I am re-reading my college economics textbook (Principles of Macroeconomics by Mankiw). (I know he's a New Keynesian, but I'm going to read Economics for Real People after to get the Austrian background.) Mankiw talks about the market for loanable funds in which there is a downward sloping demand curve and an upward sloping supply curve. He gives an example of a tax reduction on interest and dividends as something that would shift the supply curve to the right, increase the quantity of money lent, and decrease interest rates. The idea is that if the effective rate of return on saving increases, then households will consume less and save more. What I don't get is how the supply of loanable funds increases just because people shift consumption into saving. If I have $50 and I put it into my bank account instead of spending it on a new baseball bat, that is supposed to increase the supply of loanable funds. But even if I spend it on the baseball bat after all, won't the money go into the bank account of the store I bought the bat from? Either way, doens't the $50 end up in someone's bank account? What is the net difference in the supply of loanable funds?
I just thought I would point out that Economics for Real People is a good book, but, as the name suggests, the target is the common Joe. You'll get disapointed if you expect to find nearly that kind of detail.
Equality before the law and material equality are not only different but are in conflict with each other; and we can achieve either one or the other, but not both at the same time. -- F. A. Hayek in The Constitution of Liberty
That sounds like complete nonsense to me.
The amount of money available for loans is completely uncorrelated with customer bank deposits. The Federal Reserve will create as much money as necessary, via monetizing the debt. If there's a "shortage" of cash (i.e., the Fed Funds Rate is rising), then the Federal Reserve will purchase debt and create more cash. The Federal Reserve may print as much money as it pleases via purchasing debt; the Federal Reserve has (literally) an infinite budget.
If you put money in a checking account, you're earning a negative inflation adjusted return. Inflation really is 7%-30% (depending on what measure you use), but you only get credited 1%-2% on your checking account. People saving money "stimulates the economy", because savers are letting the financial industry steal their wealth.
If you put your wages in a checking account, that means you worked in exchange for (literally) nothing. Over time, your savings will be eroded by inflation.
I have my own blog at FSK's Guide to Reality. Let me know if you like it.
vp3434: I am re-reading my college economics textbook (Principles of Macroeconomics by Mankiw). (I know he's a New Keynesian, but I'm going to read Economics for Real People after to get the Austrian background.) Mankiw talks about the market for loanable funds in which there is a downward sloping demand curve and an upward sloping supply curve. He gives an example of a tax reduction on interest and dividends as something that would shift the supply curve to the right, increase the quantity of money lent, and decrease interest rates. The idea is that if the effective rate of return on saving increases, then households will consume less and save more. What I don't get is how the supply of loanable funds increases just because people shift consumption into saving. If I have $50 and I put it into my bank account instead of spending it on a new baseball bat, that is supposed to increase the supply of loanable funds. But even if I spend it on the baseball bat after all, won't the money go into the bank account of the store I bought the bat from? Either way, doens't the $50 end up in someone's bank account? What is the net difference in the supply of loanable funds?
I think that's a good question. I'm not sure of what is the correct answer, but I'll try this:
1) The money used for consumption isn't necessarily kept in demand deposits, it can be withdraw as cash too, which prevent that money to be loaned out by banks.
2) Keeping money in demand deposits causes higher reserves to be kept by banks, as opposed to time deposits (savings account).
3) There's a timing factor that when new deposits are made into bank B that were withdrawn from bank A, it will take some time to be effectively loaned out.
But otherwise, because of the current fractional reserve banking system, demand deposits are effectively loaned out and contribute to the credit inflation and lowering of the interest rate.
There is no contradiction, because saving and lending is infact the same thing. When you put money into a bank account, what you are doing is lending your money to the bank. Your money is not saved in some vault with your name on it or anything, its lent out to whoever is willing to pay the interest rate for borrowing the money. This is fractional reserve banking. I know its got a bad reputation, but its a wonderful free market invetion. It makes it possible to connect short time lenders with long time borrowers. Statistically a large number of short time lenders, as a whole, act as one long time lender. As long as the borrowers are of high quality, all those lenders will get their deposits back on request. As long as the bank is able to pay back the deposits on request it has not broken any contract.
Cheers
In a market economy, saving does not increase the supply of loanable funds. Saving increases the demand for capital goods, since saving is needed to pay for capital goods in the first place. However, the supply of loanable funds is effected by indirect investment, or certificates of deposit. When time preferences become lower, it means that investment and saving rise simultaneously. As such, more people invest in CDs, raising the supply of loanable funds, which lowers the interest rate. This helps the economy lengthen the production structure.
