This post is about the creation of non-bank money. TH reckons there is something missing from the way we think about it.
Economics is full of assumptions. They serve a role of course – the world is highly complex and we have limited capacity with which to analyse it, so assumptions help. But assumptions can also be a hindrance because you tend to rely on models that don’t always fit the reality you want to think about.
TH reckons that one of the assumptions that the profession might need to relax is the idea that we use only one money. In reality, we most likely use many moneys. Sometimes we use cash, sometimes bank deposits, sometimes other assets as money. Sometimes it is also foreign cash, foreign bank deposits or other money like foreign financial assets. This might not be so true for individuals, but it is true for many businesses.
Most macroeconomic models don’t really have much room for money at all let alone many moneys. This is a big failing of macroeconomics. When they do, the models typically assume just one money. Sometimes domestic bank deposits are treated as money, but they are treated as perfect substitutes for cash so it doesn’t really change much.
This is probably OK when bank deposits are created by a solvent bank that is a member of the central bank’s clearing house. But what about for other deposit taking institutions that aren’t “banks” because they don’t belong to the central clearing house (in the sense that they can’t rely on the central bank to settle any unsettled balances with other banks)? Now matters get more complicated. You could think of deposit taking institutions like the now defunct Banksia in Australia, for example. Banksia deposits were money-like in that often they were used as a means of payment, but in reality they were likely to be less liquid than bank deposits or cash – i.e. they were less money-like than cash.
Here is a different example, consider a Korean bank that issues US dollar deposits (perhaps to a computer manufacturer that sells computers and prefers to trade in dollars) and makes US dollar loans (perhaps to similar Korean computer company that uses the credit to buy imported computer components). Clearly, the Korean bank customer treats the US dollar deposit as money, but it is not so clear just how liquid that deposit is. Why? Because if there was ever a run on the Korean bank’s US dollar deposits, it would not have access to the US Federal Reserve to satisfy its customers or to settle unsettled balances with other banks. Instead it has access to the clearing house run by the Bank of Korea, which can print won, but not dollars. TH reckons people would only treat these deposits like money if they could be fairly sure that the bank had some means of satisfying a large unexpected increase in withdrawals.
This raises an interesting question. How would one model the supply of US dollar money created by banks in Korea? There are two dimensions to this issue. One is how do you add cash and mere money substitutes to come up with a measure of the money supply (or the abundance of liquidity perhaps)? The second dimension is, suppose that under some conditions, the Korean bank US dollar deposits could be considered to be money, then how much money does the Korean bank produce?
Not sure about the answer to the first question, but here is TH’s thought on the second. The supply of Korean US dollar bank deposits is determined by demand and supply. The supply is given by the old fashioned money multiplier:
Ms= 1/rr. Reserves.
Where rr is the ratio of Reserves to its deposit base, and Reserves are the value of US dollar reserve assets (say cold hard cash) that the Korean bank has in its vault.
The demand for those US dollar Korean bank deposits is probably a function of a bunch of things, which TH will divide into the reserve ratio and everything else, X. The reserve ratio affects demand because the higher the reserve ratio, the less likely that the bank will have a run – no need to run if there is a tonne of cash in the vault. From a bank’s point of view, since reserves are expensive to hold, they will hold the minimum necessary to satisfy depositors concerns about a run. Let’s suppose that:
Md= a.rr +X
These two equations solve for the equilibrium values of M and rr (labelled on the axis with *s).
Remember the M on the axis refers to the value of US dollar deposits created by a Korean bank (or domestic deposits created by a “non bank”). The model helps us to think through how the supply of US dollar deposits is determined. Do a couple of simple thought experiments. First imagine what happens if the Korean bank, gets its hand on more reserves. Perhaps it borrows them from the central bank of Korea, then the Ms curve shifts up (as per the Ms equation), but to be induced to treat the extra deposits as money, the bank must increase its reserve ratio.
The other experiment to do is to think about a fall in the willingness to hold US dollar Korean bank deposits. This shifts the Md curve down. In this case, the bank can offset some of the fall in demand for its deposits by increasing the reserve ratio.