Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary Systems

by L. Randall Wray

Banks have a very small quantity of reserves relative to the deposits (of various kinds) that they have created, some of which they promise to convert on demand to cash or reserves (called “high powered money”).

type of “leverage”: the practice of holding a small amount of government currency in reserve against IOUs denominated in the state’s unit of account while promising to convert those IOUs to currency or reserves.

borrowing from other banks (called the interbank overnight market; this is the fed funds market in the United States)

(or, increasingly, by an electronic transfer from their account to the account of the wholesaler).

Alternatively, the wholesaler might not be willing to wait until the end of the period for payment. In this case the wholesaler can sell the retailer’s IOUs at a discount (for less than the amount that the retailer promises to pay at the end of the period). The discount is effectively interest that the wholesaler is willing to give up to get the funds earlier than promised.

In this case the retailer will finally pay the holder of these IOUs (perhaps a financial institution) at the end of the period, which effectively earns interest (the difference between the discounted amount paid for the IOUs and the amount paid by the retailer to extinguish the IOUs).

As we have discussed previously, banks explicitly promise to convert their liabilities to currency (either immediately in the case of demand deposits, or with some delay in the case of time deposits).

Banks, in turn, clear accounts using government liabilities.

There are typically far more liabilities lower in the pyramid than there are high in the pyramid, at least in the case of a financially developed economy.

Note however that in the case of a convertible currency, the government’s currency is not at the apex of the pyramid.

Perhaps the most useful way is to distinguish between those types of institutions that have direct access to the central bank and those that do not.

When something goes wrong, the nonbanks and shadow banks turn to banks for finance (lending against the nonbank’s IOUs); the banks in turn go to the central bank.

But when expectations turn ugly, the banks won’t lend, so the nonbanks cannot make good on promises. That led to the liquidity crisis beginning in late 2007;

Bitcoins pose a huge liquidity risk. Ultimately, anyone with bitcoins has to convert them into a national unit of account – dollars, say, or euros – to pay taxes or personal debts and to make other transactions.

In a crisis, an important role played by the central bank is to operate as a “lender of last resort”, providing reserves on demand to financial institutions.

Originally this was to stop a “bank run” – depositors trying to exchange their deposits for cash. That type of run is now rare thanks to deposit insurance.

and they can lend against toxic waste MBSs (those subprime mortgage-backed securities that triggered the Global Financial Crisis – maybe a bad idea?).

It can use collateral requirements as a way to supervise/regulate banks since the central bank can encourage them to make only safe loans by narrowing what it accepts as collateral.

Banks can become illiquid, and they can become insolvent.

A liquidity problem is different: the assets might be perfectly good, but if they cannot be quickly marketed without losing value, then a bank facing withdrawals cannot cover them by selling assets.

Where are the money tokens? They are the checking and savings accounts on the balance sheet.

did not get it from anywhere: a checking account was created ex nihilo, that is, from nothing, by entering a number (200) in a computer.

The checking account is just a legal promise to convert to cash on demand, and to accept payment in the form of the bank’s own IOUs.

It turns out that most people are satisfied with just having a deposit in the checking account and rarely ask for cash.

If Mr. X cannot make payments, or if the bank cannot access reserves as needed, then the bank gets in trouble; it can become insolvent or illiquid.

Bank A will get the reserves via the source that is the least costly.

Bank A makes money as long as the interest it receives on the advance to Mr. X is higher than the interest it pays to the Federal Reserve.

Of course, private banks and the central bank have many other assets and liabilities, as well as net worth on their balance sheets.

So, if Bank A has a $300 bond, it surrenders it to the Federal Reserve in exchange for reserves. The Fed will usually give only, say, $285 if the discount is 5 percent.

In the real world, banks extend credit, creating deposits in the process, and look for the reserves later.

We can say the interest rate is exogenously controlled (set by the central bank) but it is not theoretically exogenous because the overriding policy is to peg the exchange rate.

With what is called Quantitative Easing (QE), the Fed “exogenously” increases bank reserves far beyond what banks want to hold.

We conclude that in normal circumstances, reserves are “endogenous” as central banks accommodate demand for them, while the interest rate is “exogenous” as the central bank sets the overnight rate target.

With QE, the central bank pays interest of, say, 25 basis points (0.25%) on reserves held and charges 50 basis points (0.50%) on overdrafts (reserves lent).

Calling this “borrowing” by the Fed is misleading, which is why I do not use that term. The

For the purposes of the simplest explication, it is convenient to consolidate the treasury and central bank accounts into a “government account”.

The government gets the jet, the private seller gets a demand deposit.

Note that the tax liability reduces the seller’s net worth and increases the government’s (after all, that is the purpose of taxes – to move resources to the government).

The implication of “balanced budget” spending and taxing by the government is to move the jet to the government sector, reducing the private sector’s net worth.

government responds by selling a bond (bonds are sold as part of monetary policy, to allow the government to hit its overnight interest rate target):

Compared with Case 1a, the private sector is much happier! Its total wealth is not changed, but the wealth was converted from a real asset (jet) to a financial asset (claim on government).

Fed

Without the Treasury standing behind the Fed, we’d be back in the nineteenth century where bank notes did not clear at par.

Actually, the Fed is legally a creature of Congress.

(which, as set in the Federal Reserve Act, is the fiscal agent for the Treasury and holds the Treasury’s balances as a liability on its balance sheet).

debt issuance to “the open market”.

Consequently, the Treasury’s operations are inseparable from the Fed’s monetary policy operations related to setting and maintaining its target rate.

Since it doesn’t have sufficient deposits, it will need to initate an “auction” of a new issue of bonds.

Central banks have a second function that has come to dominate the thinking of most observers: they are the bank for banks – running the payments system and maintaining par clearing.

Also note that there are approximately 40 primary dealers that are required to bid competitively for Treasury securities, which keeps rates as low as possible. The dealers do this mainly because their clients will deal only with primary dealers. This means that Treasury can always sell securities and can always get deposits at the Fed in order to spend.