James M. Buchanan was a leading and founding member of the Virginia School of Political Economy. In my view, his central contribution was to frame public finance as voters choosing to fund government spending programs with taxes. (Buchanan aways explained that this framing came from Wicksell.) This is opposed to the mainstream tradition of determining what taxes are the least harmful way to fund "necessary" government spending. Or to take this to its most grandiose extreme, to determine both the optimal provision of public goods and the least distortionary form of taxation so that "social welfare" is optimized. At least, that was the focus of his Public Finance course at Virginia Tech.
Buchanan's approach led to a focus on what constitutional rules would allow ordinary voters to choose taxes and government spending in the least harmful way. How government debt and money creation could distort those decisions was a key concern. That was certainly what I took away from his Constitutional Economics course at George Mason.
In my view, Buchanan's views on monetary theory harked back to "old Chicago." Simons, Mints, and the like. There is a basic framing of money as hand-to-hand currency issued to fund government spending. And further, that this power of money creation needs to be restricted by some kind of rule. Like most of those in the Virginia School, for years, Buchanan was persuaded by the "new" monetarists, (most centrally, Milton Friedman,) that a rule restricting the quantity of money is the best option.
Just last spring, I was fortunate to participate in a Liberty Fund conference on the monetary constitution. For the most part, the participants were divided between advocates of free banking and a gold standard, and those who favored some kind of monetary constitution to restrain the monetary authority. Buchanan mostly listened, but made a presentation where he strongly advocated a constitutional restriction on money, requiring stabilization of the price level.
My views on current events--things like the debt limit and the platinum coin "gambit"--are very much influenced from what I learned from James M. Buchanan.
Thursday, January 10, 2013
Monday, January 7, 2013
Woodford Endorses NGDPLT (again)
Woodford has again endorsed nominal GDP level targeting. I particularly agree with his point that it is important to define the target in terms of levels and not growth rates and further, that nominal GDP targeting avoids having to determine a controversial estimate for potential output.
Saturday, January 5, 2013
Deposit Money and the Liquidity Effect
If there is an excess supply of checkable deposits, those with excess balances spend them. Those who receive those payments now have excess holdings of deposits, and they spend them. This is called the "hot potato effect."
There is certainly nothing in this process that requires that the expenditures of deposits be solely on nondurable consumer goods and services. The excess money balances might be spend on any number of real or financial assets.
When the prices of these assets rise, this tends to lower yields. They are held because of a flow of income or services, and the value of those services relative to the current price of the assets is smaller.
If the interest rates that banks pay on deposits is assumed to be fixed, then the lower interest rates on other assets reduces the opportunity cost of holding deposits. This will increase the amount of deposits people want to hold. Meanwhile, the interest margin that banks earn from issuing checkable deposits will fall, reducing the quantity of deposits that banks find it profitable to issue. The surplus of deposits disappears.
In the special case where checkable deposits and some kind of uniform "bonds" are the only two goods in existence, then it is possible to imagine that people will be unable to spend deposit balances. If holding money is the only alternative to holding bonds, and holding bonds is the only alternative to holding money, then money will only be spent by those who prefer to hold bonds rather than money.
However, in the real world, where there is a huge variety of real and financial assets, as well as nondurable consumer goods and services, there can be no presumption that those spending deposits want to hold smaller deposit balances or those selling other assets want to hold more money. A person selling a financial asset for deposits will often intend to use the deposits received to purchase some other asset.
Still, if the interest rate on deposits is given, and excess deposit balances are spent on a variety of financial and real assets, all of their yields will be driven down, making deposits relatively more attractive to hold and less attractive to issue. No doubt there would continue to be many purchases and sales of consumer goods and services and a variety of real and financial assets. There would be no presumption that those spending deposits want to hold smaller deposit balances or those selling for deposits want to hold larger balances. Still, there would be no excess supply of checkable deposits and no room for the "HPE."
