Money Creation, the Bank of England, and Nick Rowe

The Bank of England's recent explanation of the money creation process has predictably led to another blogosphere debate regarding how this stuff 'really works.' The BoE clearly supports the typical Post-Keynesian view, with Nick Rowe leading the monetarist charge against it.

Attempting to reconcile Nick Rowe's view with the BoE's provides a good opportunity to use some of the central banking vocabulary I discussed a couple months ago. That is, we must be specific about how the operational target, which is under the purview of monetary policy implementation, links up with the intermediate and final targets, which are under the purview of monetary policy strategy. It also provides a good opportunity to review the various ways in which central banks implement monetary policy (AKA the rates vs. quantity debate).

Nick vigorously rejects the idea that the central bank sits idly by, supplying reserves to banks as demanded in order to keep the interbank rate (the operational target) fixed. He insists that if the inflation rate (the final target) departs from the aims of monetary policy strategy, then the central bank will change the interbank rate. If I understand him correctly, he believes that this means the central bank must resist supplying whatever quantity of reserves banks demand:

"No! Have these guys never heard of inflation targeting? The BoE does not sit idly by, happily “supplying” whatever is demanded at a fixed rate of interest. If banks decide to lend more, and this increases spending and pushes inflation up above target, the BoE will raise that rate of interest, precisely because the BoE cannot keep inflation on target if it simply lets reserves be “supplied on demand” at a fixed rate of interest.

They have an ant’s eye-view of the economy. They really need to step back and see the big picture. Any increased demand for reserves that is a result of actions that would lead to inflation rising above target will be met with a refusal to supply *any* additional reserves. The BoE will raise the rate of interest to make the supply curve of reserves perfectly inelastic in that case." (emphasis mine)

He's definitely correct in that there are intermediate/final targets (the inflation rate in this case) that guide the setting of the operational target (the interbank rate). But in concurrence with JKH, I don't think what the BoE has written contradicts this. Furthermore, as I currently understand Nick Rowe, I think he is wrong in believing that the BoE must toggle with the quantity of reserves in order to achieve the interest rate consistent with their inflation target.

As I've been heavily detailing in my monetary policy implementation series, whether we use Bindseil-ian or Woodford-ian models, central banks can achieve their target interest rate through any combination of quantities and rates. EDIT: Also, we should all speak more precisely: there is no "one quantity of reserves" that banks demand. There is a demand curve that has some elasticity to it, and the elasticity depends in large part on banks' uncertainty that they will end the reserve maintenance period short or long reserves.

To illustrate how the central bank can address Nick Rowe's concerns, I left the following response on JKH's post. Most of the individual pieces of my reply have been beaten like a dead horse on the blogosphere, although I'm not sure I've seen the operational and strategic elements of monetary policy tied together in a dynamic fashion.

"Nick, I’m going to expound upon your broader view of what the CB does, which is correct, but argue that you’re still focusing too singularly on quantity of reserves. To simplify matters, I’m going to assume the central bank targets a fixed price level, rather than growth rate in prices.

Suppose to attain the price level the CB desires, they decide the target rate needs to be 1.5%. This will lead to a level of bank lending activity consistent with their price level target. Once in equilibrium, the CB maintains the target rate by setting the floor rate (IOR) at 1% and the ceiling rate is 2%. Let’s say the reserve demand curve flattens out to 2% at 100 reserves and flattens to 1% at 200 reserves. Assume that setting reserves at 150 achieves the 1.5% interest rate. Let’s say this also corresponds to a level of deposits and loans around ~1500, where the reserve requirement ratio is 10% (thus 150 reserves).

Now say all the sudden the price level increases beyond the central bank’s target. Say the central bank thinks that if deposits/loans were brought down to 1000, then they would achieve their price level target again. Assume they think that if the interest rate is at 2%, then loans/deposits will decline from 1500 to 1000. So how can the CB achieve this?

In the short-run, assume that reserve demand won’t change very much because it takes a while for the economy to respond to the new interest rate of 2% (meaning loans/deposits stays around 1500, so demand for reserves stays around 150). In this case, the CB can simply change the floor and ceiling to 1.5% and 2.5% respectively, to hit its target of 2%. Of course, since this doesn’t impact demand for loans in the short run, it might not have much of an impact on inflation.

But say in the medium to long-run, the higher rate of 2% finally starts to dampen lending. Say loans/deposits declines to 1000, such that reserve demand centers around 100. Since there are 150 reserves in circulation, that means there will be an increasing number of excess reserves that will send rates towards the current floor of 1.5%. That’s a problem though, because the CB needs to maintain the 2% rate to maintain equilibrium. So how can it do this?

It has several choices. It can leave sufficient excess reserves in the system and set the floor rate to 2%. In this case, it can achieve its rate of 2% without changing the quantity of reserves. Alternatively, it can keep the corridor at 1.5%-2.5% but soak up some reserves to keep the rate at 2% (maybe the new corridor flattens at 50 and 150 reserves, so soaking up 50 reserves to leave 100 reserves in the system hits the rate of 2%). Another alternative is to increase the reserve requirement ratio from 10% to 15%: assuming the same probability density function of banks ending the reserve maintenance period short or long, then the CB can leave the corridor at 1.5%-2.5% AND leave the quantity of reserves the same to achieve an interest rate of 2%. The idea is that 15% of 1000 is 150, and that is the quantity of reserves the banking system already has."
Note, for sake of argument, I'm simply going along with the assumption that the central bank can effectively tame inflation by raising rates.