The reason why monetary expansion is bad is because it messes with the interest rate temporarily by increasing the supply of loanable funds without an increase in saving/investment. This causes incorrect market signals which lengthens the production structure. What's wrong with this picture is that when monetary expansion ceases and the real interest rate rises, the demand for capital goods plummets because the increase in loanable funds was not sustainable and only the action of a central bank not individual saving and investment.
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DriftWood:There is no contradiction, because saving and lending is infact the same thing. When you put money into a bank account, what you are doing is lending your money to the bank. Your money is not saved in some vault with your name on it or anything, its lent out to whoever is willing to pay the interest rate for borrowing the money. This is fractional reserve banking. I know its got a bad reputation, but its a wonderful free market invetion. It makes it possible to connect short time lenders with long time borrowers. Statistically a large number of short time lenders, as a whole, act as one long time lender. As long as the borrowers are of high quality, all those lenders will get their deposits back on request. As long as the bank is able to pay back the deposits on request it has not broken any contract.
errrrrrrr, wrong. Putting your money in a bank in an irregual deposit means that you demand that money be returned to you at any time. So if the bank loans out that money and you demand it back before that money is returned, the bank is forced to fail and close down. The only reason this is possible today is because the Fed provides a larger supply of money so as many banks won't fail (and thereby fueling fractional reserve banking).
What you're talking about is a mutuum contract, which today is known as a certificate of deposit. This is when an individual lends money to the bank which is then loaned out for a higher interest rate. This is different since the original lender cannot withdraw any of his money at any time, which prevents the creation of new money.
Of course, in our modern government-controlled banking industry fractional reserve banking means that saving and an increase of loanable funds goes hand in hand. This is a bad thing though since it fuels never ending high monetary expansion.
Nope, I know what you are saying, i just dont agree.
Lets take the usual (irregular) deposit account, the contract is that the bank will return the deposited money on request (and pay a bit of interest). Nothing else, there is no mention in the contract what the bank may do with the money in the meantime. There is no mention that the bank has to keep the money in a vault, or wether it may invest it or lend it out. As long as the depositor gets his money back on request, no contract has been broken and no trust has been violated.
You are saying that without fractional reserve banking the bank could not keep its contract, and you are right. But fractional reserve banking would work even without a govt or a expanding money supply. There is lots of confusion out here about what fractional reseve banking is. All that fractional reserve banking is, is lending out deposit money (that has to be redemed on request), to long term borrowers. It works because all those borrower pay enough mortage payments, to cover the requests for money withdrawl that the depositors make. Sure, its a fine balance to get right. But that its the banks problem, if it breaks any conbtract it will get sued. Banks are pretty good at this balancing act, as most big banks have been around a hundred years. This system would work even under a gold coin system, it does not rely on increasing money supply.
DriftWood:All that fractional reserve banking is, is lending out deposit money (that has to be redemed on request), to long term borrowers.
And how does that not expand the money supply?
If I have a legal claim to $100 dollars sitting in the bank and they loan it out to someone else while I still have a 'redemed on request' claim on this money then where did the extra money that they loaned come from if not from expanding the money supply? Two different people have a legal claim on the exact same thing at the exact same point in time yet this is OK for some reason because they manage to balance (with the help of the Fed backed banking cartel) the amount of money coming in with the amount going out and if things get out of hand there's always the Fed to bail them out or if things get really bad the taxpayers.
That's an understatement because a few different people have a legal claim for the exact same good under 10% reserve banking and there's no possible way that all of these claims could be satisified at once.
I agree that there is a lot of confusion about fractional reserve banking but most of it stems from the fact that printing fake warehouse receipts to a fungible good is fraud...or the opinion that it isn't against bailment laws because 'there is no mention in the contract what the bank may do with the money in the meantime.'
How is money different than any other good that the warehouse can have complete control (with the added bonus of not being liable for losses incurred while this money is in their hands) while the manager of a grain silo would be liable for both fraud and losses if they practiced the same policies as banks?
DriftWood:This system would work even under a gold coin system, it does not rely on increasing money supply.
You may have noticed that we aren't on a gold coin system for precisely the reason that if there is an actual commodity backing the money supply there is a limit to the amount on expanding they can do.
