The Financial System and The Economy - Éric Tymoigne PDF

THE FINANCIAL

SYSTEM AND
THE ECONOMY
PRINCIPLES OF MONEY AND BANKING

Éric Tymoigne

THE FINANCIAL
SYSTEM AND THE
ECONOMY
PRINCIPLES OF MONEY AND BANKING

FIRST DRAFT
ÉRIC TYMOIGNE

© August 2016 by Eric Tymoigne. All rights reserved.

TABLE OF CONTENTS
PREFACE ....................................................................................................................................................................... V
CHAPTER 1: BALANCE-SHEET MECHANICS ......................................................................................................................................... 1
WHAT IS A BALANCE SHEET? ............................................................................................................................................. 2
BALANCE SHEET RULES..................................................................................................................................................... 4
CHANGES IN THE BALANCE SHEET ....................................................................................................................................... 6
Net cash flow ........................................................................................................................................................ 6
Net addition to assets and liabilities ..................................................................................................................... 7
Net income ............................................................................................................................................................ 8
Net capital gain ..................................................................................................................................................... 8
CHAPTER 2: CENTRAL-BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS................................................... 10
BALANCE SHEET OF THE FEDERAL RESERVE SYSTEM ............................................................................................................. 11
FOUR IMPORTANT POINTS .............................................................................................................................................. 12
Point 1: The Federal Reserve notes are a liability of the Fed. ............................................................................. 12
Point 2: The Fed does not earn any cash flow in USD ......................................................................................... 13
Point 3: The Fed does not lend reserves and does not rely on the taxpayers ..................................................... 14
Point 4: Banks cannot do anything with reserve balances unless they are dealing with other Fed account
holders ................................................................................................................................................................ 16
CAN THE FED BE INSOLVENT OR ILLIQUID? ......................................................................................................................... 17
CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL-BANK BALANCE SHEET .................................................20
THE MONETARY BASE AND THE MONEY SUPPLY ................................................................................................................... 21
RESERVES: REQUIRED, EXCESS, FREE, BORROWED, NON‐BORROWED ...................................................................................... 23
HOW DOES THE MONETARY BASE CHANGE? ....................................................................................................................... 27
CAN THE FED ISSUE AN INFINITE QUANTITY OF MONETARY BASE? .......................................................................................... 29
CHAPTER 4: MONETARY-POLICY IMPLEMENTATION .............................................................................................................. 33
WHAT DOES THE FED DO IN TERMS OF MONETARY POLICY AND WHY? ..................................................................................... 34
TARGETING THE FFR PRIOR TO THE 2008 FINANCIAL CRISIS .................................................................................................. 37
A GRAPHICAL REPRESENTATION OF THE FEDERAL FUNDS MARKET ........................................................................................... 40
TARGETING FFR AFTER THE GREAT RECESSION ................................................................................................................... 41
CHAPTER 5: FAQS ABOUT CENTRAL BANKING.............................................................................................................................47
Q1: DOES THE FED TARGET/CONTROL/SET THE QUANTITY OF RESERVES AND THE QUANTITY OF MONEY? ...................................... 48
Q2: DID THE VOLCKER EXPERIMENT NOT SHOW THAT TARGETING RESERVES IS POSSIBLE? ........................................................... 49
Q3: IS TARGETING THE FFR INFLATIONARY? ...................................................................................................................... 51
Q4: WHAT ARE OTHER TOOLS AT THE DISPOSAL OF THE FED? ............................................................................................... 52
Q5: WHAT IS THE LINK BETWEEN QE AND ASSET PRICES?..................................................................................................... 53
Q6: HOW AND WHEN WILL THE LEVEL OF RESERVES GO BACK TO PRE‐CRISIS LEVEL? THE “NORMALIZATION” POLICY ....................... 54
Q7: IS THERE A ZERO LOWER BOUND? .............................................................................................................................. 55
Q8: WHAT ARE THE EFFECTS OF A NEGATIVE INTEREST‐RATE POLICY? ..................................................................................... 59
Q9: HOW DID CENTRAL BANKERS JUSTIFY USING NEGATIVE INTEREST RATES AND QE? ............................................................... 60
Q10: SHOULD THE FED FINE‐TUNE THE ECONOMY? ............................................................................................................ 60
Q11: IS THE FED A PRIVATE OR A PUBLIC INSTITUTION? ....................................................................................................... 62
Q12: WHAT ARE NO‐NO SENTENCES FOR WHAT THE FED DOES? (WILL GIVE YOU A ZERO ON MY ASSIGNMENTS) ............................ 63
CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS........................................................................................ 66
MONETARY POLICY AND THE U.S. TREASURY ..................................................................................................................... 67
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Treasury’s involvement in monetary policy during the 2008 crisis ..................................................................... 69
Other examples of Treasury’s involvement in monetary policy .......................................................................... 72
FISCAL POLICY AND THE FED ........................................................................................................................................... 74
A NECESSARY COORDINATION OF TREASURY AND CENTRAL BANK ACTIVITIES ............................................................................ 76
TO GO FURTHER: CONSOLIDATION OR NO CONSOLIDATION? THAT IS THE QUESTION. ............................................................ 77
TO GO EVEN FURTHER: WHAT ARE THE RELEVANT QUESTIONS TO ASK FOR A MONETARILY SOVEREIGN GOVERNMENT? ............... 79
CHAPTER 7: LEVERAGE ..............................................................................................................................................................................84
WHAT IS LEVERAGE? .................................................................................................................................................... 85
WHAT ARE THE ADVANTAGES OF LEVERAGE? ..................................................................................................................... 86
WHAT ARE THE DISADVANTAGES OF LEVERAGE? ................................................................................................................. 86
Interest‐rate risk ................................................................................................................................................. 86
Higher sensitivity of capital to credit and market risks ....................................................................................... 87
Refinancing Risk and Margin Calls ...................................................................................................................... 87
Impact On mortgage debt ................................................................................................................................................ 87
Impact on security‐based debt: Margin call risk .............................................................................................................. 89
EMBEDDED LEVERAGE ................................................................................................................................................... 89
BALANCE‐SHEET LEVERAGE, SOME DATA ........................................................................................................................... 91
THE FINANCIALIZATION OF THE ECONOMY ......................................................................................................................... 92
CHAPTER 8: THE PRIVATE BANKING BUSINESS .......................................................................................................................... 96
THE BALANCE SHEET OF A BANK ....................................................................................................................................... 97
WHAT DO BANKS DO? ................................................................................................................................................. 100
WHAT MAKES A BANK PROFITABLE? ............................................................................................................................... 100
RISKS ON THE BANK BALANCE SHEET ............................................................................................................................... 103
BANKING ON THE FUTURE ............................................................................................................................................ 105
EVOLUTION OF BANKING SINCE THE 1980S ..................................................................................................................... 107
CHAPTER 9: BANKING REGULATION ................................................................................................................................................. 111
EXAMPLES OF BANK REGULATIONS ................................................................................................................................. 112
Reserve requirement ratios ............................................................................................................................... 112
Capital adequacy ratios .................................................................................................................................... 113
CAMELS rating .................................................................................................................................................. 114
Underwriting requirements ............................................................................................................................... 115
WHY ARE THERE STILL FREQUENT AND SIGNIFICANT FINANCIAL CRISES IF REGULATION IS SO TIGHT? ............................................. 115
Deregulation, competition and concentration ............................................................................................................... 115
Deenforcement and desupervision ................................................................................................................................ 118
Regulatory arbitrage....................................................................................................................................................... 119
THEORIES OF BANK CRISES AND BANKING REGULATION: TWO VIEWS ..................................................................................... 120
Laissez faire, laissez passer: Crises as Random events ...................................................................................... 120
Save capitalism from itself: Crises as internal contradictions ........................................................................... 122
CHAPTER 10: MONETARY CREATION BY BANKS ........................................................................................................................ 127
MONETARY CREATION BY BANKS: CREDIT AND PAYMENT SERVICES ....................................................................................... 128
WHAT CAN WE LEARN FROM THE EXAMPLE ABOVE? .......................................................................................................... 132
Point 1: The bank is not lending anything it has: when providing credit services, the bank swaps promissory
notes with its clients ......................................................................................................................................... 132
Point 2: The bank does not need any reserves to provide credit services ......................................................... 132
Point 3: The bank is not using “other people’s money”: it is not a financial intermediary between savers and
investors ............................................................................................................................................................ 133
point 4: The bank’s promissory note is in high demand .................................................................................... 134
HOW DOES A BANK MAKE A PROFIT? MONETARY DESTRUCTION .......................................................................................... 135
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INTERBANK PAYMENTS, WITHDRAWALS, RESERVE REQUIREMENTS, AND FEDERAL GOVERNMENT OPERATIONS: THE ROLE OF RESERVES
............................................................................................................................................................................... 138
WHAT LIMITS THE ABILITY OF A BANK TO PROVIDE CREDIT SERVICES? .................................................................................... 140
MOVING IN STEP ........................................................................................................................................................ 141
LIMITS TO MONETARY CREATION BY THE CENTRAL BANK AND PRIVATE BANKS .......................................................................... 142
TO GO FURTHER: A SIDE NOTE ON ALTERNATIVE VIEWS OF BANKING: THE MONEY MULTIPLIER THEORY AND FINANCIAL
INTERMEDIATION. ....................................................................................................................................................... 142
CHAPTER 11: ECONOMIC GROWTH AND THE FINANCIAL SYSTEM ................................................................................... 147
THE REAL EXCHANGE ECONOMY .................................................................................................................................... 148
Money supply is a veil ....................................................................................................................................... 148
Finance and the economy ................................................................................................................................. 149
Conclusions ....................................................................................................................................................... 151
THE MONETARY PRODUCTION ECONOMY ........................................................................................................................ 152
Money is everything .......................................................................................................................................... 152
Why monetary incentives matter? And what are other implications? ............................................................. 153
Finance and the economy ................................................................................................................................. 154
Beyond incentives: the role of macroeconomic forces ...................................................................................... 155
Conclusions ....................................................................................................................................................... 157
CONCLUSION ............................................................................................................................................................. 157
CHAPTER 12: INFLATION ......................................................................................................................................................................... 160
THE QUANTITY THEORY OF MONEY: MONETARY VIEW OF INFLATION ..................................................................................... 161
INCOME DISTRIBUTION AND INFLATION: A NON‐MONETARY VIEW OF INFLATION ..................................................................... 164
TO GO FURTHER: KALECKI EQUATION OF PROFIT, INTEREST RATE AND INFLATION ................................................................ 168
CHAPTER 13: BALANCE-SHEET INTERRELATIONS AND THE MACROECONOMY ....................................................... 171
A PRIMER ON CONSOLIDATION ...................................................................................................................................... 172
THE THREE SECTORS OF THE ECONOMY ........................................................................................................................... 173
SOME IMPORTANT IMPLICATIONS .................................................................................................................................. 175
point 1: The beginning of the economic process requires that someone goes into debt. ................................. 175
point 2: Not all sectors can record a surplus at the same time ......................................................................... 176
point 3: Public debt and domestic private net wealth ...................................................................................... 180
point 4: Business cycle and sectoral balances ................................................................................................... 182
CONCLUSION ............................................................................................................................................................. 184
TO GO FURTHER: SECTOR BALANCES FROM THE PERSPECTIVE OF THE NATIONAL INCOME AND PRODUCT ACCOUNTS ................. 184
TO GO EVEN FURTHER: NIPA AND FA DEFINITIONS OF SAVING ...................................................................................... 185
CHAPTER 14: FINANCIAL CRISES......................................................................................................................................................... 190
DEBT DEFLATION ........................................................................................................................................................ 191
Step 1: Overindebtedness and distress sales ..................................................................................................... 192
Step 2: Distress sales and deflation, the “Dollar Disease” ................................................................................ 192
Step 3: Deflation and debt liquidation; the “Debt Disease” .............................................................................. 192
Step 4: Prices and profit and net worth, the “Profit Disease” ........................................................................... 193
Step 5: the “Amplifier effect” ............................................................................................................................ 194
Step 6: Pessimism .............................................................................................................................................. 194
Step 7: Interest‐rate spread .............................................................................................................................. 195
Conclusion ......................................................................................................................................................... 196
ORIGINS OF DEBT DEFLATION ........................................................................................................................................ 197
Real exchange economy: Efficient markets and imperfections ......................................................................... 197
Monetary production economy: The financial instability hypothesis ............................................................... 198
Financial fragility ............................................................................................................................................................ 199
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The Financial instability hypothesis ................................................................................................................................ 200
HOW TO DEAL WITH FINANCIAL CRISES ............................................................................................................................ 202
TO GO FURTHER: PONZI FINANCE AND THE BALANCE SHEET ............................................................................................ 203
TO GO EVEN FURTHER: MINSKY AND INCOME VS. CASH INFLOW .................................................................................... 204
CHAPTER 15: MONETARY SYSTEMS ................................................................................................................................................... 207
FINANCIAL INSTRUMENTS ............................................................................................................................................. 208
A SPECIFIC FINANCIAL INSTRUMENT: MONETARY INSTRUMENTS ........................................................................................... 209
AT WHAT PRICE SHOULD A FINANCIAL INSTRUMENT CIRCULATE AMONG BEARERS? .................................................................. 210
FAIR VALUE AND PURCHASING POWER ............................................................................................................................ 212
ACCEPTANCE OF MONETARY INSTRUMENTS ..................................................................................................................... 214
TRUST AND MONETARY SYSTEM: TRUST IN THE ISSUER VS. SOCIETAL TRUST ............................................................................ 216
WHY ARE MONETARY INSTRUMENTS USED? THE MONETARY FUNCTIONS ............................................................................... 218
CHAPTER 16: FAQS ABOUT MONETARY SYSTEMS ...................................................................................................................... 222
Q1: CAN A COMMODITY BE A MONETARY INSTRUMENT? OR, DOES MONEY GROW ON TREES? .................................................. 223
Q2: CAN A MONETARY INSTRUMENT BECOME A COMMODITY? ........................................................................................... 224
Q3: IS MONEY WHAT MONEY DOES? .............................................................................................................................. 225
Q4: ARE CONTEMPORARY GOVERNMENT MONETARY INSTRUMENTS IRREDEEMABLE? OR, IS THE FAIR VALUE OF CONTEMPORARY
GOVERNMENT MONETARY INSTRUMENTS ZERO? ............................................................................................................... 227
Q5: IS MONETARY LOGIC CIRCULAR? .............................................................................................................................. 228
Q6: DO ISSUERS OF MONETARY INSTRUMENTS PROMISE A STABLE PURCHASING POWER? ......................................................... 228
Q7: ARE MONETARY INSTRUMENTS NECESSARILY FINANCIAL IN NATURE? .............................................................................. 229
Q8: ARE CREDIT CARDS MONETARY INSTRUMENTS? WHAT ABOUT PIZZA COUPONS? WHAT ABOUT PRETEND‐PLAY BANKNOTES AND
COINS? WHAT ABOUT BITCOINS? .................................................................................................................................. 229
Q9: WHAT WERE SOME ERRORS MADE IN PAST MONETARY SYSTEMS? .................................................................................. 230
Q10: DO LEGAL TENDER LAWS DEFINE MONETARY INSTRUMENTS? WHAT ABOUT FIXED PRICE? ................................................. 232
Q11: IS IT UP TO PEOPLE TO DECIDE WHAT A MONETARY INSTRUMENT IS? WHO DECIDES WHEN SOMETHING IS DEMONETIZED? ...... 232
Q12: CAN ANYBODY CREATE A MONETARY INSTRUMENT? .................................................................................................. 232
CHAPTER 17: HISTORY OF MONETARY SYSTEMS ....................................................................................................................... 235
MASSACHUSETTS BAY COLONIES: ANCHORING OF EXPECTATIONS AND INAPPROPRIATE REFLUX MECHANISM ................................. 236
MEDIEVAL GOLD COINS: FRAUD, DEBASEMENT, CRYING OUT, AND MARKET VALUE OF PRECIOUS METAL ...................................... 237
TOBACCO LEAFS IN THE AMERICAN COLONIES: LEGAL TENDER LAWS AND SCARCITY OF MONETARY INSTRUMENTS .......................... 239
SOMALIAN SHILLING: THE DOWNFALL OF THE ISSUER AND CONTINUED CIRCULATION OF ITS MONETARY INSTRUMENT ..................... 240
GLOSSARY ................................................................................................................................................................. 242
ABOUT THE AUTHOR ................................................................................................................................................... 248

iv

PREFACE
This text is the preliminary draft for a textbook that is the result of an extensive revision of posts published
on the blog neweconomicperspectives.org. Why write a new money and banking text when there are
already so many available? There are three main reasons. First, texts usually do not have a coherent theme
that runs through them and that ties together all the chapters. Second, the monetary and banking
chapters usually leave a lot to be desired because they present outdated views or are too limited in their
presentation of the topic. Three, the macroeconomic sections usually do not use what was presented in
the previous chapters, leave aside important debates in academia, and only briefly deal with balance sheet
interrelationships to analyze macroeconomic issues. This preliminary text deals with these three issues.
Throughout the text, the concept of balance sheet is central and used to analyze all the topics presented.
Not only are balance sheets relevant to understand financial mechanics, but also they force an inquirer to
fit a logical argument into double‐entry accounting rules. This is crucial because if that cannot be done
there is an error in the logical argument.
The monetary and banking aspects and their relation to the macroeconomy are analyzed extensively in
this text by relying on the literature that has been available for decades in non‐mainstream journals, but
that has been mostly ignored until recently. Gone is the money multiplier theory, gone in the financial
intermediary theory of banks, gone is the idea that central bank control monetary aggregates, gone is the
idea that finance is neutral in any range of time, and gone is the idea that nominal values are irrelevant.
Preoccupations about monetary gains, solvency and liquidity are central to the dynamics of capitalism,
and finance is not constrained by the amount of saving.
The chapters dealing with monetary systems are also much more developed than a typical textbook. As
such, the “money” chapter, usually first in M&B texts, only comes much later in the form of three chapters,
once balance‐sheet mechanics and financial concepts, such as present value, have been well understood.
In addition, the link between macroeconomic topics and banking theory is fully established to analyze
issue of inflation, economic growth, financial crisis, and financial interlinkages.
Of course, all this is still work in progress. There are many chapters missing for a full text and some of the
chapters will need to be rewritten to account for comments by my students and others. Below is a list of
missing Chapters that will be added between January and June 2017 (some of this is already included in
the book but is underdeveloped):
1. Overview of the financial system (how financial companies differ because of different balance
sheets)
2. Financial state of different macroeconomic sectors, flow of funds analysis (who is a net creditor?
Etc.)
3. Federal Reserve System institutional analysis
4. Interest rate and interest rate structure
5. Pricing of securities
6. Securitization
7. Derivatives
8. Monetary policy in action (issues surrounding interest‐rate rules, transmission channels, etc.)
v

9. International monetary arrangements and exchange rates
10. Modeling (theory of the circuit, including the money supply in models, stock‐flow coherency,
portfolio constraints, capital gains, using models, etc.)
In the second draft, the first five Chapters above will be Chapters 2, 3, 4, 5 and 6 respectively; Chapter 1
will still be about balance sheet mechanics and will be expanded. The Chapter 2 in the text below will be
included in Chapter 3 above. Securitization and derivative will be included after studying banks in details
(i.e. after Chapter 10 below). International arrangement will come toward the end of the book.
In order to use this preliminary edition, it is recommended that institutional analysis be done first by the
instructor. Any text will do for that purpose but the lecturer can emphasize how the structure of balance
sheets differs between financial companies in order to explain what each financial company does.
I wish to thank all the readers of the posts that form the basis of this preliminary text. Their comments
were very helpful to improve clarity of the text and correct some mistakes. Many thanks to Stavros N.
Karageorgis for carefully reading and editing the draft.

vi

CHAPTER 1:
After reading this chapter you should understand:
What a balance sheet is
Why a balance sheet changes
How a balance sheet changes

CHAPTER 1: BALANCE‐SHEET MECHANICS
The U.S. financial system is extremely complicated. Figure 1.1 provides an overview of that system
that consists of three main categories; financial markets, financial companies and regulatory and
supervisory institutions. While most parts of that system will be at least mentioned in this draft,
the draft focuses mostly on the Federal Reserve System and depository institutions.
International Financial Markets (Foreign Exchange Markets, Eurocurrencies, Eurobonds, Foreign Bonds)
Capital Markets: Securities with a maturity superior to one year Primary Market
(Stocks, Bonds, Asset-Backed Securities)
Financial Markets Money Markets: Securities with a maturity of one year or less Organized Exchanges
(BAs, CDs, CPs, Federal funds loans, RPs, bills) Secondary Market
OTC Markets
Insurance Markets (Forwards, Futures, Options, Swaps)
Organized Exchanges (CBOT, CBOE, NASDAQ, NYSE)

Financial-Market Companies
Security Firms (Investment Banks, Brokerage Firms)
Commercial Banks
Depository Institutions
Thrift Institutions (Credit Unions, Savings Banks, Savings and Loan Associations)
Financial Sector Financial Companies
Financial Investment Companies (Hedge Funds, Pension Funds, Mutual Funds, Real Estate Investment Trusts)
Insurance Companies (Life Insurance Companies, Property and Casualty Insurance Companies, Monolines)
Finance Companies (Business Finance Companies, Consumer Finance Companies, Sales Finance Companies, SPEs)
Government-Sponsored Enterprises (FAMC, FCS, FHLBS, FHMLC, FNMA,

Government Financial Agencies SLMA)
Government Loan Guarantee Programs and Government Loan Programs (Ex-
Im Bank, FHA, FCA, GNMA, SBA, VA, DLP)
Federal Reserve System (Fedwire, Discount Window, Open Market Trading
Desk)
Private: National Associations (SIFMA, FINRA, NBA, NFA), Organized Exchanges, Clearing Systems (OC
Corp., CHIPS), Credit-Rating Agencies
Regulatory and Supervisory Institutions
Government: Department of Housing and Urban Development (FHFA), Department of Labor, Department of
Treasury (OCC, OTS), Independent Federal Agencies (CFTC, FCA, FDIC, Federal Reserve Board, Reserve
Banks, Fedwire, FTC, NCUA, SEC, CFPB), Interfederal agencies (FFIEC, FSOC), State Banking and
Insurance Commissioners
CBOE: Chicago Board Options Exchange, CBOT: Chicago Board of Trade, CFPB: Consumer Financial Protection Bureau, CFTC: Commodity Futures Trading Commission, DLP: Direct Loan Program,
Ex-Im Bank: Export-Import Bank, FAMC: Federal Agricultural Mortgage Corporation (“Farmer Mac”), FCA: Farm Credit Administration, FCS: Farm Credit System, FDIC: Federal Deposit Insurance
Corporation, FFIEC: Federal Financial Institution Examination Council, CHIPS: Clearing House Interbank Payment System, FHA: Federal Housing Administration, FHFA: Federal Housing Finance
Agency, FHLBS: Federal Home Loan Banks System, FHMLC: Federal Home Loan Mortgage Corporation (“Freddie Mac”), FNMA: Federal National Mortgage Association (“Fannie Mae”), FSA: Farm
Service Agency, FSOC: Financial Stability Oversight Council, FTC: Federal Trade Commission, GNMA: Government National Mortgage Association (“Ginnie Mae”), FINRA: Financial Industry
Regulatory Authority, NASDAQ: National Association of Securities Dealers Automated Quotation System, NBA: National Bankers Association, NCUA: National Credit Union Administration, NFA:
National Futures Association, NYSE: New York Stock Exchange, OC Corp.: Option Clearing Corporation, OCC: Office of the Comptroller of the Currency, OTC: Over-the-Counter, OTS: Office of
Thrift Supervision, SBA: Small Business Administration, SEC: Securities and Exchange Commission, SIFMA: Securities Industry and Financial Markets Association, SLMA: Student Loan Marketing
Association (“Sallie Mae”), SPE: Special Purpose Entity, VA: Department of Veteran Affairs.
Figure 1.1. The U.S. financial sector
The core of the financial system consists of financial documents and among them are balance
sheets. Balance sheets provide the foundation upon which most of an M&B course can be taught:
monetary creation by banks and the central bank, nature of money, financial crises, securitization,
financial interdependencies, you name it, it has to do with one or several balance sheet(s). As
Hyman P. Minsky used to note, if you cannot put your reasoning in terms of a balance sheet there
is a problem in your logic.
WHAT IS A BALANCE SHEET?
It is an accounting document that records what an economic unit owns (its “assets”) and owes (its
“liabilities”). The difference between its assets and liabilities is called net worth, or equity, or capital
(Figure 1.2).
2


Figure 1.2 A balance sheet
There are many different ways to classify assets and liabilities. For our purposes, a balance sheet
can be detailed a bit according to Figure 1.3. Financial assets are claims on other economic units;
non‐financial assets (aka real assets) may be reduced to physical things (cars, buildings, machines,
pens, desks, inventories, etc.) but may also include intangible things (goodwill among others).
Demand liabilities are liabilities that are due at the request of creditors (cash can be withdrawn
from bank accounts at will by account holders); contingent liabilities are due when a specific event
occurs (life insurance payments to a widow); dated liabilities are due at specific periods of time
(interest and principal mortgage payments are due every month).

Figure 1.3 A simple balance sheet
Balance sheets can be constructed for any economic unit. That unit can be a person, a firm, a sector
of the economy, a country, anybody or anything with assets and liabilities. Table 1.1 shows the
balance sheet of all U.S. households (and non‐profit organizations) in the United States. In 2014,
U.S. households owned $98.3 trillion worth of assets and owed $14.2 trillion worth of liabilities,
making net worth equal to $84.1 trillion (98.3 – 14.2). Households held $29.2 trillion of non‐financial
assets and $69.1 trillion of financial assets. Their two main liabilities were mortgages ($9.4 trillion)
and consumer credit (credit card debts, student debts, healthcare debts, etc.) ($3.3 trillion).
3


Table 1.1 Balance sheet of households and NPOs.
Source: Financial Accounts of the United States
BALANCE SHEET RULES
A balance sheet follows double‐entry accounting rules so a balance sheet must always balance, that
is, the following must always be true:
Assets = Liabilities + Net Worth
The practical, and central, implication is that a change in one item on the balance sheet must be
offset by at least one change somewhere else so that a balance sheet stays balanced.
4

Start with a very simple balance sheet. The only asset is a house worth $100k that was purchased
by putting down 20k and asking for $80k from a bank (Figure 1.4).

Figure 1.4 A simple balance sheet
What is the impact of a bank forgiving $40k of principal on the mortgage? The value of mortgage
went down by 40k and the value of net worth went up by 40k so that the accounting equality is
preserved (Figure 1.5)

Figure 1.5 Effect of forgiving some of the mortgage principal
Going back to the first balance sheet, what is the impact of the value of the house going up by $20k?
The asset value went up by $20k and the net worth went up by $20 and here again the accounting
equality is preserved. (Figure 1.6).

Figure 1.6 Effect of higher house price
Sometimes, to get to the point more quickly and to highlight the changes, economists prefer to use
so‐called “T‐accounts” (because the shape of the table looks like a T) that record only the changes
in the balance sheet (Δ means “change in”). The offsetting accounting entry is shown more clearly.
It comes from opposite changes in two items on the right side of the balance sheet (Figure 1.7), and
a change in asset and net worth by the same amount (Figure 1.8). Of course, these are not the only
5

two ways the offsetting is done to preserve the accounting equality. We will encounter other cases
as we move forward. The point is that one must change at least two things in a balance sheet to
make sure that the equality A = L + NW is preserved. One must always ask: what is (are) the
offsetting entry change(s)? This has practical implications when studying how banks and central
bank operate.
Household
ΔAssets ΔLiabilities and Net Worth
Mortgage: ‐$40
Net worth: +$40
Figure 1.7 T‐account that records the decline of the mortgage principal

Household
House: +$20 Net worth: +$20
Figure 1.8 T‐account that records the higher house value
CHANGES IN THE BALANCE SHEET
One can classify factors that change a balance sheet in four categories:
‐ Cash inflows and outflows: net cash flow.
‐ Purchases and sales of assets, issuance and repayment of debts: Net acquisition of assets
and liabilities.
‐ Incomes and expenses: net income.
‐ Capital gains and capital losses: net change in the market value of assets and liabilities.
The last three categories are recorded more carefully in other accounting documents than the
balance sheet, but this section focuses on their relation to the balance sheet.
NET CASH FLOW
Cash inflows and cash outflows lead to a change in the outstanding value of monetary balances
held by an economic unit, that is, a change in the quantity of physical currency or funds in a bank
account held on the asset side. Some assets lead to cash inflows while some liabilities and capital
(dividend payments) lead to cash outflows.
If the cash inflows are greater than the cash outflows, monetary assets held by an economic unit
go up. The economic unit can use them to buy assets or pledge them to leverage its balance sheet
(see Chapter 7). If net cash flow is negative, then monetary‐asset holdings fall and the economic
unit may have to go further into debt to pay some of its expenses (Figure 1.9).
6


Figure 1.9 Balance sheet and cash flow
Going back to the balance sheet of Figure 1.4, assume that a salary of $40k is earned and that part
of the salary is used to service a 30‐year fixed‐rate 10 % mortgage. Assuming linear repayment of
principal to simplify (actual mortgage servicing is calculated differently), Figure 1.10 shows what
the cash flow structure looks like.

Figure 1.10 Balance sheet and cash flows, an example
The balance sheet at the beginning of the following year is shown in Figure 1.11 (assuming all cash
flows involve actual cash transfer instead of electronic payments). Quite a few things have changed
in the balance sheet. There is a net inflow of cash of $29.3k, the principal of the mortgage fell by
the amount of principal repaid, and the change in net worth accounts for these two changes.

7


Figure 1.11 Balance sheet after the cash‐flow impacts
NET ADDITION TO ASSETS AND LIABILITIES
Net cash flow records the net addition of monetary balances but there are many other assets on
the balance sheets. Overtime, assets loss value via depreciation, or destruction, or repayment of
principal; some assets are sold while others assets are purchased. The net change in the monetary
value of assets (acquisitions minus loss of value and sales) impacts the balance sheet. Depreciation
is counted as an expense and so impacts net income. Similarly, liabilities on the balance sheet are
progressively repaid (principal repayment) or reduced in other ways, while new liabilities are issued
by an economic unit. The net issuance of liabilities (new liabilities – principal reductions) also
impacts the balance sheet of their issuers. They also impact the balance sheet of the creditors given
that the liabilities of someone are the financial assets of someone else.
Current net worth = Previous net worth + Net addition to assets and liabilities of the period
Figures 1.4 shows the impact of acquiring non‐financial assets (the house) and incurring new
liabilities (the mortgage). Figure 1.5 shows the impact of a decline in the principal amount of the
mortgage.
NET INCOME
Net income leads to a change in net worth:
Current net worth = Previous net worth + Net addition to assets and liabilities of the period +
Net income of the period
Net income can be positive or negative so net worth may rise or fall depending on what the value
of net income is. In the previous example (Figures 1.10 and 1.11), net cash flow and net income are
the same thing; however, not all incomes necessarily lead to cash inflows (see Chapter 4 and
Chapter 10). There is a debate about whether one should record capital gains and losses in the
income statement. For the purpose of this section, the two are clearly separated.
NET CAPITAL GAIN
The value of assets and liabilities change merely because of changes in their market prices even
though their quantities has not changed (no net addition). If accounting is done on a “mark‐to‐
8

market” basis, i.e. by valuing balance‐sheet items on the basis of their current market value, these
changes are accounted in the balance sheet. Some assets see their prices go up (capital gains) while
other see their prices go down (capital losses) and the difference between capital gains and capital
losses (net capital gains) affects the net worth accordingly:
Current net worth = Previous net worth + Net addition to assets and liabilities of the period +
Net income of the period + Net acquisition of assets and liabilities of the period + Net capital
gains of the period
The example of Figure 1.3 is a simple illustration of the impact of capital gains.
The effect of a change in the market prices of assets and liabilities may not be recorded in the
balance sheet if they are valued on a cost basis. For financial assets, there are three options to
record their value. Level 1‐valuation uses the available market price. Level‐2 valuation, for assets
that do not have an active market, uses a proxy market as a point of reference. Level‐3 valuation,
also called mark‐to‐model (or more cynically “mark‐to‐myth”), uses an in‐house model to give a
dollar value to the asset. During the 2008 crisis, major financial institutions argued that the market
prices of some assets did not reflect their true value because of a panic in markets. The Securities
and Exchange Commission allowed them to move to level‐2 or level‐3 valuation to avoid recording
capital losses on their assets. Many analysts have been critical of that decision and considered it to
be a convenient way to hide major losses of net worth by financial institutions.
Summary of Major Points
1‐ A balance sheet is one of the important financial documents used to record the financial state of
an economic unit
2‐ Assets represent what is owned and liabilities represent what is owed by an economic unit
3‐ Net worth or capital or equity is the difference between the monetary value of assets and
liabilities
4‐ A balance sheet must balance, i.e. at all time the following must be true: Assets = Liabilities + Net
Worth
5‐ A balance sheet follows double‐entry accounting rules: a change somewhere leads to at least
one offsetting change somewhere else to ensure that the balance sheet stays balanced.

Keywords
Balance sheet, non‐financial assets, financial assets, demand liability, time liability, contingent
liability, net worth, capital, net income, net cash flow, net capital gain, net acquisition of assets and
liabilities, level‐1 valuation, level‐2 valuation, level‐3 valuation

Review Questions
Q1: What does a balance sheet do?
Q2: If the value of assets goes up and the value of liabilities goes down, what happens to net worth?
Q3: If the value of assets and liabilities changes by the same amount, what happens to net worth?
Q4: If outstanding assets depreciate faster than the acquisition of new assets, what happens to the
value of assets? To the value of net worth?
Q5: If an economic unit takes on new debt faster than it repays outstanding principal, what happens
to the level of liabilities? Of net worth?

9

CHAPTER 2:
After reading this Chapter you should understand:
What the main components of a central‐bank balance sheet are
How a central bank provides reserves
That a central bank does not rely on taxpayers
That a central bank does not lend reserves
That a central bank does not use any domestic monetary instruments
That a central bank does not earn any cash flow in the domestic currency
That banks cannot buy anything with reserve balances from the public

CHAPTER 2: CENTRAL‐BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS
The Federal Reserve System (the Fed) is a typical central bank. It provides the currency of the
nation, it is the depository and fiscal agent of the Treasury, it provides advances of funds to banks,
and it intervenes in financial markets. In order to understand how all this is done, it is important to
understand the balance sheet of the Fed. This Chapter applies the insights of Chapter 1 to study the
balance sheet mechanics of the Fed.
BALANCE SHEET OF THE FEDERAL RESERVE SYSTEM
Table 2.1 shows the actual balance sheet of the Federal Reserve System. It sums the assets,
liabilities, and capital of all twelve Federal Reserve banks and consolidates them (i.e. removes what
Fed banks owe to each other). The main asset is Treasury securities that amounted to about $718
billion in January 2005.

Table 2.1 Actual balance sheet of the Federal Reserve System
Source: Board of Governors of the Federal Reserve System (Series H.4.1)
The main liability is outstanding Federal Reserve notes (FRNs) issued—that is, held outside the
twelve Federal Reserve banks’ vaults—that amounted to $718 billion in January 2005. This line in
the balance sheet includes all FRNs issued regardless who owns them. A distant second liability was
reserve balances (“deposits of depository institutions”) that amounted to $31 billion.
11

Capital consists mostly of the annual net income of the Fed (“surplus” line) and the shares that
banks must buy when becoming members of the Federal Reserve System (the “capital paid in” line).
These shares are not tradable, cannot be pledged (banks cannot use them as collateral and they
cannot be discounted), do not provide a voting right to banks, and pay an annual dividend
representing 6% of net income of the Fed.
Any left‐over net income is transferred to the U.S. Treasury and the Secretary of the Treasury can
use the funds only for two purposes: to increase Treasury’s gold stock or to reduce outstanding
amount of Treasuries.1
For analytical purposes, it is best to rearrange the balance sheet of the Fed according to Figure 2.1.
Through this book, a lot will be done with L1, L2 and L3 as well as A1 and A2 because they are all
central to the understanding of domestic monetary policy operations. In addition, L1 only contains
the FRNs held by banks, the domestic public and foreigners. Indeed, for analytical purposes,
economists like to measure the outstanding value of FRNs in circulation, that is, FRNs held outside
the vaults of private banks (“vault cash”), of the Federal Reserve banks, and of the U.S. Treasury.
FRNs held by the Treasury are included in L3, FRNs held by the Federal Reserve banks are included
nowhere (they have not been issued so they are not a liability yet).
Assets Liabilities and Net Worth
A1: Securities L1: Federal Reserve notes in
circulation and vault cash
A2: Domestic private banks’
promissory notes L2: Reserve balances (Checking
A3: Foreign‐denominated assets account due to banks)
L3: Treasury’s account and Federal
A4: Coins and Treasury currency
Reserve notes held by Treasury
A5: Other assets (buildings, furniture,
etc.) L4: Accounts due to foreigners and
others
L5: Other liabilities (including equity
capital)
Figure 2.1 A simplified balance sheet of the Federal Reserve System
FOUR IMPORTANT POINTS
POINT 1: THE FEDERAL RESERVE NOTES ARE A LIABILITY OF THE FED.
One immediately notes that the central bank does not own any cash or a bank account in US dollar,
i.e. there are no domestic monetary instruments on its asset side besides a few Treasury currency
items (United States notes, etc.) and some coins. The Fed does not use coins to spend, it acts as
coin dealer on behalf of the Treasury,2 that is, Fed buys all new coins from the U.S. Mint at face
value and sells them to banks at their request by debiting their reserve balances. The Fed also buys
back coins that banks have in excess by crediting their reserve balances. Gold certificate account
(first line under assets) are just electronic entries to record the safe keeping of some of the gold
stock owned by the U.S. Treasury; The Fed does not own any gold.3 The Fed does own some foreign
monetary instruments (SDR accounts, accounts at foreign central banks, foreign currency).
12

What the U.S. population considers to be “money,” the Federal Reserve notes (FRNs), is recorded
as a liability on the balance sheet of the Fed. FRNs are a specific security issued by the Fed and the
Fed owes the holders of the FRNs. Chapter 15 studies what is owed. FRNs are secured by some of
the assets of the Federal Reserve banks, most of them are Treasuries (Figure 2.2)

Figure 2.2. Level and composition of the assets pledged against the FRNs out of the Federal
Reserve vaults, trillions of dollars
Source: Board of Governors of the Federal Reserve System (Series H4.1)
Note: USTS means U.S. Treasury security, MBS means mortgage‐backed security.
POINT 2: THE FED DOES NOT EARN ANY CASH FLOW IN USD
When the Fed receives a net income in US dollars it does not receive any cash flow, i.e. no monetary
asset goes up. What goes up is net worth. How does that occur? Suppose that banks request an
advance of funds of $100 repayable the next day with a 10% interest. Today the following is
recorded:
Fed
Promissory notes of banks: +$100 Reserve balances: +$100
The Fed just typed an entry on each side of its balance sheet, one to record the crediting of reserve
balances and one to record the Fed is now a creditor of private banks by holding a claim on banks.
The next day banks must pay back $100 and an additional $10. The full repayment of the principal
leads to:
Fed
Promissory notes of banks: ‐$100 Reserve balances: ‐$100
13

What about the $10 payment? It leads to an additional decrease in reserve balances and the
offsetting operation is an increase in net worth at the Fed (and a decrease in net worth at private
banks)
Fed
Reserve balances: ‐$10
Net worth: +$10
These two T‐accounts are normally consolidated into one:
Fed
Promissory notes of banks: ‐$100 Reserve balances: ‐$110
Net worth: +$10
Here we go! The Fed records an income gain!
How does it transfer that to the Treasury? Easy! A Fed employee types the following on a keyboard:
Fed
Treasury’s account: +$10
Net worth: ‐$10
The transfer of funds between accounts is like keeping scores by changing amounts recorded on the
liability side. Banks lost 10 points, Treasury gained 10 points.
POINT 3: THE FED DOES NOT LEND RESERVES AND DOES NOT RELY ON
THE TAXPAYERS
In Table 2.1, there is a line labeled “loan” on the asset side, and one will often hear and read—even
in Fed documents—that the Fed lends reserves to banks. In the balance sheet of Figure2.1, there is
no “loan” but instead there is “A2: Domestic private banks’ promissory notes.”
This textbook will not the use the words “loan,” “lender,” “borrower,” “lending,” “borrowing,”
when analyzing banks (private or Fed) and their credit operations. Banks do not lend money—they
are not money lenders—and customers do not borrow money from banks. Words like “advance,”
“creditor,” “debtor,” are more appropriate words to describe what goes on in banking operations.
The word “lend” (and so “borrow”) is really a misnomer that has the potential of confusing—and
actually does confuse—people about what banks do. “Lending” means giving up an asset
temporarily: “I lend you my car for a few days” is represented as follows in terms of a balance sheet:
Dr. T
Car: ‐$100
Claim on borrower of car: +$100
Alternatively, if someone goes to see a loan shark for his gambling habits and borrows $1000 cash,
then the balance sheet of the loan shark changes as follows
14

Loan shark
Cash: ‐$1000
Claim on gambler: +$1000
The loan shark loses cash temporarily—he does lend cash—and if the gambler does not repay
quickly with hefty interest, the loan shark comes with a baseball bat and breaks his legs (or worse!).
“To lend” is really not a proper verb to explain what the Fed does because reserve balances and
FRNs are not assets of the Fed, they are its liabilities. As shown in point 2, when the Fed provides
reserve balances to banks, the Fed gives to banks its own promissory note (reserve balances) and
banks give to the Fed their own promissory notes. What the Fed does is to swap/exchange
promissory notes with banks. This is one way for banks to obtain reserves balances. Chapter 4 and
Chapter 10 explain why banks are so interested in the Fed’s promissory note and how they obtain
reserves. Figure 2.3 shows what the banks’ promissory note looks like.

Figure 2.3 Template of the promissory note issued by banks to the Discount Window
Source: Federal Reserve Bank Services (Operating circular No. 10)
15

In this legal document (and others attached to it), a bank recognizes that it is indebted to the Fed
because the Fed provided an advance of funds, that is, credited the bank’s reserve balance. Now
the bank promises to comply with the terms of the contract that details time table for repayment,
interest, collateral requirements, covenants, what happens in case of default, etc. The Fed keeps a
copy of this document in its vault; it is an asset for the Fed (A2 in Figure 2.1) because the bank made
a legal promise to the Fed. The Fed can force the bank to comply with the demands of the promise.
The main point is that, when the Fed provides funds to banks, the Fed does not give up something
it first had to acquire. The Fed does not use “tax payers’ money” (or anybody else’s money) as we
often heard during the 2008 financial crisis when large emergency advances had to be provided to
many financial institutions. When the Fed provides/advances funds to banks, it just credits the
accounts of banks by keystroking amounts. Chapter 10 shows that the same logic applies to private
banks.
POINT 4: BANKS CANNOT DO ANYTHING WITH RESERVE BALANCES

UNLESS THEY ARE DEALING WITH OTHER FED ACCOUNT HOLDERS
One may also note that nobody in the U.S. population has a bank account at the Federal Reserve.
Only domestic banks, foreign central banks, and other specific institutions (such as the International
Monetary Fund and some government‐sponsored enterprises) have an account at the Fed.4 When
banks use their accounts at the Fed to make or to receive a payment, the only other institutions
that can receive the funds (or make a payment to banks) are those that also hold an account at the
Fed. Banks cannot use their reserve balances to buy something from an economic unit that does
not have an account at the Fed because funds cannot be transferred. Similarly, you and I cannot
make electronic payments to a person who does not hold a bank account.
This is what happens when banks spend $100 from their reserve balances:
Fed
This T‐account is incomplete because it lacks the offsetting accounting entry. What are the
possibilities? Below are three of them:
1‐ Banks ask for FRNs:
Fed
FRNs: +$100
2‐ Banks settle taxes (theirs or that of the US population):
Fed
3‐ Banks participate in an offering of securities by a government‐sponsored enterprise:
16

Fed
GSEs’ account: +$100
You may think of other ways to transfer $100 worth of funds on the liability side of the Fed. Once
again, the Fed is basically keeping scores by transferring funds among account holders and keeping
a tab.
The main point is that banks cannot buy anything with reserve balances from anyone in the
domestic economy except from each other and other Fed account holders. Banks as a whole cannot
use reserve balances to acquire any security issued by the private sector or any goods and services
(one bank could use its reserve balance to buy such things from another bank). More reserves do
not provide banks more purchasing power in the domestic economy to buy existing bonds, stocks,
houses, etc.
If banks wanted buy something from someone in the domestic economy with Fed currency, they
would have to get more vault cash first (case 1 above). Chapter 10 shows that banks do not operate
that way to make payments. Nor do banks lend cash (they are not the loan shark of point 2).
CAN THE FED BE INSOLVENT OR ILLIQUID?
No. The Fed cannot “run out of dollars” because it is the issuer of the dollar. The Fed could have a
negative net worth and still be able to operate normally and meet all its creditors’ demands.
The main role of net worth in a private balance sheet is to protect the creditors (the holders of the
liabilities). Think of the house example in Chapter 1. The house was funded by $80k of funds
obtained from a bank and $20k down. If the mortgagor defaults, the bank can foreclose and sell
the house. With a net worth of 20k, the home price can fall by 20% before the bank is unable to
recover the funds advanced to the mortgagor. If the down‐payment had been 0% (mortgage was
$100k), when the bank forecloses it does not have any financial buffer against a fall in house price.
For the Fed, this is financially irrelevant, although politically it may raise some eyebrows in
Congress. It can meet all payments due denominated in USD at any time, no matter how big they
are.
17

1‐ The main liability of the Federal Reserve System is the cash we have in our wallet, Federal Reserve
notes.
2‐ The main asset of the Federal Reserve System is Treasury securities.
3‐ Lending means temporarily giving up an asset; as such the Federal Reserve System does not lend
reserves because reserves are its liability.
4‐ To credit the account of its account holders, the Federal Reserve System swaps promissory notes
with them.
5‐ To obtain an advance from the Fed, private banks must provide collateral to back their
promissory note.
6‐ Paying interest to the Fed increases its net worth and debits the Fed accounts of whomever is
paying the interest. There is no cash flow gain, i.e. no increase in monetary balances on the asset
side of the Fed’s balance sheet.
7‐ Banks can only transfer funds in/out of their Fed accounts from/to other Fed account holders, in
the same way you and I can only transfer funds from our checking account to another checking
account. As such private banks cannot buy anything with their reserve balances from the public.
8‐ The Federal Reserve System issues the U.S. currency so it cannot run out of U.S. currency and
can pay any debt it owes denominated in the U.S. dollar.

Keywords
Currency in circulation, Federal Reserve note, reserve balance, loan, lending, advance, swapping.

Review Questions
Q1: Do the Federal Reserve banks own any domestic monetary instruments?
Q2: Do the Federal Reserve banks use coins to buy assets?
Q3: Why do the Federal Reserve banks not lend reserves?
Q4: Why is it not possible for private banks to buy things from the public by using their reserve
balances?
Q5: What can private banks buy with their reserve balances?
Q6: When private banks pay an interest to the Federal Reserve banks, how do Federal Reserve
banks record this income gain? Is there any gain of cash flow?
Q7: Why is it not possible for the Federal Reserve System to be insolvent?

Suggested Readings
Check the “General Information” tag of the Discount Window website:
https://www.frbdiscountwindow.org/
Check “About the Fed” here: http://www.federalreserve.gov/aboutthefed/default.htm
Check the website of the Board of Governors of the Federal Reserve System, especially the
following: http://www.federalreserve.gov/monetarypolicy/bst_fedsbalancesheet.htm. Table 5
contains an interactive section about the balance sheet of the Fed.

18

Database Exploration
How to retrieve time series data about the balance sheet of the Fed?
Step 1: Go to Series H.4.1: http://www.federalreserve.gov/releases/h41/
Step 2: Click on “PDF” and look for Table 5. Use it as a reference point to select data.
Step 3: Click on “Data download program.”
Step 4: Select option A “Build your package.”
Step 5: In “2. Category” select “Assets” and “Liabilities and Capital.”
Step 6: Continue with the subcategories and components. You can select more or less details
relative to Table 5.
Step 7: Continue with other miscellaneous selections (frequency, time frame, etc.) and download.
Tip: Always download “total assets” and “total liabilities” so you can sum all the components of
each category and make sure they equal the total. If not, you forgot a component.

1 For detail see Section 7 of Federal Reserve Act.
2 See Current FAQs: “What is the role of the Federal Reserve with respect to banknotes and coins?” at
http://www.federalreserve.gov/faqs/currency_12626.htm
3 See Current FAQs: “Does the Federal Reserve own or hold gold?” at http://www.federalreserve.gov/faqs/does‐the‐
federal‐reserve‐own‐or‐hold‐gold.htm
4 A recent working paper released by the Bank of England proposes to expand the access to accounts at the Bank of
England to the general population. Staff Working Paper No. 605, “The macroeconomics of central bank issued digital
currencies” by John Barrdear and Michael Kumhof.
19

CHAPTER 3:
After reading this Chapter you should be able to understand:
What reserves and monetary base are
What the most common means to obtain reserves for banks are
How the composition of reserves has changed over time
How reserves and monetary base are injected into, and removed from, the
economy

CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL BANK BALANCE SHEET
The previous Chapter explained how the balance sheet of the Fed works. The current Chapter
begins to study the details of how the Fed operates in the economy in terms of monetary policy. To
understand what the Fed does, it is first necessary to define the monetary base and see how it
relates to the Fed’s balance sheet. The Chapter quickly looks at the difference between monetary
base and money supply, and also looks more carefully at what reserves are.
THE MONETARY BASE AND THE MONEY SUPPLY
The monetary base (aka “high‐powered money”) is defined as:
Monetary Base = Reserve balances + vault cash + currency in circulation
In its widest meaning, “in circulation” refers to any monetary instrument not held by its issuer;
Federal Reserve Notes (FRNs) outside the Federal Reserve banks and any Treasury‐issued cash
outside the Treasury. Economists prefer to use a narrower definition. Currency in circulation is any
currency outside vaults of private banks (“vault cash”), of the Treasury, and of the Fed—what is
held by “the public.”

Figure 3.1 Monetary base, billions of dollars
Sources: Board of Governors of the Federal Reserve System (H3 and H6 series)
Technically, cash means currency and coins. The Fed and Treasury use the word “currency” to mean
paper money only. Currency in circulation includes mostly FRNs, but also some Treasury currency
(United States notes, silver certificates) and national bank notes (issued prior to the creation of the
Fed in 1913) that the Treasury still agrees to take at face value at any time.1 The distinction between
coins and currency is mostly statistical and does not have any analytical power. Chapter 15 shows
that the material of which something is made is irrelevant to determine if it is a monetary
instrument. This book uses the word cash and currency interchangeably.
To simplify, the U.S. monetary base can be reduced to (see Figure 2.1 for meanings of L1 and L2):
21

Monetary base = L1 + L2
That is, the monetary base is the sum of reserve balances and FRNs held by entities other than the
Fed and the Treasury.
Until recently, currency in circulation was the largest component of the monetary base and it grew
steadily to almost $1.4 trillion today, most of which are FRNs,2 and between one‐half and two‐thirds
of the value of currency in circulation is held abroad.3 The global financial crisis led a large increase
in reserve balances from about $24 billion on average from January 1959 to August 2008 to about
$2.5 trillion today (Figure 3.1).

Figure 3.2 Money supply (M1 aggregate), billions of dollars
Source: Board of Governors of the Federal Reserve System (Series H.6)
The monetary base is not the same thing as the money supply. Money supply means monetary
instruments held by non‐bank economic units and outside the Treasury and other official foreign
institutions. There are several ways to measure that, and monetary aggregate M1 is the narrowest
(Figure 3.2):
M1 = Currency in circulation + Private‐bank checking accounts of non‐banks, non‐federal, non‐
official foreign economic units + others
M1 relates to the Fed’s balance sheet only via part of L1. Since 1959, FRNs in circulation has
represented a growing proportion of the monetary base (Figure 3.2). From 20% in the 1960s to 30%
in the early 1990s. The 1990s recorded a rapid growth in the share of FRNs in circulation that peaked
at 56% of the monetary base in 2007 and has been around 40% to 50% since the late 1990s. The
proportion of demand accounts represented about 80% of the monetary base in the 1960s, but this
share fell quickly and almost continuously following the emergence of alternatives to demand
accounts. The share of demand accounts in the monetary base reached 20% of the monetary base
right before the 2008 financial crisis. Since the crisis, the share of demand accounts has increased
sharply to reach 40% of the monetary base. Traveler’s checks have always been an insignificant
22

component of the money supply. For reasons related to monetary policy detailed in Chapter 5
(Question 1), the growth rate of M1 increased in 2009.
It is important to make a distinction between the money supply and the monetary base because
the central bank has no direct influence on the money supply. The Fed does not deal with the public
directly, private banks do. Even for FRNs, private banks are in charge of injecting FRNs into the
economy, and they do so only if customers want to withdraw cash. In a 2010 interview4 Chairman
Bernanke noted regarding the announced purchase of $600 billion of Treasuries (aka “quantitative
easing”):
One myth that's out there is that what we're doing is printing money. We're not
printing money. The amount of currency in circulation is not changing. The money
supply is not changing in any significant way.
Translated in the terms of what was presented above, Bernanke states that L2 has gone up
dramatically but that M1 has not changed. The Fed did not issue FRNs to the public (L1 did not
increase), it just credited the accounts of banks by buying Treasuries from them and, as Chapter 2
shows, banks cannot do much with reserve balances.
One should note that the Treasury’s account at the Fed (L3) and its accounts at private banks (called
Treasury Tax and Loans accounts (TT&Ls)) are not part of the monetary base or the money supply.
They are “funds.” The outstanding value of the Treasury’s accounts is not counted in any definition
of the monetary base or the money supply.
RESERVES: REQUIRED, EXCESS, FREE, BORROWED, NON‐

BORROWED
Within the monetary base, reserves are central to monetary‐policy operations so this section
studies a bit more carefully the reserve‐side of the monetary base. Total quantity of reserves is:
Total reserves = Reserves balances + applied vault cash = L2 + part of L1
Applied vault cash are the FRNs that banks decide to use to calculate the quantity of reserves they
report to the Fed (the rest of vault cash is called “surplus vault cash”). From the 1990s and until the
Great Recession, applied vault cash had represented the majority of total reserves and peaked to
about 80% of total reserves. Since August 2008, reserves balances have been, by far, the main
component of total reserves (Figure 3.3).
It is possible for reserve balances (L2) to be negative, that is, the Fed allows banks to have an
overdraft; however, the Fed expects that banks close any overdraft at the end of each day. If a bank
cannot do so, the Fed charges a very high interest rate because the overdraft is a form of
uncollateralized advance, contrary to Discount Window advances. If the overdraft persists, the Fed
may take a closer look at how the bank runs its business.

23


Figure 3.3 Decomposition of total reserves in terms of forms, billions of dollars
Total reserves can be decomposed into other categories than those based on the form reserves
take. One may also be interested in knowing how banks obtained their reserves. The Fed is the
monopoly supplier of reserves and there are two ways for the Fed to provide reserves:
- Discount Window operations: advances funds by swapping promissory notes with banks
(see Chapter 2): “borrowed reserves”
- Open‐market operations: Fed buys some financial assets from banks either permanently
(“outright purchases”) or temporarily (“repurchase agreements”): “non‐borrowed
reserves”
Total reserves = borrowed reserves + non‐borrowed reserves
Non‐borrowed reserves have been the main source of reserves for banks (Figure 3.4) because the
Fed discourages the use of the Discount Window (interest rate is higher and Fed may increase
supervision if a bank comes to the Window too often). The stigma of going to the Window is so
strong that, during the 2008 crisis, the Fed had to change its Discount Window procedures to entice
banks that desperately needed reserves to come.
Non‐borrowed reserves was negative during most of 2008 and peaked at about ‐$330 billion in
October 2008 just about at the same time as borrowed reserves reached their peak value (Figure
3.5). Non‐borrowed reserves is measured by total reserves minus borrowed reserves. Borrowed
reserves is measured by A2 in Figure 2.1. For reasons related to monetary developments discussed
in Chapter 4, total reserves became smaller than A2 during the 2008 financial crisis. The central
bank provided a lot of advances but removes most of the reserve injection that resulted from the
advance.

24


Figure 3.4 Decomposition of total reserves in terms of sources, billions of dollars

Figure 3.5. Borrowed and non‐borrowed reserves during the 2008 financial crisis
Sources: Board of Governors of the Federal Reserve System (Series H.3)
Finally, the total quantity of reserves can be decomposed in terms of the reasons why banks hold
reserves. Banks in the United States must have a certain proportion of reserves relative to the
outstanding value of the bank accounts they issued:
25

- Required reserves: The quantity of reserves banks must hold in proportion of the bank
accounts they issued.
- Excess reserves: whatever quantity of reserves that banks have in excess of required
reserves.
Total reserves = Required reserves + excess reserves
Up until the 2008 crisis, banks held reserves mostly because they had to do so (Figure 3.6). Excess
reserves was virtually zero (Chapter 4 explains why). Up until the crisis, the quantity of reserves was
also relatively stable over decades and averaged $40 billion (Figure 3.7).
One may sometimes encounter the word “free reserves,” which just means the difference between
excess reserves and borrowed reserves. Throughout this series, the most important categorization
will be the last one: excess versus required reserves.

