MONETARY THEORY E. STREISSLER – SS 2013 1) Why Money?
1.1 Transactions Demand or Store of Value?
1.1.1.1
Three functions of money:
- to facilitate transactions
- as a store of value
- serves as an abstract entity
as a unit of account
1.1.1.2 KEYNES popularized a slightly different triad of motives for holding
money: the transactions, precautionary and speculative motive.
1.1.1.3 The first two motives arise during the flow of regular business, the
third during the irregular business, the third during the irregular
(infrequent) stock decision of accumulating assets.
1.1.1.4 Both precautionary and speculative demand are due to
uncertainty, the speculative demand due to the degree and the timing of
price variation. Both are “insurance against loss”.
1.1.1.5. Is there a separate transactions demand, that is not
precautionary. Is money needed in cases of complete certainty?
1.1.2
The ARROW-DEBREU-Case
In the general equilibrium model without transaction costs, without the
cost of writing a contract and with an auctioneer as costless ghost a
market clearing price vector is found at the beginning of time for every
known possible state of the world. Afterwards there is no exchange proper
but only delivery with certainty. Money is useless and does not exist.
1.1.3 Various Types of Transactions Demand
can therefore be explained by transaction costs (“frictions”).
1.1.3.1 Economizing on accounting costs:
ARROW-DEBREU implies a huge accounting scheme for clearance. Using
slips of paper which go from hand to hand may be cheaper.
But: this cost advantages is progressively reduced by technical progress.
1 1.1.3.2. Economizing legal costs: Using money in spot markets may be
cheaper than writing a huge contract for contingent futures markets. By
using money we chose a cheaper suboptimization using only local
information. By decentralizing decision taking and trading at disequilibium
prices we inhibit a full general equilibrium.
1.1.3.3 Economizing on transaction chains: Using money is an indirect and
cost saving way of finding appropriate trading partners, which the
auctioneer had done for us.
But: to split exchange into two independent halves (MARX) is also risky.
“Money a contrivance for sparing time and labour” (J. St. MILL).
1.1.3.4 Economizing on the costs of quality information by using the best
known and standardized commodity as medium of exchange. A double
coincidence of information is necessary (ALCHIAN).
1.1.3.5 Money a huge externality, a public good. Only because money is
generally acceptable in settlement of debt the advantages enumerated
can arise.
1.1.4 Various Types of Precautionary
Demand due to different uncertainties
1.1.4.1 Avoiding risk of default: We have to use cash if we are not trusted
as a debtor: “In God we trust, all others pay cash”.
1.1.4.2 We need money to bridge the uncertainty of timing of receipts and
disbursals. We can thus economize on the cost of synchronizing purchases
and sales (Note: demand for money therefore depends not on the volume,
but on the irregularity of the time structure of transactions).
1.1.4.3 We need a medium of exchange with the lowest possible asset
value uncertainty. As legal tender money has zero price variation relative
to itself. The most liquid commodity “certainly realizable at short notice
without loss” (HICKS).
1.1.5 Money as store of value
1.1.5.1 Transfer of purchasing power to future periods with a certain or
uncertain need (income uncertainty).
But: This property money shares with all other assets.
SAMUELSON: A socially useful contrivance for intergenerational transfer.
1.1.5.2 In order to profit from the price variability of a final asset (by
snapping up bargains of short duration) we need money.
2 In conclusion: Money is the cheapest commodity to be used in
decentralized exchanges, partly because of its general acceptability, partly
because of its ultimate liquidity.
But: is such a commodity unique?
1.2 Money in the Utility or the Production Function?
1.2.1 By its very existence money has high social utility by enabling the
division of labour and by saving transaction costs.
But if the institution of money has utility, this does not yet mean that this
is also true for each price of money.
1.2.2 As it saves cost money is of indirect utility to the individual. “It is
not for its own sake that men desire money, but for the sake of what they
can purchase with it” (A. SMITH). Indirectly useful means are called
inputs. Money should therefore be put into the production function in
modeling, production being the totality of commodity transformations till
the final consumer can use them. However: it is an input supplied by the
demanders.
1.2.3 Commonly money is introduced into the utility function (PATINKIN
1956). In doing this it should, however, be realized that the utility of
money depends upon production sets (including institutional
arrangements) and prices. The utility function with regard to money is
neither separable nor continous.
1.3 Kinds of Money
The various uses of the concept of money imply different kinds of money.
