Tuesday, January 1, 2013

Checkable Deposits and "HPE"

The "Hot Potato Effect" applies to checkabe deposits.  

Suppose the quantity of checkable deposits rises beyond the demand to hold them.   Those holding excess balances in their checkabe deposits spend the excess funds.  Those receiving the payments now have excess balances in their checkable deposits, and spend them as well.  

What brings the process to an end?   The added expenditure on goods and services results in higher prices.   The higher prices reduce the real quantity of checkable deposits.   Alternatively, the higher prices raise the nominal demand for checkable deposits.

One the price level has risen enough that the real quantity of deposits fall to the real demand, the HPE is at an end.   With the alternative framing, once the price level rises enough so that the nominal demand for checkable deposits rises enough to match the nominal quantity of deposits, the HPE ends.

Suppose that banks pay competitive interest rates on checkable deposits.  Does that mean that the HPE no longer applies?   Not at all.   Interest on checkable deposits increases the real demand for checkable deposits.   Given the price level, this is an increase in the nominal demand for checkable deposits as well.   Still, if the quantity of checkable deposits is greater than the demand, then those with the excess balances spend them.   Those receiving the funds now have excess balances.   When the price level rises enough so that he real quantity of deposits falls enough to meet the real demand for checkable deposits, the HPE ends.   Alternatively, the price level rises enough for the nominal demand for checkable deposits rises enough to match the nominal quantity.

It would be possible, of course, for the banks to increase the interest rate paid on checkable deposits enough so that the nominal quantity demanded equals the quantity.   But why would the do that?

When someone goes to a shop to make a purchase, the seller does not insist that the deposit the buyer uses to make the payment pay a sufficient interest rate so that the seller will be willing to hold the deposit.   The seller cares nothing at all about the interest paid on the buyer's deposit, because he intends to deposit the check (or electronic payment) in his own checkable deposit.

Obviously, it would be foolish for a seller for some product to negotiate with the buyer regarding the interest rate paid on deposits by his own bank.   What does the buyer have to do with that?  

However, the key element to understanding monetary theory is that the seller of some product or asset does not make a sale only if he is willing to hold a larger balance in his checkabe deposit.   Sellers accept payments all the time intending to then spend the money on other goods, services, or assets.


  1. For a while there the "Hot Potato Effect" was the "Hot 'Tater Effect."

  2. Wasn't it some time in the 70s that banks began paying interest on checkable deposits? Did this innovation produce a noticeable increase in the quantity of checkable deposits?

    Of course, the government could, through OMOs, itself acquire and retire (in effect, hoarding) the excess deposits, nipping the HPE in the bud.

  3. I don't usually say "taters," but often I think of them that way. Thanks.

  4. Banks create deposits in the first place because it's profitable to do so, because deposits pay a lower interest rate than bonds. If they created too many deposits, then the excess would cause the bond-deposit yield gap to shrink, and banks would respond by selling bonds, which destroys the deposits.

    In your story, deposits appear out of nowhere for no reason, and can't be destroyed. Hence they are a hot potato.

    In my story, deposits are created to make a profit, and are destroyed when they are no longer profitable. No hot potato.

  5. Max:

    How exactly does the excess of checkable deposits cause the bond-deposit gap to shrink?

    If it were to shrink--if the opportunitity cost of holding money is smaller, then the demand to hold deposits would rise.

    But why?

    There is no reason for banks to raise the interest rate they pay.

    And if the interest rate they can earn on "bonds" falls, then they are likely to lower the interest rate they pay.

    1. Here's a simpler way of putting it. In competitive equilibrium, the deposit yield is equal to the bond yield minus a management fee. Bank customers have a choice between holding their wealth in deposits or bonds. They can hold deposits and pay the management fee, or hold bonds and escape the fee.

      The choice isn't deposits or goods, it's deposits or bonds.

