It’s Demand for Money, Not Demand for Currency

As regular readers know, I am a guy who sort of stumbled into monetary economics and as such, I have been going through a process of discovering the minutia of how everyone else thinks about money and trying to reconcile this with what I think I know. And it turns out that there are a lot of little issues that come up which make it hard for me to explain what I am thinking in the context of existing paradigms. These issues all basically revolve around the reason that money is valuable. I think this is because “money” represents the contractually obligated payment of debt. Most others seem to start from some kind of explanation that can basically be summed up as “it just is.”

The “it just is” explanation makes sense in the context of commodity money, since commodities have value independently of their use as money. However, I think this explanation is highly suspect when it comes to “fiat” money, which I would call “credit money.” Of course, historically, the line between the two is a bit blurred and this has largely, in my view, prevented the profession from drawing clear distinctions between them. Instead, we have basically just substituted base money in for the old commodity money and built our models around the assumption that this base money works essentially the same way except that we can make the quantity whatever we want.

This leads to a plethora of little assumptions that are difficult to flush out because, individually, they seem like they don’t matter. But they seem this way because they fit into a larger paradigm which is built on this (I think erroneous) belief about the reason money is valuable.

One such issue is the way we think about the demand for money. The simple version of the conventional wisdom goes something like this: There is a quantity of money in circulation. An individual can get rid of this only by spending it. The price of holding this money is the nominal interest rate. If people have more money than they desire to hold, they try to spend it. When everyone is trying to hold less money, either prices have to go up or interest rates have to fall until they are all holding the desired amount.

The problem with this is that people have another option (or options depending on how you look at it) which is to lend it or deposit it. However, the conventional wisdom has a nice way of dealing with this by conflating the two.

In the basic Macro 101 money multiplier model, we say that there is some amount of base money which gets multiplied by the banking system in the following way: People deposit some amount of it into banks who then lend it. The people who borrow it then spend it. The people who receive this money then deposit some of it into a bank and the process repeats until people and banks are holding their desired (or required) quantities of this base money.

In this process, the willingness of people to hold currency (base money) is crucial. The less currency they are willing to hold, the more they deposit at each iteration and the higher the money multiplier. This means that there is more spending which means higher “aggregate demand” and higher prices (and potentially higher output). This willingness to hold currency, naturally, depends on the rate of interest since this is the price paid for holding it rather than depositing it. People are assumed to pay this price because currency is more liquid. In the 101 treatment, it is typically (though implicitly) assumed that all spending is done with currency.

In this context, the banks are essentially reduced to an intermediary between borrowers and lenders. So when you deposit money, you are really lending it to someone else in order that they may spend it. So even though an individual may avoid either holding or spending the money, someone else has to end up holding or spending it and in aggregate all “money” (currency) gets either held or spent.

In this context, the interest rate can be thought to be determined endogenously as the rate at which the quantity of loans demanded is equal to the quantity supplied in the form of deposits, given the quantity of base money in circulation. Alternatively, we can think of the central bank setting (targeting) a given interest rate and providing the quantity of base money which is demanded at that rate (required to hit the target). In this context the distinction is seemingly unimportant.

In this model, anything which increases the money supply or decreases the demand for base money (including reducing the reserve ratio) increases “aggregate demand” and either prices or output or both.

However, this is not what I think the primary function of banks is. The primary function of banks is to create liquidity. This, I believe is true even in an entirely decentralized, free banking sector with a commodity standard. I have argued this before, so I won’t go through the whole spiel again here but I want to point out how this changes the way we look at money.

First of all, let us notice that it is the creation of a particular form of liquid asset (demand deposits) which separates banks from all other financial intermediaries. For instance, a bond fund acts as an intermediary between borrowers and lenders. However, a bond fund cannot create additional “money” the way a bank can. If you invest with a bond fund, you must take dollars (or whatever) out of your bank account, give them to the fund who can then give them to the borrower (buy bonds). The quantity of dollars in the system doesn’t change.