Distinguish: commodity and token money;
Currency and demand deposits, the former created by monetary
authorities, the latter by private firms.
Inside and outside money, the latter a claim without a debtor.
From the angle of the banks: high powered money or monetary base.
M1: Currency outside the cash till of the banks and demand deposits
M2: M1 + time deposits
M3: M2 + savings deposits
3 M2 and M3 serve as store of value, M1 (mostly) for the other functions.
1.4 Business demand for money
1.4.1 Business demand for money, by far the largest part, cannot sensibly
be described by a utility function.
1.4.2 The BAUMOL-TOBIN model supplies the basic model on inventory
theoretic lines. Money and another financial asset (a savings deposit),
which yield interest at rate i considered. Withdrawal of money has fixed
transaction cost b. If payment proceeds at uniform rate (“sawtooth
profile”) find optimal money “inventory” that minimizes cost. Y: total
expenditure per payment period of a regular income payment; C: batch of
money withdrawn at each withdrawal.
(1)
Total cost
(2)
dTK
bY i
0 2 
dC
C
2
2bY
C opt 
i
(3)
TK 
bY iC

C
2
1.4.3 This square root formula yields an income elasticity relative to real
income of ½ (relative to inflationary nominal income increases of 1) and
an interest elasticity of – ½ . The short term rate is the relevant interest
rate. As b becomes 0, so does money demand.
Note: a partial equilibrium model.
1.4.4 If both receipts and disbursal are random it can be shown:
a) If they are completely synchronized money demand is zero.
b) If only the frequency or probability per period of both disbursals and
receipts rises, additional money demand low (Elasticity ⅓ or 0 according
to model).
c) If average transaction size rises additional demand much higher
(Elasticity ⅔ or 1).
Thus Transaction structure is crucial.
1.4.5 If fixed transaction cost b becomes too higher (larger than i  Y / 2 )
only cash is held and income elasticity is 1.
4 2) Classical Theory of Money and Inflation
2.1 Quantity Equation and Quantity Theory
2.1.1 The quantity theory of money goes back to the 16th cent. (J. BODIN)
and explained the general inflation 1500 – 1625 by the inflow of gold and
silver from America.
2.1.2 As financial institutions developed during the 17th century hordes of
money were dissolved and monetary circulation became more rapid. Thus
changes in the velocity of circulation of money were added to the
explanation (J. LOCKE).
2.1.3 The old quantity theory of money – or rather quantity of money
theory of inflation – thus developed stated: Taking due regard to the
rapidity of money turnover the quantity of money supplied relative to that
of commodities determines the general price level.
A theory of the consequences of the supply of money.
2.1.4 The theory can be formally expressed in terms of the quantity
equation or equation of exchange, which is, however, more general then
the theory.
In a monetary economy (where goods buy money and money goods, but
not goods goods: CLOWER) the actual money payments in bilateral
contracts exactly correspond to completed demands for commodities.
Thus in the aggregate
(1)
M V  P  Q
M is called money stock, M  V the volume of monetary circulation; V:
velocity
2.1.5 This is an identity, an equation always true by definition because V
is defined ex post as the average times per period money has actually
changed hands. The transactions variable Q (and with it V and P) can also
be alternatively defined as turnovers, gross national product or national
income.
2.1.6 Inflation is a general rise in the price level P or equivalently a fall in
purchasing power. Not every price has to rise but only the average.
Usually we furthermore postulate a sustained rise.
5 2.1.7 Useful economic identities are not empirically empty tautologies but
state that the variables used are relatively independent of each other and
the most important variables.
In the very widest sense the quantity theory is just the sensible use of this
equation, in a wide sense it states that changes in M influence V, R and P
and changes in V and R in their turn influence P.
2.1.8.1 As a theory of the price level the quantity theory can be written:
(2)
P 
V
M
Q
2.1.8.2 In the narrower sense the old quantity theory adds three
macroeconomic propositions: a) M can be changed exogenously: b) such
changes have no lasting effect on V; c) or on Q. Then prices change in the
long run proportionately to deviations of M from Q.
2.1.8.3 To get linear equations monetarists use logarithms. For small
changes we can write in growth rates:
(3)
qP  qV  qQ  qM
2.1.8.4 In the very narrowest sense one use of the theory considered V an
institutional constant, at least in the long run (HOLTROP).