Figure 3.6 Decomposition of total reserves in terms of uses, billions of dollars

26


Figure 3.7 Decomposition of total reserves in terms of uses until august 2008, billions of dollars
HOW DOES THE MONETARY BASE CHANGE?
The monetary base goes up or down depending on what happens to the other items in the balance
sheet of the Fed. Following the point that balance sheets must balance we have (using Figure 2.1):
L1 + L2 = A1 + A2 + A3 + A4 + A5 – L3 – L4 – L5
So monetary base will be injected when:
‐ The Fed buys something (i.e. acquires an asset) from banks or the public
- Higher A1: Buying securities (T‐bills, T‐bonds, etc.)
- Higher A2: Advances of Federal Funds
- Higher A3: Buying foreign currency from private banks
- Higher A5: Buying a pizza, a building, or a service from someone
- The other Fed account holders spend in the US economy and when the Fed pays dividends
to banks
- Lower L3: Treasury spends
- Lower L4: US exports, government‐sponsored enterprises buy mortgages from
banks
- Lower L5: Fed pays dividends to member banks
27

Monetary base is reduced when the opposite transactions occur. Buying coins from the Treasury
does not change the monetary base because L3 goes up by the same amount as A4; it is an intra‐
federal government transaction. Let us go through two examples:
Case 1: The Federal Reserve buys T‐Bills worth $100 from banks
Fed
ΔA1: +$100 ΔL2: +$100

Banks
T‐bills: ‐$100
You have just witnessed the creation of monetary base: The central bank credits the account of
banks by typing “100” on the keyboard of a computer. The Fed could also have printed bank notes
(ΔL1 = +$100) but purchases from banks are done electronically because of convenience.
Case 2: Dr. T pays his income taxes worth $1000.
Assume that Dr. T still mails his income‐tax paperwork with a check payable to the United States
Treasury. The Treasury receives the check and brings it to the Fed. To simplify, the following ignores
Treasury’s tax and loan accounts (TT&Ls) because that just complicates the analysis without adding
any insights at this point (see Chapter 6). The Fed sends the check to the bank of Dr. T. and so the
bank debits the bank account of Dr. T by $1000.
Bank of Dr. T.
Account of Dr. T.: ‐$1000
What is the offsetting operation on the bank’s balance sheet? The $1000 have to go to the Treasury.
Given that we assumed that the Treasury only has an account at the Fed we know that the offsetting
operation cannot be (it would be if TT&Ls had been included):
Bank of Dr. T.
Account of Dr. T.: ‐$1000
TT&Ls: +$1000
The Treasury only has an account at the Fed so the following will occur when the $1000 are
transferred (which would be the second step if TT&Ls were included in the analysis):
Fed
But that again begs the question: What is the offsetting accounting entry on the balance sheet of
the Fed? It cannot be “Account of Dr. T: ‐$1000” because Dr. T does not have an account at the Fed.
The answer is that when the Fed receives the check, it has a claim on Dr. T.’s bank. The bank settles
that claim by giving up reserves and the funds are transferred into the account of the Treasury.
28

Interbank claims (claims among private banks, and between the Fed and private banks) are always
settled with transfers of reserves.
Bank of Dr. T.
Reserve balances: ‐$1000 Account of Dr. T.: ‐$1000

Fed
You have just witnessed the destruction of monetary‐base: taxes destroy monetary base. The
central bank deleted $1000 in the reserve balance and keystroked $1000 in the account of the
Treasury.
Of course, if the Treasury spends then reserve balances are credited, and if Treasury spends more
than its taxes then there is a net injection of reserves: fiscal deficits (government spending larger
than taxes) lead to a net injection of reserves. Keep that in mind for Chapter 4.
As a side note, one may note that Dr. T’s balance sheet changes as follows when taxes are paid:
Dr. T.
Account of Dr. T.: ‐$1000 Net worth: ‐$1000
An alternative accounting would be if Dr. T had owed a known dollar amount of taxes for a while,
i.e. if the Treasury held some tax receivables against Dr. T. In that case, instead of net worth, it
would be tax receivables that would go down by $1000.
CAN THE FED ISSUE AN INFINITE QUANTITY OF MONETARY

BASE?
Yes, it technically can because the monetary base is composed of liabilities of the Fed. In practice
though, the Fed’s ability to inject reserves is constrained by the operational requirements of
monetary policy. Chapter 4 shows that if the central bank issues reserves regardless of the needs
of banks, it is not be able to achieve a specific policy interest rate it sets for itself unless it changes
its operational procedures.
At the origins of the Fed, some constraints were also put on the types of securities that the Fed
could buy or that banks could pledge as collateral with their promissory notes to get an advance
from the Discount Window. There was a fear that the Fed would over issue monetary base given
its broad monetary power. Here is the language of the preamble of the 1913 Fed Act states:
To provide for the establishment of Federal reserve banks, to furnish an elastic
currency, to afford means of rediscounting commercial paper, to establish a more
effective supervision of banking in the United States, and for other purposes.
“Elastic currency” just means that the Fed is able to add and remove monetary base at the will of
banks and the public, that is, in response to the needs of the economy. However, until 1932, the
29

Fed operated under the Real Bills Doctrine (RBD). What that meant was that the Fed ought to only
accept securities that “self liquidate” in A1 and as collateral for A2 (see Figure 2.1). Self‐liquidating
securities are those that are issued and destroyed in relation to economic activity. Firms issue
securities to produce goods and services (see Chapter 10) and repay them when firms sell their
production. The idea was that by tying monetary‐base creation to the financing of economic
activities, the Fed would avoid inflationary tendencies that could come from an elastic currency.
Monetary base (and so money supply as the thought of the time—erroneously—went) would grow
in‐sync with production.
In practice, RBD never worked out well for both theoretical and practical reasons. WWI led to a
large holdings of Treasuries by the Fed. The Great Depression led to the elimination of the doctrine,
and the 1932 Banking Act widened dramatically the types of securities the Fed could accept if
needed (Table 3.1).

Table 3.1 Holdings of securities by the Fed, 1915‐1950
Source: Marshall’s Origins of the Use of Treasury Debt in Open Market Operations: Lessons for
the Present
One of the problems of RBD is that it relied on private indebtedness (issuances of securities by
companies to finance production, “real bills”) for monetary policy to work. During a recession,
banks did not have enough real bills to sell or pledge to the Fed because economic activity is
moribund so private issuance plunges. This is problematic because the scarcity of real bills limited
the ability of banks to obtain reserves, just at the time when banks desperately needed additional
reserves to counter bank runs (people running to banks to ask for cash) and make interbank
payments.
More recently, Dodd‐Frank Act of 2010 amended the Federal Reserve Act to constrain the capacity
of the Fed to use “emergency powers,” that is, its ability to accept any type of securities from
anybody. This was a reaction to the advances provided to AIG; AIG was not part of the Federal
30

Reserve System. It was also a reaction to the opaqueness of the Discount Window operations during
the crisis and how questionable some of the transactions were.
The Fed needs to be able to fight panics and the ensuing liquidity crisis when everybody (including
every banks) is trying to get their hands on the currency. This is, indeed, why the Fed was created.
It can only do so by being able to buy, or accept as collateral, a wide verity of securities.
This leads us to a final important point. Given that the Fed provides a safety valve in the financial
system, this safety may lead to moral hazard. Financial‐market participants may take more risks
knowing that, if things go south, the Fed will intervene to avoid a collapse of the financial system.
As a consequence the Fed must do two things:
- The Fed should also have ample regulatory and supervisory powers, and it should use them.
That is what the last bit of the preamble is all about.
- The Fed should discourage moral hazard and promote safe banking practices by accepting
only securities that are of quality (that is based on sound underwriting and not in default)
and from solvent institutions: The Fed exists to squash banking liquidity crises (temporary
inability to access funds), not to keep insolvent banks alive (permanent inability to pay
creditors).
Unfortunately, these two conditions have not been met recently and moral hazard has increased
dramatically.
The alternative is Andrew Mellon’s advice to Hoover: “liquidate labor, liquidate stocks, liquidate
farmers, and liquidate real estate…it will purge the rottenness out of the system.” However, the
cleansing properties of market mechanisms do not work properly, especially so in times of financial
crisis and panic (see Chapter 14).
1‐ Banks hold reserves mostly because they are required to do so.
2‐ The Fed provides reserves to banks mostly by buying short‐term Treasuries from them, either
temporarily or permanently.
3‐ Currently, the Fed is able to provide as many reserves as needed by banks.
4‐ Until 1932, the Fed was limited in its ability to provide reserves to banks because of constraints
on the type of assets it could buy or take as collateral from them.

Keywords
Total reserves, required reserves, excess reserves, free reserves, borrowed reserves, non‐borrowed
reserves, reserve balances, vault cash, overdraft, applied vault cash, surplus vault cash, Real Bills
Doctrine, elastic currency

Review Questions
Q1: When a bank borrows reserves from another bank is that classified as borrowed reserves?
Q2: Is all vault cash part of total reserves?
Q3: Are excess reserves those that are not wanted by banks?
Q4: What is the impact of a fiscal deficit on the monetary base?
Q5: When the Fed sells Treasuries to banks, what happens to the monetary base?
Q6: What are the two types of operations that the Fed uses to provide reserves to banks?
31


1 See the following link for an explanation of the role of the Fed in terms of coins and notes:
http://www.federalreserve.gov/paymentsystems/coin_about.htm
2 See http://www.federalreserve.gov/faqs/currency_12773.htm
3 Board of Governors of the Federal Reserve System, Currency and coins services:
http://www.federalreserve.gov/paymentsystems/coin_about.htm
4 See the following 2010 interview with 60 minutes: https://www.youtube.com/watch?v=LxSv2rnBGA8
32

CHAPTER 4:
What monetary policy is all about
Why monetary policy is done
How the Federal Reserve implements monetary policy
How monetary policy operations changed following the Great Recession
How monetary policy can be conceptually analyzed

CHAPTER 4: MONETARY POLICY IMPLEMENTATION
Chapter 2 examined the balance sheet of the Fed and Chapter 3 provided important information
about the meaning of reserves and other basic concepts and their relation to the balance sheet of
the Fed. This Chapter examines how a central bank implements monetary policy.
WHAT DOES THE FED DO IN TERMS OF MONETARY POLICY
AND WHY?
While the details of operating procedures have changed through time, the federal funds rate (FFR)
has progressively gained in importance as a relevant operating tool (that is, as a means to
implement monetary policy) since the 1920s. The FFR is the yearly rate of interest at which
participants in the federal funds market lend and borrow federal funds (“fed funds” for short) to
each other overnight. For example, if the FFR is at 3% it means that if a bank borrowed $100
continuously for a year at that rate it would have to pay a $3 of interest. The equivalent daily rate
is 0.0081% so if a bank borrows $100 in the evening, it has to repay the $100 plus $0.0081 of interest
payment the next morning. While that does not seem much, when tens of billions of dollars are
involved daily even such small interest rate can bring substantial income to the lender of fed funds.1
Fed funds are the dollar value of the accounts at the Federal Reserve (L2, L3, and L4 in the balance
sheet presented in Figure 2.1). Holders of these accounts include private banks, the U.S. Treasury,
government‐sponsored enterprises, the International Monetary Fund, securities firms, among
others. Some of these account holders need more funds (usually banks)2 while others usually have
more than needed. The fed funds market3 allows these participants to meet and make deals.

Figure 4.1 Daily average of FFR (grey line) and FFR target (black line), percent
Source: Federal Reserve Bank of New York.
The Fed is highly interested in the FFR and aims at targeting that rate, that is, the Fed wants to make
sure that the FFR prevailing in the market does not deviate too much from the FFR desired by the
34

Fed (the FFR target) (Figure 4.1). Most of the time the Fed targets a specific number but sometimes
it targets a range. This is the case today with a range of 0.25‐0.5%. From the late 1970s until 1991,
the Fed also had a range that was as high as 16%‐22% in mid‐1981 and as wide as 13%‐20% in early
1980 (Figure 4.2). Since 1994, the FFR target has been public information as the Fed has committed
to be more transparent.
The Fed is highly interested in this interest rate for two main reasons. First, the FFR is a cost for
banks so if the cost changes, the interest rates they charge to customers change. Second, market
participants make portfolio choices (that is, buy or sell assets) with the aim of maximizing the rate
of return on assets. They compare portfolio strategies and choose those that provide the highest
yield. While making these portfolio choices, financial‐market participants take into account future
monetary policy (that is, future FFR targets), which ends up impacting the current interest rate of a
wide range of securities.
Regarding the cost side of FFR, banks need reserves for four purposes (see Chapter 10 for further
explanation):
‐ Cash withdrawals by customers: people get cash from banks.
‐ Reserve requirements: banks must keep a certain quantity of reserves that is a proportion
of the dollar amount in the bank accounts they issued.
‐ Interbank debt settlements: paying debts due to other banks.
‐ Payments to other Fed account holders: for example tax payments leads to a drainage of
reserves.

Figure 4.2 Monthly FFR average and target FFR range, 1979‐1990, percent
Source: Transcripts of the FOMC meetings
Note: After 1990, the FOMC targeted a FFR digit

35

By far, the largest day‐to‐day need for reserves is interbank settlements because banks that do not
have enough reserves to make the necessary payments must get reserves to avoid default. They
may get them either from other banks or other fed funds holders, or may go to the Fed. In any case,
banks have to pay interest and the FFR is what banks pay to get reserves through the fed funds
market (“non‐borrowed reserves”). This cost is then routinely passed on to their customers so that
when the FFR rises, rates on mortgages, advances to students, credit cards, etc. also go up (see
prime bank rate in Figure 4.3).
In terms of portfolio choices, say that in 2016 you have $1000 and you want to figure out a way to
make the highest gains over the next two years. Say only two portfolio strategies are available. A
“long‐term strategy” is to buy and hold for two years a 2‐year security that pays 5%. A “short‐term
strategy” is to buy a 1‐year security that pays 3% and to reinvest the proceeds in 2017 into another
1‐year security. Your choice between the two strategies should depend on what you expect the 1‐
year rate to be in 2017. You are indifferent between the two strategies if they provide the same
rate of return, which means that you expect a 1‐year yield of about 7% in 2017 (solve $1000*(1.05)2
= $1000*1.03*(1+x) where x is the expected one‐year rate in 2017). If you expect the 1‐year rate to
be higher than 7%, the short‐term strategy is more profitable. In that case, financial‐market
participants will sell outstanding 2‐year securities and buy 1‐year securities, which raises the 2‐year
rate and lowers the 1‐year rate until the two strategies provide the same rate of return. For
example, if the expected 1‐year rate is 8%, then if the 2‐year rate goes up to 5.2% the 1‐year rate
is 2.5%. Generalizing the logic, a rising FFR (similar to 1‐year rate going up) raises the rates on
longer‐term securities. Long‐term rates depend on expectations about future monetary policy and
if FFR is expected to rise (fall), long‐term rates will rise (fall).
There is a very high correlation between the FFR and all other interest rates. The correlation is
about 0.99 for short‐term securities and about 0.8 for long‐term securities like T‐bonds (Figure 4.3).
Beyond expectations about future FFR, the interest rate on securities, especially of longer terms to
maturity, is also influenced by inflation risk, tax risk, credit risk, liquidity risk, among others, which
makes the link between FFR and longer‐term securities less strong.
By influencing all interest rates, the Fed hopes to influence the willingness of the private sector to
spend on goods and services; the ultimate goal being to influence inflation and employment. For
example, if the Fed thinks that inflationary pressures are building up, the reasoning goes at follows:
Higher expected inflation by the Fed leads to a higher FFR target, which raises the FFR, which raises
other rates, which discourages private economic units from seeking external funds and raises
thriftiness, which slows down spending on goods and services, which lowers inflation (see Chapter
12). There are a lot of steps between FFR and inflation/employment, and one may doubt it works
well, but that is the logic behind the intervention of the Fed in the fed funds market.
The Fed has a dual mandate, that is, its goal is to achieve both price stability (currently defined
unofficially as achieving a 2% inflation rate) and full employment (defined as being at an
unemployment rate at which inflation is stable, the “NAIRU”). Other central banks, like the
European Central Bank, only focus on price stability.
36


Figure 4.3 FFR and other rates
Source: Board of Governors of the Federal Reserve System (series H.15)
TARGETING THE FFR PRIOR TO THE 2008 FINANCIAL CRISIS
While banks do need reserves, they also do not like to hold more reserves than they need because
reserves did not use to pay any interest. Chapter 3 shows that, prior to the crisis, banks held very
few reserves, and most of them were held because the Fed required it. Banks like to keep a bit of
37

excess reserves to avoid the overnight‐overdraft penalty rate (Chapter 2 explains that reserve
balances can be negative).
What happens if banks cannot get enough fed funds for their needs? Banks cannot create more
than what is available, only the Fed can. If the Fed does not add more fed funds then the FFR rises
steeply and quickly given that bank must have the reserves they need. A higher FFR does not
incentivize banks to demand less fed funds; their demand for reserves is inelastic and mostly non‐
discretionary.
What happens if banks have too much fed funds? Banks cannot destroy/remove fed funds, only the
Fed can. If the Fed does not remove enough fed funds, the FFR will fall very quickly to 0% given that
banks do not have any other use for the excess reserve balances they have. A lower FFR does not
give banks an incentive to supply less fed funds.
To minimize fluctuations in the FFR and keep it around the target, the Fed intervenes daily to add
or to remove fed funds by adding or removing reserve balances according to the needs of banks. If
the FFR is above target then the Fed adds reserves, if the FFR is below target the Fed removes
reserve balances.
The way the Fed does this is via open‐market operations that usually involve exchanging reserves
with T‐bills with banks (Figure 4.4):
‐ If FFR < FFRT, banks lend and borrow at an interest rate that is too low relative to what the
Fed wants. To correct that the Fed sells T‐Bills to banks, which drains reserves.
Fed
T‐bills: ‐$100 Reserve balances: ‐$100

Banks
T‐bills: +$100
‐ If FFR > FFRT, banks lend and borrow at too high an interest rate relative to what the Fed
wants. Banks have too few reserves. To correct that the Fed buys T‐bills from banks by
crediting their reserve balances.
Fed
T‐bills: +$100 Reserve balances: +$100

Banks
T‐bills: ‐$100
Reserve balances: +$100
The open‐market operations can be permanent (“outright purchase/sale” by the Fed) or temporary
(“repurchase agreement” and “reverse repurchase agreement”: the Fed and banks agree to
perform the opposite transaction the following morning). For banks to agree to trade with the Fed
instead of putting reserves in the market—or for banks to get reserves from the Fed instead of
38

borrowing from other banks—the Fed has to provide incentives. The Fed also has to make trades
that ensure that the FFR stays around its target.
Suppose that a bank has $1000 worth of reserves that it is ready to supply in the fed funds market.
Suppose that the FFR is currently at 3% (so a daily rate of 0.0081%), where the Fed wants it to be,
but if the bank supplied the funds the FFR would fall to 2%. How can the Fed entice the bank not to
dump the funds in the market? One way is to do something similar to the following: the Fed sell to
the bank one T‐bill for $999.92 and promises to buy it back the next day for $1000. This provides a
daily rate of return of 0.0081% to the bank.
The Fed does something similar when banks borrow fed funds at a rate higher than what the Fed
wants (FFR > FFRT). It buys T‐bills at a price consistent with FFRT. That forces those willing to lend
fed funds to comply with the FFRT; otherwise, no bank will borrow from them given that the Fed
offers to provide reserves at a lower rate.

Figure 4.4 Targeting the FFR: Open‐market operations
The Fed could do this all day long and FFR would be on target all the time, but practically the Fed
only intervenes once a day and accepts that the FFR fluctuates around the target. Each day, the Fed
anticipates the approximate need for reserves by estimating how the items that change the
monetary base will change during the day (A1 through A5, L3, L4, and L5 of Figure 2.1).
The Fed is basically applying a sort of buffer‐stock policy on reserves in the same way diamond
cartels limit the supply of diamond to control diamond price (I am sorry to tell you that diamonds
are not rare). The main difference between the Fed and diamond cartels is that the Fed has
complete pricing power because it is the monopoly supplier of reserves.
Beyond day‐to‐day intervention in the fed funds market to maintain a FFRT, the Fed also sometimes
changes its FFRT. Given that the demand for reserves is almost perfectly inelastic and given how
small the increments and decrements in the FFRT are (usually 25 basis points at a time, that is, 0.25
percentage point), when the Fed changes its FFRT, it usually does not do anything for the target to
be reached. If the Fed decides to lower the FFRT, it does not have to inject reserves first for the
target to be reached. If the Fed decides to raise the FFRT, it does not have reduce the quantity of
39

reserves to reach the target. The FFR will move quickly around the target following the
announcement of a change.4
Another way to understand that point is to again go back to the point that banks cannot do much
with reserve balances, so any reserves they have in excess they will supply in the fed funds market.
If the Fed announces it will offer reserves at a lower FFRT, banks must comply with the new FFRT
when they offer to lend reserves, otherwise nobody will borrow from them. If the Fed announces
it offers reserves at a higher FFRT, banks with reserves to lend also raise at which they offer to lend
reserves. Otherwise, they forego an income opportunity because banks that need reserves have
nowhere else to go (only the Fed can create more reserves and it will do it only at a higher FFR). It
is “the Fed’s way or the highway.”
A GRAPHICAL REPRESENTATION OF THE FEDERAL FUNDS

MARKET
The Fed supplies, at a cost equal to the FFR target, whatever quantity of reserves is needed (Figure
4.5). The demand for reserves is almost perfectly insensitive to changes in FFR.5 Banks must meet
interbank payments, tax payments, reserve requirements and withdrawals regardless of what the
FFR is, and banks have very little incentive to ask for more reserves when rates fall because, as
explained in Chapter 3, banks cannot do much with them.

Figure 4.6 The federal funds market
The fact that the supply of reserves is horizontal seems to suggest that the Fed supplies an infinite
quantity of reserves. That is not the case, all that is saying is that the Fed supplies whatever banks
demand. If banks want more reserves (demand curve shifts to the right), the Fed supplies more. If
banks want fewer reserves, the Fed removes reserves; the currency is “elastic.” The Fed does not
proactively add or remove reserves:
‐ If the Fed adds reserves without consulting banks, the FFR falls to zero.
‐ If the Fed removes reserves without consulting banks, the FFR rises to infinity.
Thus, while the Fed does the injection and deletion of reserves, the Fed adds or removes only on a
defensive basis to maintain the FFR on target.
40

What monetary policy is all about is setting the price of reserves and letting the quantity of reserve
adjust. The FFR is a policy variable that does not reflect any scarcity or abundance of reserves, or
the preference of banks for reserves. A low FFR can prevail with very few reserves because if banks
do not need many reserves, the Fed does not supply many at a given FFRT. A high FFR can prevail
with a very large quantity of reserves because if banks need lots, the Fed supplies lots at a given
FFRT.
TARGETING FFR AFTER THE GREAT RECESSION
As the financial crisis grew from 2007 onward, the Fed began to lower its interest rate target from
late 2007 (Figure 4.1) and, from early 2008, to provide significant quantities of emergency funds to
the financial system (Figure 4.6). At first, the Fed neutralized the impact of all emergency advances
by selling Treasuries so its supply of Treasuries fell by 40% in about six months (Figure 4.6). The Fed
provided reserves to bank X that was in difficulty, bank X paid its creditor bank Y, bank Y had excess
reserves available to lend in the fed funds market, Fed drained all excess reserves by selling
Treasuries to bank Y. This allowed the Fed to maintain a positive FFR while also helping struggling
financial institutions.
In September 2008, the collapse of Lehman Brothers led to a panic and the Fed responded by
providing large amounts of emergency advances (A2 of Figure 2.1 went up a lot). No fed funds
market participant was willing to lend reserves to anybody; the fed funds market froze and the FFR
became highly volatile (Figure 4.1). Emergency advances by the Discount Window led to a very large
increase in reserve balances by almost $1 trillion by early 2009. From September 2008 until the end
of the year, in order to keep FFR positive, the Fed did try to neutralize some of the impact of its
massive emergency operations by working with the Treasury (Chapter 6 delves into the Treasury‐
central bank coordination). However, in order to fight the recession (and so potential deflation and
unemployment), the Fed also rapidly lowered its FFR target, eventually to reach zero (0‐0.25%
range to be precise) by December 2008 (Figure 4.1).
The Fed then wondered what it could do next to help lower interest rates further given that the
FFR target was at 0% and given that the Fed did not intend to have a negative FFR target. Two things
were done:
1‐ Promise not to raise the FFR target for a long time (“forward guidance”): this pushed
expectations of a rise in FFR further in the future and so lowered other interest rates.
2‐ Outright purchases of long‐term securities with the goal of lowering long‐term interest
rates (“credit easing” followed by “quantitative easing”). By buying long‐term securities,
the Fed raised the price of these securities which lowered their yield.
The Fed bought outright long‐term Treasuries but also long‐term private securities (Mortgage‐
backed securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae)6 (Figure 4.6, Table 4.1).
It did so without neutralizing the impact on reserves so reserves balances increased rapidly beyond
the needs of banks (see Chapter 3). As a consequence, if the Fed had continued to operate as it did
before the crisis, the FFR would have stayed stuck at 0% for as long as there would have been a
large quantity of excess reserves.
41


Figure 4.6 Assets of Fed and excess reserves (white line), trillions of dollars
Source: Board of Governors of the Federal Reserve System (series H.4.1)

Table 4.1 Maturity distribution of securities, loans, and selected other assets and liabilities,
January 20, 2016, millions of dollars
Currently, the Fed wants to be able to raise the FFR even though banks have ample quantities of
excess reserves. To do so, it has changed its operating procedures by paying interest on reserve
balances (L2). This theoretically puts a floor on the FFR because if banks can earn interest on their
Fed accounts, they do not have an incentive to lend these reserves in the fed funds market if the
FFR goes below the interest rate on reserve balances (IOR).
The Fed and other central banks now operate under a “corridor” framework (Figure 4.7). In theory,
the FFR can only fluctuate between the IOR and the discount window rate (DWR). The FFR target is
42

set in the middle of the corridor and the three rates (IOR, FFRT and DWR) move together. There is
a horizontal band instead of a horizontal line. Banks have no incentive to lend reserves if FFR is
below IOR so FFR cannot fall below that. Banks have no incentive to borrow in the fed funds market
if the DWR is lower than FFR so FFR will not rise above the DWR.

Figure 4.7 Interest‐rate corridor
In practice, the corridor in the United States is porous. In terms of the floor, other Fed accounts do
not qualify to receive interest so their holders have an incentive to keep lending fed funds in the
market even if FFR is below IOR. Government‐sponsored enterprises (in L4), especially the Federal
Home Loan Banks,7 were a major source of excess supply of fed funds. Since the end of 2015, the
Fed has solved this problem 8 by indirectly paying interest to other account holders through an
auction mechanism. Now the IOR is a true floor. In terms of the ceiling, access to the Discount
Window is highly stigmatized and contains some non‐monetary costs in terms of increased
supervision and loss of reputation. As a consequence, banks refrain from going to the Window even
if DWR is inferior to FFR. The true ceiling in that case is the overnight‐overdraft penalty rate. During
the 2008 financial crisis, the Fed dealt with this problem by providing fed funds through the Window
via occasional auctions in which participants could bid anonymously.
A corridor policy does not have to be implemented only in period of excess reserves. If a central
bank wants to intervene less frequently in the overnight market, a corridor policy can be useful to
limit the volatility of the overnight interbank rate. For example, the ECB has been operating that
way since the beginning (Figure 4.8). It intervenes in the market only once a week and lets the
ceiling and floor do the job of containing the overnight rate around the target overnight rate during
the rest of the week. Narrowing the gap between the floor and the ceiling would reduce the
volatility of the overnight rate. The Fed had been on a semi‐corridor since 2003 when the Fed
decided to raise DWR above the FFRT and to move both in sync while IOR stayed at zero all the
time.
43


Figure 4.8 Corridor of ECB
Source: Kahn’s Monetary Policy under a Corridor Operating Framework

1‐ The Federal Reserve targets the cost of reserves not the quantity of reserves. It does so by setting
the cost of providing advances (Discount Window operations) and by setting the cost at which banks
lend to, and borrow from, each other (open‐market operations).
2‐ By setting directly the cost of reserves, the Federal Reserve can indirectly influence all other
interest rates. The influence is the strongest on short‐term market rates and on interest rates that
banks charge to their customers.
3‐ Through changes in interest rates, the Federal Reserve hopes to change spending habits and so
to influence employment and inflation.
4‐ When the Fed changes its FFR target, it does not have to change the quantity of reserves to make
the FFR move toward the target. In order to maintain the FFR around a given FFR target, the Fed
intervenes daily to perform open‐market operations.
5‐ The Fed cannot supply fewer or more reserves than banks demand, otherwise it misses its FFR
target. The Fed adds or removes reserves according to the demands of banks.
6‐ A high FFR can prevail with a large quantity of reserves and a low FFR can prevail with a small
quantity of reserves. FFR is a policy variable not a market‐determined variable.
7‐ Quantitative easing led to a large increase in excess reserves. In order to be able to raise the FFR
when it wants, the Fed changed its operating procedures by paying interest on reserves. Quite a
few central banks now operate under a corridor framework.

Keywords
Federal funds rate, federal funds market, Discount Window rate, interest rate on reserves, corridor
framework, quantitative easing, open‐market operation, outright purchase/sale, repurchase
agreement, discount window operations, elastic currency.

44

Review Questions
Q1: If the Fed supplies more reserves than banks want, what happens to the FFR? What if supplies
less? What will the Fed do to maintain the FFR on target?
Q2: What does a horizontal supply of reserves means in terms of the supply of reserves and the
federal funds rate?
Q3: How can a corridor framework help reduce the volatility of the FFR? What would happen to the
FFR if the discount rate, interest rate on reserves and FFR target were all equal?
Q4: Why are the interest rates set by banks highly correlated with the FFR?
Q5: Why are market rates correlated with the FFR? What happens if it is expected that the FFR will
fall?
Q6: If the Fed had not adopted a corridor framework, what would have been the problem for future
monetary policy?
Q7: How could a corridor fail to contain the FFR?
Q8: What does it mean for the Fed to provide an elastic currency?

Suggested readings
“Come with me to the FOMC” by Governor Duke briefly presents what goes on during a meeting:
https://www.federalreserve.gov/newsevents/speech/duke20101019a.htm
Chapter 7 of Meulendyke’s U.S. Monetary Policy and Financial Markets is a detailed version of
Duke’s speech, albeit a bit dated: https://research.stlouisfed.org/aggreg/meulendyke.pdf
Kahn’s Monetary Policy under a Corridor Operating Framework provides a readable presentation of
the corridor framework.
More advanced readings are:
Dow, S.C. (2006) “Endogenous money: structuralist,” in P. Arestis and M.C. Sawyer (eds) A
Handbook of Alternative Monetary Economics, 35‐51, Northampton: Edward Elgar.
Fullwiler, S.T. (2008) “Modern central bank operations—General principles,”
http://www.cfeps.org/ss2008/ss08r/fulwiller/fullwiler%20modern%20cb%20operations.pdf
Fullwiler, S.T. (2013) “An endogenous money perspective on the post‐crisis monetary policy
debate,” Review of Keynesian Economics, 1 (2): 171‐194.
Lavoie, M. (2006) “Endogenous money: Accomodationist,” in P. Arestis and M.C. Sawyer (eds) A
Lavoie, M. (2010) “Changes in central bank procedures during the subprime crisis and their
repercussions for monetary theory,” International Journal of Political Economy 39 (3), 3‐23.
Moore, B.J. (1988) Horizontalists and Verticalists: The Macroeconomics of Credit Money.
Cambridge: Cambridge University Press.
Moore, B.J. (1991) “Money supply endogeneity: ‘reserve price setting’ or ‘reserve quantity setting’,”
Journal of Post Keynesian Economics, 13 (3): 404‐413.

45


1 Historical data about the federal funds market can be found at the Federal Reserve Bank of New York:
https://apps.newyorkfed.org/markets/autorates/fed‐funds‐search‐result‐page
2 See “Who’s Borrowing in the Fed Funds Market?” by Gara Afonso, Alex Entz, and Eric LeSueu at
http://libertystreeteconomics.newyorkfed.org/2013/12/whos‐borrowing‐in‐the‐fed‐funds‐market.html
3 See The Federal Funds Market: A Study by a Federal Reserve System Committee by the Federal Reserve System at
https://fraser.stlouisfed.org/docs/meltzer/bog1959.pdf
4 This absence of a liquidity effect has been well documented. See Fullwiler, S.T. (2003) “Timeliness and the Fed’s Daily
Tactics.” Journal of Economic Issues 37 (4): 851‐880
5 This graph ignores complications that comes from reserves requirements, which would flatten the demand for reserves
at the FFRT. See Fullwiler, S.T. (2013) “An endogenous money perspective on the post‐crisis monetary policy debate”
Review of Keynesian Economics, 1 (2): 171‐194.
6The Federal National Mortgage Association (Fannie Mae) was a government agency created in 1938 to improve the
liquidity of mortgages by acting as dealer of FHA/VA‐insured mortgages. Until the 1966 credit crunch, Fannie Mae
remained a minor player in the secondary market for mortgages because it exclusively dealt in conforming mortgages.
The crunch led Fannie Mae to enlarge its dealership to conventional mortgages and it became the largest player in the
secondary mortgage market. In order to cope with this new state of affairs, Fannie Mae was split in 1968 into the
Government National Mortgage Association (Ginnie Mae) and Fannnie Mae. Ginnie Mae took the previous role of Fannie
Mae and is focused on maintaining a secondary market by providing guarantee on MBSs backed by FHA/VA‐insured
mortgages. Fannie Mae was converted into a government‐sponsored enterprise by acting as a dealer of conventional
mortgages. Federal Home Loan Mortgage Corporation (Freddie Mac) was created by an act of Congress in 1970 to
compete with FNMA in the conventional mortgage market.
7 See “Who’s Lending in the Fed Funds Market?” by Gara Afonso, Alex Entz, and Eric LeSueur from the Federal Reserve
Bank of New York at: http://libertystreeteconomics.newyorkfed.org/2013/12/whos‐lending‐in‐the‐fed‐funds‐

market.html
8 More details about the reverse repurchase agreement operations is available here:
https://www.newyorkfed.org/markets/rrp_faq.html
46

CHAPTER 5:
Why targeting the quantity of reserves is not practically possible and goes
against the purpose for which the Fed was created
Why providing an elastic supply of currency is not by itself inflationary
How quantitative easing impacts financial markets
What a normalization policy is
How central banks can set negative nominal interest rate
Why central banks want interest rates to be negative
What the impact of negative interest rates is on the profitability of banks
What are some potential issues with fine tuning the economy with monetary
policy

CHAPTER 5: FAQs ABOUT CENTRAL BANKING
Previous Chapters studied the balance sheet of the Fed, definitions and their relation to the balance
sheet of the Fed, and monetary‐policy implementation. This Chapter answers some FAQs about
monetary policy and central banking. Each of them can be read independently.
Q1: DOES THE FED TARGET/CONTROL/SET THE QUANTITY OF
RESERVES AND THE QUANTITY OF MONEY?
The Fed does not set the quantity of reserves and does not control the money supply (M1). It sets
the cost of reserves; that is it.
In terms of reserves, the Fed was created to provide an “elastic currency,” i.e. to provide monetary
base according to the needs of the economic system in normal and panic times. It would be against
this purpose to implement monetary policy by unilaterally setting the monetary base without any
regard for the daily needs of the economic system.
In terms of the money supply, the Fed has no direct influence. Even Federal Reserve notes (FRNs)
are supplied through private banks, and banks supply only if customers ask for cash. The Fed does
not force feed FRNs to the public, i.e. FRNs cannot be “helicopter dropped” via monetary policy. If
the Fed did this, not only would it operate against the Federal Reserve Act, but also it would lead
people to take the FRNs, bring them to banks, banks would have more reserves, FFR would fall, Fed
would remove excess reserves to bring FFR back up—back to square one.
The Fed may have an indirect influence on the money supply through changes in its FFR target
because changes in the cost of credit may change the willingness of economic units to go into debt,
but the link is tenuous (see Q10).
Through its policy of Quantitative Easing, the Fed may have an indirect influence in two other ways.
First, if the Fed buys long‐term Treasuries from banks, banks usually have an incentive to replenish
their holdings of Treasuries because they allow to meet capital requirements (see Chapter 9)
without compromising too much profitability and liquidity. Treasuries have a low‐capital weight,
have a liquid market, and pay interest income. Banks will buy securities from non‐bank economic
units by crediting the bank accounts of the latter (see Chapter 10). Second, if the Fed wants to buy
securities from non‐central‐bank account holders, the Fed works through banks and the following
occurs:
Fed
Securities: +$100 Reserve balances: +$100

Banks of sellers of securities
Reserve balances: +$100 Account of sellers: +$100

Sellers of securities
Account of sellers: +$100
Securities: ‐$100
48

The money supply goes up by $100 when “account of sellers” increases by $100 (but it does not if
only reserve balances go up by $100).
Q2: DID THE VOLCKER EXPERIMENT NOT SHOW THAT

TARGETING RESERVES IS POSSIBLE?
In the 1970s, the Monetarist school of thought gained some influence in policy circles. Monetarists
argued that there is a close relation between the quantity of reserves and the money supply, and
that the role of a central bank is to control the quantity of reserves in order to influence the money
supply and ultimately inflation (see the quantity theory of money in Chapter 12). The Fed, under
the leadership of Paul Volcker, tried to implement a monetary‐policy procedure that aimed at more
closely targeting reserves and monetary aggregates, with the hope of taming a double‐digit
inflation rate.
Practically, the Fed changed interest‐rate targeting from a narrow range to a wide range (see
Chapter 4), which increased the level and volatility of the FFR dramatically (Figure 5.1). The Fed did
not allow the FFR to move freely as a targeting of total reserves implies.
There is an academic debate about how truly “Monetarist” the Volcker experiment was, and this
debate is reflected in the FOMC discussions of the time
MR. ROOS. Well, if the level of borrowing comes in higher than we would
anticipate, [can’t] you reduce the level of the nonborrowed reserves path
accordingly? Can’t you adjust your open market operations for the unexpected
bulge in borrowing or the unexpectedly low borrowing if you ignore the effect on
the fed funds market? Can’t you just supply or withdraw reserves to compensate
for what has happened?
[…]
CHAIRMAN VOLCKER. The Desk can’t [adjust] in the short run. It’s fixed. In a sense
they could do it over time if people are borrowing more, as they may be now. They
seem to be borrowing more than we would expect, given the differential from the
discount rate. But in any particular week it is fixed.
MR. ROOS. Do we have to supply the reserves?
CHAIRMAN VOLCKER. We have to supply the reserves.
MR. ROOS. [Why] do we have to supply the reserves? If we did not supply those
reserves, we’d force the commercial banks to borrow or to buy fed funds, which
would move the fed funds rate up. (FOMC meeting, September 1980, page 6)
Mr. Roos was deeply dissatisfied with the Fed still using a FFR target, albeit in the form of a wide
range. While the Fed had a total‐reserve growth target related to the 3‐month growth rate of M1,
if banks needed more than what was targeted, the Fed would supply extra reserves in order to
relieve pressures on the FFR. Roos argued against this lenient reserve targeting and was for a total
abandonment of any FFR targeting and a strict targeting of total reserves. Here he is in 1981:
I think there’s a very basic contradiction in trying to control interest rates explicitly
or implicitly and achieving our monetary target objectives. And I would express
49

myself as favoring the total elimination of any specification regarding interest
rates. (Roos, FOMC meeting, February 1981, page 54)
Most Federal Open Market Committee members were against that position on the ground that the
role of the Fed is precisely to promote an elastic monetary base. The Fed was not created to dictate
what the quantity of reserves ought to be but to eliminate liquidity problems through smooth
interbank‐debt clearing and settlement at par, lender of last resort, and interest‐rate targeting. In
addition, banks mostly hold reserves because they are required to, so if the Fed does not supply
enough reserves to meet the requirements then banks will break the law.
The experiment was a monetary‐policy failure. The Fed was never able to reach its reserve or
money targets and the experiment contributed to massive financial instability and a double‐dip
recession. One may even doubt that it contributed significantly to the fall in long‐term inflation,
which had more to do with the downward trend in oil prices, oil‐saving policies and greater
international labor competition:
May I remind you that we shouldn’t take too much credit for the price easing? I
never thought we were totally at fault for the price increases that we suffered from
OPEC and food; and I don’t think the fact that OPEC and food have calmed down
has a great deal to do with monetary policy per se, except in the very long run.
(Teeters, FOMC meeting, July 1981, page 46)
The Volcker experiment was, however, a public‐relation success. Most FOMC members knew that
reserve targeting was not possible; still, it allowed them to claim that they were not responsible for
the high interest rates of the period:
I do think that the monetary aggregates provided a very good political shelter for
us to do the things we probably couldn’t have done otherwise. (Teeters, FOMC
meeting, February 1983, page 26)
I think the important argument, and really the reason why we went to this
procedure, was basically a political one. We were afraid that we could not move
the federal funds rate as much as we really felt we ought to, unless we obfuscated
in some way: We’re not really moving the federal funds rate, we’re targeting
reserves and the markets have driven the funds rate up. That may have had some
validity at the time, and I had some sympathy for it. But as time goes on, I’ve
become more and more concerned about a procedure that really involves trying to
fool the public and the Congress and the markets, and at times fooling ourselves in
the process. (Black, FOMC meeting, March 1988, page 12)
Of course the high and volatile FFR was precisely the result of the change in monetary‐policy
procedures. If needed, some FOMC members were willing to do the same thing in the future:
Well, I have only a little to add to all of this. I think Tom Melzer is probably right:
We’re going to need to shift the focus to some measure or measures of the money
supply as we proceed here if we can, both for substantive reasons and also because
that has some political advantages as well, as we go forward. (Stern, FOMC
meeting, December 1989, page 50)
50


Figure 5.1 Average and standard deviation of the FFR
Source: Federal Reserve Board, NY Federal Reserve Bank
Q3: IS TARGETING THE FFR INFLATIONARY?
With the failure of the Volcker experiment, the FOMC entered a period of operational uncertainty
until the mid‐1990s. The Fed was back on a tight FFR target procedure (there was still a wide range
until 1991 but the Fed mostly targeted the middle of the range) and this was deeply unsatisfactory
to FOMC members.
We’ve advanced from pragmatic monetarism to full‐blown eclecticism. (Corrigan,
FOMC meeting, October 1985, page 33)
No, I would say that we have a specific operational problem that we have to find a
way of resolving. Just to be locked in on the federal funds rate is to me simplistic
monetary policy: it doesn’t work. (Greenspan, FOMC meeting, October 1990,
pages 55–56)
In a world where we do not have monetary aggregates to guide us as to the thrust
of monetary policy actions, we are kind of groping around just trying to characterize
where the stance is. (Jordan, FOMC meeting, March 1994, page 49)
The Fed was unwilling to disclose that it was targeting the FFR, and continued to announce targeted
growth ranges for monetary aggregates even though it did not use them for policy purposes.
[In response] to talk that says we can significantly influence this – or as the
phraseology goes that if we lower rates, we will move M2 up into the range – I say
“garbage.” Having said all of that, I then ask myself: ‘What should we be doing?’
Well, we have a statute out there. If we didn’t have the statute, I would argue that
we ought to forget the whole thing. If it doesn’t have any policy purpose, why are
51

we doing it? By law [we have] to make such forecasts. And if we are to do so, I
suggest that we do them in a context which does us the least harm, if I may put it
that way. (Greenspan, FOMC meeting, February 1993, page 39)
We do not, in fact, discuss monetary policy in terms of the Ms between Humphrey‐
Hawkins meetings. Don Kohn dutifully mentions them because he thinks he ought
to, but that is not the way we think about monetary policy. (Rivlin, FOMC meeting,
February 1998, page 91)
To announce to the general public that the FOMC was targeting the FFR would be going against all
the Monetarist principles (reserve targeting, money multiplier theory, quantity theory of money).
Targeting an interest rate, and so having an elastic supply of reserves (horizontal supply at a given
FFRT), seemed to indicate that the Fed was no longer willing to control inflation. FOMC members
themselves believed that was the case:
Many analysts, both inside and outside the Fed, argued that using the Federal funds
rate as the operational target had encouraged repeated over‐shooting of the
monetary objectives. (Meulendyke 1998 49)
Talking about the FFR target became a taboo and “the Committee deliberately avoided explicit
announced federal funds targets and explicit narrow ranges for movements in the funds rate”
(Kohn, FOMC Transcripts, March 1991, page 1):
I must say I’m still quite reluctant to cave in, if you will, on this question that we
can do nothing but target the federal funds rate. (Greenspan, FOMC transcripts,
March 1991, page 2)
As a practical matter we are on a fed funds targeting regime now. We have chosen
not to say that to the world. I think it’s bad public relations, basically, to say that
that is what we are doing, and I think it’s right not to; but internally we all recognize
that that’s what we are doing. (Melzer, FOMC transcripts, March 1991, page 4)
We will see later why the entire Monetarist logic is flawed. Monetary policy is always about
providing an elastic supply at a given interest rate. There is nothing intrinsically inflationary about
this. Having an “elastic currency” usually just means supplying whatever quantity of reserves banks
want, and usually banks do not want much.
While all this was very well understood by many economists long before Volcker’s experiment (see
for example Nicholas Kaldor),1 it took FOMC members until the mid‐1990s to get comfortable with
FFR targeting.
Q4: WHAT ARE OTHER TOOLS AT THE DISPOSAL OF THE FED?
Monetary policy is always about setting at least one interest rate. While today the Fed operates
mostly through the fed funds market, it has other tools at its disposition to help influence interest
rates.
One is the (re)discount rate, the rate at which banks can obtain borrowed reserves (see Chapter 3).
This interest rate is now higher than the FFR target but from the mid‐1960s until 2003 the discount
rate was usually below the FFR target. The Fed decided to put the discount rate above the FFR
target to put a ceiling on the FFR and so limit upward volatility in FFR (see Chapter 4).
52

Reserve requirement ratios can also help target the FFR. These ratios state how many total reserves
banks must keep on their balance sheet as a proportion of the bank accounts they issued. While
these ratios are often discussed in relation to the ability of banks to create checking accounts, their
actual purpose is once again to help target the FFR. By raising reserve requirement ratios, the
demand for reserves becomes more predictable given that a greater proportion of the reserves
available must be held by banks. With a more stable demand for reserves comes less volatility in
the FFR.
Q5: WHAT IS THE LINK BETWEEN QE AND ASSET PRICES?
The link cannot be one where banks have excess reserves that they use to buy assets in the
secondary market. Chapter 2 explains that banks cannot do this as a whole. They could buy from
one another, but if they all have reserves they want to get rid of, this is not possible because no
bank wants to sell assets for reserves.
The link goes through the following channels:
1‐ The Fed buys large quantities of securities from banks which raises their prices and so
lowers their yields.
2‐ As yields on these securities fall, economic units seek assets that provide higher yields. They
will look for assets with large expected capital gains, especially so knowing that others are
experiencing the same problems and are “searching for yield.” They will continue to buy
these securities, which will raise their prices, until all rates of return are equalized once
adjusted for risks.
Financial companies have to do the second step because they try to reach the target rates of return
that they promised to their stakeholders. Pensioners expect a substantial rate of return from their
pension funds, wealthy individuals expect a substantial rate of return from hedge funds, mutual
funds shareholders wants a substantial rate of return…and they all check every quarter if financial
companies stay on course to meet the promised target. Long‐term Treasuries used to provide a
safe and simple way to meet this promise; no longer so.
Bill Gross (a well‐known portfolio manager who specializes in bond trading) brought the point
forward very clearly. He hopes that the Fed will raise the FFR to make it easier to reach targeted
rates of return. He notes2 that low FFR prevents savers from earning enough to pay for healthcare,
retirement and other costs because yields on financial assets are so low compared to the expected
7% or 8%. If the Fed does not help by raising the FFR, financial‐market participants will take large
risks on their asset side (speculative, high credit risk, and structured securities) and liability side
(high leverage) to try to reach their targeted rate of return.
There is a broad problem though. In an economy in which the growth of the standard of living is
low, why should anyone expect that demanding 7‐8% be sustainable? Those can only be achieved
through capital gains and leverage, and the combination of these two is highly toxic (see Chapter 9
and Chapter 14). Instead of the Fed raising its FFR, it should be the rentiers who should reduce their
expectations of rates of return. An economy that grows at 2% per year cannot sustainably provide
a real rate of return higher than 2%; even that is a stretch. Other means3 must be used to meet the
challenge of an aging economy than increasing the financialization of the economy.
53

Q6: HOW AND WHEN WILL THE LEVEL OF RESERVES GO BACK
TO PRE‐CRISIS LEVEL? THE “NORMALIZATION” POLICY
Normalization policy4 means the willingness of the Fed to do two things: 1‐to raise the FFR to a
more normal level 2‐ to reduce the size of its balance sheet in order to return the proportion of
excess reserves to pre‐crisis value. Chapter 4 shows how this would be done for the FFR. Regarding
reserve balances, Chapter 3 shows that their dollar amount is determined as follows:
L2 = Assets of the Fed – (L1 + L3 + L4 + L5)
Most of L2 is now composed of excess reserves, which is unusual. A graphical representation of this
balance‐sheet identity is Figure 5.2.

Figure 5.2 Balance sheet of the Fed and reserve balances
Source: Board of Governors of the Federal Reserve System (Series H.4.1)
The implication of this balance‐sheet identity is that reserves balances will fall either when assets
of the Fed decline given other liabilities, or when the other liabilities of the Fed rise given assets.
Let us look at each case in turn.
Given liabilities other than reserves balances, reserves will not go back down until the following
happens to the securities held by the Fed:
1‐ Securities issued by non‐fed‐account holders mature (let us call them “private securities” to
simplify)
2‐ The Fed decides to sell some securities to banks.
If the Fed let Treasuries mature the account of the Treasury (L3), not reserve balances, is debited:

54

Fed
Treasuries: ‐$100 L3: ‐$100

Treasury
L3: ‐$100 Treasuries: ‐$100
When private securities held by the Fed, currently agency‐guaranteed MBS,5 mature the following
occurs:
Fed
Private securities: ‐$100 Reserve balances: ‐$100

Banks of issuer
Reserve balances: ‐$100 Account of issuer: ‐$100

Issuer of private securities
Account of issuer: ‐$100 Private securities: ‐$100
If all MBS held by the Fed matured at once, that would reduce reserve balances by almost $2 trillion
(the Fed does not plan to sell most of the MBS it holds).6
Given assets, reserve balances will go down if banks need to make payments to other Fed account
holders or if banks convert reserve balances into cash. For example, if the Treasury ran fiscal
surpluses, reserve balances would fall as funds would move from L2 to L3. While the Fed may ask,
and has asked, for the Treasury’s help in managing monetary policy (see Chapter 6), the Fed has
mostly no control over what happens to liabilities that impact reserve balances.
One may note to conclude that, besides changes in assets and liabilities, another way to reduce
excess reserves without reducing the quantity of reserves is to raise reserve requirement ratios. As
to when the reserves will be back to their usual level, nobody knows. The pace of decline will change
as the economic environment change, which brings us to a final point. There is no need for the Fed
to be proactive about normalizing its balance sheet because, with the change in monetary policy
procedures that occurred in 2008, the Fed can target the overnight interbank rate.
Q7: IS THERE A ZERO LOWER BOUND?
This question is so 2013! There is no lower bound. The discount rate is the most straightforward to
grasp because the Board of Governor has perfect control over the discount rate and can set it
wherever it wants whenever it wants. There is no operational constraint that prevents the Board
from setting a discount rate at ‐1%, ‐10% or even ‐100%, it just needs to announce tomorrow that
this is what it is and that is it.
55

The federal funds rate is slightly more complicated but not that much. To set a negative fed fund
rate, the Fed just has to do overnight repos on securities at a premium. If one applies this to zero‐
coupon securities like T‐bills, the present value of a T‐bill is:
P = FV/(1 + d)t
P is the market price, FV is the face value, d is the discount factor, and t is time to maturity (let us
set t = 1 to simplify). Usually, d is positive meaning that the Fed buys T‐bills at $90 and bankers
agree to buy back the next day at $95 (d = 5%). After the 2008, one can assume that d = 0%, that is,
if bankers want reserves from the Fed, they sell T‐bills at $90 and promise to buy them back at $90
the next day. To set d negative, the only thing the Fed has to do is to buy at $95 and resell at $90.
In this case the federal funds rate target will be negative 5%: 90/95 – 1. If the Fed performs enough
of these kinds of operations, the federal funds rate will reach the ‐5% target. Remember that the
Fed sets the price of reserves. It can set it wherever it wants: “It is the Fed’s way or the highway.”
Which interest rate can be below zero? Any of them as long as the Fed is committed to doing so by
buying enough of securities at a price consistent with the interest rate it wants to target.
The interest rates used in the corridor framework (see Chapter 4) are under the total control of the
Fed so they are easy to make negative. The Swedish central bank shows us how this is done under
a corridor framework (Figure 5.4). The Swiss central bank shows us how it is done with a negative
overnight interbank rate range (Figure 5.3).

Figure 5.3 Target overnight rate range and daily overnight rate, Swiss National Bank, percent
Source: Swiss National Bank

56


Figure 5.4 Corridor of the Sveriges Riksbank, percent
Note: The “deposit rate” is the interest rate on reserve balances, the “lending rate” is the rate
charged by the central bank for advances (the discount rate of the Fed), the “repo rate” is the
rate at which the central bank performs open‐market operations (the targeted overnight rate).
Of course, if a central bank has negative policy rates and is expected to continue to have negative
rates for a while, this enters into portfolio strategies and pushes longer‐term rates into/toward
negative territories (Figures 5.5 and 5.6). But, the European Central Bank is going further and is
buying large quantities of long‐term government bonds. And financial‐market participants took
notice 7 and bought government bonds in anticipation of the intervention of the ECB. Financial‐
market participants are so sure the ECB will buy a lot of securities that they are willing to buy at a
premium (so yields to maturity are negative) (Figure 5.4). They will sell to the ECB who will be the
one taking the loss by holding to maturity.
For example, take a 1‐year zero‐coupon government security with a face value of $1000. Normally,
this security will trade at a discount, that is, economic units will only buy it for less than $1000
because it does not pay any coupon. They will earn an income by keeping the security until the
Treasury repays the $1000 at maturity. If the security is bought at $800 then the rate of return is
$200/$800 = 25% (rate of return is what the earning you get for what you paid for it). Rates of
return on Eurozone government 1‐year securities are now negative because securities sell at a
premium. For example, if one has to pay $1200 on a 1‐year zero‐coupon security and gets $1000 at
maturity, the rate of return is ‐$200/$1200 = ‐17%. Nobody will want to buy that unless one expects
someone else to buy at, say, $1300 in upcoming days or months. The ECB is willing to do so and will
take a loss of $300 (‐23% rate of return) when the securities mature, while financial market
participants make a return of $100/$1200 = 8%.
57


Figure 5.5 Yields on government bonds
Source: The Economist

Figure 5.6 Yields on Swedish government securities, percent
Source: Swedish Central Bank
58

Q8: WHAT ARE THE EFFECTS OF A NEGATIVE INTEREST‐RATE
POLICY?
It depends on which rate is concerned. A simplified bank profit is:
Profit of banks = (ROA*other assets + IOR*R) – FFR*fed funds debt
ROA is the return on assets held by banks (say you have a $1000 mortgage with an interest rate of
5%, this 5% is an income for the bank equal to ROA*mortgage = 5%*$1000 = $50). IOR is interest
on reserve balances and R is reserve balances. There are no other debts than those incurred from
getting reserves in the fed funds market either from Fed or from other market participants than
banks. Interest payments on interbank loans cancel out in the aggregate profit of banks, it is an
income for one bank and an expense for another).
‐ Given everything else, negative FFR raises the profitability of banks because banks are paid
to get an advance of reserves.
‐ Given everything else, negative IOR lowers the profitability of banks. This is especially
significant today given how large reserve balances are.
Banks will react to these effects in several ways in order to preserve their profitability. To counter
a negative IOR, banks may do three things:
‐ Ask their customers to pay a fee on their checking accounts (either a larger one or raise the
minimum quantity of funds in an account below which a fee is paid)
‐ Raise the bank prime rate (i.e. interest rate paid by the most creditworthy economic units)
or acquire riskier assets so as to raise ROA.
‐ Raise leverage on the funding of assets with positive ROA.
If the fee on bank accounts is too large, customers may ask for cash and close their accounts, but
that is not really a problem for banks given that:
1‐ If the FFR is negative, banks can borrow all the reserves they need and be rewarded for it.
Today they have plenty of reserves so this effect is limited, but it also means that meeting
cash withdrawals is easy.
2‐ Banks work by granting advances and making electronic payments so some individuals
must have deposits. In addition, nobody can access cash (Federal Reserve notes) if one does
not have an account in the first place, and banks create these accounts by providing
advances. Advances pay interest.
The real problem is a negative IOR in the context of a large quantity of excess reserves. It acts like
a tax and may incentivize banks to take more risks. This effect is all the more strong given that banks
do not need to borrow in the fed funds market so a negative FFR has a limited ability to offset the
negative impact of a negative IOR.
In terms of negative bond rates, the impact is that bondholders make capital gains by selling to the
central bank (see Q7). The central bank hopes that bondholders will use some of their capital gains
to consume and so stimulate the economy. Given how unequal wealth distribution is, the ability of
this channel to work seems doubtful. It is a form of trickle‐down economics.
59

Q9: HOW DID CENTRAL BANKERS JUSTIFY USING NEGATIVE

INTEREST RATES AND QE?
Here is the logic followed:
1‐ A negative policy rate in a time of deflation (or low/zero inflation) allows us to keep the real
interest rate low (allows us to lower the real rate). Economic units pay attention to the real
rate (interest rate less inflation) when they decide to go into debt. If policy rate goes
negative that should incentivize economic units to go into debt.
2‐ By buying a lot of securities from banks, banks will have a lot of excess reserves and will be
encouraged to provide credit. And there will be a demand for credit given step 1.
3‐ Now that QE provided banks with lots of excess reserves, banks are supposed “to lend”
(see money multiplier theory in Chapter 10). By setting IOR negative, banks will have less
incentive to cling on their reserves and instead will provide credit. Indeed, if they keep
reserves a negative IOR would lead to losses (see Q8).
4‐ Beyond the positive impact of bank credit, negative policy rates and quantitative easing
also help push down other rates, which promotes capital gains by securities holders and so
consumption.
There are several issues but the three main ones are:
1‐ The ability of banks to grant credit is unrelated to the quantity of excess reserves they have.
Chapter 4 shows that banks cannot do much with reserve balances (see Chapter 10).
Central banks can feed banks to tons of reserves and may even threaten banks’ profitability
with negative IOR, but it is just like beating a dead horse; banks are stuck with reserves.
2‐ In a depressed and over‐indebted economy, incentivizing economic units to go into debt is
the wrong way to proceed.
3‐ The form of trickle‐down economics that quantitative easing and negative yield rates
represent has never worked.
We need a bottom‐up approach8 that focuses on providing jobs, fighting poverty, and meeting the
needs of the nation. Fiscal policy is the means to do so.
Q10: SHOULD THE FED FINE‐TUNE THE ECONOMY?
While the Fed is heavily involved in “fine‐tuning” the economy—i.e. making sure the economy is
not too hot (inflation) nor too cold (unemployment) by moving the FFR target up and down—one
may note that the Fed (and other central banks) was not created for that purpose. Central banks
were created either to finance the crown/state, or to promote financial stability (both goals are
actually intertwined as shown in Chapter 6).
Some economists, like Hyman Minsky, think that fine‐tuning and promoting financial stability are
incompatible goals. A central bank should focus on promoting financial stability through low and
stable nominal interest rates, as well as proper regulation, supervision and enforcement. The Fed
could also influence financial innovations by refusing to accept as collateral any financial instrument
60

that promotes “Ponzi finance” (see Chapter 14). Fine‐tuning the economy with interest rates
implies raising interest rate during an expansion, which ultimately contributes to problems with
servicing debts. Given that decisions to go into debt are not interest‐rate sensitive, raising rates just
pushes economic units to go more into debt to pay existing debts. The hope is that income and
capital gains will ultimately enable the full repayment of debts.
More broadly, the link between FFR and the end goals of employment growth and inflation control
is tenuous and subject to perverse linkages. For example:
‐ The link between interest rates and business investment is very weak, with investment by
companies overwhelmingly dependent on expected net cash flows.
‐ Higher interest rate raises the cost of doing business and firms may pass that cost to their
clients, resulting in inflation.
‐ Higher interest rate also raises the income of rentiers and so their consumption. If the
economy has a large proportion of rentiers (pensioners, wealthy individuals, etc.) then
raising rates may be inflationary.
‐ Higher interest rate raises the private‐debt burden and promotes financial instability.
‐ Interest‐rate volatility promotes financial innovations to remove the sensitivity of profit to
interest‐rate swings.
‐ Increments in FFR are small and announced well in advance, giving plenty of time to
economic units to adapt in order not to let their decisions be influenced by the cost of
credit.
Instead of nudging incentives so that, maybe, the private sector will spend, some economists
promote a more direct approach. In times of crisis, implement large scale fiscal spending to meet
the needs of the nations (in the US, one of these needs would be infrastructure that is in really bad
shape).9 At any time, involve the government in direct job creation by employing people in similar
way it was done in the New Deal; a Job Guarantee program. In times of expansion, constantly check
financial innovations and forbid financial practices related to Ponzi finance or at least remove any
safety net for them.
Finally, there have been some debates 10 also about how to set the FFR target. In the more
mainstream literature, this issue boils down to what to include in the Taylor rule (a rule that
determines what the optimal FFR target should be given a state of the economy) and how much
weight to put on each element that influences the rule. In the non‐mainstream approach, the
discussion is broader and includes discussions about the distributive and destabilizing impacts of
monetary policy. Some authors want the central bank to target a specific interest rate to make
rentiers’ income stable and related to the productivity gains of the economy. Others want to leave
FFR permanently around zero and let other rates do the job of sorting credit risk, inflation risk, etc.
A positive FFR just adds extra income to rentiers and does not reward any risk (see Q5 with Bill
Gross).
For your reading pleasure below are three extracts from some Federal Open Market Committee
meetings that illustrate some of the previous points. First on the lack of interest‐rate sensitivity:
In addition to the input that we bring to these meetings and the usual sources of
our own research staff and directors, last Friday when Vice Chairman Schultz visited
us in San Francisco we called in a special small group of bankers, businessmen, and
61

academicians for a very frank exchange of views. We sounded them out about their
feelings on the economy and on Fed policy, and I must say, Fred, that I thought the
reactions were quite candid and somewhat humiliating in a way. The bankers
generally expressed the view that as yet there’s very little evidence that the high
level of interest rates is having any significant total effect on cutting off credit
demand. Now, one has to add to that the expressions we got from them in our
usual go‐around with bankers and bank directors that these high rates are having
a cutting effect on the so‐called middle market for business borrowers – the smaller
firms – and for mortgage loans and some small farmers. That’s where the incidence
of the high interest rate effect has been felt thus far in our part of the country. But
as a general matter, even if the businessmen present were mostly from big
concerns, they simply indicated that the higher rates per se are not having any
effect at all on their capital projects. If a project is worthwhile, it‘s not going to get
cut off by a one or two percentage point increase in the cost of funds. A minority
expressed the view that this is leading to some greater caution on inventory policy,
which is already being viewed as quite cautious. One major real estate developer
present indicated that the higher rates are just built into their projects and aren’t
having any dampening effect at all. (Balles, FOMC meeting, September 1979, page
27)
Second on the cost impact of raising interest rates:
Interest rates may be [low] after tax, or in real terms, but they are still contributing
to cost and are creating, I think, some of the upward pressure on prices. (Teeters,
FOMC meeting, May 1981, page 10)
There is deterioration in the inflation rate stemming from interest costs and energy
costs, and those are not trivial sources of deterioration. At the end of the day it
doesn’t have to be labor costs that are causing the overall inflation deterioration.
(Greenspan, FOMC meeting, November 2000, page 85)
Q11: IS THE FED A PRIVATE OR A PUBLIC INSTITUTION?
Partly due to the culture of the United States, and partly due to strong economic interests against
centralized institutions, the Federal Reserve System is an oddly organized public‐private
partnership. Member banks do hold stocks issued by the System that provide a dividend payment
but this dividend payment is not guaranteed, the stocks do not provide any voting rights, and they
cannot be traded. For example, recently 11 Congress decided to divert some of the dividend
payments to fund highway expenses.
In addition, all leftover income of the System must be transferred to the Treasury. Note that this
makes for an odd situation. The Fed holds Treasuries that pay interest, part of this interest income
ends up going back to the Treasury: the Treasury pays itself interest! In addition, the Treasury tries
to maximize its earnings from the Fed through cash management.12
Instead of looking at stock holdings and income payment, a more relevant analysis of the political
economy of the Fed looks at its structure and who can make decisions regarding monetary policy
and emergency operations. In terms of monetary policy, the influence of Wall Street is large, with
strong representation on the Federal Open Market Committee via members with former ties to
62

major banks (in 2016 half the Fed presidents have former ties to two major banks: Goldman Sachs
and Citibank). Financial sector members tend to be more hawkish and more concerned, if not
obsessed, with price stability. This leads them to want to raise the FFR target early, leading to a
level of employment lower than it would otherwise have been. They are also friendlier to the
financial industry and more lenient in terms of regulations and in terms of response to a financial
crisis. Finally, there is a risk of regulatory capture.
If one combines this with the fact that economists at the Board are mostly pro‐market supply‐sided
economists (economic growth is ultimately a supply‐side thing), financial regulation and
enforcement do not make much sense and raising rates very early in anticipation of inflation makes
sense. Many economists, however, doubt that markets are efficient and that demand has no role
to play in the long run.
Q12: WHAT ARE NO‐NO SENTENCES FOR WHAT THE FED

DOES? (WILL GIVE YOU A ZERO ON MY ASSIGNMENTS)
1‐ “The Fed controls the money supply”: No, it does not, it sets an interest rate, what happens
after that is up to firms and households and their desire for external funds (see Chapter 4).
2‐ “The Fed injects reserves which lowers the interest rate” or, worse offender, “The Fed injects
money which lowers interest rate”. Under normal circumstances (that is, pre‐Great
Recession, which is what most people have in mind when saying this), the Fed does not
proactively inject reserves, it waits for banks to ask. And, the Fed’s monetary policy never
injects money, i.e. never deals directly with the public (M1) (see Chapter 4).
3‐ “The Fed printed money during the financial crisis”: No, it just credited account by
keystroking dollar amounts, no Federal Reserve notes were printed. More to the point,
none of these funds entered the money supply, that is, funds held by the public.
4‐ “The Fed used taxpayers’ money during the financial crisis”: No, it just credited accounts of
banks by keystroking dollar amounts (see Chapter 2).
5‐ “Banks use reserves to buy stocks and corporate bonds”: No banks cannot do that with
reserves (see Chapter 2).
6‐ “The large inflow of reserves in banks did not lead to inflation because banks did not lend
the reserves or based on reserves”: No, banks do not operate that way, bank credit and
quantity of reserves are unrelated (see Chapter 10)
7‐ “Central banks lend reserves”: No, the Fed does not lend reserves because reserves are its
liability (see Chapter 2).
8‐ “Fiscal deficits raise interest rates”: No, there was a hint about this in Chapter 3. More is
coming in Chapter 6.
63

1‐ Setting an interest rate does not mean supplying an infinite quantity of reserves. It just means
supplying what banks want.
2‐ The Volcker experiment aimed at following more closely the Monetarist principles of monetary‐
policy making. In practice, the Fed widened dramatically the target range for the FFR but it never
completely let the FFR respond to market forces.
3‐ FOMC members did not understand that targeting the FFR was not inflationary until the middle
of the 1990s.
4‐ Normalizing the balance sheets means returning the quantity of excess reserves back to its pre‐
Great Recession proportion in total reserves. This can be done by selling assets to banks or by letting
some of the securities held by the Fed mature.
5‐ Normalizing the balance sheet of the Fed is not necessary given that the Fed has changed its
procedures for setting the FFR.
6‐ The FFR and discount rate are policy variables completely under the control of the Fed. They can
be set wherever the Fed wants, even in negative territory.
7‐ In order to set market rate into negative values, the Fed just has to complete enough purchases
of securities at a premium.
8‐ By providing capital gains and by making it costly to hold reserves, a negative interest rate policy
is supposed to promote economic activity.
9‐ Fine‐tuning the economy may be difficult and counterproductive because rising interest rates
may promote financial fragility and may be inflationary. In addition, business investment is not very
sensitive to changes in interest rates; the transparent and gradual monetary policy strategies used
since the mid‐1990s have made spending decisions even less sensitive to interest‐rate hikes.

