How Banks Expand the Money Supply

[ShackledNation]

It is well accepted that under our current banking system, banks create much of this country's supply of money.

it's much more accurate to say the banks do as the Fed
wishes in order that the country maintains a stable money supply.

Not really. The Fed pumped money into the banks through QE wishing them to lend it, but they haven't. Banks don't simply do what the Fed wants. They do what will get them the most profit.

 

[EdwardBaiamonte]

It is well accepted that under our current banking system, banks create much of this country's supply of money.

it's much more accurate to say the banks do as the Fed
wishes in order that the country maintains a stable money supply.

Not really. The Fed pumped money into the banks through QE wishing them to lend it, but they haven't. Banks don't simply do what the Fed wants. They do what will get them the most profit.

well the policy was to lower rates to 0% and they acheived that plus they did a ton more with QE and many other things. They could have charged interest on reserves to force the banks to lend but out of respect for their business judgement they understood that the obama economy stinks and not much lending made sense.

 

[TakeAStepBack]

Banks not lending is how the velocity was controlled to stabilize the currency influx. It was mostly reserved. Except for politicians, bankers, and their friends.

 

[EdwardBaiamonte]

Banks not lending is how the velocity was controlled to stabilize the currency influx.

except if the banks had made a ton of loans they would have been happy so they were not trying to slow down velocity at all.

 

[TakeAStepBack]

Right. It was the Fed that dictated lending practice when the bailouts were in full swing. They still od, when it comes down to it. Banks would have lend and velocity would have put the scheme in jeopardy.

 

[Kimura]

It is well accepted that under our current banking system, banks create much of this country's supply of money.

it's much more accurate to say the banks do as the Fed
wishes in order that the country maintains a stable money supply.

Not really. The Fed pumped money into the banks through QE wishing them to lend it, but they haven't. Banks don't simply do what the Fed wants. They do what will get them the most profit.

But it should be obvious that banks cannot lend out reserves from these operations. All QE ended up being was an asset swap. All we saw was a change in overall asset composition and term structure of government sector liabilities, there wasn't an increase in non-government net financial assets.

The FED takes assets - US Treasuries - and swaps them out with reserves in the banking system. The only consequence is that the private sector has interest taken away which it could have earned on those Treasuries, which would be more than the 0% it would have earned with cash balances. There is no new money added to the economy, all we have seen is an increase in liquidity as the government takes longer-term securities onto its balance sheet.

 

[ShackledNation]

it's much more accurate to say the banks do as the Fed
wishes in order that the country maintains a stable money supply.

Not really. The Fed pumped money into the banks through QE wishing them to lend it, but they haven't. Banks don't simply do what the Fed wants. They do what will get them the most profit.

But it should be obvious that banks cannot lend out reserves from these operations. All QE ended up being was an asset swap. All we saw was a change in overall asset composition and term structure of government sector liabilities, there wasn't an increase in non-government net financial assets.

The FED takes assets - US Treasuries - and swaps them out with reserves in the banking system. The only consequence is that the private sector has interest taken away which it could have earned on those Treasuries, which would be more than the 0% it would have earned with cash balances. There is no new money added to the economy, all we have seen is an increase in liquidity as the government takes longer-term securities onto its balance sheet.

The Fed buys U.S. treasuries from the banks by creating money out of thin air. They are not spending already existing money. Say Bank A has a reserve balance of $100 at the Fed. The Fed then buys $100 in Treasuries from Bank A. It then credits the reserve balance to be $200. There is now $100 more money than before in the form of reserves.

Now of course bank reserves aren't typically counted as money since they in no way circulate in the economy. But the additional reserves are there, and allows banks to eventually make more loans as a result (thus truly expanding the money supply).

 

[Kimura]

Not really. The Fed pumped money into the banks through QE wishing them to lend it, but they haven't. Banks don't simply do what the Fed wants. They do what will get them the most profit.

But it should be obvious that banks cannot lend out reserves from these operations. All QE ended up being was an asset swap. All we saw was a change in overall asset composition and term structure of government sector liabilities, there wasn't an increase in non-government net financial assets.

