The payment of a positive return on overnight reserves held by the commercial banks equal to the current policy rate will tend to increase the volume of broad money in the system (ignore any reserve requirements in place when answering).
Answer: False
The answer is False.
This question and answer is related to the information provided for Question 1.
In general, the payment of a positive return on overnight reserves held by the commercial banks equal to the current policy rate will tend to increase the volume of reserves held by banks.
This is because the opportunity cost of holding the reserves is eliminated and so banks will seek to avoid the penalties of running short of reserves in the event of an unexpected daily demand for higher reserves.
The current question is exploring the notion that there is a close relationship between the level of bank reserves and the money supply. That relationship is at the heart of the mainstream macroeconomics depiction of the way the monetary system operates.
They argue that there is a close relationship between what is known as the monetary base and broad money. In mainstream economics, the link is provided by the money multiplier model.
However, that construction of banking dynamics is false. There is in fact 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 Modern Monetary Theory (MMT) there is very little spoken about the money supply. In an endogenous money world there is very little meaning in the aggregate concept of the "money supply".
The mainstream monetarist 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 via the 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.
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".
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).
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.
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