Keywords
Volcker experiment, premium, fine‐tuning, normalization, excess reserves, total reserves

Review Questions
Q1: How did the Volcker experiment lead to an increase in the volatility of the FFR? Did the Fed
abandon completely interest‐rate targeting?
Q2: FOMC members did not believe that setting an interest rate was a sustainable monetary policy
practice; why not? Why were they wrong?
Q3: How does QE impact the yields of securities? Why the link cannot be one in which banks buy
securities with reserves?
Q4: How can banks offset the adverse impact of negative interest rates on the profitability of banks?
Q5: What are the two ways through which QE is supposed to boost economic activity? What are
potential issues with this policy?

Suggested readings
For an analysis of FOMC meetings during the period 1979‐1999 see chapter 6 of Central Banking,
Asset Prices, and Financial Fragility by Eric Tymoigne.
Kaldor, N. (1982) The Scourge of Monetarism, Oxford: Oxford University Press.

64


1 A succinct profile of Nicholas Kaldor was written in the central bank of the Slovak Republic BIATEC, Volume XIV, 12/2006
http://www.nbs.sk/_img/Documents/BIATEC/BIA12_06/26_30.pdf
2 See “Bill Gross: Americans are being "cooked alive" by the Fed's zero interest rates” by Chis Matthew at
http://fortune.com/2015/09/23/bill‐gross‐federal‐reserve‐interest‐rates/
3 See Wray, L.R. (2006) “Global Demographic Trends and Provisioning for the Future” Levy Economics Institute, Working
Paper No. 468 at http://www.levyinstitute.org/pubs/wp_468.pdf
4 See “Policy Normalization Principles and Plans As adopted effective September 16, 2014” by the Federal Open Market
Committee at http://www.federalreserve.gov/monetarypolicy/files/FOMC_PolicyNormalization.pdf
5 See “About MBS/ABS” by the Securities Industry and Financial Markets Association at
http://www.investinginbonds.com/learnmore.asp?catid=11&subcatid=56&id=134
6 See “Policy Normalization Principles and Plans As adopted effective September 16, 2014” by the Federal Open Market
Committee at http://www.federalreserve.gov/monetarypolicy/files/FOMC_PolicyNormalization.pdf
7 See “Euro Area's Negative‐Yielding Debt Tops $2 Trillion on Draghi” by Lucie Meakin at
http://www.bloomberg.com/news/articles/2015‐11‐23/euro‐area‐s‐negative‐yielding‐debt‐tops‐2‐trillion‐on‐draghi
8 See Tcherneva, P.R. (2013) “Reorienting Fiscal Policy: A Critical Assessment of Fiscal Fine Tuning” Levy Economics
Institute, Working Paper No. 772 at http://www.levyinstitute.org/pubs/wp_772.pdf
9 See the Infrastructure Report Card by the American Society of Civil Engineers at
http://www.infrastructurereportcard.org/
10 See Tymoigne, E. (2006) “Asset Prices, Financial Fragility, and Central Banking” Levy Economics Institute, Working Paper
No. 468 http://www.levyinstitute.org/pubs/wp_456.pdf. See also
11 See “Fed Money Tapped in Highway Bill as Banks Get Dividend Break” by Cheyenne Hopkins at
http://www.bloomberg.com/news/articles/2015‐12‐01/fed‐surplus‐tapped‐in‐highway‐bill‐as‐banks‐get‐dividend‐
break
12 Santoro, P.J. (2012) “The Evolution of Treasury Cash Management during the Financial Crisis,” Federal Reserve of New
York Current Issues in Economics and Finance, 18 (3): 1‐8.
65

CHAPTER 6:
How and why the central bank and Treasury must coordinate their fiscal and
monetary operations
How the Treasury helps the central bank implement monetary policy on a daily
basis
Why the Treasury is involved in the implementation of monetary policy
Why the financing of the Treasury by the central bank is not optional and must
always occur directly or indirectly
How the central bank gets involved in financing the Treasury
Why a monetarily sovereign government does not face any financial
constraint
What relevant questions a monetarily sovereign government must answer

CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS
This Chapter concludes the study of central banking matters included in this draft. The Chapter
studies how the Fed is involved in fiscal operations and how the U.S. Treasury is involved in
monetary‐policy operations. The extensive interaction between these two branches of the U.S.
government is necessary for fiscal and monetary policies to work properly.
Once again, the balance sheet of the Federal Reserve provides a simple starting point. The Treasury
holds an account (called Treasury’ General Account, TGA) at the Fed, which is part of L3. To simplify,
this Chapter assumes that the Fed still follows the monetary‐policy procedures that it followed prior
to the 2008 crisis.
MONETARY POLICY AND THE U.S. TREASURY
When Treasury spends, the Fed debits the TGA and credits reserve balances. Simultaneously,
private bank credits the account of private economic units. Say the Treasury buys $100 worth of
paper from a paper company.
Fed
TGA: ‐$100

Bank
Reserve balances: +$100 Account of paper company: +$100

Paper company
Paper: ‐$100
Account of paper company: +$100

Treasury
TGA: ‐$100
Paper: +$100
If Treasury receives $25 of income tax payments, the following happens:
Fed
TGA: +$25

Bank
Reserve balances: ‐$25 Account of taxpayer: ‐$25

67

Taxpayer
Account of taxpayer: $25 Net worth: ‐$25

Treasury
TGA: +$25 Net worth: +$25
Therefore, in case of a deficit (taxes less than expenses), there is a net injection of reserves. The
consolidation of the two previous fiscal operations is:
Fed
TGA: ‐$75
If the Fed does not neutralize the impact of the fiscal deficit by removing the extra reserves, banks
will dump everything in the Fed Funds market and the FFR rapidly falls toward 0% (see Chapter 4).
As long as the Fed targets a positive FFR, it has to neutralize the impact of daily fiscal deficits (L3
falls)—that lower the FFR—and the impact of daily fiscal surpluses (L3 rises)—that raise the FFR.
The Treasury understood the impact of its fiscal operations on money markets long before the Fed
was created. In the current set up, the Treasury has helped the Fed to achieve its FFR target through
two means:
1‐ Cash management: The Treasury collects proceeds from taxes and bonds issuances in
thousands of private bank accounts called the “Treasury’s Tax and Loan accounts” (TT&Ls).
Treasury moves funds between its TT&Ls and TGA to help monetary policy.
2‐ Public‐debt management: The Treasury changes the level of its outstanding Treasuries, or
changes the structure of its Treasuries (proportion of short‐term vs. long‐term securities).
Given that fluctuations in the TGA (L3 in Figure 2.1) influence reserve balances (L2 in Figure 2.1),
until the Great Recession the Treasury limited these fluctuations by keeping the TGA around $5
billion (Figure 6.1). Treasury employees met every morning with Fed employees to discuss the
expected net cash flow on TGA for the day and to decide on the quantity of funds to move in or out
of TT&Ls to meet the $5 billion target.
For example, say the TGA is currently at $5 and that this is the target of the Treasury. If the Treasury
expects to spend $2, it would call $2 from its TT&Ls during the day. Cash flows of the TGA are very
erratic throughout the day so they cannot be offset perfectly. Assume that spending occurs first
(payment to a paper company):
Bank
Reserve balances: +$2 Account of company: +$2

Fed
TGA: ‐$2
68

The injection of reserves is removed by calling funds from TT&Ls:
Bank
Reserve balances: ‐$2 TT&Ls: ‐$2

Fed
TGA: +$2
So overall the net impact on reserve balances is zero and the balance sheet of the Fed is unchanged.
The only change is on the liability side of private banks.
Bank
Account of company: +$2
TT&Ls: ‐$2

Figure 6.1 TGA, weekly averages until 9/17/2008, billions of dollars
Source: Board of Governors of the Federal Reserve System (H.4.1. series)
TREASURY’S INVOLVEMENT IN MONETARY POLICY DURING THE 2008
CRISIS
Lehman’s collapse in September 2008 led to a large injection of reserves but this injection was
partly contained by a rapid increase in other liabilities that peaked in value at $1.7 trillion on the
week of November 5th 2008 (Figure 6.2). The cause of the increase is a massive cash and debt
69

management operation by the Treasury that started late September 2008. First, Treasury
transferred tens of billions of dollars from its TT&Ls into the TGA, thereby breaking with its attempt
to maintain TGA at $5 billion. Second, Treasury issued “Supplementary Financing Program” T‐bills
(SFP bills), and immediately put the proceeds into a new Treasury’ account at the Fed called
“Treasury’s Supplementary Financing Account” (TSFA) (Figure 6.3).

Figure 6.2 Balance sheet of the Federal Reserve, trillions of dollars
Why did the Treasury do this? To help drain reserves in order to maintain the FFR on target. The
FFR target was positive until December 2008, so reserves had to be drained in order to maintain
the FFR around the non‐zero target. Chapter 4 explains that the Fed had been neutralizing the
impact of emergency programs on reserves since December 2007. It had been doing so by selling
its holdings of Treasuries to banks and in six months the outstanding value of its holdings fell from
$780 billion in January 2008 to $480 billion in June 2008. If the Fed had continued to neutralize
emergency programs in that fashion, it would have run out of Treasuries very quickly with the panic
of September 2008. It is all the more so that the Fed had started to lend some of its Treasuries, so
the dollar amount of unencumbered Treasuries actually dropped to $250 billion.
In order to avoid running out of Treasuries, the Fed asked the Treasury to help drain reserves via
cash management (TT&Ls to TGA transfers) and debt management (issuance of SFP bills). The T‐
bills were issued at the request of the Fed for monetary‐policy purposes, that is, to help drain
reserves. 1 The outstanding dollar amount of SFP bills peaked at almost $560 billion in late
October/early November 2008. After that, the outstanding dollar amount went down quickly for
reasons explained below. Combined with its cash management operations, Treasury removed up
to slightly more than $600 billion worth of reserves. As the Discount Window was advancing
reserves to banks in difficulty, the Treasury was simultaneously draining them (Figure 6.4).
70


Figure 6.3 Treasury’s accounts at the Fed, billions of dollars

Figure 6.4 Injection (+) and ejection (‐) of reserve balances, trillions of dollars
Source: Federal Reserve (Series H.4.1)
In its announcement of the Program, the Treasury misrepresented the purpose of SFP bills by
stating that their purpose was to “provide cash for use in the Federal Reserve initiatives.”2 Of course
this is incorrect because the Fed does not need cash from anybody, it creates cash.
71

The Treasury rapidly reduced its help through the SFP program by agreeing to roll over only $200
billion of T‐bills. Treasury did so because its help was no longer as needed (FFR target was at zero),
and because of the debt‐ceiling debate of the time that almost killed the program in early 2010.
OTHER EXAMPLES OF TREASURY’S INVOLVEMENT IN MONETARY

POLICY
The Treasury has used other debt and cash management techniques in the past in order to help
monetary policy. For example, Treasury used to be able to have an intraday overdraft on its TGA;
unlimited from 1914 to 1935 and up to $5 billion from 1942 until 1979 (Table 6.1).3 As such, at
times, the TGA would carry a negative balance during the day and, by the end of the day, the TGA
would be replenished by direct financing of the Fed. The Treasury issued “special certificate of
indebtedness” to the Fed and in exchange the Fed credited the TGA.
The Treasury used this overdraft authorization exclusively for monetary‐policy purposes. For
example, before a major tax season:
On occasion, the Treasury, in anticipation of heavy tax receipts during heavy tax
months, will, under statutory authority, replenish balances at Federal Reserve
Banks by borrowing directly from such banks through the issuance of special
certificates of indebtedness, rather than withdrawing funds from Treasury tax and
loan accounts. These funds are borrowed for only a few days and enable the
Treasury temporarily to make disbursements in excess of its current receipts thus
providing the banks with additional reserves in advance of a later unavoidable
drain. (U.S. Treasury 1955, 282, italics added)
This allowed the Treasury to replenish its TGA without having to drain its TT&Ls. The Treasury did
this not because it was running out of money:
At the time [Treasury’s administrators] have used the overdraft in the past, it has
not been when they have had no balances with the banks. They have usually had
very substantial balances with the banks. And they could have drawn on those
balances to meet the overdraft. That, however, […] would be undesirable and
unstabilizing to the money market to withdraw the [TT&Ls] for such a very short
period of time. It would then build up unnecessary balances in the Reserve banks,
and would create a deficiency of reserves in the banks throughout the country, and
would compel them to sell securities or to borrow from the Federal Reserve banks
(Eccles in U.S. House 1947, 7))
Throughout most of WWII, the Fed was targeting the entire yield curve (that is, all the interest rates
on Treasuries) and Treasury helped through debt management (Figure 6.5). The strict targeting of
T‐bond rate at 2.5% was relaxed a bit toward the end of the war, but Treasury and Fed still did not
want the rate to deviate too much from 2.5%. After the war, fiscal surpluses removed T‐bonds from
the market even though there was high demand for them. This situation raised their price and the
yield on 10‐year T‐bonds declined steadily toward 2%. To bring back the T‐bond rate up toward
2.5%, more T‐bonds needed to be supplied. Unfortunately, the Fed did not hold enough T‐bonds so
the Treasury supplied more:
72

At any rate, the effect of a budget surplus at that time was terribly important in all
of the monetary and debt management operations that went on. […] At that time,
the Federal Reserve System owned practically no long‐term Government bonds
and, therefore, in its open‐market operations was unable to supply the market with
that type of investment. The Treasury Department, however, held large amounts
of long‐term bonds in various investment accounts. After consultations and
discussions, both at a staff level and at a policy level, between the Treasury and the
Federal Reserve and in full agreement, the Treasury Department, through the
open‐market committee of the Federal Reserve, sold large amounts of long‐term
Government bonds so as to fill the demand and to prevent a further decline in the
long‐term interest rate. During this period, the Treasury sold $1.5 billion of long‐
term bonds. However, the amount was not adequate to satisfy the demand nor to
increase the market yield on such securities. Thereupon, the Treasury Department,
after consultation with the Federal Reserve and with full agreement on the part of
both, sold a nonmarketable 18‐year issue in the amount of $1 billion. The purpose
of this sale was to mop up any remaining investment funds that were exerting
upward pressure on the market. (Wiggins in U.S. Senate, 1952, p. 227, p. 237))
From a fiscal perspective this seems strange—a Treasury trying to raise the cost of its indebtedness
and a Treasury issuing securities when running a fiscal surplus—but again all this was done for
monetary‐policy purposes, and more broadly for what was considered the social purpose.
(1) (2) (3) (1) (2) (3) (1) (2) (3)
1923 30 1 156.5 1943 48 28 1,302 1963 - - -
1924 14 1 184 1944 - - - 1964 - - -
1925 15 1 182 1945 9 7 484 1965 - - -
1926 14 1 246 1946 - - - 1966 3 3 169
1927 46 1 251.5 1947 - - - 1967 7 3 153
1928 20 1 316 1948 - - - 1968 8 6 596
1929 17 1 314 1949 2 2 220 1969 21 12 1,102
1930 18 1 218 1950 2 1 180 1970 - - -
1931 18 1 219.5 1951 4 2 320 1971 9 7 610
1932 8 1 32 1952 30 9 811 1972 1 1 38
1933 4 1 9 1953 29 20 1,172 1973 10 6 485
1934 - - - 1954 15 13 424 1974 1 1 131
1935 - - - 1955 - - - 1975 16 7 1,042
1936 - - - 1956 - - - 1976 - - -
1937 - - - 1957 - - - 1977 4 4 2,500
1938 - - - 1958 2 2 207 1978 - - -
1939 - - - 1959 - - - 1979 N/A N/A 2,600
1940 - - - 1960 - - - 1980 - - -
1941 - - - 1961 - - - 1981 - - -
1942 19 6 422 1962 - - - 1982 - - -

Table 6.1 Direct financing of the Treasury by the Fed to close the TGA overdraft: Number of
Days Used (1), Maximum Number of Days Used at any One Time (2), and Maximum Outstanding
at any Time (Millions of Dollars) (3)
Sources: U.S. House (1962), U.S. Treasury (1978), Board of Governors of the Federal Reserve
System (1979)

73


Figure 6.5 U.S. Interest rates in the 1930s, 1940s and 1950s, percent.
Sources: NBER, Board of Governors of the Federal Reserve System
Note: Grey area is represents U.S. official involvement in World War Two.
There have been other cash and debt management techniques used by the Treasury but those
above should give you a sense that the Fed cannot do it alone given the way it operates in terms of
monetary policy (it uses Treasuries so Treasury must supply enough securities), and given that
Treasury has an account at the Fed (a fiscal surplus/deficit drains/injects reserves). In other
countries the institutional details change, but some coordination between Treasury and central
bank is needed for monetary‐policy operations to work properly.
FISCAL POLICY AND THE FED
For a government that has monetary sovereignty, one that issues its own currency and securities
only denominated in its unit of account, the central bank always helps one way or another to
finance the budget of the Treasury. After all, central banks were created in part to help finance the
state, that is, to make sure that the state has the financial means to fulfill its goals expressed in the
annual budget. Once again, the following focuses on the United States.
The most straightforward involvement of the Fed into fiscal operations was the availability of an
overdraft on TGA until the late 1970s. As stated in the previous section, in practice this overdraft
facility had been strictly used for monetary‐policy operations, but it could be used for fiscal
purposes in case of “national emergency.” The $5 billion limit was, however, very limiting for that
purpose and there were Congressional hearings in the 1960s that looked into the possibility of
expanding that limit and making the overdraft line permanent (authorization of the overdraft had
to be renewed by Congress every two years). This went nowhere because the use of the overdraft
for fiscal purposes was seen as inflationary and unsound. The Treasury always justified the use of
74

the overdraft as a brief and occasional means to finance its expenditures in order to avoid
disruptions in the money market.
Even though direct financing was discouraged and later forbidden, the Treasury uses Fed’s
monetary instruments to spend. Thus, one way or another, the Treasury will get financed by the
Fed because only the Fed supplies the funds that the Treasury uses. Indeed, while TT&Ls are used
to receive bond and tax proceeds, they are just a tool that allows for smoothing out the impact of
tax and bond proceeds on reserves. Ultimately, all the proceeds go to the TGA, which drains
reserves. As a consequence the Fed has to ensure that banks have enough reserves to allow the
Treasury to be able to make the transfer from TT&Ls to TGA.
In addition, the Fed also has been heavily involved in treasury auctions4 to ensure that they go on
smoothly. Chairman Eccles again provides an insightful insider’s view on the financing of the
Treasury:
[In past Congressional hearings] there was a feeling that […] Government
[borrowing] directly from the Federal Reserve bank […] took off any restraint
toward getting a balanced budget. Of course, in my opinion, that really had no
relationship to budgetary deficits, for the reason that it is the Congress which
decides on the deficits or the surpluses, and not the Treasury. If Congress
appropriates more money than Congress levies taxes to pay, then, there is naturally
a deficit, and the Treasury is obligated to borrow. The fact that they cannot go
directly to the Federal Reserve bank to borrow does not mean that they cannot go
indirectly to the Federal Reserve bank, for the very reason that there is no limit to
the amount that the Federal Reserve System can buy in the market. […] Therefore,
if the Treasury has to finance a heavy deficit, the Reserve System creates the
condition in the money market to enable the borrowing to be done, so that, in
effect, the Reserve System indirectly finances the Treasury through the money
market, and that is how the interest rates were stabilized as they were during the
war, and as they will have to continue to be in the future. So it is an illusion to think
that to eliminate or to restrict the direct borrowing privilege reduces the amount
of deficit financing. Or that the market controls the interest rate. Neither is true.
(Eccles in U.S. House, 1947, 8)
If the Treasury does not get the funds it needs to implement Congressional mandates, and if
Congress passes a budget in deficit, then the democratic process will not be fulfilled (the budget
cannot be implemented), and interest rates will rise.
In terms of auctions of Treasuries, the Fed makes sure they are always successful; “bond vigilantes”
have no influence. The Fed has done so in many different ways; one way was to buy whatever was
leftover during an auction. The Fed had to do so, either because until the 1970s T‐bond auctions
were not well established and so participation was not always as high as needed, or because the
Fed was targeting the entire yield curve.
Now today in pricing a new Treasury issue, the Federal [Reserve] is in the position
of underwriter. During the period of the offering the Federal [Reserve] tries to see
to it that the Treasury's issue is successful […] It stabilizes the market just the way
any underwriter does. (Martin in U.S. Senate, 1952, p. 96)
Another way has been to provide a dependable refinancing channel to the Treasury because the
Fed is still allowed to participate in auctions to replace its maturing Treasuries.
75

Finally, today the Fed participates indirectly in the financing of Treasury through the Primary Dealer
System. During an auction, primary dealers must submit a reasonable bid and the Fed ensures that
they have enough reserves at time of settlement by purchasing, or repoing, outstanding Treasuries.
Prior to the Primary Dealer System, the Fed also ensured that banks had enough reserves to settle
an auction. For example during World War Two (see Figure 6.6 for reserve data during that period):
It was evident that all funds needed for financing the war which were not raised by
taxation or by the sale of Government securities to nonbank investors would need
to be raised by the sale of securities to the banking system. At first commercial
banks were able to draw down excess reserves by several billion dollars, but later
they had to be supplied with a considerable amount of additional reserve funds in
order to purchase the necessary securities […] In general, further reserve funds
were supplied by Federal Reserve purchases of short‐term Government securities.
(Martin in U.S. Senate, 1952B, p. 288)
Thus, one way or another the Fed will ensure that auctions never fail; and in the process it will be
financing either directly or indirectly the Treasury.

Figure 6.6 Total reserves, Aug. 1917 to Dec. 1958, billions of dollars
Sources: Banking and Monetary Statistics 1914‐1941, Banking and Monetary Statistics 1941‐
1970.
A NECESSARY COORDINATION OF TREASURY AND CENTRAL

BANK ACTIVITIES
The Treasury and the central bank must work extensively together for fiscal and monetary policies
to work properly. The central bank cannot be fully independent from the Treasury:
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The history of central banking, as was brought out earlier by the chairman, is that
central banking cannot get too far away from the policies of Government too long;
and that while central banks historically have won battles against the Government,
they have always lost the war. (Wiggins in U.S. Senate, 1952, p. 235)
The central bank has independence of tools (interest‐rate setting) and goals (inflation, etc.) but
must work Treasury operations into its daily activities. Similarly, the Treasury needs to work
monetary‐policy considerations in its daily activities otherwise interest‐rate stability would not be
maintained and inflationary pressures could more easily materialize.
TO GO FURTHER: CONSOLIDATION OR NO CONSOLIDATION?
THAT IS THE QUESTION.
It should be clear from the previous sections that ultimately all the funds that the Treasury uses
come from the Fed. Indeed, while taxes and bond issuances debit the account of private economic
units and credit TT&Ls, ultimately the Treasury needs funds in its account at the Fed (the TGA). And
these funds cannot exist before reserves exist unless the Fed directly provides funds to the
Treasury. Put in terms of T‐accounts, assumes that the TGA gets credited $100:
Fed
TGA: +$100
There are only a few possible offsetting operation. One is that the Fed directly finances the
Treasury:
Fed
Treasuries: +$100 TGA: +$100
Another is that other Fed accounts are drained as a results of tax settlement or the settlement of
auctions of Treasuries:
Fed
TGA: +$100
Other Fed accounts: ‐$100
In the latter case, the Fed previously had to provide those funds to the holders of these accounts,
either by advancing funds to them or by buying something from them (see Chapter 4). The Fed is
then indirectly financing the Treasury by working through intermediaries (primary dealers, banks,
etc.).
Pushing a bit further, it is quite clear that tax payments cannot be settled unless reserves are
injected first in the banking system either by the Fed (through advances or purchases: assets go up,
L2 goes up) or by the Treasury (via spending: L3 falls, L2 goes up). The same applies to proceeds
from issuing Treasuries. Monetary financing of the Treasury is not optional, it occurs one way or
another. Either the Fed buys Treasuries directly from the Treasury, or it buys them indirectly by first
providing funds to primary dealers through some outright or temporary purchases of Treasuries.
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Some economists following Modern Money Theory (MMT) have used these conclusions and noted
that no analytical insight is gained from making a distinction between Treasury and central bank
when dealing with a monetarily sovereign government. We might as well consolidate them into
one economic unit, the government. Consolidation is actually not infrequent in economic analysis,
but MMT pushes for consolidation based on a detailed analysis of the inner workings of Treasury
and central bank relationships. It is a theoretical simplification that is grounded in a detailed
institutional analysis. More importantly, MMT claims that consolidation has some implications for
understanding the role of taxes and government‐bond issuances for a monetarily sovereign
government.
The balance sheets of Treasury and central bank look as follows (the word “currency” is used
broadly to mean all forms of central bank monetary instruments: cash and reserve balances).
Treasury Department
A1T: Physical assets and financial claims on L1T: Treasuries held by central bank
the non‐federal sectors L2T: Other liabilities plus net worth
A2T: TGA+ FRNs held by Treasury

Central bank
A1CB: Physical assets and financial claims L1CB: Monetary base
on the non‐federal sectors L2CB: TGA + FRNs held by Treasury
A2CB: Treasuries L3CB: Other liabilities and net worth
The government balance sheet is:
Federal government
A1: Physical assets and financial claims on L1: Monetary base
the non‐federal sectors L3: Other liabilities held by the domestic
non‐federal sectors and the rest of the
world plus net worth
Tax payments lead to:
- ΔL1 < 0: government currency is returned to the government
- ΔL2 > 0: higher net worth of government (or ΔA1 < 0 if a tax liability is on the balance
sheet, for example, tax receivables are part of A1)
Government spending (fiscal policy) and advances (monetary policy) inject government currency:
ΔL1 > 0.
Taxes do not fund the (consolidated) government, that is, there is no crediting of a government
checking account, no accumulation of funds by government: taxes destroy government currency
(ΔL1 < 0). In addition, injection of government currency (ΔL1 > 0) must occur before taxing because
tax payment is done by handing over to the government its currency (ΔL1 < 0). This is exactly what
was said in the previous sections.
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Government‐bond issuance leads to
- ΔL1 < 0: government currency is returned to the government
- ΔL2 > 0: interest‐earning securities are issued
Bond issuances are equivalent to a transfer of funds from a checking account to a savings account.
They are part of monetary‐policy operations. The previous sections showed that this was illustrated
in times of stress in the monetary system.
MMT authors tend to like to work with a consolidated government because they see it as an
effective strategy for policy purposes (see next section), but also because the unconsolidated case
just hides under layers of institutional complexity the main point: one way or another the Fed
finances the Treasury, always. This monetary financing is not optional and is not, by itself,
inflationary.
TO GO EVEN FURTHER: WHAT ARE THE RELEVANT

QUESTIONS TO ASK FOR A MONETARILY SOVEREIGN
GOVERNMENT?
An advantage of the “Taxes don’t pay for anything” position is that it allows one to frame existing
debates differently. Instead of judging a program in terms of “how are we going to pay for it?”, one
may now look at what the social needs are and figure out how to implement their production. That
is the hard part. The financing of production is easy: it is always monetary financing, one way or
another.
Focusing the political discussion on taxes and how or who will pay, who gets the benefits, etc.
moves away from the public purpose of government and into an individualized benefit/cost
analysis: “I paid taxes, what do I get for it?” The simplest answer is maybe nothing because the
purpose of government is not to benefit any specific individual but society as a whole. Or maybe an
individual asking this question is too narrowly defining his/her benefits to their immediate, material
and personal aspects. Some families may not have kids and so may not personally benefit from
paying taxes for public schooling, but a better educated population has immense benefits now and
for the future, which does impact the quality of life of all.
In addition, moving away from the “taxes pay for” framework helps to better tackle some problems,
simply because taxes for a monetarily sovereign government are not meant to pay financially for
anything, but rather to free up some resources (goods, workers, services, raw materials, etc.) for
the public purposes. For example, the Social Security problem is not a financial problem; Social
Security cannot go bankrupt. There is no need for a Trust Fund, no need to put dollars in a locked
box, no need for payroll taxes. Social Security benefits can be paid the day they are due just by
typing a number on the computer. The funds will come from debiting the TGA. TGA will obtain funds
directly or indirectly from the Fed.
The hard part is figuring out how and what to produce to meet the needs of an aging society. We
will need more infrastructure, workers, goods and services that cater to the needs of an older
population; we will need to raise the productivity of available workers. That cannot be done by the
Treasury saving dollars. Instead, the Treasury should probably spend more on making schooling and
training easier to access, and should provide some financial help to individuals and businesses
79

willing to be involved in solving the problems of the future. The government should also be involved
directly through infrastructure spending and others. All this means more federal government
spending today, not less.
Taxes and tax structures are important but not for financing purpose but to promote price stability,
to change behaviors and to correct arbitrary inequalities. Payroll tax does none of that. It raises the
cost of labor, it discourages employment and it is regressive.
In the end, the problem of paying for something is not a financial issue for a monetarily sovereign
government, it is a political and productive one. If Congress is willing to do it, it will get funded; if it
gets funded then comes the problem of finding the resources to implement the project. The really
relevant questions are: “What do we want the government to do for us?”, “Do we want a
government that represents 50% of GDP or 20% of GDP?”, “Do we want the burden of switching
real resources to schooling, childcare, eldercare, etc. to be shared by society through higher taxes,
or do we want to individualize that burden through higher personal expenses?”, “Do we prefer a
society in which everybody fights for himself or do we prefer a cooperative society?” Once these
questions are answered (hopefully through democratic process), the public purpose is clearly
defined and the point becomes to implement it. Paying for its implementation in financial terms is
easy; paying in real resources may be hard (especially at full employment).
Keynes’s How to Pay for the War is a classic example of the correct way to frame the question. He
notes that: “A government which has control over the banking and currency system can always find
the cash to pay for its purchases of home‐produced goods.” The problem of how to pay is not a
financial problem as long as goods and services are available for purchase in the denomination of
the currency issued by the government. The problem is this at the time: “Every use of our resources
is at the expense of an alternative use,” “the size of the cake is fixed.” There are opportunity costs
and if nothing is done inflation will grow out of control as government competes with the private
sector to access resources to fight the war. The problem is one of production and consumption. In
peace‐time, the economy is usually below full employment so to produce more one just needs to
employ more. But at full employment, some choices must be made that involve giving up some
alternatives and making sacrifices; that is what “paying for” means. The private sector must sacrifice
some consumption to free resources for government uses. The questions are: who should sacrifice
the most? How much sacrifice should there be? How should the sacrifice be implemented?
In the context of the war, priorities are easy to set given the broad political consensus about what
the public purpose is (winning the war): when three quarters of the cake used to go for private
consumption, now only one quarter can go for that purpose. People have to live at subsistence level
to be able to win the war. Government could try to achieve this through voluntary saving (war bond
issuances), or by rationing, but the most effective way to achieve that is to cut purchasing power at
the source: if people do not have as big a monetary income they will not go shopping as much. This
can be done through taxing (permanent sacrifice of private consumption) or deferred pay
(temporary sacrifice of private consumption), with the aim of reducing private monetary income to
what is needed to meet subsistence.
While Keynes puts the choice in front of us in a blunt fashion given the dramatic situation of the
time, the same applies in peace time. The two main differences are that, first, there is more
flexibility in terms of resources given that usually the size of the cake can grow and, second, that a
political consensus about the public purpose is less easily achieved. Of course, some countries that
are monetarily sovereign may not have much resources and may not export enough to obtain the
80

foreign goods and services needed to fulfill the public purpose. In that case it is difficult, but not
impossible, to implement the social purpose. If, in addition, a country is not monetarily sovereign,
then implementing the public purpose is even harder.
1‐ A fiscal deficit leads to an net injection of reserves and so pushes down FFR and other short‐term
interest rates
2‐ To neutralize the impact of fiscal operations on the FFR, the Treasury uses cash and debt
management techniques. These techniques have varied in amount and obviousness overtime
depending on the circumstance and the political appetite for an overt interaction between central
bank and Treasury.
3‐ The Treasury has helped to implement monetary policy by issuing Treasuries at the request of
the Fed, by taking an overdraft at the Fed instead of using funds in its TT&Ls, by targeting a stable
amount of funds in its TGA, among others.
4‐ The central bank has been involved in financing the Treasury, either directly or indirectly through
the banking system. Monetary financing of the Treasury is not optional, it is required for monetary
policy to work properly, for the settlement of taxes to be possible and for the settlement of auctions
of Treasuries to be possible
5‐ The coordination between the Fed and the Treasury is always extensive and ensures that the
Treasury always can finance its budget. Treasuries auctions cannot fail.
6‐ There is no financial constraint on the federal government, it cannot run out of dollars. There
are, however, political constraints that define the public purposes, and productive constraints that
define how much the government can spend without generating inflationary pressures.
7‐ During the Great Recession, the Treasury helped the Fed to drain some of the reserves injected
via the Discount Window by issuing Treasuries at the request of the Fed and by moving all the funds
in a special account at the Fed.
8‐ The Fed can target perfectly the entire Treasuries yield curve if it wishes to do so. It did so during
World War Two.
9‐ Once one understands how deep the coordination between the Fed and the Treasury is, one may
argue that taxes do not finance the government and neither do Treasuries. All financing is monetary
because reserves must be injected first before taxes can be paid and Treasuries can be bought.

Keywords
TGA, TT&Ls, TSFA, excess reserves, FFR, cash management, debt management, tax
receivable/payable

81

Review Questions
Q1: If the Fed or Treasury did not neutralize the impact of a fiscal deficit, what would happen to the
FFR? What would happen to other rates?
Q2: If the Fed did not ensure that banks have enough reserves, how would that create problems
for tax settlements, Treasuries auction settlements, and targeting the FFR? Explain each case in
detail.
Q3: How did the Treasury help the Fed during the Great Recession? Why did the Fed request the
help of the Treasury?
Q4: Explain how the Fed was and is still involved in the direct financing of the Treasury
Q5: Explain how the Fed has been involved in the indirect financing of the Treasury and why
auctions of Treasuries cannot fail.

Suggested readings
For a more detailed analysis of the cash management technics used during the Great Recession by
the Treasury read Santoro, P.J. (2012) “The Evolution of Treasury Cash Management during the
Financial Crisis,” Federal Reserve of New York Current Issues in Economics and Finance, 18 (3): 1‐8.
For a discussion of the historical role of the U.S. Treasury in monetary policy and the reasons for its
involvement, see U.S. Treasury (1955) Annual Report of the Secretary of the Treasury on the State
of the Finances for the Fiscal Year Ended June 30 1955. Washington, D.C.: Government Printing
Office, pages 275‐290:
http://fraser.stlouisfed.org/docs/publications/treasar/AR_TREASURY_1955.pdf
Bruce K. Maclaury provides an interesting and accessible discussion of the independence of the
central bank and its necessary coordination with the U.S. Treasury.
https://www.minneapolisfed.org/publications/annual‐reports/perspectives‐on‐federal‐reserve‐
independence‐a‐changing‐structure‐for‐changing‐times.
For an historical analysis of the auctions of long‐term Treasuries and the role the Federal Reserve
has played, see Garbade, K.D. (2004) “The Institutionalization of Treasury Note and Bond Auctions,
1970‐75,” Federal Reserve Bank of New York Economic Policy Review, May: 29‐45.
https://www.newyorkfed.org/medialibrary/media/research/epr/04v10n1/0405garbpdf.pdf
More advanced readings are:
Bell, S.A. (2000) “Do Taxes and Bonds Finance Government Spending?” Journal of Economic Issues
34 (3): 603‐620.
Mitchell, W. F., and Muysken, J. (2008) Full employment abandoned: Shifting sands and policy
failures. Cheltenham: Edward Elgar. (CHAPTER 8)
Tymoigne, E. (2016) “Government monetary and fiscal operations: Generalising the endogenous
money approach,” Cambridge Journal of Economics, forthcoming
Wray, L.R (2007) “The employer of last resort programme: Could it work for developing countries?”
International Labor Organization, Economic and Labour Market Papers 2007/5.
http://natlex.ilo.ch/public/english/employment/download/elm/elm07‐5.pdf
______. (2015) Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary
Systems, Second Edition. New York: Palgrave.
82


1 See Federal Reserve Bank of New York, “Statement Regarding Supplementary Financing Program,” September 17, 2008
at https://www.newyorkfed.org/markets/statement_091708.html
2 See U.S. Treasury, “Treasury Announces Supplementary Financing Program,” September 17, 2008, HP‐1144 at
https://www.treasury.gov/press‐center/press‐releases/Pages/hp1144.aspx
3 “Over the years, a variety of provisions had permitted the Treasury to borrow limited amounts directly from the Federal
Reserve. Options for such loans existed until 1935. Temporary provisions for direct loans were reintroduced in 1942 and
renewed with varying restrictions a number of times thereafter. Authority for any kind of direct loans to the Treasury
lapsed in 1981 and has not been renewed.” (Meulendyke 1998, 238, n.3)
4 The following link brings you to a video made by two of my students that provides a visual explanation:
https://www.youtube.com/watch?v=Wgcv_wJOLcA
83

CHAPTER 7:
What leverage is
What the advantages and disadvantages of leverage are
How beneficial leverage is for profitability
Why leverage increases the sensitivity of an economic unit to developments in
the financial sector

CHAPTER 7: LEVERAGE
Given that the concept of leverage will be used often in the upcoming Chapters, this Chapter spends
some time explaining what leverage is and some of its impacts on the balance sheet of economic
units.
WHAT IS LEVERAGE?
Leverage is the ability to acquire assets in an amount that is larger than what one’s own capital
allows one to buy. Say that an economic unit has a net worth of $100, that it has no debt and that
the counterpart is $100 in cash (Figure 7.1). The balance sheet looks like this:

Figure 7.1 A balance sheet without leverage
What is the leverage? Leverage = asset/net worth = asset/equity = A/E = $100/$100 = 1. No debt
used, all the cash the economic unit has was acquired without the help of any debt (e.g., grandpa
gave you $100 for Christmas, or you worked to get $100). Now the economic unit decides to use its
cash to buy a bond that pays 10% yearly (Figure 7.2).

Figure 7.2 Another balance sheet without leverage
What is the leverage? Leverage = A/E = $100/$100 = 1. Still no leverage but asset portfolio allows
the economic unit earns interest income: Cash inflow is $10 yearly as interest payment. Of course,
buying a bond involves additional risks compared to cash:
 Default risk (the bond issuer does not pay the $10 interest and cannot repay part or all the
principal due)
 Market risk (the market value of the bond declines and one might have to sell it for less
than what one paid for it)
Going back to case 1, now the economic unit decides to get a $900 advance from a bank at 1% and
to buy 10 bonds that pay 10% (Figure 7.3). What is the leverage? Leverage = A/E = $1000/$100 =
10. The economic unit has acquired 10 times more assets than what its capital allows to buy. It did
so by going into debt. This example is the simplest form of leverage. There are many ways to
introduce leverage in a financial deal. Some of that leverage does not have to be reflected on the
balance sheet in the form of a debt to someone. As long as one can acquire an asset by paying
upfront only a fraction of the value of that asset, there is some leverage.
85

CHAPTER 7: LEVERAGE

Figure 7.3 A balance sheet with 10x leverage
WHAT ARE THE ADVANTAGES OF LEVERAGE?
A key metric of profitability is the return on equity (ROE). This return is the ratio of profit over
equity. The ROE can be decomposed as follows:
Profit/Net worth = (Profit/Assets)*(Assets/Net worth)
ROE = ROA * Leverage
Return on Assets (ROA) measures the earning power of the assets on a balance sheet; ROE
measures how successfully an economic unit used its own capital. Leverage multiplies the impact
of ROA on ROE because it allows an economic unit to acquire more assets without having to pay
the full amount due with one’s own funds. Thus leverage gives the following advantages:
1‐ Better nominal return:
- No leverage: income = net income = $10
- 10x leverage: income = 10 x $10 = $100, Net income = $100 ‐ $9 = $91 > $10
2‐ Better return
• Return on Asset (ROA)
- No leverage: interest/bond = $10/$100 = 10%
- 10x leverage: net interest/bond = ($100 ‐ $9)/$1000 = 9.1%
• Return on equity (ROE)
- No leverage: interest/equity = $10/$100 = 10% = ROA
- 10x leverage: net interest/equity = ($100 ‐ $9)/$100 = $91/$100 = 91%
By leveraging 10x, ROE is 10 times higher than ROA (9.1% vs 91%) simply because one could acquire
ten times more assets.
WHAT ARE THE DISADVANTAGES OF LEVERAGE?
INTEREST‐RATE RISK
86

CHAPTER 7: LEVERAGE
What if the interest rate on bank debt goes up to 12% in the previous example?
- No leverage: cash outflow = $0 => net cash flow = $10
- 10x leverage: cash outflow = $900 x .12 = $108 => net cash flow = ‐$8.
This risk is especially high if an economic unit went into debt on a short‐term basis for a long‐term
portfolio strategy. Assume one plans to hold 10 bonds for 2 years but issued debt with a 6‐month
term to maturity; then one needs to refinance (i.e. repay the debt and ask for credit again) three
times.
But there are more worries because economic units care much more about percentage gains (ROE)
than nominal gains. In this case, ROE losses are also multiplied by the size of the leverage.
- No leverage: ROA = ROE = 10%
- 10x leverage: ROA = ‐$8/$1000 = ‐0.8%
- 10x leverage: ROE = ‐$8/$100 = ‐8%
HIGHER SENSITIVITY OF CAPITAL TO CREDIT AND MARKET RISKS
The same percentage decline in the value of bonds (due to default or loss of market value) leads to
much bigger decline in equity (Figure 7.4).
- No leverage: A 10% decline in the value of the bond wipes out only 10% of net
worth
- 10x leverage: A 10% decline in the value of bonds wipes 100% of net worth
Chapter 9 shows that banks can only tolerate a limited decline in the value of their assets. Indeed,
not only are they highly leveraged, but there are regulations governing the amount of capital they
are required to have, as well.

Figure 7.4 Impact on capital of a 10% decline in the value of bonds under no leverage and 10x
leverage
REFINANCING RISK AND MARGIN CALLS
IMPACT ON MORTGAGE DEBT
87

CHAPTER 7: LEVERAGE
Say that in 2006 a household wants to buy a house that costs $100k and that the bank states that
one must provide a 20% down‐payment. How much of the cost of the house is the bank willing to
fund at the maximum?
0.8*100000 = $80000
Now, say that the value of the home goes down to $50000. Assuming the bank is still willing to
provide up to 80% of the house value, the maximum the bank will provide is:
.8*50000 = $40000
For the same house, the bank is willing to provide less of an advance.
Table 7.1 shows three different contract structures with actual numbers when a household agrees
to issue an $80k mortgage note:
Year 2006 2006 2016
Case A B C
Structure A 30‐year fully An 30‐year IO with a 30‐year 5% fixed‐rate
amortized with a fixed 10% fixed rate, starts to fully amortized
rate of 10% amortize after 10 years
Debt Service $8,424.69 for 30 years First 10 Years: $8000 $5153.49 for 30‐years
Last 20 years: $9264.21

Table 7.1 Mortgage notes with different terms
In the U.S. the traditional mortgage is a fixed‐rate fully amortized (i.e. for which principal is repaid
bit by bit every month) mortgage (case A). During the 2000s housing boom, a lot of prime and
subprime households choose to issue interest‐only mortgages (IOs) (case B). With an IO, a
mortgagor can choose to pay only the interest due for a certain time period (say 10 years), and after
that the principal must be repaid bit by bit. This means that for a period of time, case B is cheaper
than case A.
The proportion of IO issued by non‐prime households in a given year went from virtually 0% to 30%
of mortgages issued by non‐prime households. As the Fed started to raise interest rate in 2004, the
proportion of pay‐option mortgages issued by non‐prime households grew (Figure 7.5). Pay‐option
mortgages allow debtors to pay only part of the interest due.
The selling point offered by mortgage brokers was that IO are cheaper to service for 10 years and
that, while it is true that one might not be able to make that additional $1264 payment that will
come in 10 years, there is no need to worry because refinancing at better terms is always possible
given that home prices always go up.
Come 2016 and the household can cannot make the additional $1264 payment. What can be done?
Let us refinance by issuing an $80000 fixed‐rate mortgage with better terms (option C) and by using
the funds to repay the $80000 due on the IO mortgage. So the household goes to a bank with the
intention to get a credit of $80000. Unfortunately, the bank states it can only provide $40000, i.e.
it refuses to refinance unless the household can come up with $40000. Why? Because the home
value is now $50000.
In times of crisis, the refinancing problem induced by the decline in the value of houses is actually
reinforced by the fact that the loan‐to‐value ratio declines. So instead of granting an advance of up
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CHAPTER 7: LEVERAGE
to 80% of the home value, now a bank will do only 60%, which means that the household can only
get $30000 from the bank.

Figure 7.5 Share of exotic mortgages in non‐prime mortgage originations, percent.
Source: Federal Deposit Insurance Corporation (FDIC Outlook, Summer 2006).
IMPACT ON SECURITY‐BASED DEBT: MARGIN CALL RISK
A broker allows an economic unit to have outstanding bonds with a nominal value 10 times as large
as the value of equity. What if suddenly:
- The value of bonds declines. Net worth declines so leverage is much higher than 10 and the
broker demands additional collateral (and so net worth in the balance sheet) to restore a
10x leverage.
- The broker increases the margin requirement (loan‐to‐value ratio declines), that is, decides
to lower the allowed leverage from 10 to 5. This is equivalent to saying that now in order
to be able to get external funds to buy $1000 worth of bonds one must put down $200
instead of $100.
EMBEDDED LEVERAGE
Leverage comes in many forms and may not be directly observable in the balance sheet. In fact,
financial institutions try to hide leverage as much as possible to circumvent regulation, and, in the
worst cases, to confuse potential clients who are attracted by the high promised ROE.
A form of leverage that gained attention during the recent crisis is embedded leverage—or leverage
on leverage. Figure 7.6 presents a “simple” case of embedded leverage.
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CHAPTER 7: LEVERAGE
Households SPE1 SPE 2 SPE 3
Houses Subprime Subprime High‐rate Low‐rate High rate Mezzanine Senior‐AAA

Mortgages Mortgages MBSs MBS CDOs CDOs CDO2s
(60 %)
Mezzanine
CDOs (14%)
Equity (very Low‐rate Low‐rate Other CDO2

thin or none) MBSs (5%) CDOs (10%) (40%)
Figure 7.6 Financial layering or embedded leverage.
The following is going on in this picture:
1‐ A bunch of households with poor creditworthiness issued mortgages to a bank to finance
100% of their houses ($100k house is financed by $100k mortgage) (balance sheet A)
2‐ The bank did not want to keep the mortgages on its balance sheet so the bank created an
SPE1 (special purpose entity 1) that purchased the mortgages. To finance the purchase,
SPE1 issued bonds collateralized by the mortgages (mortgage‐backed securities, MBS) of
two different ratings, low and high, with low representing 5% of the issuance. The debt
service received from subprime mortgages is used to service the MBSs (balance sheet B)
3‐ Nobody wanted to buy the low‐rate MBS so the bank created SPE2 to purchase them. SPE2
issued bonds backed by MBSs (collateralized debt obligations, CDOs). The debt service from
low‐rate MBSs is used to service CDOs (balance sheet C)
4‐ Nobody wanted to buy the mezzanine CDOs that represent 14% of all the CDOs issued by
SPE2. The bank created yet another SPE that bought the mezzanine CDOs by issuing bonds
backed by them (CDO squared). AAA CDO2s are bought by pension funds, others are bought
by hedge funds and others. The debt service from the mezzanine CDOs provides the cash
flow necessary to service the CDO2s (Balance sheet D)
Taken in isolation, i.e. looking at SPE3 alone, AAA CDO2s seem very safe because the value of
mezzanine CDOs must fall by 40% before the principal on the AAA CDO2s starts to be impacted
(other CDO2s act as equity for AAA CDO2s). A pension fund that looks only at that deal does not
even blink; AAA CDO2s provide higher yield than AAA corporate bonds: Buy! Buy! Buy!
Of course, the higher yield was achieved by the embedded leverage. Say that households start to
default, what is the default rate that makes AAA‐CDO2 worthless?
- A 5% loss on the mortgages makes low‐rate MBS worthless (they are the first to take the
loss in this SPE structure), which makes SPE2 insolvent and so all CDOs worthless.
- CDO2 become worthless much faster. If the mezzanine CDOs are worthless then CDO2 are
worthless. Mezzanine CDOs are worthless after a 1.2% decline in the value of subprime
mortgages (5%*24%)! Suddenly those AAA CDO2 do not seem that safe anymore, especially
so knowing that delinquency rates on subprime mortgages are way north of 1.2%.
However, one needs to look at the entire chain of securitization to understand that. Most
buyers of AAA CDO2 did not do that (they usually could not do that given the information
available) and only looked at the high return of AAA CDO2 relative to AAA corporate bonds,
together with the 40% buffer against loss provided by other CDO2.
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CHAPTER 7: LEVERAGE
There is a way to estimate what the leverage is in this type of transaction.1 Financial institutions
created many SPEs that bought from each other.2
BALANCE‐SHEET LEVERAGE, SOME DATA
The Financial Accounts of the United States provide simple measures of balance‐sheet leverage that
are easy to get for the private non‐financial sector because actual balance sheets are provided. We
are not so lucky for the financial sector for which data about total assets is not available. One can
get an idea of the leverage used by financial institutions by using the ratio (liabilities +
equity)/equity, knowing that in theory the sum of liabilities and equity ought to be equal to total
assets. In practice the sum of liabilities and equity is not very reliable and gives leverage levels that
sometimes are much too high. Figure 7.8 only presents preliminary data that seems to pass the
smell test. Chapter 8 presents official leverage data in the banking sector.
Figures 7.7 and 7.8 give a broad idea of the relative leverage across sectors and of the trend in
leverage. Clearly, the non‐financial sector is less leveraged than the financial sector with households
being the least leveraged of all sectors. Overall, leverage in the non‐financial sector grew relatively
smoothly until the Great Recession, especially so for households. Leverage in the financial sector is
much more volatile.

Figure 7.7 Balance‐sheet leverage in the nonfinancial private sectors, assets/net worth
Source: Board of Governors of the Federal Reserve System (Series Z.1)

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CHAPTER 7: LEVERAGE

Figure 7.8 Balance‐sheet leverage in the financial sector, (liabilities+equity)/equity
THE FINANCIALIZATION OF THE ECONOMY
The financial industry is in the business of dealing with leverage. Its business is about incentivizing
other economic unit to go into debt (that is what most of its assets are: claims on others) and the
financial sector itself uses a lot of leverage to boost the profitability of its business. Banks grant
credit, pension funds rely on financial claims to pay pensions, etc. For every creditor there is a
corresponding debtor and so for every financial asset there is a corresponding financial liability:
“financialization” also means “debtization” of the economy.
The financialization of the economy means that the financial sector has become much more
important to the daily operations of the economic system than it used to be. The private
nonfinancial sectors have become more dependent on the smooth functioning of the financial
sector in order to maintain the liquidity and solvency of their balance sheets, and to improve or
maintain their economic welfare.
Households have become more reliant on financial assets to obtain an income (interest, dividends
and capital gains) and have increased their use of debt to fund education, healthcare, housing,
transportation, leisure, and, more broadly, to maintain and grow their standard of living.
Nonfinancial businesses also have recorded a very rapid increase in financial assets in their portfolio
and a growing use of leverage. Some of them, like Ford or GE (until recently), have a financial branch
that provides more cash balances than their core nonfinancial activity (Figures 7.11) and about half
of their cash flows. The counterpart of these trends has been a growing share of outstanding
financial assets held by private finance (Figure 7.9). From the late 1960s, the share of financial
assets held directly by households dropped significantly from about 55 percent to about 35 percent.
Instead, a growing share of assets has been held by private financial institutions, which went from
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CHAPTER 7: LEVERAGE
25 percent in the late 1940s to 40 percent right before the crisis. The rest of the world recorded
most of the rest of the gains from 2 percent to 10 percent of U.S. financial assets. The share of
national income going to the financial industry has also grown quite significantly after WWII (Figure
7.10). A first wave occurred in the 1950s and a second one in the 1980s and 1990s. Today, about
18% of national income goes to the financial sector, something not seen since the 1920s.

Figure 7.9 Distribution of U.S. financial assets among the different macroeconomic sectors.

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CHAPTER 7: LEVERAGE

Figure 7.10 Proportion of national income earned by the financial sector.
Sources: BEA, Historical statistics of the United States

Figure 7.11 Percent of cash balance coming from financial activities
Source: SEC (10K statements)

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CHAPTER 7: LEVERAGE
1‐ To leverage is the act of going into debt
2‐ This debt can be on the balance sheet or can be hidden off‐balance sheet
3‐ Leverage helps to boost the return on equity by multiplying gains but it can also multiply losses.
4‐ The use of leverage has increased throughout non‐financial economic sectors, while leverage is
usually higher in the financial industry. The financial industry uses a lot of off‐balance‐sheet
leverage.
5‐ The financial sector has played an ever increasing role in the economic life of the non‐financial
sector by providing an increasing share of national income and by providing advances to maintain
existing standards of living.

Keywords
Financialization, debtization, leverage, embedded leverage, return on asset, return on equity,
interest‐rate risk, refinancing risk, margin call risk, interest‐only mortgage, pay‐option mortgage

Review Questions
Q1: Why may a decline in home prices create a problem for refinancing a mortgage?
Q2: If the leverage is 3X, what does it mean?
Q3: If the leverage is 3X, what would happen to net worth following a 5% decrease in the value of
assets? What would happen to ROE given ROA?
Q4: Why does the financialization of the economy implies the debtization of the economy?