2.1.8.5 If we have an exogenous growth process of Q, only an excess
supply of M over Q is inflationary.
2.1.8.6 The Cambridge equation is a similar ex-ante statement, a demand
function for money relating desired cash holdings to income. As an
aggregate (4a) and individual (4b) statement it says:
(4a)
M  k  P Q  k  y
k  1/ v 
(4b)
md  k j y j
“The same collection of symbols can thus be interpreted as an accounting
identity, as a demand function for money, or as a theory of the price
level”.
2.1.8.7 If k is a constant, (4) implies an income elasticity of one and
because of this and the neglect of interest is not compatible with BAUMOLTOBIN or a transactions structure theory of money demand.
6 2.2 The velocity of circulation
2.2.1 The quantity theory best at home with the currency school idea that
money is created exogenously by monetary authorities, not with the
banking school idea that banks create it endogenously in the course of
current business.
Note: small open economies are via the balance of payments more in the
banking school position.
2.2.2 But as some residual influence of the authorities on M remains, they
will use the quantity theory as a framework for attempts to influence P
and Q as targets via M as instrument. For this they have to have ex ante
notions how V will change. Unfortunately changes in V can be nearly of
the same magnitude as those in M. It became well-known that:
2.2.3 Velocity is a cyclical variable, increasing during booms and falling
during recessions, as
- export and investment shares, financed by more rapidly circulating
money, are high during booms;
- the wage share financed by less rapidly circulating money is low;
- speculative balances, being relatively less profitable, are low.
2.2.4 Velocity is interest sensitive, being positively correlated with short
term interest as opportunity cost of holding money.
2.2.5 Velocity is inflation sensitive, being positively related to it as another
opportunity cost of holding all nominal assets.
2.3. SAY’s Law and WALRAS’ Law
2.3.1 Call d the vector of commodity quantities demanded, s those
supplied (or initial endowments, or wealth), z excess demands d n  1 and
s p  1 or alternatively md and ms demand and supply of money, p the
money price vector, c the opportunity cost of holding money. From utility
functions not including money (SMITH) we derive demand functions of the
individual
(5)
d i  d i s; p;
7 Assume that as binding budget constraint (in a one period economy) no
individual can spend more than he earns. We can then derive SAY’ Law:
The aggregate excess demand for all commodities is zero:
(6)  pi di  si    pi zi  0
n
n
2.3.2 SAY’s Law is certainly true in a barter economy. In a money
economy it is true, if money is only “the great wheel of circulation”
(SMITH) without speculative and store of value use and commodities can
be traded costlessly without limit within the constraint (6).
2.3.3 In a monetary economy, were we can buy commodities by
accumulating money stock, we get WALRAS Law:
(7)  pi zi  ms  md   zn 1
n
Excess demand of money and goods, taken together, is necessarily for
every individual, and thus for the economy, zero. Sensible only in a
multiperiod context.
2.3.4 WALRAS Law necessarily true ex-ante for our plans if we do not wish
to defraud. But note: credits are commodities and their quantities
therefore not given before trading.
Also necessarily true ex-post, but now with other prices, other quantities
especially of endowments and even other commodities (bad debts).
2.4. The real balance effect
2.4.1 The real balance effect (PATINKIN) examines the individual
reactions to changes in money which cause a change in the price level.
Real balances: the nominal amount of money divided by the price level; or
the amount of money necessary to buy a given bundle of commodities.
2.4.2 If in the system
(4b)
md  k  pi di
all commodity prices are multiplied with the same factor, we get excess
demand for money. But if for every individual money balances are
exogenously increased to the same extent as prices, we have pure
inflation without change in real demand. If we change all money balances
8 of all individuals to the same extent and no other changes in real wealth
occur, all prices change equi-proportionately.
2.4.3 These conditions are extreme and unrealistic. Apart from the same
increase of money balances for all, all financial assets must also change
equi-proportionately and there must be no distributional effects of
adjustment which, via interest earned, change real wealth. Finally the
economy has to be in initial equilibrium.
2.4.4 The real balance effect is used in business cycle theory to show that
if a fall in real demand causes a price decline, money balances make the
economy self-equilibrating.
But (J. FISHER):
- The real balance effect is only true for the small part of total money that
is outside money
- If debtors have a higher propensity to spend than creditors price level
changes do not act neutrally on expenditure out of inside money and
other financial assets and the told real balance effect becomes
indeterminate.