The problem with this scenario is the assumption that the interest rate paid on checkable deposits remains fixed when the interest rates on earning assets are falling. Given the costs of providing intermediation services, a banking system facing reduced yields will lower the interest rates they pay on deposits. With interest rates on checkable deposits falling in proportion to other interest rates, there is no change in the opportunity cost of holding checkable deposits. With interest rates on checkable deposits falling with other interest rates, in particular, the banks' earning assets, there is no reduction in the interest margin earned by banks and so no reduction in the quantity they choose to issue.
Rather than a surplus of checkable deposits forcing banks to raise the interest rates they pay on checkable deposits enough so that firms and households are willing to hold the existing quantity, to the degree that excess money balances are spent on assets and drive down their yields, the indirect effect is to "compel" banks to instead decrease the yields they pay on checkable deposits.
Superficially, this process exacerbates a surplus of checkable deposits. The surplus leads to lower interest rates, which by impacting the earnings on bank asset portfolios results in lower interest rates on checkable deposits, a lower demand to hold deposits and so an even larger surplus. However, the reality is that because the interest rates banks pay on deposits depend on what they earn, it simply means that there is no tendency for lower interest rates to close off the surplus of checkable deposits.
If there is a surplus of money, then the excess money is spent on a variety of goods and services, including a variety of financial assets. Those receiving the money now have excess balances, and they spend them as well. While the yields on financial assets may be driven down, checkable deposits are themselve a financial asset, and their yields will be driven down as well, because the issuers will only be willing only pay lower interest rates the checkable deposits.
Consider a different scenario. The quantity of checkable deposits is equal to the demand to hold them. The demand for investment falls or the supply of saving rises. This results in a lower natural interest rate. Lower interest rates will reduce the quantity of saving supplied and increase the quantity of investment demanded. Saving and investment return to equality.
As interest rates throughout the economy fall, the opportunity cost of holding deposits at any given deposit interest rate falls, and so the quantity of deposits demanded rises. Meanwhile, the banks' interest margin decreases, and so the amount of money they want to issue falls. The increase in saving or decrease in investment appears to results in a shortage of money.
However, what that ignores is the incentive of banks to change the interest rates they pay on checkable deposits along with other interest rates. By simply reducing the interest rates paid on deposits along with the interest rates that they earn, the banks avoid any shortage of money.
However, from the point of view of the banks, a decrease in interest rates due to an excess supply of checkable deposits appears no different from a decrease in interest rates due to a change in the natural interest rate--more saving or less investment or both.
Now, if people were only willing to accept deposits in payment if they wanted to hold them, and insisted on a higher interest rate to hold a larger quantity, then this would not be a problem at all. A surplus of checkable deposits would directly result in higher interest rates on deposits, while a decrease in other interest rates in the economy would directly result in lower interest rates on checkable deposits.
However, since those wanting to hold deposits do not have to go to a money shop and buy them, and those wishing to sell deposits don't have to find a willing buyer, there is no reason for deposit interest to adjust anything like they would if there were a Walrasian auctioneer adjusting them. Instead, the "hot potato effect" applies to money in the form of checkable deposits.
There is certainly nothing in this process that requires that the expenditures of deposits be solely on nondurable consumer goods and services. The excess money balances might be spend on any number of real or financial assets.
When the prices of these assets rise, this tends to lower yields. They are held because of a flow of income or services, and the value of those services relative to the current price of the assets is smaller.
If the interest rates that banks pay on deposits is assumed to be fixed, then the lower interest rates on other assets reduces the opportunity cost of holding deposits. This will increase the amount of deposits people want to hold. Meanwhile, the interest margin that banks earn from issuing checkable deposits will fall, reducing the quantity of deposits that banks find it profitable to issue. The surplus of deposits disappears.