Suggested readings
Chapter 1 of Guns, Traders and Money by Satyajit Das relates personal recollections surrounding
leverage is a very clear and funny way and present how leverage can be built outside the balance
sheet.
For a more technical view of leverage and its relation to regulation, the Basel III leverage ratio
framework provides an example of a regulatory framework for different forms of leverage:
http://www.bis.org/publ/bcbs270.pdf

1 Check page 26 of Riddiough, T.J. (2010) “Can Securitization Work? Economic, Structural and Policy Considerations.” At
https://www.fdic.gov/bank/analytical/cfr/mortgage_future_house_finance/papers/Riddiough.PDF
2 In 2010, Propublica made a nice visual made with actual data in “Interactive: CDOs’ Interlocking Ownership,” by Jeff
Larson and Karen Weise at https://www.propublica.org/special/interactive‐cdos‐interlocking‐ownership#cdo/
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CHAPTER 8:
What banks do
How banks make a profit
What the risks of the banking business are
How the banking industry has changed over the past four decades

CHAPTER 8: THE PRIVATE BANKING BUSINESS
The US financial system is extremely complicated and this preliminary text shades light only on
some corners of that system by focusing on the banking sector. Since the beginning of this text,
Chapters have emphasized the importance of balance sheets to get a solid understanding of the
mechanics at play in the financial sector. This Chapter continues that trend.
THE BALANCE SHEET OF A BANK
Figure 8.1 depicts the balance sheet of a commercial bank. Promissory notes issued by others
include any kind of agreement between the bank and an entity that promised to pay some
monetary amount(s). That entity can be a domestic or foreign, household (mortgage note or any
other customer notes), company (business credit, corporate securities), and government
(Treasuries, municipals). Promissory notes may or may not have a market in which they can be
traded. If they have a market they are called “securities”, if they do not they are called “loans and
leases” (Chapter 2 and Chapter 10 explain that the word “loan” is really inappropriate). Chapter 3
studied in details reserves, which are themselves a promissory note as explained in Chapter 15, but
are singled out for analytical purposes. Non‐financial assets include real estate, computers,
goodwill etc.
Reserve balances and vault cash Promissory notes issued by the bank
Promissory notes issued by others (aka “accounts,” “CDs,” etc.)
(aka “loans and leases,” “securities”) Net worth/Equity/Capital
Non‐financial assets
Figure 8.1. Balance sheet of a typical commercial bank
Promissory notes issued by the bank include checking accounts, savings accounts and other
transaction accounts. They also include other liabilities such as certificates of deposits (CDs), bonds
and other securities issued by the bank. One may choose to include shares here or in net worth; for
our purposes, it is not that important.
As usual, net worth is the residual item and its main role, as explained in Chapter 2, is to protect
the creditors of the bank, i.e. those who hold the promissory notes issued by the bank (you and I
for the accounts, CD holders, etc.).
Figures 8.2 and 8.3 show how the composition of financial assets and liabilities of US banks has
changed since 1945 (quantity of non‐financial assets is not available). After WWII, banks were
stuffed with Treasuries and reserves that represented about 75% of their assets. A switch occurred
progressively toward privately‐issued notes and municipals as banks turned their business activity
toward supporting the growth of the economy instead of the war effort. Today, percentage‐wise,
Treasuries and reserves are marginal items in the assets of banks.
Bank accounts (“deposits”) are still the main liability of commercial banks but the structure of
accounts changed with checking accounts representing about 10% of liabilities in 2010 versus 75%
after WWII. Time and savings accounts have grown in proportion, and they represented about 55%
of the liabilities of banks in 2010. Figure 8.2 also clearly shows the rise of the federal funds market
from the 1960s (see Chapter 4). Figure 8.2 does not show interbank lending debt given that it is the
balance sheet of the banking sector. Indeed, if bank X owes to bank Y, when they are put together
in one balance sheet the consolidation removes debt owed to each other. Federal funds and
repurchase agreements (RPs) are liabilities with other participants of the federal funds market.
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Figure 8.3 shows how the predominance of “private depository institutions” (commercial banks and
thrifts) in the financial sector has changed through time. From 1980 until 2000, the share of financial
assets held by banks fell dramatically from 50% of all financial held by the financial industry to about
20%; this has been a stable proportion since 2000. Instead, money managers (mutual funds,
pension funds, etc.) have gained in importance as did financial institutions related to securitization
that together held about 55% of the financial assets held by the financial industry in 2015. Money
lenders (pay‐day loans, etc.) have also recorded an increase in the proportion of financial assets
they hold since the 1970s.

Figure 8.1 Financial assets of US‐chartered commercial banks
Source: Board of Governors of the Federal Reserve System (series Z.1)
Note: Other securities includes corporate and foreign bonds, mutual funds shares, corporate
shares, and open‐market papers.

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Figure 8.2 Financial liabilities and corporate shares of US‐chartered commercial bank
Note: Others include net taxes payables, corporate bonds, open‐market papers, net interbank
transactions, and miscellaneous liabilities.

Figure 8.3 Allocation of financial assets within the financial sector
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WHAT DO BANKS DO?
The previous balance sheet hints that banks are involved in many crucial activities including:
‐ Credit services: Swapping promissory notes to allow liquidity, creditworthiness, and
maturity transformation
‐ Payment services: Transferring funds between bank accounts
‐ Retail portfolio services: Providing income‐earning opportunities for small entities with
excess monetary balances and providing cash at will.
A central aspect of the balance sheet of banks is that the promissory notes issued by banks have a
shorter term to maturity than the promissory notes on their asset side. Banks are involved in
maturity transformation. They accept promissory notes from their customers for which the
principal will not be repaid for a long time. In exchange, they give their customers some promissory
notes that are due relatively quickly. Checking accounts are due at the demand of their bearers and
CDs come due at most in a few years, whereas the principal on mortgage notes will be fully repaid
in decades.
A central implication of maturity transformation is that banks have an inherent need for a stable
refinancing source because they must fund long‐term positions in assets with short‐term liabilities.
To limit the refinancing risk (that was exemplified with households in Chapter 7) that comes with
this balance‐sheet structure, a central bank that provides stable low‐cost refinancing channels is
crucial.
Some of the promissory notes that banks issue have another other interesting property for
potential clients. Chapter 15 explains that their financial characteristics are such that they ought to
trade at par if they do not carry any credit risk and if the financial structure is properly set up. Today,
transfers between bank accounts are done at par, conversions into Federal Reserve note are done
at par, and in case of default FDIC guarantees the funds in bank accounts, and the interbank
payment system works smoothly. The main takeaway is that banks provide to their customers a
reliable means of payments that is widely accepted. By contrast, the promissory notes issued by
clients are not widely accepted so making payments with them is difficult, if not impossible.
WHAT MAKES A BANK PROFITABLE?
Like any other for‐profit business, a bank operates to meet its profitability target while being
constantly on the look‐out to maintain its liquidity and solvency. At least, that is the hope. When
banks are run by fraudsters or are focused on short‐term results, concerns about liquidity and
solvency go out of the window.1 The profit of a bank depends on the following components:
Profit of a bank = Net capital gains + Net interest income + Other income – Other expenses than
interest payments
Net capital gains is the difference between capital gains and capital losses. This net change can be
positive (net capital gain) or negative (net capital loss). Net interest income (aka net interest
margin) is the difference between interest earned on bank assets and interest paid on bank
liabilities. Other income include fees and other charges imposed on customers. Net interest income
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is the biggest source of income for banks but its proportion in bank income has declined since the
early 1980s for reasons explained in the last section. In 2014, net interest income represented
about 60% of the income earned by banks compared to 80% from about the mid‐1940s to the early
1980s (Figure 8.4). Net interest income is the lowest proportion of profit for the largest banks.

Figure 8.4 Sources of income of FDIC‐insured banks.
Source: FDIC Annual Financial Data
Banks, however, are not interested in monetary profit per se. Instead, a key measure of profitability
is the return on equity (ROE), the ratio of monetary profit over net worth. Chapter 7 explains that
this ratio can be decomposed into the return on assets (ROA) and leverage (Figure 8.5). ROE and
ROA averaged 9.7% and 0.84% respectively from 1984 to 2014. The ROA of the largest banks is
more volatile and has been relatively higher since the late 1990s (Figure 8.6). The larger the bank,
the higher the leverage (Figure 8.7), but balance‐sheet leverage has mostly fallen over time and
Tier‐1 leverage has converged to 9 for all banks, 11 for the biggest banks, 8 for the smallest.
Banks have a ROE target (among other targets) in mind to which bonuses of employees are related
(if a bank reaches or passes the target, employees can expect a good bonus). Bank employees have
two means whereby to reach the target if ROE is falling away from it: raise ROA and/or increase
leverage.
Raising ROA means charging a higher interest rate on customers’ notes (higher mortgage rate,
higher consumer credit rate, etc.), charging more fees, buying higher‐yield securities, trading
securities more aggressively to make bigger capital gains, and/or reducing expenses. Given
expenses, all this means taking more credit risk and market risk, because raising ROA implies
catering to less creditworthy economic units or being involved in more volatile trading strategies.
Raising leverage means increasing the size of liabilities relative to net worth. Chapter 7 explores the
concept of leverage more carefully in terms of its advantages and risks. Chapter 9 explains that
banks are limited at any point in time in their ability to leverage by regulation, but they always
“innovate” over time to bypass regulations.
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Figure 8.5 ROA, ROE, leverage of all FDIC‐insured institutions
Source: FDIC Graph Book

Figure 8.6 Annual return on assets
Source: FDIC Aggregate Time Series Data
Note: Banks with over $10 billion in assets represent about 10% of the FDIC‐insured banks (595
institutions). Most FDIC‐insured banks (62% or 3800 institutions) are between $100 and $1
billion.
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Figure 8.7 Tier‐1 leverage (inverse of tier‐1 leverage capital ratio)
Note: Tier‐1 capital is a component of capital.
RISKS ON THE BANK BALANCE SHEET
The profitability of a bank critically depends on the following:
• The ROA which depends on:
– Creditworthiness of the issuers of promissory notes (credit risk): households,
businesses, and government may not be able to service their promissory note,
which means that a bank does not receive its expected income and instead records
a loss.
– Actual and expected market value of securities (market risk): capital gain and losses
are recorded on a daily basis for some assets.
• The cost of funding the banking business (refinancing risks induced by interest‐rate risk,
maturity mismatch risk): cost of acquiring reserves and cost of holding accounts (i.e. giving
incentive to account holders not to withdraw their funds in order to avoid having to borrow
reserves or to sell interest‐earning assets to get reserves). If the Fed raises FFR quickly,
banks that have fixed‐rate long‐term assets see their net interest income dwindle quickly.
Creditworthiness, capital gains and losses, and bank‐funding costs are influenced by the state of
the economy, expected interest rates, future monetary and fiscal policies and many other factors.
For example, if it is expected that economic activity will slowdown, then one may expect that layoffs
will rise and so that some debtors will have problems servicing their debts. Chapter 4 explains how
expected monetary policy impacts current asset prices and refinancing cost.
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This means that, to run a banking business properly, a banker must form expectations about a wide
range of factors. Of course, these expectations usually turn out to be incorrect. When expectations
are under‐optimistic, bankers are pleasantly surprised and may double‐down on the risks they take.
When expectations are over‐optimistic, things can turn sour very quickly if credit analysis was not
done properly, if capital, liquidity, and loss‐reserve buffers are inadequate, or if fraud has been
prevalent.
Figure 8.8 shows the impact of credit and market risks. The value of promissory notes falls as
economic units default or the value of securities falls. This impacts net worth and so the ability to
meet the capital requirements presented in Chapter 9 (in the example a 15% loss on promissory
notes leads to a decline in the capital ratio from 20% to 5%). If a bank is unable to meet its capital
requirements, regulators may demand that the bank be closed.
Figure 8.9 shows the value of non‐tradable promissory notes that were past due by at least 30 days
relative to the value of tier‐1 capital and loan‐loss reserves. Loan‐loss reserves are not the same
thing as bank reserves, they are extra capital that banks keep to buffer against expected losses on
the non‐tradable promissory notes of their clients. In general, the larger the banks the worst the
performance, that is, the larger the bank, the higher the proportion of past due loans. This can be
explained by looking at Figure 8.6. Major banks (those with assets worth at least $1 billion) have
increased their ROA to maintain their ROE. Raising the ROA means acquiring more risky assets, that
is, assets that have a higher likelihood of defaulting.

Figure 8.8 Impact of default and/or capital losses

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Figure 8.9 Noncurrent loans & leases as a percent of tier‐1 capital plus loan‐loss reserves
BANKING ON THE FUTURE
A study of the profitability of banks clearly shows that this business is all about “banking on the
future.” There is a myriad of future economic events that influences the assets and liabilities of
banks and so how profitable, solvent and liquid banks are. In terms of assets, the role of banks is to
judge and validate (or not) the expectations that are brought to the table by their clients. As the
saying goes in the banking industry, “I’ve never seen a pro forma I didn’t like.” Economic units that
want to go into debt with a bank always present a very favorable view of their project and future
economic prospects. The role of bankers ought to be to tame that vision of the future into a more
realistic view, in the sense that the view conforms more closely to past economic trends and past
history of probable success.
Bankers are supposed to do this by requesting documents that provide evidence that an economic
unit will be able to fulfill the requirement of the promissory note (usually pay interest and principal
due on time), and by requesting some guarantees in terms of covenants (e.g., ability to check how
a business is run or ability to influence business management if needed) and collateral (ability to
seize assets held by the economic unit in case of default). Bankers are then supposed to check this
information against a given set of standards that defines what a creditworthy economic unit is. Such
standards include among others:
‐ The debt‐service to income ratio: what is a sustainable amount of interest and principal
payment relative to the income earned? 20%, 30%, 40%?
‐ The value of monetary balances relative to the value of debt: what is a sustainable amount
of liquid savings that an economic unit should have relative to an amount of debt? 10%,
50%, 60%?
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‐ The loan‐to‐value ratio: What is the maximum amount of credit a customer can ask relative
to the value of a collateral? Is it ok to have a mortgage that represents 50% of the house
value, 80%, 100%?
In practice, given that the future is uncertain and given the elastic nature of the standards used,
assessing creditworthiness is not always easy. In addition, banking is a competitive sector so
assessing creditworthiness is influenced, not only by the need to check carefully an economic unit’s
ability to pay, but also by the need to maintain and grow market shares. If a TV maker has sold all
the black‐and‐white TVs that could be sold, the next step is not to close shop or to rely only on
repairs and replacements. The next step is to invent color‐TVs, flat‐screen TVs, 3D‐TVs, etc. so that
consumers have an incentive to ditch their old TVs and buy new ones. The same dynamics are at
play in banking. Maintaining market share may require banks to “innovate”:
‐ By pushing existing and new clients into new “low cost” products. A typical example of that
was the mid‐2000s, when clients were incentivized to go into interest‐only mortgages, pay‐
option mortgages, cash‐out refinance mortgages, home‐equity advances.
‐ By incentivizing existing clients to go further into debt or to refinance. A typical example of
that is the 2001 refinancing wave of prime mortgagors when they refinance into fixed‐rate
mortgages with lower rates.
‐ By loosening credit standards when the pool of what is deemed a creditworthy client is
shrinking and new business opportunities must be sought to maintain ROE. After the 2001
refinancing wave among prime households, banks turned toward non‐prime households
for new business opportunities.
Thus, over time, credit standards may loosen. When previously one had to have a debt‐service to
income ratio of at most 30% to be considered creditworthy, now banks are ok with 40%. The
mortgage boom of the mid‐2000s broke all standards of creditworthiness, with bankers willing to
provide high‐interest‐rate mortgages to customers with no proof of income, job or assets (the
infamous “NINJA loans”) in an amount that represented over 100% of the value of a house. Even
prisoners could get a mortgage.2 The only way to make that type of mortgage profitable was to
resell the house at a price high enough to cover the repayment of all the principal and interest due.
This implies finding another person willing to go into debt to buy the house at this higher price. A
typical Ponzi game was at play.
Some bank managers thought that “the whole system was based on raping the public” and refused
to lower their credit standards; but, this came at the cost of accepting a massive loss of market
share.3 Most bankers, especially on Wall Street, cannot accept such a decline; in fact they cannot
even accept stable market shares, as Mr. Blankfein noted:
It should be clear that self‐regulation has its limits. We rationalised and justified
the downward pricing of risk on the grounds that it was different. We did so
because our self‐interest in preserving and expending our market share, as
competitors, sometimes blinds us—especially when exuberance is at its peak.
(Blankfein 2009)
Wall‐street financial institutions are growth‐oriented businesses and so must find ways to
constantly expand their business. The loosening of credit standards will occur all the faster given
that the banking structure is such that it rewards bankers based on the volume of promissory notes
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accepted instead of the quality of promissory notes. As explained below, the banking industry has
moved in that direction since the 1980s at least.
This pressure to loosen credit standards has been illustrated neatly quite a few times. For example
Wojnilower noted in 1977:
In the 1960s, commercial bank clients frequently inquired how far they could
prudently go in breaching traditional standards of liquidity and capitalization that
were clearly obsolescent. My advice was always the same—to stick with the
majority. Anyone out front risked drawing the lightning of the Federal Reserve or
other regulatory retribution. Anyone who lagged behind would lose their market
share. But those in the middle had safety in numbers; they could not all be
punished, for fear of the repercussion of the economy as a whole. […] And if the
problem grew too big for the Federal Reserve and the banking system were
swamped, well then the world would be at an end anyhow and even the most
cautious of banks would likely be dragged down with the rest. (Wojnilower 1977,
235‐236)
John Maynard Keynes noted more than eighty years ago while talking about financial‐market
participants: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to
succeed unconventionally.”4
EVOLUTION OF BANKING SINCE THE 1980s
The promotion of competition and short‐run rewards, together with the lack of regulatory
enforcement (see Chapter 9) and a monetary policy focused on fine‐tuning the economy (see
Chapter 4), have pushed banks to move away from a business model that promotes careful
underwriting and toward market‐share growth. Figure 8.4 gives a hint of that trend. This banking
system is more unstable because it promotes an increase in the size of leverage (indebtedness is
bigger) and a decline in the quality of leverage (more dangerous financial products, fewer
guarantees, less verification).
Within banks, there are two important desks, the loan‐officer desk (whose task is to judge the
quality of the projects proposed by potential clients and to tame optimism) and the position‐making
desk (whose task is to finance and to refinance the asset positions taken by the bank). In the
originate‐and‐hold banking model, the point of a bank is to establish long‐term relationships with
clients based on trust and recurring credit agreements, and to make a profit based on the net
interest margin. A bank carefully checks the 3Cs of credit analysis: cash flow, collateral, and
character. Think of George Bailey in It’s a Wonderful Life as the stereotypical banker of this type of
banking model: he knows his neighborhood well and does business there, he knows most of his
clients personally, he keeps his clients’ promissory notes in the bank vault, he makes a profit by
waiting patiently for debts to be serviced; if a client has a problem they sit down and try to work it
out given that George’s success depends on his client’s success.
This form of banking always exists at any point in time (that is what banking is after all), but it
thrived after the Great Depression when competition in the financial industry was reduced and the
central bank kept its refinancing cost stable and low. With increased competition from other
financial institutions and changes in the monetary policy practices of the Fed, this banking model
became less viable as the interest‐rate risk became too great. Chapter 5 shows that the Volcker
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experiment led to a very large increase in the level and volatility of the federal funds rate. This

occurred at a time when banks had a lot of fixed‐rate long‐term assets on their balance sheet (think
mortgages) so their net interest margin shrank. This is all the more so given that rising short‐term
rate pushed banks to raise the rate on their savings accounts. Regulation Q (a Fed regulation
regarding the maximum interest rate that savings account and certificates of deposit could carry)
limited banks’ ability to do so, and so lots of economic units removed funds from their savings
accounts and put them into more lucrative, but still liquid, financial instruments. Regulation Q was
relaxed as FFR rose and was ultimately abandoned.
Banks pushed for—and obtained—a deregulation of their business to allow them to diversify the
assets they could buy and to allow them to provide more attractive rates on their liabilities. This
ultimately led to the savings and loan (S&L) crisis when savings and loan institutions (banks that
specialized in holding mortgage notes) were hit by massive credit risk. From the early 1980s, they
had taken positions in more risky assets to offset the higher cost of their liabilities induced by the
Volker experiment, and widespread fraud by top bank managers followed deregulation. 5 Other
banks were not immune from the crisis and also recorded large defaults (Figure 8.9). The S&L crisis
marks the end of the originate‐and‐hold banking model.

Figure 8.10 Trading revenues from cash and derivative positions
Source: OCC Quarterly Report on Bank Derivatives Activities
Note: Data discontinued for all banks as of Q2 2014
Note: The number and composition of “Top Banks” vary through time. Currently there are four
top banks: JP Morgan Chase, Bank of America, Citibank, and Goldman Sachs.
This model has now been replaced by an originate‐and‐distribute banking model. Profit‐making
activities have been shifted toward the position‐making desk. While net interest margin is still a
significant source of profit for banks, its importance has diminished substantially (Figure 8.4). Banks
no longer look for a long‐term individualized relationship with recurring borrowers; the relation is
impersonal and judged in minutes through a credit‐scoring method. Promissory notes of customers
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are packaged and sold to special purpose entities that fund the purchase by issuing bonds
(mortgage‐backed securities, collateralized debt obligations, etc.). Banks make money from the
fees that come from passing the debt service to the SPEs, and have been more involved in trading
activities, especially top banks that currently get between 6% and 9% of their gross revenue from
trading (Figure 8.10).
1‐ The main assets of commercial banks are mortgages, consumer credit and other promissory
notes of economic units resulting in advances provided to the private sector.
2‐ The main liabilities of commercial banks are deposits of all sorts, with small time‐deposits
(certificates of deposits) and savings accounts representing the majority of the liabilities.
3‐ Over the past 30 years, the importance of commercial banks and other depository institutions
has declined, with a greater share of financial assets held within the financial industry going to
money managers and issuers of securitized products.
4‐ The business of banking involves settling payments between private non‐bank economic units,
providing opportunities for small savers to access higher earning financial assets, supplying the
currency to the non‐bank sectors, and helping economic units to finance economic and speculative
activities.
5‐ While the majority of the income of banks comes from interest receipts, the share of that income
has declined by 20 percentage points since 1980.
6‐ The size of leverage in the banking industry has declined. Major banks (those with over $1 billion
in assets) take more risks on their liability side (more leverage) and asset side (reliance on riskier
financial assets that provide higher ROA).
7‐ The business of banking is influenced by all sorts of internal and external factors that influence
the value of their assets, default risk, and the interest rate they pay on their liabilities. On one side,
banks try to anticipate adverse changes in these factors to protect their balance sheet, but on the
other side each bank also will tend to ignore those factors, or to discount them, if anticipating them
decreases its current market share.
8‐ Banking is about anticipating the future while also keeping up with the competition to avoid
losing market shares. As such, credit standards are elastic and tend to loosen over a period of
economic prosperity and to sharply tighten during a recession.
9‐ Banks have moved away from a business structure that involves acquiring non‐tradable
promissory notes and keeping them until they mature. Much more emphasis is put on trading
securities.

Keywords
Bank profit, promissory note, loan and lease, security, certificate of deposit, mortgage, credit
service, payment services, retail portfolio services, credit standards, maturity transformation, net
interest income, net capital gain, return on equity, return on assets, leverage, loan‐to‐value ratio,
debt service, originate and hold model, originate and distribute model

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Review Questions
Q1: What is the impact of a decline in the value of bank assets on the net worth of banks? Why is
that a problem for banks?
Q2: Why do banks exist?
Q3: If interest rates on the liabilities of banks go up, what happens to their profit?
Q4: In order to provide an advance of funds, what does a bank do? Why does it need to do that?
Q5: Why does the profitability of a bank depend on the ability of its customers to fulfill their
promissory notes?
Q6: Have banks become more or less dependent on the ability of their customer to service their
debts?
Q7: Do big banks take more or less risk than small banks? How so?
Q8: Why is it important for a bank to loosen its credit standards at about the same pace as its
competitors? What happens if it is more conservative than others? Less conservative then others?

Suggested readings
For a succinct view of the evolution of banking since the 1960s and a bullish view of its recent
development, read “Banking” a 2004 speech by Chairman Greenspan:
http://www.federalreserve.gov/BOARDDOCS/Speeches/2004/20041005/default.htm
Hyman, H.P (1984) “Banking and industry between the two wars: The United States,” Journal of
European Economic History, 13 (Special Issue): 235‐272.

1 See Black, W.K. (2005) The Best Way to Rob a Bank is to Own One. Austin: Texas University Press.
2 See Part 4 of Klein, A. and Goldfarb, Z.A. (2008) “The bubble,” The Washington Post, June 15, 16, 17 at
http://www.washingtonpost.com/wp‐dyn/content/article/2008/06/14/AR2008061401479_4.html
3 See Schwartz, N.D. (2007) “Can the Mortgage Crisis Swallow a Town?” The New York Times, September 2 at
http://www.nytimes.com/2007/09/02/business/yourmoney/02village.html
4 In Chapter 12 of the General Theory. Available at
https://www.marxists.org/reference/subject/economics/keynes/general‐theory/ch12.htm
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CHAPTER 9:
Why banks need to be regulated and supervised
How banks are regulated and supervised
What has led to a decline in the ability and willingness to regulate banks and
to enforce existing regulations
Why economists may have different views about the more relevant way to
perform bank regulation

CHAPTER 9: BANKING REGULATION
It may surprise you to know that the banking sector is one of the most regulated industries in the
United States, with each bank having to file regulatory documents with several agencies. These
regulations determine how banks should and should not operate their business in terms of many
aspects; from disclosure of information to potential customers, to means of determining
creditworthiness of a potential client, to the quantity of reserves to hold, to management issues,
among others. For example the National Association of Mortgage Brokers noted in 2006
Mortgage brokers are governed by a host of federal laws and regulations. For
example, mortgage brokers must comply with: the Real Estate Settlement
Procedures Act (RESPA), the Truth in Lending Act (TILA), the Home Ownership and
Equity Protection Act (HOEPA), the Fair Credit Reporting Act (FCRA), the Equal
Credit Opportunity Act (ECOA), the Gramm‐Leach‐Bliley Act (GLBA), and the
Federal Trade Commission Act (FTC Act), as well as fair lending and fair housing
laws. Many of these statutes, coupled with their implementing regulations, provide
substantive protection to borrowers who seek mortgage financing. These laws
impose disclosure requirements on brokers, define high‐cost loans, and contain
anti‐discrimination provisions. Additionally, mortgage brokers are under the
oversight of the Department of Housing and Urban Development (HUD) and the
Federal Trade Commission (FTC); and to the extent their promulgated laws apply
to mortgage brokers, the Federal Reserve Board, the Internal Revenue Service, and
the Department of Labor.
Let us focus on four examples of regulation.
EXAMPLES OF BANK REGULATIONS
RESERVE REQUIREMENT RATIOS
The reserve requirement ratio (RRR) dictates the quantity of total reserves banks must have in
proportion to the accounts they issued (see Chapter 3). Table 9.1 shows what the ratios look like
today in the US. If a bank issued less than $15.2 million of transaction accounts (checking accounts
and others) it does not have to have any reserves, 3% between 15.2 to $110.2 million worth of
outstanding transaction accounts, and 10% beyond that. Some countries do not have any reserve
requirements.
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Requirement
Liability Type
% of liabilities Effective date
Net transaction accounts 1
$0 to $15.2 million2 0 1‐21‐16
More than $15.2 million to $110.2 million3 3 1‐21‐16
More than $110.2 million 10 1‐21‐16
Nonpersonal time deposits 0 12‐27‐90
Eurocurrency liabilities 0 12‐27‐90

Table 9.1 Reserve requirement ratios for the United States.
Source: Board of Governors of the Federal Reserve System
CAPITAL ADEQUACY RATIOS
Say that a bank has the following balance sheet: the value of assets is $100, bank accounts are $90
and net worth is $10. The net worth acts has a buffer for account holders against losses on assets,
i.e. as long as, the value of assets falls by 10% or less, the bank can fully repay all account holders
by liquidating its assets (assuming, of course, that at time of liquidation markets are well behaved
and allow quick liquidation at low cost). Regulators want to make sure that banks have enough
capital to protect their creditors against a substantial decline in the value of bank assets. This is all
the more so given that the government may guarantee that customers will get the funds in their
bank accounts even if a bank goes bankrupt.
Since 1988, with the Basel Accords, central banks have tried to make capital regulation more
uniform across the world. Table 9.2 shows the current capital adequacy ratios (CAR) for FDIC‐
insured banks. We will focus on the total risk‐based CAR (Total RBC ratio column). In the US, a bank
should have at least 8% of capital, preferably at least 10%, relative to its risk‐weighted assets. This
means that the maximum weighted balance‐sheet leverage ought to be 12.5 (A/E = 1/0.08) and
preferably 10.

Table 9.2 Capital adequacy ratios.
Source: FDIC Capital Regulation Manual.
Assets are weighed according to the risk that their nominal value falls. Assume that a bank has the
following balance sheet (Figure 9.1):
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Mortgage notes = $40 (100%) Bank accounts = $104
Municipal bonds = $30 (80%) Capital = $6
U.S. Treasuries = $30 (0%)
Reserves = $10 (0%)
Figure 9.1 Bank balance sheet with weights
The ratio capital/assets is $6/$110 = 5.45%, which is below the 8% minimum CAR. However, assets
weigh more heavily if they have a higher chance of generating losses. Mortgage notes are illiquid
and contain credit risk so they are attached a 100% weight, municipals contain credit risk but are
somewhat liquid so they have a weight of 80%, U.S. Treasuries contain no credit risk and trade in
the most liquid financial market in the world so they are attached no weight. Same with reserves.
So the actual capital ratio is $6/($40 + $24) = 9.38%, not ideal but adequate.
Basel Accords have evolved over time as central banks have tried to account for changes in the
financial industry and for drawbacks of the previous versions of the Accords (the Accords are in
their third version). As one may expect, the way to set the weights and proper value of assets can
get very complicated. The last section will explain why one may doubt that this type of regulation
will be successful.
CAMELS RATING
Beside the well‐known RRR and CAR, regulators such as the FDIC also calculate a CAMELS rating for
each bank:
– C: Capital adequacy
– A: Asset quality
– M: Management quality
– E: Earnings level and quality
– L: Liquidity
– S: Sensitivity to market risk (change in the nominal value of securities)
CAMELS rating goes from 1 (strong business) to 5 (highly troubled). A rating of 4 or higher leads
regulators to check carefully a bank and if necessary to issue a cease and desist order
In a cease and desist order, a bank must stop immediately its dangerous activities (risky credit,
improper management, too low capital ratio, etc.) and must find means to restore its soundness
permanently (as measured by the CAMELS rating). Restoring permanent soundness (i.e., desisting
from dangerous activities) may imply significant changes in management and business strategies,
and may involve finding reliable sources of funding, and other relevant restructuring operations.
The board of a troubled bank is given a limited amount of time (e.g., 60 days) to comply with the
demands of its regulator. If the board cannot comply, the bank is closed and the regulator uses the
least costly procedure to take care of the problem bank: liquidation or facilitation of acquisition by
another bank.

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UNDERWRITING REQUIREMENTS
One would think that banks carefully check the creditworthiness of a customer before they accept
her promissory note. They would ask for proof of income and verify with the Internal Revenue
Services (nobody inflates his income on an income‐tax statement), carefully determine the value of
available collateral, and judge ability to pay based on the overall debt service that would come due.
After all, this is what banks are supposed to do; their job is precisely to judge ability to pay and to
tame expectations.
As noted in Chapter 8, during the housing boom all this went out of the window, banks
manufactured creditworthiness by inflating it on credit application (sometimes raising the income
stated on a mortgage application without the knowledge of the applicant), they did not bother to
check with the IRS even though it can be done easily (they did not do so for the obvious reason that
they lied on the application), they maintained a black list of house appraisers who were honest and
would not provide an inflated valuation of a house, they qualified households on the basis of
interest payments calculated from a very low interest rate (aka teaser rate) that would prevail only
for a few months. It is as if your mechanic did everything to wreck the engine of your car. So it
turned out regulations had to be put in place to tell bankers what they are supposed to do!
This is included in Title 14 of the Dodd‐Frank act. It forces mortgagees to determine the capacity to
pay of mortgagors on the basis of other means than the expected refinancing sources and expected
equity in the house, as well as to verify income and to qualify individuals based on the full debt
service:
A determination under this subsection of a consumer’s ability to repay a residential
mortgage loan shall include consideration of the consumer’s credit history, current
income, expected income the consumer is reasonably assured of receiving, current
obligations, debt‐to‐income ratio or the residual income the consumer will have
after paying non‐mortgage debt and mortgage‐related obligations, employment
status, and other financial resources other than the consumer’s equity in the
dwelling or real property that secures repayment of the loan. A creditor shall
determine the ability of the consumer to repay using a payment schedule that fully
amortizes the loan over the term of the loan. (Dodd‐Frank Act, 768)
While Title 14 is limited to residential mortgages (commercial mortgages were a big problem during
the S&L crisis and other promissory notes should also follow the same underwriting methods), this
Title is a great contribution to financial stability…if enforced. The need for such a regulation
suggests how much the banking industry has changed for the worse.
WHY ARE THERE STILL FREQUENT AND SIGNIFICANT

FINANCIAL CRISES IF REGULATION IS SO TIGHT?
This is, at least, a three‐part answer: 1‐ there was some deregulation that has promoted
competition and concentration, 2‐ the willingness and ability to enforce the law has diminished, 3‐
regulatory arbitrage and regulatory apathy.
DEREGULATION, COMPETITION AND CONCENTRATION
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The Great Depression put in place financial regulations that compartmentalized the financial
industry. Banks were forbidden to perform some activities related to financial markets, they were
limited in the types of assets they could hold, and they had access to a low cost and stable
refinancing source via the central bank. This led to a very stable banking system with very few and
limited problems. Table 9.3 shows the gross saving of depository institutions grew at a slower but
steadier pace compared to the post‐1970s period. The number of failures and assistances was also
dramatically smaller—around 4 failures and assistances per year versus 113 from the 1980s—and
represented only 2.8 percent of all failures and assistances that occurred between 1945 and 2010.
Taking a broader historical perspective, Figure 9.2 shows that the stability of the banking from 1940
to 1980 also stands out.
U.S.
Gross Saving, Average Credit Commercial
Depository
Growth Rate Unions Banks
Institutions
1945‐1971 8.2% 15.1% 9.1%
1982‐2010 24.0% 14.1% 11.7%
Gross Saving, Std.

Deviation
1945‐1971 15.1% 20.1% 16.4%
1982‐2010 225.8% 31.2% 26.1%
Insured Bank Failures
Number (% of total) Yearly Average
and Assistances
1945‐1971 100 (2.8%) 3.7
1982‐2010 3266 (93.5%) 112.6

Table 9.3 Gross saving and failures of FDIC‐insured depository institutions.
Sources: Board of Governors of the Federal Reserve System, Federal Deposit Insurance
Corporation.
Note: Gross saving is defined as undistributed profit plus consumption of fixed capital
Chapter 8 notes that the enthusiasm of banks for the originate‐and‐hold model declined sharply in
the 1980s. They pushed for a deregulation of their industry to be able to offer higher interest rate
on their liabilities and to widen the type of assets they could hold (1980 Depository Institution
Deregulation and Monetary Control Act, 1982 Garn St. Germain Act). Then, banks lobbied to
deregulate branching restrictions (1994 Riegle‐Neal Interstate Banking and Branching Efficiency
Act), to be able to participate in broader financial activities (1999 Financial Modernization Act), and
to limit regulation in the derivative markets (2000 Commodity Futures Modernization Act).
Today, the U.S. banking industry is highly concentrated (Figure 9.3) and a few large financial holding
companies dominate the industry. 80% of the assets of the banking industry are concentrated in
the 595 largest banks that account for about 10% of FDIC‐insured banks. Among these, the top 5/7
banks hold almost all the derivative contracts held by banks. Table 9.4 shows the recent data about
derivative holding concentration among FDIC‐insured institutions; the seven biggest institutions
hold 97% of derivate contracts held by FDIC‐insured institutions, worth almost $170 trillion
notionally. The high concentration of the industry means that if one of the banks fails, it may have
a major impact on the financial system. Banks may become “too big to fail,” and so must be saved
even though they are not economically viable. This may promote moral hazard and increase
financial instability over time.
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Figure 9.2 Annual number of bank suspensions (1892‐1941) and bank failures (1934‐2015)
Sources: FDIC (Bank failures) and Monetary and Banking Statistics 1914‐1941 (Bank
suspensions)
Note: Bank suspensions include banks that closed temporarily or permanently on account of
financial difficulty; excludes times of special bank holiday. Bank failures refer to banks that
closed permanently.

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Figure 9.3 Concentration of the banking industry
Note: Largest FDIC Insured Bank have over $10 Billion of Assets (595 institutions in 2016 or 10%
of the industry)

Percent of Spot Foreign
Derivative
Total Number of Exchange Size
Report Date Contracts
Derivative Banks Contracts Grouping
(Trillions)
Contracts (Billions)
December 7 Largest
$169.3 97% 7 $928.0
31, 2015 Participants
December All Other
$4.7 3% 1,400 $105.5
31, 2015 Participants

Table 9.4. Concentration of derivatives notional amounts
DEENFORCEMENT AND DESUPERVISION
Overall, there was a deregulatory trend but the fact remains that this industry is still heavily
regulated. However, for a set of regulations to work properly it has to be enforced. With the return
of free‐market thinking as a dominant framework of thought in the 1970s, enforcement took a toll.
Free‐market thinkers who do not believe in government intervention were put in charge of major
regulatory bodies; individuals such as Alan Greenspan at the Fed, Robert Rubin at the Treasury, and
Christopher Cox at the SEC. These are individuals who believe in the self‐cleansing and self‐
stabilizing properties of market.1 As such, according to them, there is no need to do anything to
prevent fraud and dangerous financial practices, or to make sure that banks do not get involved in
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predatory business practices. Markets take care of it, after all, as the thought goes, a business is
judged by its clients so if the clients do not like what a business does, the business will close.
Thus, in recent years, regulators like the Federal Reserve deliberately loosely implemented existing
regulations or chose “to not conduct consumer compliance examinations of, nor to investigate
consumer complaints regarding, nonbank subsidiaries of bank holding companies”.2 In addition, the
Federal Reserve and the Office of the Comptroller of the Currency (OCC) blocked efforts of federal
regulators, and states like Georgia and North Carolina were prohibited by OCC and the OTS from
investigating local subsidiaries of nationally chartered banks. Chairman Bair at the FDIC worked with
Federal Reserve Governor Gramlich to raise concerns about predatory mortgage practices starting
in 2001 but their effort did not lead anywhere. Chairman Born at the Commodity Futures and Trade
Commission (CFTC) raised concerned about derivatives and wanted to make them more
transparent but was shut down by Congress.3
In 1994, a Government Accountability Office (GAO) report strongly criticized the existing derivatives
legislation. It noted that “no comprehensive industry or federal regulatory requirements existed to
ensure that U.S. OTC derivatives dealers followed good risk‐management practices” and that
“regulatory gaps and weaknesses that presently exist must be addressed, especially considering the
rapid growth in derivatives activity”.4 None of the recommendations was implemented and instead
large cuts were made by Congress to the budget of the GAO. These cuts were estimated to reduce
the staff of the GAO by 850 persons (20 percent of its employees).
Other regulators also suffered large cuts to their staff. The FDIC staff was cut drastically and
constantly from 20,000 employees in the early 1990s to 5,000 employees right before the Great
Recession (Figure 9.4). This occurred at the same time as the financial industry became more
concentrated and more complex. In addition, the cut in staff was much more rapid than the decline
in the number of FDIC insured institutions to be supervised, thereby increasing the burden of
supervision on each employee. This double trend of increasing complexity and increasing burden
on supervisors drastically decreased their capacity to perform effective supervision and regulations.
The SEC, under Christopher Cox (who, like Alan Greenspan, is a follower of Ayn Rand’s economic
thinking), also decreased its staff and, by 2009, the Securities and Exchange Commission had 400
people to examine 11000 investment advisers, which led it to contract with private auditors and
other external reviewers. In addition, the SEC did not develop the necessary tools it needed to
perform effective regulation.
REGULATORY ARBITRAGE
Beyond deregulation, desupervision and deenforcement, banks themselves have always found
means to bypass partly some of the regulations that they have found too constraining. An example
of that are capital regulations that banks have bypassed partly through securitization. Securitization
allows banks to remove highly‐weighted assets (that is carrying high risks) from their balance sheet
without compromising their profitability. Regulatory arbitrage is a common response of banks to
new regulations. To counter it, regulation needs to be flexible and broad enough, and regulators
need to act quickly; both requirements are lacking with regulators today focused on limiting
intervention to avoid hurting bank profits and competitiveness with foreign institutions. In addition,
a bank can choose its main regulator, and a bank can change its regulator if it thinks another one
will be more lenient. This “regulator shopping” is all the more prevalent given that regulators
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compete to get the most banks under their wings because regulators are funded partly through the
fees they charge for supervision.

Figure 9.4 Number of employees at the Federal Deposit Insurance Corporation.
Source: FDIC.
THEORIES OF BANK CRISES AND BANKING REGULATION:

TWO VIEWS
The way the banking system is regulated heavily depends on regulators’ understanding of what
causes banking crises. There are two broad views regarding the origins of banking crises and
financial crises more generally; one states that crises are random events in an otherwise self‐
stabilizing economic system based on market principles, another states that bank crises are the
result of the inner working of markets.
LAISSEZ FAIRE, LAISSEZ PASSER: CRISES AS RANDOM EVENTS
Greenspan summed up neatly the first view when he characterized the 2008 financial crisis as a
“once‐in‐a‐century credit tsunami.” Crises are equivalent to weather calamities that affect the
return on assets (see Chapter 7). These adverse random shocks are amplified by individual
imperfections (think of any deviation from the cold rational homo economicus) and market
imperfections (lack of information, etc.). Market imperfections can themselves contribute to the
growing risk of financial crises if they contribute to the mispricing of securities, which leads rational
agents to take too much risk on their assets and liabilities given the price signal. Thus, according to
this view, the recent crisis is the product of mispriced assets (like CDOs) that led to the issuance of
too many of them (see discussion about embedded leverage in Chapter 7), and of a “black‐swan”
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event, that is, an unusually large negative shock. One might call this view the “shit‐happens” view
of financial crises.
In this type of view, there is no point in trying to promote a regulatory framework that proactively
helps prevent crises and limit their strength—in the same way no one can proactively prevent the
occurrence and reduce the strength of tsunamis. Market mechanisms weed out problems by
themselves because, with enough disclosure, financial‐market participants will not engage in
fraudulent practices, and unsustainable business will be closed down. Anything that promotes
market mechanisms is praised and that includes the recent innovations in derivatives and
securitization. Policy makers such as Alan Greenspan and academics such as Philip Das made
statements in the mid 2000 that illustrate well this position:
Development of financial products, such as asset‐backed securities, collateral loan
obligations, and credit default swaps, that facilitate the dispersion of risk… These
increasingly complex financial instruments have contributed to the development
of a far more flexible, efficient, and hence resilient financial system than the one
that existed just a quarter‐century ago. (Greenspan 2004, 2005)
Financial risks, particularly credit risks, are no longer borne by banks. They are
increasingly moved off balance sheets. Assets are converted into tradable
securities, which in turn eliminates credit risks. (Das 2006)
Given that markets usually get it right, instead of having regulations that constrain market
mechanisms, regulation should focus on limiting the destructive impact of financial crises on
economic activity and improving disclosure of information and market mechanisms. Following the
tsunami analogy, the goal is to build high enough seawalls so that protection is available against
most tsunamis. If there is a “once‐in‐a‐century” tsunami…well…too bad…at least we tried!
In terms of banking regulation, the goal is to put in place large enough liquidity and capital buffers
in the balance sheets of banks. The Basel accords are an example of such regulatory view:
Given the scope and speed with which the recent and previous crises have been
transmitted around the globe as well as the unpredictable nature of future crises,
it is critical that all countries raise the resilience of their banking sectors to both
internal and external shocks. (Basel 2010a: 2)
With enough capital, banks will be able to protect their creditors against most declines in the value
of their assets. With enough liquid assets, the value of assets will decline less than it would have
otherwise. At the same time, having too much capital and liquidity puts downward pressures on
the ROE that banks can earn because leverage declines and ROA is lowered (the more liquid an
asset, the lower the ROA). The point, therefore, becomes to find the optimal level of capital and
liquidity. The move toward risk management is the ultimate expression of this belief. It uses
complex mathematical algorithms to determine what the appropriate level of buffers is given
existing risks on‐ and off‐balance sheets. The goal has been to refine the measurement of different
risks as well as the methods used to calculate the appropriate level of each buffer. The government
has a limited role to play in determining appropriate buffers, especially for “sophisticated” financial
institutions. The government also has not much to say about the way banks should be managed,
the proper underwriting procedures, and the types of assets that banks should be allow to hold.
Bankers know best.
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SAVE CAPITALISM FROM ITSELF: CRISES AS INTERNAL

CONTRADICTIONS
Another view of financial crises argues that they are the normal result of profit‐seeking operations
of banks, and that the way the banking system is structured greatly dampens or amplifies the
destabilizing effect of profit‐seeking operations. While an unstable banking system can be
attributed in part to greed and irrational or “bad” people, the most important contributor is the
way the banking system is set up. The more of a role is given to market mechanisms, the more
unstable the financial system will be. The issue is not one of mispricing, lack of disclosure, black
swan, massive tsunami, or imperfections. Tsunamis are created by the very practices of banks when
trying to make a buck and, if banks are left alone, their practices will lead to a “once‐in‐a‐century
tsunami.” Put differently, financial crises are not the results of “bad luck” because nature threw a
tantrum; banks make their own luck. As such, one may also doubt that capital regulation and other
buffer‐requirement approach will do much to prevent financial crises. 5 They are too passive
regulations.
As explained in Chapter 8, over a period of stability, banks are incentivized to change their
underwriting practices by lowering credit standards and/or deemphasizing income as the main
means of servicing debts. Some of this loosening is welcomed when banks have tightened credit
standards so much that economic growth cannot proceed well. This tends to happen after financial
crises, when bankers become too careful. 6 However, credit standards are elastic and, when
profitability is threatened, loosening credit standards is the easy road, especially during a period of
economic stability when economic news is good. Periods of economic stability feed the models
used by bankers with information that suggests that leverage is safe and risk‐taking is warranted.
Beyond banks, other financial institutions such as pension funds have an incentive to buy CDOs and
other risky financial assets (even a non‐investment grade securities) in order to maintain the
targeted ROE they promised their pensioners; this is so especially when interest rates are very low.
More broadly, corporate businesses have some profitability target to meet that is largely invariant
to the growth of their assets, thereby pushing them to innovate and to use leverage to reach that
target. Again, a very rational response to profitability pressures defined by a target ROE.
As such, risk‐management tools may provide information that suggests that it is safer not to engage
in certain activities, but this information will be ignored if it threatens market shares and
profitability:
To some extent […] all risk management tools are unable to model/present the
most severe forms of financial shocks in a fashion that is credible to senior
management […].To the extent that users of stress tests consider these
assumptions to be unrealistic, too onerous, […] incorporating unlikely correlations
or having similar issues which detract from their credibility, the stress tests can be
dismissed by the target audience and its informational content thereby lost.
(Counterparty Risk Management Policy Group III 2008: 70, 84)
This is so especially in an environment where it is difficult to reach the target ROE and the search
for yield is intensive. Chapter 8 illustrates how the banking system (and financial system as a whole)
is driven by competitive pressures and the need to stick with the majority to avoid losing market
shares. As such, financial institutions will engage in unsustainable financial practices if that means
keeping profitability up. Given that profit is the only relevant metric to judge a business, market
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mechanisms will not weed out unsustainable practices if they sustain profit. As these accumulate,
the economic system becomes more fragile and ultimately collapses under a debt‐deflation (see
Chapter 14).
The point is that the weeding out of bad apples that market proponents argue occurs to prevent
crises does not happen. The problem comes from too much focus on profit as the key metrics of
health for a business. From the bank managers’ standpoint, if the business is profitable, it means
they do what customers want and so are fulfilling a need (never mind that this may involve “raping
the public” as shown in Chapter 8). Regulators see profit as a key measure of health because profit
grows capital (see Chapter 1) and so improves buffers against crises. However, from a financial
stability perspective, a key issue is not merely if profit is generated but how that profit is generated.
If this second question is ignored, the weeding out mechanism used by markets is the crisis itself,
and that ends up destroying the entire economy and wiping out any buffer available. So much for
a smooth self‐stabilizing mechanism.
Given that credit standards are elastic concepts, one may wonder if there is a means to know what
a sustainable credit practice is and how to use that for regulatory purpose. Fortunately yes. Hyman
P. Minsky provides us with a useful categorization of underwriting practices in terms of Hedge,
Speculative and Ponzi finance. Chapter 14 studies this categorization more carefully. The main point
is that if debt is underwritten on the basis of income (income‐based credit), it is much less likely to
lead to financial instability. If, instead, banks grant advances by qualifying clients on the basis of the
expected rise in the value of a collateral or other assets (asset‐based credit), then the economic
system is prone to financial instability. The recent housing boom with its dangerous mortgage
practices, presented in Chapter 8, is an example of such unsustainable underwriting practices.
The problem is not merely one of knowing if a customer will be able to service his debt (the main
concern of banks), but also how a customer will service his debt: servicing debt with income is
sustainable, debt servicing by liquidating assets is not. It is not sustainable because while an
individual may be able to do it by relying on a bonanza (asset prices went up as expected and can
be liquidated easily), for the system as a whole it is impossible to liquidate assets. Markets rely on
a balance of buyers and sellers and if a significant proportion of debtors rely on a strategy that
involves selling assets to service debts, asset prices will plunge when liquidation occurs. A Ponzi
strategy is sustainable only for so long, given that the number of participants (and indebtedness)
must exponentially grow to keep the strategy going.
With the H/S/P categorization in mind, the point is to discourage, and if necessary, forbid any
economic growth process that is not based on sound financial practices (income‐based credit), even
if everybody is profiting from the continuation of this process in the short term, and even if the
financial community ends up considering those practices acceptable and a normal way to do
business. In order to do so, the financial practices of economic agents should be checked carefully
and growing signs of asset‐based credit should be tackled immediately, even if there is no bubble,
no rising default rate, rising wealth and profit.
This policy agenda is, of course, much broader and more ambitious than the previous one, but its
relevance has been demonstrated many times. For example, prior to the savings and loan crisis,
several in‐field supervisors wanted to shut down some thrifts that were recording large profits,
because they were suspected of being involved in Ponzi finance sustained by massive frauds.
However, there were strong pressures from their bosses and politicians not to close these thrifts
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because their profitability made them models for the industry. 7 Those thrifts were allowed to
continue to operate but ended up costing hundreds of billions of dollars when they failed.
Similarly, during the housing boom of the mid‐2000s, households’ wealth grew very rapidly,
financial companies registered record‐high profits, and homeownership also reached a record high,
but all these gains were wiped out once the economy collapsed. Homeownership is back to its level
prior to the housing boom, and is still falling (Figure 9.5).

Figure 9.5 Homeownership rate in the U.S. (Percent).
Source: U.S. Census Bureau
Steps should have been taken since at least 2003 to prevent the unsustainable growth of
homeownership and dangerous business practices. This should have been done by forbidding no‐
doc mortgages, by limiting access to pay‐option mortgages to households with enough cash buffer
and income, by not allowing financial institutions to create Ponzi‐generating financial innovations,
and by regulating closely all new financial activities. Instead, in 2004, Greenspan praised the
dynamic mortgage market and argued that rising mortgage debt among U.S. households was not a
problem because households’ wealth was rising thanks to rapidly rising home prices; precisely what
asset‐based credit is all about.8
Finally, asset‐based credit is impossible to buffer properly in an economically profitable way and so
should not be allowed at least by banks. An alternative is to remove any government backing from
economic activities that rely on, or promote, asset‐based credit, which implies isolating the
payment system from those activities.
In the end, CDOs and other financial innovations were problematic not because they were
mispriced (although they surely were), but because they were encouraging financial practices that
are unsustainable even if priced correctly. Asset‐based credit always fails because there is
ultimately no income to meet the debt service and assets must be liquidated in distress. Financial‐
market participants are always willing to pay for something if that means more profit (even more
so when bonuses are based on short‐term profitability), and they will get a better idea of what to
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pay with more information. But profit‐seeking activity is different from financial‐crisis avoidance
activity. In fact, these two activities usually are complete opposite activities and the latter is never
on the radar of any particular firm (“if we fail, we fail together, nobody gets blamed; let me focus
on my profit” is the thought as Wojnilower illustrates in Chapter 8).
1‐ Banks are heavily regulated because they are at the core of the payment system. If they fail en
masse, the economy freezes because other economic units cannot get paid, cannot make
payments, and cannot obtain currency.
2‐ Banks must have a certain proportion of capital relative to the weighted value of their assets.
This is supposed to allow banks to be able to sustain large unexpected adverse shocks on their
assets, while still being able to pay their creditors
3‐ Banks must have a certain proportion of reserves relative to the outstanding value of the bank
accounts that they have issued. This is supposed to allow them to meet unexpected large demand
for cash by customers.
4‐ If banks do not comply with regulations, regulators may issue a cease and desist order and give
a limited amount of time for a bank to comply. After that time, the bank is either sold to another
bank or its assets are liquidated to pay the creditors.
5‐ The banking industry has become highly concentrated and highly dependent on derivatives and
capital gains to maintain its profitability. This is the results of a period of deregulation,
desupervision and deenforcemnt that have allowed major banks to broaden their activities.
6‐ Some economists believe that markets self‐regulate and that, at most, banks only need to be
protected against the most probably shocks that may adversely impact their balance sheet. This
can be done by passive regulation such as capital regulation. Other economists believe that banks
make their own luck, that is, that financial crises are the product on the loosening of credit
standards during period of economic prosperity. As such, regulation of the banking business must
be more thorough, flexible and proactive, and must focus on the type of assets acquired by, and
underwriting methods used by banks.

Keywords
Reserve requirement, capital requirement, CAMELS rating, efficient markets, financial instability
hypothesis, risk management techniques, underwriting requirements

Review Questions
Q1: What is the role of capital regulation? Underwriting regulation?
Q2: What does a CAMELS rating measure and how does it do it?
Q3: What has happened to the banking industry over the past 30 to 40 years and why?
Q4: What can be done in terms of regulation if one believes that financial crises are random events,
aka black‐swan events?
Q5: What type of regulation should be put in place if one believes that financial crises are the result
of the way banks conduct their business?
Q6: How can an increase in the concentration of the banking industry, together with deregulation
and lack of enforcement, promote the occurrence of financial crises?

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Suggested readings
For a relative easy read with a compelling narrative about saving & loan white collar crimes and the
fight of some regulators to stop them read The Best Way to Rob a Bank Is to Own One: How
Corporate Executives and Politicians Looted the S&L Industry by William K. Black.
More advanced readings:
Cargill, T.F. and Garcia, G.G. (1982) Financial Deregulation and Monetary Control: Historical
Perspective and Impact of the 1980 Act. Stanford: Hoover Institution Press.
Campbell, C. and Minsky, H.P. (1987) “How to Get Off the Back of a Tiger or, Do Initial Conditions
Constrain Deposit Insurance Reform?” In Federal Reserve Bank of Chicago (ed.) Proceedings of a
Conference on Bank Structure and Competition, 252‐266. Chicago: Federal Reserve Bank of Chicago.
Minsky, H.P. (1975) “Suggestions for a cash flow‐oriented bank examination,” in Federal Reserve
Bank of Chicago (ed.) Proceedings of a Conference on Bank Structure and Competition, 150‐184,
Chicago: Federal Reserve Bank of Chicago.
Knutsen, S. and Lie, E. (2002) “Financial fragility, growth strategies and banking failures: The major
Norwegian banks and the banking crisis, 1987‐92.” Business History, 44 (2): 88‐111.