Also haven't been any real bank runs since we went off the gold standard for this reason, what are you going to withdrawal but a bunch of worthless pieces of paper instead of a real good that can't be effectively counterfeited so you don't have to 'run' to the bank to make sure you get your money before the bank closes its doors because it can't fulfill its contractual obligations to *all* its customers.
Especially under 'a gold coin system' is it apparent that fractional reserve banking expands the money supply because the only other option is to get out a pick and shovel and dig up some more gold. I really can't believe you would suggest otherwise.
"And how does that not expand the money supply? [...] If I have a legal claim to $100 dollars sitting in the bank and they loan it out to someone else while I still have a 'redemed on request' claim on this money then where did the extra money that they loaned come from if not from expanding the money supply? Two different people have a legal claim on the exact same thing."
You have to remember that this other person that spent your money is now in debt to you. He will pay you back the full amount, and then some (interest). So when he spends your money, your no longer have any money in the bank. What you are left with is a note that says "Hi. I noticed you where not using your money, so I took it and spent it. Dont worry though, I'll give you back the money, and a little for your trouble whenever you want". Ofcourse, that is a simplification.. what really is going on is that all the depositors money is put into the same pool of money, the overall money in the pool stays much the same.. sometimes one depositors take out all their money, but they dont all do it at the same time.. which means that there always is lots of money in the pool gathering dust. So what they do is let borrowers, borrow money from that pool. When the borrowers make mortage payments, they put money back into the pool.. eventually every borrower will have put back all the money they borrowed into the pool and then some (interest). You see? There is always enough money in the pool to cover the random withdrawl request by depositors.
Dont get confused though, no money is created here. Its just a creative and innovative way of lending money. Both lenders and borrowers preferr this way of lending as it is less restrictive, more efficient and therefore cheaper. Imagine if you had $100 you wanted to lend out. Would you rather lend it out signing a contract that read "you will get back your money this time next year, and you will make one years worth of interst." Or would you rather sign a contract that read "you will get back your money whenever you want it, and you will get paid interest depending on however long your money was lent out". You see, the second contract is much better for you. You can decide that you want back your lent out money at any time. This is what happens with your money when you keep it with a bank. All your life savings have been lent out to other people, who have spent it already. However this does not matter as all the borrowers of the bank are paying back their loand to the bank on a regular basis. There are so many of them, that the bank always has enough money in its vaults to pay you back your money whenever you needed it.
But what about bank runs? What happens if all depositors requested their money back at the same time. This is rare, but sound banks have nothing to fear. They can always raise money by selling assets. What assets does a bank have? Its got lots of those borrowers that keep paying back mortages every month. Thats a bond that pays x percent of interest a year. It can sell that on the open market and raise money. It could seel all its mortage backed bonds, and if the bank had not undervalued the price of risk involved with its borrowers, then it could raise enough money to pay back all the depositors at once. A bank only has to fear a bank run if it prices risk incorrectly, that is if it loans out money to risky borrowers at a low interest rate.
You see? This system would work just fine even under a gold coins system. Its just another way to lend out money, no money is created in the process.
Why is it people pop into here and assume we're a bunch of idiots and just need a little voodoo economic theory to see the light?
What is this you're promoting here, some variation on the Real Bills Doctrine?
DriftWood:You have to remember that this other person that spent your money is now in debt to you. He will pay you back the full amount, and then some (interest). So when he spends your money, your no longer have any money in the bank.
Then this wouldn't be a 'demand deposit' now would it.
If one were to put their money into something like a CD then your theory would be true, the assumption is that the bank has full control of your money for the duration of the deposit, but the problem comes from them doing this for checkable deposits as well. Here your theory completely falls apart since through the magic of fractional reserve banking seven other people also have a legal claim to your deposited money as the base of this inverted pyramid.
I see you completely skipped over the question about bailment law and the morality of this whole system though. Little surprise there since everyone knows that fractional reserve banking by its very nature creates money in the process of its day to day workings.
Don't even start in on the little semantics game of saying credit isn't 'money' either, just for the sake of simplicity we'll say 'money and money substitutes' equals 'money' to make typing a little easier, ok?
DriftWood:You see? This system would work just fine even under a gold coins system. Its just another way to lend out money, no money is created in the process.
