The ECB on Money

July 30th, 2014
in Op Ed

Enhancing Monetary Analysis

by Dirk Ehnts, Econoblog101

The ECB discusses money in its paper "Enhancing monetary analysis". Chapter 1 is titled "The role of money in the economy and central bank policy". It was prepared by Giacomo Carboni, Boris Hofmann and Fabrizio Zampolli. The ECB distinguishes inside and outside money.

Follow up:

Banknotes and coins - or in short, currency - are normally the most secure form of money. They are issued by the central bank and/or government, which vouches for their general acceptability and the stability of their purchasing power. Equally safe are the deposits held at the central bank, normally available only to banks. Banks use them both as a means to settle payments among themselves and as a reserve to meet unusual demands for withdrawals of currency by their depositors. Along with the currency in circulation, the deposits held at the central bank constitute the so-called "monetary base", "central bank money" or "outside money".5 This money is usually "legal tender", which means that any potential creditor is obliged by law to accept it in settlement of any debt.6


5 It is known as "outside" money to highlight the fact that it is created by the public sector as opposed to the private sector (and could be in principle controlled more easily) or as "high-powered" money to stress the fact that it constitutes the basis of the entire monetary pyramid whereby banks - by operating a fractional reserve system - create a volume of media of exchange that is a multiple of the money created by the central bank.
6 Importantly, the exact definition of "legal tender" may differ from country to country.


The second paragraph (separated by lines) are the footnotes of the first.  A different term for central bank money would be reserves. The paragraph on legal tender is somewhat interesting. Footnote 6 says it may differ from country to country. Nevertheless, tax payments ultimately are made in reserves (or what the ECB calls central bank money). Sadly, the ECB does not mention this and completely erases the fiscal part from the whole story. That probably has created the blind spot which led to the creation of a euro zone in which sovereign bonds were not risk free. The ECB continues then describes endogenous money (my highlighting):

Deposits issued by private banks, which are what most individuals and companies have access to, are held for the safety and the convenience that they offer over currency. Not only are they less subject to the risk of theft, but they also offer the convenience of a range of payment options, such as cheques (now less common than in the past), debit and credit cards, and electronic transfers. Other types of securities are also used as a means of payment - for example, certain IOUs issued by private non-financial corporations and widely traded on financial markets (commercial paper), or units in money market funds. The overall amount of money in circulation is, to a large extent, determined by the behaviour of banks and the (profit-seeking) behaviour and interaction of a myriad of private agents.

This, I think, is correct. The amount of money (=deposits in banks) in circulation is largely determined by banks lending to the private sector. What does not determine the amount of money (=deposits in banks) is the central bank, which is in the business of setting the interest through, as the ECB says, variations of the amount of reserves (=central bank deposits of banks). The text goes on describing the money multiplier, but then backing away from this concept:

However, as recently pointed out by Goodhart (2010), a major drawback of the money multiplier approach to money supply analysis is its entirely mechanistic character, which does not offer an account of the behaviour of the central bank, private banks or the private sector money-holders. The pace of financial deregulation and financial innovation over the last few decades has certainly challenged the notion of a stable money multiplier. Also, in times of crisis, money multipliers may prove to be highly unstable and hence may be a poor guide to predicting the effect of monetary policy measures on the money supply. This has become manifest during the global financial crisis, where the massive expansion of base money by central banks was not reflected in the development of broader monetary aggregates because of a collapse of money multipliers when banks were hoarding reserves.

So, the view of the ECB of money is correct. There are some parts omitted from the picture, like the idea that taxes drive money and not price stability, but the description of the two monetary circuits - bank deposits and central bank deposits - is correct. One would have hoped for some more detailed descriptions of interbank clearing and fiscal operations, but there is some good literature (like Fullwiler 2008 and Wray's MMT Primer) out there which explain it from a balance sheet perspective. Since the BoE and other institutions and academics agree with this, maybe we have a new New Consensus?









Make a Comment

Econintersect wants your comments, data and opinion on the articles posted.  As the internet is a "war zone" of trolls, hackers and spammers - Econintersect must balance its defences against ease of commenting.  We have joined with Livefyre to manage our comment streams.

To comment, just click the "Sign In" button at the top-left corner of the comment box below. You can create a commenting account using your favorite social network such as Twitter, Facebook, Google+, LinkedIn or Open ID - or open a Livefyre account using your email address.















 navigate econintersect.com

Blogs

Analysis Blog
News Blog
Investing Blog
Opinion Blog
Precious Metals Blog
Markets Blog
Video of the Day
Weather

Newspapers

Asia / Pacific
Europe
Middle East / Africa
Americas
USA Government
     

RSS Feeds / Social Media

Combined Econintersect Feed
Google+
Facebook
Twitter
Digg

Free Newsletter

Marketplace - Books & More

Economic Forecast

Content Contribution

Contact

About

  Top Economics Site

Investing.com Contributor TalkMarkets Contributor Finance Blogs Free PageRank Checker Active Search Results Google+

This Web Page by Steven Hansen ---- Copyright 2010 - 2016 Econintersect LLC - all rights reserved