# Saturday Quiz – July 31, 2010 – answers and discussion

Here are the answers with discussion for yesterday’s quiz. The information provided should help you work out why you missed a question or three! If you haven’t already done the Quiz from yesterday then have a go at it before you read the answers. I hope this helps you develop an understanding of modern monetary theory (MMT) and its application to macroeconomic thinking. Comments as usual welcome, especially if I have made an error.

Question 1:

The policy direction of some EMU nations to resolve their so-called fiscal crisis is to reduce wages and prices in order to restore competitiveness. While harsh this will ultimately improve the competitive position of Greece, Portugal, Ireland and other nations currently in external deficit by increasing aggregate demand via net exports.

The temptation is to accept the rhetoric after understanding the constraints that the EMU places on member countries and conclude that the only way that competitiveness can be restored is to cut wages and prices. That is what the dominant theme emerging from the public debate is telling us.

However, deflating an economy under these circumstance is only part of the story and does not guarantee that a nations competitiveness will be increased.

We have to differentiate several concepts: (a) the nominal exchange rate; (b) domestic price levels; (c) unit labour costs; and (d) the real or effective exchange rate.

It is the last of these concepts that determines the “competitiveness” of a nation. This Bank of Japan explanation of the real effective exchange rate is informative. Their English-language services are becoming better by the year.

Nominal exchange rate (e)
The nominal exchange rate (e) is the number of units of one currency that can be purchased with one unit of another currency. There are two ways in which we can quote a bi-lateral exchange rate. Consider the relationship between the \$A and the \$US.

• The amount of Australian currency that is necessary to purchase one unit of the US currency (\$US1) can be expressed. In this case, the \$US is the (one unit) reference currency and the other currency is expressed in terms of how much of it is required to buy one unit of the reference currency. So \$A1.60 = \$US1 means that it takes \$1.60 Australian to buy one \$US.
• Alternatively, e can be defined as the amount of US dollars that one unit of Australian currency will buy (\$A1). In this case, the \$A is the reference currency. So, in the example above, this is written as \$US0.625= \$A1. Thus if it takes \$1.60 Australian to buy one \$US, then 62.5 cents US buys one \$A. (i) is just the inverse of (ii), and vice-versa.

So to understand exchange rate quotations you must know which is the reference currency. In the remaining I use the first convention so e is the amount of \$A which is required to buy one unit of the foreign currency.

International competitiveness

Are Australian goods and services becoming more or less competitive with respect to goods and services produced overseas? To answer the question we need to know about:

• movements in the exchange rate, ee; and
• relative inflation rates (domestic and foreign).

Clearly within the EMU, the nominal exchange rate is fixed between nations so the changes in competitiveness all come down to the second source and here foreign means other nations within the EMU as well as nations beyond the EMU.

There are also non-price dimensions to competitiveness, including quality and reliability of supply, which are assumed to be constant.

We can define the ratio of domestic prices (P) to the rest of the world (Pw) as Pw/P.

For a nation running a flexible exchange rate, and domestic prices of goods, say in the USA and Australia remaining unchanged, a depreciation in Australia’s exchange means that our goods have become relatively cheaper than US goods. So our imports should fall and exports rise. An exchange rate appreciation has the opposite effect.

But this option is not available to an EMU nation so the only way goods in say Greece can become cheaper relative to goods in say, Germany is for the relative price ratio (Pw/P) to change:

• If Pw is rising faster than P, then Greek goods are becoming relatively cheaper within the EMU; and
• If Pw is rising slower than P, then Greek goods are becoming relatively more expensive within the EMU.

The inverse of the relative price ratio, namely (P/Pw) measures the ratio of export prices to import prices and is known as the terms of trade.

The real exchange rate

Movements in the nominal exchange rate and the relative price level (Pw/P) need to be combined to tell us about movements in relative competitiveness. The real exchange rate captures the overall impact of these variables and is used to measure our competitiveness in international trade.