In the special case where checkable deposits and some kind of uniform "bonds" are the only two goods in existence, then it is possible to imagine that people will be unable to spend deposit balances. If holding money is the only alternative to holding bonds, and holding bonds is the only alternative to holding money, then money will only be spent by those who prefer to hold bonds rather than money.
However, in the real world, where there is a huge variety of real and financial assets, as well as nondurable consumer goods and services, there can be no presumption that those spending deposits want to hold smaller deposit balances or those selling other assets want to hold more money. A person selling a financial asset for deposits will often intend to use the deposits received to purchase some other asset.
Still, if the interest rate on deposits is given, and excess deposit balances are spent on a variety of financial and real assets, all of their yields will be driven down, making deposits relatively more attractive to hold and less attractive to issue. No doubt there would continue to be many purchases and sales of consumer goods and services and a variety of real and financial assets. There would be no presumption that those spending deposits want to hold smaller deposit balances or those selling for deposits want to hold larger balances. Still, there would be no excess supply of checkable deposits and no room for the "HPE."
The problem with this scenario is the assumption that the interest rate paid on checkable deposits remains fixed when the interest rates on earning assets are falling. Given the costs of providing intermediation services, a banking system facing reduced yields will lower the interest rates they pay on deposits. With interest rates on checkable deposits falling in proportion to other interest rates, there is no change in the opportunity cost of holding checkable deposits. With interest rates on checkable deposits falling with other interest rates, in particular, the banks' earning assets, there is no reduction in the interest margin earned by banks and so no reduction in the quantity they choose to issue.
Rather than a surplus of checkable deposits forcing banks to raise the interest rates they pay on checkable deposits enough so that firms and households are willing to hold the existing quantity, to the degree that excess money balances are spent on assets and drive down their yields, the indirect effect is to "compel" banks to instead decrease the yields they pay on checkable deposits.
Superficially, this process exacerbates a surplus of checkable deposits. The surplus leads to lower interest rates, which by impacting the earnings on bank asset portfolios results in lower interest rates on checkable deposits, a lower demand to hold deposits and so an even larger surplus. However, the reality is that because the interest rates banks pay on deposits depend on what they earn, it simply means that there is no tendency for lower interest rates to close off the surplus of checkable deposits.
If there is a surplus of money, then the excess money is spent on a variety of goods and services, including a variety of financial assets. Those receiving the money now have excess balances, and they spend them as well. While the yields on financial assets may be driven down, checkable deposits are themselve a financial asset, and their yields will be driven down as well, because the issuers will only be willing only pay lower interest rates the checkable deposits.
Consider a different scenario. The quantity of checkable deposits is equal to the demand to hold them. The demand for investment falls or the supply of saving rises. This results in a lower natural interest rate. Lower interest rates will reduce the quantity of saving supplied and increase the quantity of investment demanded. Saving and investment return to equality.
As interest rates throughout the economy fall, the opportunity cost of holding deposits at any given deposit interest rate falls, and so the quantity of deposits demanded rises. Meanwhile, the banks' interest margin decreases, and so the amount of money they want to issue falls. The increase in saving or decrease in investment appears to results in a shortage of money.
However, what that ignores is the incentive of banks to change the interest rates they pay on checkable deposits along with other interest rates. By simply reducing the interest rates paid on deposits along with the interest rates that they earn, the banks avoid any shortage of money.
However, from the point of view of the banks, a decrease in interest rates due to an excess supply of checkable deposits appears no different from a decrease in interest rates due to a change in the natural interest rate--more saving or less investment or both.
Now, if people were only willing to accept deposits in payment if they wanted to hold them, and insisted on a higher interest rate to hold a larger quantity, then this would not be a problem at all. A surplus of checkable deposits would directly result in higher interest rates on deposits, while a decrease in other interest rates in the economy would directly result in lower interest rates on checkable deposits.
However, since those wanting to hold deposits do not have to go to a money shop and buy them, and those wishing to sell deposits don't have to find a willing buyer, there is no reason for deposit interest to adjust anything like they would if there were a Walrasian auctioneer adjusting them. Instead, the "hot potato effect" applies to money in the form of checkable deposits.
