Econintersect: Zoltan Jakab and Michael Kumhof have published a working paper with the above title for the Bank of England which compares the hypothetical loanable funds model of banking with models based on the actual banking function of money creation.
The reason that what models are used for understanding the economy is clear from this study: The loanable funds (intermediation) models fail to show responses to shocks of the kind that are seen in real crises. The financing (money creation) models predict changes in bank lending that are far larger, happen much faster, and have much greater effects on the real economy. The following graphs show some modeling results of models based on the two operational models of banking.
Note that in some cases the two types of models predict entirely opposite initial reactions to a credit crash due to higher borrower riskiness (like the 2008 Great Financial Crisis – GFC).
For loanable funds theory (ILF) consumption is predicted to rise for 3-4 months before gradually declining. The financing by money creation model (FMC) consumption drops rapidly in the first 1-3 months following the shock.
The following graph from Trading Economics shows the behavior of U.S. retail sales in the time period which contains the Lehman bankruptcy, the primal shock of the GFC.
For the complete paper, click on the title page below:
Editor’s note: Michael Kumhof has contributed to GEI: Inequality, Leverage and Crises (Michael Kumhof and Romain Ranciere, GEI Analysis, 07 February 2011)