unless you have a decent grounding in the basic operation of the monetary system already. Whilst their explanations of the banking system are very detailed, very accessible and mostly correct, their monetary theory is very much a view of how a fiat currency regime could work as opposed to how it does work, and they wildly misrepresent basic macroeconomic concepts when it suits them to make a point. (the most relevant example here is their model's assumption that governments can and do spend money into existence. Whilst this is theoretically possible in a fiat currency system, it's very different from the actual mechanisms in place, and entirely impossible with the Euro)
  - nhaehnle 13y ago
    > the most relevant example here is their model's assumption that governments can and do spend money into existence There are three points here. First of all, they are very clear that this only applies to monetarily sovereign governments (i.e., not Euro members, not state governments). Second is their claim that directly spending money into existence is the more natural way of looking at things, and everything involving debt issuance is a voluntary add-on. That's not how things developed historically, but it does make sense when you think about how you would design a state-run currency from first principles. Third is their claim that, as a first order approximation, even when all sorts of debt issuance dances are in place, the economy behaves as if they weren't and government simply spent money into and taxed money out of existence. [1] The second point is admittedly a bit philosophical and subjective. You might care more about the historical account than the first principles account. However, the third point is quite objective, and if you have a concrete example of how debt issuance actually makes a significant macro-economic difference that contradicts MMT, I would be highly interested (and I assume MMT economists would be as well). [1] One way to look at it is this: Debt issuance is a red herring; what matters is the central bank policy of (usually) maintaining a positive interest rate. Debt issuance is only a way of shifting the cost of this policy from the central bank's books into the general government budget, i.e. it is a political that hides the true cost of monetary policy so that the public won't be as outraged about it.
notahacker 13y ago
In summary - banks' liabilities to you (your deposits) are backed by assets. One of these is cash, but this doesn't earn the bank any return. Banks therefore prefer to hold much larger quantities of interest-earning assets like loans made to other parties, or government bonds (these are assets to a bank because they are promises by third parties to pay the bank money in the long term). - For the same reasons as the payment clearing system is "netted-out" at the end of the day, the balancing of these banks' assets and liabilities is netted-out at the end of the day. If the risk-weighted assets of one bank doesn't match its liabilities - particularly if it doesn't have enough cash - it needs to borrow from another bank. If a bank has too much non-interest earning cash at the end of the day, on the other hand it will prefer to earn a low risk return by lending to another bank. This is the "base interest rate" we're talking about; the minimum amount of return a bank expects from making a very safe loan. - Banks could earn a similarly low-risk and low-return by buying government bonds with their spare cash instead, so the interbank lending rate is closely linked to bond prices. The Fed, ECB or Bank of England can take advantage of this by buying and selling government bonds to keep the interbank lending rate at a target level. - Why would they want to do this? Because the interbank lending rate (and bond prices) affects the rates for all other types of lending that banks do (the interbank lending rate plus a usually relatively large risk premium, plus a bit on top for profit). - Why would they care so much about the price of lending? Because as the banking system's balance between assets and liabilities is only required to be eventually consistent, banks are given the right to create loans that far exceed the cash (and other banks' liabilities) previously deposited with them, provided they can borrow the funds at the end of the day. And because this credit creation is legal - and essential to financial markets' efficient operation - the only way the government can influence the total quantity of money circulating in the economy is by manipulating the minimum price of credit. As the total amount of credit created by the banking system far exceeds the amount of cash created by the central bank, the economy is very sensitive to the effect of small interest rate changes on demand for credit.
- kaonashi 13y ago
  Minor quibble: banks do earn interest on reserve balances since 2008. The rate maintenance strategy was changed at that time to address cost instead of quantity.

Permit 13y ago

"How the Economic Machine Works" was a really great explanation of the different ways a government can influence inflation and deflation: http://www.youtube.com/watch?v=PHe0bXAIuk0 http://www.youtube.com/watch?v=PHe0bXAIuk0

yetanotherphd 13y ago

The St Louis federal reserve has a good article describing both monetary policy and how it is implemented. http://research.stlouisfed.org/aggreg/meeks.pdf http://research.stlouisfed.org/aggreg/meeks.pdf

gendal 13y ago

Excellent point. The original version of the slide had two extra boxes labelled "lender of last resort" and "open market operations"... :-) Thanks for the motivation to perhaps write a part two to this post.

