Thursday, 27 March 2014

The Demand and Supply of Money and Other Financial Assets




I've read a few bits recently about the demand and supply of money, in particular over the question of whether the quantity of money is determined by supply and demand. Nick Rowe puts the monetarist case very well and I'm going to try and paraphrase him here.

It's helpful to look at a simplified balance sheet, like that shown below.  Here we have lenders holding bank-issued money, borrowers with loans, and banks.  Banks have nil net worth, so money equals loans.



Savers
Borrowers
Banks
Money
M

-M
Loans

-L
L

We can then hypothesise a money demand function that says that the demand for money balances is in some fixed proportion to nominal income.  Maybe this applies only in the long run, so that there is a gradual adjustment towards it, but in long run equilibrium the demand and supply of money will be equal, so we can write M = kPY.

What is the causal interpretation here?  Well, the quantity of money in existence is being determined in the loan market.  An increased demand or supply of loans leads to a greater supply of money.  Borrowers spend the money they borrow.  If this leads to lenders holding excess money balances then they will tend to spend these until income and money holdings are in balance again, basically until the condition M = kPY is met.

So in this limited framework, we might say that the quantity of money is supply determined and that the supply of money then determines nominal GDP.  We have skipped over the question of the extent to which loan volumes themselves depend on nominal GDP, but otherwise I tend to agree that this is a useful way of looking at these dynamics.  So saying here that the quantity of money is supply determined seems to me to be reasonable.

What I am less happy with is the idea that this is necessarily a story about money.  It is a story of money here, but that is because we have severely limited the number of monetary assets that appear.  So let's expand our balance sheet so that banks are now funded with transaction accounts (which we'll call money) and  what we'll call savings bonds, which cannot be used for exchange.



Savers
Borrowers
Banks
Money
M

-M
Savings Bonds
B

-B
Loans

-L
L


Now, we find that an increase in lending adds to the total quantity of money and savings bonds.  But, in itself, it doesn't tell us the split between the two.  To determine that we need to know something about the relative demand for each.  So, once we allow for banks to have liabilities other than money, we can no longer really say that the quantity of money is essentially supply determined.  Of course, banks will have preferences as to their liability mix, so supply conditions will matter as well, but no more so than demand.

The further point here, is that once we allow for a financial sector with liabilities other than money, the same principal applies to lending by non-bank financial intermediaries (NBFIs).  So, we can imagine that what we have called banks in the balance sheet above instead includes all financial intermediaries.  We have banks that issue money and savings bonds and NBFIs that issue only savings bonds (but that might hold money or borrow through loans).  We now need to specify that what we have called money means instead just that money held outside the financial sector and loans means loans outside the financial sector.

Now there is no immediate difference between additional lending by banks as opposed to NBFIs.  Both will initially increase the amount of money held outside the financial sector, but how the balance between money and savings bonds develops then depends very much on the preferences of savers.

So I don't have much of a problem with an analysis that says that the quantity of financial assets is determined in the lending market and that that quantity then impacts on nominal GDP.  However, in a world with many different financial assets, which are often close substitutes, this does not imply that the quantity of any one particular asset (including money) is itself supply determined.

11 comments:

  1. A bank will always lend on good collateral if it's sufficiently profitable to do so. Now , what is the supply of collateral ? In relation to gdp , it's huge. Net worth at market value , across the U.S. economy , is on the order of $100 trillion. Even assuming market value swings of as large as +/- 30% , the collateral value is still huge compared to gdp. This is asset value only - financial , real , and other , such as intellectual property. You also have multiple trillions in potential collateral in the form of future income streams that can be pledged by credit-worthy companies and individuals.

    So , "supply" is a non-issue. Loans can always be made in volumes sufficient to blast gdp thru the roof based solely on current unencumbered assets and future income as collateral. What's left is demand for those loans. Do borrowers have a desire for loans on the terms that banks would offer those loans - here is where the multiple variables of interest rates , loan maturities , and , most importantly , "animal spirits" deriving from the state of the underlying economy , interact to determine if those loans are made and that "new money" enters circulation.

    It's the end user who makes the final decison. The Fed has some influence , by either greasing the skids or gumming them up , but ultimately it's only operating on the margin.

    Marko

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    1. I believe that demand and supply conditions are both important in determining the quantity of loans advanced.

      It is true that there is a very large amount of potential collateral available. However, much of this is the hands of people who do not need or wish to borrow. Many borrowers are borrowing up to the limit of what is acceptable to banks and there are always people who would like to borrow but are not considered credit worthy. So, the way banks assess risk and the way this varies over the cycle is important.

      Banks are also constrained by capital availability. Although, in theory and in the long run, they can always raise more capital so it's just a question of cost, in practice capital issuance is very sticky. So financial innovation, particularly around capital usage has recently been an important factor in determining loan volumes.

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  2. Nick: fair enough. Only some loans are issued in the form of newly-created money.

    Simplify. Suppose banks buy houses, instead of buying IOUs, and pay the market price for houses. And suppose nobody cares whether they sell their house to the bank for new money or any other buyer for old money. Banks decide how many houses to buy with newly-created money. The stock of money is supply-determined. PY adjusts until the quantity of money demanded equals the quantity supplied.