3) KEYNES’ vs. FRIEDMAN’s theory of Monetary Demand
3.1 KEYNES’ Monetary Theory
3.1.1 KEYNES’ contribution
3.1.1.1 KEYNES basic criticism of the quantity theory in GT 1936 was that
changes in expectations will change desired monetary holdings. This can
be shown only in a multiperiod model: “The importance of money
essentially flows from its being a link between the present and the future”
(GT 293).
3.1.1.2 Money is considered by him within a stock equilibrium concept, as
an asset, essentially the store of value.
3.1.1.3 Implicitly financial markets are thought to “clear” most rapidly
while commodity price changes are slower and wage changes slower still.
Thus a monetary shock changes the interest rate first.
3.1.1.4 “The rate of interest is not the ‘price’ which brings into equilibrium
the demand for resources to invest with the readiness to abstain from
present consumption. It is the ‘price’ which equilibrates the desire to hold
wealth in the form of cash with the available quantity of cash” (GT 167).
9 Equilibrium reached when money supply, M, taken as given, equals money
demand, L, governed by liquidity preference. Thus money supply and
demand explain the rate of interest, not the price level:
(1)
M  Li 
3.1.1.5 The alternative to money envisaged is a long-run bond, in fact a
consol, the relevant interest rate therefore the long-run interest rate.
Money is held when bond prices are much above normal because of the
risk of loss in buying the bond: the speculative motive. Thus more money
is held at low interest.
3.1.1.6 “The necessary condition is the existence of uncertainty as to the
future rate of interest” (GT 168). For interest to change smoothly there
has also to be “a variety of opinion”. In fact it is not really the interest
rate but its relation to an expected level, which is decisive. A super-shortrun theory of rational expectations (BEGG) and without a unique
equilibrium.
3.1.1.7 The speculative motive refutes decisively A. SMITH’s foundation of
SAY’s Law on the irrationality of foregoing current profit: the possibility of
capital loss had been forgotten!
3.1.1.8 Velocity becomes a variable depending above all on interest and
the state of expectations:
2
With low interest monetary demand can become highly interest elastic
though with KEYNES not infinitely so (liquidity trap). Can be derived from
BAUMOL-TOBIN model, properly so, as KEYNES primarily thought of
business money demand.
3.1.2 Evaluation
3.1.2.1 KEYNES basic vision is that uncertainties in financial markets
cause high interest rates that have depressive effects. This valid diagnosis
has, however, nothing essentially to do with money.
3.1.2.2 His idea that the initial impact of money is on interest rates is not
in conflict with many monetarist dynamic models. However, the implied
distributional effects on wealth make final equilibrium path dependent.
3.1.2.3 If one recognizes that speculative balances are held as time or
savings deposits it is necessary to supplement KEYNES own analysis with
10 a banking view that money will vanish endogenously which in
consequence leads to conclusions the quantity theory cannot refute.
3.1.3 Puzzles
3.1.3.1 KEYNES misunderstood the quantity theory thinking it said that
every money increase is equally inflationary or that it had only real effects
below full employment, exactly points that FRIEDMAN denied.
3.1.3.2 KEYNES assumes for his analysis that the rate of interest is
certainly above the full employment level and also possibly so low that it
cannot fall further. That is only possible in (his own) deflationary situation.
3.1.3.3 In fact he explicitly says money supply is too low and should be
augmented by a central bank under public control (235 GT) thus
propounding the same analysis of the “Great Contraction” as FRIEDMANSCHWARTZ.
3.2 Keynesian Theories of Inflation
3.2.1 Demand Pull Inflation
3.2.1.1 Real (in contrast to monetary) demand pull inflation arises when
at current prices aggregate demands exceeds aggregate supply (this
excess being called the inflationary gap) and supply cannot be increased
instantaneously at current prices.
3.2.1.2 In SAMUELSON’s income-expenditure diagram full employment
income lies to the left of equilibrium real income.
3.2.1.3 Expenditure may lie above income because a) for the agents in
question expenditure does not depend upon income; b) expectations are
optimistic; or c) agents accumulate financial assets (i.e. those
accumulated during repressed inflation).
WICKSELL’s inflationary spiral: the reason for demand for and creation of
new credit is a market rate of interest below the natural rate.
3.2.1.4 It was thought economic policy had just to lower aggregate
demand by fiscal or monetary measures and was thereby in no danger of
harming employment.