      And if bonds didn't exist, it still wouldn't be a choice between deposits and goods. It would be a choice between deposits and illiquid investments. Either way, an excess of deposits results in banks selling assets, not an increase in prices.

  6. Bill,

    I was going to ask, along the lines that Max mentioned, but slightly broader: Excess demand deposit balances might result in flows into other financial assets, bond and or stocks, not necessarily goods and services. I think Hayek alluded to "asset price inflation" as part of inflation. This of course, does not mean necessarily, that the hot potato stops with the bond/stock seller, but the path will likely involve asset prices.

  7. Suppose you worked for a living. Would you quit your job because the net yield on your deposit account is too low? Or would you just spend your income on good, services, or other assets?

    If people spend more on bonds, then it is true that bond yields may well drop. If the interest rate on deposits is assumed constant, that reduces the opportunity cost of holding money.

    However, the banks now have lower earnings on their asset portfolio, and so they reduce the interest rate paid on deposits.

    It is true, of course, that reducing the interest rate paid on deposits exacerbates the surplus of funds.

    Or more exactly, the HPE occurs and there is no liquidity effect. To create a liquidity effect in a deposits it is necessary to assume that the interest rate paid on deposits is sticky.

    Anyway, where you are going wrong is assuming that there is a Walrasian auctioneer that chooses a interest margin for banks so that quantity supplied equals quantity demanded.

    The Walrasian Auctioneer calls out a margin. All the banks respond with a quantity supplied of deposits. All those wanting to hold deposits respond with how many they want to hold. If there is a shortage or surplus, the Walrasian auctioneer calls out a new margin.

    Nothing like this occurs in reality.

  8. If zero-nominal interest currency is taken to be the epitomy of money, then an excess supply of money can create a liquidity effect. Those with excess money spend it on financial assets, raising their prices and reducing their yields. Money is assumed to have a zero yield so this reduces the difference between the yield on currency and other assets. The opportunity cost of holding money falls, increasing the demand to hold money.

    If money is instead takes the form of interest bearing deposits, then the reduction in the yields on finanical assets is at the same time a decrease in the yield banks' earning assets. This reduces their supply of deposits--the interest rates they are willing to pay.

    Of course, this reduces the demand to hold deposits, but really it just means that lower nominal interest rates has no effect on the demand to hold money.

    The lower interest rates still impact the demand for consumer and capital goods. Spending on output rises.

    When prices of goods and services rise enough, the demand to hold money rises to match the quantity.

    Now, if you assume that interest rates on deposits are sticky in the short run, then lower interest rates on other assets reduces the opportunity cost of holding money and increases the demand to hold just like with currency. The lower interest rates on nonmonetary assets still increase investment and consumption--more edemnad on other goods.

    But without this stickiness of deposit interest rates, then lower yields on finanicial assets just reduces the yield on deposits and does nothing to clear up the excess supply of money. The HPE continues.

  9. Bill, here's an idea.

    As consumers spend excess deposits, banks will quickly build up large interbank deposits with each other. Banks don't try to get rid of excess interbank deposits by spending them into the economy. Rather, they'll simultaneously begin to cancel their accounts with each other, thereby reducing the amount of deposits in the system. This withdrawal of spending power via the interbank system happens before consumer spending of excess deposits has any lasting effect on prices. So the HPE effect is quickly neutralized.

  10. JP Koning:

    Yes, the banks cancel their intebank deposits so the quantity of deposits remains the same. If there was an excess supply of deposits initially, then leaving the quantity the same leaves an excess supply. The HPE continues until the price level rises enough so that the real quantity of deposits falls to meet the real demand.

    What doesn't exist is a multiplier effect. If one bank increases the quantity of its deposits, there is no process by which the other banks increase their deposits by a multiple of that initial increase.

    If if the quantity of all bank deposits is greater than the demand to hold them, interbank clearings doesn't directly extinguish the excess deposits so that they return to the amount demanded.

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