nhaehnle 13y ago

The gist is that even though movements between banks tend to balance fairly well, they don't balance exactly. Therefore, banks can end up with excess reserves or a shortage of reserves, which they are then interested in lending out / borrowing, respectively. Or they might be interested in buying or selling other assets, such as bonds, to bring their excess reserves closer to zero. When a central bank sets the interest rate, it's talking about the interest rate at which such short term loans happen. It does so by simply participating in the market until the interest rate is where it wants it to be. These things are addressed fairly well in http://neweconomicperspectives.org/p/modern-monetary-theory-primer.html http://neweconomicperspectives.org/p/modern-monetary-theory-...

notahacker 13y ago
I'd avoid setting too much stock in Modern Monetary Theory unless you have a decent grounding in the basic operation of the monetary system already. Whilst their explanations of the banking system are very detailed, very accessible and mostly correct, their monetary theory is very much a view of how a fiat currency regime could work as opposed to how it does work, and they wildly misrepresent basic macroeconomic concepts when it suits them to make a point. (the most relevant example here is their model's assumption that governments can and do spend money into existence. Whilst this is theoretically possible in a fiat currency system, it's very different from the actual mechanisms in place, and entirely impossible with the Euro)
- nhaehnle 13y ago
  > the most relevant example here is their model's assumption that governments can and do spend money into existence There are three points here. First of all, they are very clear that this only applies to monetarily sovereign governments (i.e., not Euro members, not state governments). Second is their claim that directly spending money into existence is the more natural way of looking at things, and everything involving debt issuance is a voluntary add-on. That's not how things developed historically, but it does make sense when you think about how you would design a state-run currency from first principles. Third is their claim that, as a first order approximation, even when all sorts of debt issuance dances are in place, the economy behaves as if they weren't and government simply spent money into and taxed money out of existence. [1] The second point is admittedly a bit philosophical and subjective. You might care more about the historical account than the first principles account. However, the third point is quite objective, and if you have a concrete example of how debt issuance actually makes a significant macro-economic difference that contradicts MMT, I would be highly interested (and I assume MMT economists would be as well). [1] One way to look at it is this: Debt issuance is a red herring; what matters is the central bank policy of (usually) maintaining a positive interest rate. Debt issuance is only a way of shifting the cost of this policy from the central bank's books into the general government budget, i.e. it is a political that hides the true cost of monetary policy so that the public won't be as outraged about it.

notahacker 13y ago

In summary - banks' liabilities to you (your deposits) are backed by assets. One of these is cash, but this doesn't earn the bank any return. Banks therefore prefer to hold much larger quantities of interest-earning assets like loans made to other parties, or government bonds (these are assets to a bank because they are promises by third parties to pay the bank money in the long term). - For the same reasons as the payment clearing system is "netted-out" at the end of the day, the balancing of these banks' assets and liabilities is netted-out at the end of the day. If the risk-weighted assets of one bank doesn't match its liabilities - particularly if it doesn't have enough cash - it needs to borrow from another bank. If a bank has too much non-interest earning cash at the end of the day, on the other hand it will prefer to earn a low risk return by lending to another bank. This is the "base interest rate" we're talking about; the minimum amount of return a bank expects from making a very safe loan. - Banks could earn a similarly low-risk and low-return by buying government bonds with their spare cash instead, so the interbank lending rate is closely linked to bond prices. The Fed, ECB or Bank of England can take advantage of this by buying and selling government bonds to keep the interbank lending rate at a target level. - Why would they want to do this? Because the interbank lending rate (and bond prices) affects the rates for all other types of lending that banks do (the interbank lending rate plus a usually relatively large risk premium, plus a bit on top for profit). - Why would they care so much about the price of lending? Because as the banking system's balance between assets and liabilities is only required to be eventually consistent, banks are given the right to create loans that far exceed the cash (and other banks' liabilities) previously deposited with them, provided they can borrow the funds at the end of the day. And because this credit creation is legal - and essential to financial markets' efficient operation - the only way the government can influence the total quantity of money circulating in the economy is by manipulating the minimum price of credit. As the total amount of credit created by the banking system far exceeds the amount of cash created by the central bank, the economy is very sensitive to the effect of small interest rate changes on demand for credit.

kaonashi 13y ago
Minor quibble: banks do earn interest on reserve balances since 2008. The rate maintenance strategy was changed at that time to address cost instead of quantity.