Friday, February 19, 2010

Bank Lending, CD's and Monetary Disequilibrium

Suppose the demand for loans expands, and banks accommodate this by funding new loans with newly-issued Certificates of Deposit. Those obtaining the bank loans have more money to spend. But those buying the banks' C.D.s have less money to spend. Ignoring secondary effects, there is no impact on aggregate nominal expenditure.

There is a shift of funds from those buying the C.D.s to those obtaining bank loans. Presumably, it will be matched by a shift in the allocation of resources. Hopefully, this shift will be value enhancing. If it is value enhancing, the productive capacity of the economy is slightly higher than it otherwise would be, but it has nothing to do with a change in nominal expenditure.

It is possible that this transaction would be value enhancing, but it cannot be made because the bank cannot make new loans due to inadequate capital--inadequate net worth. Perhaps the bank took losses because of poor past investment decisions and government prohibits banks from making new loans until they somehow rebuild their net worth. It is even possible that potential CD buyers would refuse to buy C.D.s from poorly capitalized banks.

Regardless, the inability of the banks to make these value enhancing transactions would prevent an enhancement of the productive capacity of the economy, but would have nothing to do with aggregate nominal expenditure. The potential borrower would not have the funds to spend. The potential CD buyer instead has the funds to spend.

Does that mean that banking is irrelevant to nominal expenditure? No, banks are very much involved because banks don't just fund their loans with Certificates of Deposits. They also fund their loans with transactions accounts. Further, banks don't use all of their available funds to make loans or buy securities, but rather hold vault cash or balances at the Federal Reserve banks. It is the relationship between the amount of "reserves" banks choose to hold and the amount of monetary liabilities that banks create, that has a major impact on nominal expenditure.

Unfortunately, the simple truths of money and banking are masked when central banks manipulate these relationships to control short term interest rates. They don't disappear, but rather whatever loans the banking system wants to fund given the target interest rates will be funded, in the last resort, by transactions accounts created by the system. Unlike the C.D.s, where the depositor chooses to hold them, the transactions accounts are simply accepted in payment. While someone is, of course, holding them, they may intend to spend them. It is the ability of central banks to manipulate this process, so that loans are funded by deposits that people may not want to hold, that allows them to manipulate interest rates.

If capital requirements impact banks is such a way that it would lower the equilibrium value of the particular interest rate that a central bank is targeting, the way the central bank is going to keep interest rates from falling is by manipulating the relationship between bank reserves and transactions deposits so that there is a reduction in the amount of transactions deposits used to fund loans. That is what will tend to depress nominal expenditures. If the central bank fails to respond to the prospective decreases in nominal expenditures by a sufficiently large decrease in its target for interest rates, then nominal expenditures will fall.

But the reason for the drop in nominal expenditure isn't the decrease in bank lending. It is rather that the central bank is creating an excess demand--a shortage--of transactions accounts to keep interest rates from falling faster than it prefers. And it is that imbalance between the supply and demand for transactions accounts--money--that depresses nominal expenditure.

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