If we abstract away from hand-to-hand currency and focus on the checkable deposits that households and firms use to make most purchases, then an excess supply of money is a situation where the quantity of those deposits is greater than the demand to hold them. While there are a variety of possible responses to this situation, spending the excess money balances on some good, service, or asset is obvious and natural.
If this additional spending would be a problem, for example because spending on currently produced output is already pressing against productive capacity, then how can the excess supply of money be corrected? There are two obvious solutions. Either the quantity of money needs to decease, which will reduce the quantity to the existing demand. Or else, the interest rate paid on money (on checkable deposits) needs to increase, to raise the demand to hold money to the existing quantity. Of course, combinations of reduced quantity and increased yields would also be possible.
An excess demand for money, on the other hand, is a situation where the amount of money people want to hold exceeds the existing quantity. While there are many possible responses, the most natural response is to reduce expenditures out of current income to rebuild money holdings to the desired level. Selling off other assets would be an alternative approach.
If the reduced flow of spending on output and assets, or additional asset sales, are seen as a problem, presumably because the flow of spending falls below the productive capacity of the economy, there are two obvious solutions. The quantity of money can be increased or else the interest rate paid on money can be decreased. An increase in the quantity of money raises the quantity to the existing demand to hold money. A decrease in the interest rate paid to those holding money reduces their desired money holdings to the existing quantity. And, of course, a combination of both would be possible.
What about changes in the price of the deposits? A dollar price of a dollar balance in a bank deposit is fixed by redeemability. Short of default, a bank must adjust the quantity or interest rate paid on deposits so that there is no excess supply. If a bank is going to allow its customers to deposit receipts and make payments, it is going to need to provide effective two-way convertibility. It will have to correct an excess demand by raising the quantity issued or lowering the interest rate paid.
However, this still allows for the possibility of disequilibrium between the quantity of base money and the demand to hold base money. Base money is issued by the monetary authority (often called the central bank,) and the deposits of private banks must be redeemed with this base money. If a bank is going to participate in the payments system, and allow its customers to deposit checks (or the electronic equivalent,) then the bank effectively accepts deposits of base money by accepting it in exchange for payments drawn on other banks.
Base money takes two forms, zero-nominal-interest hand-to-hand currency and reserve balances at the monetary authority. Abstract away from hand-to-hand currency.
If there is an excess supply of base money, then the quantity of base money is greater than the demand to hold it. If that is considered a problem, then there are two solutions. The quantity of base money could be decreased, or the interest rate paid on base money increased. A decrease in the quantity brings the quantity down to the existing demand to hold it. An increase in the interest rate paid on base money raises the demand to hold base money up to its existing quantity. Combinations of reduced quantity and higher interest rates paid on reserve balances are possible.
If there is an excess demand for base money, then the quantity of base money is less than the demand to hold it. If that is a problem, then there are two solutions. The quantity of base money could be increased or the interest paid on base money could be decreased. The first raises the quantity of money to the existing demand, and the second reduced the demand to hold base money to the existing quantity.
With zero-nominal-interest hand-to-hand currency, adjusting the nominal interest rate paid on the currency is difficult. This requires than any excess supply or demand for this type of base money be corrected by adjustments in the quantity.
The ABC's are a good start. But there is one complication. Attempting to increase the quantity of money buy purchasing assets that have a yields equal to or lower than the interest rate being paid on money may easily be ineffective, with the demand to hold money simply rising in parallel with the quantity of money. The solution is to lower the interest rate paid on money or else purchase assets with yields greater than that paid on money.
For private banks, insisting on a positive margin between the interest earned and paid, this should be natural. The competitive interest rate that banks are willing to pay on checkable deposits should remain below the interest rates banks obtain from earning assets.
If zero-nominal-interest currency is taken to be the "model" of money (rather than deposits,) and the financial assets that the monetary authority buys have positive yields, then there is no problem. Only if the financial assets the monetary authority typically purchases have a zero or negative yield (because they are easier to store than currency) would there be a problem.
But if the monetary authority chooses to subsidize those holding reserve balances by paying an interest rate higher than the financial assets it buys, then increases in the quantity of money might be unable to correct an excess demand for money.
Very useful article. I have some questions.
- For both an excess demand and an excess supply of money it seems that as well as changing the qty of money and/or changing interest rates an appropriate change in the general price level would also lead to a new equilibrium. Are you just assuming sticky prices here as this is an article on banking and the money supply ?
- It looks like the banks in your model are FRBs operating from base money controlled by a central bank. Assuming that is a correct I can see than when banks experience a reduced demand for money they would need to raise interest rates and/or reduce lending in order to avoid an potential outflow but when demand for money increases then if they did nothing they would simply accumulate additional reserves of base money. It would rather be the desire to increase profits that would motivate them to increased lending/reducing interest rates. Is my understanding correct ?
- "For private banks, insisting on a positive margin between the interest earned and paid, this should be natural". Perhaps I am reading too much into this but it sounds like you are saying that in a period of increased demand for money (like now) private banks would have the incentive to do their own profit-motivated "quantitative easing" by using excessive reserves that they choose not to lend out to buy assets that offer a higher yield than the interest rate they are paying out to depositors ? It seems they could keep on doing this until the money supply returns to equilibrium.
I think a commercial bank offers banking services in addition to a balance. Bonds don't offer that, so bonds aren't a perfect substitute even if the market interest rate is 0% on both and would be expected to be so for a period of time.
Changes in the price level should cause the real quantity of money (deposits or hand-to-hand currency) to adjust to the real demand to hold money. I suppose the assumption in this post is that prices (including wages) are sticky.
I really was not assuming that banks receiving deposits of base money necessarily do anything. If a bank receive deposits and holds the matching increase in reserve balances, then it has adjusted the quantity (supply) of it deposits to meet the demand by firms and households. But it has increased its demand to hold base money. The monetary authority needs to either increase the quantity of base money or else lower the interest rate it pays.
As for your last point, I can see that under current conditions banks have little interest in buying additional assets that have higher interest rates. I would focus more on their incentive to quit paying so much for deposits.
I agree that "perfect substitutes" might be too strong.
Did you mean to make this comment on a different post where I was making that claim?
Anyway, the idea is that when interest rates on bonds get very low and banks begin to hold reserves because they have an equal (or higher) yield, then the fact that the reserve balances can be used to settle interbank claims, serve as money, isn't too relevant. On the margin, there is zero valuation of the additional payments services.
For a household or firm, the same would be true. If you keep money in your checking account because it is insured by the FDIC or because bonds have lower yields, then the fact that you will be able to just write checks to get rid of those additional balances rather than sell them isn't too relevant.
Frankly, it seems to me that any additional "liquidity yield" on the money makes the situation worse. If the monetary authority buys bonds with a lower explicit yield that the explicit yield on the money, if there is a higher implicit liquidity yield on the money created, this would raise the demand for money more than if there were no such yield.
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