Home > Macro/Monetary Theory > Reserve Requirements and Monetary Policy

Reserve Requirements and Monetary Policy

I have been trying to describe in detail the way money is linked to debt.  (If you are jus joining us start here, then go here and here.)  This leads naturally into a discussion of monetary policy which I will now begin to undertake.  I will provide a simple model of the way I look at monetary policy but first some discussion about what determines the aggregate supply of money is required.  I will begin with a gold standard in order to further highlight the similarity and difference between that system and a fiat money regime.

As I have been arguing so far, “money” as we know it is really credit created by banks.  Under a gold standard, you can take your gold to the bank and convert it into “money” (for instance bank notes or a checking account).  You can also convert other real assets into money like a house or a car or a business, this money just happens to be denominated in units of gold.  The quantity of money in circulation can expand far beyond the quantity of gold but this requires other assets to be put up for collateral. (Note that these assets may not always be as obvious as a house, they could be something like the produce of labor in the future.)

So if we want to deal with broader macroeconomic questions, we have to ask what determines the extent to which this process of money creation will be carried out.  Under a “free gold standard,” by which I mean a system free from any government restrictions other than the enforcement of the convertibility of the money into gold at the stated conversion rate, the extent to which money will be able to be created is limited by the willingness of the public to hold that money.  This is a matter of liquidity preference.

The price of gold (both the spot price and the rate of change) will be determined (at least primarily) by “real” factors in the gold market (quantity of gold, expected future production, expected future demand, etc.) and the value of money will be anchored to the value of gold.  (I say “primarily” because the evolution of the value of gold over time depends partly on it usefulness as a medium of exchange/store of value and money acts as a substitute in these regards so the extent of credit creation likely has some effect on the gold price but put that aside for now.  (For more on this topic see this post and this one and this one.  Note however that my thinking on these things is evolving fairly rapidly and some things like the definition of money may not be entirely consistent throughout.)

In this system, people are able to convert gold into money (and vise-versa) at par but the banks will find that they can issue additional money backed by other assets and charge some rate of interest.  The reason they are able to do this is that there is excess demand for liquidity when the price of liquidity is zero.  So essentially, when someone mortgages their house, they are converting the house into a different asset (money) which has liquidity characteristics more closely resembling those of gold.  It is more easily transported, divided, recognized, etc.  For this service they are willing to pay some positive nominal interest rate.

But the bank can only make a profit on the quantity of money it is able to float above the quantity of gold it has.  This money floats because of the willingness of people to hold their wealth in that form as opposed to others and this willingness will depend on the interest rate.  The higher the rate, the less money people will be willing to hold.  This may mean any of the following: they take out fewer loans, they pay off existing loans, they redeem money for gold.  Which one it means for any individual obviously depends on the financial condition they find themselves in at the time.

It is important to not here that, assuming financial markets are perfectly competitive, the marginal liquidity preference of money will have to be the same for everyone and equal to the cost of holding the money which is the interest rate.  To see why this is important notice that borrowing and lending can take place outside of banks as well.  So if one person is accumulating a lot of money to the point where their demand for liquidity is low, they can either turn it in for gold and hold gold, or they can lend it in the financial markets to someone else who’s demand for liquidity is higher.  This process of non-bank borrowing and lending does not create additional money, it only distributes the existing money in such a way that the people with highest demand for liquidity end up holding it.

But if at the current market rate of interest, the quantity of money in circulation is greater than that which can be held by the public at large when their marginal liquidity preference of money is equal to that rate, then some holders of that money will not be able to find borrowers at that rate and they will bid the rate down.  This lower rate will cause some people who were holding debt at the higher rate to “refinance” with debt from non-bank lenders and retire the money by paying off debts from the bank until the money supply and interest rates fall to a point where the marginal conditions are met for everyone.  Similar arguments can be made for other disequilibrium scenarios.  So the interest rate is linked to the quantity of money in circulation relative to the demand for liquidity.