The Trillion Dollar Platinum Coin Gambit
The U.S. Constitution gives Congress the authority to borrow money. Since WW2, Congress has allowed the Treasury to borrow as it wishes, subject to a total limit on borrowing.
Since the federal government has been running deficits more or less continuously since the late sixties, the limit has been increased periodically.
If the limit was not increased and the national debt reached the limit, then the budget would need to be balanced immediately. The government could only spend the revenue it receives from taxes and fees.
The national debt is made up various bonds, bills, and notes. They are constantly coming due, and the Treasury sells new bonds to pay off the old bonds.
If the debt limit was reached, refinancing the existing debt would still be allowed. When the old bonds are paid off, the national debt decreases below the limit. When the new bonds are sold, the national debt rises back to the limit.
It is only new borrowing to fund current expenditures that would be prohibited. Current expenditure would be limited to current tax revenue. However, there is the matter of interest on the national debt. Bonds and notes typically require regular interest payments. Bills are sold at a discount from face value and when they are paid off at face value, interest must be paid. Interest is a current expense. If the debt limit is reached, interest must be paid out of current receipts--tax revenues and fee income.
The government would default on its debts if it failed to pay off the bonds as they mature and pay the interest when it is due. To avoid default, then, the government would have to reduce all other expenditures to whatever tax revenues (and fee income) remains after paying interest on the national debt.
In my view, the President has the inherent authority to allocate the remaining funds as he sees best. While he has no authority to exceed what has been appropriated by Congress on any line item, it is simply impossible to spend more money than is available.
If the President decides that other current expenditures are more important than paying interest on the national debt, then he has chosen to default. Since default on U.S. debts is contrary to the U.S. Constitution, this would be illegal. In my view, short of a constitutional amendment, the President must treat interest on the national debt as an absolute priority.
If Congress disagrees with the President's priorities, it can reduce the appropriations for those things the President is spending on, leaving more money for other purposes. Of course, Congress could also raise taxes or authorize additional borrowing--increase the debt limit. If Congress were to reduce the appropriation to pay interest on the national debt, then it would be choosing to default. This would be unconstitutional, and the President could and probably should pay the interest anyway.
In the late sixties, President Nixon decided to restrain government spending to reduce projected deficits. The national debt was below the limit. Congress passed a law requiring that the President spend all appropriated money.
This is the law that supposedly means that failure to increase the debt limit leads to default. Supposedly, the President must just spend money as if there were sufficient funds until it runs out. Interest payments due after the money runs out would not be paid. And so, failure to increase the debt limit leads to default.
This is absurd. If taxes and borrowing are not adequate to fund appropriated spending, then the President must limit spending to what is available to be spent, and interest payments must be paid first.
I am the Mayor of a small Town. We have a budget and Council has approved line items for many things. However, our expenditures are limited to the funds we have available. It is normal for expenditures to be timed according to when the funds become available and if the funds are slow to arrive, the expenditures will be postponed. Revenues in the budget are forecasts, and if revenues are less than the forecast, the "postponement" ends up being permanent.
Some expenditures are more important than other expenditures. Paying principal and interest is very high on the list. Further, there are some line items that no one insists be spent. For example, if the "office supplies" line has left over funds, no one will complain.
But then, my Town is not in a position to borrow whenever we want. (There are restrictions imposed by state law.)
For those of us who are fiscally conservative, the ability of the federal government to borrow whenever it wants is a problem! While President Nixon wanted to spend less than Congress wanted (in some areas, anyway,) President Obama wants to spend more. He and his supporters find it convenient to treat the law requiring that all appropriated funds be spent as primary.
But....
There is another source of funds besides borrowing and tax revenues.