The real exchange rate (R) is defined as:

R = (e.Pw/P) (2)

where P is the domestic price level specified in \$A, and Pw is the foreign price level specified in foreign currency units, say \$US.

The real exchange rate is the ratio of prices of goods abroad measured in \$A (ePw) to the \$A prices of goods at home (P). So the real exchange rate, R adjusts the nominal exchange rate, e for the relative price levels.

For example, assume P = \$A10 and Pw = \$US8, and e = 1.60. In this case R = (8×1.6)/10 = 1.28. The \$US8 translates into \$A12.80 and the US produced goods are more expensive than those in Australia by a ratio of 1.28, ie 28%.

A rise in the real exchange rate can occur if:

• the nominal e depreciates; and/or
• Pw rises more than P, other things equal.

A rise in the real exchange rate should increase our exports and reduce our imports.

A fall in the real exchange rate can occur if:

• the nominal e appreciates; and/or
• Pw rises less than P, other things equal.

A fall in the real exchange rate should reduce our exports and increase our imports.

In the case of the EMU nation we have to consider what factors will drive Pw/P up and increase the competitive of a particular nation.

If prices are set on unit labour costs, then the way to decrease the price level relative to the rest of the world is to reduce unit labour costs faster than everywhere else.

Unit labour costs are defined as cost per unit of output and are thus ratios of wage (and other costs) to output. If labour costs are dominant (we can ignore other costs for the moment) so total labour costs are the wage rate times total employment = w.L. Real output is Y.

So unit labour costs (ULC) = w.L/Y.

L/Y is the inverse of labour productivity(LP) so ULCs can be expressed as the w/(Y/L) = w/LP.

So if the rate of growth in wages is faster than labour productivity growth then ULCs rise and vice-versa. So one way of cutting ULCs is to cut wage levels which is what the austerity programs in the EMU nations (Ireland, Greece, Portugal etc) are attempting to do.

But LP is not constant. If morale falls, sabotage rises, absenteeism rises and overall investment falls in reaction to the extended period of recession and wage cuts then productivity is likely to fall as well. Thus there is no guarantee that ULCs will fall by any significant amount.

Question 2:

At present, bank lending is capital-constrained rather than reserve constrained. If the central bank forced banks to maintain a reserve ratio of 100 per cent then lending would also be reserve constrained.

In a “fractional reserve” banking system of the type the US runs (which is really one of the relics that remains from the gold standard/convertible currency era that ended in 1971), the banks have to retain a certain percentage (10 per cent currently in the US) of deposits as reserves with the central bank. You can read about the fractional reserve system from the Federal Point page maintained by the FRNY.

Where confusion as to the role of reserve requirements begins is when you open a mainstream economics textbooks and “learn” that the fractional reserve requirements provide the capacity through which the private banks can create money. The whole myth about the money multiplier is embedded in this erroneous conceptualisation of banking operations.

The FRNY educational material also perpetuates this myth. They say:

If the reserve requirement is 10%, for example, a bank that receives a \$100 deposit may lend out \$90 of that deposit. If the borrower then writes a check to someone who deposits the \$90, the bank receiving that deposit can lend out \$81. As the process continues, the banking system can expand the initial deposit of \$100 into a maximum of \$1,000 of money (\$100+\$90+81+\$72.90+…=\$1,000). In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial \$100 deposit into a maximum of \$500 (\$100+\$80+\$64+\$51.20+…=\$500). Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity.

This is not an accurate description of the way the banking system actually operates and the FRNY (for example) clearly knows their representation is stylised and inaccurate. Later in the same document they they qualify their depiction to the point of rendering the last paragraph irrelevant. After some minor technical points about which deposits count to the requirements, they say this:

Furthermore, the Federal Reserve operates in a way that permits banks to acquire the reserves they need to meet their requirements from the money market, so long as they are willing to pay the prevailing price (the federal funds rate) for borrowed reserves. Consequently, reserve requirements currently play a relatively limited role in money creation in the United States.

In other words, the required reserves play no role in the credit creation process.