1 When the full blown crisis occurred in the September 2008, Greenspan and others conceded that they went too far in
believing in the efficiency of markets—it was the time for a public mea culpa. Donald Kohn, former Vice Chairman of the
Federal Reserve, stated: “I placed too much confidence in the ability of the private market participants to police
themselves” (Kohn in House of Commons 2011: Ev3). A humble Greenspan was asked to testify to Congress and created
some stir by stating:
I made a mistake in presuming that the self‐interest of organizations, specifically banks and others,
were such is [sic] that they were best capable of protecting their own shareholders and their equity
in the firms. (Greenspan in U.S. House of Representatives 2008b: 34)
Similar remarks were made in the United Kingdom by Adair Turner, chair of the U.K. Financial Services Authority (FSA):
In the past, in the years running up to the crisis, it was the strong mindset of the FSA—shared with
securities and prudential regulators and central banks across the world, it was almost part of our
DNA—that we assumed that financial innovation was always beneficial, that more trading and more
liquidity creation was always valuable, that ever more complex products were by definition beneficial
because they completed more markets, allowing a more precise matching of instruments to investor
demand for liquidity, risk and return combinations. And that mindset did affect our approach—and
the approach of the whole world regulatory community—to the setting of capital requirements on
trading activity; it affected our willingness to demand risk reduction in the CDS market; and it
influenced the degree to which we could even consider short‐selling bans in conditions of exceptional
market volatility.[…] [Stepping out of that mindset] poses for regulators the challenge of complexity,
because it involves rejecting an intellectually elegant but also profoundly mistaken faith in ever
perfect and self‐equilibrating markets, ever rational human behaviors. (Turner 2009)
2 Appelbaum, B. (2009) “Fed held back as evidence mounted on subprime loan abuses,” The Washington Post, September
27 at http://www.washingtonpost.com/wp‐dyn/content/article/2009/09/26/AR2009092602706.html
3 Watch “The Warning” by PBS Frontline at http://www.pbs.org/video/1302794657/
4 Government Accountability Office (1994) Financial Derivatives: Actions Needed to Protect the Financial System, Report
No. GAO/GGD‐94‐133, May, at http://www.gao.gov/assets/160/154342.pdf
5
http://www.levyinstitute.org/conferences/minsky2015/minsky2015_tymoigne.pdf
6 In 2014, Chairman Bernanke could not refinance his mortgage http://www.bloomberg.com/news/articles/2014‐10‐
03/why‐even‐ben‐bernanke‐cant‐refinance‐his‐mortgage‐chart
8 “The mortgage market and consumer debt,” remarks by at America’s Community Bankers Annual Convention,
Washington, D.C., October 19, 2004. http://www.federalreserve.gov/boardDocs/speeches/2004/20041019/default.htm
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CHAPTER 10:
What banks do before providing credit
How banks create their monetary instruments
How banks destroy their monetary instruments
How banks make a profit
What the limits to the monetary creation process by banks are

CHAPTER 10: MONETARY CREATION BY BANKS
The last three Chapters have explained how the operations of banks are constrained by profitability
and regulatory constraints, and how banks operate to try to bypass these constraints. It is now time
to go into the details of how banks provide credit and payment services to the rest of the economy.
MONETARY CREATION BY BANKS: CREDIT AND PAYMENT

SERVICES
Bank A just opened for business and its balance sheet looks like this:
Bank A
Building: $200 Net worth: $200
Now comes household #1 who wants to buy a house worth $100 from household #2. #1 sits down
with a banker (a.k.a. loan officer) who asks a few questions regarding annual income, available
assets, monetary balances, the down‐payment #1 is willing to make, among others. The banker asks
for documentation that corroborates the answers provided by #1.
The banker also shows #1 what financing options are available; that is, the banker shows #1 what
type of mortgage note household #1 has to issue to be accepted by bank A. Figure 10.1 is taken
from an actual website.
‐ For 100% financing (no down‐payment by household), the bank is prepared to provide up
to $330,000 and it will only accept a 30‐year 5.125% fixed‐rate mortgage note. The bank
will not accept a 20‐year mortgage note, or a 3.875% note for 100% financing.
‐ For up to 97% financing (household provides at least a 3% down‐payment), the types of
mortgage note that a household can issue to the bank widen. The bank is willing to accept
a 30‐year 3.875% fixed‐rate note, or a 15‐year 3.125% fixed‐rate note, among others. The
maximum face value of the note that the bank will accept is $417,000 unless the household
is able to provide a 20% down‐payment.
#1 picks one of the options and fills up a credit application that is attached to all the documentation
provided by #1. The credit application is then sent to the credit department for further analysis
(check the 3Cs of Chapter 8) and either approved or not.
All this is similar to bond issuances by corporations, except that mortgage notes do not have an
active market in which they can be traded. In the case of a bond, a corporation may issue a bond
with terms that are different than what market participants want. The bond will trade at a discount
or a premium in that case. If Ford issues a 10‐year 5% corporate bond but the market yield is
currently 6% (i.e. market participants want a 6% rate of return), market participants will only buy
the bond from Ford at a discount. To simplify, assume a bond with a $1000 face value and a 5%
coupon rate (every year the bond pays $50 of interest income), then to get a 6% yield someone
should pay $833 (50/833=6%); a 17% discount.
Unfortunately for #1, there is no active market for its promissory notes, so if #1 does not issue a
mortgage note with the terms required by A, its note will trade at 100% discount; A will not buy it
(#1 could always check what another bank would offer). That is the disadvantage of non‐tradable
promissory notes over securities; the issuer is completely bound by what potential bearers require
in terms of the characteristics of the promissory note (interest rate, term to maturity, etc.).
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Figure 10.1 Example of types of mortgage note a bank will accept
Figure 10.2 shows what a mortgage note looks like. It is a legal document that formalizes a promise
made by a household to a bank. The household issued a 30‐year fully‐amortized fixed‐rate 7.5%
note to a bank called “Shelter Mortgage Co.,” which means that, over 30 years, the household
promises to pay an annual interest representing 7.5% of the outstanding note value and to repay
some of the principal every month. That comes down to a monthly payment of $1896.27. The
mortgage note is accompanied by a mortgage deed (and many other documents). The deed is a
legal document that establishes the right of the bank to seize the house if the household does not
fulfill the terms of the mortgage note.
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Figure 10.2 A mortgage note
Going back to our household #1 that wants to buy a $100 house, suppose that bank A agrees to
acquire from #1 a 30‐year 5% mortgage note with a $100 face value. How does A pay for it? Bank
A issues its own promissory note, called “bank account,” to #1.
Bank A
30‐year 5% mortgage note of #1: $100 Bank account of #1: $100
Building: $200 Net Worth: $200
Or, in terms of t‐account, we have the following first step:

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Bank A
30‐year 5% mortgage note of #1: +$100 Bank account of #1: +$100

#1 then pays #2 and, for the moment, let us assume #2 opens an account at A (we will see what
happens below when #2 has an account at a different bank):
Bank A
Building: $200 Bank account of #2: $100
Net Worth: $200
Or in terms of t‐accounts, we have the following when the payment occurs:
Bank A
Bank account of #1: ‐$100
Bank account of #2: +$100

Household #1
House: +$100
Bank account at A: ‐$100

Household #2
House: ‐$100
Bank account at A: +$100
While the above shows the logic of what goes on when a bank provides credit services, the bank
also provides payment services. This means that, in practice, the accounting is simpler because A
makes the payment on behalf of #1, it does not let #1 touch any funds. Instead, A directly credits
the account of #2 so the first step is actually:
Bank A

And the final balance sheet is (#1 does not need to have a bank account for the payment to go
through, A just credits the account of #2 by typing “100” on the computer)
Bank A
The promissory note of the bank called “bank account” is one type of monetary instrument as
explained in Chapter 15.
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WHAT CAN WE LEARN FROM THE EXAMPLE ABOVE?
POINT 1: THE BANK IS NOT LENDING ANYTHING IT HAS: WHEN
PROVIDING CREDIT SERVICES, THE BANK SWAPS PROMISSORY NOTES
WITH ITS CLIENTS
The accounting of the previous section is commonly referred to as “bank lending,” i.e. the A is said
to lend $100 to #1. As stated in Chapter 2, when studying central banking, “lending” means giving
up temporarily an asset, “I lend you my pen for a minute.” This is clearly not what is going on. Banks
are not in the business of allowing customers to temporarily use some of the banks’ assets: that is
a loan shark business. The bank is not lending anything it owns. Lending would mean this:
Bank A
30‐year 5% mortgage note of #1: +$100
Reserves: ‐$100
Household#1 is borrowing cash from the bank. But what happened is this:
Bank A

One may ask: Is there not an indirect lending of reserves though? After #1 gets its account credited,
it could withdraw reserves and make a cash payment to #2. #1 would then have to get reserves
back to A. The answer is no for two reasons:
‐ We have just seen that in practice the bank makes the payment for #1. That payment does
not need to result into any reserve drainage (it did not above).
‐ As shown below, #1 does not have to give back reserves to A to repay its debt, and #1
rarely, if ever, does so in practice.
So not only is #1 not borrowing reserves from A, but also #1 is not giving back reserves to A. There
is no lending or borrowing of reserves going on between A and #1, either directly or indirectly. What
a bank does do is to swap promissory notes with economic units and to make payments for them.
Reserves may enter the picture at the time of the provision of payment services, never at the time
of the provision of credit services.
POINT 2: THE BANK DOES NOT NEED ANY RESERVES TO PROVIDE
CREDIT SERVICES
While it may need reserves to provide payment services (that is to transfer funds to #2), A does not
need any reserves to provide credit services to #1. All it does with household #1 is to exchange
promissory notes:
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‐ The household makes the following promise: pay 5% interest on the outstanding mortgage
value for 30 years and repay some of the principal every month.
‐ The bank makes the following two promises:
o To convert bank accounts into Federal Reserve notes at the will of the account
holders
o To accept its own promissory note when #1 services the mortgage.
All these are promises and none of the issuers has to have what is needed to fulfill the promise right
away when he issues his promissory notes. That is the point of finance; it is about banking on the
future (see Chapter 8).
Think of a pizza shop that issues coupons for a free pizza. The shop does not have to make pizzas
first before it issues the coupons; it will make pizzas only if people show up with coupons.
Converting the coupons into pizzas is costly for the shop and so affects its profitability, but the
issuance of coupons is not constrained by the current availability to pizzas. The shop is just making
a promise and anybody can make any kind of promise. The hard parts are, first, to convince
someone of the genuineness of this promise and, second, to fulfill the promise once it has been
accepted by someone.
In the same way, a bank does not have to have any Federal Reserve notes now to be able to issue
a bank account that promises Federal Reserve notes on demand. A bank will need reserves only if
account holders request cash or make payments to someone who has an account at another bank.
The Fed will provide reserves on demand, i.e. at the will of solvent banks, so banks never worry
about being unable to get reserves (see Chapter 4). Reserves will never run out. What banks do
need to worry about is the cost of acquiring reserves. In normal times, this cost is predictable and
relatively stable but the Volcker experiment shows that a central bank may make reserves
prohibitively expensive.
POINT 3: THE BANK IS NOT USING “OTHER PEOPLE’S MONEY”: IT IS
NOT A FINANCIAL INTERMEDIARY BETWEEN SAVERS AND INVESTORS
This is a development of the first and second point. A view of banking, from which the word
“lending” probably comes from, is that banks are intermediaries between savers and investors.
Some people come to deposit cash and then banks lend the cash. It is quite clear that a bank is not
lending any funds that some deposited (nobody deposited anything in our example). And, worse
offender, a bank is certainly not using others’ bank accounts to grant credit. Assume that household
#3 comes to bank A to get a $100 credit, A never does this:
Bank A
Bank account of #2: ‐$100
Bank account of #3: +$100
That is, it does not take the funds of #2 and give them to #3. This t‐account would be a payment
from #2 to #3, not a credit by bank A. To provide a credit is exactly what credit means, it is about
crediting accounts. The crediting is done by typing a number on the computer. Once this number is
entered, the bank is liable to the account holder for the two reasons presented above.
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Banks do not wait for depositors before they engage in the provision of credit services. Say
household #3 comes to open an account by depositing $50 worth of Federal Reserve notes. The
following occurs:
Bank A
Reserves: +$50 Bank account of #3: +$50
This deposit does not enhance the ability to provide credit services because A is not in the business
of lending reserves to non‐bank economic units. The ability of the bank to acquire non‐bank private
promissory notes is unrelated to the quantity of reserves on its balance sheet because a bank pays
for them by issuing its own promissory notes.
There is one case where a bank does need reserves to acquire a promissory note: if a bank buys the
note from an institution with a Federal Reserve account. For example:
‐ If a bank participates in an auction of Treasuries, the Treasury only accepts federal funds in
payment. In the past, the Treasury sometimes allowed banks to pay for the Treasuries by
crediting the TT&Ls (another cash management method used for monetary‐policy purpose
beyond the ones presented in Chapter 6), but it no longer does since 1989.
‐ if it buys promissory notes from another bank
In the first case, the balance sheet changes as follows (says the bank buys $10 worth of Treasuries
from the Treasury)
Bank A
Reserves: ‐$10
Treasuries: +$10
And on the balance sheet of the Fed the following occurs
Fed
Reserve: ‐$10
TGA: +$10
And the Treasury:
Treasury
TGA: +$10 Treasuries: +$10
Chapter 6 showed that the Fed always ensures that banks have enough reserves to make the
auction successful. The supply of Federal Reserve notes by savers is irrelevant for the success of
auctions of Treasuries.
POINT 4: THE BANK’S PROMISSORY NOTE IS IN HIGH DEMAND
Why did #1 enter in an agreement with A? Because nobody else would accept #1’s promissory note
and a large number of economic units accepts A’s promissory note (if someone does not, A offers
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conversion into cash that most accept in payments). Chapter 15 explains why bank monetary
instruments are widely accepted.
If #2 had been willing to accept #1’s promissory note then none of the previous agreement would
have been needed. The problems with #1’s promissory note are two fold:
‐ There is a credit risk: #2 is not sure that it will get paid the interest due and that it will be
able to make payments to #1 by giving back to #1 its promissory note. If #2 knew that it
would become heavily indebted ($100 is a lot in our example) to #1 in the future, then
assuming that #1 is creditworthy, #2 may be willing to accept #1’s promissory note for the
payment of the house. Later #2 could use #1’s promissory note to pay debts owed to #1.
‐ There is a liquidity risk: the promissory note only comes due in 30 years so household #1
does not have to take it back before that time (though it could because mortgage notes
usually allow accelerated repayment of principal). In the meantime, #2 is stuck with this
promissory note that nobody else will accept.
Bank A’s promissory note is due at any time the bearer wants (it converts into cash on demand and
it can be used to pay the bank at any time) and the creditworthiness of a bank is strong. This is all
the more so given that the government guarantees that A’s promissory note can always be
converted into Federal Reserve notes at par, and that the (nominal) value of A’s promissory note
will not fall even if A goes bankrupt. All this makes the A’s promissory note free of credit risk and
perfectly liquid.
HOW DOES A BANK MAKE A PROFIT? MONETARY

DESTRUCTION
Banks are dealers of promissory notes: banks take non‐bank non‐federal promissory notes and in
exchange give their own promissory note. Banks make a profit by taking back their own promissory
notes. At the beginning of the second month, #1 starts to honor its promise made to A by servicing
the mortgage note. The monthly principal due is 27 cents ($100/(30*12), assuming linear
repayment of principal) and the first interest payment is 41 cents (the annual interest rate is 5% so
on a monthly basis the rate is 0.407% = (1.05)1/12 – 1) making the total debt service for the first
month $0.68. How does #1 pay this?
There are two ways this amount can be paid; one is by giving $0.68 in cash to the bank. Another
more common solution is to follow up on the promise embedded in the bank’s promissory note:
Bank A promised to take back its promissory note as means of payment of debts owed to Bank A.
Thus, another means to pay the mortgage is to debit $0.68 from the account of #1. Let us assume
that #1 has an account at A, that account first needs to be credited:
Bank A
Building: $200 Bank account of #2: $100
Net worth: $200
How can household #1 get funds credited to its account?
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o Case 1: #1 receives a $1 payment from the federal government either by selling
something to the government or by receiving a transfer payment. The balance
sheet of the bank would look like this (Chapter 6 shows that transactions with the
federal government lead to reserve crediting and debiting)
Bank A
Reserves: $1 Bank account of #2: $100
o Case 2: #1 works for business α that produces widgets. Business α just started. It
has not sold anything yet but must purchase raw materials and pay #1 (the only
employee) to be able to produce widgets. In order to do that, α asked for a $10
operating line of credit from A (an operating line of credit is an off‐balance sheet
item unless it is used). When α pays #1 the following happens:
Bank A
Credit line payable by α : $1 Bank account of #2: $100
Business α has gone into debt by $1 to be able to pay the monthly wage of
household #1. Note how similar case 2 is to the first section: business gets credit,
banks makes payment, business does not touch any funds.
o Case 3: #1 receives a $1 from #2. Why? I will let you decide.
One may note that any payment made to #1 that does not come from the government (or an
institution that has a federal reserve account) (case 1), or from funds that got created previously
by #1 going into debt (case 3), requires that someone other than #1 goes into debt toward a bank
(Case 2). Otherwise #1 cannot get access to the payment services offered by A.
Let assume that case 2 prevailed so now #1 has enough funds to pay A the first monthly service of
$0.68. How is that recorded? It is exactly the same procedure as debt‐service payments by banks
to the central bank.
Bank A
30‐year 5% mortgage note of #1: $99.73 Bank account of #1: $0.32
Building: $200 Net worth: $200.41
Or in terms of t‐accounts:
Bank A
30‐year 5% mortgage note of #1: ‐$0.27 Bank account of #1: ‐$0.68
Net worth: +$0.41
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Again, as in the case of a central bank presented in Chapter 2, the bank is not gaining any cash flow
from the transaction. Its profit does not increase the quantity of reserves on the asset side. What
profit does is to raise the net worth of the bank. As noted in the first Chapter, profit is just an
addition to net worth, the monetary gain that profit represents may not translate into any cash
flow gains. What the servicing of debts owed to banks does is to destroy bank monetary
instruments, that is, bank liabilities.
While there is no cash flow gain for A, profit is extremely important for the viability of its business.
Indeed, the bank needs to meet its capital ratio and making a profit improves net worth. In addition,
capital is extremely important to allow any bank to further develop its credit service because it can
now create more promissory notes, given that it has more capital to protect its creditors.
Let us look at how the capital position of A evolved through time (to simplify the unweighted capital
ratio is calculated):
1‐ After it opened:
Bank A
Capital ratio = net worth/assets = $200/$200 = 100%
2‐ After it granted credit to #1:
Bank A
Capital ratio = $200/$300 = 66.7%
3‐ After it granted credit to α and made the payment to #1:
Bank A
Capital ratio = $200/$301 = 66.4%
4‐ After it received the mortgage service payment from #1:
Bank A
Building: $200 Net worth: $200.41
Capital ratio = $200.41/$300.73 = 66.64%
Until A receives the mortgage service payment, its capital position worsens as A grants more credit.
Profit allows a bank to restore its capital position and to further pursue the provision of credit
services. It also allows a bank to pay its own employees without further lowering its capital position.
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So if A has one employee (household #3) who receives a monthly salary of 20 cents, then the
following is recorded:
Bank A
Building: $200 Bank account of #3: $.2
Net worth: $200.21
Bank A pays #3 by typing a number on the computer. The capital ratio is 66.57%, still better than
the 66.4% that prevailed after A granted credit to α.
INTERBANK PAYMENTS, WITHDRAWALS, RESERVE

REQUIREMENTS, AND FEDERAL GOVERNMENT OPERATIONS:
THE ROLE OF RESERVES
Reserves are conspicuously absent from the previous discussions but banks do need reserves as
explained in Chapter 3. Reserves enter the picture with payment services (interbank payments),
retail portfolio services (withdrawals and deposits), the law (reserve requirements) and federal
government operations (taxes, government spending, and auctions of Treasuries), as well as
transactions with other Fed account holders (we will leave that aside).
Let us go back to the point where #1 pays #2 and now let us say that #2 has an account at bank B
instead of bank A. In that case, A instructs B to credit the account of #2 on behalf of A and A
acknowledges it is indebted to B:
Bank A
30‐year 5% mortgage note of #1: $100 Debt to bank B: $100

Bank B
Promissory note: $170 Bank account of #2: $100
Debt of bank A: $100 Other bank accounts: $50
Interbank debts are settled with reserves but there is a small problem: bank A does not have any
reserves! How could A get them right now? There are several possibilities:
1‐ Selling non‐strategic tradable assets to another bank or the Fed, say Treasuries: bank A
does not have any (the building is a strategic assets because A cannot operate without it,
the mortgage note of #1 is not tradable).
2‐ Getting reserves in the interbank market: borrow from a fed funds market participant with
excess funds (see Chapter 4).
3‐ Getting reserves from the Fed: swap promissory note with Fed via the Discount Window
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4‐ Recording an overnight overdraft on its reserve balance.
Over time there will be other means for A to get reserves because:
5‐ Other banks will ask A to make payments on their behalf to economic units with accounts
at A.
6‐ Some economic units will come to deposit Federal Reserve notes at A
7‐ The government will make payments to economic units with accounts at bank A (see case
1 above).
But right now bank A does not have the reserves so it needs to use sources 1 through 4. Recording
an overnight overdraft is the costliest solution because it requires the payment of very high
penalties.1 Going at the window is possible but, in normal times, there is a large stigma in the US
and it is costly. Borrowing reserves in the federal funds market is usually the preferred means to
get reserves. Assume that, first, Bank A uses the overdraft facility to pay Bank B:
Bank A
30‐year 5% mortgage note of #1: $100 Net worth: $200
Reserves: ‐$100
Building: $200
As long as the balance is negative only during the day, bank A does not have to pay any interest on
it. Before the end of the day, bank A borrows reserves in the interbank market from bank C:
Bank A
30‐year 5% mortgage note of #1: $100 Debt to bank C: $100
Reserve: $0 Net worth: $200
Building: $200
This debt is due the next morning and, at the end of the next day, bank A will need to borrow again
from bank C or another bank until it receives enough reserves from sources 5, 6, or 7. While it
borrows from other banks, it must pay the interest rate that prevails on the interbank market,
which, to simplify, is the Federal Funds rate target. Say bank A has to borrow every night for a
month, then its profit for the first month, assuming a FFR of 2%, is:
Profit = Interest received – interest paid = 0.41%*100 – 0.083%*100 = $0.327
As long as the FFR stays below the interest rate on the mortgage note, the bank is profitable. It is
not as profitable as it would have been had it not borrowed reserves, but it is profitable.
Beyond the need to make interbank payments, in some countries banks are also required to meet
some reserve requirements. Bank A has the following balance sheet if we continue from the last
balance sheet of the previous section:
Bank A
Building: $200 Bank account of #3: $.2
Net worth: $200.21
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The outstanding value of bank accounts is $104.93 so A now needs to get $10.49 of reserves on its
balance sheet if the reserve requirement ratio is 10%. Again the sources of reserves are 1 through
7 but if A needs them right away only sources 1‐3 are available for reserve requirement purpose (A
cannot have an overdraft in that case). The accounting implications and profit implications are the
same as just presented. For example if it borrows from bank B:
Bank A
Reserve: $10.49 Bank account of #3: $.2
Building: $200 Debt to bank B: $10.49
Net worth: $200.21
Beyond reserves needed for interbank debt settlements and reserve requirements, Chapter 6 also
looks at the need to get reserves to settle auctions of Treasuries and to pay taxes.
In all these cases (and the case of withdrawals of cash by account holders), the central bank always
accommodates the needs of the banking system to ensure that the payment system works properly
(economic units get paid and debts are settled), to ensure that banks follow the law (only the Fed
can provide the reserves that banks need to meet reserve requirements), and to ensure that non‐
bank economic units can get the cash they need (see Chapter 4). Banks are never constrained by
the quantity of reserves available, as long as a central bank merely targets an interest rate.
While the quantity of reserves does not constrain bank A in any way, the Fed does set a price on
the supply of reserves and this price impacts the profitability of bank A. As such, banks try to find
the cheapest sources of reserves, which usually means attracting and keeping depositors. Banks
also try to economize on reserve needs by net clearing interbank debts before settling them, among
other means.
Finally, banks do not try to hold more reserves than what they need. As shown in Chapter 3, in
normal times, most reserves are held because banks are required to do so. Demand for excess
reserves is very small and virtually zero. As shown in Chapter 4, banks have almost no incentive to
keep excess reserves because they can get any quantity of reserves they want at any time, because
they cannot do much with reserves, and because keeping excess reserves lowers ROA. Banks do
not proactively try to get reserves ahead of credit activities and, if credit activity slows, they slow
their demand for reserves and may want to avoid attracting new depositors to avoiding building
excess reserves. They may keep a slight quantity of excess reserves to avoid having to record an
overnight overdraft.
WHAT LIMITS THE ABILITY OF A BANK TO PROVIDE CREDIT

SERVICES?
Say that a bank really wants to increase aggressively its market share; this will tend to draw the
attention of regulators for several reasons:
1‐ In order to grow fast, the best strategy is to provide credit to economic units that other
banks do not want to qualify; for short non‐prime economic units. This can be done by
loosening credit standards faster than other banks and/or, as shown in Chapter 8, by
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offering to accept promissory notes with initial low monthly payments but upcoming large
payment shocks (hopefully refinancing will be possible down the road). Both cases lead to
a higher chance of default and so a higher probability of loss of net worth for a bank. The
decline in the quality of assets may attract the attention of regulators.
2‐ The proportion of liquid assets relative to illiquid assets declines faster than its peers.
3‐ Its interbank debt will balloon rapidly as payments made on behalf of the bank grow
quickly, which pushes down its profitability and so its ability to build its capital base.
4‐ The quality of its earnings declines. If a bank grants a lot of pay‐option mortgages to non‐
prime economic units, these units will usually only pay part of the interest due. However,
accrual accounting allows a bank to record the whole debt service due as received and to
record “phantom profits.” This may again attract the attention of regulators if accrual
interest income grows out of proportion (accrual accounting is not a problem per se and is
a convenient means to smooth business operations if used properly).
Basically, if a bank grows faster than the rest of the industry, its CAMELS rating tends to increase
relative to others and its interbank debt becomes unsustainable. Ultimately regulators will issue a
cease and desist order. Note that if a bank grows fast by providing credit to non‐prime clients at a
premium interest rate, then, given interbank debt, its short‐run profitability rises as leverage and
ROA rise. However, such a bank will then experience massive losses in the near future that will
lower rapidly profit and capital. As such, there are two limits to the monetary creation process
induced by the swapping of promissory notes:
‐ The credit standards: if A considers that #1 does not meet the 3Cs of credit analysis, A will
not accept #1 promissory note and so will not credit #1’s bank account (or #2’s).
‐ Regulation, but not through reserve requirements given that the Fed will provide all the
reserves needed to fulfill the requirements, but, rather, through regulatory elements that
impact CAMELS rating, that constrain the loosening of credit standards, and that limit the
types of assets banks can hold (see Chapter 9).
MOVING IN STEP
As noted in Chapter 8, there is safety in numbers. As long as banks grow in step, that is, as long as
they create bank accounts at about the same speed (and so acquire assets at the about same
speed), they may not attract the attention of regulators:
1‐ Interbank debt for a bank will not balloon out of control: requests to make payments on a
bank’s behalf are offset by requests to make payments of behalf of others banks.
2‐ Leverage may rise, at least until debt servicing starts, and liquidity may fall but all this occurs
at the industry level so no bank is singled out.
As long as underwriting is done properly, ultimately, banks will make a profit and capital will be
gained and so leverage will decline overtime. However, as explained in a Chapter 8, things may get
out of hand if most banks aggressively pursue growth in market shares and search for yield.
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LIMITS TO MONETARY CREATION BY THE CENTRAL BANK

AND PRIVATE BANKS
Finance is not a scarce resource as long as the government is monetarily sovereign. Banks and the
central bank can create an unlimited quantity of monetary instruments whenever they want. While
they can create an unlimited quantity of monetary instruments, they will not do so for the following
reasons:
- For the central bank: under normal circumstances (see Chapter 4), the main limit to the
reserve creation process is the need to maintain the overnight interbank rate positive,
which basically implies that the central bank must supply whatever banks demand; no
more, no less.
- For banks: core limits to the monetary creation process are profitability and regulatory
concerns.
I will finish this Chapter with Figure 10.4, which illustrates the points made above. The supply of
credit is slightly upward sloping and then becomes vertical as banks ration credit given a set of
credit standards. The supply slopes upward to reflect the fact that, at a point in time, as credit
grows, the creditworthiness of the remaining pool of acceptable economic units falls. A given set
of credit standards defines what a minimum level of creditworthiness is and anybody below that
level will not be granted credit (hence the vertical supply of credit). The demand for credit is
downward sloping but not very elastic. As explained in Chapter 5, demand for credit by businesses
is very insensitive to interest‐rate conditions.

Figure 10.4 The market for bank credit
TO GO FURTHER: A SIDE NOTE ON ALTERNATIVE VIEWS OF

BANKING: THE MONEY MULTIPLIER THEORY AND FINANCIAL
INTERMEDIATION.
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A now discredited view of monetary creation by banks argues that banks actively seek excess
reserves to be able to provide credit. The logic goes as follows with a 10% reserve requirement
ratio:
1‐ The central bank injects excess reserves by buying $100 worth Treasuries from bank A
2‐ Reserves do not earn any interest, so Bank A provides a credit of $100 to household #1 who
makes a $100 payment to households #2 at bank B. Bank B now has $100 of extra bank
account on its liability side and $100 of extra reserves on its asset side. Bank B has $90 of
excess reserves. It grants a credit of $90 to household #3 who pays $90 to household #4 at
bank C. Bank C has now $90 of extra reserves and has issued $90 of extra bank account so
excess reserves is $81, upon which Bank C provides $81 credit to household #5, etc. This
continues until there are no excess reserves left in the banking system.
3‐ The sum of bank accounts created is $100 by bank A, $90 by bank B, $81 by bank C, $72.9
by bank D, etc., which amounts to $1000: With $100 of excess reserves banks could create
$1000 of bank accounts.
4‐ Conclusion: bank credit is constrained by the quantity of excess reserves and the reserve
requirement ratio. Both can be used by the central bank to target the money supply and
ultimately inflation.
There are several issues with this view of how banks provide credit and so create monetary
instruments:
- Step 1 never happens under normal monetary policy set up (see Chapter 4): any unwanted
excess reserves are drained out of the banking system to prevent a fall of FFR to zero.
Chapter 3 notes that banks have very little need for reserves. The Volker experiment (see
Chapter 5) tried to move toward reserve targeting with the goal of targeting money supply,
but this was a failure.
- It is just not how banks operate (step 2): Banks are profit‐seeking institutions; they do not
wait for reserves to grant credit. They grant credit first and look for reserves afterwards, in
the same way a pizza shop prints coupons first and then make the pizzas as needed.
Flooding banks with reserves just reduces their ROA; it acts like a tax.
- Banks cannot force economic units to go into debt. Bank credit is demand‐driven so even if
banks have a lot of reserves that does not improve their ability to provide credit. Bank A
had to wait for #1 to show up before anything could happen. And while bank A could have
tried to entice #1 to come to the bank for financing, ultimately it is #1 who decides to take
a credit.
- Milton Friedman himself recognized the problem with this approach: “Given the monetary
policy of supporting a nearly fixed pattern of rates on government securities [during WWII],
the Federal Reserve System had no effective control over the quantity of high‐powered
money. It had to create whatever quantity was necessary to keep rates at that level. Though
it is convenient to describe the process as running from an increase in high‐powered money
to an increase in the stock of money through deposit‐currency and deposit‐reserve ratio,
the chain of influence in fact ran in the opposite direction—from the increase in the stock
of money consistent with the specified pattern of rates and other economic conditions to
the increment in high‐powered money required to produce that increase.” (Friedman and
Schwartz 1963, 566). There are two main problems with his view:
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- He seems to view the WWII experience as a special case instead of the general case:
a central bank always targets interest rates, at least the overnight interbank rate
and at least within a band (see Chapter 4).
- His theoretical position is untenable: if causality is known with certainty to be
reversed (money supply to reserves instead of reserves to money supply), then one
cannot proceed as if the opposite were true because “it is convenient.”
Another view of banking is that banks lend “other people’s money.” People save and deposit cash
in the bank, and the bank proceeds to lend the cash deposited. The Chapter touched on this above
but here are the problems:
• Banks do not lend the savings of households: banks do not temporarily take Paul’s funds
and given them to Pierre.
• Banks do not lend reserves to non‐banks: they do not look if Paul deposited enough cash
before granting credit to Pierre.
• Banks are not in the business of lending anything they have: Pierre does not temporarily
take cash from the bank, and, usually, does not give back cash to a bank when he services
his debt.
• Savers can deposit cash, but savers are not the source of cash, cash comes from the Fed.
And the Fed creates cash at the demand of banks so saving does not constraint credit.
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1‐ Banks are not money lenders because their monetary instruments are their liability not their
assets. One cannot lend one’s own debt.
2‐ Banks are promissory note dealers. They take non‐bank promissory notes and in exchange give
their own promissory notes. Contrary to most non‐bank promissory notes, bank promissory notes
are widely accepted and perfectly liquid.
3‐ If customers’ default on their promissory notes, the value of the assets of banks falls and they do
not earn a profit, so banks are very interested in making sure that customers are creditworthy.
4‐ Monetary creation by banks merely involves accounting entries. These accounting entries make
banks liable because their promissory notes are convertible in cash and can be used to paid debts
owed to banks.
5‐ The money supply does not fall from the sky; it involves a simultaneous debt creation. Banks
promise to pay customers, customers promise to pay banks. Banks accept their customers’
promissory note because banks think that their customers are involved in activities that are
profitable. As such, monetary creation moves in sync with the needs of the economic system; these
needs may or may not be related to production and the purchase of goods and services.
6‐ Banks are not bound by the quantity of reserves when they create monetary instruments. Their
monetary instruments are just promises to obtain reserves at the demand of the bearers. Banks do
not have to what they promise to deliver when they create monetary instruments. In addition, the
central bank provides reserves at the demand of solvent banks, so solvent banks never have to
worry about not getting the reserves they need when needed (at a price).
7‐ Monetary creation by banks is limited by regulatory and profitability concerns. They have to
comply with capital requirements and asset quality requirements, among others, and promissory
notes that have a poor creditworthiness negatively impact their profitability.
8‐ The money multiplier theory and the financial intermediary theory of banks are no longer seen
as valid by most of the academic community.

Keywords
Credit standards, promissory notes, overdraft, capital ratio, credit service, payment service, retail
portfolio services, net worth, interbank debt, withdrawals, reserves, money multiplier, credit line,
credit receivable/payable

Review Questions
Q1: When banks provide credit what is the accounting side of this operation?
Q2: If a customer comes to ask for a bank credit what will the bank do? Why?
Q3: When customers service their promissory notes what happens to the quantity of reserves held
by banks?
Q4: What do banks do with the cash that some customers deposit?
Q5: Why is bank credit not limited by the quantity of reserves? Why are savers irrelevant for credit
operations?
Q6: How does profit help to meet capital requirement? And why is that allowing banks to continue
to keep their business going?
Q7: What are the problems with the money multiplier theory at each stage of the argument? What
about the financial intermediation theory of banking?

145

Suggested readings
For an oldie but goodie video that explains correctly how banks grant advances watch
https://www.youtube.com/watch?v=OJMJ24U0Jp4#t=136
Following the failure of reserves injection to boost bank credit (or inflation), the Bank of England
published a paper that explains correctly banking operations and rejects other theories:
http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prerel
easemoneycreation.pdf
More advanced reading:
Carpenter, S. and Demiralp S. (2012) “Money, reserves, and the transmission of monetary policy:
Does the money multiplier exist?” Journal of Macroeconomics 34 (1): 59‐75.
Dow, S.C. (2006) “Endogenous money: Structuralist,” in P. Arestis and M.C. Sawyer (eds) A
Moore, B.J. (1988) Horizontalists and Verticalists: The Macroeconomics of Credit Money.
Cambridge: Cambridge University Press.
Keister, J. and McAndrews, J. (2009) “Why are banks holding so many excess reserves?” Federal
Reserve Bank of New York Current Issues in Economics and Finance 15 (8): 1‐10:
www.newyorkfed.org/research/current_issues/ci15‐8.pdf
Lavoie, M. (2006) “Endogenous money: Accomodationist,” in P. Arestis and M.C. Sawyer (eds) A
Wray, L. R. (1990) Money and Credit in Capitalist Economies: The Endogenous Money Approach,
Aldershot: Edward Elgar.
Wray, L. R. (2007) “Endogenous money: Structuralist and Horizontalist”
http://www.levyinstitute.org/pubs/wp_512.pdf

1 Federal Reserve’s policy on Overnight Overdrafts at http://www.federalreserve.gov/paymentsystems/oo_policy.htm
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CHAPTER 11:
Why economists disagree about how the financial system contributes to
economic prosperity
How the financial system can benefit, or be detrimental to, economic
prosperity
How different views about how money supply is created lead to different
understandings of how money supply can contribute to economic prosperity
What the role of monetary incentives is in influencing economic outcomes

CHAPTER 11: ECONOMIC GROWTH AND THE FINANCIAL SYSTEM
The previous Chapter concludes the study of banking operations. The next step is to incorporate
them into the analysis of macroeconomic issues and this Chapter begins the discussion of such
topics by focusing on economic growth.
Money is the life‐blood of capitalist enterprise and finance is about money now for money later. As
such, a well‐developed financial system is essential for economic activity in a capitalist economy.
The broader the range of promissory notes that can be issued, the more accommodative the
financial system is to the demands of the productive system. Households cannot fund the purchase
of a house with a credit card and there is no point in buying groceries with a 30‐year mortgage.
While all this may seem obvious, economists have been divided about the relevance of finance for
economic activity. This divide ultimately rests on different premises on how to do economics, which
John Maynard Keynes characterized as Real Exchange Economy versus Monetary Production
Economy.
Before I go further, a word of caution. Economists and national income accounts use the word
“investment” in a specific way. Investment means adding to the quantity of real assets, i.e. growing
productive capacities. One cannot invest in shares, bonds, and other financial assets but merely in
machines and raw materials (knowledge is also an area emphasized by economists). Portfolio
choice, which is usually what people have in mind when talking about (financial) investment, is not
the same thing as (physical) investment.
THE REAL EXCHANGE ECONOMY
MONEY SUPPLY IS A VEIL
Until at least the 1980s, most economists believed that finance is neutral, 1 i.e. irrelevant for
economic activity. The study of exchange within a barter economy with small independent
producers—think of farmers with their own plot of land—is regarded as a satisfactory proxy to
understand the basics of capitalism:
Despite the important role of enterprises and of money in our actual economy, and
despite the numerous and complex problems they raise, the central characteristic
of the market technique of achieving co‐ordination is fully displayed in the simple
exchange economy that contains neither enterprises nor money. (Friedman 1962,
13)
The point is to understand how market exchange helps economic units to manage the prevailing
natural scarcity of resources by allocating resources according to given sets of initial allocations,
preferences and techniques of production. Once this is understood, money supply can be added to
the analysis but it does not substantially change anything. It merely smooths exchange, is not
sought after for itself, and so does not influence allocation, production, and distribution. Capitalism
is equivalent to a barter economy with money. In addition, monetary instruments are
conceptualized as commodities used as medium of exchange. As such, a willingness to hoard
monetary instruments and to reduce spending on other things is merely changing the structure of
demand for goods and services; it does not change its level. As a consequence, the level of economic
activity is not impacted by monetary incentives and the willingness to hoard monetary instruments.
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Put in terms of the financial industry, one may think of financial markets and banks as institutions
used by economic units to borrow and lend current production; finance is a market for
intertemporal output:
It may be supposed in theory that the entrepreneur borrows these consumption
goods from the capitalists in kind, and then pays them out in kind in the shape of
wages and rents. At the end of the period of production he repays the loan out of
his own product, either directly or after exchanging it for other commodities. […] If
this procedure were adopted by all entrepreneurs who work with borrowed
capital, competition would bring about a certain rate of interest that would have
to be paid to the capitalists in the form of some commodity or other. […] Now if
money is loaned at this same rate of interest, it serves as nothing more than a cloak
to cover a procedure which, from the purely formal point of view, could have been
carried on equally well without it. (Wicksell 1898, 103‐104)
Assume a barter economy in which the only product is potatoes and in which workers and other
income earners are paid in potatoes. Some economic units may have too many potatoes for current
consumption, so they save potatoes. Potato savers can go into a market in which they lend their
potatoes to economic units who plant potatoes—the potato investors. The following year, there
will be more potatoes than what was planted, as each potato is a seed that can be used to produce
more potatoes, the marginal product of potatoes. This marginal product is at the foundation of the
interest rate earned by the potato savers; their reward is more potatoes in the future, which means
that interest and principal servicing creates an automatic demand for output (as did payment of
wages). Monetary considerations can be added to this story, but they do not add anything to the
understanding of what goes on in the financial industry. Money supply and other financial claims
are just claims on production, that is, the money supply is a mere medium of exchange.
Monetary considerations are irrelevant and “the objectives of agents that determine their actions
and plans do not depend on any nominal magnitudes. Agents care only about ‘real’ things, such as
goods […] leisure and effort” (Hahn 1982, 34). As such, economic units strive to get involved in the
most productive economic activities in order to produce as much as possible in relation to their
preferences. Markets are there to help them discover the most productive economic activities in
the most efficient way. This way of thinking goes back at least to 19th century Austrian economists
such as von Böhm‐Bawerk and Menger.
In many current macroeconomic models, this reasoning is simplified even further by getting rid of
any market and assuming a farmer who is both a saver and an investor (as well as
producer/consumer and employer/employee). He saves potatoes today to plant them. The amount
he saves (and so invests) depends on the reward received to be next year. The reward is the
marginal product of potatoes.
FINANCE AND THE ECONOMY
This understanding of finance is grafted to a specific theory of economic growth. Economic growth
is driven by “supply factors”, i.e. the growth rate of inputs: physical capital (“machines”) and labor.
Finance helps economic growth because the ability to invest (that is, to grow physical capital: Kt =
Kt‐1 + It‐1) depends on the ability to save and the point of finance is to allocate saving—saving drives
investment.
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Going back to the potato economy, in order to have more potatoes next year, one needs to save
more today. Say that if one plants a potato at year 0 one gets two potatoes at year 1. To get three
potatoes at year 2, one must not consume one and half potatoes at year 1. Of course, saving is
painful because one gets fewer potatoes to eat, so saving must be rewarded (one more potato next
year). The question becomes: is the reward worth the pain? The graphical way to represent all this
is the loanable funds market (Figure 11.1).

Figure 11.1 The loanable funds market
Economic units meet in a market to borrow and lend current output, “potatoes.” The higher the
interest rate provided to reward saving, the more saving there is, i.e. the more economic units
reduce their current consumption and supply potatoes to economic units who invest. The interest
rate needs to rise because each additional unit of saving is increasingly painful. The interest rate is
of course a physical reward, a real interest rate, more potatoes in the future. Savers/lenders are
not interested in monetary earnings so their credit standards are set in real terms.
The opposite goes on with the planters of potatoes/borrowers. The incentive to invest decreases
as the reward to pay out increases. The reason for that is found in the production process. As more
potatoes are planted, the nutritive quality of a given quantity of soil declines and so each additional
potato seed will produce fewer potatoes. As such, investors can afford to pay a smaller reward for
each additional potato that is invested. In technical terms, the marginal product of capital falls as
more capital is used in the production process given other inputs.
The government may come in the market to borrow real resources too:
The government's fundamental objective is to borrow a given amount of real
resources, not a given amount of money. (Friedman 1952, 690)
This leads to the well‐known “crowding out” effect (Figure 11.2). As government enters the
loanable funds market, the real interest rate rises and private investment declines. Assume a
market without a government that is at equilibrium (Figure 11.1). As the government comes to
borrow potatoes (Figure 11.2), it competes with the private sector for the current quantity of saved
potatoes. As in any other “well‐behaved” market, a higher demand for something increases the
150

price of that thing. This is the market to borrow potatoes, so the real interest rate (i/P) will rise until
the market finds a new equilibrium. A higher interest rate reduces the incentive to invest.
ΔI < 0

Figure 11.2 The crowding out effect
CONCLUSIONS
In the end, finance is a mere intermediary between savers and investors and what finance does is
to help barter intertemporal output. There are several conclusions one can draw from this view:
1‐ The amount of current investment is constrained by the amount of current output that has
been saved. To encourage more investment today, one must discourage present
consumption (that is, promote saving today), and saving allows the transfer of current
output through time: saving is just delayed consumption.
2‐ The whole point of finance is to allocate saving to the most deserving investment projects,
which are the ones who are involved in the most productive activities (the investment
projects with the highest marginal product).
3‐ Banks are just intermediaries between savers and investors: banks lend unconsumed
output on behalf of savers.
4‐ When government deficit spends, it discourages investment and so discourages the growth
of the economy. Government should avoid deficit spending.
5‐ While the financial system works with money, money is just a veil, a mere medium of
exchange to smooth market mechanisms. What is really going on is the borrowing and
lending of current output. Monetary payments generated by financial contracts are
irrelevant for the course of the economy because all contracts are real contracts, that is,
account for inflation or deflation to maintain purchasing power constant; Valorism prevails
(see Chapter 15)
6‐ The economy is always at full employment because saving is just delayed consumption, and
firms know this given that there is a market for intertemporal output (financial markets)
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that signals future consumption. As such, a decline in current consumption does not lead
firms to reduce their production. Instead, firms increase their productive capacities to
respond to the higher future demand for goods and services induced by the payment of
interest income.
7‐ Monetary results are driven by real results: nominal interest rates are driven by the
marginal product of capital and expected inflation, economic growth is driven by the
growth of inputs
In the end, finance and its monetary dealings do not matter. The real exchange economy
perspective has changed slightly since the early 1990s. What makes finance matter are market
imperfections. Finance can specialize in circumventing imperfections such as asymmetries of
information. In that case, finance can be rationed, which prevents the occurrence of the equilibrium
that would prevail under a perfectly competitive set up (fewer potatoes are saved and so
investment is lower than it would have been otherwise). Asymmetry of information can also
reinforce negative shocks on the economy and create financial crises (see Chapter 14).
THE MONETARY PRODUCTION ECONOMY
MONEY IS EVERYTHING
Some economists argue that capitalism is not merely a barter economy with money. Capitalism is
a monetary economy, that is, an economy in which allocation, production, and distribution are
influenced by monetary/nominal incentives. While economic units may adjust nominal rewards to
account for inflation and taxes, the nominal gains are not driven by underlying physical variables.
Instead, it is the other way around, nominal outcomes drive real outcomes.
As such, while the REE view sees limited or no role for the inclusion of monetary considerations in
its core theoretical framework, Keynes noted that this is at odds with the way capitalism functions:
The classical theory supposes that […] only an expectation of more product […] will
induce [an entrepreneur] to offer more employment. But in an entrepreneur
economy this is a wrong analysis of the nature of business calculation. An
entrepreneur is interested, not in the amount of product, but in the amount of
money which will fall to his share. He will increase his output if by so doing he
expects to increase his money profit, even though this profit represents a smaller
quantity of product than before. […] Thus the classical theory fails us at both ends,
so to speak, if we try to apply it to an entrepreneur economy. For it is not true that
the entrepreneur’s demand for labour depends on the share of the product which
will fall to the entrepreneur; and it is not true that the supply of labor depends on
the share of the product which will fall to labour. (Keynes 1933c (1979): 82–83)
Monetary considerations are crucial at the beginning and at the end of the economic process.
Businesses need monetary instruments to start the production process because employees and
sellers of raw material demand monetary payments. Businesses judge the relevance of an economic
activity—and so employ people in this activity—in relation to its ability to generate a large enough
monetary profit. Firms and their employees are not interested in consuming what they produce;
they are interested in selling their production for monetary gains. Going back to our potato farmer,
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his employees do not want to be paid in potatoes and the farmer is not merely interested in
producing potatoes. As such, even if an individual is highly motivated and highly experienced in
producing potatoes (his marginal product is very high), the individual will not be hired if it is
expected that the output he will produce cannot be sold at a high enough price. Indeed, while
lowering the price of potatoes may allow to sales more of them, deflation comes with its own
problems given the existence of debts that require fixed monetary payments (see Chapter 14).
Thus, monetary incentives have a strong influence on the level and organization of production.
Veblen made this point that by focusing on the difference between the engineer’s perspective and
the businessman’s perspective. From an engineer’s perspective, the goal is to produce as many
potatoes as possible to solve a physiological problem (hunger). As such, the goal is to find the most
efficient ways to produce an abundance of potatoes. From a businessman’s perspective, the only
thing that matters is that a monetary profit be generated. This may entail a sabotage of production
(leaving fields idle, letting potatoes rot) in order to maintain an artificial scarcity of potatoes.
Indeed, capitalist techniques of production are so productive that letting them loose would drive
the price of potatoes to zero. The supply of potatoes must be constrained. In addition, the demand
side must constantly be aroused to create new needs and wants because people do not have
naturally unlimited preferences. They get contented quickly unless invidious comparisons and
consumption habits are constantly stimulated through advertisement and other means. As such
scarcity is not a natural state; it is rather a requirement of an economy that is managed by capitalist
businesses.2 While abundance is possible, it is not a viable economic state for capitalism.
WHY MONETARY INCENTIVES MATTER? AND WHAT ARE OTHER

IMPLICATIONS?
Part of the answer is that banks are in the business of dealing with promissory notes that involve
monetary payments not in‐kind payments. Another has to do with state’s involvement in the
monetization of economies via the imposition of monetary dues.3 If one focuses on the role of
banks, the emphasis on monetary incentives is initiated at two stages of credit operations:
1‐ Banks judge ability to pay based on credit standards set in monetary terms (see Chapter 8):
a “normal” nominal debt service to monetary income, or “normal” nominal value of
collateral relative to bank advances, a “normal” nominal amount of liquid assets.
2‐ Debtors to a bank must make payments in monetary terms; they cannot pay banks with
potatoes.
Beyond the impact on incentives, bank operations have several important macroeconomic
implications:
1‐ Banks are not constrained by the level of current saving to grant credit. As noted in Chapter
10, banks are not in the business of lending anything they own. They do not lend other
people’s money, they do not lend reserves, and they do not lend potatoes on behalf of
savers; not even “as if.”
2‐ Servicing the debts due to banks does not create an automatic demand for current output:
payments to banks destroy monetary gains of non‐banks (see Chapter 10); that is it. Again
there are no savers behind banks asking for their potatoes back with interest (in potatoes).
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3‐ The expected demand for goods and services becomes key to economic activity. Firms
employ workers and use existing productive capacities only if they believe they will be able
to sell their product to make a high enough monetary gains.
4‐ In this type of economy, purchasing power concerns, even though relevant, are usually
outweighed by liquidity and solvency concerns. Economic agents are happier if their buying
power increases but, usually, economic agents pay a lot more attention to balance sheet
risks: “Liquidity is a fundamental recurring problem whenever people organize most of
their income receipt and payment activities on a forward money contractual basis. For real
world enterprises and households, the balancing of their checkbook inflows against
outflows to maintain liquidity is the most serious economic problem they face everyday of
their life.” (Davidson 2002: 78). Say that workers labor for one hour and earn a wage rate
of w = $5, and that they have to pay a debt commitment of CC = $2 each month to service
their debts, and assume that the general price level is P = $1. The real wage earned by
workers is w/P = 5 and the net wage of workers is w – CC = $3. Assume that workers get a
raise that doubles their wage so that w = $10, and that the general price level is also
doubled P = $2. The real wage is unchanged but the capacity of workers to meet their debt
commitments is much improved, w – CC = $8.
5‐ “Neutrality is […] restricted to the realm of ‘helicopter economics’” (Gale 1982: 15). In
capitalism, banks do not suddenly allocated bags of money with which individuals do not
know what to do; monetary creation by banks is endogenous to the economic process. In
addition, bank monetary creation comes with a simultaneous creation of a debt that
requires monetary payments (see Chapter 10). These monetary payments force economic
units to focus their attention on monetary considerations in their decision‐making process.
One can extend that point to monetary creation by the Treasury via fiscal policy. Automatic
stabilizers generate an endogenous monetary creation by the state that comes with a
simultaneous creation of net financial wealth (see Chapter 13). The state also imposes of
tax liabilities that involves future monetary payments (see Chapter 15).
6‐ Eliminating a market surplus by lowering output prices may not be a viable solution. Firms
must make sure that they can sell their output at a high enough price to generate a
monetary gain that allow them to pay their creditors and to realize a monetary profit. If
prices fall too much, a debt‐deflation occurs and market mechanisms promote financial
instability (falling prices lead to higher surpluses of output) (see Chapter 14).
7‐ Current saving does not incentivize current investment; saving discourages investment:
Firm will not invest if current spending (and so sales) is falling. Saving is not delayed
consumption because savers are not paid in kind. This is all the more so given that a fall in
sales leads to layoffs and so losses of income by employees.
Thus, economic growth is driven by demand conditions because of monetary considerations. As
such, expected sales are usually too low to justify employing everybody willing to work, so there is
a chronic underemployment of resources. In addition, there is no given state of the economy out
there (a “natural” growth rate) that is independent of current demand conditions. If productive
capacities become too heavily used, firms invest.
FINANCE AND THE ECONOMY
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The first phase of the economic process is to ask for credit at banks (the financing phase). The role
of banks is to judge if the expectations of firms are reasonable (see Chapter 8). Banks provide credit
to anybody who shows up and is deemed creditworthy. The standards of creditworthiness
accommodate a range of economic units (think economic units with different credit scores). Banks
charge more to less creditworthy economic units and ration credit (Figure 11.3).

Figure 11.3 The market for bank credit
Once they have been granted credit, businesses can buy the resources needed to start the
production required to meet the expected demand. Will that raise inflation? Chapter 12 notes that
if the growth of credit raises the output gap or pushes up the growth rate of unit cost of labor then
yes; however, usually the economy operates below full employment and can adjust to an increase
in the wage bill and spending.
The next step (the funding phase) is to sell what was produced. If expectations are correct or are
too pessimistic, then all output is sold; otherwise there are some inventories. Once they have sold
their product, firms repay their debts to banks. Once debts and expenses have been paid, firms
realize a profit, that is, their net worth rises. If monetary gains are not realized or are too small, a
business may ultimately close. Households also save some of the incomes they received, which
increases their net worth but reduces firms’ potential profits. Firms may try to capture some of the
income saved by households by issuing securities to fund the acquisition of assets and/or to
refinance their debts.
Thus, saving is the end result of the economic process not the beginning. It matters during the
funding phase but not the financing phase. At that time, like at any other time, interest rates are
driven by monetary conditions. One of these monetary conditions is the policy rate of the Fed,
which has a strong influence on all other nominal rates through cost and portfolio channels (and of
course, economic units do care about nominal interest rates because of their impact on liquidity
and solvency).4 As such, government deficit and investment may not have much of an impact on
interest rates.
BEYOND INCENTIVES: THE ROLE OF MACROECONOMIC FORCES
While monetary incentives are central to the dynamics at play in a capitalist economy, the MPE
approach also argues that one cannot use microeconomic analysis to draw conclusions about the
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economy as a whole. By relying on conclusions drawn from studying how economic units make
decisions in isolation (microeconomy), one misses the financial interdependences that exist among
economic units. When these financial interdependences are taken into account, they lead to
counterintuitive conclusions relative to personal experiences.
For example, at the individual level, income is independent of spending (a household does not earn
more if it shops more); however national income is not independent of spending. The more is spent,
the more is earned: GDP = C + I + G + NX. To simplify, the more people shop, the more people are
employed and so the greater the number of people who draw an income, and so the higher national
income. When someone spends, that creates incomes for others.
As such, saving cannot be the beginning of the economic process for an economy. Income allows
saving, but, at the macroeconomic level, spending creates income and so spending creates saving.
The Kalecki equation of profit more is a neat way to show that for business saving. National
accounting identities tell us that gross domestic product can be determined in three ways, two of
which are the income approach and the expenditure approach:
W + Z + UnD + TU ≡ C + I + G + NX
With U gross profit of firms, UnD the disposable net profit of firms (i.e. profit after accounting for
business income tax, distribution, and subsidies), W employees’ compensations, Z the gross non‐
wage incomes paid by firms (dividends, interests, rental income), and TU business income tax (tax
on profit), C the consumption level, I the level of investment, G the level of government spending,
and NX net exports. Accounting for net tax payments induced by taxes and transfer payments in all
sectors one gets:
WD + ZD + UnD ≡ C + I + DEF + NX
With the subscript D indicating disposable income (i.e. after tax and transfer payments), and DEF
the government budget deficit (including transfer payments). Subtracting WD + ZD from each side
and defining CU as the consumption out of disposable net profit one has:
UnD ≡ CU – SH + I + DEF + NX
With SH (= SW + SZ = (WD – CW) + (ZD – CZ)) the saving level of households (wage earners and rentiers).
Kalecki argues UnD is not under the control of firms, whereas variables on the right side
(expenditures) depend on discretionary choices, so the causality runs from spending to profit so:
UnD = CU – SH + I + DEF + NX
More spending leads to more business saving (profit).
Saving is clearly differentiated from investment contrary to the REE approach. Saving is an increase
in net worth; it is financial accumulation (see Chapter 1). It is different from physical accumulation,
which is investment. In the REE approach saving and investment are the same thing—physical
accumulation. For the MPE approach, this is not appropriate because capitalist economies are
monetary economies so income is earned in monetary form and saving is done in monetary form.
More importantly, at the macroeconomic level, it is not possible to transfer national income
through time by saving it. Indeed, given that national income is driven by spending, as thriftiness
goes up national income falls. The only way to transfer income through time is by investing it, i.e.
by buying goods and services for the purpose of maintaining or increasing productive capacities;
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however, not consuming (saving) depresses investment. If people consume fewer potatoes, there
is no incentive to plant the resulting excess inventory of potatoes to produce more potatoes.
CONCLUSIONS
Money supply is never neutral in a monetary production economy. The money supply is not only
used as a medium of exchange but also as a means of payment, so it must be present at every step
of the economic process for that process to work smoothly. Several conclusions can be drawn from
this view:
1‐ There is no saving constraint on the economic system. At the macroeconomic level, saving
is created by spending.
2‐ The financial system exists to provide financial resources to the most profitable economic
activities. These activities may or may not be productive, may or may not be efficient, may
or may not be useful; these criteria are not relevant to the decision to provide funds. The
financialization of the economy has pushed businesses away from the production of goods
and services (see Chapter 8).
3‐ Banks are not intermediaries: they do not lend on behalf of savers. A bank does not lend
anything to non‐bank, it is not a potato lender nor a money lender; it is a dealer in
promissory notes that require monetary payments (see Chapter 10).
4‐ When government increases deficit spending, it boosts sales and creates more monetary
income, which promotes economic activity unless the economy is at full employment (in
which case prices go up). There is no crowding out effect from government deficits because
finance is not a limited resource (it is not based on saving) and production is demand driven
(if government demands more output, more is produced).
5‐ Monetary incentives are crucial because debts owed to banks and government create a
need to have reliable streams of future monetary incomes; Nominalism prevails (see
Chapter 15).
6‐ The economy is usually below full employment because it usually goes against monetary
incentives to be at full employment (it is not profitable, or as profitable, in money terms).
Promoting thriftiness discourages economic activity because profit declines as sales
decline. A market for intertemporal output does not exist.
7‐ Real results are driven by monetary results: Anything that is monetarily profitable and
anyone who meets standards of creditworthiness will be financed. The financing stage
allows the creation of output, and the output is used potentially to increase productive
capacities during the funding stage.
Beyond all these implications, Chapter 13 shows that economic activity requires that at least one
economic sector goes into debt for economic activity to proceed.
CONCLUSION
The way one should include finance into economic analysis is subject to sharp divisions among
economists. These divisions ultimately rest of very different premises used to do economics. This
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division is old and can be found in debates between Malthus and Ricardo in the early part of the
19th century: “I cannot agree with Adam Smith, or with Mr. Malthus, that it is the nominal value of
goods, or their prices only, which enter into the consideration of the merchant” (Ricardo 1820
(1951): 26). These different premises lead to very different policy prescriptions that rest on a very
different understanding of how the financial system works with the rest of the economy. Chapters
15 and 16 shows that many of these differences can be boiled down to a different understanding
of the nature of monetary instruments: For the REE, monetary instruments are a mere commodity
and so demanding money is also demanding output; for MPE, monetary instruments are financial
instruments.
1‐ The economic profession can be divided according to the premises it uses regarding the role of
monetary incentives and monetary outcomes on the direction of economic activity. The real
exchange economy view argues that monetary aspects are irrelevant, except for imperfections, and
that capitalism can be understood without including monetary aspects. The monetary production
economic view argues that monetary aspects are crucial and must be included at the beginning, the
middle and the end of the analysis of capitalist economies.
2‐ In the real exchange economy, credit standards are set in real terms, finance is constrained by
the amount of output saved, and finance is about moving output through time by incentivizing
people not to consume. The economy is a giant market for current and future output and the role
of finance is to allocate output between the present and the future.
3‐ In the intertemporal market, if government borrows real resources then it removes access to
real resources by the private sector, which crowds out investment. There is a given size of output
and any use by one economic unit is at the expense of others.
4‐ Monetary instruments are a mere medium of exchange; they help to make transactions more
efficient but they do not alter the structure of transactions, which is determined by relative prices.
5‐ In the monetary production economy, credit standards are set in nominal terms, finance is not
constrained by saving of output or by saving by depositors of cash. There is no way to transfer real
output by saving it, i.e. by not consuming it. A decline in consumption depresses economic activity
so reduces current output and future output. The only way to transfer output through time is by
investing, but investment is not constrained by saving and is discouraged by thriftiness. Put
differently, the size of the pie is not fixed so more demand leads to more output; and if individuals
increase their thriftiness then sales fall and that discourages the expansion of productive capacities.
6‐ Given that monetary aspects are crucial in the monetary production view, the economy is
demand‐led not supply‐led. Sales drive production not the other way around, so a decline in sales
(higher saving) leads to a decline in production.
7‐ There are two phases of economic activity: the financing phase and the funding phase. The
former involves the financial sector in the production of output; the latter involves the financial
sector in the acquisition of output. Saving is created by income and income is financed by credit;
therefore, saving cannot exist before credit. Saving may have a role to play in the second phase by
reducing the demand for current output and by providing additional financial funds to acquire long‐
term assets.
7‐ This difference of opinion about how do to do economics is old and involves very different
paradigms.

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Keywords
Crowding out effect, intertemporal output, saving, investment, credit standards, demand‐led,
supply‐led, financing phase, funding phase

Review Questions
Q1: What is the crowding out effect and how does it work?
Q2: What are the arguments against the crowding out effect, both in terms of resources as well as
finance?
Q3: Why does saving not lead to a decline in economic activity in the real exchange economy? Why
does it do so in the monetary production economy?
Q4: What is the financing phase? How is finance involved in that phase? What about the funding
phase?
Q5: Does investment create saving or does saving create investment?
Q6: Is saving needed for banking or is it not?
Q7: Is economic activity demand driven or supply driven? How is that related to the views regarding
the role of finance in the economy?
Q8: According to John Maynard Keynes: “Dishoarding and credit expansion provides not an
alternative to increased saving, but a necessary preparation for it. It is the parent, not the twin, of
increased saving.” Explain that sentence by using the monetary production economy view.
Q9: In order to promote economic growth, should policymakers promote saving or should they
promote spending?
Q10: If economic units suddenly increase their willingness to hoard monetary instrument, will that
lower economic activity? Why? Why not?

Suggested readings
Chapter 1 of Capitalism and Freedom by Milton Friedman is a very clear and concise presentation
of the real exchange economy framework.
Dudley, D. (1980) “A Monetary Theory of Production: Keynes and the Institutionalists,” Journal of
Economic Issues 14 (2): 255‐273.
Dugger, W.M. and Peach, J.T. (2008) Economic Abundance: An Introduction, Armonk: M.E. Sharpe.
Keynes, J.M. (1933) “The characteristics of an entrepreneur economy,” reprinted in D.E. Moggridge
(ed.) (1979) The Collected Writings of John Maynard Keynes, vol. 29, 87‐101, London: Macmillan.

