If the central bank regulated that banks have to hold reserve equivalent to their outstanding loans this would restrict lending.
Answer: False
The answer is False.
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.
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.
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Question 5 - Premium question
In the context of population ageing, the fact that a sovereign government is never financially constrained means that it can always provide first-class health care to its citizens.
The answer is False.
Does the dependency ratio matter? It surely does but not in the way that is usually assumed.
The standard dependency ratio is normally defined as 100*(population 0-15 years) + (population over 65 years) all divided by the (population between 15-64 years). Historically, people retired after 64 years and so this was considered reasonable. The working age population (15-64 year olds) then were seen to be supporting the young and the old.
The aged dependency ratio is calculated as:
100*Number of persons over 65 years of age divided by the number of persons of working age (15-65 years).
The child dependency ratio is calculated as:
100*Number of persons under 15 years of age divided by the number of persons of working age (15-65 years).
The total dependency ratio is the sum of the two. You can clearly manipulate the "retirement age" and add workers older than 65 into the denominator and subtract them from the numerator.
If we want to actually understand the changes in active workers relative to inactive persons (measured by not producing national income) over time then the raw computations are inadequate.
Then you have to consider the so-called effective dependency ratio which is the ratio of economically active workers to inactive persons, where activity is defined in relation to paid work. So like all measures that count people in terms of so-called gainful employment they ignore major productive activity like housework and child-rearing. The latter omission understates the female contribution to economic growth.
Given those biases, 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.
I would also include the unemployed and the underemployed in this category although the statistician counts them as being economically active.
If we then consider the way the neo-liberal era has allowed mass unemployment to persist and rising underemployment to occur you get a different picture of the dependency ratios.
The reason that mainstream economists believe the dependency ratio is important is typically based on false notions of the government budget constraint.
So a rising dependency ratio suggests that there will be a reduced tax base and hence an increasing fiscal crisis given that public spending is alleged to rise as the ratio rises as well.
So if the ratio of economically inactive rises compared to economically active, then the economically active will have to pay much higher taxes to support the increased spending. So an increasing dependency ratio is meant to blow the deficit out and lead to escalating debt.
These myths have also encouraged the rise of the financial planning industry and private superannuation funds which blew up during the recent crisis losing millions for older workers and retirees. The less funding that is channelled into the hands of the investment banks the better is a good general rule.
But all of these claims are not in the slightest bit true and should be rejected out of hand.
So the predominant debate is that a fiscal crisis is emerging and that we have to make people work longer despite this being very biased against the lower-skilled workers who physically are unable to work hard into later life.
We are also encouraged to increase our immigration levels to lower the age composition of the population and expand the tax base. Further, we are told relentlessly that the government will be unable to afford to provide the quality and quantity of the services that we have become used too.
However, all of these remedies miss the point overall. It is not a financial crisis that beckons but a real one. Dependency ratios matter because they tell us how many workers will be available to produce real goods and services at any point in time. So we can make projections about real GDP growth for given projections about productivity once we have an idea of these underlying dependency ratios.
Clearly we want to be sure that the projected real needs of the population are capable of being met with the likely available resources.
So the only question we need to ask about the future population trends relate to whether there will be enough real resources available to provide aged-care, etc at a desirable level in the future? However, that is never the way the debate is framed. The worry is always that public outlays will rise because more real resources will be required "in the public sector" than previously.
However these outlays are irrelevant from a financial point of view. The government can purchase anything that is for sale in the currency it issues at any time. There is never a question that the government cannot afford to buy something that is available.
It is the availability that is the issue. As long as these real resources are available there will be no problem. In this context, the type of policy strategy that is being driven by these myths will probably undermine the future productivity and provision of real goods and services in the future.
It is clear that the goal should be to maintain efficient and effective medical care systems. Clearly the real health care system matters by which I mean the resources that are employed to deliver the health care services and the research that is done by universities and elsewhere to improve our future health prospects. So real facilities and real know how define the essence of an effective health care system.
Further, productivity growth comes from research and development and in Australia the private sector has an abysmal track record in this area. Typically they are parasites on the public research system which is concentrated in the universities and public research centres (for example, CSIRO).
Unfortunately, tackling the problems of the distant future in terms of current "monetary" considerations which have led to the conclusion that fiscal austerity is needed today to prepare us for the future will actually undermine our future.
The irony is that the pursuit of budget austerity leads governments to target public education almost universally as one of the first expenditures that are reduced.
Most importantly, maximising employment and output in each period is a necessary condition for long-term growth. The emphasis in mainstream integeneration 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.
But all these issues are really about political choices rather than government finances. The ability of government to provide necessary goods and services to the non-government sector, in particular, those goods that the private sector may under-provide is independent of government finance.
Any attempt to link the two via fiscal policy "discipline:, will not increase per capita GDP growth in the longer term. The reality is that fiscal drag that accompanies such "discipline" reduces growth in aggregate demand and private disposable incomes, which can be measured by the foregone output that results.
Clearly surpluses help control inflation because they act as a deflationary force relying on sustained excess capacity and unemployment to keep prices under control. This type of fiscal "discipline" is also claimed to increase national savings but this equals reduced non-government savings, which arguably is the relevant measure to focus upon.
So even though the government is not financially constrained it might adopt a policy platform that undermines productivity growth and leaves the economy short of real productive resources at a time in the future when they will be needed to fulfill its socio-economic program.
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