3.2.1.5 Bent HANSEN (1951), refined the analysis by distinguishing
between a “goods” and a “factor” gap. More relevant to economic policy in
a longer run inflation, where the authorities do not wish to endanger
11 future supply, is the division into a “demand gap of firms” and a
“household demand gap”.
3.2.1.6 Demand pull theory tries to use the competitive partial equilibrium
demand and supply framework. But, of course, in the aggregate D and S
are not independent and the negative slope of the demand curve cannot
be shown by the real balance effect, as this is ambiguous (see 2.4.4).
However, in fact, only a slope of the D-curve smaller than that of the Scurve is needed which is not in doubt close to full employment.
3.2.2 Cost Push Inflation
3.2.2.1 Inflation continued in 1958 in the US during a fall in GDP and
rising unemployment. A “new” inflation theory became necessary: cost
push inflation:
3.2.2.2 Independently from the current level of demand an increase in the
cost of an important category of inputs can be the cause of inflation in the
goods market. Thus, as the term “push” signifies, cost push theory is not
a competitive theory but relies on monopoly or oligopoly power in the
input market and at least the ability to pass on cost increases in the goods
market.
3.2.2.3 Under unchanging conditions monopoly power is, however, not
enough to prove inflationary pressure: The “high” level of monopoly price
must not be confused with rising prices.
3.2.2.4 Without a demand shift upwards a price increase only results if:
a) A fully informed rational monopolist raises his price if demand becomes
less elastic;
b) A potential monopolist has irrationally not used his power and now uses
it in fully informed way;
c) The monopolist does not know the demand curve and “gropes” upward;
d) not fully informed oligopolists “leap frog” on each other, hoping to gain
a larger share of profit.
3.2.2.5 This shows that a fallacious assumption of still rising demand or at
least the expectation of rising demand in the future are necessary. Most
situations show in fact, mixed demand and cost inflation.
3.2.2.6 Various types of cost push:
a) Wage-push by trade unions.
b) Raw material push or directly imported inflation.
c) Profit push or mark up pricing inflation (G. ACKLEY), a theoretically
12 weak idea, as profits are not costs and monopoly power alone is not
enough.
3.2.2.7 Demand reducing measures with cost push inflation are costly in
terms of production and employment. Therefore: an incomes policy,
keeping all input prices low at relatively “just” levels. So far only
successful on a long run, voluntary basis.
3.2.2.8 Evidently somehow means to pay higher costs abound. The role of
money not made clear.
3.3 FRIEDMAN’s Monetary Theory
3.3.1 FRIEDMAN’s Contribution
3.3.1.1 “Inflation, stimulated by cheap money policies, not the widely
heralded post-war depression turned out to be the order of the day.”
3.3.1.2 In FRIEDMAN’s vision – in contrast to KEYNE’s – the private sector
is inherently stable relying on long-run expectations oriented towards
long-run data (i.e. permanent income). The government, on the other
hand, is less well informed than the market, its policies being a “black
box” that we do not fully understand.
3.3.1.3 FRIEDMAN’s is firmly wedded to a currency theoretic view: The
authorities can control the monetary base so that inflation is a mere sign
of their pig-headedness. Falsified in the 70ies and 80ies. See
“GOODHART’s Law”.
3.3.1.4 Though (wrongly) purporting merely to present an “oral” tradition
of Chicago he in fact created a New Quantity Theory: “The quantity theory
is in the first instance a theory of the demand for money… The analysis of
the demand for money on the part of ultimate wealth-owning units… can
be made formally identical with that of the demand for a consumption
service”.
Thus it is theoretically up to date theory of consumer decision taking
analyzing – as all quantity theory – mainly transaction demand. Finally:
“The quantity theorist accepts the empirical hypothesis that the demand
for money is highly stable – more stable than functions such as the
consumption function that are offered as alternative key relations”. Thus
the volume of saving not that of money serves as a shock absorbing
reserve medium.
13 3.3.1.5 The velocity of circulation is not a constant, but a stable function
of a few parameters:
(1)
, ,
, , ,
rb: bond interest rate, re return on equities,
rate of inflation, w: “ratio
of non-human to human wealth”, : real income, u stands “for any such
variables that can be expected to affect tastes and preferences”.