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    1. That's a good analogy , but I see it the same way. The bank can only decide to buy a house if one is offered for sale. Homeowners have to decide to sell first. The desire to sell a house is equivalent to the desire to take out a loan. If the bank buys the house , it's new money , or someone else buys it with old money. Just as in my scenario someone can either take out a loan by pledging collateral , or sell that collateral on EBay. The bank always wants to buy homes , or make loans , if it's profitable to do so. The bank can't simply summon homeselling behavior , or borrowing behavior , at will , they can only try to entice it into being by offering good terms , limited by their desire to profit themselves. Sometimes that will work , sometimes not. Banks can more readily limit supply , but if profitable opportunities exist , it can be hard to convince them to even do that.

      Now , if you set up each bank with a fleet of helicopters , that would be a different story. Nobody could resist the allure of cash floating down from the heavens. For a while , anyway.

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    2. Well, I think I'd see that the same way. If these house buying banks fund themselves with a mixture of money and savings bonds, then we have to look to saver preferences to determine how much money they will keep and how much they will convert into savings bonds. It's only really the total volume of financial assets that this supply-determined principal applies to, not any one particular asset.

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    3. Nick; yes, but banks will choose the rate they offer on (non-monetary) savings accounts, so banks can still determine how much money they sell, taking those preferences into account. If the banks offer a low rate of interest on savings accounts, people will prefer to get rid of excess deposits by spending them on something else, rather than converting them to savings accounts. Which means the hot potato process gets rolling.

      Take the extreme case: who in Zimbabwe would put his excess money into a saving account, rather than spending it as quickly as possible?

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    4. Yes I agree that banks are not indifferent to the balance between money and savings accounts, and that they will adjust rates accordingly. I'm not saying that the quantity of money is exclusively demand determined, merely that it's not exclusively supply determined.

      I'm not convinced though how much people's spending habits respond to changes in the interest on savings. I think if savings rates come down, people might be prepared to hold more in non-interest bearing accounts, but I don't think they go out and spend much more. Actually, I think the more important effect of interest rate changes is a distributional one.

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  3. Maybe we should divide the question of "whether the quantity of money is determined by supply and demand" into two time periods:

    1. The instant of money creation.

    2. The period between events of money creation.

    At the instant of money creation by new bank loan, demand must equal supply. By definition. By practice. By accounting.

    The period between money creation events is a period of constant supply (except for money destruction events). We should be able to measure how much money is floating around by observing the value of outstanding bank loans.

    During the period between money creation events, the demand for money is difficult to measure. If we seek methods of measuring demand, we might consider the number of loan applications. We might also consider that the number of people seeking employment from other parties is a disguised demand for money. The rate of formation of small enterprises or self-employment schemes could be a similar disguised demand for money.

    We might consider applications for unemployment benefits as a measure of demand for money, but I think that statistic is tainted as a measure of demand for money because unemployment benefits ARE a payment of money. Unemployment benefits are, in-reality, a form of employment.

    Perhaps there is a very good way to measure the demand for money between loan events. I just don't see a good way at this time.

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    1. Measuring demand (or supply) of anything independently of the quantity actually traded is very difficult. We can only do it indirectly.

      We also need to distinguish here between short term demand i.e. how much money I want to be holding today, as opposed to long term demand, i.e. how much I want to be holding in the future. If I'm holding an excess balance now, it doesn't mean I want to go and get rid of as quickly as possible, it may be more about running it down over a period of time.

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  4. The U.S. IRS has decided that Bitcoin is PROPERTY. This decision tweaked my economic paradigm. Isn't ALL MONEY property? I put up a post on the subject at http://mechanicalmoney.blogspot.com/2014/03/have-labor-now-seeking-property-money.html.

    Now if all money is property, doesn't every loan of money, even privately made loans, increase the amount of PROPERTY? Remember, even privately made loans (that had documentation) could result in the sale of the documents and rights. The loan documents would be property, so yes, the amount of property would increase when the loan was made even if we economist argued that the amount of "money" did not increase.

    As to the difficulty of measuring money and loans, I certainly agree with you that it is difficult. My focus has been trying to discover which metrics within the NIPA best predict or follow GDP. I notice that with some data series, it is hard to know if the data is leading or following, or merely simultaneous. I remain unsatisfied in this area of research.

    To conclude this comment, I will say that loans are a measure of money movement. Both loans and money seem to be property. It seems to me like loans should be measured as money to learn total money supply but this certainly leads to a question of how to count deposits at banks AND a question of how to integrate long termed loans.

    The goal is better understanding of the interaction of GDP and MONEY!

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    1. What the IRS decides is only relevant for its characterisation for the purposes of treatment under the US tax code. It shouldn't have any bearing on how we want to look at things from an economic perspective. The term "property" is used here simply because of its meaning in US tax law, not for any wider meaning.

      But generally I would agree that every new loan increases the gross amount of financial assets in the economy and thereby alters the structure of rights to future resources. That applies whoever is making the loan, whether a bank or not.

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