Note that there is no need for people to redeem their money for gold unless they become concerned that the bank is or may become insolvent due to people failing to repay their loans and the value of the assets backing those loans (in terms of gold) being insufficient.  If nobody ever became concerned about this, the gold that the banks had on hand relative to the money outstanding would be inconsequential.  However, because people sometimes do fail to repay their loans, and the value of collateral is subject to market fluctuations, there is some danger of this.  The holdings of gold which the bank stands ready to redeem for their notes acts as a kind of buffer against this problem.

In theory, if a bank had a bunch of bad loans, it could go into some form of bankruptcy, liquidate all the assets it had, including good loans and collateral seized from bad loans for gold (or “money” attached to other sound banks) and distribute this to the people holding accounts at the bank or notes from the bank.  This means that some risk of loss from the loans of the bank would be born by the holders of the bank’s “money.”  The willingness to convert that money into gold at par acts as an indication of the solvency of the bank.  So in essence the willingness of people to hold money rather than gold comes down to a balancing between the liquidity premium and the risk premium here described.  These things may fluctuate over time and the bank may need to balance them by redeeming gold for money or vise-versa.

The more gold reserves a bank has on hand relative to its money outstanding (given the soundness of its loans) the lower the risk premium which will be associated with that money.  The less concerned people are about this risk, the more willing they will be to hold money at any given interest rate and the more banks will be able to expand the money supply for a given quantity of gold reserves without it coming back and being redeemed for gold.

In this way, banks allow for the conversion of less liquid assets into a more liquid form and the extent to which this goes on is determined by some balance between the demand for liquidity and the associated risk involved in that conversion.  The exact extent also depends on the structure of the banking market.  For instance, if banking is perfectly competitive, we could expect the money supply to be expanded to the point where the resulting nominal interest rate provides banks with zero economic profit.  If it is a monopoly, we can imagine the bank choosing the quantity of money and associated nominal rate in order to maximize their profit.  For more on this see this post.

As far as I know this form of pure free-market banking has never actually existed.  I suspect something similar has at some point somewhere and that this essentially describes the genesis of fractional reserve banking but if it has, it was a long time ago and I can’t point to a specific example.  An alternate way of constraining the extent of credit creation is through a statutory reserve requirement.  This can exist along with a gold standard.  In this case, there are two constraints on credit creation: the quantity that the market will bear based on the arguments laid out above and the quantity which it is legally possible to create from the quantity of reserves available to the banking system.  At any given time only one of these will be binding (except for the special case where they are both the same).

In other words, the reserve requirement may be meaningless (at least in the aggregate) because it may require a level of reserves which is less than what would naturally occur in an entirely free market or it may arrest the process of credit creation at some level lower than that.  In the latter case, the quantity of available reserves, along with the reserve requirement determine the quantity of total credit (money) which will be created by the banking system.

A pure free banking system would not be possible without a gold standard (or at leas some sort of similar standard) because it would create an enormous moral hazard for the banks.  Banks are able to float money because people are willing to hold it.  People are willing to hold it because they believe it will hold its value.  The reason it is possible for banks to expand the supply of credit in the way described without it losing value is that ever dollar they create creates a corresponding future liability.  This means that the supply of money created in this way is systematically anchored to the quantity of real goods backing those claims.  Over time the liabilities grow because of the positive interest rate but the money does not and the differential represents the bank’s profit.  But this is only possible with some regulating force like a gold standard.  To see why, consider two things that could occur without it.

1.  Banks could create a lot of money and use it to simply buy stuff.  This would create no corresponding liability.  Without that liability acting as a counterweight to pull money out of the system should the demand for that money decline, the only mechanism left to bring the market into equilibrium will be the price level.  So the more money they print, the more prices will rise.  But because of this, and the fact that there is no limit to what they can print, there will be no reason to believe that the value of a dollar from that bank will have a certain value in the future, and the willingness to hold it will likely collapse to zero and the money will become worthless.