1 See Gertler, M. (1988) “Financial structure and aggregate economic activity: An overview,” Journal of Money, Credit and
Banking, 20 (3), Part 2: 559‐588.
2 See Galbraith’s Affluent Society, especially Chapters 10, 11 and 13.
3 Forstater, M. (2005) “Taxation and Primitive Accumulation: The Case of Colonial Africa.” In The Capitalist State and Its
Economy: Democracy in Socialism, Research in Political Economy, Volume 22, 51‐65.
4 Tymoigne, E. (2006) “Fisher's Theory of Interest Rates and the Notion of 'Real': A Critique,” Levy Economics Institute,
Working Paper No. 456 http://www.levyinstitute.org/publications/fisher‐theory‐of‐interest‐rates‐and‐the‐notion‐of‐real
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CHAPTER 12:
How economists are divided about what causes inflation
Why inflation occurs according to different approaches
What the policy implications are of the different views of inflation

CHAPTER 12: INFLATION
When inflation is mentioned, it is usually in relation to the cost of buying newly produced goods
and services for consumption purposes. Another type of inflation concerns asset prices, i.e. the
price of non‐producible commodities and old producible commodities. This Chapter does not study
asset‐price inflation, which concerns theories of interest rate. There are two broad ways to
categorize existing explanations of inflation (and deflation); monetary explanations and real
explanations (“real” means related to production). Below are two popular theories based on such
a categorization.
THE QUANTITY THEORY OF MONEY: MONETARY VIEW OF

INFLATION
The quantity theory of money (QTM) is a logical extension of the real exchange economy framework
presented in chapter 12. It starts with the identity MV ≡ PQ with M the money supply, V the velocity
of money (the speed at which the money supply circulates to complete all necessary transactions),
P the price level, and Q the quantity of output. The identity is a tautology; it just says that the
monetary value of transactions on goods and services (PQ) is equal the monetary value of financial
transactions needed to complete the transactions on goods and services. To get a theory of output
price (the QTM), one must make some assumptions about each variable and make a causal
argument. The QTM assumes that:
‐ H1: M is constant (or grows at a constant rate) and is controlled by the central bank through
a money multiplier (see Chapter 10).
‐ H2: V is constant (habits of payments are stable).
‐ H3: Q is constant at its full employment level (Qfe) or grows at its constant “natural” rate
(gQfe). Supply conditions (productive capacities) are supposed to be independent of the
demand conditions (spending on goods and services).
Given this set of hypotheses we have:
P = MV/Qfe
Or, in terms of growth rates (V is constant so its growth rate is zero):
gP = gM – gQfe
If the money supply grows faster than the natural rate of economic growth, there is some inflation
(gP > 0). If gM = 2% and gQfe = 1% then gP = 1%. If the central bank increases the growth rate of the
money supply, inflation rises by the same percentage points while the growth rate of production is
unchanged. Inflation has monetary origins.
The economic logic is the following in terms of price level. First, suppose some money falls into the
hands of economic units. How? Milton Friedman is famous for arguing that economists do not need
to care about how the money supply enters the economy; one can merely assume that it falls from
a helicopter. Following H1, one may say that the central bank injects reserves, which leads to a large
increase in the amount of bank credit.
So now economic units have additional monetary instruments. They could save them but H2 implies
that economic units have hoarded everything they wanted to hoard so economic units rush to
stores to spend. Given that the economy is at full employment, the only way the economic system
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can adjust to the large increase in the demand for goods and services is through an increase in

prices. Money is “neutral,” it does not impact production.
The main policy implication is that central banks are best suited to tackle inflationary problems,
while productive issues are best left to relative price adjustments via market mechanisms. The
central bank can manage output prices by targeting the quantity (growth rate) of reserves and by
setting the reserve requirement ratio. This will constrain the quantity (growth rate) of the money
supply and set a specific price level (inflation). Controlling inflation is an easy job; a central bank
just needs to decide what its inflation target is (gPT) and to determine what the natural growth rate
of the economy is (gQfe). If, for example, a central bank has an inflation target of gPT = 2% and the
natural growth rate of the economy is gQfe = 3%, the growth rate of the money supply should be gM
= 5%. Assuming a stable multiplier, this means that the growth rate of reserves should be 5%.
This argument has been extended to a central bank that targets an interest rate. Most central
bankers now recognize that monetary stimulus is not neutral in the short‐term, hence the ability to
fine‐tune the economy—that is, to make sure the economy is neither too hot (rising inflation) nor
too cold (rising unemployment)— through an interest‐rate policy. However, in the medium to long‐
run, the neutrality of money is argued to prevail, hence the importance of inflation targeting.
Central bankers can use that to guide their short‐run policy. Central banks should determine a
reference value for the growth of money supply (gM*). This value should be consistent with the
inflation target (gPT), the prevailing natural growth rate, and the existing trend of velocity (gV):
gM* = gPT + gQfe – gV
If gM > gM*, a central bank is too lax (i.e., its interest rate target should be higher) and inflation will
be above target in the medium term.
There are several issues with that approach that relate to the hypotheses made to reach the
conclusion, and to the causality at play:
‐ The money supply is not controlled in any way by the central bank. Not only does the money
multiplier theory not apply, but also the growth of the money supply is driven primarily by
the demand for bank credit by private economic units (banks cannot force feed credit to
economic units) and by government spending and taxing (see Chapter 10 and Chapter 6).
‐ Interest‐rate targeting has only a remote and uncertain effect on the growth of the money
supply, even more so on inflation (see Q.10 in Chapter 5).
‐ The economy is rarely at full employment so if the demand for goods and services increases
the supply of goods and services increases.
‐ Measuring the natural growth rate of the economy is actually difficult. More importantly,
the demand for goods and services and the supply of goods and services are not
independent factors. Demand matters even in the “long run.” 1 Greenspan put it nicely
during an FOMC meeting:
Let me just say very simply – this is really a repetition of what I’ve been
saying in the past – that we have all been brought up to a greater or lesser
extent on the presumption that the supply side is a very stable force. […]
In my judgment our models fail to account appropriately for the
interaction between the supply side and the demand side largely because
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historically it has not been necessary for them to do so. (Greenspan,
FOMC meeting, October 1999, pages 46–47)
‐ In terms of basic empirical evidence, the strong correlation between money supply and
price that one should expect were this theory to be correct does not exist, even in the long‐
run (Figures 11.1 and 11.2). While correlation improves as the length of time increases
(one‐year correlation is 0.55, five‐year correlation is 0.67, ten‐year correlation is 0.71), the
correlation is weaker than what the theory suggests.
‐ The fact that inflation and money supply growth are positively correlated does not tell us
the direction of causality. One may doubt that the causality goes from M to P given the
strong assumptions required for that to be the case. The next section will develop this
point.

Figure 12.1 Annual growth rate of CPI and of the money supply, percent
Sources: Bureau of Labor Statistics, Board of Governors of the Federal Reserve System.

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Figure 12.2 Five‐year growth rate of CPI and of the money supply, percent
Sources: Bureau of Labor Statistics, Board of Governors of the Federal Reserve System
INCOME DISTRIBUTION AND INFLATION: A NON‐MONETARY
VIEW OF INFLATION
Another theory of the price level starts with an identity grounded in macroeconomic accounting:
PQ ≡ W + U
This is the income approach to GDP. It says that nominal GDP (PQ) is the sum of all incomes. For
simplicity, there are only two incomes: wage bill (W) and gross profit (U). All of them are measured
before tax. Divide by Q on each side:
P ≡ W/Q + U/Q
W is equal to the product of the average nominal wage rate (w) and the number of hours of labor
(L): W = wL (for example, if w is $5 per hour and L is equal to 10 hours, then W is equal to $50).
Thus:
P ≡ wL/Q + U/Q
Q/L is the quantity of output per labor hour, the average productivity of labor (APL):
P ≡ w/APL + U/Q
w/APL is the unit cost of labor. U/Q is a macroeconomic mark‐up over the labor cost. To get to a
theory, the following assumptions are made:
‐ H1: the economy is usually not at full employment and Q (and economic growth) changes
with expected aggregate demand (this is Keynes’s theory of effective demand).
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‐ H2: w is set in a bargaining process that depends on the relative power of wage‐earners
(the conflict claim theory of distribution underlies this hypothesis)
‐ H3: U, the nominal level of aggregate profit, depends on aggregate demand (Kalecki’s
theory of profit underlies this hypothesis, see below)
‐ H4: APL moves with the needs of the economy and the state of the economy; it is procyclical
to the state of aggregate demand for goods and services.2 In general, in periods of labor‐
time scarcity gAPL goes up while, during an economic slowdown, gAPL goes down before
employees are laid off.
Thus:
P = w/APL + U/Q
The price level changes with changes in the unit cost of labor and the size of the macroeconomic
mark up. In terms of rates of growth:
gp ≈ (gw – gAPL)sW + (gU – gQ)sU
With sW and sU the shares of wages and profit in national income (sW + sU = 1). Thus, inflation has
two sources:
‐ Cost‐push inflation: the growth rate of the unit labor cost of labor (gw – gAPL) depends on
how fast nominal wage grows on average relative to the growth rate of the average
productivity of labor. The correlation between the unit cost of labor and inflation is very
strong both in the “short‐run” (0.82 for yearly growth rates) and “long‐run” (0.93 for five‐
year growth rates) (Figure 12.3).
‐ Demand‐pull inflation: U follows Kalecki’s equation of profit which states that the level of
profit in the economy is a function of aggregate demand (see Chapter 11). Thus, the term,
gU – gQ represents the pressures of aggregate demand on the economy; it is an output gap.
If gU (the growth of aggregate demand) goes up and gQ (the growth of aggregate supply) is
unchanged, then gP rises given everything else. However, to assume that gQ is constant is
not acceptable unless the economy is at full employment. Usually, a positive shock on
aggregate demand growth leads to a positive increase in aggregate supply growth because
the rate of utilization of productive capacities is below one (that is, less than 100%) even in
“the long run.”
Note that the money supply is absent from this equation. The money supply does not directly affect
output prices. Spending may impact inflation but it depends on the state of the economy.
One may note that the growth rate of wages is by itself not as relevant. It is its relation to the growth
rate of the average productivity of labor that matters. Time‐series data provides another insight
into the role of the unit cost of labor (Figure 12.4). From the mid‐1960s to the early 1980s, unit cost
of labor was a main source of high inflation. Nominal wage growth outpaced productivity growth;
both grew on average. The former was in the 5‐10% range whereas the latter was mostly in the 0‐
5% range. In the late 1960s, wage growth outpaced productivity growth because of workers’
strength in wage bargaining due to low unemployment and strong unions. The 1970s oil shocks
boosted inflation and workers tried to maintain their real wage (they failed) by demanding an
increase in nominal wages. This further reinforced inflation because productivity could not keep up
with wage demands. The internationalization of production processes and the decline in the power
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of unions have tamed the ability of wages to outpace productivity, even in periods of prolonged
economic growth.

Figure 12.3 Annual growth rate of unit cost of labor and growth rate of PCE, percent
Sources: Bureau of Economic Analysis, Board of Governors of the Federal Reserve System

Figure 12.4. Unit cost of labor growth rate and PCE inflation, percent
Sources: Bureau of Economic Analysis, Bureau of Labor Statistics
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When combined with the explanation of monetary creation presented in Chapter 10, this theory of
inflation provides an explanation of the correlation between price and money supply that involves
a reversed causality compared to the QTM. Higher costs of production and higher demand
pressures push up the price of goods and services, which increases the size of the bank advances
that economic units request: higher P (gP) leads to higher M (gM).
A broader point is that the growth of the money supply is not by itself inflationary because money
supply grows with the needs of the economic system; economic units are not suddenly allocated
bags of money supply with which they do not know what to do:
‐ Firms request bank credit to start production (pay workers, buy raw material) and repay
their bank debts (which destroys money supply) once production is sold: money supply
moves in part with the need of the productive system
‐ Federal government spending (that injects money supply) and taxing (that destroys money
supply) move automatically in a countercyclical fashion to tame inflationary pressures
(“automatic stabilizers”): during an expansion (a recession), the growth rate of government
spending falls (rises) and the growth rate of taxes rise (falls). In the US, most of the
automatic stabilizer effect comes from wild fluctuations in the growth rate of taxes (in a
recession economic units have less income so they are taxed less) (Figure 12.5).
So the money supply is not something that falls from the sky, its injection and destruction in relation
to the production process must be explained and the debts incurred by monetary creation must be
included in the analysis (See Chapter 10). If the economy is growing, money supply grows, if
economic units do not want to hold monetary instruments they may just use them to accelerate
the repayment of their bank debts.

Figure 12.5 Automatic stabilizers.
Source: Bureau of Economic Analysis.
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In terms of policy, the theory means that inflation is managed best by buffer‐stock policies and

income policies, or a combination of both such as a job‐guarantee program.3 Monetary policy does
not have much of a direct impact on inflation, and an increase in interest rates can contribute to
inflation through the cost and demand impacts of higher interest rates (see below and Chapter 5).
The role of a central bank is to preserve financial stability through the provision of a stable low cost
refinancing source and through regulation.
TO GO FURTHER: KALECKI EQUATION OF PROFIT, INTEREST

RATE AND INFLATION
For readers who want to know more, this section develops a few points. The income‐approach to
GDP can be developed further to account for rentiers’ income, which, to simplify, only comes from
the distribution of profit. Gross profit is the sum of net profit, non‐wage income distribution, and
taxes on profit:
PQ ≡ W + U ≡ W + Z + UnD + TU  P ≡ w/APL + Z/Q + UnD/Q + TU/Q
With U gross profit of firms, UnD the disposable net profit of firms (i.e. profit after accounting for
business income tax, distribution, and subsidies), W employees’ compensations, Z the gross non‐
wage incomes paid by firms (dividends, interests, rental income), and TU business income tax (tax
on profit). For small values of gQ and gAPL, we have:
gP ≈ (gw – gAPL)sW + (gZ – gQ)sZ + (gUnD – gQ)sUnD + (gTu – gQ)sTu
The assumptions are that gw results from a bargaining process between employees and firms. gZ
depends on monetary policy and the state of liquidity preference (Z depends on the level and
structure of interest rates). gAPL is procyclical to the state of the economy. gQ is determined by
expectations of monetary profits (Keynes’s effective demand). As shown below, gUnD is determined
by the Kalecki equation of monetary profit. Finally, the growth of profit taxes depends on the tax
structure and economic activity. For the sake of the argument, one can assume that national
income shares are constant and sum to one (sW + sZ + sUnD + sTu = 1).
Inflation can go up and down as gUnD, gw, gZ and gTu go up and down, but their effects will be
mitigated by changes in productivity growth and output growth. Only when the latter two are fixed
or sluggish relative to the former four can inflation permanently take place; this is a state of “true
inflation” to use Keynes’s terminology. One economic condition during which this can occur is full
employment, but this is not the only one. Prices may go up quickly because of, for example, an
uncontrolled wage‐price spiral induced by high expectation of inflation, competition between
unions for relative wage improvements, or a rise in costs not controlled by residents (e.g., an oil
shock for net oil‐importing countries). Rising interest rates also can promote inflation by raising
costs of production (Chapter 5 noted that FOMC members are aware of this inflationary channel).
This explanation of inflation does not discard the possibility of a monetary source of inflation, but
it requires that several conditions be met because the relation between money supply and inflation
is highly indirect. First, if funds are injected via portfolio transactions (swapping of non‐monetary
assets for monetary assets), output‐price inflation may occur only if desired stocks of monetary
assets are fulfilled, if receivers of monetary assets decide to spend their excess funds on existing
goods and services, and if the economy is in a sluggish state. Economic units may want to hoard
more, may use excess funds to buy financial assets (which would lower interest rates) and/or to
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repay their bank debts (which would lower the money supply), and the economy usually is able to
increase production when demand increases.
Second, if funds are injected into the private domestic sector via income transactions (e.g., wage
payments), inflation will occur only if the economy is slow to respond (so that UnD/Q increases). The
Kalecki equation of profit expresses this more formally. Chapter 11 showed that
UnD = CU – SH + I + DEF + NX
Thus:
gUnD = (gCusCu – gShsSh + gIsI + gGsG – gTsT + gXsX – gJsJ)/sTu
Where si is the share of variable i in national income (or GDP) which is assumed to be constant. As
the economy gets to full employment, any type of spending (public or private, consumption or
investment) will tend to be inflationary. Higher interest rates can contribute to demand‐pull
inflation if the growth of consumption by rentiers increases too fast as a result of higher interest
income.4 The inflationary tendencies can be mitigated by the growth rate of tax, the growth rate of
production, the growth rate of the average productivity of labor and the growth rate of saving.
1‐ The quantity theory of money asserts that inflation has monetary origins. The money supply
grows too fast relative to the productive capacities of the economy.
2‐ According to the QTM, the main role of a central bank is to keep inflation under control either
by targeting monetary aggregates through a money multiplier process (reserve targeting) or
through variations in the cost of reserves (FFR targeting). Modern proponents of that view work
the argument through a FFR‐targeting view.
3‐ According to some economists, the QTM makes some extreme hypotheses and has an inaccurate
understanding of the monetary creation process. The economy is usually not at full employment
and productive capacities are driven by demand conditions. The money supply is created and
destroyed according to the needs of the economic system. It is not something that suddenly drops
from the sky—and exogenously determined occurrence—that the system must find a way to
assimilate.
4‐ Some economists view the root of inflation in the conflict over the distribution of income. This
creates cost‐push and demand‐pull sources of inflation. As such, raising interest rates may be
inflationary.
5‐ According to that approach, the job of a central bank is to promote financial stability. Other tools
must be used to deal with inflation that have more fiscal aspects.

Keywords
Natural growth rate, velocity of money, unit labor cost, output gap, money multiplier, Kalecki
equation of profit, inflation, income distribution

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Review Questions
Q1: In the QTM, if the level of money supply suddenly rises what happens to the price level? What
is the economic logic behind that result? What if it is the growth rate of the money supply that rise?
Q2: If the central bank increases the growth rate of reserve what happens according to the quantity
theory of money?
Q3: What are the empirical and theoretical problems with the notion of natural growth rate?
Q4: What is the view of monetary creation underlying the quantity theory of money and how is that
at odd with the way money supply is actually injected in the economic system?
Q5: If wage rate grows faster than the unit cost of labor, what happens to inflation? What is the
economic logic behind that result?
Q6: If aggregate demand growth faster than aggregate supply, what are the means for the
economic system to adjust in the quantity theory and in the distribution theory?
Q7: Rising interest rates can be inflationary according to the distribution theory; why?

Suggested readings
Friedman, M. (1987) “The quantity theory of money,” in Eatwell, J., Milgate, M. and Newman, P
(eds) The New Palgrave: A Dictionary of Economics,. New York: Palgrave Macmillan.
Kalecki, M. (1971) “The determinants of profits,” in M. Kalecki (ed.) Selected Essays on the Dynamics
of the Capitalist Economy, 78–92, Cambridge: Cambridge University Press.
Lavoie, M. (2014) “Inflation theory,” chapter 8 Post‐Keynesian Economics: New Foundations.
Northampton: Edward Elgar
Rowthorn, R. (1977) “Conflict, inflation and money” Cambridge Journal of Economics 1 (3): 215‐
239.

1 See Chapter 6 of Marc Lavoie’s Post‐Keynesian Economics: New Foundations for a formal overview of the literature.
2 See Matias Vernango’s “Is labor productivity still pro‐cyclical? Okun's Law is still fine” at
http://nakedkeynesianism.blogspot.com/2015/03/is‐labor‐productivity‐still‐pro.html
3 See Bill Mitchell’s “What is a Job Guarantee?” at http://bilbo.economicoutlook.net/blog/?p=23719
4 See Scott Fullwiler’s “Functional Finance and the Debt Ratio—Part IV” at
http://neweconomicperspectives.org/2013/01/functional‐finance‐and‐the‐debt‐ratio‐part‐iv.html
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CHAPTER 13:
What balance sheet interrelations are
What the basic principles of national accounting are
Why not all sectors of the economy can be in surplus at the same time
Why a government deficit is sustainable as long as monetary sovereignty
prevails and other sectors want to net save
Why taking proactive actions to reduce the public debt is unnecessary and
counterproductive
How business cycles can be explained partially by looking at balance‐sheet
interrelations

CHAPTER 13: BALANCE‐SHEET INTERRELATIONS AND THE MACROECONOMY
Earlier Chapters have focused on the mechanics of a specific balance sheet, specifically that of the
central bank and of private banks. This Chapter looks at the balance‐sheet interrelations between
the three main macroeconomic sectors of an economy: the domestic private sector, the
government sector and the foreign sector. This macro view provides some important insights about
issues such as the public debt and deficit, policy goals that are more likely than others to be
achieved, the business cycle, among others.
A PRIMER ON CONSOLIDATION
The balance sheet of the domestic private sector puts together the balance sheets of all domestic
private economic units. This means that claims that these sectors have on each other are removed
(that is, cancel each other out) from the balance sheet of the domestic private sector. For example,
assume that the following two balance sheets exist
Households
Assets Liabilities and Capital
Bank accounts Mortgages
Foreign currency held by households Net worth of households
Real assets of households

Banks
Mortgages Bank accounts
Treasuries held by banks TT&Ls
Real assets of banks Net worth of banks
If they are consolidated we have as a first step:
Households + Banks
Bank accounts Mortgages
Foreign currency held by households Net worth of households
Real assets of households Bank accounts
Mortgages TT&Ls
Treasuries held by banks Net worth of banks
Real assets of banks
The terms in bold appear on both sides of the balance sheet and are eliminated in the consolidation
process so the balance sheet of households and banks is:
Households + Banks
Foreign currency held by households TT&Ls
Treasuries held by banks Net worth of households and banks
Real assets of households and banks
The only financial claims left are those issued to, and issued by, sectors of the economy other than
households and banks. Thus, the consolidation process eliminates some important financial
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interlinkages. This is fine as long as one is merely interested in looking at relationship between
sectors, but one should be mindful that this is a simplified picture that hides some important
aspects of the economy.
THE THREE SECTORS OF THE ECONOMY
The analysis of financial interlinkages among the three main sectors can be done by starting from
the National Income and Product Accounts (NIPA), but the derivation from the Financial Accounts
of the United States is more intuitive (the derivation from NIPA is done at the end of this Chapter).
The following is a quick refresher from Chapter 1. A balance sheet is an accounting document that
records what an economic unit owns (assets) and owes (liabilities) (Figure 13.1).
Financial Assets (FA) Financial Liabilities (FL)
Real Assets (RA) Net Worth (NW)
Figure 13.1 A basic balance sheet.
Financial assets are claims issued by other economic units and real assets are things that have been
produced. Financial liabilities are claims issued to other economic units. A balance sheet must
balance, that is, the following equality must hold all the time: FA + RA ≡ FL + NW. Or put diﬀerently:
NW ≡ NFW + RA
This means that the wealth of any economic sector comes from two sources, net financial wealth
(NFW = FA – FL) and real wealth (RA).
Each macroeconomic sector has a balance sheet (Figure 13.2). DP is the domestic private sector, G
is the government sector, F is the foreign sector also called the “rest of the world.” The government
sector includes all the levels of domestic government (local, state, federal) and the central bank.
While the Financial Accounts of the United States include the balance sheet of the central bank in
the domestic financial sector—the domestic financial sector includes domestic financial businesses
and monetary authority—, it is more relevant to include the central bank in the government sector
(see Chapter 6). The domestic private sector includes domestic households, domestic non‐profit
organizations, domestic financial businesses, domestic non‐financial businesses, and domestic
farms. The foreign sector includes anything else (foreign governments, foreign businesses, foreign
households, etc.). Note that the adjective “domestic” is always used for the reference country that
is studied. “Foreign” includes all other countries.
ADP LDP AG LG AF LF

FADP FLDP FAG FLG FAF FLF
RADP NWDP RAG NWG RAF NWF

Figure 13.2 Balance sheets of macroeconomic sectors
For every creditor there is a debtor, so if one adds together the claims of the creditors and the
debtors they must cancel out. For the world economy (all sectors consolidated together):
(FADP – FLDP) + (FAG – FLG) + (FAF – FLF) ≡ 0
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This implies that the sum of all net worth equals the sum of all real assets, that is, only real assets
are a source of wealth for the world economy (NW = RA):
(NWDP – RADP) + (NWG – RAG) + (NWF – RAF) ≡ 0
For a domestic economy (government and domestic private sectors are consolidated), there are
two sources of wealth: real wealth and net financial wealth obtained from the foreign sector. The
public debt is not a source of financial wealth (or poverty) for the domestic economy because it is
an asset for the domestic private sector but a debt of the domestic government. The domestic
money supply is not a source of financial wealth for the domestic economy because it is an asset of
a domestic holder and a liability of a domestic issuer.
Given that the previous identities hold in terms of levels at any point in time (aka “stocks”), they
also hold in terms of changes in levels over a period of time (aka “flows”):
Δ(FADP – FLDP) + Δ(FAG – FLG) + Δ(FAF – FLF) ≡ 0
And, knowing that the Financial Accounts defines saving as a change in net worth (S = ΔNW) and
investment as a change in real assets (I = ΔRA), it is also true that:
(SDP – IDP) + (SG – IG) + (SF – IF) ≡ 0
This last identity is similar to the NIPA identity (S – I) + (T – G) + CABF ≡ 0 (see below for some
differences). (S – I) and Δ(FA – FL) are both officially called “net lending”, one measured from the
capital account, (S – I), and the other measured from the financial accounts, Δ(FA – FL).
A few words on the way all this is sometimes presented by economists. Beware that economists
may change the name of these two items. (S – I) may be called “net saving” (which is different from
how the Financial Accounts define net saving) or “surplus” (if S > I) and “deficit” (if S < I), and Δ(FA
– FL) may be called “net financial accumulation” (NFA). Thus, we have:
NFADP + NFAG + NFAF ≡ 0
If an economic sector accumulates more claims on other sectors than the other sectors accumulate
claims on the economic sector in question, the economic sector records a positive net financial
accumulation, it is a net creditor (aka “net lender”) during the period—Δ(FA – FL) > 0. If the opposite
is true, the sector is a net debtor (aka “net borrower”) during the period. Finally, this identity is
sometimes rewritten as:
DPB + GB + FB ≡ 0
With DPB the domestic private balance, FB the foreign balance (the opposite of the domestic
current account balance), GB the government balance, and “balance” being measured either
through the capital accounts (net saving) or through the financial accounts (net financial
accumulation).
Finally one may note that given that NW – RA ≡ FA – FL, then:
(S – I) ≡ Δ(FA – FL)
The operations on goods and services are mirrored by financial operations. Thus, a deficit, or net
dissaving, is mirrored by a net financial disaccumulation; to spend more than what is earned one
must sell assets or go into debt. Similarly, a surplus, or net saving, is mirrored by a net financial
accumulation for the sector.
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No theory, behavioral equations and statements of causal relations, was used above to explain the
accounting identities (a bit of this is done below to examine the business cycle). The identities
simply state that a net injection of funds by a sector must be accumulated in another sector. Every
dollar must come from somewhere and must go somewhere.
SOME IMPORTANT IMPLICATIONS
They are many implications but the main one is that one must not study a sector in isolation.
Anything that a sector does has an impact on other sectors. When a forecast about the budgetary
trend of the government is made, the forecaster must recognize the implications for other sectors
to see if the forecast is realistic. This is usually not done. For example, the Congressional Budget
Office in the early 2000s expected the federal government’s surplus to continue to grow but
neglected to look at the implication in terms of the domestic private sector.1 A continuously rising
government surplus implies continuously rising domestic private deficit given the foreign balance,
which is not sustainable. Only the federal government of a monetarily sovereign government can
sustain permanent deficits (see Chapter 6). There are many other implications and uses of this
framework such as macroeconomic theory, the madness of fiscal austerity, among others. 2
POINT 1: THE BEGINNING OF THE ECONOMIC PROCESS REQUIRES

THAT SOMEONE GOES INTO DEBT.
Let us start with an economy in which nothing has been produced or acquired yet.
ADP LDP AG LG AF LF
FADP = 0 FLDP = 0 FAG = 0 FLG = 0 FAF = 0 FLF = 0
RADP = 0 NWDP = 0 RAG = 0 NWG = 0 RAF = 0 NWF = 0
Say that someone in the economy wants to build a house that costs $10 to build. In order for
domestic production to start, workers must be paid, raw material must be purchased (those had to
be produced first by the way).
If a private business is in charge of doing all this, it must obtain funds and Chapter 10 explains how
this is done. The balance sheet of the domestic private sector would look like this once the house
is built:
ADP LDP
RADP = 10 NWDP = 10
Consolidation eliminates the debt owed by the homebuilder to a bank, as well as wages and raw
material payments, because they are all internal to the sector. Once produced, if the house is
acquired by a domestic household for $11, the following is recorded at the macro level:
ADP LDP
RADP = 11 NWDP = 11
Again all this hides quite a few underlying financial transactions:
1‐ Households got a mortgage and paid the homebuilder who made a $1 profit
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2‐ Firm repaid its $10 debt with interest
3‐ House was transferred from firms’ balance sheet to household’s balance sheet.
The next period the process would start all over again. This time the firm may have some savings
from the previous period to finance part of the production.
If, instead, the government buys the house, it must first fund the purchase by using a promissory
note (FLG):
ADP LDP AG LG
FADP = 11 NWDP = 11 RAG = 11 FLG = 11
Spending by the government has allowed the domestic private sector to acquire a financial claim.
It is a claim on the government.
If a foreign economic unit buys the house and the housebuilder requires payment in US dollars,
there are several ways the payment can be done but all of them involve the foreign sector going
into debt in dollars. For example:
‐ The foreigner may ask for a bank advance in US dollars at a domestic bank
‐ The foreigner may write a check in a foreign currency (say euros) but when the domestic
bank of the housebuilder receives the check, it will send the check back to the foreign bank
of the buyer to request a dollar payment. The foreign bank will need to borrow US dollars
to settle its debt with the domestic bank.
Once the house is sold, the firm makes a $1 profit that it uses to pay interest, dividend and taxes.
What is left over is retained earnings, the saving of the firm. Households will also save some funds.
But none of that can occur unless someone goes into debt to start production. And for savings to
be bigger, debt must increase.
POINT 2: NOT ALL SECTORS CAN RECORD A SURPLUS AT THE SAME
TIME
It is quite straightforward to notice that not all sectors can be net creditors at the same time. At
least one sector must be a net debtor if another sector is a net creditor because for every creditor
there must be a debtor. Most of the time, the domestic private sector is in surplus and the
government sector is in deficit (Figure 13.3, Figures 13.4). From 2000 to 2010, New Zealand was a
particularly odd case where the private sector was in deficit while government and foreign sectors
were in surplus. To simplify, let us assume that NFAF = 0, therefore:
NFADP ≡ ‐ NFAG
That is, in a closed economy, for the private domestic sector (households and private companies)
to be able to record a surplus (NFADP > 0), the government must run a fiscal deficit (NFAG < 0).
Put differently, when the government spends, it injects funds into the economy, and when it taxes
it withdraws funds from the economy (see Chapter 6). If the government spends more than what
it taxes, there is a net injection of funds by the government in the economy and this net injection
must be accumulated somewhere. In the simple case, it is the private domestic sector that must
accumulate the funds injected.
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Of course, the reverse logic applies too. When the private sector deficit spends, it injects a net
quantity of funds into the economy that can only go to the government. This allows the government
to run a surplus. A powerful consequence of this simple accounting rule is that a policy that aims at
achieving a government surplus implies, in a closed economy, that this policy aims at achieving a
domestic private sector deficit.
One way to avoid this is to try to achieve a domestic current account surplus, in which case, a
country can achieve domestic surpluses across the board—let us call that the “golden state.” The
green area on Figure 13.4b shows how small the golden state is relative to all other possibilities.
Among OECD countries, it has been achieved mainly by northern European countries during the
first decade of the new millennium (Figures 13.4b and Figure 13.4c). The Great Recession has led
most government to deficit spend and only Norway has been able to maintain the golden state
(Figure 13.4d).
This state is difficult to achieve because a domestic current account surplus means that the foreign
sector records a current account deficit (FB < 0). Again, not all sectors can be in surplus at the same
time because for every net exporter (and/or net foreign income earner) there must be at least one
net importer (and/or at least one net foreign income payer). Thus, for a domestic economy to
achieve the golden state on a regular basis, there must be at least one foreign country that is willing
to deficit spend vis‐à‐vis the domestic economy. This is hardly possible to sustain given that
countries strive to reach current account surplus most of the time.
More importantly, the golden state is not achievable at the world level. If all economies try to
achieve a current account surplus, the best they can achieve is a balanced current account (FB = 0),
which brings us back to the identity:
NFADP ≡ ‐ NFAG
Ultimately policy makers should confine themselves to trying to manage what goes on in their
domestic economy. If a country is lucky, developments in the rest of the world may ultimately allow
that country to reach the golden state; but basing policy choices on the goal of reaching the golden
state is a very long shot. In addition, policies that aim at achieving the golden state limit the ability
of domestic sectors to deficit spend, which constrains the ability of the domestic economy to grow.
Indeed, the goal becomes to constraint domestic spending by curtailing wage growth, by curtailing
government spending and by raising taxes. This keeps costs down (and so keeps the price of exports
low to attract foreign buyers) and limits imports (a growing domestic spending usually requires
more imports and so makes it difficult to reach a domestic current account surplus).
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Figure 13.3 Net financial accumulation in the United States, percent of GDP.

Figure 13.4a Sectoral balances, an international perspective, 1995‐2000 average, Percent of GDP
Source: OECD

178


Figure 13.4b 2000‐2005 average
Source: OECD

Figure 13.4c 2005‐2010 averages.

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Figures 13.4d 2010‐2014 averages
Note: 2010‐1015 average for Italy, Norway, Sweden and the UK
POINT 3: PUBLIC DEBT AND DOMESTIC PRIVATE NET WEALTH
The public debt of the United States is the face value of outstanding U.S. Treasury securities. It

includes both marketable (T‐bills, T‐notes, T‐bonds, TIPSs, and a few others) and non‐marketable
securities (United States notes, gold certificates, silver certificates, U.S. savings bonds, Treasury
demand deposits issued to States and Local Gov., all sorts of government account series securities
held by Deposit Funds).
In the early 2000s, the expectation of the day was that fiscal surpluses would continue to go on and
rise even more.3 Figure 13.5 shows the projected path of the public debt and the monetary base.
What are the implications of such a trend of the public debt?
To simplify the analysis, assume that: 1‐ the government sector only includes the federal Treasury
and the central bank 2‐ at the moment the only liability of the government is Treasuries (no central
bank liability is outstanding) 3‐ a closed economy (no foreign sector) 4‐ the following balance sheets
prevail:
ADP LDP
FADP (Treasuries): $100 FLDP (tax receivables): $50
RADP: $350 NWDP: $400

AG LG
FAG (tax receivables): $50 FLG (Treasuries): $100
RAG: $1150 NWG: 1100

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Figure 13.5 Public debt and monetary base.
Source: Marshall’s Origins of the Use of Treasury Debt in Open Market Operations: Lessons for
the Present
Now the Treasury wants to eliminate all its financial liabilities: no more public debt! What are the
means to do so?
‐ Case 1: Let Treasuries mature and do not repay holders of Treasuries: 100% tax on principal
=> FADP = 0, the domestic private sector losses all its financial assets.
ADP LDP
FADP: $0 FLDP (tax receivables): $50
RADP: $350 NWDP: $300
‐ Case 2: Switch to a Treasury’s financial instrument not considered a liability (Coins are
treated as equity by the Federal Accounting Standards Advisory Board):
ADP LDP
FADP (Coins): $100 FLDP (tax receivables): $50
RADP: $350 NWDP: $400

AG LG
FAG (tax receivables): $50 FLG: $0
RAG: $1150 NWG: 1200
‐ Case 3: Switch to another liability of the government that is not included in the public debt:
repay with Federal Reserve’s liabilities:

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ADP LDP
FADP (Reserves): $100 FLDP (tax receivables): $50
RADP: $350 NWDP: $400

AG LG
FAG (tax receivables): $50 FLG (reserves): $100
RAG: $1150 NWG: 1100
All these cases are detrimental to the domestic private sector because they remove a default‐free,
liquid, interest earning security from the balance sheet—Treasuries. Treasuries are essential to
create wealth in the domestic private sector, to meet capital requirements, to earn interest income
in a safe way, and to access the refinancing channels of the central bank. So be careful what you
wish for when arguing for repaying the public debt.
POINT 4: BUSINESS CYCLE AND SECTORAL BALANCES
One can get a partial understanding of the business cycle just by studying the interactions between
the three balances. First, one may note that usually all three sectors wish to be in surplus:
‐ Domestic private sector needs to record a surplus to avoid bankruptcy.
‐ State and local governments need to record a surplus to avoid bankruptcy.
‐ Federal government
o strives to be in surplus to show that government is fiscally responsible like other
domestic sectors.
o tends toward a surplus during an expansion because of the automatic stabilizers.
‐ Foreign sector: Political and financial stability reasons to reach a surplus.
Of course it is not actually possible for all of them to be in surplus at the same time, but all of them
usually want to be in a surplus at the same time.
Start with a situation where the non‐government sector (NG is the consolidation of DP and F) is at
the surplus it desires (NGBd):
‐ Step 1: there is a growing economy with NGB = NGBd > 0: Non‐government sector net saves
what it desires. In that case it must be true that GB < 0, the government is in deficit.
‐ Step 2: Government wants to be in surplus (GBd > 0). In a growing economy, automatic
stabilizers lower the deficit of the government, which is what the government wants. But,
if the government is dissatisfied with the pace of return toward a surplus, it may implement
austerity policies that raise taxes (T) and/or lower spending (G) (“the country must live
within its means”), which compounds the effect of automatic stabilizers. Thus ∆GB > 0 and
so ∆NGB < 0.
‐ Step 3: NGB < NGBd so the non‐government sector tries to find ways to increase its net
financial accumulation:
o If DPB < DPBd : consumption and investment decline
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o If FB < FBd: Domestic exports decline (i.e. foreign imports decline)
‐ Step 4: Decline in non‐government spending (C, I, X), together with the decline in
government spending (G), lead to a decline in aggregate income (GDP = C + I + G + NX). The
decline in aggregate income leads to an automatic rise in G and an automatic decline in T,
so the government balance falls (∆GB < 0). Income stabilizes.
‐ Step 5: the fall in the government balance leads to a rise of the non‐government balance
(∆NGB > 0) until NGB = NGBd. Back to step 1.
The only two ways to get a short‐term stationary state (that is, a situation where the level of
aggregate income does not change) are:
‐ Way 1: For GBd to be negative, i.e. the government is willing to be in deficit, and the deficit
equals the equilibrium deficit level (GB*). The equilibrium deficit level is the one compatible
with the desired net saving of the non‐government sector: GB* = NGBd. This is a viable
solution for a monetarily sovereign government, but politicians are reluctant to argue for a
permanent fiscal deficit given the lack of understanding of how a monetarily sovereign
government operates by the general population, politicians and most economists.
Bankruptcy, accelerating inflation, and bond vigilantes are usually invoked, although none
of them are relevant (See Chapter 6).
‐ Way 2: For NGBd to be negative:
o DPBd negative: this did happen in the late 1990s and early 2000s in the United
States (Figure 13.3), which made GB > 0 possible. Australia, New Zealand and some
European countries also have recorded a negative domestic private balance
(Figures 13.4a, 13.4b, and 13.4c). However, domestic private sector in deficit is not
sustainable because it implies, ultimately, Ponzi finance (see Chapter 14). The Great
Recession led to massive government deficits that allowed the domestic private
sector to reach a positive net saving in all OECD countries on record (Figure 13.4d).
o FBd negative (desired negative current account balance by foreigners so domestic
current account is positive and large enough to fulfill the desired net saving of the
government and domestic private sector): A negative FB can be tolerated by a
foreign sector if it is a developing country, or if the foreign country understands the
need to provide the international reserve currency to satisfy the needs of the rest
of the world. However:
 If a country needs to deficit spend vis‐a‐vis the rest of the world, it means
that either the domestic private sector or the government do so, or both.
If the domestic private sector does it, it is unstable, if the government does
it, it depends on the denomination of the debt (if in domestic currency, no
problem).
 For the country supplying the international reserve currency, negative
domestic CAB is sustainable only if the currency in unconvertible. If the
currency is convertible, then the Triffin dilemma holds. The dilemma is that
the country must have a deficit in its current account balance in order to
supply the currency that the rest of the world needs, but the country faces
threats of conversion demands as the supply of reserve currency grows
among other countries.
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CONCLUSION
The macroeconomic sectoral balance identity shows that some desires are not compatible or
extremely hard to achieve. As such, regardless of the number of economic adjustment—
devaluation, change in interest rate, aggregate income fluctuation, etc.—some desires can never
be achieved and it is highly destructive to continue policies that aim at achieving incompatible
desires. It is best to set policy goals and desires that are compatible with accounting rules and to
be aware that:
- One’s surplus is someone else’s deficit
- One’s saving is someone else’s dissaving
- One’s export is someone else’s import
- One’s spending is someone else’s income
- One’s financial asset is someone else’s debt
- One’s credit is someone else’s debit
Accounting rules can be combined with insights from the way monetary systems work to draw some
important conclusions:
• Private domestic sector should avoid being a net debtor because it tends to lead to financial
instability (see Chapter 14)
• A monetarily sovereign federal government usually needs to be in deficit, unless a domestic
current account balance can be achieved, because such a government is always able to
service debts denominated in its unit of account.
• Some economies need to be net importers:
- If they have limited economic development and resources. In that case, direct
foreign aid instead of private lending is the way to go.
- If they provide the international currency (United States today). In that case, the
rest of the world wants to net save in that currency and so the currency‐issuing
country must record a current account deficit.
• Given that some countries need to be net importers, others need to be net exporters: there
may be a need to clear debt overtime if it accumulates too fast, and to set the interest rate
low relative to growth.
TO GO FURTHER: SECTOR BALANCES FROM THE PERSPECTIVE
OF THE NATIONAL INCOME AND PRODUCT ACCOUNTS
At the aggregate level, the National Income and Product Accounts (NIPA) managed by the Bureau
of Economic Analysis records all economic operations on goods and services. NIPA shows us that
the expenditure approach to gross domestic product (GDP) holds as a matter of accounting:
GDP ≡ C + I + G + NX
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The gross domestic product is the sum of all final expenditures on goods and services, including
domestic private final consumption (C), domestic private investment (I), government spending on
goods and services (G), and net exports (NX). We also know that the income approach to GDP holds
as a matter of accounting:
GDP ≡ YD + T
That is, with minor discrepancies, the gross domestic product is the sum of all gross incomes, or,
stated alternatively, the sum of all domestic disposable incomes (YD)—wages, profits, interest and
rent—and the amount of overall taxes (net of transfers) on income and production (T). This means
that:
YD + T ≡ C + I + G + NX
We also know that, when accounting for international income sources, the U.S. International
Transactions Accounts (USITA) (that accounts for the relation between the United States and the
rest of the world) tells us that:
CABUS ≡ NX + NRA
The current account balance (CAB) is the sum of the trade balance (net exports) and net revenue
from abroad (NRA) (net of unilateral current transfers).
If one combines the NIPA and USITA and now includes in T the taxes earned on foreign income
(NRAD is disposable net revenues from abroad) we get the following:
YD + NRAD + T ≡ C + I + G + CABUS
We also know that, in the NIPA, aggregate saving (S) is defined as the difference between disposable
income and consumption, S ≡ YD + NRAD – C, therefore:
(S – I) + (T – G) – CABUS ≡ 0
Or, given that for every net exporter there is a net importer (CABF = ‐CABUS):
(S – I) + (T – G) + CABF ≡ 0
This last identity is similar to the one obtained from the Financial Accounts except that it is derived
from GDP and so is merely concerned with current output (that is, newly produced goods and
services).
TO GO EVEN FURTHER: NIPA AND FA DEFINITIONS OF

SAVING
The National Income and Product Accounts (NIPA) definition of saving is different from that of
Financial Accounts (FA) and they are compatible only under specific conditions. 4 NIPA saving is
defined as unconsumed income. For example, households saving is defined as disposable income
minus spending on consumption goods: S = YD – C. FA saving is defined as the increase in net wealth:
S = ΔNW.
This difference reflects the different purpose of each account. NIPA is focused on measuring current
economic activity with gross domestic product (GDP) at the core of the analysis. So, for example,
say that an economy produces apples and some of the apples are used to make apple tarts. GDP is
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the dollar value of apples left for final consumption and the dollar value of apple tarts. This is the
production for the year. NIPA saving is the value of whatever income was paid less purchases of
apple tarts and apples for final consumption.
FA is broader in its perspective, given that it aims at measuring what goes on in balance sheets.
Balance sheets are impacted by many more things than just current production because, among
others:
1‐ They contain real assets that were previously produced
2‐ They contain financial assets
3‐ The value of assets changes overtime because of changes in prices (capital gains/losses)
instead of addition to the stock of assets via production or issuance of new securities.
4‐ Some consumption goods are durable.
5‐ Liabilities require principal repayment.
For example, say that a household owns nothing and owes nothing. The household starts to work
and gets paid $10 so its balance sheet is now:
AH LH
FAH (bank account): $10 NWH: $10
Saving is equal to $10 according to FA because net wealth increased by $10, and here NIPA would
also agree given that nothing has been consumed. Now the household goes to the store and buys
$2 worth of apples and that is the only spending for the month:
AH LH
FAH (bank account): $8 NWDP: $10
Apples: $2
According to NIPA, saving is $8 whereas it is still $10 for FA. Once the household eats the apples,
the definitions give the same value again:
AH LH
FADP (bank account): $8 NWDP: $8
The source of difference in this case is that NIPA measures consumption by the amount of spending
done for that purpose (buying the apple at the store). Consumption in a balance sheet means that
the value of real asset falls (the apples have been eaten). Recently the Bureau of Economic Analysis
created the Integrated Macroeconomic Accounts that aim at integrating the two approaches into
one single accounting framework.
Kenneth Boulding5 developed an entire framework based on definitions consistent with balance
sheets. A clear difference is made between “spending” (using funds to buy the apples: real assets
go up and financial assets fall) and “consuming” (eating the apples: real assets depreciate).
Developments in economic theory have also aimed at making sure that the accounting of a model
is tight. Stock‐flow consistent macroeconomic modeling ensures that a model accounts for all the
interdependences between the sectors that the model contains.6
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1‐ Balance sheets of different economic sectors are interrelated by a web of financial claims.
Economic units owe and own claims on each other.
2‐ In order for an economic sector to accumulate financial instruments, i.e. to record a surplus,
another sector must issue some financial instruments, i.e. record a deficit. There cannot be a
creditor without a debtor.
3‐ If the government sector wants to reach a surplus, this necessarily means that it effectively
desires that at least one sector be in deficit. Unless the foreign sector is willing to deficit spend, the
previous statement means that the domestic private sector must deficit spend.
4‐ A fiscal surplus leads to a decline in the public debt, which means that other sectors lose Treasury
securities. Treasury securities are central to maintaining the liquidity and profitability of other
economic units.
4‐ Deficit spending by the private sector is not sustainable because it means that the sector is
continuously dishoarding assets or going into debt. Both ultimately lead to insolvency.
5‐ A business cycle can be explained in part by the fact that all sectors try to reach a surplus at the
same time.
6‐ In order to start the economic process, one sector must deficit spend.

Keywords
Public debt, surplus/deficit, net financial accumulation/disaccumulation, net saving/disaving, net
lending/borrowing, golden state, Triffin dilemma

Review Questions
Q1: If the government runs a surplus, what does that usually mean for the domestic private sector?
Q2: If the government runs a deficit, under what condition is it sustainable financially?
Q3: What are the impacts of a government surplus on the cash flow and net saving of the domestic
private sector?
Q4: Why does a government surplus tend to create the condition for a recession? And why does a
deficit tend to promote prosperity?
Q5: What do national accounts tell us about the feasibility of a budgetary policy that aims at
achieving a surplus?
Q6: If a sector records a deficit what does it imply for its net financial accumulation? What happens
to financial assets given liabilities? What happens to liabilities given financial assets? Find concrete
example of what would happen if you recorded a deficit?
Q7: Why is the golden state of a fiscal surplus, domestic private sector surplus, and domestic
current account surplus hard to achieve?

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Suggested readings
Papadimitriou D., Chilcote, E. and Zezza, G. (2006) “Are housing prices, household debt, and growth
sustainable?,” Levy Economics Institute, Strategic Analysis, January.
Papadimitriou, D., Shaik A., dos Santos, C. and Zezza, G. (2002) “Is personal income sustainable?,”
Levy Economics Institute, Strategic Analysis, November.
Godley, W. and Wray, L.R. (1999) “Can Goldilocks survive?,” Levy Economics Institute, Policy Note
No. 1999/4.
Godley, W. and Lavoie, M. (2007) Monetary Economics: An Integrated Approach to Credit, Money,
Income, Production and Wealth, New York: Palgrave Macmillan.
Ritter, L.S. (1963) “An exposition of the structure of the flow‐of‐funds accounts,” Journal of Finance,
18 (2): 219‐230.

Database Exploration
How to retrieve time series data about the sectoral balance? There are three ways to do this; NIPA,
IMA, and FA. All methods are presented (Tip: Summing across sector at a point in time must give
you a value of zero, unless there is a statistical discrepancy, otherwise you did not select all the
necessary sectors)
With the Financial Accounts
Step 1: Go to http://www.federalreserve.gov/releases/z1/ (Note: Series Z.1 is a complicated and
constantly changing dataset)
Step 2: Click on “Data download program.”
Step 3: Select Category A. “Build your package.”
Step 4: Select “FA Flow, SA”
Step 5: Select “Rest of the world (S2)”, “General government (S13)” and “Private domestic sectors”
Step 6: Select “Net lending (+) or borrowing (‐) (capital account)” (Note: net lending data from
financial account contains a large statistical discrepancy)
Step 7: Select frequency and others and then download

With the National Income and Product Accounts
Step 1: Go to http://www.bea.gov/iTable/index_nipa.cfm and click “Begin using the data…”
Step 2: Click on “Section 5” and then “Table 5.1 Saving and Investment by Sector”
Step 3: Select “Net lending or net borrowing” for the domestic private sector and for the
government. The discrepancy will be the result of statistical discrepancies and the rest of the world.

With the Integrated Macroeconomic Accounts
Step 1: Go to http://www.bea.gov/national/nipaweb/Ni_FedBeaSna/Index.asp
Step 2: Select “Table S.2.a Selected Aggregates for Total Economy and Sectors (A)”
Step 3: Select “Net lending (+) or net borrowing (‐)” either from the capital account of the financial
account. The capital account has less statistical discrepancy.

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1 Papadimitriou, D., Shaik A., dos Santos, C. and Zezza, G. (2002) “Is personal debt sustainable?,” Levy Economics Institute,
Strategic Analysis, November. http://www.levyinstitute.org/pubs/sa/perdebt.pdf
2 See Scott Fullwiler’s “The Sector Financial Balances Model of Aggregate Demand and Austerity”
http://neweconomicperspectives.org/2011/06/sector‐financial‐balances‐model‐of.html
See Rob Parenteau’s “Leading PIIGS to Slaughter, Part 2” http://www.nakedcapitalism.com/2010/03/parenteau‐leading‐
piigs‐to‐slaughter‐part‐2.html
3 Papadimitriou, D., Shaik A., dos Santos, C. and Zezza, G. (2002) “Is personal debt sustainable?,” Levy Economics Institute,
Strategic Analysis, November. http://www.levyinstitute.org/pubs/sa/perdebt.pdf
4 See “Alternative Measures of Personal Saving” by Maria G. Perozek and Marshall B. Reinsdorf at
http://www.bea.gov/scb/pdf/2002/04April/0402PersonalSaving.pdf
5 See A Reconstruction of Economics by Kenneth Boulding
6 Watch two lectures by Marc Lavoie on stock‐flow modeling at http://neweconomicperspectives.org/tag/stock‐flow‐
consistent‐modeling
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CHAPTER 14:
What happens during a major financial crisis
Why financial crises exist
What can be done to stop an on‐going financial crisis
How financial crises can be prevented or tamed

CHAPTER 14: FINANCIAL CRISES
While visiting the London School of Economics at the end of 2008, the Queen of England wondered
"why did nobody notice it?" In doing so, she echoed a narrative that had been promoted among
some prominent economists: the Great Recession (“it”) was an accident, a random extreme event
that no‐one saw coming.1 This narrative is false. Quite a few economists saw it coming and it was
not an accident.2 Chapter 9 shows how different theoretical frameworks about financial crises lead
to different regulatory responses. This Chapter studies more carefully the mechanics of financial
crises and how an economy gets there.
DEBT DEFLATION
Definitions of financial crises can be more or less broad. Some economists restrict the definition to
banking crises, others may use a statistical definition that takes a specific percentage fall in a
financial index as an indication of a financial crisis. In any case, financial instability has increased
since the 1980s.3
The most serious financial crises involve reinforcing feedbacks between asset prices and leverage,
leading to a downward spiral of debt write offs and decreases in asset prices. These financial crises
are called “debt deflations” after Irving Fisher’s analysis of the Great Depression. The main
implication of a debt deflation is that market mechanisms break down under the combination of
over‐indebtedness and deflation: lower prices do not clear markets but make matter worse.

Figure 14.1 An unstable equilibrium
One way to represent that graphically is with the supply and demand diagram of Figure 14.1. The
demand curve is upward sloping because higher prices lead to higher wealth and so higher demand
for goods and services. There is an equilibrium point but it is an unstable equilibrium, i.e. price
mechanisms do not bring the market to equilibrium. For example, at P1 there is a surplus of goods
and services, this leads to a fall in prices. Deflation decreases the quantity supplied and the quantity
demanded in such a way that the surplus grows. A similar result can be found by postulating a
downward sloping supply curve. As prices fall, more goods and services are supplied to try to service
debts. There are many feedback loops involved in a debt deflation but the process starts with some
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economic units that become “overindebted.” The following presents Fisher’s argumentation in his
1932 Booms and Depressions.4
STEP 1: OVERINDEBTEDNESS AND DISTRESS SALES
Some economic units, e.g. (non‐financial) businesses, are unable to pay their debts with their
available monetary assets (cash and bank accounts). If refinancing options are not available—banks
severely ration credit—businesses in difficulty must find ways to sell non‐monetary assets to
recover enough funds to service their debts. They liquidate their inventories, sell other types of
financial assets than monetary assets, and sell some superfluous real assets (Figure 14.2).

Figure 14.2 Distress sales
Note: The “+” sign means that things move in the same direction: more overindebtedness leads
to more distress sales (and less overindebtedness leads to less distress sales).
STEP 2: DISTRESS SALES AND DEFLATION, THE “DOLLAR DISEASE”
The sudden massive sales of non‐monetary assets lead to a decline in their prices. The lower prices
of assets lowers the ability of businesses to recover funds from the sales. Businesses are then forced
to sell more at distress, which further pushes down prices. This is the first reinforcing feedback loop
of a debt‐deflation.

Figure 14.3 Dollar disease
Note: the sign “‐“ means that things move in the opposite direction: higher distress sales lowers
prices, leading to higher distress sales.
STEP 3: DEFLATION AND DEBT LIQUIDATION; THE “DEBT DISEASE”
Once they have recovered some funds, businesses service debts owed to banks and government—
which reduces the money supply—and service debts owed to others (e.g., corporate bonds held by
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households). Some businesses may have to default and ultimately their debts are written off by
creditors, which negatively impacts the creditworthiness of businesses and the net worth of
creditors (see Chapter 8).
Following the quantity theory of money (which Fisher promoted), the decline in the money supply
lowers prices even further, so there is a second reinforcing feedback loop: more distress sales lead
to more debt liquidation, which leads to a lower quantity of money and so lower prices and then
more distress sales.

Figure 14.4 Debt disease
STEP 4: PRICES AND PROFIT AND NET WORTH, THE “PROFIT DISEASE”
The debt and dollar diseases create a deflationary spiral that is reinforced by additional feedback
loops. First, as asset prices fall, the profit from sales and net worth of business fall given everything
else, which further increases their overindebtedness and so feeds back into the dollar and debt
diseases. Prices of assets fall even more.

Figure 14.5 Profit disease
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STEP 5: THE “AMPLIFIER EFFECT”
Declines in profit and net worth mean that non‐financial businesses have an incentive to lay off
employees. Some banks may also have to close because losses from debtors are too high to be
sustained by their balance sheet (see Chapter 8). Households, who record shrinkage of their income
and prospects of unemployment, lower their consumption. Rising unemployment reduces
aggregate spending, which further reduces profit and aggregate income. In addition, the decline in
spending further pushes down the value of goods and services and other real assets. Now
households, in addition to businesses, have problems in servicing their debts, which reinforces the
debt write offs and decline in the net worth of banks.

Figure 14.6 Amplifier effect
STEP 6: PESSIMISM
As the economy records falling prices, declining economic activity, rising unemployment, rising
defaults, and shrinking balance sheets, confidence among economic units declines and hoarding
rises. Higher hoarding lowers the velocity of money and so prices are pushed further down (again
this presentation follows the quantity theory of money). Lower confidence also decreases the
willingness of banks to grant credit, and increases their willingness to hang onto their reserves to
meet withdrawals, interbank payments and other dues at the lowest cost possible; the overnight
interbank market freezes (see Chapter 4).
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Figure 14.7 Confidence crisis
STEP 7: INTEREST‐RATE SPREAD
With the crisis of confidence spreading and with raging deflationary pressures and economic crisis,
interest rates shoot up. This quickly spreads through the outstanding debts if interest rates on
financial contracts are floating rates, which squeezes net profit (profit – debt commitments) and so
increases overindebtedness.
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Figure 14.8 Risk premium disease
CONCLUSION
Overindebtedness and deflation feed on each other through several feedback loops. All these
feedback loops make things worse and worse: difficulty to service debt leads to lower prices, which
increases the difficulty to service debts.
If left alone, a debt deflation stops only when the face value of outstanding debts has been lowered
sufficiently through repayments and write offs to make the servicing of debts bearable. The decline
in the debt burden loosens the need for distress sales (Figure 14.9). Of course, in the process banks
close, households lose their savings and their economically active members become unemployed,
businesses close, and resources are wasted (output is left to rot, labor power and knowledge are
left unused and decay quickly, capital equipment depreciates, etc.). According to market
proponents, this is fine because a debt deflation punishes all economic units that made “bad”
decisions. Banks that overextended credit, businesses that did not satisfy their customers,
households who are not flexible enough, etc. As Treasury Secretary Andrew Mellon stated during
the Great Depression: “liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate…it
will purge the rottenness out of the system. High costs of living and high living will come down.
People will work harder, live a more moral life. Values will be adjusted, and enterprising people will
pick up from less competent people.”
There are two main problems with this view. First, Chapter 8 explains that what is considered in
hindsight a “bad”/incompetent decision may have been necessary prior to the crisis in order to
keep up with the competition and to avoid losing market share and income. Second, a debt
deflation is not a selective process. It destroys economic status indiscriminately by spreading
through declines in net wealth, job losses, losses of savings, declines in confidence, shutdowns of
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financing opportunities, and an overall sharp decline in economic activity. Think of a fire that starts
because someone smoked in bed. This person may “deserve” to have a destroyed home but, if
nothing is done to stop the fire, the entire town may be destroyed.