A bank, on the other hand, can take my deposit in a checking account, let’s say $100, and then lend it. When they do this, I still have $100 which I can spend at any time and somebody else now also has $100 that they can spend at any time. [Please note, that this is not an anti-fractional-reserve rant, I’m not saying this is bad, just that it is important. I’m working up to something much more subtle.] The reason you get a higher rate of return (normally) in a bond fund than in a checking account is that the checking account is more liquid.  In particular, it is worth noting that, like currency, a balance in your checking account is nominally denominated and represents a contractually (legally) acceptable form of payment of debts unlike shares in a bond fund or accounts receivable from a loan you made to your friend.  The latter must first be sold at some market rate to obtain some form of money (either cash or deposits) before a debt can be paid.

So whereas a bond fund makes a profit (which is to say “exists”) because it has (or is perceived to have) an advantage in determining profitable investments, the bank makes a profit because it is able to “borrow” at a lower rate (compared to a bond fund or other financial intermediary) because of its ability to offer a more liquid product in return which in turn is due to its ability to multiply a dollar into two dollars (and collectively into much more).

Now the subtle thing that I am working up to here is that it is not the willingness to hold currency that matters, it is the willingness to hold dollars in all forms (or insert unit of your choice). And this is where the “endogenous” vs. “exogenous” money debate starts to matter.

So the first thing to notice is that cash is not necessarily more liquid than demand deposits, they are differently liquid. There are some transactions for which cash is more convenient and there are some for which demand deposits are more convenient. In today’s world, it is probably the case that the latter make up the majority of transactions and even if they don’t, it is certainly not the case that cash is at all times preferred to deposit accounts and we only deposit money because it pays a higher interest rate. On the contrary, even if all transactions were slightly more convenient with cash, we would still hold most of our “money” in deposit accounts and withdraw it from time to time to make purchases because holding all of that cash would be inconvenient. So we can’t say that it is the interest rate which induces us to hold deposits instead of currency. It is actually liquidity preference. And indeed, until 2011, it was illegal to pay interest on demand deposits in the U.S. (and after that interest rates have essentially been zero anyway).

Now the thing we care about is neither the demand for currency nor the demand for money in a broader sense. What we are really interested in is aggregate demand. The question is which one of these, if either, helps us understand the behavior of aggregate demand.   Thinking about the demand for base money works fine for this purpose under two assumptions. The first is that the thing which is exogenous is the supply of base money. Second is that the process of multiplication, as outlined above, adheres to a stable process in all regards other than the demand for base money.

The first assumption is sort of wrong in the sense that it is not the way that monetary authorities say they conduct policy but taken alone, there is room to argue that this is not an important distinction which I and others have done. I think this does matter but only after we address the second assumption.

The second assumption holds much of the time but not always. It just so happens that it is when it breaks down that we run into problems. Specifically, it is the assumption that money which is deposited automatically gets loaned and money that is loaned automatically gets spent (therefore adding to aggregate demand) that is problematic. Assuming this allows us to draw a straight line from depositing currency to spending and keeps our “either spend it or hold it” paradigm intact.

However, if we look at this a different way, with “endogenous” money, things change. Instead of imagining that the central bank just dumps in a certain quantity of money and the system goes from there, imagine that they operate as “lender of last resort” to the banks and stand ready to supply whatever quantity of base money is demanded at a given rate. So the supply curve faced by banks will be perfectly elastic (horizontal) at that rate. Then the supply of loans will be perfectly elastic at some rate which accounts for the cost of running a bank and the risk of a given loan. This will then be independent of the willingness to hold currency.

Now if the rate on deposits is allowed to float freely, that rate will rise to the rate at which the central bank stands ready to lend reserves (the discount rate or federal funds rate). But if it is prohibited by law from being greater than zero, then it will be zero. This rate on deposits will affect the composition of people’s money holdings between currency and deposits but in neither case will that decision between currency and deposits ration the amount of loans made. If the quantity of deposits is less than the amount required to make the loans which are demanded at the discount rate, then the difference will be made up by borrowing from the central bank.