The actual operations of the monetary system are described in this way. Banks seek to attract credit-worthy customers to which they can loan funds to and thereby make profit. What constitutes credit-worthiness varies over the business cycle and so lending standards become more lax at boom times as banks chase market share (this is one of Minsky’s drivers).

These loans are made independent of the banks’ reserve positions. Depending on the way the central bank accounts for commercial bank reserves, the latter will then seek funds to ensure they have the required reserves in the relevant accounting period. They can borrow from each other in the interbank market but if the system overall is short of reserves these “horizontal” transactions will not add the required reserves. In these cases, the bank will sell bonds back to the central bank or borrow outright through the device called the “discount window”.

At the individual bank level, certainly the “price of reserves” will play some role in the credit department’s decision to loan funds. But the reserve position per se will not matter. So as long as the margin between the return on the loan and the rate they would have to borrow from the central bank through the discount window is sufficient, the bank will lend.

So the idea that reserve balances are required initially to “finance” bank balance sheet expansion via rising excess reserves is inapplicable. A bank’s ability to expand its balance sheet is not constrained by the quantity of reserves it holds or any fractional reserve requirements. The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank.

The major insight is that any balance sheet expansion which leaves a bank short of the required reserves may affect the return it can expect on the loan as a consequence of the “penalty” rate the central bank might exact through the discount window. But it will never impede the bank’s capacity to effect the loan in the first place.

The money multiplier myth leads students to think that as the central bank can control the monetary base then it can control the money supply. Further, given that inflation is allegedly the result of the money supply growing too fast then the blame is sheeted home to the “government” (the central bank in this case).

The reality is that the reserve requirements that might be in place at any point in time do not provide the central bank with a capacity to control the money supply.

So would it matter if reserve requirements were 100 per cent? In this blog – 100-percent reserve banking and state banks – I discuss the concept of a 100 per cent reserve system which is favoured by many conservatives who believe that the fractional reserve credit creation process is inevitably inflationary.

There are clearly an array of configurations of a 100 per cent reserve system in terms of what might count as reserves. For example, the system might require the reserves to be kept as gold. In the old “Giro” or “100 percent reserve” banking system which operated by people depositing “specie” (gold or silver) which then gave them access to bank notes issued up to the value of the assets deposited. Bank notes were then issued in a fixed rate against the specie and so the money supply could not increase without new specie being discovered.

Another option might be that all reserves should be in the form of government bonds, which would be virtually identical (in the sense of “fiat creations”) to the present system of central bank reserves.

While all these issues are interesting to explore in their own right, the question does not relate to these system requirements of this type. It was obvious that the question maintained a role for central bank (which would be unnecessary in a 100-per cent reserve system based on gold, for example.

It is also assumed that the reserves are of the form of current current central bank reserves with the only change being they should equal 100 per cent of deposits.

We also avoid complications like what deposits have to be backed by reserves and assume all deposits have to so backed.

In the current system, the the central bank ensures there are enough reserves to meet the needs generated by commercial bank deposit growth (that is, lending). As noted above, the required reserve ratio has no direct influence on credit growth. So it wouldn’t matter if the required reserves were 10 per cent, 0 per cent or 100 per cent.

In a fiat currency system, commercial banks require no reserves to expand credit. Even if the required reserves were 100 per cent, then with no other change in institutional structure or regulations, the central bank would still have to supply the reserves in line with deposit growth.

Now I noted that the central bank might be able to influence the behaviour of banks by imposing a penalty on the provision of reserves. It certainly can do that. As a monopolist, the central bank can set the price and supply whatever volume is required to the commercial banks.

But the price it sets will have implications for its ability to maintain the current policy interest rate which we consider in Question 3.
The central bank maintains its policy rate via open market operations. What really happens when an open market purchase (for example) is made is that the central bank adds reserves to the banking system. This will drive the interest rate down if the new reserve position is above the minimum desired by the banks. If the central bank wants to maintain control of the interest rate then it has to eliminate any efforts by the commercial banks in the overnight interbank market to eliminate excess reserves.