The FED takes assets - US Treasuries - and swaps them out with reserves in the banking system. The only consequence is that the private sector has interest taken away which it could have earned on those Treasuries, which would be more than the 0% it would have earned with cash balances. There is no new money added to the economy, all we have seen is an increase in liquidity as the government takes longer-term securities onto its balance sheet.

The Fed buys U.S. treasuries from the banks by creating money out of thin air. They are not spending already existing money. Say Bank A has a reserve balance of $100 at the Fed. The Fed then buys $100 in Treasuries from Bank A. It then credits the reserve balance to be $200. There is now $100 more money than before in the form of reserves.

Now of course bank reserves aren't typically counted as money since they in no way circulate in the economy. But the additional reserves are there, and allows banks to eventually make more loans as a result (thus truly expanding the money supply).

The FED creates money by crediting private banks accounts. The sale of Treasuries provide an interest bearing alternative to bank reserves. It doesn’t matter if they are sold by the FED through open market operations or by the Treasury as new issues, the effect is the same. We have swapped out reserves for Treasuries. This enables the FED to meet its overnight rate target.

Treasuries are nothing more than dollar deposits at the FED, similar to a savings account. Reserve accounts are like checking accounts. Cash and Treasuries are effectively the same thing, both are liabilities of the government, the only difference being the interest and duration paid by the two. Cash really isn't a unique asset class, it’s just an extremely liquid government liability.

When you purchase a Treasury, for example, all you do is exchange cash for a less liquid type of liability. There’s no change in the money supply or amount of liabilities. All that changes is the rate of interest, and when the government removes those Treasuries, they’re simply changing the term structure of their liabilities through a series of debits and credits between reserve accounts and securities accounts.

At the end the day, when all is said and done, the amount of cash in circulation doesn't change. All we’re seeing is that banks are holding more reserves over at the FED.

I'll put together an example, give me a few minutes.

 

[Kimura]

Before FED purchases Treasuries:


ShackledNation Bank

Reserves 50 Deposits 100

Loans 20 Capital 10

Bonds 40


After the FED purchases Treasuries:

ShackledNation Bank


Reserves 90 Deposits 100

Loans 20 Capital 10

Bonds 0


As we can see the total amount of net financial assets are the same. The composition of the bank’s balance sheet has changed. This is where people ask: where did the FED get the $$$$ to purchase the Tresuries? It’s ex-nihilo, they didn't really get it from anywhere, but it’s $$$$ that’s being injected into the private sector. It’s just being swapped out with something that was spent into existence. The FED simply takes them on as assets, in this case Treasuries, and also accounts for brand new liabilities (reserves), but this hasn't altered the money supply.

QE 101 in a nutshell, btw.

 

[ShackledNation]

But it should be obvious that banks cannot lend out reserves from these operations. All QE ended up being was an asset swap. All we saw was a change in overall asset composition and term structure of government sector liabilities, there wasn't an increase in non-government net financial assets.

The FED takes assets - US Treasuries - and swaps them out with reserves in the banking system. The only consequence is that the private sector has interest taken away which it could have earned on those Treasuries, which would be more than the 0% it would have earned with cash balances. There is no new money added to the economy, all we have seen is an increase in liquidity as the government takes longer-term securities onto its balance sheet.

The Fed buys U.S. treasuries from the banks by creating money out of thin air. They are not spending already existing money. Say Bank A has a reserve balance of $100 at the Fed. The Fed then buys $100 in Treasuries from Bank A. It then credits the reserve balance to be $200. There is now $100 more money than before in the form of reserves.

Now of course bank reserves aren't typically counted as money since they in no way circulate in the economy. But the additional reserves are there, and allows banks to eventually make more loans as a result (thus truly expanding the money supply).

The FED creates money by crediting private banks accounts. The sale of Treasuries provide an interest bearing alternative to bank reserves. It doesn’t matter if they are sold by the FED through open market operations or by the Treasury as new issues, the effect is the same. We have swapped out reserves for Treasuries. This enables the FED to meet its overnight rate target.

The Fed doesn't expand the money supply by selling treasuries to the banks, it expands the money supply by buying them from the banks. The Fed is not buying new issues, it is buying issues the banks already have.