The platinum coin gambit is a proposal that the Treasury mint a $1 trillion platinum coin and deposit it at the Fed. The Treasury then writes checks against its Fed deposit, funding the deficit with newly created money (the coin) rather than by borrowing.
Congress gave the Secretary of the Treasury authority to mint platinum coins as he sees fit. The intention was to authorize the Treasury to mint coins that had a legal tender value much lower than their metallic value, and then sell them to investors for more than the metallic value. For example, a $100 coin weighs about an ounce, and the current market value of the metal is about $1,500. The Treasury sells them for a bit more than $1500 and earns a small profit. The $100 legal tender value of the coin is irrelevant--unless there is a very radical drop in the market value of platinum.
There is also a $10 coin that is made of platinum worth about $150. Now, suppose that same coin, with platinum worth $150, was instead denominated as $1000?
The metal value of the coin would be a cost to the Mint, but people would be willing to pay approximately $1,000 for such a coin. Instead of selling the coin for a small amount more than its metallic value, the Treasury would earn $850 per coin it sells.
What would the buyers do with these coins? Most likely, they would deposit them in their banks. And what would their banks do with them? Most likely, they would deposit them at the Fed. And what would the Fed do with them? Most likely, nothing. (If the Fed thought that bank reserves were being driven too high, it would sell off some of its other assets--government bonds or mortgage backed securities. But it might not do anything at all.)
What would the Treasury do with the $1000 it gets for the coin? It would deposit it at the Fed, and spend $850 on goods and services.
However, rather than "sell" the coins for approximately $1,000, the Treasury could simply spend them. For example, when the bonds and bills making up the national debt come due, the Treasury could pay them off with the $1,000 platinum coins. Those receiving the coins would deposit them in their banks. The banks would deposit them in the Fed, and the result is the same.
The $1 Trillion dollar coin just takes this idea to an extreme. Rather than minting many $1,000 coins, a single coin deposited at the Fed has the same affect.
In my view, avoiding congressional limits on borrowing by turning a law authorizing issuing and selling coins with a small legal tender value and high metallic value for a price higher than that metallic value into an issue of coins with a small metallic value but a high legal tender value would be wrong.
However, there is no need to use platinum coins at all. The Treasury could mint dollar coins and use them to pay its bills. Those receiving the dollar coins would deposit them at their banks, which would then deposit them at the Fed. The seigniorage on dollar coins is about 85 cents.
Of course, there is really no reason for the Treasury to spend the coins. It would be simpler to deposit them at the Fed. Today, the Fed asks the Mint for coins to meet the demands of banks. The Mint delivers them and the Fed pays for them by crediting the Treasury's account.
Turn that around. The Treasury delivers the coins to the Fed based on how much it needs to spend and the Fed pays for them by crediting the Treasury's account, which then just spends the money.
Some might argue that this procedure is unconstitutional. The Federal government makes all of its coins legal tender (as well as Federal Reserve notes,) but the Constitution doesn't give Congress the power to make anything legal tender. The several States have that power, but they can only declare gold and silver legal tender.
However, if the coins were made of gold or silver, then there would be no problem. There would be nothing unconstitutional about having a one ounce silver coin denominated as $1,000. There is no requirement that the Mint buy silver for a price of $1,000 an ounce. It could pay the market rate of approximately $38, make coins denominated as $1,000, and either spend them or deposit them at the Fed (or a private commercial bank) and then write all checks it needed.
Of course, that would require Congress to authorize such a silver coin. If instead, Congress insisted that coins of one ounce be denominated $38 or less, then that source of funds would not be available to the Treasury. But if the current cupro-nickel coins that Congress has authorized are constitutional then the Treasury has the power to mint lots of authorized coins and fund all the spending it wants.
(Given this legal source of funds, perhaps the Treasury is required to use this power to fund all legal appropriations!)
In my view, this possibility simply illustrates that the U.S. has an inadequate monetary constitution. The Treasury should not have the ability to create money to spend by minting coins. It should have to get Congressional approval to raise taxes or borrow money.
