There’s a certain group of people who believe that if you want to know how money affects the economy, then you need to talk to bankers. I’m not one of them.
As an analogy, consider the following imaginary conversation:
Fred: I worked at BestBuy during the 1990s.
Me: Was it interesting?
Fred: Yes, it was a period of soaring demand for personal computers.
Me: Um, don’t you mean the supply of personal computers was soaring?
Fred: Well more supply too, but the market was really driven by soaring demand. Extra supply just piles up in inventory if you don’t have buyers. It’s demand that drives the market; supply is just a necessary condition. Trust me, I worked there.
If you’ve studied economics from a textbook that teaches NRFPC (in other words, mine), then you know that Fred is speaking nonsense. To establish whether supply or demand was the driving force in the 1990s, you look at the correlation between quantity and price. And given that soaring sales were associated with plunging prices, we can infer that supply was the key factor.
Fred was too close to the picture to see it clearly. To him it looked like quantity sold was fueled by demand. He overlooked how Moore’s Law was sharply boosting supply, which led to much lower prices and many more people buying PCs.
I often hear people say that bank reserves don’t drive bank lending. That no banker looks to see if he has enough reserves before deciding whether to make a loan. That’s like saying that the BestBuy salesperson doesn’t look at Dell Computer production data before making a sale.
More reserves can lead to more loans in one of two ways. In the Keynesian model, more reserves lead to lower interest rates on loans, and this encourages more lending. In the market monetarist model (my view), more reserves leads to more NGDP via the excess cash balances effect. As NGDP rises, firms and individuals wish to borrow more money.
In the Keynesian model, real bank lending rises, and in the long run monetarist model nominal bank lending rises. In reality, you have some of each.
Here’s Paul Krugman:
Actually, Tobin-Brainard is to many of the controversies that swirl around banks and money as IS-LM is to controversies about interest-rate determination. When we ask, “Are interest rates determined by the supply and demand of loanable funds, or are they determined by the tradeoff between liquidity and return?”, the correct answer is “Yes”— it’s a simultaneous system.
Similarly, if we ask, “Is the volume of bank lending determined by the amount the public chooses to deposit in banks, or is the amount deposited in banks determined by the amount banks choose to lend?”, the answer is once again “Yes”; financial prices adjust to make those choices consistent.
Now, think about what happens when the Fed makes an open-market purchase of securities from banks. This unbalances the banks’ portfolio — they’re holding fewer securities and more reserve — and they will proceed to try to rebalance, buying more securities, and in the process will induce the public to hold both more currency and more deposits. That’s all that I mean when I say that the banks lend out the newly created reserves; you may consider this shorthand way of describing the process misleading, but I at least am not confused about the nature of the adjustment.
Yes, it’s a simultaneous system. Adding reserves (base money) has a million indirect effects on every nominal variable in the economy, and, if prices are sticky, real variables as well. If you don’t want to call that “lending out reserves” that’s fine (I don’t use that phrase either), but we understand the dynamic process.
And this Krugman comment also rang a bell with me:
I’m actually kind of reluctant to even get into this, because any discussion of these issues brings out the people who believe that they have discovered the hidden secrets of the monetary universe, somehow missed by generations of economists. But here goes anyway.
Yes, I know the feeling.