Treasuries are nothing more than dollar deposits at the FED, similar to a savings account. Reserve accounts are like checking accounts. Cash and Treasuries are effectively the same thing, both are liabilities of the government, the only difference being the interest and duration paid by the two. Cash really isn't a unique asset class, it’s just an extremely liquid government liability.

Treasuries owned by the Fed are assets to the Fed and liabilities to the U.S. Government. They are essentially loans made to the U.S. government, that can then be bought and sold.

When you purchase a Treasury, for example, all you do is exchange cash for a less liquid type of liability.

When I purchase a treasury with cash, I am exchange cash for a less liquid type of asset from my perspective, not liability.

There’s no change in the money supply or amount of liabilities. All that changes is the rate of interest, and when the government removes those Treasuries, they’re simply changing the term structure of their liabilities through a series of debits and credits between reserve accounts and securities accounts.

That is true, unless the purchase of the Treasury is by the Federal Reserve. Say I have a bank deposit account with $100 in it. I purchase a $100 treasury from Bob with that account. Bob's deposit account is credited $100, and $100 is deducted from mine. No change in money supply.

Now say the Federal Reserve buys a treasury from Bank A. The Fed credits Bank A's deposit account by $100. But whose account does it deduct from? Nobody's. Thus you have an increase of $100--the monetary base has increased by $100. That larger base ultimately allows for an expansion of the money supply once the banks start issuing loans made possible by the increased reserves.

At the end the day, when all is said and done, the amount of cash in circulation doesn't change. All we’re seeing is that banks are holding more reserves over at the FED.

I'll put together an example, give me a few minutes.

Oh absolutely, the cash in circulation doesn't change. And until the banks start creating more loans made possible by the increase in reserves, you wont see more money in circulation either. The point is that by purchasing treasuries from the banks, the Fed has expanded the monetary base. This expansion allows for banks to loan more money, but the banks may also choose not to do so and just keep the excess reserves. That is the current situation.

 

[ShackledNation]

Before FED purchases Treasuries:


ShackledNation Bank

Reserves 50 Deposits 100

Loans 20 Capital 10

Bonds 40


After the FED purchases Treasuries:

ShackledNation Bank


Reserves 90 Deposits 100

Loans 20 Capital 10

Bonds 0


As we can see the total amount of net financial assets are the same. The composition of the bank’s balance sheet has changed. This is where people ask: where did the FED get the $$$$ to purchase the Tresuries? It’s ex-nihilo, they didn't really get it from anywhere, but it’s $$$$ that’s being injected into the private sector. It’s just being swapped out with something that was spent into existence. The FED simply takes them on as assets, in this case Treasuries, and also accounts for brand new liabilities (reserves), but this hasn't altered the money supply.

QE 101 in a nutshell, btw.

The total amount of net financial assets for the bank, yes. Of course--that was never a dispute. I apologize if I seemed to say otherwise.

But before, in total, there existed in the economy (of this very limited example of course) $50 of reserves and $40 of bonds. After the Fed bought the bonds, you now have $90 in reserves and $40 in bonds. This is in contrast to my example with the two private individuals in the above post. Before the buying of the bond in that case, the overall supply was $100 in deposits and $100 in bonds. After the purchase of the bond, the supply remained $100 in deposits and $100 in bonds. That is the key difference I am pointing out. The Federal Reserve doesn't deduct from its account when it buys bonds. It has no such account that limits how much it can buy. It just adds to the banks' accounts.

The increased reserves will allow for a greater expansion of the money supply than would have been possible before.

 

[Kimura]

The Fed buys U.S. treasuries from the banks by creating money out of thin air. They are not spending already existing money. Say Bank A has a reserve balance of $100 at the Fed. The Fed then buys $100 in Treasuries from Bank A. It then credits the reserve balance to be $200. There is now $100 more money than before in the form of reserves.

Now of course bank reserves aren't typically counted as money since they in no way circulate in the economy. But the additional reserves are there, and allows banks to eventually make more loans as a result (thus truly expanding the money supply).