Anyways, the takeaways are:

A) Yes – the central bank sets rates based on their price target. I'm in agreement with Nick here.

B) No – the central bank does not necessarily have to change the quantity of reserves to keep the price level where it wants it. I disagree with Nick here. It could change the quantity of reserves, but it could instead only change rates. Or it could only change reserve requirements without changing rates or quantities. Or it could change some combination of both rates and quantities (see here). There are lots of possibilities!

The more fundamental point is that if inflation is connected to the quantity of bank lending, then we need to consider what bank lending is a function of. Bank lending is a function of what JKH said in his post: “mostly of capital and pricing of risk.” The central bank ultimately affects this by changing the interest rate, and changing the interest rate may or may not involve changing the quantity of reserves.


  1. ATR: OK, the central bank can shift the demand function for base money, by changing the rate of interest on reserves, or by changing the rate of interest on overdrafts (floor and ceiling rates). Fair point. But this is not the main point of the argument with those who call themselves "endogenous money" people.

    The idea that the stock of base money is determined by, and responds passively to, changes in demand for base money is just false. The rate(s) of interest set by central bank for 6.5 week periods are not exogenous with respect to changes in the demand for base money. They cannot be exogenous, if the central bank wants to hit any sort of price level target, or any other vaguely reasonable target.

    Monetary policy is not "just one damn interest rate after another". http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/04/monetary-policy-is-just-one-damn-interest-rate-after-another.html

    You get those points. The "endogenous money" people don't.

    If I wanted to get into a good argument with you, I would make a stronger claim. The Law of Reflux is wrong. It is possible for creators of money to create an excess supply of money. Money is not like other assets, simply because it is the medium of exchange. This is Yeager's point against Tobin. The stock of money is supply-determined in a way that the stock of bonds is not. This is a hard point to explain. This is perhaps my clearest post on the topic: http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/01/two-extreme-fiscalmonetary-worlds.html

  2. Or maybe this post makes my point more clearly: http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/02/what-is-an-excess-demand-for-money.html

  3. Thanks so much for the replies and for considering my argument! Maybe you're right this misses their point. I'm not sure - I'd need them to respond to really know. It seems like it's a nice middle ground for everyone to stop and take breath at, though. Also - JKH has already said he agrees that the interest rate is endogenous to the price target. I'm pretty sure any endogenous money person worth their salt would agree with this.

    (By the way, for completeness, I think the CB can also shift the demand function for reserves by changing reserve requirements.)

    I'll check your links as well.

    Lastly, I'll just repost this comment I left on your blog for others:

    "... I did just realize that I could use this same argument against 'the CB must supply reserves at will to maintain the target' people as well: the central bank could instead change their corridor rates or reserve requirements to maintain the target, without defensively supplying more or less reserves. They might argue they already know this, but then they should be more careful when they make their arguments."

    1. ATR: Thanks. Agreed on the reserve requirements (just for completeness). And agreed that your same argument could be used equally against the BoE and others. (I hadn't seen that!)

      I think that when most of us are arguing about this, we talk about the central bank setting *the* rate of interest, and don't make the distinction between those three rates of interest. Implicitly we are holding those two spreads constant when we argue about supply and demand, because (at least in normal times) the Bank of Canada (and others?) always does hold those two spreads constant (at 25 basis points each side of the overnight rate target), so we tend to ignore it.

      JKH is very good, especially on the actual details of central bank/commercial bank interface. But he gets fuzzier on the distinction between supply, quantity supplied, and actual quantity sold. (Ditto for the demand side.) So sometimes stuff gets lost in translation. And sometimes he needs to "zoom out" more, to see the bigger picture. But I reckon he gets it. Dunno about some of them others!

      I would very much appreciate your thoughts on my two posts. I'm pretty sure I'm onto something here. It's the same point Leland Yeager has made, and David Laidler has made, in the past (or closely related to their points). But I find it very hard to make that point clearly.

      Take one example (this is Laidler's argument): suppose, just suppose, that the money demand function were perfectly interest-inelastic. (I know it isn't, but just suppose.) And consolidate the central and commercial banks into one big central bank, just to make it simpler and easier for me. That would seem to imply that the central bank would be unable to increase the stock of money by cutting the rate of interest at which it makes loans. Because, by assumption, that cut in the rate of interest would not increase the quantity of money demanded. But (as long as the demand for *loans* is not perfectly interest-inelastic), the quantity of loans demanded would increase if the central bank cut the rate of interest, and so the stock of money would expand, and start a hot potato process in which Y and/or P would eventually increase. In fact, with the demand for money being perfectly interest-inelastic (by assumption) the standard LM curve would be vertical, and the central bank would be more powerful than normal.

