Monetary Policy and the Expanded Loanable Funds Model R.J. Barbera Why were central banks created? The Bank of England, one of the first central banks, focused upon preventing financial crises. The simple idea was that at times, after excessive private borrowing, lenders panic and financial instruments stocks, bonds, bank loans, mortgages begin to plunge in value. The central bank, Walter Bagehot advised, needed to step into the financial marketplace and provide funds to banks, in order to prevent a financial system collapse. Post WWII, central banks (CBs) around the world embraced a more activist role. CBs felt responsible for keeping the overall price level relatively steady. CBs established targets for changes in the overall price level the inflation rate. Low inflation was deemed critical for healthy economic growth. Some CBs goals explicitly mentioned strong real growth, alongside low inflation. In today s world, all central banks agree that they must protect the financial system and keep inflation low, in order to afford the economy its best chance to have a strong labor market and a strong real growth rate. Central Bank Operations: Buying and Selling Treasury Securities We have stressed that we can think metaphorically about CBs, by imagining the CB driving a bus. The bus driver steps on the brake when he fears the economy may overheat and generate inflationary or financial market excesses. Conversely, the bus driver steps on the gas when he fears economic growth is faltering and unemployment is on the rise. What are the actual mechanics involved when the CB steps on the brake or the gas? Day-to-day the CB tries to achieve its goals by conducting open market operations. A CB open market operation involves buying or selling treasury bills. Let us follow, step-by-step, the actions and reactions that unfold, as the CB conducts open market operations, in an effort to speed up economic growth (step on the gas). The CB buys t-bills. It does so by creating bank reserves, which it gives to a bank, in exchange for a t-bill. We can represent such a purchase, by looking at the change in the CB balance sheet and the change in a commercial bank balance sheet, a consequence of this open market operation: Central Bank Commercial Bank* assets liabilities assets liabilties t-bills +100 reserves +100 t-bills -100 reserves +100 *think B of A or Citibank
We now have a picture of a commercial bank with additional reserves, provided by the CB. The CB is funding some of the government s borrowing needs, by buying the t-bill from the Commercial Bank. We reject the idea that banks will ALWAYS lend out the new reserves they have received from the CB. Our expanded loanable funds model requires us to look at what open market operations do to interest rates, before we judge whether the open market operations will be stimulative. Let us now look at the same open market operation, within a bank version of our expanded loanable funds model: The CB purchase t-bills, lowering the amount of government debt that has to be absorbed by the private sector. This raises the price, and lowers the interest rate on t-bills. In the graph presented above, the real interest rate on t-bills falls to 1% from 2%. Recall that the t-bill interest rate and the rate that banks charge one another to borrow funds, the federal funds rate, normally equal one another. Thus the Fed, by buying t-bills and lowering the t-bill rate, simultaneously lowered the federal funds rate.
Assume that inflation expectations are 2%. That means banks, after the Fed s open market operations, now have access to federal funds at 3%, down from 4%. We know banks lend long-term, to risky borrowers. Suppose banks, as compensation for the Duration and the Default risk of the loans, demand 3% more than their cost of funds. In this example, banks cost of funds, after open market operations, has fallen from 4% to 3%. That means they can offer companies loans at 6% down from 7%. Note at 6%, corporations have a longer list of profitable projects, they borrow more, and the economy accelerates. (The chart below depicts real rates. Real corporate borrowing rates fall from 5% to 4%.)
Fostering Stronger Loan Growth and the Money Multiplier We can return to our T-Account analysis, and see how the lower interest rates result in more loans and larger bank balance sheets as both loan levels and deposit levels rise. This is the money multiplier in operation. In the four steps provided below, we see that an initial infusion of reserves can generate a succession of additional loans. As the next session makes clear, this dynamic only unfolds if the Fed s open market operation successfully lowers banks funding costs. STEP 1 STEP 2 Bank America Bank America assets liabilities assets liabilities t-bills -100 t-bills -100 reserves +100 reserves 10 loans +90 STEP 3 STEP 4 Citi bank Citi bank assets liabilities assets liabilities reserves +90 deposit +90 reserves 9 deposit +90 loans +81 Step 1: The CB conducts open market operations, buying t-bills in exchange for created reserves. Step 2: Bank of America lends all but 10% of the reserves to a corporate borrower. Step 3: The borrower deposits its $90 at Citibank, increasing Citi s deposits and reserves by $90. Step 4: Citibank lends all but 10% of the reserves to a corporate borrower. This continues, expanding the size of bank deposits and bank loan portfolios.