The Fed doesn't expand the money supply by selling treasuries to the banks, it expands the money supply by buying them from the banks. The Fed is not buying new issues, it is buying issues the banks already have.

When the FED purchase assets, whether Treasuries or even MBS, it does so by crediting banks with reserves. Excess reserves suck but the FED gives the banks a bit of interest. It's a ZIRP environment.

Treasuries owned by the Fed are assets to the Fed and liabilities to the U.S. Government. They are essentially loans made to the U.S. government, that can then be bought and sold.

They're assets to the non-government and liabilities of the federal government. The FED is part of the government sector. All the FED does is provide the monetary basis for the Treasury's fiscal policy.

When I purchase a treasury with cash, I am exchange cash for a less liquid type of asset from my perspective, not liability.

Both are assets to the non-government, but liabilities of the federal government so I agree. It just depends on what side of the ledger you're looking at it from.

That is true, unless the purchase of the Treasury is by the Federal Reserve. Say I have a bank deposit account with $100 in it. I purchase a $100 treasury from Bob with that account. Bob's deposit account is credited $100, and $100 is deducted from mine. No change in money supply.

Now say the Federal Reserve buys a treasury from Bank A. The Fed credits Bank A's deposit account by $100. But whose account does it deduct from? Nobody's. Thus you have an increase of $100--the monetary base has increased by $100. That larger base ultimately allows for an expansion of the money supply once the banks start issuing loans made possible by the increased reserves.

Actually, Bank A's reserve account is credited and it's securities account is debited. It's a series of debits and credits, this is the asset swap.

From a business standpoint, the end result is that it will decrease a bank's earnings by 100 or 2 basis points.

Oh absolutely, the cash in circulation doesn't change. And until the banks start creating more loans made possible by the increase in reserves, you wont see more money in circulation either. The point is that by purchasing treasuries from the banks, the Fed has expanded the monetary base. This expansion allows for banks to loan more money, but the banks may also choose not to do so and just keep the excess reserves. That is the current situation.

Banks can only lend out reserves to other banks. A bank can't lend out reserves to individuals, households and firms, since they don't have reserve accounts at the FED. Unless you're a bank, you cannot borrow reserves. All banks need is credit-worthy borrowers to lend.

There is no expansion of the monetary base with QE. Reserves aren't part of the broad measure of the money supply.

 

[ShackledNation]

When the FED purchase assets, whether Treasuries or even MBS, it does so by crediting banks with reserves. Excess reserves suck but the FED gives the banks a bit of interest. It's a ZIRP environment.

Agreed.

They're assets to the non-government and liabilities of the federal government. The FED is part of the government sector. All the FED does is provide the monetary basis for the Treasury's fiscal policy.

If the Fed owns treasuries, they are assets to the Fed. If you define the Fed as part of the government, then they are assets to one part of the government (the Fed) and liabilities to another part of government (The treasury). That is just a restatement of what I said. We are in agreement on that.

Both are assets to the non-government, but liabilities of the federal government so I agree. It just depends on what side of the ledger you're looking at it from.

Agreed.

Actually, Bank A's reserve account is credited and it's securities account is debited. It's a series of debits and credits, this is the asset swap.

From a business standpoint, the end result is that it will decrease a bank's earnings by 100 or 2 basis points.

That is just another way of saying what I already responded to. Whether you say the securities account is debited or the bank no longer owns the bond is the exact same thing.

Bank A's reserve account is credited, and its securities account is debited. The Federal Reserve "securities account" is credited for it now owns the bond, but it does not debit the equivalent of its "reserve account" because it has none. Reserves are not created in place of a bond, they are created in addition to the bond.

Banks can only lend out reserves to other banks. A bank can't lend out reserves to individuals, households and firms, since they don't have reserve accounts at the FED. Unless you're a bank, you cannot borrow reserves. All banks need is credit-worthy borrowers to lend.

I didn't say banks were lending out reserves to non-banks. I completely acknowledge that they do not. Banks create loans and deposits out of thin air. To fulfill the reserve requirement, they just have to make sure they have a 1/10 ratio (generally speaking) of reserves to deposits. With an increase in reserves, that increases the ratio, allowing for banks to create more loans. These loans are not financed by lending out reserves, they are financed by the creation of new deposits by the bank.