2.  The other side of the coin: When someone takes out a loan, they do so with some expectation about the value of the money they will have to obtain in the future to repay the loan.  The value of the money in the future, of course, depends on the quantity of that money which is available in the future and that is at the discretion of the bank.  So a potential borrower has to try to imagine how much money lending the bank will be doing in the future.  Since loans carry a positive interest rate, there is never enough money to pay them all back without additional credit creation.  This raises the possibility that at some point, the bank could decide to stop creating more such credit and essentially pull the rug out from under its current debtors in order to make it difficult for them to repay and thus be able to repossess their collateral.  Borrowers, of course would have to anticipate this and this may lead to nobody being willing to borrow.

In either case, people on one side of the market (holders of money) or the other (holders of debt) are at the mercy of the bank who is unrestrained in their ability to expand or contract the money supply.  But a gold standard makes it impossible to alter the value of money much above or below that of gold.  If they tried, people would simply start swapping one for the other (either redeeming money for gold or using gold to repay loans).  This imposes a degree of discipline on an otherwise unconstrained issuer of credit.

A reserve requirement is an alternative mechanism for imposing some discipline on the process of credit creation.  This prevents banks from expanding credit beyond a certain amount determined by that requirement and the quantity of available reserves.  (The second problem is solved by having a competitive market for creation of interchangeable money so one bank cannot unilaterally restrict it.)  As I said, this can (and did) exist along with a gold standard but when it does, the two are to some degree redundant.  Once you have a legal reserve requirement, the gold standard is no longer necessary for the system to function.

So once you remove the gold standard, the value of money will not fall to zero because the gold was only a small part of the assets that were actually backing that gold.  But now that value will no longer be anchored to the value of gold.  It will instead be determined by the degree of credit expansion which is allowed to go on at any given time (and expectations of the same).  This, in turn, will depend (at least in “normal” times) on the quantity of available reserves and the reserve requirement which are determined by some central authority (the central bank).

So in essence, the reserves (base money) which the central bank issues are simply a license to create credit (liquidity).  Because the creation of credit is limited by the amount of reserves and the reserve requirement, and in “normal times” (more on this later) that total quantity that can be created is less than the quantity which would be demanded if the price of liquidity were zero, the price of liquidity will be positive and therefore banks will be able to make profits by creating credit and therefore, they will compete to get the reserves which allow them to do this.  This will be reflected in a positive rate on deposits (when you transfer your “money” from one bank account to another, a corresponding quantity of reserves must be transferred along with it), as well as a positive discount rate (the rate at which banks borrow and lend reserves to each other).  The price banks receive for creating liquidity is then represented by the difference between this (let’s imagine that the two previously mentioned rates are equal) rate and the rate at which they are able to lend.

In this case, the willingness to hold money, and the corresponding willingness to hold debt, will be determined by expectations about the future stance of “monetary policy” (most importantly the size of the money base and the level of reserve requirements) along with the state of the credit markets (demand for money, demand for currency relative to bank accounts, supply of goods etc.).  This willingness to hold money and debt, combined with the current supply of money/debt will then determine the state of the current credit markets (interest rates, price level, etc.).

Next (tomorrow unless fate conspires against me) I will present a simply dynamic model of this which I think provides a good explanation of liquidity traps.


  1. March 18, 2014 at 2:09 am

    Mike, up here in Canada we have neither a gold standard nor does the Bank of Canada impose reserve requirements. But we’re not going off the rails.

    • Free Radical
      March 19, 2014 at 1:47 am

      You don’t have a reserve requirement? That’s news to me, I’ll look into that. However, it doesn’t necessarily torpedo my theory, as I try to explain in the post with the model, the reserve constraint can become non-binding. Based on my current thinking though, I couldn’t explain positive nominal rates (at least on reserves) in this case. Actually I think I just thought of how it could still work out but I will have to look at Canada a bit more carefully before I dig into it. Mainly I wonder what the reserve ratio looks like (how high and how volatile).

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