      What this implies is that the quantity of money is (in some sense) determined by the central bank's supply function, and the demand for *loans*, and not by the demand for *money*. So, in some sort of strange sense, the stock of money is purely supply (of money) determined, and not demand (for money) determined. The central bank can "force" people to hold more money than they wish to hold.

      Because people will *borrow* extra money from the central bank even if they do not wish to *hold* extra money. Because money is, after all, the medium of exchange.

    2. Hi Nick -

      Actually, it is one of my main goals to understand as best I can what you and your intellectual opponents argue on these very issues. I actually started this mission by getting as micro and operational as I could - thus the significant amount of time I've spent learning the logic, math, and models behind Bindseil, Woodford, etc. on these monetary policy operational issues. I figured that if I'm going to truly understand the potency of monetary policy, I should understand how it functions at the most basic level first. I had previously read a lot of that stuff in the Post-Keynesian sphere of the blogosphere on monetary policy operations, and it was pretty good, but I wasn't entirely satisfied with the rigor. I could spend years more on it, but at this point I think it makes sense to take a break and shift to the more macro-strategic aspect of monetary (and fiscal) policy. What I'm doing first is re-reading a 1st year mainstream macro textbook cover to cover - as you recommended. I'd also like to use more advanced textbooks, and consider serious works of literature from the heterodox side as well.

      Point being, I don't think I'm worth much of a response right now. You're going to have to give me a lot of time, but I hope to get to it :).

  4. "Anyways, the takeaways are: A) B)"

    Yes, I agree with this. Good to see that Nick agrees with it too, makes me feel safer. You may remember that I tried to mediate the debate here. But as Nick points out, there seems to be something else to the debate that stokes people's passions than the points we are making. That's why there's 150+ comments on Nick's post.

    1. Good to know you agree as well (and JKH, for the vast, vast majority of this). I'm particularly happy Nick is in agreement as well. I had to pull out the Woodford weapon, but it worked, haha!

      But yeah, there is something else. I'll let JKH and Nick try to crystallize exactly what that is. I won't hold my breath though - this debate shows up in one form or another every couple months, and has been doing so for many years. I honestly do think some progress has been made, though.

      This is how I view it currently, at risk of re-hashing some of the very basics:

      The 'endogenous money' side might perceive Nick et al. as believing the following in a somewhat literal sense: the way that the central bank restricts lending is by refusing to give banks reserves, because banks need those reserves in a tangible sense to hand-out loans. Quite literally - without those reserves, banks are telling customers they simply just don't have the money to lend, because the Fed isn't giving it to them.

      Now, I believe Nick et al. (or at least Nick) has acknowledged that caricature is not accurate. Yet he insists there is some value to viewing it that way (and from here I think all the passions start flying). In any case, I think he insists because he thinks monetary policy ultimately determines how much banks lend (from the zoomed out, long-run viewpoint). Where I come in is to say - "Okay - pause ! Let's assume for the moment that monetary policy somehow does ultimately determine how much banks lend (let's just assume, and not argue that, for now). The typical mainstream view is that the central bank steers the economy to where it wants it by causing changes in interest rates that are relevant to inflation and output. So maybe the central bank does determine the 'lending fate' of banks in a long-run sense. But there is no need to insist this is fundamentally done via restriction/expansion of quantity of reserves versus administered rates versus reserve requirements. It can be operationally done via a combination of these features (what you and me are saying)." (And then JKH makes the technical correct regarding capital considerations.)

      Now, I feel like Nick still thinks if you zoom out enough, it's really manipulating the quantity of money that's at the heart of it all. And the Post-Keynesian people might concede that the nuts and bolts operational stuff actually can involve quantity, but would probably still insist that if *conventional* monetary policy causes changes in output/inflation at all, it's fundamentally due to changes in one of the key funding rates of the economy (irrespective if the nuts and bolts stuff involved rates, quantities, reserve requirements, etc.). In slightly other contexts, I believe Nick has noted that this is the standard New Keynesian view as well (except that many heterodox economists are probably much more skeptical of the power of monetary policy).

      But I don't want to put words in peoples' mouths.

    2. BTW - I also think that sometimes people get attached to defending 'their team,' and 'rates' and 'quantity' are nice teams to join. I'm frequently guilty of this - most of us are, I'd like to think.

    3. I like you summary, and there's certainly something to the 'team' aspect. See Scott Sumner, for instance:

      "I suppose it’s a fine explanation of monetary policy if you go for the interest rate approach to monetary economics, it’s just that I hate that approach."

      Do you follow the Sumner side of the debate at all?

      One thing that makes these conversations difficult to follow is that the structure of the "imaginary" central bank they are debating isn't specified at the outset. Are they debating monetary policy with the assumption of a pre-2008 Fed, with no interest on reserves? Is it a central bank running a channel, like the Bank of Canada? Most of Nick's and Sumner's posts are implicitly about the latter, but that sort of structure is getting rarer. If this detail was ironed out at the beginning of each blog post we might have less conflict.

    4. I agree it would help.

      No - I didn't even know he was involved. I supposed I should have, though. I'll check it out.

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