There is no expansion of the monetary base with QE. Reserves aren't part of the broad measure of the money supply.

That is incorrect. QE by definition expands the monetary base.

"A central bank implements quantitative easing by buying specified amounts of financial assets from commercial banks and other private institutions, thus raising the prices of those financial assets and lowering their yield, while simultaneously increasing the monetary base."

Perhaps you are incorrectly defining monetary base as physical cash?

I already acknowledged that expanding the monetary base does not expand the broad measure of the money supply. But the monetary base is not the broad measure of the money supply--do not conflate the two.

My point is quite simple. When the Fed buys bonds from banks (or other assets) it expands the monetary base. The increased reserves of the bank allow it to create more loans and expand credit. This is done not through lending reserves, but simply by issuing more loans which simultaneously create deposits. Although these increased reserves allow for an expansion of lending, the banks may very well choose not to do so, whether it be through other restrictions or because there are no credit-worthy borrowers in the eyes of the bank, etc.

 

[EdwardBaiamonte]

The Fed buys U.S. treasuries from the banks by creating money out of thin air. They are not spending already existing money. Say Bank A has a reserve balance of $100 at the Fed. The Fed then buys $100 in Treasuries from Bank A. It then credits the reserve balance to be $200. There is now $100 more money than before in the form of reserves.

Now of course bank reserves aren't typically counted as money since they in no way circulate in the economy. But the additional reserves are there, and allows banks to eventually make more loans as a result (thus truly expanding the money supply).


The Fed doesn't expand the money supply by selling treasuries to the banks, it expands the money supply by buying them from the banks. The Fed is not buying new issues, it is buying issues the banks already have.

When the FED purchase assets, whether Treasuries or even MBS, it does so by crediting banks with reserves. Excess reserves suck but the FED gives the banks a bit of interest. It's a ZIRP environment.

Treasuries owned by the Fed are assets to the Fed and liabilities to the U.S. Government. They are essentially loans made to the U.S. government, that can then be bought and sold.

They're assets to the non-government and liabilities of the federal government. The FED is part of the government sector. All the FED does is provide the monetary basis for the Treasury's fiscal policy.



Both are assets to the non-government, but liabilities of the federal government so I agree. It just depends on what side of the ledger you're looking at it from.

That is true, unless the purchase of the Treasury is by the Federal Reserve. Say I have a bank deposit account with $100 in it. I purchase a $100 treasury from Bob with that account. Bob's deposit account is credited $100, and $100 is deducted from mine. No change in money supply.

Now say the Federal Reserve buys a treasury from Bank A. The Fed credits Bank A's deposit account by $100. But whose account does it deduct from? Nobody's. Thus you have an increase of $100--the monetary base has increased by $100. That larger base ultimately allows for an expansion of the money supply once the banks start issuing loans made possible by the increased reserves.

Actually, Bank A's reserve account is credited and it's securities account is debited. It's a series of debits and credits, this is the asset swap.

From a business standpoint, the end result is that it will decrease a bank's earnings by 100 or 2 basis points.

Oh absolutely, the cash in circulation doesn't change. And until the banks start creating more loans made possible by the increase in reserves, you wont see more money in circulation either. The point is that by purchasing treasuries from the banks, the Fed has expanded the monetary base. This expansion allows for banks to loan more money, but the banks may also choose not to do so and just keep the excess reserves. That is the current situation.

Banks can only lend out reserves to other banks. A bank can't lend out reserves to individuals, households and firms, since they don't have reserve accounts at the FED. Unless you're a bank, you cannot borrow reserves. All banks need is credit-worthy borrowers to lend.

There is no expansion of the monetary base with QE. Reserves aren't part of the broad measure of the money supply.

In economics, the monetary base (also base money, money base, high-powered money, reserve money, or, in the UK, narrow money) in a country is defined as the portion of the commercial banks' reserves that are maintained in accounts with their central bank plus the total currency circulating in the public (which includes the currency, also known as vault cash, that is physically held in the banks' vault).