One way it can do this is by selling bonds back to the banks. The same would work in reverse if it was to try to contract the money supply (a la money multiplier logic) by selling government bonds.

The point is that the central bank cannot control the money supply in this way (or any other way) except to price the reserves at a level that might temper bank lending.

So if it set a price of reserves above the current policy rate (as a penalty) then the policy rate would lose traction for reasons explained in the answer to Question 3.

The fact is that it is endogenous changes in the money supply (driven by bank credit creation) that lead to changes in the monetary base (as the central bank adds or subtracts reserves to ensure the “price” of reserves is maintained at its policy-desired level). Exactly the opposite to that depicted in the mainstream money multiplier model.

The other fact is that the money supply is endogenously generated by the horizontal credit (leveraging) activities conducted by banks, firms, investors etc – the central bank is not involved at this level of activity.

You might like to read these blogs for further information:

Question 3:

A central bank can reduce bank lending while maintaining its target monetary policy rate by increasing the rate that provides reserves to the commercial banks.

This question is related to Question 2 and the answers are complementary.

The facts are as follows. First, central banks will always provided enough reserve balances to the commercial banks at a price it sets using a combination of overdraft/discounting facilities and open market operations.

Second, if the central bank didn’t provide the reserves necessary to match the growth in deposits in the commercial banking system then the payments system would grind to a halt and there would be significant hikes in the interbank rate of interest and a wedge between it and the policy (target) rate – meaning the central bank’s policy stance becomes compromised.

Third, Any reserve requirements within this context while legally enforceable (via fines etc) do not constrain the commercial bank credit creation capacity. Central bank reserves (the accounts the commercial banks keep with the central bank) are not used to make loans. They only function to facilitate the payments system (apart from satisfying any reserve requirements).

Fourth, banks make loans to credit-worthy borrowers and these loans create deposits. If the commercial bank in question is unable to get the reserves necessary to meet the requirements from other sources (other banks) then the central bank has to provide them. But the process of gaining the necessary reserves is a separate and subsequent bank operation to the deposit creation (via the loan).

Fifth, if there were too many reserves in the system (relative to the banks’ desired levels to facilitate the payments system and the required reserves then competition in the interbank (overnight) market would drive the interest rate down. This competition would be driven by banks holding surplus reserves (to their requirements) trying to lend them overnight. The opposite would happen if there were too few reserves supplied by the central bank. Then the chase for overnight funds would drive rates up.

In both cases the central bank would lose control of its current policy rate as the divergence between it and the interbank rate widened. This divergence can snake between the rate that the central bank pays on excess reserves (this rate varies between countries and overtime but before the crisis was zero in Japan and the US) and the penalty rate that the central bank seeks for providing the commercial banks access to the overdraft/discount facility.

So the aim of the central bank is to issue just as many reserves that are required for the law and the banks’ own desires.

Now the question seeks to link the penalty rate that the central bank charges for providing reserves to the banks and the central bank’s target rate. The wider the spread between these rates the more difficult does it become for the central bank to ensure the quantity of reserves is appropriate for maintaining its target (policy) rate.

Where this spread is narrow, central banks “hit” their target rate each day more precisely than when the spread is wider.

So if the central bank really wanted to put the screws on commercial bank lending via increasing the penalty rate, it would have to be prepared to lift its target rate in close correspondence. In other words, its monetary policy stance becomes beholden to the discount window settings.

The best answer was false because the central bank cannot operate with wide divergences between the penalty rate and the target rate and it is likely that the former would have to rise significantly to choke private bank credit creation.

You might like to read this blog for further information:

Question 4:

A national government that issues its own currency is not revenue-constrained. However, inflation may render it impossible for the government to use budgetary policy to meet the nominal demands for pensions and health care by an increasing proportion of the population.

The question explores the real constraints on the provision of pensions and health care rather than the false financial constraints that the mainstream choose to make as the centrepiece of the intergenerational debate. So there is resonance in this question with Question 2 and the answers complement each other.