This use of everything that was then fashionable is a red herring. By
assumptions that set most things constant FRIEDMAN arrives at a theory
in fact poorer than most:
(2)
,
As the two monetarist variables velocity depends on expected inflation
and real permanent income.
In the long run velocity falls as the income elasticity of money (defined as
M2) is 1.8. In the short run in contrast it rises during booms and falls
during depression because it is geared to an income (the permanent one)
that is in the boom lower than measured.
3.3.1.6 In the monetarist transmission mechanism excess money balances
are spent on everything thus driving prices up directly (not, as with
KEYNES, indirectly via interest rates and investment). The interest
elasticity of the demand for money is low.
3.3.1.7 As a policy prescription the authorities should keep to a publicly
announced constant rate of expansion of the money supply. (FRIEDMAN
and the monetarists tend to think in growth rates).
What rate of expansion is not very important – any sustained rate
stabilizes expectations further. “Optimal” would perhaps be a rate of
expansion that causes deflation at the level of real short term interest
rates, thus making the nominal rate zero.
3.3.1.8 1971 he reformulates his theory as a theory of nominal income:
(3)
(4)
∙
∗
∗
14 ∗
Equation (4) defines the nominal rate of interest as the long run real ratevirtually a constant- plus expected inflation; or a constant and the growth
of long run expected nominal income. Thus V essentialy depends only on
inflation.
FRIEDMAN always uses adaptive expectations, which depend on past
developments. Thus nominal income depends upon the present stock of
money and the past history of the development of the stock of money.
3.3.2 Evaluation
3.3.2.1 When monetarism was widely adopted, it was past its prime. The
currency theoretic fixation and the consumer theoretic assumption of a
stable V proved wrong in the 70ies and 80ies.
3.3.2.2 With moderate inflation, inflation is of small importance in
explaining V, while real interest fluctuated widely.
3.3.2.3 FRIEDMAN’s theory is not in conformity with general equilibrium
thought.
3.3.2.4 He is very unreliable in the ideas be assigns to other authors.
3.4 Monetary Interest Rate Theory
3.4.1 Prior to KEYNES one typically used a semi-monetary interest theory:
the loanable funds theory: the rate of interest is determined by the supply
of loanable funds (savings and new money creation) and the demand for
them (investment and money hording). Thus mainly the credit market
decisive.
3.4.2 KEYNES liquidity preference theory, in contrast a stock equilibrium
theory (see 3.1.1.5), was the first purely monetary interest theory. But,
as FRIEDMAN says, it gives only “the initial impact of increasing the
quantity of money at a faster rate than it has been increasing.”
3.4.3 FRIEDMAN propounds a second purely monetary theory of nominal
interest: It just reflects (is positively correlated with) the rate of inflation.
This theory (equation (4)) he calls after Irving FISHER.
3.4.4 The conflict between these two theories is highly confusing.
Monetary authorities “would have to start out in what seems” like the
opposite direction”. “Low interest rates are a sign that monetary policy
has been tight.”
15 3.4.5 FISHER had thought the adjustment mechanism of interest to
inflation to be in general very slow so that the current relation between
the two very loose one. FRIEDMAN in practice by far overestimated the
rapidity of interest to inflation.
4) The Supply of Money
4.1 The Function of Banks
4.1.1 One historical root of banking was the experience of goldsmiths,
with whom coined money had been deposited for safe-keeping against a
receipt, that they could without undue risk lend out for profit part of the
deposits. As the endorsed deposit receipts also circulated from hand to
hand the volume of monetary circulation thereby increased.
4.1.2 Banks thus are dealers in credits and debts. Another historical root
is the brokerage of loans by “scriveners” acting as intermediaries. A third
is the clearing house function of international fairs.
4.1.3 A developed bank system performs at least eight functions:
4.1.3.1 It provides an accounting system for the transfer of wealth;
4.1.3.2 Guarantees payment of little known debtors.
4.1.3.3 provides various international financial services;
4.1.3.4 provides portfolio management services
4.1.3.5 in the course of which it provides loan size intermediation
4.1.3.6 and loan term structure intermediation
4.1.3.7 and loan information brokerage.
4.1.3.8 Finally it insures the income stream of a part of capital against
default and interest fluctuation.
4.2 The Simple Credit Multiplier
4.2.1 As a theory of total money supply the credit multiplier assumes a
stable relationship between the two components of M1, primary money
and private bank money.