More importantly, the U.S. Constitution should require that the monetary authority be limited by a sensible nominal anchor, ideally a growth path for spending on output. Requiring that money be "coined" and hinting that it be made of gold or silver, is approximately worthless as a limit on monetary abuse.
And really, the $1 trillion dollar platinum coin shows what a worthless restraint that is.
Friday, January 4, 2013
McTeer's Monetarist Proposal
Former Dallas Fed President Bob McTeer, writing on his Economic Policy blog, proposes that the Fed allow interest rates to rise while keeping monetary policy accommodative. He claims this is "heresy." He explains that the reason for his proposal was discussion by members of the FOMC proposing that quantitative easing be reversed first even while policy interest rates remain near zero.
I agree with his proposal. I think all interest rates should be left free to adjust according to market forces rather than manipulated by the Fed. If a large quantity of base money has the consequence of market forces driving certain interest rates down to zero, then so be it. But if those interest rates rise above zero, despite the quantity of base money, the Fed should not increase (or decrease) base money to keep them at zero.
On the other hand, I believe that a much more important policy change is to target the growth path of nominal GDP. Base money should adjust however much it takes to get nominnal GDP the target level, and interest rates, even short and safe ones, should be free to adjust with the supply and demand for credit.
I suppose that the Fed's "lower the unemployment rate to 6.5% as long as medium term inflation expectations don't rise above 2.5%," might be consistent with a "high" quantity of base money and "high" short term interest rates. I even think a high permanent target for base money, or some broader measure of the quantity of money would be consistent with higher short term interest rates. However, I am more and more convinced that much of the liquidity effect that the Fed uses to manipulate short term rates are intimately tied to termporary shifts if base money--shifts that should have approximately no effects on nominal spending on output.
I agree with his proposal. I think all interest rates should be left free to adjust according to market forces rather than manipulated by the Fed. If a large quantity of base money has the consequence of market forces driving certain interest rates down to zero, then so be it. But if those interest rates rise above zero, despite the quantity of base money, the Fed should not increase (or decrease) base money to keep them at zero.
On the other hand, I believe that a much more important policy change is to target the growth path of nominal GDP. Base money should adjust however much it takes to get nominnal GDP the target level, and interest rates, even short and safe ones, should be free to adjust with the supply and demand for credit.
I suppose that the Fed's "lower the unemployment rate to 6.5% as long as medium term inflation expectations don't rise above 2.5%," might be consistent with a "high" quantity of base money and "high" short term interest rates. I even think a high permanent target for base money, or some broader measure of the quantity of money would be consistent with higher short term interest rates. However, I am more and more convinced that much of the liquidity effect that the Fed uses to manipulate short term rates are intimately tied to termporary shifts if base money--shifts that should have approximately no effects on nominal spending on output.
Kroszner on Fed Communications
Former Fed Board of Governor Randy Kroszner mentions a target for nominal income and a "whatever it takes" approach to communicating policy in a New York Times piece.
The highest priority in the economic revival plan of the newly elected prime minister, Shinzo Abe, is to strong-arm the Bank of Japan into acknowledging that it will do simply “whatever it takes” to reverse deflation there and allow a recovery to take root.
Mark J. Carney, the head of Canada’s central bank and soon to be the governor of the Bank of England, also seems to be embracing the “whatever it takes” theory of communications: tying monetary policy to a single measure of overall economic health (like nominal income) rather than multiple metrics (inflation, inflation expectations, unemployment numbers) that may be even easier to understand.
The Fed might well consider alternative economic indicators as it assesses whether its interventions are reducing uncertainty and promoting recovery. But the key, it seems, is to be forthcoming about its thinking with the American people. For now, the bank’s smart, calibrated open-mouth policy has been a step in the right direction.
Well, only a parenthetical statement by a former governor and the article as a whole is a giant confusion of money and credit, but every little bit helps.