Governments in most advanced nations are facing a major medium- to longer-term challenge with respect the demographic change. A rising proportion of their populations will require retirement pension assistance of some kind and it is likely (but not inevitable) that health care outlays will also rise in line with the ageing population.

There is no doubt that dependency ratios are rising. The usual construction of the dependency ratio is as 100*(population 0-15 years) + (population over 65 years) all divided by the (population between 15-64 years). This clearly rises when the birth rate falls and the population remains alive for longer. In the blog – Another intergenerational report – another waste of time – I consider why this definition is inadequate.

The key point is that we are really wanting to focus on the changes in active workers relative to inactive persons (measured by not producing national income) over time, which the definition above clearly fails to do. So the effective dependency ratio recognises that not everyone of working age (15-64 or whatever) are actually producing. There are many people in this age group who are also “dependent”. For example, full-time students, house parents, sick or disabled, the hidden unemployed, and early retirees fit this description.

This depiction, is in itself, biased because it only focuses on activity in relation to being engaged in paid work. For example, major productive activity like housework and child-rearing is ignored by a focus on paid work only.

We should also count the unemployed and the underemployed within the “dependent” category although statisticians count them as being economically active. While dependency ratios will rise (however defined) if the population ages, governments have deliberately maintained persistently high pools of underutilised labour resources and have therefore heightened any challenges that will emerge from the rising dependency ratios.

So the only relevant question about the ageing population and the challenges for governments relates to whether the rising dependency ratio will reduce the growth of production of real goods and services in the future and therefore reduce material standards of living.

The mainstream debate chooses to focus on the “financial” aspects of these projected changes arguing that they will imply rising budget deficits which they define as being unsustainable. Of-course, their use of the term unsustainable is circular – true by definition and without any application to a modern monetary system where the sovereign government issues its own currency.

Please read the following blogs – Fiscal sustainability 101 – Part 1Fiscal sustainability 101 – Part 2Fiscal sustainability 101 – Part 3 – to see what fiscal sustainability means.

The mainstream emphasis on “costs” of retirement pension and health care systems and how these “costs” will “blow the budget deficits out” demonstrate how far of the mark they are in providing relevant commentary.

The “budget costs or outlays” are financial not real constructs. Once a person enters the intergenerational debate in this way – financial rather than real – you know they do not understand the true nature of the issue they are discussing.

The relevant issue relates to real resource availability in the future.

There will be no financial constraints on any sovereign government running deficits in perpetuity should that be the appropriate macroeconomic policy setting (in relation to the behaviour driving the other sectoral balances). Ultimately, these deficits are endogenous which means they are driven by the non-government sector spending. If the latter wants to net save as an overall sector then the government sector has to run deficits for growth to be stable.

An ageing population will require choices to be made in relation to real resource trade-offs. Will there be enough real resources available? This is not a financial matter – it is a matter of whether there will be real goods and services produced in sufficient volumes for us and the government to buy in the future. If there are real goods and services produced in sufficient quantity to allow for adequate health care and pension entitlements (the former using resources, the latter commanding them) then the sovereign governments will always be able to afford to purchase them and provide them to our advantage.

How these real resources are distributed in the future becomes a political issue. The outcomes in the future will be resolved by political means in similar ways to now. But financial constraints will never be binding on a government with a political mandate to pursue high quality health care etc.

Clearly, if there are finite real resources then choices have to be made about what gets produced and provided. The question focuses on this issue.

If total spending in the economy including the rising pension and health care spending exceeds the real capacity of the economy to meet this demand with output then inflation becomes the issue.

To reduce the danger of this occurring in the face of rising dependency ratios, productivity growth is essential. This is why the neo-liberal approach to the problem which pressures governments to run budget surpluses now (erroneously characterising this as “saving for the future”) is so dangerous.

Resource availability in the future will be enhanced by the research and development that is done now. Mainstream remedies to perceived budget blow-outs typically manifest as cuts to education, for example. Nothing could be more stupid.