16 4.2.2 In a mechanistic theory the simple credit multiplier assumes the
relationship to be constant: The public uses the two types of money in a
fixed relationship and the banks accommodate this desire.
4.2.3 For this we make three assumptions:
a) There is a fixed currency ratio “cur” of total money payments of the
public in currency, the rest is deposited.
b) There is a fixed reserve ratio “res” the banks hold in currency against
all their deposits, being the sum of legal minimum and voluntary reserves.
c) Banks never hold excess reserves but immediately lend out surplus
currency.
4.2.4 Out of one unit of additional currency in the economy (1-cur) is
deposited and (1-res) (1-cur) lent out by the bank in form of a credit line.
The credit is immediately with drawn and used in the same way in further
rounds.
4.2.5 Over an finite number of rounds total money creation triggered by
one unit of additional currency is given by the credit multiplier m, which is
a number larger than one and the higher the lower the reserve ratio of
banks and the lower the currency ratio of the public.
(1)
1
1
1
1
1
…
4.2.6 (1-cur)m is held as demand deposits and
∙ as currency by the
public, while 1
∙
is the amount of currency held in the coffers of
the banks as reserves.
4.2.7 Exactly the same multiplier results if the banks decide that its
reserves are excessive and lend our one unit of currency.
4.2.8 NIEHANS gives an alternative derivation with an equity ratio of
equity capital E held against loans L and uses a redeposit ratio s(=1-cur)
of loans. According US-usage he assumes that a credit line has to be
treated as a deposit D. R is reserves and D* the inflow of new deposits.
From the balance sheet equations (2) he then derived the credit multiplier
(3):
(2a)
∙ (2b) E = eL
∗
(3)
17 (2c) D=sL+D*
Equity thus increases the multiplier and larger banks with larger s have a
higher multiplier.
4.2.9 This mechanistic multiplier gives only an upper limit of money
expansion, each bank having only a small, the whole system a far larger
power to create money.
4.3 Bank money creation as an optimization process
4.3.1 If one considers optimal behaviour towards risk and the balancing of
earnings against cost this upper limit is never reached (ORR and MELLON
AER 1961), the marginal credit multiplier showing considerable
fluctuations. Its stability is, on the other hand, assumed by monetarism.
4.3.2 Deposits and withdrawals can be thought to follow a random
process, on whose variance the probability of running out of reserves
basically depends.
4.3.3 The bank should expand its productions of deposits until the
resulting marginal gain is just equal to the marginal cost.
Call X with drawls, R reserves, p the penalty cost of running out of
reserves, c the marginal cost of administering loans of the average default
percentage then (assuming risk neutrality):
(4)
The net return on the loan has to be made equal to the penalty cost times
the probability of running out of reserves.
The higher the net loan return, the lower the penalty cost and the lower
the withdrawal variance, the lower “res” and thus the higher the
multiplier.
4.3.4 In a more complex theory it should be recognized
a) that p varies between the different earnings assets of the bank;
b) that p becomes large for large reserve losses;
c) that the bank can influence the withdrawal probability through the
conditions of its different types of deposits.
4.3.5 As there is a stochastic scale effect of falling relative risk if one deals
in many independent deposits and credits, high risk markets are
dominated by large banks.
18 4.3.6 As basically the same consideration also work on the optimal
behavior of the public, “cur” will for instance be lower with a high deposit
interest rate.
4.3.7 The parameters in (4) will vary during the business cycle in such a
way that the credit multiplier rises in the boom and falls during recession;
4.3.8 so that money creation is much less expansionary during recession.
4.4 Credit Rationing
4.4.1 Average default risk, d, will be the higher, the higher the rate of
interest, which leads to credit rationing, by the banks, a non-market
clearing optimal behavior due to asymmetric information, the bank
knowing only the default probability of classes of customers.
4.4.2 In type I rationing some or all loan applicants get a smaller loan
than they desire at the quoted loan rate of interest;
in type II rationing some loan applicants are denied a loan even though
for the bank they are indistinguishable from accepted applicants.
4.4.3 Credit is extended up to the point where the marginal increase in
default probability just equals the net interest return.
4.4.4 The positive dependence of default risk on interest may have four
reasons (CLEMENZ):
a) At higher interest more risky projects are offered and
b) less honest customers apply and
c) investors put less effort into their investment management and
d) less able entrepreneurs apply.
4.4.5 Credit rationing is likely to increase during recession so that the
credit multiplier further falls then. 19