Wednesday, 17 June 2015

Banks and Liquidity Preference


Consider a simple economy with three sectors: households, firms and government.  There are two assets: government bills and loans to firms.  Firms can hold bills, but we'll assume their holdings are generally zero.  All loans to firms are made by households.  The national balance sheet looks like this.


Households
Firms
Government
Loans
L
- L

Bills
B

- B

(To avoid needing to include money as a separate asset class, we'll assume here that the bills are used as the medium of exchange.  This could be through direct physical exchange.  Alternatively, all bills could be held in individual accounts in a central registry with households and firms making payments by instructing the registry to transfer ownership interests.)

For simplicity, we will assume that firms wish to invest as much as they can and are limited only by the amount that households are prepared to lend.  Household behaviour can then be split into two decisions that are strictly independent. 

First, they make a decision that determines the total addition to their holdings of financial assets.  It is usual to think of this as being a decision about how much they spend on consumption, given their income expectation and other factors.  The accumulation of financial assets - saving - is the residual.

Secondly, they make a decision which determines the split between making additional loans and acquiring additional bills.  It will be useful to think of this as being a decision about the amount of additional loans they want to make.  We can imagine that bills are riskless and households have no limits on how many they hold, but that loans to firms carry default risk and households wish to manage their exposure.

It is crucial to recognise that these are two separate decisions.  Households can decide to spend less on consumption, without changing their decision about how much to lend to firms.  Likewise, they can decide to lend more to firms, without changing their decision about how much to consume.  Putting this latter point another way, a household decision to save more is not a pre-condition of an increase in loans to firms.

Each decision affects expenditure independently.  We have assumed that firms will spend all they can borrow, so the decision to lend affects expenditure directly.  As we have noted, this is not dependent on a decision by households to consume less.  So although, for the economy as a whole, investment must equal income less consumption, both investment and consumption are separately determined, making income the thing that needs to adjust.

If we were instead to assume that there was just one decision and the amount to be loaned to firms had to be exactly equal to the amount saved, then we would have the sort of situation conjured up by loanable funds imagery.  We could imagine that the amount to be loaned was determined by the amount households decided to save.  This might be the case in a simple barter model where saving could only be undertaken by retaining real goods

How do banks fit into this picture?  The answer is all to do with the lending decision and not the saving decision.  If the amount to be loaned to firms is still decided entirely by households, then banks are mere conduits - what people often mean when they question whether banks are just intermediaries.  On the other hand, if part or all of that decision falls to banks, then they immediately become an active part of the process.

We can illustrate this by adding banks into our balance sheet in two different ways.  In the first (shown below), banks hold the loans and households hold deposits at the bank instead. 


Households
Firms
Banks
Government
Deposits
D

- D

Loans

- L
L

Bills
B


-  B

We need to make two further assumptions here.
a) that households decide between bills and deposits in the same way that they did between bills and loans; and
b) that banks accept any amounts deposited, which they then automatically lend out.

In this case, we can see that the lending decision still rests entirely with households, notwithstanding that banks are making the actual loans.  This is a true banks-as-simple-intermediaries model.

Alternatively, we might add in banks as shown below:


Households
Firms
Banks
Government
Deposits
D

- D

Loans

- L
L

Bills


B
- B

In this scenario, a decision by households to increase holdings of deposits is the same as a decision to save.  There is no way for households to do one and not the other.  Rather than making two separate decisions, households now only get to make one.  The split between loans and bills - essentially the decision to lend - is in the hands of banks.  So, now, bank behaviour is crucial.

In reality, we are somewhere between these  two situations.  Bank decisions on lending are important, but household decisions matter too.  A major factor in the financial crisis was non-banks (households, here) trying to switch from bank debt (deposits) to government securities (bills).

Once we start to consider separate objectives for households and banks, we need to start bringing interest rates into the picture (or rather interest rate differentials).

We can see here the critical importance of portfolio decisions and how they are made.  This basic idea is really what liquidity preference is about in Keynesian and post-Keynesian economics.  Liquidity preference is perhaps an unfortunate term because, although liquidity is an important element, we need to look at aspects of portfolio preference that go beyond that.

6 comments:

  1. Nick, you write “We need to make two further assumptions here. a) that households decide between bills and deposits in the same way that they did between bills and loans; and b) that banks accept any amounts deposited, which they then automatically lend out.”

    It seems to me that, for completeness, you should add a third assumption here: c) banks do not create extra deposits for extra lending to firms. But this seems to be a strange assumption, because in your model, the existing deposits must have been created somewhere in the past in a process of autonomous bank lending to firms.

    Anton

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    Replies
    1. I think that's what I was trying to get at with my assumption (b), in that I was trying to suggest that banks only lend out as and when deposits are made.

      The creation of deposits in this version arises from households depositing bills. Banks then lend out the bills to firms.

      I was trying to suggest a set-up where this would happen without banks making any active decision. So the amount that was loaned out would simply be the amount households chose to deposit. Making loans by creating new deposits (without a prior deposit of bills) would involve the bank making an independent decision.

      I suspect it was a mistake in this post to treat bills as the medium of exchange rather than a seperate state issued money. That might have been clearer.

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    2. Also, here, rather than describing State bills as currency of households would it not be more appropriate to describe them as savings tools of households.

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    3. Certainly they are a means of saving for households- in fact, bills, loans and deposits are the only possible means of saving for households in this model.

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    4. As you you are looking at the role of Banks, its a bad start to have Government Bills portraid as currency as government bills aren't used as currency. The Government sells Bonds in order to fascilitate the tranfer of deposits from the deposit accounts of bond buyers to the deposit accounts of the recipients of governent spending or to the deposit accounts of legacy bond holders. Governmens bills aren't currency. The deposits are the currency.

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    5. It's actually not so unusual in monetary economics to talk about bonds being used as a medium of exchange, with the idea being that bonds are used as liquid asset backing for transaction accounts. Often, there's no point in separately recording the transaction accounts themselves. And I deliberately did not want to do so here as that would caused confusion with deposit accounts backed by loans. I was trying to limit the number of entities as much as possible to focus on the key point.

      But I agree that this has been confusing.

      Maybe another way to approach this is to say that B includes both bills and base money and that the government (or the central bank) exchanges bills for base money on demand at a fixed rate. This latter point means we don't need to worry about how people decide between the two.

      We can then either allow for deposits to be also used as a medium of exchange, or we can assume that all deposits are like savings accounts and that all payments (including the advancement of new loans) have to be made in base money. Either way, portfolio preference is the crucial element, although the liquidity of deposits (including the ability to use them for exchange purposes) is likely to have a bearing on households' portfolio decisions.

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