HT Tyler Cowen.
Wednesday, January 2, 2013
The Yields on Deposits and Monetary Disequilbrium
Too many economists focus on solely equilibrium.
It would possible for the yields on checkable deposits to always be at a level where households and firms are willing to hold the existing quantity. It would be possible for the yields on checkable deposits to always be a level where the quantity of deposits that banks choose to issue exactly matches the quantity that households and firms want to hold.
The first is a Marshallian-type equilibrium. The quantity of deposits is determined by the banks, and the yield adjusts each "market day" so that the quantity demanded equals that given quantity. It is like the fisherman bringing in the catch, and then the price on the fish market adjusting until all fish are sold.
The second is a Walrasian-type equilibrium. The Walrasian auctioneer calls out an interest rate on deposit, and each household and firm reports back the quantity of deposits they want to hold. At the same time, each bank reports the amount of deposits it wants to issue. If the two don't match, the Walrasian auctioneer calls out a new deposit interest rate. The natural approach is to call out a higher deposit interest rate if there is a shortage and a lower deposit interest rate if there is a surplus. Once the to match, then the banks issue deposits and the households and firms take them and hold them. The deposit market is in equilibrium.
Nothing like this occurs for checkable deposits.
For the Marshallian fish market, the existing quantity of fish must be sold for money during the market day. The money price of fish adjusts enough so that the amount of fish purchased equals the amount of fish that exist.
Checkable deposits serve as money and so there is no need for those who currently hold them to sell them for money. They can instead simply spend them for assorted goods and services, including other assets. Most importantly, there is no need for those receiving the deposits to want to hold them. They can instead plan to spend them on goods and services, including other financial assets as well.
There is no Walrasian auctioneer. In typical markets, sellers quote prices in terms of money and offer output for sale. Buyers then decide how much they want to buy with money. If the sellers run out of output at the going price, there is a shortage. If buyers don't purchase the entire quantity offered for sale, there is a surplus. The sellers then revise their plans and choose a price and quantity combination.
Again, checkable deposits serve as money and so those who want to hold them do not need to use money to buy them. People sell their products (including resources like labor) for checks or electronic payments, which when deposited increase their deposit balances. They then refrain from spending it. Further, those who were spending the money by writing checks don't necessarily intend to reduce their holdings of checkable deposits. Instead, they might intend to rebuild those balances from their earnings of deposits as they sell their products, including services. Still further, banks issuing new checkable deposits don't need to sell them for money and then use the money to purchase earning assets. Because the checkable deposits are money, they can be directly used to purchase the earning assets.
The banks issuing deposits or those currently holding them who want to hold less do not need to first sell them for money, and so there is no need to offer buyers a higher yield to convince them to accept the deposits. Those wishing to hold more deposits do not need to go to a deposit store and buy them with money. They don't have to offer to accept a lower interest rate to entice someone to give up their deposits.
These considerations explain why deposit interest rates do not immediately change so that the quantity of deposits supplied and demanded match. And further, they show why it is that the "HPE" (hot potato effect) applies to deposits that serve as the media of exchange. Those with excess balances in their checkable deposits spend them. They do not need to offer a higher yield on them to get sellers to accept them. Sellers do not ask buyers what is the current interest rate on the buyers checkable deposit before accepting a check. Nor to they quickly check the yield that they are earning on their checking account before deciding to give up their wares. They accept the payment intending to spend their receipts on other goods and services, including other assets.
The reverse situation is true as well. Those short on money can and do simply refrain from spending the balances. They don't have to "buy" the checkable deposits for money, offering a higher price and lower yield. Those who sell less and so earn less income reduce their expenditures as well. No one shows up to the bank offering to "buy" deposits at a lower interest rate.
The notion that interest rates on deposits will always adjust so that the demand to hold deposits matches the existing quantity is false. The notion that interest rates on deposits will always adjust so that the quantity of deposits supplied will match the quantity of deposits demanded is false. The reason is that checkable deposits serve as the medium of exchange.