You keep saying that but give no proof to back it up other than a fallacious description of the inner workings of the banking system. Why don't you demonstrate how this would work through an example or something...maybe a description of how the bank's asset and liability accounts would change as a result of a person depositing money and the bank loaning it out to one of their customers who then spends it.
I would do this myself but all you need to do is search the forum archives to find an example I posted earlier that demonstrates the exact opposite of what you're claiming here. And I'm too lazy to do it again...
Most excellent question. Incomes are paid to households for the production of goods and services. The goods can be consumer goods, like baseball bats and new cars and food. And they can also be investment goods like a factory and sheet metal bending machines. The incomes buy the goods and services in what is known as the "circular flow." But only the amount of income paid for the creation of consumer goods can buy the consumer goods over some time period, say a year. This is true because the incomes paid exactly equals the dollar value of output. This is the Income/Output identity. The income paid to households (i.e. "employees") for the creation of investment goods is known as a "leakage" out of the circular flow. In other words, if the work force makes 80% consumer goods and 20% investment goods, then collectively the households are stuck with 20% of their income that they have nothing to buy with it since they don't want to buy the investment goods-only firms want investment goods. So, you are correct when you say that your $50 will get loaned out regardless of whether it is deposited in your checking account or in Big five Sporting Goods checking account. Here's another kicker that it took me forever to wrap my brain around: just because you "save" some of your personal income just not mean that it gets borrowed for investment purposes. Obviously, banks make many loans for consumption purposes. So lots of "savers'" money is loaned out to other non savers who want to buy a new car, for example. So when your Econ 1A text says that Savings=Investment they mean NET savings in the macro economy. As a country, if half of the population each "saved" $5000 per year but the other half of the population all borrowed $5000 per year to buy new cars, there would be NO net savings and NO creation of investment goods. When we talk about an economy shifting from consumption towards savings, we are saying that the economy is choosing to increase its quantity of investment goods it produces at the expense of using those resources to produce consumption goods. In this situation, the people are growing their economy by deferring some consumption today for more in future periods.
OP: I think you're mistaken. Mankiw set the market up with a lot of assumptions. Savings is simply a term he used and he didn't specify what type of savings. The market he was talking about was purely hypothetical.
To keep things simple, we assume that the economy has only one financial market, called the market for loanable funds. All savers go to this market to deposit their saving, and all borrowers go to this market to get their loans. (Mankiw 168)
The market was where households DIRECTLY supplied firms. There was no "middle man" per se; no banks.
Essentially he's just introducing you to a supply and demand curve.
Hope that cleared it up.
EDIT: sorry, this topic is old. Didn't read the timestamp.
"But fractional reserve banking would work even without a govt or a expanding money supply."
Why would anyone treat a fractionally-backed dollar on par with a fully-backed dollar? They wouldn't.
"There is lots of confusion out here about what fractional reseve banking is. All that fractional reserve banking is, is lending out deposit money (that has to be redemed on request), to long term borrowers. It works because all those borrower pay enough mortage payments, to cover the requests for money withdrawl that the depositors make.Sure, its a fine balance to get right. But that its the banks problem, if it breaks any conbtract it will get sued. Banks are pretty good at this balancing act, as most big banks have been around a hundred years."
Banks, especially the really big ones, simply *arent' allowed to fail.* They have been bailed out and propped up time and time again, by various governments. Nice try.
"This system would work even under a gold coin system, it does not rely on increasing money supply."
Any system that involves ex nihilo creation of money is necessarily and by definition, inflationary. If there is any "confusion out here about what fractional reserve banking is," it's not with those of us who are arguing against fractional reserve banking.
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no third solution
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David Z
"The issue is always the same, the government or the market. There is no third solution."