Further, maximising employment and output in each period is a necessary condition for long-term growth. The emphasis in mainstream intergeneration debate that we have to lift labour force participation by older workers is sound but contrary to current government policies which reduces job opportunities for older male workers by refusing to deal with the rising unemployment.

Anything that has a positive impact on the dependency ratio is desirable and the best thing for that is ensuring that there is a job available for all those who desire to work.

Further encouraging increased casualisation and allowing underemployment to rise is not a sensible strategy for the future. The incentive to invest in one’s human capital is reduced if people expect to have part-time work opportunities increasingly made available to them.

You might like to read these blogs for further information:

Question 5:

The growth of bank reserves and the growth in the stock of money have followed a similar path in the recent crisis which signifies that credit creation has been tightly constrained by the recession.

It has been demonstrated beyond doubt that there is no unique relationship of the sort characterised by the erroneous money multiplier model in mainstream economics textbooks between bank reserves and the “stock of money”.

You will note that in MMT there is very little spoken about the money supply. In an endogenous money world there is very little meaning in the aggregate.

Central banks do still publish data on various measures of “money”. The RBA, for example, provides data for:

• Currency – Private non-bank sector’s holdings of notes and coins.
• Current deposits with banks (which exclude Australian and State Government and inter-bank deposits).
• The M1 measure – Currency plus bank current deposits of the private non-bank sector.
• The M3 measure – M1 plus all other ADI deposits of the private non-ADI sector. So a broader measure than M1.
• Broad money – M3 plus non-deposit borrowings from the private sector by AFIs, less the holdings of currency and bank deposits by RFCs and cash management trusts.
• Money base – Holdings of notes and coins by the private sector, plus deposits of banks with the Reserve Bank and other Reserve Bank liabilities to the private non-bank sector.

Note that ADI are Australian deposit-taking institutions; AFI are Australian financial intermediaries; and the RFCs are Registered Financial Corporations. Here is the RBA’s excellent glossary for future reference.

The mainstream theory of money and monetary policy asserts that the money supply (volume) is determined exogenously by the central bank. That is, they have the capacity to set this volume independent of the market. The monetarist portfolio approach claims that the money supply will reflect the central bank injection of high-powered (base) money and the preferences of private agents to hold that money. This is the so-called money multiplier.

So the central bank is alleged to exploit this multiplier (based on private portfolio preferences for cash and the reserve ratio of banks) and manipulate its control over base money to control the money supply.

To some extent these ideas were a residual of the commodity money systems where the central bank could clearly control the stock of gold, for example. But in a credit money system, this ability to control the stock of “money” is undermined by the demand for credit.

The theory of endogenous money is central to the horizontal analysis in MMT. When we talk about endogenous money we are referring to the outcomes that are arrived at after market participants respond to their own market prospects and central bank policy settings and make decisions about the liquid assets they will hold (deposits) and new liquid assets they will seek (loans).

A leading contributor to the endogenous money literature is Canadian Marc Lavoie. In his 1984 article (‘The endogenous flow of credit and the Post Keynesian theory of money’, Journal of Economic Issues, 18, 771-797) he wrote(page 774):

When entrepreneurs determine the effective demand, they must plan the level of production, prices, distributed dividends, and the average wage rate. Any production in a modern or in an “entrepreneur” economy is of a monetary nature and must involve some monetary outlays. When production is at a stationary level, it can be assumed that firms have at their disposal sufficient cash to finance their outlays. This working capital, in the aggregate, constitutes credits that have never been repaid. When firms want to increase their outlays, however, they clearly have to obtain extended credit lines or else additional loans from the banks. These flows of credit then reappear as deposits on the liability side of the balance sheets of banks when firms use these loans to remunerate their factors of production.

The essential idea is that the “money supply” in an “entrepreneurial economy” is demand-determined – as the demand for credit expands so does the money supply. As credit is repaid the money supply shrinks. These flows are going on all the time and the stock measure we choose to call the money supply, say M3 is just an arbitrary reflection of the credit circuit.

So the supply of money is determined endogenously by the level of GDP, which means it is a dynamic (rather than a static) concept.