It would possible for the yields on checkable deposits to always be at a level where households and firms are willing to hold the existing quantity. It would be possible for the yields on checkable deposits to always be a level where the quantity of deposits that banks choose to issue exactly matches the quantity that households and firms want to hold.
The first is a Marshallian-type equilibrium. The quantity of deposits is determined by the banks, and the yield adjusts each "market day" so that the quantity demanded equals that given quantity. It is like the fisherman bringing in the catch, and then the price on the fish market adjusting until all fish are sold.
The second is a Walrasian-type equilibrium. The Walrasian auctioneer calls out an interest rate on deposit, and each household and firm reports back the quantity of deposits they want to hold. At the same time, each bank reports the amount of deposits it wants to issue. If the two don't match, the Walrasian auctioneer calls out a new deposit interest rate. The natural approach is to call out a higher deposit interest rate if there is a shortage and a lower deposit interest rate if there is a surplus. Once the to match, then the banks issue deposits and the households and firms take them and hold them. The deposit market is in equilibrium.
Nothing like this occurs for checkable deposits.
For the Marshallian fish market, the existing quantity of fish must be sold for money during the market day. The money price of fish adjusts enough so that the amount of fish purchased equals the amount of fish that exist.
Checkable deposits serve as money and so there is no need for those who currently hold them to sell them for money. They can instead simply spend them for assorted goods and services, including other assets. Most importantly, there is no need for those receiving the deposits to want to hold them. They can instead plan to spend them on goods and services, including other financial assets as well.
There is no Walrasian auctioneer. In typical markets, sellers quote prices in terms of money and offer output for sale. Buyers then decide how much they want to buy with money. If the sellers run out of output at the going price, there is a shortage. If buyers don't purchase the entire quantity offered for sale, there is a surplus. The sellers then revise their plans and choose a price and quantity combination.
Again, checkable deposits serve as money and so those who want to hold them do not need to use money to buy them. People sell their products (including resources like labor) for checks or electronic payments, which when deposited increase their deposit balances. They then refrain from spending it. Further, those who were spending the money by writing checks don't necessarily intend to reduce their holdings of checkable deposits. Instead, they might intend to rebuild those balances from their earnings of deposits as they sell their products, including services. Still further, banks issuing new checkable deposits don't need to sell them for money and then use the money to purchase earning assets. Because the checkable deposits are money, they can be directly used to purchase the earning assets.
The banks issuing deposits or those currently holding them who want to hold less do not need to first sell them for money, and so there is no need to offer buyers a higher yield to convince them to accept the deposits. Those wishing to hold more deposits do not need to go to a deposit store and buy them with money. They don't have to offer to accept a lower interest rate to entice someone to give up their deposits.
These considerations explain why deposit interest rates do not immediately change so that the quantity of deposits supplied and demanded match. And further, they show why it is that the "HPE" (hot potato effect) applies to deposits that serve as the media of exchange. Those with excess balances in their checkable deposits spend them. They do not need to offer a higher yield on them to get sellers to accept them. Sellers do not ask buyers what is the current interest rate on the buyers checkable deposit before accepting a check. Nor to they quickly check the yield that they are earning on their checking account before deciding to give up their wares. They accept the payment intending to spend their receipts on other goods and services, including other assets.
The reverse situation is true as well. Those short on money can and do simply refrain from spending the balances. They don't have to "buy" the checkable deposits for money, offering a higher price and lower yield. Those who sell less and so earn less income reduce their expenditures as well. No one shows up to the bank offering to "buy" deposits at a lower interest rate.
The notion that interest rates on deposits will always adjust so that the demand to hold deposits matches the existing quantity is false. The notion that interest rates on deposits will always adjust so that the quantity of deposits supplied will match the quantity of deposits demanded is false. The reason is that checkable deposits serve as the medium of exchange.
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