Douglas in Oakland: Most excellent question. Incomes are paid to households for the production of goods and services. The goods can be consumer goods, like baseball bats and new cars and food. And they can also be investment goods like a factory and sheet metal bending machines. The incomes buy the goods and services in what is known as the "circular flow." But only the amount of income paid for the creation of consumer goods can buy the consumer goods over some time period, say a year. This is true because the incomes paid exactly equals the dollar value of output. This is the Income/Output identity. The income paid to households (i.e. "employees") for the creation of investment goods is known as a "leakage" out of the circular flow. In other words, if the work force makes 80% consumer goods and 20% investment goods, then collectively the households are stuck with 20% of their income that they have nothing to buy with it since they don't want to buy the investment goods-only firms want investment goods. So, you are correct when you say that your $50 will get loaned out regardless of whether it is deposited in your checking account or in Big five Sporting Goods checking account. Here's another kicker that it took me forever to wrap my brain around: just because you "save" some of your personal income just not mean that it gets borrowed for investment purposes. Obviously, banks make many loans for consumption purposes. So lots of "savers'" money is loaned out to other non savers who want to buy a new car, for example. So when your Econ 1A text says that Savings=Investment they mean NET savings in the macro economy. As a country, if half of the population each "saved" $5000 per year but the other half of the population all borrowed $5000 per year to buy new cars, there would be NO net savings and NO creation of investment goods. When we talk about an economy shifting from consumption towards savings, we are saying that the economy is choosing to increase its quantity of investment goods it produces at the expense of using those resources to produce consumption goods. In this situation, the people are growing their economy by deferring some consumption today for more in future periods.
Douglas,
Thanks for your post. To be clear, are you saying the supply of loanable funds and interest rates do not change whether I spend $50 or deposit it, and that Mankiw is wrong?
I am not an accomplished economist and I don't know about Mankiw. Sorry, I stumbled on to this blog looking for something else. Having said that, what I said previously was that your fifty bucks will get loaned out and circulated throughout the banking system regardless of whether you spend it or save it. The "supply of loanable funds", if I understand correctly, is the name given to the "net savings" in the economy, which is the total incomes earned in the macroeconomy that are not spent on consumption. So, it WOULD make a difference whether you spent your money on the baseball bat or "saved" it. The thing is, when you "save" your fifty bucks, that is definitely personal savings for YOU, but the banker might loan your fifty to someone who takes the money and goes and buys a baseball bat with it. In this case, your "savings" is spent on consumption, it's just done by someone instead of you. No "net savings" is created here. Per some given time period, if we add up all of the Income in the macroeconomy (which exactly equals output:GDP) and subtract the total spending on consumption (C) nationwide, what's left over is "net savings" (S) and will be the amount loaned to businesses who spend it on investment goods (I). So maybe think of it this way: lot's of people save and lot's of people borrow and lots of firms borrow. Firms only get to borrow if people ("households") save more money than borrow it for consumption spending. So, nationwide, we need more people who are wiling to "save" the fifty bucks rather than buy a baseball bat if we want to have "net savings" nationwide. From what I understand the net savings in the U.S. is pathetically small now. Anyway, as far as I know, the total money supply gets loaned out, except for the reserves that the banks are required to keep on hand. But how much of it is loaned to businesses depends on net savings (S). I assumed there were no government expenditures or imports or exports. Another way to think about it, which helped me when this subject was frying my brain, is that if you see investment goods being created in the economy, like you walk by a factory that is rolling out assembly line equipment, you can be sure there is net savings in your economy. Furthermore, the people who work in that factory are earning incomes that they will not be able to spend on the stuff they are making. They will have no use for that stuff. Only firms will buy that stuff. Those people will spend their money on the stuff that other people are making, like autos and cola and hamburgers and clothing and iPods, i.e. "consumption" goods. The important point to realize here is that when everyone buys ALL of the consumer goods made that year, they will be bought with exactly the amount of income that was earned in producing them. The amount of income earned at the assembly line equipment factory has no where to be spent. There's nothing left for the consumers to buy. So this left over income is what the firms borrow for investment. By the way, econ textbooks just absolutely suck at explaining this. I have no idea why. It is like the Twilight Zone or something. Anyway, this is the way I understand this, but I'm a novice in econ, so don't take my word on it without checking other sources. Hope it gives you a little more ammunition to work with. Oh, as far as your interest rate question..I'm not sure but I'll take a stab at it. I don't think that interest rates would change as a consequence of your deposit. I don't think interest rates would change until there was a "shift" in either the "supply" function for loanable funds or a shift in the "demand" function for loanable funds. The very instant you put your money into the the loanable funds market someone else might be taking their's out. An example of such a "shift" would be if for some reason everyone across the nation became nervous and uncertain about the future and decided to hold off on major purchases and save instead, this would shift the supply of funds curve rightward and lower the interest rate. In other words, at any given interest rate people would choose to save more than before. The intersection of the supply and demand functions would now be at a new, lower, equilibrium interest rate.
that is great
I just thought I would point out that Economics for Real People is a good book, but, as the name suggests, the target is the common Joe. You'll get disappointed if you expect to find nearly that kind of detail.
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