Figure 14.9 A stabilizing loop
ORIGINS OF DEBT DEFLATION
While the mechanics of a debt deflation are well known and widely accepted, what causes them is
subject to debate: why do economic units become overindebted in the first place? Again, keeping
with the distinction of previous Chapters on macroeconomic topics, this section makes a distinction
between the real exchange view and the monetary production view.
REAL EXCHANGE ECONOMY: EFFICIENT MARKETS AND

IMPERFECTIONS
In this view, money and finance are neutral and financial markets are efficient. The Efficient Market
Hypothesis (EMH) states that markets allocate scarce resources toward the most productive
economic activities, and allocate financial risks toward economic entities that are most able to bear
them. The EMH also states that market mechanisms self‐correct and eliminate any disequilibrium
such as bubbles or crashes. In order to introduce the possibility of financial crises, either markets
have to be imperfect, or market participants have to behave imperfectly/irrationally.
In terms of market imperfections, a lot of emphasis is put on the existence of asymmetries of
information. Banks have much less information about the quality of a project than potential
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customers. Bankers try to protect themselves by requiring collateral. This is supposed to give an
incentive to economic units who request an advance of funds to do their best to make their project
successful (otherwise economic units lose the collateral).
Following a negative random shock, the value of collateral declines, which leads debtors to limit
their entrepreneurial effort—because a decline in the value of the collateral means that they have
less to lose by defaulting—, which increases the chances of financial difficulties. Banks take notice
and start to ration credit. This generates a credit crunch, which leads to further declines in net
worth and collateral and so less effort and a greater risk of default.
Recent research efforts by scholars who follow the REE approach have focused on the reversion
mechanisms (how a crisis occurs) instead of the propagation mechanisms (how a crisis spreads
following a shock). Crises are rendered endogenous by linking effort to the business cycle. The more
effort individuals put into their business, the more productive they are, which leads to a greater
supply of commodities and so lower prices. Lower prices lead to lower net gains, which leads to
lower effort and so to a greater risk of default.
Given that the mathematical models developed to back this view are all set in real terms, and given
that the random shock is applied to the productivity of an input (e.g., land), this type of analysis
applies well to a pre‐capitalist agricultural economy (see Chapter 11). Nature decides which
economic state occurs (good or bad weather). Financial crises are equivalent to weather calamities
that decrease agricultural output.
The imperfection view can be complemented by the Monetarist view of financial crises and by the
irrational approach developed by behavioral economics. The former states that financial crises are
due to the incompetence of policymakers, and the latter states that behavioral imperfections of
individuals contribute to the emergence of crises. People have limited cognitive capacities that
restrict their capacity to acquire and interpret information, and market participants care about
things that a “rational economic man” should not care about. As a consequence, a market economy
is prone to bubbles, herd behavior, cascade of information, and misallocation of resources, leading
to overindebtedness and ultimately a debt deflation. One may try to correct for these behavioral
problems by creating markets that provide signals that allow market participants to make the right
decisions.
MONETARY PRODUCTION ECONOMY: THE FINANCIAL INSTABILITY

HYPOTHESIS
According to the MPE view, the previous type of analysis ignores important aspects of capitalist
economies. For example, government deficits do promote financial stability, which is seen as an
empirical puzzle in the REE view, given that deficits ought to crowd out investment and so make
things worse. The REE view is also too micro‐oriented and lacks a system‐view of financial crises
that recognizes major sources of instability outside the realm of individual behavior/effort.
The Financial Instability Hypothesis (FIH) is an alternative to the EMH. The main claim of the FIH is
that periods of economic stability are fertile grounds for the growth of financial fragility, i.e. the
growth of the risk of debt deflation. Hyman P. Minsky, who relies on the work of Fisher, Keynes and
Schumpeter, is the main developer of the FIH and provides a more detailed analysis of what
“overindebtedness” means and its impacts. He concludes that stability is destabilizing.
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FINANCIAL FRAGILITY
According to Minsky, the degree of financial fragility of economic units—how badly overindebted
they are—can be classified as hedge finance, speculative finance or Ponzi finance. Hedge finance
means that an economic unit is expected to be able to meet its liability commitments with the net
cash flow it generates from its routine economic operations (work for most individuals, profit from
going concerns for companies) and monetary balances. Even though indebtedness may be high
(even relative to income), an economy in which most economic units rely on hedge finance is not
prone to debt deflation, unless unusually large declines in routine cash inflows and/or unusually
large increases in cash outflows occur. Even then, monetary savings are usually available in a large
enough quantity to provide a buffer against unforeseen problems. As such, it is not expected that
the servicing of debts will be problematic and so no refinancing (going into debt to service existing
debts) and/or sales of non‐monetary assets is expected.
Speculative finance means that routine net cash flow sources and monetary balances are expected
to be sufficient to pay the income component (interest, dividend, among others), but too low to
pay the capital component (debt principal, margin calls, cash withdrawals, among others) of
liabilities. As a consequence, an economic unit needs either to go into debt or to sell some non‐
monetary assets in order to service the principal due. Economic units usually expect that rolling
debts over (i.e. paying the principal on old debts by issuing new debts) will be possible instead of
liquidating assets. The length of time during which routine cash flows are expected to fall short of
capital repayment depends on the economic unit. Chapter 8 explains that the business model of
banks is such that refinancing is usually needed to service the capital component of liabilities; as
such banking requires a reliable and cheap refinancing source. Other businesses may only have a
temporary need to roll over their debts.
Ponzi finance, also called interest‐capitalization finance, means that an economic unit is not
expected to generate enough net cash flow from its routine economic operations, nor to have
enough monetary savings to pay the capital and income service due on outstanding financial
contracts. As a consequence, in order to service a given level of outstanding debts, Ponzi finance
relies on the growing availability of refinancing sources, and/or an expected liquidation of non‐
monetary assets at rising prices. At the microeconomic level, an economic unit that uses Ponzi
finance to fund its assets is highly financially fragile. At the macroeconomic level, if key economic
units behind the growth of the economy are involved in Ponzi finance, the economic system is
highly prone to a debt deflation.
Note that this categorization is not merely a measure of the use of external funding, i.e. of the size
of leverage. It is also a measure of the quality of the leverage. At the core of this analytical
categorization is an analysis of the means that are expected to be used to fulfill financial contracts.
Hedge finance is not expected to require any refinancing operation or liquidation of non‐monetary
assets to service debts; Ponzi finance requires a growing use of refinancing and liquidation to
service debts. This has important regulatory implications as shown in Chapter 9, because knowing
how one can service debt becomes as important, if not more important, than knowing if one can
service debts: low default probability (if) does not mean low financial fragility (how).
Ponzi finance should be differentiated from the existence or non‐existence of a “bubble.” The
categorization does not aim at measuring the accuracy (however, defined) of the price of assets
used to service debts. Ponzi finance means that leverage and asset prices end up going up together
and feed on each other on the upside. Higher leverage requires higher collateral value and so higher
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asset prices, and the funding of assets at a price that grows faster than income rises requires higher
leverage. This is the crucial dynamic regardless of the correctness of the value of asset prices
because, bubble or not, the size of a potential debt deflation grows with the duration of the use of
Ponzi finance. Without Ponzi finance there cannot be a debt deflation because there is no leverage
involved in the asset‐price appreciation. Without a debt inflation (that is a situation in which asset
prices and debt become highly interdependent on the upside), there cannot be a debt deflation.
Ponzi finance is also different from fraud (which can prevail at hedge, speculative or Ponzi stage).
Ponzi finance is an unsustainable financial process regardless of the legality of a financial structure.
Indeed, in order to persist, it requires an exponential growth of financial participation, which is not
possible because, ultimately, there is a limited number of economic agents that can or will
participate.
The H/S/P categorization does not apply to monetarily sovereign governments, i.e. governments
that issue their own nonconvertible currency and that issue public debt denominated in their
currency. Examples of monetarily sovereign governments are the United States Federal
Government, the Japanese national government, the United Kingdom national government, the
Chinese and Mexican central governments. Examples of non‐monetarily sovereign governments
are national governments of the Eurozone, the United States under the gold standard before 1933,
state and local governments in the United States and, any country that issues securities
denominated in a foreign currency. When a government is monetarily sovereign, it has a monopoly
over the currency supply and so always can meet payments denominated in its currency as they
come due. Hedge finance applies to any sovereign government that is monetarily sovereign
because such a government cannot be forced to default; default is purely voluntary. In addition,
the federal government may provide bonds and other default‐free liquid securities that boost the
liquidity of the balance sheets of the private sector. The long period of financial stability in the
United States after World War II was the result of highly liquid balance sheets in the private sector
due to large government deficits during World War II that flooded the private sector with safe
assets (see Chapter 8).
THE FINANCIAL INSTABILITY HYPOTHESIS
According to the FIH, during a period of prolonged expansion, the proportion of economic units
involved in speculative and Ponzi finance grows, and so the risk of a debt deflation increases. The
period of expansion may record minor recessions—e.g., the 1991 and 2000 downturns in the United
States—that do not significantly tame the state of expectations of private economic units and so
do not significantly make underwriting practices more prudent. As such, the FIH is not a theory of
the business cycle but rather focuses one what causes significant recessions.
Contrary to the behavioral explanation, irrationality is not at the heart of instability. The boom, with
its mania, just amplifies the dynamics that emerged previously during a period of prolonged
expansion. Contrary to the market imperfection explanation, market mechanisms promote
instability not stability. The heart of the problem is not found in individuals making dumb/irrational
decisions but rather in the system in which they operate. Capitalism is a much more financially
unstable economic system than those that previously existed. Capitalism’s incentives and
mechanics push economic units into Ponzi finance.
There are several channels through which financial fragility grows and they have to do with anything
that changes the relation between income and debt service. Anything that pushes an economic unit
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from a state in which income is greater than debt service to a state in which income is less than
debt service represents such a channel. This can happen either because income level (or growth)
falls and/or debt service level (or growth) rises. Factors that impact both are described briefly:
• Structural causes:
- Banks are speculative units: the maturity of banks’ liabilities is short relative to the
maturity date of banks’ assets so they need to refinance all the time. Banks aim at
lowering the maturity of their assets to limit the maturity mismatch, which promotes
speculative finance in the non‐bank sectors. For example, in the US, the 30‐year
mortgage is not a product of private banking but of government intervention and it
must be subsidized to persist. Banks much prefer shorter‐term mortgages (say 10
years) that require households to refinance, which creates a dependence on the
direction of home prices (Chapter 7 explains that if home prices fall refinancing may
not happen).
- Changes in banking business: move away from the originate‐and‐hold model to the
originate‐and‐distribute model, which creates adverse incentives in terms of
underwriting and debt reworking (see Chapter 8).
• Economic causes
- Search for profit and market share, and market saturation: ROE = ROA x leverage (see
Chapter 8).
- Inequalities: the need to use debt to sustain a given standard of leaving has increased
(student debt, healthcare debt, etc.)
- Unexpected events: The FIH leaves some room for adverse random shocks (say a
hurricane destroyed many houses and businesses, which triggers massive payments by
insurance companies)
• Policy reasons:
- Deregulation, desupervision and deenforcement (see Chapter 9): fraud grows and
underwriting worsens.
- Fiscal policy: A period of prolonged expansion that is led by a monetarily sovereign
government will not lead to financial instability. Fiscal deficits boost macroeconomic
profit (see Chapter 11) and personal savings and provides cash flows as well as safe
financial assets to the private sector. However, as shown in Chapter 13, government’s
desire to reach a surplus, combined with the automatic stabilizers, means that non‐
government sectors may be forced to deficit spend.
- Monetary policy: During a period of expansion, the central bank raises interest rates
and that increases the debt burden. Minsky is of the opinion that fine tuning and
preserving financial stability are not compatible and argues for a central bank that
focuses on financial stability.
• Socio‐psychological reasons
- Long period of prosperity leads to a decline in risk perception because economic news
is good and it is too costly to look too much backward (see Chapter 9).
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- Uncertainty means that economic units rely on norms to make decisions. These norms
are rationalized through a convention, which is a mental construction about the current
economic trends and about what to expect. There is a strong incentive to stick to the
convention to avoid losing market share or drawing the attention of regulators (see
Chapter 8). So if Ponzi finance is considered normal, a bank will do it and will find
comfort in the fact that “everybody else is doing it so it is ok.”
HOW TO DEAL WITH FINANCIAL CRISES
Financial crises that are severe create a lot of damages if they are not managed through
government intervention. This government intervention involves both quick fixes to deal with the
immediate problems and long‐term policies to prevent moral hazard and promote stability. The
recent responses to the Great Recession provide examples of what not to do:
• Stop the liquidity crisis: central bank provides funds at penalty rate, against safe collateral,
to solvent institutions. One may argue that, during a crisis, a lot of financial assets that
previously looked safe may now be unsafe because of the lack of confidence and because
of poor economic prospects. For example, prime mortgagees may default because they lost
their job. There is a way around this issue. Central banks should accept only financial assets
that were created by following strict underwriting, that is, those that involved hedge
finance and speculative finance prior to the crisis. Central banks may record losses on them
given that a debt deflation also impacts economic units with strong creditworthiness, but
that should be minimal. Do not provide liquidity against Ponzi finance inducing financial
instruments, even if they are not in default.
– Recent crisis: Fed provided advances at near 0% rate, against poor to toxic
collateral (accepted at par), to questionable institutions, to non‐bank entities
• Stop the solvency crisis: Bank holiday to examine the books of financial institutions in detail
for a given period of time (say a week like during the Great Depression) and close insolvent
banks. Act to sustain income and to lower the debt burden. Lower the debt burden by
reworking debts of economic units who would be solvent with the reworking (during the
great depression, government bought interest‐only mortgages from banks and replaced
them with 30‐year fixed rate fully‐amortized mortgages). To sustain income, create large‐
scale long‐term fiscal policy such as a job guarantee program (Great Depression work
programs were started in a matter of days).
– Recent crisis: no significant analysis of accounting books (only 2 Fed people sent at
Lehman Brothers,5 superficial stress tests), insignificant and slow fiscal action to
stabilize income (700 billion was not enough and was implemented over years),
hide losses of financial institutions by widening level‐3 valuation, injection of
capital in banks via Treasury without any real congressional oversight, no significant
reworking of debts on non‐bank agents.
• Change incentives and regulation, supervise and enforce: prosecute top managers for
fraud, issue cease and desist orders, major reworking of regulation and supervision to deal
with problems, promote hedge finance and if necessary forbid Ponzi finance.
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– Recent crisis: Not a single prosecution of top executives, even though fraud is
obvious (ask the Federal Bureau of Investigation and rating agencies that finally had
a look at mortgage contracts), civil instead of criminal cases (the financial
institution pays fines and promises not do it again), no major reregulatory trends,
no enforcement of existing laws prior and during crisis.
Even though a financial system may be on the brinks of collapse and panic is generalized, regulatory
institutions or agencies must follow the law. If necessary, regulators may use emergency executive
powers (bank holiday) to shut down the financial system temporarily and to get to the bottom of
the problem. Lenience leads to long‐term instability because the existence of a government safety
net promotes moral hazard. Without a safety net, such as a central bank acting as lender of last
resort, economic crises would be very severe.
TO GO FURTHER: PONZI FINANCE AND THE BALANCE SHEET
When an economic unit is involved in Ponzi finance, it has to go into debt to service principal and
interest. Say that there is a balance of $100 on a credit card that represents expenses for the month
and that there is also $10 of interest due. To service the credit card debt, one must open a new
credit card to pay $110 due on credit card #1. The following month $110 + $11 of interest is due on
the second credit card. The dollar amount of financial liabilities grows. Another way to service credit
card #1 is to sell some assets worth $110. So Ponzi finance implies that the quantity of real assets
(RA) falls and/or net financial accumulation (NFA) declines because either the quantity of financial
assets falls or the quantity of financial liabilities rises. We know that RA and NFA are related to net
wealth (see Chapter 13):
ΔNW = ΔRA + NFA
Given everything else, Ponzi finance leads to a fall in net worth. There are two ways to mitigate this
decline:
1‐ Overtime the assets funded in a Ponzi way may start to generate enough cash flows to
cover debt services. Say that a company was just created and needs some time to get its
business to earn an income. In the meantime, it needs financing to pay employees, to get
the business set up, etc. During that time, the net worth of the company will fall but it is
expected that ultimately the business will be profitable and will generate enough cash flows
to pay creditors. One may call this income‐based Ponzi finance; for a while income is
insufficient but there is an expectation that this is only temporary.
2‐ The price of real assets and the price of financial assets that are still on the balance sheet
go up fast enough to more than offset the rise in debt and the liquidation of assets. The
recent housing boom that allowed households to record massive increase in net worth
while they were going massively into debt is an example of such dynamics. The
underwriting worsened so much (see Chapter 8) that the only way to make a mortgage
profitable was to sell the house at a high enough price to cover interest and other payments
due to creditors. One may call that asset‐based Ponzi finance, or a pyramid scheme; there
is no expectation that income will ever be enough to service debts. The liquidation of the
collateral and other assets at rising prices is the only expected means to make the Ponzi
financing profitable and to keep net worth rising.
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TO GO EVEN FURTHER: MINSKY AND INCOME VS. CASH

INFLOW
In most presentation of the FIH, income and cash inflow are not distinguished carefully. For
example, the FIH is often presented from the point of view of the business sector with profit (U)
reflecting the ability or inability to fulfill debt service (CC) so that U > CC is hedge finance. At the
macroeconomic level, U is determined by the Kalecki equation of profit (see Chapter 11).
At the theoretical level that might be good enough, but it is not so at the empirical level. Income
and cash flows are two different things (see Chapter 1). Income is about measuring gains in net
worth, cash flow is about measuring change in monetary assets. The Kalecki equation of profit does
not say anything about gains of monetary balances. For example, an increase in unsold inventories
raises profit because higher inventories increase real assets. Similarly for households, personal
income includes quite a few items that are unrelated to monetary gains. Vegetables grown in the
garden, service provided by owning a house, among other things, are counted as imputed income.
Unfortunately, as explained in Chapter 12, creditors demand monetary payments so earning an
income in real terms, as opposed to monetary terms, does not help an economic unit to service its
debts.
What is really important is what Minsky called the “cash box condition” and expectations based on
it: how does the sum of cash inflows and monetary balances compare to cash outflows now and in
the future? That may or may not be related to profit and personal income. The cash‐flow statement,
rather than the income statement, together with the cash‐flow expectations embedded in financial
contracts, give a better idea of the financial fragility of an economic unit.
1‐ During a major financial crisis, i.e. a debt deflation, there are several feedback loops that may
develop, which reinforce the deflationary forces at play. A debt deflation is not self‐stabilizing; the
longer it is allowed to proceed, the more destructive it gets.
2‐ A debt deflation is not self‐cleansing; it destroys economic value indiscriminately until enough
debt has been liquidated to tame the deflationary forces.
3‐ How an economy is pushed to the brink of a debt deflation is subject to debate. Some economists
believe that a debt deflation is the result of a very large adverse random shock that risk
management models did not account for because it was too costly to do so. Other economists argue
that the search for profit and the increased reliance of market mechanisms lead to an unstable
economy.
4‐ In order to deal with a financial crisis, one must promote short‐term stability by stopping the
liquidity crisis and must promote long‐term stability by dealing with the solvency crisis and the
outdated regulatory framework.
5‐ According to the efficient market hypothesis, markets tend to allocate resources and risks
properly and the only thing the government can do is to help protect against the most common
adverse shocks that may impact markets. Profit is a good indicator of financial health. According to
the financial instability hypothesis, markets tend to promote Ponzi finance and some regulations
must be put in place about financial practices and financial innovations. Profit alone is not a good
indicator of financial health because one must ask through what financial practices this profit was
achieved.

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Keywords
Efficient market hypothesis, financial instability hypothesis, debt deflation, hedge finance,
speculative finance, Ponzi finance, income‐based credit, asset‐based credit, debt liquidation, profit
disease, debt disease, dollar disease, pessimism, irrational behavior

Review Questions
Q1: Why is the dollar disease a reinforcing feedback loop? What about the debt disease? What
about the profit disease?
Q2: When does a debt deflation stop if left to market mechanisms? Why is that not a smooth and
effective way to cleanse the economy?
Q3: What are the amplifier mechanism and reversion mechanism used in the real exchange
economy view of financial crisis?
Q4: What are the sources of financial crisis in the monetary production economy view? Is it mostly
about irrational individual behaviors and improper incentives?
Q5: What can be done to deal with a financial crisis? Did the recent response to the 2008 crisis
follow the proper guidelines?
Q6: Why Ponzi finance intrinsically unstable? What is the difference between income‐based Ponzi
finance and asset‐based Ponzi finance? Does Ponzi finance necessarily, or even mostly, imply fraud
or irrational behaviors?

Suggested readings
Fisher, I. (1932) Booms and Depressions: Some First Principles, New York: Adelphy.
Minsky, H.P. (1982) “The financial‐instability hypothesis: Capitalist process and the behavior of the
economy,” in C.P. Kindleberger and J.‐P. Lafargue (eds) Financial Crises: Theory, History, and Policy,
13‐39, New York: Cambridge University Press.
Mishkin, F.S. (1991) “Asymmetric information and financial crises: A historical perspective,” in R.G.
Hubbard (ed.) Financial Markets and Financial Crises, 69‐108, Chicago: University of Chicago Press.
Charles, S. (2016) “Is Minsky’s financial instability hypothesis valid?” Cambridge Journal of
Economics 40 (2): 427‐436.
Keen, S. (2013) “A monetary Minsky model of the Great Moderation and the Great Recession”
Journal of Economic Behavior & Organization, 86 (1): 221–235.
Schwartz, A.J. (1988) “Financial stability and the federal safety net,” in W.S. Haraf and R.M.
Kushmeider (eds) Restructuring Banking and Financial Services in America, 34‐62, Washington, DC:
American Enterprise Institute for Public Policy and Research.
Shiller, R.J. (2000) Irrational Exuberance, Princeton: Princeton University Press.
Suarez, J. and Sussman, O. (1997) “Endogenous cycles in a Stiglitz‐Weiss economy,” Journal of
Economic Theory, 76 (1): 47‐71.

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1 Bezemer, D.J. (2010) “Understanding financial crisis through accounting models,” Accounting, Organizations and
Society, 26 (7): 676‐688.
2 See “Got it Right Project” at http://afee.net/?page=heterodox_economics&side=got_it_right_project
3 Bordo, M., Eichengreen, B., Klingebiel, D. and Martinez‐Peria, M.S. (2001) “Is the crisis problem growing more severe?,”
Economic Policy, 16 (32): 51‐82.
4 An electronic copy of Fisher’s book can be found at the St. Louis Federal Reserve:
https://fraser.stlouisfed.org/docs/publications/books/booms_fisher.pdf
5 A blunt testimony by William K. Black at the hearings regarding the failure of Lehman Brothers can be found here:
https://www.c‐span.org/video/?c2113/clip‐2008‐lehman‐brothers‐failure‐panel‐4
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CHAPTER 15:
What a monetary system is
How a monetary system works
Why a monetary system may be dysfunctional
Why monetary instruments are accepted
What determines the nominal value at which a financial instrument circulates
What promises are made by issuers of monetary instruments and how that
determines their fair price

CHAPTER 15: MONETARY SYSTEMS
Throughout this textbook, Chapters have used balance sheets extensively to get an understanding
of the monetary operations of developed economies, but nothing has been said about what a
monetary instrument is. It is time to spend some time on the nature of monetary instruments and
the inner workings of monetary systems. A monetary system is composed of two core elements:
 A unit of account that provides a common method of measurement: the euro (€), the
pound sterling (₤), the yen (¥), the dollar ($), etc.
 Monetary instruments: specific financial instruments denominated in the unit of account
and issued by the government and the private sector.
This Chapter first explains what financial instruments are and how monetary instruments fit within
the existing range of financial instruments. It then delves into what determines the nominal and
real value of monetary instruments, and into what makes them accepted.
FINANCIAL INSTRUMENTS
Balance sheets contain many types of financial instruments. Some of them are issued by an
economic unit (financial liabilities), others are held by that same economic unit (financial assets).
Financial instruments are just formal promises to make monetary payments. The way a promise is
structured varies widely depending on the needs of the issuer, but common questions that a
promise must answer are:
• Who is the issuer? The mark of the issuer (name, head, etc.) is present so bearers know
who is supposed to fulfill the promise embedded in the financial instrument.
• What is the unit of account used? Financial instruments cannot exist before there is a unit
of measurement for monetary transactions and outstanding balances.
• At what price will the issuer take back its promissory note? There is a face/par value that
specifies the number of units of account the financial instrument carries ($100, $10, $1, 25
cents, etc.).
• When will the issuer take back its promissory note? There is a term to maturity: The length
of time it will take to fulfill the promise, at which point the issuer must take back the
financial instrument it issued (and then destroy it to make sure nobody can reacquire it to
have a claim on the issuer). The term can go from zero (issuer takes it back whenever it is
presented by bearers) to infinity (issuer takes back at its discretion, maybe never).
• How will the issuer take back its promissory notes? The expected means that will be used
by the issuer to fulfill his promises, called more technically the “reflux
mechanisms/channels.” (Chapter 14 shows that the way this question is answered is crucial
for financial stability)
• What is (are) the reward(s)/benefit(s) for those willing to trust the issuer? Financial
instruments may reward their bearers: income, voting rights, avoid prison, etc.
• Are there any guarantees in case the issuer is unable or unwilling to fulfill the promise?
Financial instruments may be secured/collateralized: if the issuer defaults on its promises,
the bearers get paid by taking ownership of assets of the issuer (house for mortgages, etc.)
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• Is it possible to transfer the promissory note to another bearer? Financial instruments may
be negotiable, i.e. the person to whom the promise has to be fulfilled can be changed by
transferring ownership of the financial instrument. Some financial instruments are not
transferable because they name the beneficiary (e.g. savings bonds issued by U.S. Treasury)
and cannot be endorsed to someone else. Some, like checks, have limited transferability.1
Depending on how these questions are answered, the name of a financial instrument changes, in
the same way dogs and cats have different names depending on their height, color of their fur, etc.
For example, a Treasury bill does not provide any reward and is due within a year. A common share
provides a reward depending on the profit of the issuing company, gives a voting right, and the
company does not promise to take back its shares.
As stated in Chapter 10, anybody can make any kinds of promise. The hard parts are, first, to
convince others of the genuineness of the promise so they are willing to accept a financial
instrument and, second, to fulfill the promise once it has been accepted. Finance establishes a legal
framework to record the creation and fulfillment of promises, and it measures, more or less
accurately, the credibility of these promises at any point in time.
Finally, within a country, there is a hierarchy of financial instruments in the sense that some are
more easily accepted. The most widely accepted financial instruments are those that are
negotiable, of the highest creditworthiness, of the highest liquidity, and of the shortest term to
maturity. In contemporary economies with a monetarily sovereign government, central‐bank
monetary instruments are at the top of the hierarchy. They are followed by bank monetary
instruments that were made perfectly liquid following the emergence of interbank par‐clearing and
settlement and deposit guarantee. Below the previous monetary instruments are financial
instruments traded on an organized exchange (issued mostly by governments and corporations:
shares, bonds, notes, bills, etc.). At the bottom of the hierarchy, there are all sorts of promises such
as local currencies and personal promissory notes. This hierarchy is not fixed and, throughout
history, the top monetary instrument was not always a government monetary instrument.
A SPECIFIC FINANCIAL INSTRUMENT: MONETARY

INSTRUMENTS
Some issuers make the following promise to bearers:
• I will take back my promissory note whenever you want me to do so: Term to maturity is
instantaneous/zero.
• I will take back my promissory note from anybody who presents it to me: Only the issuer’s
mark is on the instrument and no beneficiary is named (either no name or “the bearer”).
• I will take back my promissory note at par in payment of debts owed me: By handing to me
my promissory notes, I will reduce any debt you owe me by the face value of the note. The
government accepts reserves to settle taxes at face value (the government does not accept
cash from the public in payment of taxes for security and tractability reasons, instead it
works through banks), banks accept at face value the funds in bank accounts to settle what
is owed to them (see Chapter 6 and Chapter 10).
The promise may contain two additional clauses:
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• I will exchange my promissory note for something else whenever the bearer wants me to
do so: there is a conversion clause. Banks promise to convert bank accounts (and banknotes
when they used to issue them) into government monetary instruments on demand.
Governments may promise conversion into gold or a foreign currency.
• I will use gold or another precious metal to make the promissory note: the promissory note
is secured. In the same way a house is collateral for a mortgage, gold may be collateral for
a coin.
This type of financial instruments are monetary instruments. Similarly to any other financial
instrument, the creation of monetary instruments involves someone becoming liable (the issuer of
the monetary instrument) because monetary instruments embed a financial promise.
AT WHAT PRICE SHOULD A FINANCIAL INSTRUMENT

CIRCULATE AMONG BEARERS?
The nominal value, P, at which a financial instrument ought to circulate among bearers is called the
fair price or fair value. The present value of expected financial rewards is a common way to judge
the fair price of many financial instruments. It is the sum of all the discounted streams of payments
that are expected by bearers until a financial instrument matures:

1 1
Where the subscript t indicates the present time, Pt is the current fair value, Yn is the nominal
income promised at a future time n, FVN is the face value that will prevail at maturity, Et indicates
current expectations about income and face value, dt is the current discount rate imposed by
bearers, N is the time lapse until maturity (n = 0 is the issuance time) (The Σ character means “sum
of”).
There is a wide variety of financial instruments that use this formula. One can classify financial
instruments according to the term to maturity (Figure 15.1).
Figure 15.1 Financial instruments and term to maturity
Note: C is the coupon payment, a form of income
At one extreme are modern government monetary instruments that provide no income (Y = 0), are
redeemed at the discretion of bearers (N = 0), and are expected to be taken back by the government
at their initial face value at any time, Pt = FV0. Government issued monetary instruments ought to
circulate at par all the time because they are zero‐term zero‐coupon financial instruments. At the
other extreme are consols that have a given expected income and are redeemed at the discretion
of the issuer (N → ∞), Pt = Et(Y)/dt. They are infinite‐term positive‐coupon financial instruments.
Shares have the same term to maturity as consols. If a collateral exists, in case of default, the fair
value depends on the expected ability of creditors to recover some of the unpaid dues embedded
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in a promise. Thus, in case of default, the fair value is equal to the expected value of the collateral
and available recourses discounted back to the present.
For example, say that company X issues 3‐year bonds with a face value of $1000 and a coupon rate
of 10%. This means that company X will buy back its bonds for $1000 in three years and will pay a
$100 coupon during three years. In that case, what market participants are willing to pay for the
bond today is (assuming an annual coupon payment to simplify):
100 100 100 1000
1 1 1 2 1 3 1 3

There is a missing element that prevents the determination of the fair price: what is the value of d
today? d represents the interest rate that market participants want (the market rate). The market
rate may be different from the interest rate offered by company X (the coupon rate):
‐ If d = 20% then P = $789.35. The bond trades at a discount (i.e. below face value). For the
first $100 provided next year, market participants are willing to pay today $83.33
($100/1.2) because $83 placed at 20% today provides $100 next year, etc.
‐ If d = 10% then P = $1000. Bond trades at par. Market participants agree that the interest
rate proposed by company X is enough, so they pay full price for the bond.
‐ If d = 5% then P = $1136.16. Market participants are getting more reward from the coupon
than what they wish, so they are willing to buy the bond at a premium (i.e. above face
value). The value of the premium is just enough to make the rate of return on the bond
equal to 5%.
As explained in Chapter 4, the value of d depends on a number of factors including the risk of default
by the issuer. The higher the probability that coupons and/or principal cannot be honored, the
steeper the discount rate, and so the further below par the 3‐year bond trades.
For a $20 unconvertible Federal Reserve note, the government does not promise any coupon and
promises to take back the FRNs at any time at $20, so:
20
0
20
1

The $20 FRN ought to trade at parity all the time. The discount factor does not matter because the
term to maturity is instantaneous.
These two examples assume that the issuer does not default. Say that right after the issuance of
the 3‐year bonds, company X announces that it cannot make neither the $100 coupon payments
nor the principal payment. Some negotiation with bondholders leads to an agreement that
company X will pay $70 coupons and $500 of principal. Then the new fair value of the bond is:
70 70 70 500
1 1 1 2 1 3 1 3

Again, the fair value depends on d, and d must have increased tremendously following the
announcement of default, which pushes down P even further.
The same applies with Federal Reserve note and other monetary instruments. Say that the
government announces it only accepts $20 FRNs for $10 at any time, i.e. a $20 FRN only redeems
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$10 of debts owed to the government. Then the new face value is actually $10 and so the fair price
is $10. In the economy, the $20 circulates among bearers for $10. Shops take the $20 note only for
$10 worth of items, banks that receive a $20 note only credit $10 to the bank accounts of the
persons who hand the $20 FRNs, and repaying bank debts with a $20 FRNs only clears $10 of bank
debts. Holders of FRNs take a 50% haircut. This may seem strange but only because we are not
accustomed to that anymore. In the Middle Ages, kings used to change the face value of their coins
all the time as explained in Chapter 17. Until the late 19th century, private bank notes were applied
a discount that varied overtime.
FAIR VALUE AND PURCHASING POWER
There are situations in which the value of all financial instruments changes at the same time relative
to the value of goods and services (output‐price inflation or deflation) or relative to another unit of
account (exchange‐rate depreciation or appreciation). These changes in purchasing power are due
either to the decisions of a monetary authority (e.g., the government decides to devalue its
currency) or to mechanisms at work in a monetary system.
The changes in the value of the unit of account should be differentiated from the changes in the
fair value of a monetary instrument. While both changes lead to the same result (changes in
purchasing power), the mechanisms at play are different. Changes in the value of the unit of
account relate to expected and actual changes in macroeconomic conditions (see Chapter 11).
Changes in the fair value relate to expected and actual changes in the characteristics of a financial
instrument (e.g., default) or in the financial infrastructure (e.g., disruption in the payment system).
For bank and government monetary instruments, this second type of changes has not occurred
since government guarantees have been put in place, interbank bank settlement at par has been
done efficiently, and inconvertible currency has become common and its supply made elastic.
One major debate of monetary history concerns the question of whether if the issuer of a monetary
instrument, and more generally any other financial instrument, is liable for the decline in the
purchasing power of what is owed to the bearers. Say that you owe $100 to someone; should you
be liable if the purchasing power of that $100 declines? More broadly, should the principal amount
you owe rise/fall to compensate for inflation/deflation? Legal scholars discuss this issue in terms of
Nominalism (that answers no) versus Valorism (that answers yes). Recently, this question has been
of greater concern for creditors, given that there has been an inflationary bias since the end of
World War Two. Governments around the world have been unwilling to let deflationary forces
develop following the horrible experience of the Great Depression (Figure 15.2).
Nominalism has prevailed throughout history. As such, financial instruments cannot be considered
to be claims on goods and services. Creditors bear the inflation risk, debtors bear the deflation risk.
While debtors may choose to issue inflation‐protected financial instruments (e.g., Treasury inflation
protected bonds), it is their discretion not their obligation.
An implication of the prevalence of nominalism is that the creditworthiness of an issuer is only
related to the ability to make the nominal payments promised (the Ys and FV in the fair price
formula) and creditworthiness cannot be judged by looking at purchasing power. As such,
inflation/deflation does not represent a decline/increase in the creditworthiness of a government,
or banks, or any other issuer of monetary instruments.
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Figure 15.2 Consumer price index in the United States: 1774‐2015 (base: 1982‐84).
Sources: Bureau of Labor Statistics and Historical Statistics of the United States.
A simple way to understand why Nominalism has prevailed is that issuers of financial instruments
have very little control over output‐price dynamics. Businesses can try to be more efficient to meet
the demands of their creditors, and households have some influence over their income and
expenditure sources. Governments have some part to play in the inflationary bias, and could do
more to promote price stability by having structural policies that deal with employment and price
stability, but even governments only have limited control over macro price dynamics. It would be
unfair to ask the issuers of financial instruments to protect their creditors for something over which
they have little control and which they have limited ability to influence.
While cases of hyperinflation are often attributed to the government running the printing press,
one needs to look at the underlying economic conditions to get to the bottom of the problem.
Political, technological and natural causes are usually underpinning problems because inflation is
usually not a monetary issue (see Chapter 11). The government printing monetary instruments en
masse is just a last desperate response to a deeper underlying problem. For example, the German
post‐World War One hyperinflation had its root in the costly Versailles agreements. The recent
episode of hyperinflation in Zimbawe has its root in colonialism, land reform and decaying
infrastructure.2 Table 11.1 shows inflation rates for several countries, all around the two world
wars.
Austria Germany Greece Hungary Poland Russia
10/1921‐ 8/1922‐ 11/1943‐ 8/1945‐ 1/1923‐ 12/1921‐
Period
8/1922 11/1923 11/1944 7/1946 1/1924 1/1924
Average monthly
47.1% 322% 365% 19800% 81.4% 57%
growth of prices

Table 11.1 Examples of hyperinflation.
Source: Studies in the Quantity Theory of Money.
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To conclude, the financial characteristics of monetary instruments lead to a stable nominal value
(parity) in the proper financial environment (see Chapter 16 for improper financial environments).
This stable nominal value plays a crucial role in the stability of the financial system because it
provides a reliable means of payment, which promotes liquidity and solvency. However, these
characteristics do not guarantee a stable purchasing power and so a monetary instrument may not
be a reliable medium of exchange. A good part of the story of monetary systems has been to try to
establish a smoothly working monetary system based on a financial instrument that is both
perfectly liquid and of stable purchasing power. This quest has been unsuccessful (only perfect
liquidity has been achieved), but it has had a tremendous influence on the views of scholars,
politicians and the general population about “money.”
ACCEPTANCE OF MONETARY INSTRUMENTS
Anybody can create monetary instruments. There are many websites that allow one to do so, and
Figure 15.3 shows a monetary instrument that I created. Let us call it the E.T. note. My name is
present and the note is worth 5 cities. The “City” is the unit of account. I deliberately chose a weird
name for the unit of account to make the point that the unit of account is an abstract and arbitrary
unit of measurement that has no essential relation to anything. While some units of account find
their origins in weight measures,3 they rapidly lost that connection (e.g., a pound sterling is not
represented by a pound of fine silver, a pound sterling is just a pound sterling).4 Other names of
units of account are just made up, sometimes to reflect political or cultural aspirations (the “Euro”),
and have never had anything to objectify them.
The E.T. note is a formal promise. By issuing it to bearers, I promise to take the note at par whenever
it is presented to me. How can I get others to accept in payments that piece of paper? The answer
depends on how credible my promise is to others: When will bearers have the opportunity to hand
it back to me and what are the benefits for doing so? If potential bearers never see any opportunity
to give the note back to me or if the reward for doing so is negligible, they will not accept the note
in payment. As such, there are three ways to make bearers realize that my promise is credible:
‐ Forced acceptance: I kill you/cut your hands/put you in prison/(fill up the blank for any
other miserable things I could to do to you) if you do not take it. The problem with force is
that it is difficult and costly to enforce, and not a very effective way to promote confidence
in the promise I made. Persuasion always works better than force so below are two ways
to persuade.
‐ Convertibility into something valuable:
o If you are one of my students: you automatically get an A in a course I teach if you
hand me some E.T. notes (the higher the dollar amount in notes to provide the
higher the demand for the notes). This is good as far as it goes, but very few people
take my courses.
o If you are not one of my students: When you give the note back to me, I will give
you some gold worth 5 cities. That will help to widen acceptance provided that 5
cities worth of gold is significant, and provided that others believe that I have the
means to get the gold I promised.
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‐ Impose a debt on bearers that can be paid with E.T. notes together with penalties if
payment is not performed:
o If you are one of my students: handing me some notes counts for a certain
percentage of your grade. Acceptance will depend on how much doing so counts.
For example, if handing back a certain number of notes counts for 100% of the
grade, then demand for E.T. notes will be high, if 1% demand will be low. I imposed
a tax on my students. Some economics departments have done such a thing with
great success to promote community services performed by students (DVDs and
Buckaroos).5
o If you are not one of my students: Any debt you owe me can be paid by handing
me some E.T. notes. Acceptance by potential bearers will depend on the extent to
which others are indebted to me, as well as my ability to enforce the payments of
dues owed to me (and to punish if payment is not made). Limited number of
debtors, ability to evade dues, and lack of effective enforcement mechanisms will
reduce the acceptance of my notes.
These means of creating an initial and basic demand for monetary instruments can be combined
but today, the ability of an issuer to entice, or to force, other economic units to become indebted
to the issuer is the main means used to create an acceptance for a monetary instrument.
In my classroom, my ability to do so is very high and, as such, I can acquire many things from my
students (including their labor power) by paying them with E.T. notes. I can then use that power for
my own selfish interest (to buy stuff from my students for my own enjoyment) or for more social
goals (community services to be performed by students). Beyond my classroom, I have no ability to
make others indebted to me and my ability to impose force or to provide something valuable in
exchange for my note is limited. As such the demand for E.T. notes is small outside the classroom.
The same applies to a government within its borders, provided it is credible; as such the
government can use that power to spend however it likes (hopefully for the benefits of its citizens)
to fulfill the demand for its currency. Outside a country, leaving aside international arrangements
that may promote a currency, the demand for a national currency will also be limited because the
ability of a national government to impose debts on foreigners is limited. If the currency allows
foreigners to obtain something valuable, either through conversion or because the economy
produces things that foreigners want (see below for other sources of demand for a monetary
instrument), foreigners will net save the currency.
The broader your “captive” population, the greater your ability to impose debts on that population
and to punish it if it does not comply, and the more widely your monetary instrument is accepted.
Guaranteeing convertibility into something else valuable will help further.
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Figure 15.3 A E.T. note worth five cities.
The monetary instruments issued by the government and banks are in high demand because they
have a large number of debtors. Government’s ability to impose tax liabilities and other dues (and
to throw people in jail if the tax is not paid) has been the preferred method to create an initial
willingness to hold government monetary instruments. The higher the ability to enforce the dues
and the lower the ability to evade the dues, the higher the demand for the government monetary
instruments. When the credibility of a state is low, the state may introduce a conversion clause that
promises gold or foreign currency on demand. While this occurred quite frequently in the past, the
financial basis for this conversion clause decreased dramatically with greater political stability,
greater monetary stability, and better enforcement mechanisms. Chapter 17 shows why
convertibility into gold used to be an important means to create a demand for government
monetary instruments.
Banks create monetary instruments by swapping promissory notes with their customers (see
Chapter 10). As such, the issuance of bank monetary instruments simultaneously creates debtors
of banks. These debtors have an automatic demand for bank monetary instruments as long as banks
have the ability to enforce the claims they have on non‐bank agents (banks can seize assets or have
other recourses if payment is not honored). For those who are not indebted to banks, the bank also
promises conversion at par into government monetary instruments. Today, the credibility of the
convertibility clause is strong, given that governments guarantee the bank’s ability to convert (FDIC
deposit guarantee, lender of last resort, and maintenance of an efficient payment system).
To conclude, in the broadest terms, the greater the credibility of the issuer, the greater its ability
to find people willing to hold its promissory notes. The acceptance of a monetary instrument
depends crucially on the credibility of the issuer in terms of fulfilling the promise it made. Indeed,
more people will have to make payments to that issuer or can get something valuable from that
issuer. This provides the core reason why a specific monetary instrument is accepted. Of course,
the same applies to any other financial instruments. Bonds with a higher credit rating are more
widely accepted, companies who are about to go bankrupt see their share price fall toward zero as
demand for them plunges. Beyond this core reason, bearers may hold a monetary instrument to
perform transactions now and in the future with other bearers (see last section). However, if the
issuer decides to demonetize its promissory note, these other reasons to hold a monetary
instrument do not maintain its fair value.
TRUST AND MONETARY SYSTEM: TRUST IN THE ISSUER VS.

SOCIETAL TRUST
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Acceptance introduces the central role of trust for a well‐functioning monetary system. Whenever
there is promise, there is trust. But one needs to be careful to understand how trust matters. The
answer to “why do you accept a $20 note?” is usually “because I trust others to do so.” To
understand why this does not go far enough (beyond the fact that this answer is circular), let us
start with another financial instrument.
Going back to the fair value example presented above. We saw that the nominal value at which a
bond trades is critically dependent on the ability of the issuer to fulfill the promises made. Say that
company X now declares it cannot make any of the payments owed on the bond. In that case the
fair value of the bond is $0—there is no demand for the bond—, unless bondholders have the ability
to seize assets of company X. Similarly, if the government states that it will not accept its $20 FRN
whenever presented by bearers, the fair price of the $20 FRN is now $0—the demand for it falls to
nothing. There is actually a complication for FRNs because they are secured by the assets of the
Fed, so, during the time of bankruptcy proceedings, FRNs will have a value equal to the expected
value of the assets of the Fed that are used to back the FRNs. Regarding monetary instruments
issued by banks, bearers must trust that: 1‐ banks will convert at par into government monetary
instruments at any time, 2‐ that they can clear debts owed to banks with bank monetary
instruments.
This brings forward an important point. While societal trust (trust of bearers about other bearers’
willingness to hold a monetary instrument) may help financial instruments to circulate more
broadly, the trust at the core of the circulation of a financial instrument is the financial credibility
of the issuer (trust of bearers about the issuer’s willingness and ability to fulfill its promise). Without
the latter, the fair value of an unsecured non‐recourse inconvertible financial instrument falls to
zero. As one may expect, Chapter 17 shows that this trust is hard to earn.
While all this necessarily follows from the logic of finance, it is not hard to find historical cases that
illustrate it. The most recent one is the transition to the Eurozone. Figure 15.4 shows a 50 French
franc note that the French government used to accept at face value in payments. From January 1
2002, the French economy moved to the Euro and its government refused French franc in
payments. To make the transition smoother, for the next ten years, the Banque de France allowed
conversion of its notes into euro‐denominated notes at the rate of 1 euro for 6.55957 French francs
(people could go to any branch of the Banque de France to get their francs converted into euros).
Since 2012, the French franc notes are no longer convertible into euro notes and their fair value is
now zero units of account. French franc notes may still have a value as collectible objects but not
as monetary instruments, they have become commodities.

Figure 15.4 A 50 French franc note.
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In the Middle Ages, coins did not have any face value marked on them. Bearers of the coins would
have to periodically listen to royal proclamations in public spaces to know at what value the King
would take his coins in payments, i.e. to know the face value. Chapter 17 shows that there were
some drawbacks to that system.
During the free banking era in the US in the mid‐1800s, Banks discouraged or refused conversion in
species on demand:
Banks sometimes used remote locations as their redemption points in order to avoid having
to redeem their notes in specie. Another method used by the banks to discourage specie demands
was to refuse to accept their own notes, except at a large discount. Customers were
told that, if they waited, the notes would be later redeemed at par, but such
promises were not always kept. The states attempted to require the banks to re‐
deem at par, but those efforts did not meet with success. (Markham 2002, 169)
This problem was compounded by widespread forgery that reinforced the reluctance of banks to
take their notes immediately at par, even in payments from debtors, because the truthfulness of
the notes could not be established. As such, given that both the convertibility promise and the
payment promise embedded in banknotes were violated, banknotes traded at a discount. This
problem was compounded by the absence of an interbank par‐clearing and settlement mechanism,
which prevented the holders of banknotes to exercise their right of immediate maturity.
While none of us thinks about the ability to pay the issuer at face value with its monetary
instrument when we accept them, without this ability there would not be a well‐functioning
monetary system. The credibility of the issuer, if strong, creates an anchor toward which bearers’
expectations about Ys and FV converge and provides stable nominal value.
WHY ARE MONETARY INSTRUMENTS USED? THE MONETARY
FUNCTIONS
We now know why economic units accept a monetary instrument. While the necessity to pay the
issuer and the availability of conversion create a demand for monetary instruments, economic units
also want to use monetary instruments for other purposes, namely daily expenses, private debt
settlements, portfolio choices, and precautionary savings. A monetary instrument can be used as:
‐ Means of payments: paying debts
‐ Medium of exchange: buying things
‐ Store of value: keeping some purchasing power for the future by saving monetary
instruments
The ability to perform these functions is not limited to monetary instruments as defined above.
Also, some authors, who define monetary instruments according to their functions (see Chapter
16), broaden the definition of monetary instruments to anything used as means of payment, and/or
medium of exchange, and/or store of value.
In any case, the ability of a monetary instrument to perform the previous functions is tied to the
creditworthiness of the issuer of that monetary instrument; otherwise, monetary instruments
would be a poor means of payment, a poor medium of exchange even the short run, and an even
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more terrible long‐term store of value than they currently are. This would be the case not because
of inflation (or depreciation), but because their fair value would not be constant.
Note that a monetary instrument cannot perform the function of unit of account because there
cannot be monetary instrument without a unit of account. As such, the unit of account cannot be
a medium of exchange, a store of value, or a means of payment. Stated another way, a monetary
system necessitates a unit of account and carriers of this unit of account, but they have separate
roles—one measures, the other records the measurement.
A unit of account can take the name of an object but it has an independent existence from the
object. This manifests itself in two ways. First, the object may disappear but the unit of account
persists; or, second, the relationship between the unit of account and the object can change. A
cowry unit of account may exist without any cowry shell being used in transactions. If cowries are
used, their value in terms of the cowry unit may change—one cowry shell may be worth one cowry
at one time and three cowries at another time.
Finally, going back to Chapter 13, if a monetary instrument is demanded for purposes and uses
other than paying the issuer, then the issuer must issue more monetary instruments than what it
gets back from its debtors. A net financial accumulation of monetary instruments by bearers means
either that the issuer must be in deficit or that it provides more advances than what is repaid. Again,
balance sheets are an easy way to explain this. To simplify, we may assume that there is only one
monetary instrument in an economy that it is issued by the government, and that the government
does not issue any other liabilities than its monetary instrument. We know that:
ΔFLG ≡ (IG – SG) + ΔFAG
(IG – SG) is the size of the fiscal deficit and ΔFAG is the net change (acquisition minus reduction) in
the quantity of financial assets held by the government. In order for the net injection of monetary
instrument to be positive (ΔFLG > 0) there are two possibilities:
- One, the government spends (I) more than it taxes (S) (taxes raise the net worth of the
government as explained in Chapter 6).
- Two, the government advances (ΔFLG > 0) more funds than what refluxes to the
government (ΔFLG < 0). That is, the government must acquire more promissory notes from
the non‐government sectors (ΔFAG > 0) than the quantity of principal repaid by the non‐
government sectors (ΔFAG < 0). This means that the non‐government sectors are
increasingly indebted to the government sector.
Treasury issues government monetary instruments by spending and it destroys government
monetary instruments by taxing. The fiscal deficit is a net injection of government monetary
instruments in the non‐government sectors (financial asset go up) without a net increase in the
financial liabilities of the non‐government sector (financial liabilities stay the same) (see Chapter 6
and Chapter13). This permanent net injection is possible because economic units want to net save
the government monetary instruments for the purposes cited above. If economic units only want to
hold government monetary instruments for tax purposes, the equilibrium fiscal position is zero;
economic units have no desire to net save the government monetary instruments.
This point is very well illustrated by the Massachusetts Bay colonies that issued inconvertible,
unsecured bills that they promised to accept in payment of taxes. The provincial government noted
the importance of a tax system for the stability of its monetary system (this allowed circulation at
par of the bills); but the government also noted that taxes tended to drain too many bills out of the
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economy compared to what was desired by private economic units (which created deflationary
forces). This created a dilemma:
The retirement of a large proportion of the circulating medium through annual
taxation, regularly produced a stringency from which the legislature sought relief
through postponement of the retirements. If the bills were not called in according
to the terms of the acts of issue, public faith in them would lessen, if called in there
would be a disturbance of the currency. On these points there was a permanent
disagreement between the governor and the representatives. (Davis 1900, 21)
Private sector desired to hold bills for other purposes than the payment of tax liabilities, but, by
draining most of the bills via taxes, the government prevented the domestic private sector from
accumulating its desired dollar amount of bills. At the same time, taxes were at the foundation of
that monetary system so they needed to be implemented as expected. Ultimately, the provincial
government was unsure about how to proceed in terms of the dollar amount in bills to recall.
Chapter 13 shows that some knowledge of national accounting helps to solve this dilemma: the size
of the fiscal position (surplus, balanced, or deficit) should be left to be determined by what non‐
government sectors want to net save.
1‐ A monetary instrument is a financial instrument. All financial instruments follow the same basic
rule of finance: the creditworthiness of the issuer is at the foundation of the nominal value of those
instruments. This creditworthiness is about the expected ability of the issuer to fulfill the promises
he made.
2‐ A government promises to take back its monetary instrument at any time at face value and does
not promise to pay any income. This means that the fair price of a government monetary
instrument is face value. A government may also a promise a conversion of its monetary instrument
into something else. The same logic applies to any other issuer.
3‐ Anybody can issue monetary instruments, i.e. zero‐coupon zero‐term securities; the point is to
get them accepted. This can be done by convincing others of the credibility of the promise
embedded in a monetary instrument.
4‐ The acceptance of current monetary instruments at par is mostly based on the ability of the
issuers to make others indebted to them and to enforce that debt. Banks make others indebted to
them when they create monetary instruments because they acquire a promissory note at the time
of the bank credit. Governments impose tax liabilities on most of their citizens.
5‐ Monetary instruments are used mostly in transactions with other economic units than the issuer.
They can be used as a medium of exchange, store of value, and means of payment. In such cases,
the issuer of monetary instruments must run a deficit or the non‐government sector must increase
its indebtedness toward the government sector.
6‐ While creditworthiness enables the creation of perfectly liquid financial instruments, this does
not guarantee a stable purchasing power. A stable purchasing power is not a promise made by
issuers of monetary instruments, but at long as relative price stability prevails this is not a problem
for monetary system.
7‐ There are two means for a monetary instrument worthless. One, it circulates at par but its
purchasing power is poor (hyperinflation). Two, prices of goods and services do not change but it
circulate at a very deep discount (default by the issuer or problem with the financial infrastructure).
8‐ A net injection of monetary instrument requires that the issuer deficit spends or that others have
a growing amount of debt owed to the issuer.
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Keywords
Unit of account, medium of exchange, store of value, means of payment, fair price, face value,
redeemable, convertible, societal trust, reflux mechanisms, nominalism, valorism, secured,
unsecured, recourse, term to maturity

Review Questions
Q1: What do you have to do if you want to issue a monetary instrument that functions properly?
Q2: Why is societal trust not a satisfactory explanation of why monetary instruments are accepted?
Q3: If the creditworthiness of the issuer of a financial instrument evaporates, what happens to the
fair price of that financial instrument, if it collateralized? If there is no collateral but there are
recourses? If it is an unsecured, non‐recourse financial instrument?
Q4: If the purchasing power of face value falls, how does that impact the creditworthiness of the
issuer of a monetary instrument?
Q5: Can a unit of account be a medium of exchange?
Q6: Can there be monetary instruments without a unit of account?
Q7: What are the two means for the non‐government sector to obtain government monetary
instruments?

Suggested readings
Bell, S.A. (2001) “The role of the state and the hierarchy of money,” Cambridge Journal of
Economics, 25 (2): 149‐163
Innes, A.M. (1913) “What is money?” Banking Law Journal 30(5): 377‐408.
________. (1914) “The credit theory of money,” Banking Law Journal 31(2): 151–168.
MacLeod, H.D. (1889) The Theory of Credit. London: Longmans and Green.
Mann, F.A. (1992) The Legal Aspect of Money. Oxford: Oxford University Press.
Olivecrona, K. (1957) The Problem of the Monetary Unit. New York: Macmillan.
Smith, T. (1832) An Essay on Currency and Banking. Philadelphia: Jasper Hardin.
Tymoigne, E. (2014) “A financial analysis of monetary systems.” In Papadimitriou, D.P (ed.)
Contributions to Economic Theory, Policy, Development and Finance. New York: Palgrave Macmillan.
Wray, L.R. (ed.) (2004) Credit and State Theories of Money, 223‐262, Northampton: Edward Elgar

1 A check drawn to pay Mr. X can be used by Mr. X to pay Mr. Y. See “How to endorse a check to someone else” at
https://www.youtube.com/watch?v=jSE6RwPOlNM
2 See Bill Mitchell’s “Zimbabwe for hyperventilators 101” http://bilbo.economicoutlook.net/blog/?p=3773
3 See “Origins of currencies: from jagged edges to flowers” http://blog.oxforddictionaries.com/2014/02/origins‐
currencies/
4 Olivecrona, K. (1957) The Problem of the Monetary Unit. New York: Macmillan.
5 For the DVD program see http://depts.drew.edu/econ/DVD/. For the Buckaroo program see
http://neweconomicperspectives.org/2009/07/berkshares‐buckaroos‐and‐bear‐dollars.html
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CHAPTER 16:
Why a gold ingot is not and has never been a monetary instrument
Why money is not what money does
Why monetary logic is not circular
Why monetary instruments circulate at face value even if they are unsecured
and inconvertible.
What errors have been made in the past when setting up monetary systems

CHAPTER 16: FAQs ABOUT MONETARY SYSTEMS
The following answers a few question in order to illustrate Chapter 15 and to develop certain points.
Q1: CAN A COMMODITY BE A MONETARY INSTRUMENT? OR,
DOES MONEY GROW ON TREES?
Let us tackle the idea that “gold is money”. Clearly, a gold ingot is not a monetary instrument. There
is no issuer, no denomination in a unit of account, no term to maturity or any other financial
characteristic. A gold ingot is just a commodity, a real asset, not a financial asset. Gold coins have
been monetary instruments and are still issued at times (Figure 16.1).

