Monetary and financial macroeconomics
Liquidity and endogenous money creation
March 25, 2017
Today’s class
• Compare the 2 banking models
• (1) Banks intermediate loanable funds (ILF)
• (2) Banks finance through money creation (FMC)
• The first one is widely used theoretically but it is not the way
banks work in reality
• Modeling banks as in (1) can lead to counter-factual dynamics
• The exposition in this class follows closely Jakab and Kumhof
(2015)
Intermediation of loanable funds
• Bank loans represent the intermediation of real savings
• The process of lending starts by collecting deposits and finishes
with the lending of those savings to another agent
• This model is associated to the Deposit Multiplier model where
the availability of central bank high powered money (reserves or
cash) imposes a limit to the changes in the balance sheets of
banks. This is because banks can only create money by
re-lending of the initial injection
• Again, the DM model is far from the reality
Intermediation of loanable funds:
deposits come before loans
• When a cheque deposit is made in a bank, the bank uses the
deposit to fund loans to other households or firms
• In this way, banks intermediate individual savings
• This approach, which is fairly standard, implies a mixing of
micro and macro arguments
• Let’s study the balance sheet of banks when a cheque of 4 euros
is deposited in bank A
Intermediation of loanable funds
Figure: Jakab and Kumhof (2015)
• Initial balance sheet
• Cheque is deposited in bank A
• The cheque is drawn from bank B
• The left panel is the balance sheet of the whole banking system
(banks A and B)
Intermediation of loanable funds
• Confusion between micro and macro arguments
• If funds are put into bank A from bank B, there is no change at
all in the consolidated banking system
• The banking system does not have more deposits in the
aggregate
Intermediation of loanable funds
• When the cheque is deposited in A, it creates a new entry on the
Liabilities side by extra 4 euros
• By double entry bookkeeping it creates another entry in the
“accounts receivable” entry on the asset side, to indicate that
bank B has a liability to deliver central bank reserves
corresponding to the value of the cheque.
• So the funds have been already lent... but to bank B! Bank A has
no additional funds to lend then
Intermediation of loanable funds
Figure:
Jakab and Kumhof (2015)
• Then bank A sends the cheque for clearing and this clearing is
settled using central bank reserves
• At this step, bank B reserves fall by 4 euros and bank A reserves
increase by 4 euros
• Can bank A lend this extra reserves to non-banks? NO!
• Central bank reserves can’t be lent to non-banks, can be used
only to make payments to banks
• central bank reserves are only in accounts at the central bank.
Only commercial banks and central government can obtain this
type of accounts
Intermediation of loanable funds
Figure: Jakab and Kumhof (2015)
Intermediation of loanable funds
• Bank A didn’t do any extra lending, except to bank B...interbank
lending
• Bank B didn’t decrease its loan position either, only deposits and
reserves changed
• In the aggregate nothing changed
• If banks cannot create money through lending (which is implied
by the ILF approach), then there cannot be more loans
Intermediation of loanable funds
• Which is the mechanism that ILF advocates have in mind?
• The story doesn’t work if we start with a cheque deposit
• If we have in mind a cash deposit, it has come from another
deposit somewhere in the system, so the same will hold
• Also size of cash/total money is tiny
• Same banking as we observe will work even in the cashless
economy
• ILF story is based on deposit of goods!
Intermediation of loanable funds
Figure: Jakab and Kumhof (2015)
Intermediation of loanable funds
• In this type of world the bank intermediates loanable funds
• The story is non-monetary
• But this type of institution is not really a bank
Finance through money creation
• In fact, banks create money (deposits) from providing loans
(financing is the main function of banks)
• When a bank makes a loan to a non-bank agent, it creates a new
loan entry to this agent (on the asset side of banks balance sheet)
and by double entry bookkeeping this operation has a
counterpart in the liability side of the bank balance sheet in the
form of deposit
• The bank creates inside money exactly at the moment in which
lending occurs
• Both operations are under the name of the same agent (who has
assets and liabilities against the bank) so NO
INTERMEDIATION HAPPENED!
Finance through money creation
• If the loan is made for physical investment purposes, then
lending and this inside money triggered investment
• Bank loans finance investment, not private savings... savings are
just a consequence of bank loans
Finance through money creation
Figure: Jakab and Kumhof (2015)
Finance through money creation
• In this example, investor A transfers the new money to investor
B who is selling the machine
• Here, investor B becomes a saver (assuming he leaves the money
in his account)
• Investor’s B savings are a result (not a cause) of bank loans
About the Deposit Multiplier
• Carpenter and Demiralp (2010) show that ther eis no empirical
relationships implied by the money multiplier in the data
• Changes in reserves are unrelated to changes in lending
• Open market operations do not have direct impact on lending
What limits money creation by banks?
• Banks profit maximization
• Policy rate
• Regulatory requirements