{"id":6624,"date":"2009-12-14T04:55:41","date_gmt":"2009-12-13T18:55:41","guid":{"rendered":"https:\/\/billmitchell.org\/blog\/?p=6624"},"modified":"2009-12-14T04:55:41","modified_gmt":"2009-12-13T18:55:41","slug":"building-bank-reserves-is-not-inflationary","status":"publish","type":"post","link":"https:\/\/billmitchell.org\/blog\/?p=6624","title":{"rendered":"Building bank reserves is not inflationary"},"content":{"rendered":"

\t\t\t\tToday I am working in Dubbo<\/a>, which is in the western region of NSW and getting into the remote parts of the state. There is a great beauty to enjoy in remote Australia which often passes people by. My field trip is in relation to continuing work I am doing with indigenous communities in this region. I will report on this work in due course. But today’s blog continues the theme I developed yesterday on bank reserves. In yesterday’s blog – Building bank reserves will not expand credit<\/a> – I examined the dynamics of bank reserves but left a few issues on hold because I ran out of time. One issue is the possible impact of expanding bank reserves on inflation. This is in part central to the mainstream hysteria at present about the likely legacies of the monetary policy response to the crisis. The conclusion is that everyone can relax – the only problem with the monetary policy response is that it will be ineffective and more fiscal policy effort is required.
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\nThis blog is intended to conclude the two-part series I started yesterday on bank reserves. It will also serve to clarify – by expressing in a different way – some of the essential principles of modern monetary theory (MMT) which are developed in Deficit spending 101 – Part 1<\/a> | Deficit spending 101 – Part 2<\/a> | and Deficit spending 101 – Part 3<\/a> – plus other blogs. Go to Debriefing 101<\/a> for a collection of blogs covering the first-principles of MMT.<\/p>\n

In yesterday’s blog – Building bank reserves will not expand credit<\/a> – I used a recent working paper from the Bank of International Settlements – Unconventional monetary policies: an appraisal<\/a> – to explain some of the operational aspects of the monetary system which are at the core of MMT and which mainstream macroeconomics fails to depict in any coherent manner.<\/p>\n

The specific context was Paul Krugman’s on-going policy suggestion that quantitative easing is required to stimulate lending. I showed that QE is largely incapable of stimulating lending and not surprisingly because lending is not reserve constrained. The conclusion was that Krugman clearly doesn’t understand the banking operations that link monetary policy to bank reserves. Developing this understanding is a core differentiating feature of MMT.<\/p>\n

The use of the BIS research paper was deliberate because it demonstates that the banking professionals also understand key components of MMT even if they use language conventions that appear to place them in the mainstream discourse. To further demonstrate this I will continue to examine this BIS working paper in the context of the impact of bank reserves on interest rate policy and the potential for inflation.<\/p>\n

In normal times (that is, not during this significant economic crisis) monetary policy is “defined exclusively in terms of a short term interest rate” where the central bank signals that it will set a “policy rate” – this is the central bank’s estimate of the rate that will achieve its policy goals. However, the central bank then has to engage in liquidity management operations:<\/p>\n

\n… to help make that interest rate effective: they ensure that a market “reference rate”, typically an overnight rate, tracks the desired interest rate level closely. As such, liquidity management operations play a purely technical and supportive role.\n<\/p><\/blockquote>\n

To understand MMT it is important to link the idea of the liquidity management operations in the monetary policy domain to the impacts of government spending and taxation arising in the fiscal policy domain. If you read any mainstream macroeconomics textbook the linking of these two domains is not made in any coherent way. In fact, because the two domains are mis-specified in that paradigm, false conclusions are drawn (for example, they claim that fiscal deficits cause interest rates to rise).<\/p>\n

When the government spends it credits bank accounts (or issues cheques which end up in the bank settlement system) and after all the transactions are completed the result is that bank reserves expand. Conversely, when the government collects taxes it debits bank accounts (or accepts cash\/cheques) and this results in a $-for-$ decrease in bank reserves.<\/p>\n

These are vertical transactions<\/a> between the government and non-government sector and thus create or destroy bank reserves. Logically, when the government runs a fiscal deficit (spending is in excess of tax receipts), the impact on bank reserves is a net positive – reserves expand in net terms. Conversely, when the government runs a fiscal surplus (spending is less than taxation receipts), the impact on bank reserves is a net negative – reserves contract in net terms.<\/p>\n

It is essential to understand these impacts because they allow you to then understand the way in which the liquidity management operations conducted by the central bank, though separate from fiscal policy, are intrinsically linked to these impacts.<\/p>\n

The link is created not because the fiscal position adopted by the government “has to be financed”. That is the common error that mainstream macroeconomics textbooks make. A sovereign government that issues its own currency does not need to finance its spending. That is so obvious that it continually surprises me that commentators persist in asserting the opposite.<\/p>\n

All the financial machinations (debt-issuance, taxation) that might look on the surface to be “financing operations” are in fact nothing of the sort. The following discussion will clarify the role that debt-issuance serves in the monetary system. The rhetoric of the government might lead one to conclude otherwise (that debt-issuance is a financing operation) but the hard reality of the daily liquidity management operations (once understood) reveal the truth – the separation of political stance from reality.<\/p>\n

The BIS say that:<\/p>\n

\nThe fulcrum of the implementation of interest rate policy is the market for bank reserves. This is a peculiar market. By virtue of its monopoly over this asset, the central bank can set the quantity and the terms on which it is supplied at the margin. As such, the central bank is able to set the opportunity cost (“price”) of reserves, the overnight rate, to any particular level, simply because it could stand ready, if it so wished, to buy and sell unlimited amounts at the chosen price. This is the source of the credibility of the signal.<\/p>\n

Crucially, the interest rate can be set quite independently of the amount of bank reserves in the system. The same amount of bank reserves can coexist with very different levels of interest rates; conversely, the same interest rate can coexist with different amounts of reserves. What is critical is how reserves are remunerated relative to the policy rate. We refer to this as the “decoupling principle”. It is a principle that has far-reaching implications for the rest of the analysis.\n<\/p><\/blockquote>\n

The signal they refer to is the announced policy or target rate. You will note that the central bank (as an integral component of the consolidated government sector with treasury) also does not have a revenue-constraint – it can buy and sell unlimited reserves at whatever price it chooses to set.<\/p>\n

The decoupling principle was examined in yesterday’s blog – Building bank reserves will not expand credit<\/a>. The following discussion clarifies the statement that “what is critical is how reserves are remunerated relative to the policy rate”.<\/p>\n

The BIS use the following figure to motivate this discussion. It appears on Page 4 of their paper <\/a>. It is a good way to understand how different reserve remuneration schemes operate in relation to monetary policy and the profit-seeking aims of the commercial banks. <\/p>\n

There various parameters in the figure are defined as follows:<\/p>\n