An approach to teaching monetary policy since deregulation

Economic Papers (Economic Society of Australia), Dec, 2008 by Trevor Coombes

1 Introduction

There has been a monumental change to Australia's macroeconomic landscape since the full institution of deregulation. Deregulation has ushered in a competitive banking system and, as a consequence, it has also ushered in full endogenisation of the money supply. Despite this change, and the subsequent challenge to standard monetary theory, it remains the case that a simple model of competitive banking woven into the nature of endogenous money processes cannot be found in macroeconomic texts.

Money endogeniety also challenges the standard description of monetary policy, because monetary policy can no longer be depicted in the Keynesian interest rate model as shifts in an exogenously-determined (vertical) money supply function. One can attempt to preserve the Keynesian interest rate model by endogenising the money supply function. This can be done by using the concept of excess reserves to derive a positive relationship between bond yields and the supply of (bank) money, so that any newly credit-created money is financed out of excess reserves. This approach is not without problems, however. Since the year 2000, when legal requirements were abolished in Australia, competitive banks no longer carry excess reserves, so that conceiving of an upward-sloping money supply function in the Keynesian money/yield space is misplaced. The Reserve Bank of Australia (RBA) has rejected the practice of implementing monetary policy by changing the quantity of bank reserves, but in this situation how does one interpret states of equilibrium where the demand for, and supply of, money intersect? Equilibrium implies zero excess reserves, yet the derivation of an upward-sloping money supply function requires the (endogenous or exogenous) preexistence of excess reserves. And though money demand relates to bond yields, the supply of bank money does not: it relates to bank interest rates.

Competitive banking makes money creation endogenous, but endogenous to what? The standard deposit multiplier, once in process, makes it clear that credit creates deposits, which can form the basis of an endogenous money story. However, this endogenous story not only reduces banks to mechanical (non-competitive) entities, it also reflects the post-Keynesian view that the demand for money is irrelevant to the money supply process, in that credit alone creates deposits. (1) It appears, therefore, that the Keynesian interest rate framework should be abandoned. (2)

The unquestioning acceptance of this post-Keynesian irrelevancy view, in which money demand is endogenous to credit, which much of academia has unwittingly done, means that the public does not exercise any preference over the amount of money held in wealth portfolios. This proposition is untenable, because it is credit that is endogenous to money demand: the public does determine the amount of money it wants to hold in wealth portfolios, so that the demand for money (and not the demand for credit) determines, and thus limits, the supply of bank money. Inspired by free bankers (Glasner, Dowd, Selgin), I shall develop this view more fully here by presenting a simple model of competitive banking, where the profit motive of banks is woven into--indeed is integral to--the money supply process. This will pave the way to depict monetary policy as shifts in the money demand function and to making sense of a vertical money supply function in a deregulated banking environment.

2 Competitive Banking and the Endogenous Money Process

A distinction needs to be drawn between the capacity of competitive banks to create money and the profitability of doing so (Glasner, 1989). Banks create deposits (bank money) as they satisfy the demand for credit, but the public's demand to hold credit-created deposits determines the profitability of advancing loans.

When a bank advances a loan to its customer, the lending-bank observes an increase in both loans and deposits. The bank has created money: one IOU, a loan that is not money is swapped for another IOU, deposits, which is money. The lending-bank's customer then spends his deposit by writing a cheque on the bank, occasioning a fall in bank deposits. If the recipient of the cheque does not want to hold the lending-bank's money the cheque will be deposited with a rival bank. When the rival bank presents the cheque to the clearinghouse the interbank claim is netted out and the lending-bank accumulates an adverse (debit) balance that is posted to its exchange settlement account (ESA) held with the RBA. Since competitive banks do not hold excess reserves, the lending-bank must sacrifice an interest-earning asset (a security). The net increase in profit is zero, because the (risk-adjusted) returns on securities and loans offset each other.

If the public does not want to hold the lending-bank's money, then the bank's effort to increase loans, by reducing loan standards and/or the interest rate it charges on loans below prevailing market rates that rival banks charge on their loans leads to an accumulation of adverse balances at the clearinghouse and the continual liquidation of other interest-earning assets. (3) Reducing loan standards and the interest rate on loans ([r.sub.L]) gives the public no incentive to hold the lending-bank's money (Glasner, 1989). The easiest and most transparent way to provide such an incentive is to pay a competitive rate of interest on deposits ([r.sub.D]). There is an incentive for banks to keep their operating costs (wages and administration costs) to a minimum, because this enables them to offer their best rate of interest paid on deposits. If the marginal operating cost of maintaining deposits is zero, and reserves are held to zero, then equilibrium rates for a bank would be [r.sub.L] = [r.sub.D].