Central banks clearly do not determine the volume of deposits held each day. These arise from decisions by commercial banks to make loans.

The central bank can determine the price of “money” by setting the interest rate on bank reserves. Further expanding the monetary base (bank reserves) as we have argued in recent blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – does not lead to an expansion of credit.

So a rising ratio of bank reserves to some measure like M3 is consistent with the view that credit creation is being constrained by some factor – such as a recession.

You might like to read these blogs for further information:

### This Post Has 4 Comments

1. The latest news is that the UK chancellor has said the government “will not tolerate” banks heaping pressure on small and medium-sized businesses and said they had an “economic obligation” to lend.

Strikes me that all the banks are doing is repricing risk back to something sensible rather than the free for all of the last few years.

How on earth can a government ‘force’ the banks to lend to anybody they don’t think is worthy of the loan – short of capitalising a new public bank? Are they going to try and flood them with reserves?

2. Bill,

I answered 2 and 3 correctly, so we agree on the matters of money and reserves as related in the questions.
But I think you are shorting the readers with your discussions on full and fractional reserve banking as they relate to credit creation, and more importantly and much less discussed, credit contraction.
For the purpose of my discussion I equate credit creation and contraction with increasing and decreasing the money supply.
I agree with your basic conclusion on frctional reserve banking:
“the required reserves play no role in the credit creation process.”.

I don’t believe this is necessarily true with full-reserve banking, where there is no other relationship between the money base per se and money creation, except that of 1 : 1 .
If the money is not in the savings or investment trust account, it cannot be lent into existence. It cannot simply be created by securing some non-collateralized asset of the borrower. This, of necessity, raises the issue of how, under full-reserve banking, money should be created if not as an asset-based debt.
For some reason, you continue to dredge up the gold-reserve notion when discussing full-reserve banking in 2010 as if we could either change the value of gold to match the money supply or reduce the money supply to conform to the value of the gold stock.
I would like to think the discussion can move beyond such histrionics, especially the Austrian-related, Why aren’t we applying a rational thought to the concept of full reserve banking today?
Does it in some way conflict with Neo-Chartalist theory? I think not.
I again provide a link to the paper of Douglas, Fisher, Graham, Whittlesey and others on A Program for Monetary Reform.
http://www.economicstability.org/history/a-program-for-monetary-reform-the-1939-document

Their purpose in proposing the “100 Percent Reserve System” is to replace what they call the “lawless variability in the nation’s circulating medium”, something that progressives have been fighting for over a century because it is in the “lawless” changes to the supply of money that banker/lenders and other asset-acquirers confiscate earned wealth from powerless borrower/rentier class among our citizenry.

I feel we spend far too much time discussing the inane relationship between the monetary base and the various measures of the money stock. So what, who cares? This blog stretches the imagination of a lot of readers by its very nature of asserting important, un-discussed relationships of the workings between various sectors of the economy, the results of which are to turn taditional macro-economics on its head. I wish we could apply the same innovative thinking to the monetary system today, not merely by showing the errors of the ways of Austrianism and so-called Neo-liberalism, but by showing how to protect the rights of free people’s to control their economic well being, via a complete public purpose relationship between those sovereign peoples and THEIR monetary system.

Having said all that, Bill, my sincere thanks for all you do.

3. Bernard Leikind says:

Dear Dr. Mitchell,

In your description of bank operations above and in your earlier blog posts, you describe the real process by which banks create loans. Your description doesn’t involve deposits to the bank. But banks supposedly are intermediaries between people who loan the bank money in the short term, depositors, and those who borrow money from the bank in the long term.

What is the role of depositors in your picture?

In your picture of loan creation, how can a bank fail? What is the meaning of bank failure?

What is a run on a bank, which involves depositors? Since banks could operate without deposits at all, as I understand your picture, why couldn’t a bank protect itself from runs by simply not bothering with taking deposits? Why can’t a bank always get the cash (or bytes) to repay any depositor by borrowing from the central bank?

I hope these don’t seem like foolish questions, and thank you for your informative blog.