Gold ingots 2009 $50 American buffalo gold coin

Figure 16.1 Gold vs. gold coin
Similarly, it is incorrect to state that “salt was money” because salt is a commodity that embeds no
promise; however, Marco Polo noted that in the Chinese province of Kain‐du:1
There are salt springs, from which they manufacture salt by boiling it in small pans.
When the water is boiled for an hour, it becomes a kind of paste, which is formed
into cakes of the value of two pence each. […] On this latter species of money the
stamp of the grand khan is impressed, and it cannot be prepared by any other than
his own officers. Eighty of the cakes are made to pass for a saggio of gold. But when
these cakes are carried by traders amongst the inhabitants of the mountains, and
other parts little frequented, they obtain a saggio of gold for sixty, fifty, or even
forty of the salt cakes, in proportion as they find the natives less civilized.
It seems that salt cakes issued by an emperor (“grand khan”) might have circulated as monetary
instruments. However, a lot of details are missing from this description:
1‐ What were the unit of account and face value? (definitely not the pound, it is China)
2‐ What was the term to maturity? Were the cakes accepted in payment of dues at any time
by the emperor?
3‐ What were the means for the emperor to make the previous financial characteristics a
reality? I.e., what were the reflux mechanics? Did the emperor levy dues that could be paid
with salt cakes at par? Did the cakes provide conversion into something? Etc. Bearers need
to be convinced, so trust about the issuer must be established.
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4‐ The bit about the amount of gold that salt cakes could buy is irrelevant. Polo is just telling
us that a commodity (gold bullions) was cheaper in the mountains. He might as well have
told us about how different the price of apples and potatoes are in different parts of the
country.
The broad point is that monetary instruments can be made of a commodity but that commodity
itself is not a monetary instrument. We all know the expression “money does not grow on trees.”
Monetary instruments are not a natural occurrence and for a commodity to become a monetary
instrument some specific financial characteristics must be added: a unit of account, a face value, a
term to maturity, among others. All this requires an issuer who promises to implement these
financial characteristics.
Say a gold miner wants his gold nuggets to be a monetary instrument, for that to be the case the
goldminer must promise:
1‐ To distinguish his gold nuggets from other gold nuggets
2‐ To declare what their face value is in terms of a unit of account
3‐ To implement that face value by promising to take back at any time the gold nuggets in
payments at the stated face value.
Now the third condition introduces a problem because it means that the gold miner; must be willing
to be paid in gold nuggets for his gold nuggets. A dubious business strategy, indeed!
Most economists that work within the Real Exchange Economy framework, do consider monetary
instruments to be commodities. Monetary instruments do grow on trees—there are fruits—and all
debt payments are denominated in fruit.2 This creates difficulties to convincingly include “money”
in models, and pushes to ignore the financial side of the economy (see Chapter 10 and 13) and the
role of nominal aspects (see Chapter 11).
Q2: CAN A MONETARY INSTRUMENT BECOME A

COMMODITY?
Yes. Numismatists are specialists at treating current and former3 physical monetary instruments as
commodities by determining the price of banknotes and coins as a function of their rarity,
peculiarity, etc. For example the $1 FRN in Figure 16.2 is worth $1200 currently because of its
peculiar serial number. But that is not its fair value as a monetary instrument. If one buys this note
and goes to a store or to a government office, the person to whom one hands the note will only
take it for $1. The same applies to the buffalo gold coin above. One can use it to pay debts owed to
the government but only $50 worth, not more nor less, even though the coin is worth thousands
of dollars as a collectible item.
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Figure 16.2 A $1 FRN worth $1200 as collectible items
Source: www.collectorscorner.com
The same applies also to gold and silver certificates. Here is how the U.S. Treasury puts it:
Although gold certificates are no longer produced and are not redeemable in gold,
they still maintain their legal tender status. You may redeem the notes you have
through the Treasury Department or any financial institution. The redemption,
however, will be at the face value on the note. These notes may, however, have a
"premium" value to coin and currency collectors or dealers. (U.S. Treasury)
One can redeem them at the Treasury (to pay debts owed to the Treasury or to get Federal Reserve
notes) or deposit them at banks, but only at face value. That is their value as monetary instrument.
Their value as a collectible item is sometimes much higher.
Finally, a fun example is the current case of the penny, which brings us back to darker times of
monetary history (see Chapter 17). A while back, National Public Radio ran a segment on penny
hoarders.4 These are people whose hobby is to hoard pre‐1982 pennies. Some even go to their local
banks and spend their evenings triaging boxes of pennies. Why would they do that would you ask?
Pre‐1982 pennies were made mostly of copper and, given that the price of a pound of copper tripled
over the past ten years, the face value of a penny is half the intrinsic value (i.e. value of the content
of copper): face value is 1 cent, intrinsic value is 2 cents, 100% profit from selling pennies for their
copper content! Currently, there is one small problem with this portfolio strategy: It is illegal to
destroy government currency. However, the government is considering the possibility of
demonetizing the penny coin because it costs more to make than its face value, and because US
residents mostly find it cumbersome to use. If the government ever demonetizes the penny coin,
penny hoarders are ready to rush to their local scrap metal dealers.
Q3: IS MONEY WHAT MONEY DOES?
Francis Amasa Walker concluded in the late 19th century that “money is what money does.” This
has been an extremely influential way of analyzing monetary systems in many different disciplines:
economics, anthropology, law, among others.
It is used in a narrow way by economists who use the Real Exchange Economy framework (see
Chapter 11) and who focus on the function of medium of exchange. In order to avoid the problem
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of double coincidence of wants induced by barter (Joe has apples and wants pears, Jane has pears
but wants peaches), a unique commodity was progressively sorted out as best for market
exchanges, the story goes. Thus, a monetary system can be detected by checking for the presence
of a medium of exchange. Anthropologists, among others, reject this narrow functional approach.
In primitive societies, exchange was not done principally, or even at all, for economic reasons and
so the nonexistence of a double coincidence of wants was not a problem.5 The broad functional
approach classifies anything as a monetary instrument as long as it performs all or parts of the
functions attributed to monetary instruments. The distinction between “all‐purpose money” and
“special‐purpose money” follows.
A main issue with the functional approach is that it does not explicitly define what “money” is,
which creates several issues:
‐ Inquirer may pick and choose depending on the circumstances, which may lead the inquirer
to impose inappropriately his own experience to explain the inner workings of completely
different societies.
‐ Inquirer may tend to assume that monetary instruments must take a physical form when
they may be immaterial.
‐ Inquirer may exclude things that are monetary instruments but are not used for any of the
preferred functions. Collectible coins and notes are monetary instruments as long as the
issuer does not demonetize them.
More broadly, too much emphasis is put on detecting things that fulfill the selected function and
not enough effort will be devoted to a detailed account of the financial mechanics at play and their
relation to the socio‐politico‐economic context: unit of account used, how the fair value was
determined and if it fluctuated, how the reflux mechanisms were implemented, etc. The example
of the salt cakes above is an illustration of that point. Just noting that something is used as medium
of exchange or means of payment, and moving on to something else, is a poor way to perform
monetary analysis.
Finally, inquirers using this approach may confuse monetary payments and in‐kind payments, may
assume that there is a monetary system where there is none, may make a truncated analysis of
monetary systems consisting mostly in a mere recollection of objects, and may miss the presence
of a monetary system. For examples, by relying on the words of an Arab merchant and an Arab
historian of the 9th and 10th century, Quiggin reports that more than a thousand years ago cowry
shells:
formed the wealth of the royal treasury […] [and] when funds were getting low, the
sovereign sent out servants to cut branches of coconut palm and throw them into
the sea. The little mollusks climbed on to the branches and were collected and
spread out on the sand to dry until only the empty shells were left. So the royal
bank was filled again. Ships from India brought goods to the Maldives and took
back millions of shells packed up in thousand in coconut palm leaves. It was a
profitable trade, for even in the seventeenth century we hear of 9,000 or 10,000
cowries being bought for a rupee and sold again for three or four times as much on
the mainland of India. (Quiggin, 1963, 25‐26)
However, from this description, one cannot conclude that cowries were monetary instruments used
by the king to finance the purchase of foreign goods and services. Indeed, it is not explained what
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the unit of account of the Maldives was and how cowries were monetized, that is, who, if anybody,
issued them as financial instruments (did the royal authority issue them and was the royal bank
ready to accept cowries in payments?), and what their relation the unit of account was. In addition,
the role of cowries as monetary instruments is doubtful for the Maldives because cowry shells were
worth nothing against goods “except by shipload” (Polanyi 1966, 190)—an extremely inconvenient
means of payment and medium of exchange. What one can conclude from the description is that
the Maldives authorities were involved in the trade of cowries with Indian and Arab merchants.
They were exporting cowries against imports of other goods—a situation of bilateral trade, not a
situation of a cowry monetary system.
Q4: ARE CONTEMPORARY GOVERNMENT MONETARY

INSTRUMENTS IRREDEEMABLE? OR, IS THE FAIR VALUE OF
CONTEMPORARY GOVERNMENT MONETARY INSTRUMENTS
ZERO?
No. A well‐functioning monetary system requires that all monetary instruments be redeemable.
Federal Reserve notes are redeemable, silver certificates are redeemable even though they are no
longer convertible in silver (see the Treasury in Q2), and bank accounts are redeemable. They are
redeemable as long as they can be returned to the issuer, hopefully at their initial face value (see
Chapter 15). They can be returned to the issuer through two channels:
‐ Bearers demand conversion into something else at a given rate: government currency for
bank accounts, foreign currency for government currency, etc.
‐ Bearers pay the issuer: governments take their currency in payments of dues owed to them,
as do banks. The payment allows bearers to avoid jail time and other legal problems.
So to be redeemable a monetary instrument does not have to be convertible. As such, the fair value
of a monetary instrument, its present value, is face value (see Chapter 15). In the past, some
governments did forget to include, or removed, a redemption clause:
Paper money has no intrinsic value; it is only an imputed one; and therefore, when
issued, it is with a redeeming clause, that it shall be taken back, or otherwise
withdrawn, at a future period. Unfortunately, most of the governments, that have
issued paper money, have chosen to forget the redeeming clause, or else
circumstances have intervened to prevent their putting it into execution; and the
paper has been left in the hands of the public, without any possibility of its being
withdrawn from circulation (Smith 1832, 49)
Probably, no government paper money was ever sent forth which was not
expected to be redeemed in full value, at some time, although that might be
distant. […] Nevertheless, the issues of government money that have not been
redeemed, or the payment of which has been either formally or tacitly renounced,
have been very numerous. (Langworthy Taylor 1913, 309)
In that case, the fair value of a monetary instrument is indeed zero because its term to maturity is
infinity, which means that its fair value is (see Chapter 15):
P = C/i
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Given that no coupon was paid, P = 0. But this does not apply today because monetary instruments
are redeemable on demand by bearers at a stable face value.
All this does not seem to be well understood. For example, recently Adair Turner wrote (and he is
far from the only one to have said so):
Monetary base is an asset for the private sector, but for the government it is a
purely notional liability (with NPV equal to Zero) since it is irredeemable and non‐
interest‐bearing. (Turner 2015)
This confuses irredeemable and inconvertible. The monetary base is redeemable, that is, it can be
returned to the issuer at face value at anytime. This point of view also raises other problems:
‐ Remember that balance sheets are interrelated (see Chapter 13) so if a financial liability is
worth zero in one balance sheet, then a financial asset must be worth zero in another
balance sheet. Turner makes an accounting error.
‐ Why would the private sector be willing to hold something that is worth zero? There is no
benefit that comes from accepting such a monetary instrument, not even avoiding prison,
because taxes cannot be paid with such government monetary instruments.
‐ If valued at zero then balance sheets should record a large loss of assets (and net worth)
for banks, firms, and households: Your monetary balances would be worth nothing in
nominal terms!
Q5: IS MONETARY LOGIC CIRCULAR?
No. As with any other financial instrument, the acceptance of a monetary instrument by anybody
ultimately rests on the confidence in the issuer, not on the confidence that other potential bearers
will accept it. While bearers may never think about the creditworthiness of the issuer when
accepting a monetary instrument from another bearer, one cannot infer from that that
creditworthiness is not essential for acceptance. One merely has to study the stock market to see
that this conclusion is incorrect. Most trading of stocks is done just for the sake of trading by
humans or by computers focused on millisecond price movements. This does not neglect the
central role of the creditworthiness of the firm that issued the stock in sustaining the fair price of
the stock. Financial mechanics cannot be denied.
Q6: DO ISSUERS OF MONETARY INSTRUMENTS PROMISE A

STABLE PURCHASING POWER?
No. If that were the case, issuers of monetary instrument would have defaulted on their promise
continuously since the beginning of financial times. They never were able to provide a stable
purchasing power, even less so since the end of World War Two (see Chapter 15). As such, the
demand for monetary instruments would be nil if a stable purchasing power was a promise
embedded in monetary instrument because the creditworthiness of the issuer would be nil.
A stable purchasing power is not a promise of any issuer of monetary instruments. This is fine for
most bearers as long as the purchasing power of monetary instruments is relatively stable in the
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short‐term. If one wants something that holds purchasing power over the medium to long run, then
one should switch to other assets.
Q7: ARE MONETARY INSTRUMENTS NECESSARILY FINANCIAL
IN NATURE?
Yes, remember: “money does not grow on trees.” While monetary instruments can be made of a
commodity that commodity, does not tell us anything about the monetary nature of a thing. A gold
coin is a monetary instrument not because it is made of gold but because of its financial
characteristics. Gold is the collateral embedded in the coin. Similarly a house is not a mortgage, a
house is the collateral for a mortgage and nothing can be learned about the inner workings of
mortgages by studying how a house is made.
The “primitive moneys” would need to be studied much more carefully to determine if some of
them were monetary instruments. Just checking if they passed hands in exchange of goods and
services, if they were used to pay for a bride, etc. is a poor means of determining the “moneyness”
of something, given that one cannot differentiate between in‐kind payments and monetary
payments. We saw above that cowry shells were not monetary instruments in the Maldives but
they were in Africa and a detailed analysis was necessary and done to establish that fact.
Q8: ARE CREDIT CARDS MONETARY INSTRUMENTS? WHAT

ABOUT PIZZA COUPONS? WHAT ABOUT PRETEND‐PLAY
BANKNOTES AND COINS? WHAT ABOUT BITCOINS?
No to all questions.
A credit card is not a financial instrument—it does not have a maturity (issuers of credit cards do
not accept credit cards in payment) and it is not related to a unit of account (it is not a carrier of
the unit of account). The underlying credit line is not a financial instrument either. The line
represents the maximum dollar value of a customer’s promissory note (called credit card
receivables) that a credit company is willing to take on its balance sheet.
Say that household #1 wants to get a credit card from Bank A. #1 fills up the required
documentation so A can check #1’s creditworthiness. #1 is approved by A and gets a $1000 credit
line. Where is that recorded on the balance sheet? Nowhere, it is an off‐balance sheet item. The
line is just saying that A will take on its balance sheet up to $1000 of #1’s promissory notes without
asking again to check #1’s creditworthiness. Chapter 10 shows what happens when a credit line is
used: A’s assets rise by the amount of the credit line drawn by #1, #1’s liabilities rise by that same
amount.
What about a pizza coupon? It has an instantaneous maturity (one can go to the pizza shop at any
time to claim a pizza), it is a convertible, but it is not a financial instrument because it does not
involve monetary payments but merely in‐kind payments: it converts into a commodity. If the
coupon could be used to pay debts owed to the pizza shop at any time and, if the pizza shop stated
at what value it would take the coupon in payments, then it would be a monetary instrument.
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Figure 16.3 shows a set of play notes that my son got with his toy cash register. In order for the
notes to become monetary instruments, the company that created them would need to do the
following:
1‐ Change the design: too close to the design of Federal Reserve notes even though it is a
crude imitation. “The United States of America” should be eliminated because they are not
issued by the United States Government.
2‐ Promise to take the notes in payment: Bearers can pay the company with the notes to buy
things from, and clear debts owed to, the company.
Finally, bitcoins do not have any issuer and are irredeemable. The first problem prevents them from
being a monetary instrument, the second problem makes them valueless as monetary
instruments.6 Bitcoins are commodities/real assets, not financial assets.

Figure 16.3 Pretend‐play monetary instruments
Q9: WHAT WERE SOME ERRORS MADE IN PAST MONETARY

SYSTEMS?
Given the characteristics of monetary instruments, they should circulate at parity all the time;
however, actual circulation at par does not define a monetary instrument. Par circulation is only
the result of the inner characteristics of a financial instrument, the ability and willingness of the
issuer to implement these characteristics, and the existence of a proper financial infrastructure that
230

allows these characteristics to be expressed in the fair value. Only recently have there been well‐
functioning monetary systems. They are not without problems, but, in general, they ensure a
smooth processing of payments (see Chapter 14 when that is not the case) and can be used as a
reliable medium of exchange (see Chapter 12 when that is not the case), both of which help to
promote economic prosperity to some extent.
For reasons related to poor techniques of production, inexperience, political instability, frauds, and
poorly developed banking systems, it took quite a long time for the proper characteristics and
infrastructure to be established. Below are some errors that were made along the way:
• No stamped face value: In the Middle Ages, kings cried up or down (i.e. changed by decree)
the face value too many times.
– What is the problem? Nobody had any idea what face value was: “there were so
many edicts in force referring to changes in the [face] value of the coins, that none
but an expert could tell what the [face] value of various coins of different issues
were, and they became highly speculative commodities” (Innes 1913, 386).
• Free‐coinage: Anybody with gold can go to the mint and get coins stamped out of ingots
(government keeps a portion of the ingots: seigniorage)
– What is the problem? Kings legalized counterfeiting. Anybody with gold could issue
a debt of the king, i.e. make the king liable. Today, in the United States, an
equivalent would be for the Bureau of Engraving and Printing to print Federal
Reserve notes for anybody who came with paper that respected the Bureau’s
specifications!
• No redeeming clause: There is no way to return to the issuer its monetary instruments
– What is the problem? Fair price is zero unless there is a collateral or a recourse.
• There is a redeeming clause but no actual means to implement it because no payment is
due to the issuer (Chapter 17 shows that taxes during the time of colonial bills were not
always implemented when they were supposed to be), or conversion is very difficult (banks
during the free‐banking era).
– What is the problem? The term to maturity is no longer instantaneous as promised
but depends on the expectations of bearers. As such the discount factor comes
back into the valuation of the fair price and so the fair price is unstable and varies
with the confidence of bearers about the issuer.
• Full‐bodied coins: At issuance the face value (FV) is the same as the market value of the
gold content (PgG with PG the price of gold per ounce and G the ounces of gold in the coin)
– What is the problem? if ∆Pg > 0 => PgG > FV => coins disappear from circulation
(melted into ingots or exported as commodities)
• Lack of a proper interbank payment system: in that case interbank debts are difficult to
clear and settle. This creates all sorts of problems going from delays in processing
payments, to loss of purchasing power because some bank monetary instruments trade at
a discount relative to other bank monetary instruments, to full blown financial crises
because payments cannot be processed and so creditors do not receive what they are owed
and in turn cannot pay their own creditors.
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Q10: DO LEGAL TENDER LAWS DEFINE MONETARY

INSTRUMENTS? WHAT ABOUT FIXED PRICE?
Legal tender laws state that, in court settlements, creditors must accept whatever is defined as
legal tender in payments of what is owed to them. If they do not accept it, they cannot sue their
debtors for unpaid dues. This does not mean that a legal tender cannot be refused during petty
transactions. The current legal tenders in the United States are Federal Reserve notes, but plenty
of shops and government offices refuse cash payments.
Something that is legal tender is not necessarily a monetary instrument. In the past, commodities
have been included in the legal tender laws, thereby, compelling creditors to accept payments in
kind. Chapter 17 develops the case of tobacco leafs in the United States, which came about because
of a shortage of monetary instruments.
Something that has a fixed price is also not necessarily a monetary instrument. It may just be a
commodity managed by an economic unit via the use of a buffer stock; the economic units
accumulates large inventories of the commodity to offset downward pressures of its price, and sells
off its inventories to offset upward pressures of its price.
Q11: IS IT UP TO PEOPLE TO DECIDE WHAT A MONETARY
INSTRUMENT IS? WHO DECIDES WHEN SOMETHING IS
DEMONETIZED?
Public opinion about what is or what is not a monetary instrument does not matter and popular
belief by itself cannot turn something into a monetary instrument. To use an analogy, one can use
a shoe to hammer nails but it does not make the shoe a hammer. The fact that everybody thinks
that shoes are hammers does not turn shoes into hammers. If everybody is delusional enough to
believe the contrary, there will be many more work‐related accidents and productivity will drop
because shoes are not built properly to hammer nails. In a similar fashion, if everybody wants to
believe that gold nuggets, tobacco leafs, or grains of salt are monetary instruments, the payment
system will not work smoothly and economic activity will suffer.
As explained in Q2, some monetary instruments are used merely as collectible items. Some persons
may also use monetary instruments as ornaments and for other non‐economic uses. These other
uses do not demonetize a monetary instrument. That can only happen if a monetary instrument
seizes to be a promise and that is up to the issuer to decide.
Q12: CAN ANYBODY CREATE A MONETARY INSTRUMENT?
Yes, as long as one does not counterfeit existing monetary instruments, one can do so.7 One should
then have a monopoly over the issuance of such an instrument. Good luck getting it accepted!

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1‐ A commodity cannot be a monetary instrument by itself, it needs additional financial
characteristics fitted onto it.
2‐ In order to detect a monetary instrument one must study the financial characteristics of what is
said to be a financial instrument. The fact that something is a legal tender, a medium of exchange,
or circulates at a stable price does not tell us much about the monetary nature of that thing.
3‐ A proper monetary analysis involves dissecting the financial characteristics of a monetary
instrument and determining if the means are available to make these financial characteristics a
reality. In doing so, one must study the reflux mechanism and the issuer’s ability to fulfill the
promises made in a financial instrument.
4‐ A monetary instrument is accepted by bearers for the same reasons that a stock or a bond is
accepted by bearers: they trust the issuer’s ability to fulfill the promise embedded in the financial
instruments. While on a daily basis bearers trade stock, bonds, cash and other monetary
instruments without thinking about how creditworthy the issuer is, if the latter announces a default
that has an immediate impact on the fair price.
5‐ Gold coins are not monetary instruments because they are made of gold. Gold is just a collateral
embedded in the coin.
6‐ Inflation and deflation do not reflect a change in credit risk for the issuer of monetary
instruments.

Keywords
fair price, face value, legal tender laws, debasement, crying down/up the coinage, term to maturity,
collateral, free coinage, full‐bodied coin, redeeming clause, convertible, redeemable,

Review Questions
Q1: Explain why bitcoins and pretend‐play notes are not monetary instruments?
Q2: Why may a legal tender not be a monetary instrument?
Q3: If the issuer of a monetary instrument defaults, what happens to the fair price of that
instrument? What does it mean for day to day transactions of that instrument?
Q4: Who determines that something is a monetary instrument?
Q5: Why is a gold nugget not a monetary instrument?
Q6: What was the problem with free coinage? Full‐bodied coins? The absence of a redeeming
clause?

1 See section on salt currency at the Encyclopedia of Money blog: http://encyclopedia‐of‐
money.blogspot.com/2011/10/salt‐currency.html
2 Kiyotaki, N. and Moore, J. (1997) “Credit Cycles,” Journal of Political Economy 105 (2): 211‐248.
3 See http://www.theguardian.com/money/2016/may/14/zimbabwe‐trillion‐dollar‐note‐hyerinflation‐investment
4 Listen to “Penny Hoarders Hope For The Day The Penny Dies” by Zoe Chase at
http://www.npr.org/2014/05/21/314607045/penny‐hoarders‐hope‐for‐the‐day‐the‐penny‐dies
5 See Ilana E. Strauss’s “The Myth of the Barter Economy” http://www.theatlantic.com/business/archive/2016/02/barter‐
society‐myth/471051/
6 See Eric Tymoigne’s “Fair price of bitzoing is zero” at http://neweconomicperspectives.org/2013/12/fair‐price‐bitcoin‐
zero.html
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7 For example of pround counterfeiters who take their art very seriously, see “'Counterfeiting is an art': Peruvian gang of
master fabricators churns out $100 bills” at http://www.theguardian.com/world/2016/mar/31/counterfeiting‐peruvian‐
gang‐fabricating‐fake‐100‐bills
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CHAPTER 17:
What some of the problems have been in setting up a monetary system
How a functional approach to monetary systems can mislead an inquirer into
the existence of a monetary instrument.
Why medieval times were dark times for monetary systems

CHAPTER 17: HISTORY OF MONETARY SYSTEMS
The goal of this chapter does not to present a complete history of monetary systems but rather to
illustrate the points and framework presented in the two previous chapters. The goal of this chapter
is to show how to study the history of monetary system by taking a few examples. The financial
mechanics at play are emphasized and linked to the socio‐politico‐economic context.
MASSACHUSETTS BAY COLONIES: ANCHORING OF

EXPECTATIONS AND INAPPROPRIATE REFLUX MECHANISM
Massachusetts Bay colonies responded to the lack of currency by issuing bills of credit that “shall
be accordingly accepted by the treasurer and receivers subordinate to him, in all publick payments,
and for any stock at any time in the treasury” (Davis 1900, 10). The government spent by issuing
the bills and levied a tax to allow bearers to redeem them. Initially, trust in the bill was low because
of the political and financial risks:
When the government first offered these bills to creditors in place of coin, they
were received with distrust. […] their circulating value was at first impaired from
twenty to thirty per cent. […] Many people being afraid that the government would
in half a year be so overturned as to convert their bills of credit altogether into
waste paper, […]. When, however, the complete recognition of the bills was
effected by the new government and it was realized that no effort was being made
to circulate more of them than was required to meet the immediate necessities of
the situation, and further, that no attempt was made to postpone the period when
they should be called in, they were accepted with confidence by the entire
community […] [and] they continued to circulate at par. (Davis 1900, 10, 15, 18, 20)
The population was unsure that the government would be willing or able to fulfill the promise to
take back the bills at any times at par in tax payment. This lack of trust was compounded by the
fact that, while the promise stipulated that bills could be returned at any time, in practice the tax
levied to redeem the bills was initially implemented only once a year. Thus, when bills were issued
initially, d was positive and bearers’ expectations about the term to maturity (E(N)) compounded
the discount applied to the bills.
1

The government asked for the help of Boston merchants who agreed to take the bills at a small
discount in payments from the government. Ultimately, the bills circulated at par as the
government retired the bills as expected in a timely fashion.
However, as explained in Chapter 15, tying the issuance of bills of credits to a specific tax created a
dilemma. The private sector wanted to accumulate the bills but taxes prevent the accumulation of
the desired dollar amount of bills. At the same time, taxes were at the foundation of the monetary
system so they needed to be implemented as expected. Ultimately, the provincial government was
unsure about how to proceed. One drastic method was to breach the promised term to maturity
by postponing the implementation of the tax levy for several years. This was an effective default
relative to the terms of the bills and a sure means to decrease the confidence in the bills and so
their fair value (ibid., 108); “this fact alone would have caused them to depreciate, even if the
amount then in circulation had been properly proportioned to the needs of the community” (Ibid.,
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20). The discount rate became positive again which lowered the purchasing power of bills given
output prices. Later on, the provincial government found a more appropriate solution to the
dilemma by broadening the types of dues that could be paid with the bills.
From this example, one can learn several useful lessons. First, trust in the issuer of a monetary
instrument requires some work to be earned but is central for the ability of that instrument to
circulate at par. Second, if the reflux mechanisms in place are inconsistent with the promise made,
there will be problems to fulfill the promise made. Colonial governments promised redemption at
the will of bearers but payments owed to the government were only implemented occasionally and
narrowly. Third, once one has made a promise, one had better keep up with it; otherwise, bearers
lose confidence quite quickly.
MEDIEVAL GOLD COINS: FRAUD, DEBASEMENT, CRYING OUT,
AND MARKET VALUE OF PRECIOUS METAL
The most complex historical case regarding the fair value of monetary instruments concerns the
medieval coins made of precious metal. There are three broad problems in this case. One relates
to the face value of the coins, another relates to the intrinsic/bullion value of the coins (i.e., the
market value of the precious‐metal content), and a third one relates to the interaction between the
first two problems.
Up until recently, the face value was not stamped so it “was carried out by royal proclamation in all
the public squares, fairs, and markets, at the instigation of the ordinary provincial judges: bailiffs,
seneschals, and lieutenants” (Boyer‐Xambeu et al. 1994, 47). This announcement declared at what
nominal value the King would take each of his specific coins in payments due to him, thereby
establishing their face value. Frequent changes in face value led to confusion among bearers,
especially so given that the spread of information was slow and inadequate.
Coins made of precious metals were a way to partly deal with the uncertainty surrounding the face
value of coins. Coins with high precious metal content would be demanded from sovereigns that
could not be trusted, either because they cried down too much, or refused some of their coins in
payments too often, or were weak politically. The higher the content of precious metal relative to
the face value, the more limited the capacity of Kings to cry down the coinage because coins would
disappear if the face value fell below the market value of the precious‐metal content. Coins would
be melted (or exported as bullions) to extract the precious metal, because more units of a unit of
account could be obtained per coin by selling the precious metal instead of handing over coins to
the King. Finally, others (e.g., mercenaries) demanded payments in such a form because they did
not expect to be debtors to the King or to meet someone in debt to the King, or to meet someone
who would expect to make transactions with someone else indebted to the King.
While the issuance of such coins was warranted given the poor political and financial stability of the
time, they created several issues related to their intrinsic value and its impact on the fair value. If
circumstances in the precious metal market pushed the value of the precious metal higher than the
prevailing face value, mint masters and money changers would melt or illegally debase (e.g.,
clipping and sweating) the coinage even if the creditworthiness of a King was excellent. In theory,
illegal debasements would occur until the intrinsic value was brought back to the face value but it
became such a habit that it continued even when the value differential was nil. Expectations about
future increases in the price of the precious metal (or future crying down) also encouraged illegal
237

debasements, even if no profit could be made right now. Fraud was further encouraged by the
imperfect production methods. Coins with the same denomination and date of issuance had
different weight and fineness even under the best circumstances. Coins also had uneven edges that
made clipping difficult to notice, if done moderately.
Fraud was problematic because it disturbed the uniformity and order that Kings wanted to establish
to give confidence in their coinage; the stamp was a certificate of authenticity of the weight and
fineness of the collateral embedded in coins. The King’s reputation was at stake. If allowed to go
on, the country would be left with a coinage of an insufficient quantity and quality to promote
smooth economic operations, and clumsy and deformed coinage encouraged forgery. In order to
prevent this from happening, Kings actively fought any fraudulent alteration of the intrinsic value
of coins. They did so through several means. One was to punish severely fraudsters:
The coins were rude and clumsy and forgery was easy, and the laws show how
common it was in spite of penalties of death, or the loss of the right hand. Every
local borough could have its local mint and the moneyers were often guilty of
issuing coins of debased metal or short weight to make an extra profit. […] [Henry
I] decided that something must be done and he ordered a round‐up of all the
moneyers in 1125. A chronicle records that almost all were found guilty of fraud
and had their right hands struck off. (Quigguin 1965, 57‐58)
Another means was to weigh the coins that were brought to pay dues, and to refuse in payments
all coins that had a lower weight than at issuance. Finally, two other ways were either to debase
(decrease the quantity of previous metal to decrease the intrinsic value) or to cry up the coinage
(increase the face value):
debasements were only necessary alterations in the quantity of silver in the coins,
in order to keep pace with the rise in the price of silver bullion in the market; […] It
has always been necessary to regulate the quantity of metal in the coins, because,
if too much was put in, they would immediately be withdrawn from circulation and
sold for bullion, […]; if too little was put, they might be imitated. (Smith 1832, 34)
In this case, debasement was not a means to increase the financing capacity of the King. It was a
legitimate means to preserve the stability of a monetary system in which the value of precious
metal played a role as collateral. However, debasement was a limited solution to offset the rising
price of precious metals because the risk of forgery grew with further debasement. Debasement
also negatively impacted the King’s creditworthiness even though he may have had nothing to do
with the problem and was trying to promote a stable monetary system.
Crying up the coins was not constrained by the risk of forgery, but it created another problem, as
potential inflationary pressures emerged when the money supply was raised unilaterally overnight
in nominal terms. Price pressures in the precious metal markets could creep into the market for
goods and services, and, once again, the King would be blamed. Finally, frequent crying up created
further confusion among the public about the face value of coins; thereby, it reinforced distrust
and demands for coins with a high content of precious metal.
If one combines changes in face value, changes in intrinsic value, as well as their interactions, the
determination of the fair value of medieval coins becomes complicated. On the one hand, abusing
crying down led to two types of speculation; one regarding the occurrence of a future crying down;
another concerning the face value of the coins relative to the intrinsic value. On the other hand,
238

developments in the precious metal markets affected expectations about future debasements or
crying up of coins.
What can we learn from this part of monetary history? First, an issuer should have some control
over when a collateral can be seized by bearers. If the collateral is embedded in the monetary
instruments, a rise in the value of the collateral above face value may lead bearers to seize it even
if the issuer has not defaulted. Second, if a monetary instrument is made from precious metal, the
intrinsic value of the coins should be lower than the face value by a margin large enough to
accommodate significant increases in the market value of the precious metal. Third, anchoring the
expectations of bearers about the face value is important for a well‐functioning monetary system.
TOBACCO LEAFS IN THE AMERICAN COLONIES: LEGAL

TENDER LAWS AND SCARCITY OF MONETARY INSTRUMENTS
The case of Virginia and other U.S. colonies in the 17th and 18th centuries is usually put forward to
make the case that tobacco leaf was a monetary instrument:
Tobacco was an accepted medium of exchange in the southern colonies. Quit rents
and fines were payable in tobacco. Individuals missing church were fined a pound
of tobacco. In 1618, the governor of Virginia issued an order that directed that “all
goods should be sold at an advance of twenty‐five percent, and tobacco taken in
payment at three shillings per pound, and not more or less, on the penalty of three
years of servitude to the Colony.” […] Virginia was using “tobacco notes” as a
substitute for currency by 1713. These notes originated after tobacco farmers in
Virginia began taking their tobacco crops to warehouses for weighing, testing, and
storage […]. The inspectors at the rolling houses were allowed to issue notes or
receipts that represented the amount of tobacco being held in storage for the
planter. These notes were renewable and could be used in lieu of tobacco for
payment of debts. […]Fines in Virginia were payable in tobacco. For example, a
master caught harboring a slave that he did not own was subject to a fine of 150
pounds of tobacco. The Maryland Tobacco Inspection Act of 1747 was modeled
after the Virginia statute. The Maryland statute required tobacco to be inspected
and certified before export in order to stop trash from being put in the tobacco.
[…] Inspection notes were given for the tobacco that was inspected. Those notes
were passed as money in Maryland. The use of warehouse receipts for tobacco and
other commodities would spread to Kentucky as settlers began to cultivate that
region. (Markham 2002, 44‐45)
Hence, tobacco leafs served as media of exchange and so, following the narrow functional
approach, were a monetary instrument. However, what the preceding description actually shows
is that the colonies of Virginia and Maryland were at the center of a trading system of tobacco
which was central to the economy of these states. By accepting tax payments, or any other dues,
in tobacco at a relatively high fixed price, governments could influence tobacco output, could
centralize output collection and redistribution, and make it easier for farmers—who usually did not
have enough monetary instruments because of their scarcity—to pay their taxes. This, however,
does not qualify payments in tobacco leafs as a monetary payment, but rather as a payment in kind
at a price that was administered. Like in feudal times, taxes could be paid in kind.
239

However, the previous quote gives us some clues about the monetary system that existed. First,
whereas tobacco was not a financial instrument, tobacco notes were a financial instrument of the
government warehouses worth a certain number of pounds and collateralized by the value of the
weight of tobacco that each note represented. Thus, tobacco notes may have become monetary
instruments; nothing clear is said about that. Second, the provision of credit through bookkeeping
was a common way to avoid the problems of barter:
One method for financing private transactions in the colonies was through records
of account kept by tradesmen and planters. Credits and debits were transferred
among other merchants and traders. This was a form of “bookkeeping barter” in
which goods were exchanged for other goods, and excess credits were carried on
account. The barter economy that prevailed in the colonies required “voluminous
record‐keeping … to carry over old accounts for many years.” This practice would
continue through the eighteenth century […]. (Ibid., 46)
The bookkeeping system was actually more complicated because credits on an account were
sometimes transferable at par. Thus, a monetary system based initially on a unit of account named
“pound” was present in the colonies, even though its functioning was not very smooth given the
excessively high scarcity of top monetary instruments and the localized emergence of bookkeeping
transfers. Tobacco leafs were not part of this monetary system.
SOMALIAN SHILLING: THE DOWNFALL OF THE ISSUER AND

CONTINUED CIRCULATION OF ITS MONETARY INSTRUMENT
In 1991, the Somalian government collapsed but its monetary instruments continued to circulate.1
One can explain why by noting that:
1. The state was central in establishing the trust about the currency prior to 1991. This is what
anchored the expectations about the face value of the Somalian shilling.
2. Given the confusion at the time the state collapsed, citizens just relied on habits, anchoring
induced by the inertia provided by historical acceptance created by the state.
3. If citizens believe that the collapse of the state is only temporary and the shilling will be
reissued later then there is an incentive to continue using it. This is very different from the
case of the transfer to the Eurozone when states spent years educating and informing their
population about the demonetization of their currency, and gave a clear date about when
demonetization would occur. In Somalia, everybody was left in the dark.
4. The belief that shilling would be again the national currency was reinforced by two aspects:
a) local governments did accept them for tax payments at least temporarily b) armed
militia, that substituted for government, started to forge some shilling notes to fill up the
void left by the collapse of the official government, and, in addition, may have allowed dues
to be paid in that currency.
All this is similar to shares that continue to trade even as a company goes through liquidation and
reorganization. Bearers are hopeful that the company will come back and be great again.
240

1‐ The use of tax liability and tax enforcement as means to create a demand for government
monetary instruments has been a common practice of government for hundreds of years.
2‐ A monetary system based on gold or other precious metal is very inelastic and subject to
monetary instability if gold is given too much importance.
3‐ While an issuer of a financial instrument may default, it does not mean that its financial
instrument will disappear if there is an expectation that the issuer will be able to restore its
creditworthiness in the future.
4‐ Tobacco leafs were not monetary instruments in the US because nobody issued them, i.e. nobody
made promises embedded in the tobacco leafs; they had no issuer.

Keywords
Debasement, legal tender laws, fraud, reflux mechanism

Review Questions
Q1: How did the inclusion of tobacco leafs in legal tender laws help the payment system?
Q2: Why is crying down the coinage problematic? How did the existence of coins made of precious
metal limit the ability to cry down the currency?
Q3: Was debasement mostly about improving the finances of the king by being able to issue more
coins with the same amount of precious metal?
Q4: How did the issuance of precious metal coins help to deal with the uncertainty of the time but
also created some instability.

Suggested readings
Bell, S.A.(2001) “The role of the state and the hierarchy of money” Cambridge Journal of Economics
25 (2): 149‐163.
Boyer‐Xambeu, M.T., Deleplace, G. and Gillard, L. (1994) Private Money and Public Currencies. New
York: M.E. Sharpe.
Forstater, M. (2005) “Taxation and primitive accumulation: The Case of Colonial Africa.” In The
Capitalist State and Its Economy: Democracy in Socialism, Research in Political Economy, Volume
22, 51‐65.
Henry, J. F. 2004. “The social origins of money: The case of egypt.” in Wray, L. R. (ed.) Credit and
State Theories of Money. Northampton: Edward Elgar.
Hudson, M. and Wunsch, C. (2004) Creating Economic Order. Bethesda: CDL Press.
Ingham, G. (2000) “Babylonian madness: On the historical and sociological origins of money,” in
Smithin, J. (ed.) What Is Money? New York: Routledge.
Littleton, A.C. (1956) Studies in the History of Accounting. Homewood: Richard D. Irwin

1 For a summary of the topic see David Andolfatto’s “Fiat money in theory and in Somalia” at
http://andolfatto.blogspot.ca/2011/08/fiat‐money‐in‐theory‐and‐in‐somalia.html
241

GLOSSARY
A Bearer: A person who holds a Collateral: Assets held by debtors
financial claim on the issuer. In most that can be taken by creditors in
Advance: Quantity of funds cases, the bearer can sue the issuer case of default. Assets are usually
provided by a bank to a customer in if the promise embedded in the sold to try to recover some of the
exchange of the customer’s claim in not fulfilled. funds owed.
promissory note.
Board of Governors: The head Commercial paper (CP): A security
Applied vault cash: The dollar institution of the Federal Reserve issued by private companies with a
amount of Federal Reserve notes System. It is composed of at most short term to maturity (one year or
that banks choose to use to comply seven governors. less).
with reserve requirements.
Bond: A security with a relatively Conforming mortgage: A mortgage
Asset: Anything that is owned by an long term to maturity. It pays a that has financial characteristics
economic unit. coupon periodically. that conform to criteria set by
Asset‐based credit (also collateral‐ Fannie Mae, Freddie Mac, and
Borrowed reserves: Reserves
based credit): A promissory note Ginnie Mae.
obtained by going through the
underwritten with the expectation Discount Window (reserves Consolidation: The act of merging
that income of the issuer will never “borrowed” from the Fed). two or more balance sheets into
be enough to service the debt. one.
Borrowing: Temporarily using the
Asymmetry of information: A assets of someone else. Consumption (also final
situation in which an economic unit consumption): The use of goods and
knows less than another economic C
service for personal enjoyment.
unit at the time of a contractual CAMELS rating: A rating that
negotiation. Contingent liability: A claim that is
measures the soundness of a bank.
due when a specific event occurs.
Automatic stabilizers: Changes in Capital: See net worth.
the level and growth rate of Conventional mortgage: Any
government spending and of taxing Capital requirement: Quantity of mortgage issued by non‐
that occur because of change in capital that a financial institution government financial institutions.
economic activity, and not because must keep relative to the size and Unconventional mortgages are
government decided to change its quality of its assets in order to those insured by government
spending or taxing habits. For protect its balance sheet against agencies (such as the Federal
example, unemployment insurance unexpected losses. Housing Administration) and that
goes up automatically in a recession have unconventional characteristics
Cash flow: Inflow or outflow of
and goes down automatically during that accommodate the needs of
monetary instruments.
an expansion. Similarly, tax economic units with a higher chance
revenues fall (rise) automatically Cash management: A deliberate of defaulting (e.g., low interest rate
during a recession (an expansion) management of the level and even though creditworthiness is not
because less (more) income is structure of monetary balances to very good).
earned by the private sector. reach a specific goal.
Convertible: The ability to hand
B Certificate of deposit (CD): A back to the issuer its promissory
promissory note issued by banks note and to get something else in
Balance sheet: An accounting with a term to maturity varying from exchange.
document that shows what is short to medium term. It is similar to
owned and owed by an economic Coupon: The income received from
a savings account, except that it is
unit. a bond and other similar securities.
illiquid until maturity.
It is an interest income, that is, its
Basis point: A one‐hundredth of a Clipping coins: The act of cutting payment is due periodically and
percentage point, 0.01%. bits out of coins. represents a proportion of the face
value of a bond. Bonds used to be in
242

GLOSSARY
paper form with small coupons Debt management: The deliberate F

attached to them that needed to be change in the level and structure of
Face value: The price at which the
detached and handed backed to the outstanding debt to reach a specific
issuer promises to take back its
bond issuer to receive the interest goal.
financial instrument. The
payment due.
Debtization: The growing use of outstanding principal due by the
Credit‐card receivable: Amount of debt in daily economic activities. It is issuer.
debt outstanding on a credit card. the counterpart of the
Fair price (also fair value): The price
financialization of the economy.
Credit risk: The probability that an at which a security ought to trade. It
economic will default on its Default: The action of declaring the may or may not be the price at
promise. inability or unwillingness to service which a security actually trade (the
debts, either at all or according to market price).
Credit standards: Criteria used by
the previously‐agreed time table.
bankers to determine how Fannie Mae: A government‐
creditworthy an economic unit is. Deficit: A budgetary situation for sponsored enterprise that buys
which spending exceeds income. conventional and government‐
Creditworthiness: Expected ability
insured mortgages from banks as
of an economic unit to service its Demand liability: A claim that is due
long as they conform to a set of
debts on time in full. at the will of the bearer.
standards it sets. It does so in order
Currency in circulation: Officially, it Discount trading: The market price to encourage them to acquire more
is mostly the value of Federal of a security is below fair price. mortgages at more affordable rates.
Reserve notes in the hands of It buys mortgages by issuing
Discount Window: A means for the
economic units others that the mortgage‐backed securities.
Federal Reserve System to provide
Federal Reserve banks, the U.S.
collateralized advances to banks. Federal funds: The dollar value of
Treasury, and banks. Theoretically,
the accounts at the Federal Reserve
coins held by others than the Discount Window operation: An
banks.
previously cited economic units are advance of reserves to bank. Banks
also included in the definition. sign a promissory note and in Federal funds market: A market in
exchange get reserves. All which participants borrow and lend
Crying up/down the coinage: The
promissory notes must be federal funds.
act of increasing/decreasing the
collateralized so if banks default, the
face value of coins by decree. Federal funds rate: The interest rate
Fed takes the assets banks put as
that is paid (received) by an entity
D collateral.
that borrows (lends) federal funds in
Dated liability: A claim that requires Dividend: The income received from the federal funds market.
payments at specific periods of a stock. Its payment is a proportion
Federal funds rate target: The
time. of the profit of a company.
federal funds rate that the central
Debasement: A legal or illegal E bank wants to see in the market.
decrease in the quantity of precious
Economic unit: An economic entity Federal Open Market Committee
metal included in a coin.
that, depending on the level of (FOMC): A committee of the Federal
Debt deflation: An economic analysis, can be a household, a firm, Reserve System composed on the
situation in which overindebtedness a government, a country, or other board of governors and the
and prices interact in such a way entity that makes decisions. presidents of the Federal Reserve
that it results in deflation, defaults, banks. It formulates monetary
Elastic currency: A currency that can
and a general decline in economic policy by meeting every six weeks or
be injected and ejected from the
activity. so and voting on the course of
economic system as needed.
action in terms of the federal funds
Debt liquidation: The act of
Excess reserves: Quantity of rate target. Presidents (except the
reducing the quantity of
reserves that is kept by banks president of the New York Federal
outstanding debts either by
beyond what the Fed requires them Reserve bank) rotate their voting
repaying them or by writing them
to hold.
off.
243

GLOSSARY
power and only five out of the 12 federal funds rate target through a That is done by buying those
can vote at any time. specific wording of current promissory notes from banks or by
monetary‐policy decisions. insuring banks against defaults on
Federal Reserve Bank: One of the
the promissory notes.
twelve banks part of the Federal Fraud: The act of gaining the trust of
Reserve System. a person and then abusing that H
trust. It is the act of deceiving for
Federal Reserve System (Fed): A Hedge finance: A financial situation
personal benefit.
government agency created to in which an economic unit is able
provide the currency of the nation, Freddie Mac: A government‐ now and in the future to service its
to facilitate interbank payments, to sponsored enterprise that competes debts with its income.
regulate member banks, to promote with Fannie Mae.
Household: A person of group of
an elastic currency, and to manage
Free reserves: Non‐borrowed persons living in the same dwelling.
economic activity. While it is
reserves held beyond what is
structured with some for‐profit I
required.
features, its activities and goals are
Illiquidity: Temporary inability to
oriented toward fulfilling the public Funding phase: A phase of the
pay creditors.
purpose expressed in its functions. economic process in which finance
Also the Fed can operate without plays a role for the acquisition of Income‐based credit: A promissory
making any profit. what has been produced. note underwritten with the
expectation that the income of the
Financial asset: A claim held against Funds: An outstanding quantity of
issuer will be sufficient to service
someone that involves contractual monetary instruments.
the debt, if not now at least
monetary payments.
G sometime in the future.
Financialization: The growing
Ginnie Mae: A government‐owned Income distribution: The
importance that the financial sector
company that guarantees the timely distribution of national income
plays in daily economic activity.
payment of principal and interest on among, wage earners and profit
Financing phase: A phase of mortgage‐backed securities earners.
economic activity in which bank collateralized by federally insured or
Inconvertible: A promissory note
credit is needed to start production guaranteed mortgages. These
that is not convertible.
mortgages are issued mostly by low‐
Fine‐tuning the economy: Policy
to‐moderate income households Inflation risk: The probability of a
strategy used by the central bank
and by veterans. By doing this, substantial fall in the purchasing
and the U.S. Treasury to ensure that
Ginnie Mae encourages banks to power of future cash flows and
an economy stays close to full
fund homeownership for veterans outstanding financial assets
employment with stable prices. It
and the poorer section of American
involves nudging incentives in the Interest on reserves: Interest rate
households.
private sector and the use of paid on reserve balances.
automatic stabilizers to move the Government‐sponsored enterprise
Intrinsic value: The market value of
economy in a specific direction and (GSE): A for‐profit firm created by
material (paper for banknotes, gold
to ensure it is neither too hot Congress to fulfill a public purpose.
for gold coins, etc.) used to make a
(inflation pressures) nor too cold Such enterprises have been created
monetary instrument.
(high unemployment). to promote homeownership,
education, the electrification of the Insolvency: Permanent inability to
Fiscal deficit: See deficit. It results in
country, among other goals that pay creditors.
the issuance of new Treasuries.
have been deemed relevant to fulfill
Investment: The purchase of goods
Fiscal surplus: See surplus. It results the public purpose. They do so by
and services for the purpose of
in the repayment of existing encouraging banks to lower the
producing goods and services.
Treasuries. interest rate and underwriting
requirements on promissory notes Irrational behavior: Behavior that
Forward guidance: A monetary
issued to fulfill the activities that deviates from the standard
policy that involves influencing
comply with the public purpose. neoclassical hypothesis about
expectations of the future path of
244

GLOSSARY
behaviors (maximization and Liquid asset: An asset that can be Net acquisition: Acquisition minus
preference ranking). traded quickly without incurring reduction in the quantity of assets
large losses of capital. An asset with or liabilities.
Issuer: An economic unit that
a relatively stable fair price. A
created a promissory note and gave Net borrowing: The opposite of net
perfectly liquid asset has a stable
it to others. That economic unit lending.
nominal value.
must now fulfill the promise
Net capital gain: Capital gains minus
embedded in the note. Liquidity risk: The probability that
capital losses.
the price of an asset will fall
J
substantially when its owner tries to Net cash flow: Cash inflow minus
Job guarantee program: An sell it quickly. cash outflow.
economic policy that provides the
M Net clearing of debt: The act of
opportunities to work for all persons
acknowledging what two (or more)
willing and able to do so. This helps Monetary aggregates: Measures of
economic units owe to each other
make a person more employable, the money supply. M1 is the
and to calculate the net amount due
use her skills for more social narrowest indicator.
by one of the economic unit. X owes
purpose while unemployed, and
Monetary base: The sum of $10 to Y, Y owes $3 to X, then X owes
provide some training experience.
reserves and cash in circulation. $7 to Y. Net clearing allows to
L simplify the settling of debts by
Monetary instrument: A security
reducing the number of transfers
Lease: The loan of an asset with the with specific financial characteristics
between debtors and creditors.
option to buy it after a period of such that its fair price is parity.
time. Net financial accumulation: See net
Money supply: The sum of currency
lending.
Legal tender laws: Laws that dictate in circulation and other monetary
what is/are the ultimate means of instruments held by the public. Net lending: A positive difference
payment. A creditor cannot pursue between the change in the quantity
Moral hazard: An increase in the
further legal actions against its financial assets and the change in
risk taking of an economic unit once
debtors if it refuses payment in legal the quantity of financial liabilities.
it knows it is protected against
tender. Over a period of time, an economic
specific adverse events. The
unit acquires more claims on others
Lending: Temporarily parting with increase in risk taking increases the
than others acquire claims on that
an asset. probability that such specific
economic unit.
adverse events will occur.
Level‐1 valuation: Financial assets
Net income: Income minus
are valued based on their market Mortgage: A promissory note
expenses.
price. backed by a residential or a
commercial property. Net saving: See net lending.
Level‐2 valuation: Financial assets
are valued based on a proxy market. Mortgage‐backed security (MBS): A Net worth (also net wealth): The
Maybe because there is no readily bond that is backed by mortgages. difference between the value of
available organized market for the The cash flow for the interest and assets and the value of liabilities.
assets held. principal payments for the bond
Nominalism: A legal view that states
comes from the servicing of
Level‐3 valuation: Financial assets that changes in the purchasing
mortgages.
are valued according to a model power ought not to impact the
created by the economic unit that N amount of principal owed.
holds them.
Natural growth rate: The growth Non‐borrowed reserves: Reserves
Leverage: A measure of the rate of productive capacities obtained through open‐market
indebtedness of an economic unit. induced by a given set of allocation, operations with the Fed or
preference and technique of borrowed from other banks.
Liability: Anything that is owed by
production.
an economic unit. Non‐financial asset: Something
owned by an economic unit that
does not involved contractual
245

GLOSSARY
monetary payments to its owner. P Recourse: The ability of creditors to

That includes machines, software, ask for more funds from debtors if
Par value: See face value.
and goodwill, among others. the sale of collateral has not been
Parity: See par value. sufficient to recover the funds
Normalization: A monetary‐policy
expected.
strategy that aims at bringing the Ponzi finance: A financial situation
FFR back to more normal levels in an in which an economic unit is not Redemption: When the issuer takes
environment of an abnormally large able now and in the future to service back its promissory note from the
quantity of excess reserves. The its debts with its income. It must bearer(s).
strategy also aims at removing most refinance or must sell assets to
Redeemable: A security can be
of excess reserves in the long run. service the interest and principal
returned to its issuer at some point
due, at least for a period of time.
O in time through some reflux
Portfolio: The set of assets held on a mechanisms.
Open‐market operations: The sale
balance sheet.
or purchases of securities by the Reflux mechanisms: The means
central bank, on a permanent or Position: The dollar value of a available to the bearers to give back
temporary basis, respectively to specific asset held on the balance a financial instrument to its issuers.
remove or add reserves. The sheet. This position can be long (one
Refinance: The act of repaying an
frequency of this market owns the specific assets) or short
old debt by issuing a new debt.
intervention varies depending on (one borrowed the specific asset).
the central bank, with the Federal Repurchase agreement: When a
Premium trading: The market price
Reserve intervening daily while the party agrees to sell/to buy
of a security is above its face value.
European Central Bank intervening something today and to buy/to sell
weekly. Principal: Outstanding amount of it back in the future.
debt left to be repaid.
Originate and hold model: Banks Required reserves: Quantity of
acquire promissory notes and hold Promissory note: A contractual reserves that a bank must have.
them to maturity. agreement to make one or several
Reserves: See total reserves.
monetary payment(s) in the future.
Originate and distribute model:
Reserve balances: Accounts of
Banks acquire promissory notes and Public debt: The face value of
banks at the Federal Reserve.
sell them almost immediately. outstanding Treasury securities. It
goes up with a fiscal deficit and it Reserve requirements ratio:
Output gap: The difference
goes down when Treasuries are Proportion of total reserves that a
between the growth rate of
repaid. bank must have in relation to its
aggregate demand and the growth
transaction accounts.
rate of aggregate supply. R
Return on asset: The value of
Outright purchase: The action of Rate of return: A measure of
monetary gains relative to the value
permanently buying a financial monetary gains in percentage rather
of assets.
asset, i.e. buying with the intention than dollar amount. The amount
of holding it. This is done when the earned relative to the cost of getting Return on equity: The value of
Fed expects that some of the access to that earning. monetary gains relative to the value
reserves available will not be of net worth.
Real Bill Doctrine: A view according
needed for an extended period of
to which the financial assets of the Risk management: Means used to
time.
Fed should only be composed of protect a balance sheet against
Overdraft: A negative balance in a self‐liquidating assets, i.e. expected and unexpected adverse
bank account. promissory notes that are issued shocks.
and destroyed in relation to
Overnight interbank market: The S
economic activity. Firms issue
market in which banks lend and
commercial papers to finance Saving: Depending on the context, it
borrow reserves to each other for
production and take back the can be the unconsumed monetary
the night.
papers when they make a profit. income or the change in net worth.
246

GLOSSARY
Scarcity: An economic situation in T‐bill: A security issued by the U.S. Vault cash: The Federal Reserve
which there are limited resources to Treasury with a term to maturity of notes in the vault of banks.
fulfill unlimited preferences. at most one‐year and that does not
Valorism: A legal view that argues
provide a coupon payment.
Secured: Backed by a piece of that the principal owed should be
collateral. T‐bond: A security issued by the U.S. adjusted to maintain its purchasing
Treasury with a term to maturity of power constant.
Security: A promissory note that is
more than ten years. More loosely,
tradable. Depending on its financial Volcker experiment: A change in
the term is used to mean any
characteristics, a security can take a monetary policy operations toward
treasuries with a term to maturity
different name such as stock, bond, a looser targeting of the federal
greater than one year.
or commercial paper. funds rate and a focus on targeting
Term to maturity: Time left before monetary aggregates.
Settlement of debts: The act of
the principal on a security is due.
paying debts. Y
Total reserves: The sum of reserve
Speculative finance: A financial Yield: See rate of return.
balances and applied vault cash.
situation in which an economic unit
Yield to maturity: The yield
is not able now and in the future to Treasury’s general account (TGA):
obtained if a security is held until it
service its debts with its income. It Account of the Treasury at the
matures.
must refinance the principal due at Federal Reserve that Treasury uses
least for a period of time or must sell to spend. Z
assets to do so.
Treasury securities: See Treasuries. Zero‐coupon security: A security
Speculation: The act of buying an that does not pay any coupon.
Treasury’s tax and loan account:
asset with the view of reselling it to
Account of the Treasury at private
make a capital gain.
banks that Treasury uses to collect
Stock (also equity or share): funds received from taxes and the
Security that represents a share of issuance of Treasuries.
the company. The bearer is the
Treasuries: Securities issued by the
owner of the company. Common
U.S. Department of the Treasury.
stocks allow the bearers to vote on
the major strategic decisions of the Triffin dilemma: If a currency is both
company. Preferred stocks do not convertible and in high demand by
give a voting right but guarantee the the rest of the world, the issuer of
payment of a dividend. that currency must supply enough
but as it supplies more the promise
Surplus: The opposite of deficit.
of convertibility becomes harder to
Surplus vault cash: Federal Reserve fulfill.
notes that banks have in excess of
U
what they use to meet reserve
requirements. Underwriting: The act of
determining the creditworthiness of
Sweating coins: The act of shaking
an economic unit.
coins in a bag to remove tiny bits of
precious metal. A less easily Unit labor cost: The ratio of wage
detectable means of debasement over the productivity of labor.
than clipping.
Unsecured: Financial claims that is
T not backed by any collateral (e.g.,
credit receivables). They may still be
Tax receivable (or payable): Taxes
some recourses for bearers.
that recorded as due but not yet
paid. V
247

ABOUT THE AUTHOR
Eric Tymoigne is an Associate Professor of Economics at Lewis and Clark College, Portland, Oregon; and
Research Associate at the Levy Economics Institute of Bard College. His areas of teaching and research
include macroeconomics, money and banking, and monetary economics. His current research agenda
includes the nature, history, and theory of money; the detection of aggregate financial fragility and its
implications for central banking; the coordination of fiscal and monetary policies; and the theoretical
analysis of monetary production economies. He has published in numerous academic journals and edited
volumes. His most recent book, coauthored with L. Randall Wray, is The Rise and Fall of Money Manager
Capitalism: Minsky’s Half Century from World War Two to the Great Recession. Tymoigne holds an MA in
economic theory and policy from the Université Paris–Dauphine and a Ph.D. in economics from the
University of Missouri–Kansas City.

248

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Organized Exchanges (CBOT, CBOE, NASDAQ, NYSE)

Government-Sponsored Enterprises (FAMC, FCS, FHLBS, FHMLC, FNMA,

POINT 4: BANKS CANNOT DO ANYTHING WITH RESERVE BALANCES

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CAN THE FED ISSUE AN INFINITE QUANTITY OF MONETARY

A GRAPHICAL REPRESENTATION OF THE FEDERAL FUNDS

Bank of New York at: http://libertystreeteconomics.newyorkfed.org/2013/12/whos‐lending‐in‐the‐fed‐funds‐

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Q9: HOW DID CENTRAL BANKERS JUSTIFY USING NEGATIVE

Q12: WHAT ARE NO‐NO SENTENCES FOR WHAT THE FED

OTHER EXAMPLES OF TREASURY’S INVOLVEMENT IN MONETARY

A NECESSARY COORDINATION OF TREASURY AND CENTRAL

TO GO EVEN FURTHER: WHAT ARE THE RELEVANT

Households SPE1 SPE 2 SPE 3

Houses Subprime Subprime High‐rate Low‐rate High rate Mezzanine Senior‐AAA

Equity (very Low‐rate Low‐rate Other CDO2

experiment led to a very large increase in the level and volatility of the federal funds rate. This

WHY ARE THERE STILL FREQUENT AND SIGNIFICANT

THEORIES OF BANK CRISES AND BANKING REGULATION:

SAVE CAPITALISM FROM ITSELF: CRISES AS INTERNAL

MONETARY CREATION BY BANKS: CREDIT AND PAYMENT

HOW DOES A BANK MAKE A PROFIT? MONETARY

INTERBANK PAYMENTS, WITHDRAWALS, RESERVE

WHAT LIMITS THE ABILITY OF A BANK TO PROVIDE CREDIT

LIMITS TO MONETARY CREATION BY THE CENTRAL BANK

TO GO FURTHER: A SIDE NOTE ON ALTERNATIVE VIEWS OF

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THE QUANTITY THEORY OF MONEY: MONETARY VIEW OF

can adjust to the large increase in the demand for goods and services is through an increase in

In terms of policy, the theory means that inflation is managed best by buffer‐stock policies and

TO GO FURTHER: KALECKI EQUATION OF PROFIT, INTEREST

ADP LDP AG LG AF LF

POINT 1: THE BEGINNING OF THE ECONOMIC PROCESS REQUIRES

The public debt of the United States is the face value of outstanding U.S. Treasury securities. It

TO GO EVEN FURTHER: NIPA AND FA DEFINITIONS OF

REAL EXCHANGE ECONOMY: EFFICIENT MARKETS AND

MONETARY PRODUCTION ECONOMY: THE FINANCIAL INSTABILITY

TO GO EVEN FURTHER: MINSKY AND INCOME VS. CASH

A SPECIFIC FINANCIAL INSTRUMENT: MONETARY

AT WHAT PRICE SHOULD A FINANCIAL INSTRUMENT

TRUST AND MONETARY SYSTEM: TRUST IN THE ISSUER VS.

Q2: CAN A MONETARY INSTRUMENT BECOME A

Q4: ARE CONTEMPORARY GOVERNMENT MONETARY

Q6: DO ISSUERS OF MONETARY INSTRUMENTS PROMISE A

Q8: ARE CREDIT CARDS MONETARY INSTRUMENTS? WHAT

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MASSACHUSETTS BAY COLONIES: ANCHORING OF

TOBACCO LEAFS IN THE AMERICAN COLONIES: LEGAL

SOMALIAN SHILLING: THE DOWNFALL OF THE ISSUER AND

paper form with small coupons Debt management: The deliberate F

monetary payments to its owner. P Recourse: The ability of creditors to

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