[Note that I consider normal open market operations, and not just lending at the discount window, equivalent to lending reserves to banks. This point is subtle but is a potential bone of contention and raises some other questions like how best to treat government borrowing in this context but I will leave this for later.]

In this context, we can see that it is the demand for loans which is important not the willingness to hold currency. If people are willing to borrow more at the rate set by the central bank, the money supply will expand and if they are not willing to borrow more, it will not, regardless of people’s preferences between holding cash and holding deposits. If people suddenly decide to hold more cash, the banks will simply borrow more from the central bank in order to make the demanded quantity of loans.

Now the central bank can still pump more money into the system by buying other assets and there will still be a type of hot-potato effect. But this is not driven by their willingness to hold currency, it is driven by their willingness to hold money and their willingness to hold debt. When they get the new money, they can either hold it (as either cash or deposits, it doesn’t matter which) or spend it on goods or they can reduce their debt. Either holding money (any kind of money) or paying down debt, increases their money to debt ratio. That is what matters. It doesn’t matter whether they hold it in the form of currency or deposits because depositing it doesn’t actually lead to more lending and then more spending.

At this point I started explaining how I think “unconventional” monetary injections work but it quickly became clear that that requires an entire post of its own so I will leave it for later. For now let me just stick to the point which I originally set out to make which is that it isn’t the willingness to hold currency relative to deposits that matters, it is the willingness to hold money (all money) relative to debt.

This point can be approached from another direction, if one is intent on taking the money supply as exogenous. It is clear that the thing the central bank wants to target is not the money supply but rather something like aggregate demand (some combination of prices and output or unemployment or something). It is obvious, I think, that if people suddenly decide to hold more currency and fewer deposits, the central bank will accommodate them by increasing the quantity of base money accordingly. In my way of looking at it this happens automatically as banks borrow more at the set interest rate but you may think of it as the central bank increasing the base through lending (which may include buying treasury securities) such that the interest rate stays the same. This would cause no change in aggregate demand.

In this case, it would be easy to do this because the increased demand for currency would increase the demand for base money. So it is hard to see how this would cause a problem if the central bank were not sticking to an arbitrary and counter-productive money-base target. Or, put another way, no demand for currency vs. deposits should cause the normal transmission mechanism to seize up. The important link in the money-multiplier chain is the willingness to borrow—the part which is typically taken for granted.

On the other hand, If people suddenly want to hold less debt and more money (any kind of money), then the central bank may not be able to pump more money in through that mechanism and increase aggregate demand, even at a zero rate. People may then start to wonder how easy it will be to get the dollars in the future to pay off their debts if the central bank’s injection mechanism is failing and they will try to get more money and less debt (and buy fewer goods) and it will spiral. The central bank will then have to find another way to inject money.

Similarly, in a state where there are large quantities of excess reserves in the banks and interest rates are near zero, if inflation expectations increased, it wouldn’t be the sudden unwillingness of people to hold currency and rush to deposit it into the banks that would lift aggregate demand, it would be the sudden willingness to borrow that would draw down reserves, increase the broad measure of money in circulation and lift aggregate demand.  It is this willingness to hold money (any kind of money) vs. willingness to hold debt that matters, not currency vs. deposits. However, this can only be seen once you notice that these two things (money and debt) are intimately related and free your mind from the shackles of the “it just is” theory of money value.

Loans and Savings

The next installment of my organic credit model, following on from these previous posts.

I.  Commodity Money

II.  Banks and Credit

III. Credit Expansion

Remember, this is intended to describe a decentralized free-market economy with free-market (commodity) money.  The connections between this and our current economy are not entirely straightforward.

Loans and Savings

When most people think about banks, they think of an entity whose function is to allocate capital by borrowing from people who wish to put off consumption until some point in the future and lending to people who would prefer to consume or invest today and pay for it with future goods.  And of course banks do perform this function.  However the function described above serves a different purpose.  In our model so far the purpose of the bank is purely to provide liquidity by allowing people to use bank credit as a medium of exchange in place of hard currency.  It is my assertion that this is the primary function of banks as it is the function which distinguishes them from other institutions which also serve to allocate capital such as stock markets, corporate bonds, mutual funds, venture capital firms, etc.  But since these two functions are bound up together, we must take a moment to distinguish between them and see how they interact.

Credit Expansion

In the previous two posts I tried to explain how currency, credit and banking come about organically in a free-market economy.  This post deals with the expansion of credit in such an economy.  This should help one better understand the relationship between the quantity of credit in circulation, velocity, and interest rates.  Next, I will delve into the role banks would naturally play in this process.

Credit Expansion

When the butcher and the baker use credit to trade, it is important that they sell as much as they buy. It is not necessary that they issue notes less than or equal to the amount of gold they have on hand. (Recall that we can have credit without having money at all.) The logic behind this is fairly simple. If the butcher issues 100 oz. worth of gold-notes but only has 50 oz. of gold, it is possible that these notes could come back to him for gold and he would have a problem. But if he is also producing meat worth 50 oz. of gold, he can sell the meat to cover the difference. If he produces 100 oz. worth of meat he can issue 150 oz. of notes and if he produces 1000 oz. of meat, he can issue 1050 oz. worth of notes before he has a problem. This, of course, assumes that he is always able to sell his goods at a certain market price. If this is not the case, he could run into trouble but I will deal with this possibility in more detail later on.

Banks and Credit

Here is the next installment dealing with credit and banking.  The next installment will go into the expansion of credit by banks in more detail.

A primitive credit model

Credit is a fundamentally different economic phenomenon from money, though they are often confused or conflated.  The two, of course, are intimately related but in theory, there is no reason that either one could not exist without the other.  Indeed there is some debate over which developed first.  The answer to this question is of no importance to the issues discussed here.  I have already laid out a story to explain the emergence of money from a barter economy without credit.  To understand credit, I will first develop the institution of credit in a barter economy with no money.  Then I will put money and credit together.

Consider a very small town where everyone knows everyone else and assume that they all generally trust each other to keep to their word.  In this town there is a butcher, a baker and a candlestick maker.  The butcher regularly buys bread from the baker and the baker regularly buys meat from the butcher.  One way that they could conduct this trade is to trade bread and meat directly.  The drawbacks to this method are well understood, most important is the fact that they would have to continuously trade quantities of equal value.

As an alternative to barter, they could each hold some amount of some other good such as gold or silver and trade this for bread and meat.  In this way if there were a trade surplus between them, it would be reflected in a balance of payments in gold or silver from one to the other.  If, for instance, the baker wanted to purchase meat of greater value than the bread that the butcher wanted to purchase, he could pay the excess in silver coins.  The butcher could then use those coins to buy other things from other people.  Meanwhile the baker would have to get the extra coins by selling bread to other people.

In this way some quantity of money can circulate in an economy and act as a store of value and a medium of exchange.  People accumulate money as a result of delivering more goods than they collect from others.  Money such as precious metals works well for this purpose because it holds its value well.  This is mainly due to its durable nature and the fact that the supply in the long run is limited by nature (highly inelastic).

It is possible though to carry on trade without this type of “hard” money.  Imagine the same butcher and baker but with no gold or silver nor any other good suitable to use as a store of value and medium of exchange.  When the baker wants to buy meat, he can simply promise to deliver some number of loaves of bread at some point in the future that the butcher may find suitable.  He may write ten notes that say “I, the baker, owe you, the butcher, one loaf of bread to be delivered at any time upon presenting this note” and bearing his signature.  These notes would then represent a contract which could be enforced by the courts.