The Zero Bound Problem As noted above, despite the powerful dynamics depicted above, we reject the idea that open market operations ALWAYS speed up loan creation and economic growth. If CB t-bill purchases do not drive interest rates lower, there is no reason to expect more loan growth and a faster pace of economic expansion. Let us review the case of CB t-bill purchases, when the t-bill rate and the federal funds rate are at ZERO. When short rates are at ZERO, the real short rate equals zero minus expected inflation. Suppose inflation expectations are 2%. Then real short rates are at -2%. Central banks would have to target a negative nominal interest rate, to get the real rate below -2%, a practice most central banks refuse to pursue. Imagine the CB chooses to buy t-bills to put additional reserves into the economy, accepting the fact that with short rates already at zero, it will not be lowering short rates. How does that look in our loanable funds depiction? See below:
Amid the zero bound, the CB purchased t-bills and lowered the amount of government debt that the private sector must buy. Due to the zero bound, the interest rate on t-bills and the federal funds rate are unchanged. In nominal terms, they remain at zero percent. In real terms they remain at -2%. Note in the graph presented above that the real interest rate on t-bills is steady at -2%. Recall that the t-bill interest rate and the rate that banks charge one another to borrow funds, the federal funds rate, normally equal one another. Thus, despite the fact that the Fed bought many t-bills, banks still face the same federal funds rate (their borrowing cost), after the open market operation. Once again, we assume that inflation expectations are 2%. That means banks, after the Fed s open market operations, have access to federal funds at 0%, the same as before the operation. We know banks lend long-term, to risky borrowers. When we are at the ZERO bound, risk appetites are usually very depressed and banks demand a large premium to lend to risky borrowers. Suppose that banks, as compensation for the Duration and the Default risk of the loans, demand 4% more than their cost of funds. In this example, banks loan rates, both before and after open market operations, will be 4%. That means the banks do not shift their supply curve and lend more at lower interest rates to borrowers. How does this play out in the t-accounts? See below: Central Bank Bank America assets liabilities assets liabilities t-bills +100 reserves +100 t-bills -100 reserves +100 Note that nothing happens! The bank gives up its t-bills for reserves. They do not lend out these excess reserves. Excess reserves grow. The fact that the open market operation did nothing to change their funding costs means that they do not change attitudes about lending. Excess reserves simply build up on bank balance sheets. The point? Open market operations work via their ability to change banks funding costs. If rates do not fall, growing reserves do nothing to stimulate growth.
Quantitative Easing as One Extraordinary Measure to Cope with the Zero Bound. How can the CB deliver lower interest rates to the corporate borrower, when short rates are at zero? The Federal Reserve Board, in the aftermath of the Great Recession, chose to start buying long bonds, in an effort to lower risky real long rates. Recall we think that the risky real long rate is higher than the riskfree real short rate for two reasons. Lenders demand compensation for lending long term. In addition, lenders demand compensation for lending to a borrower that might default. Starting in 2010, the Fed bought long dated treasury securities, in an attempt to lower the interest rate on these securities. Consider the chart below: Look at the t-bill quadrant. Federal Reserve purchases reduced the amount of t-bills that would be funded by the private sector. The Federal Reserve purchases resulted in a fall for the t-bill rate to zero. Now consider the government bond quadrant. The Federal Reserve bought t-bonds, reducing the quantity that private sector lenders would need to absorb, and thereby lowering the interest rate on t- bonds. Finally, consider the effects that flow through to the corporate bond quadrant. Private sector lenders households in our simple model now can only get 0.5% real, if they chose to buy treasury long bonds, down from 2% real, before QE. This renders the corporate bond much more attractive. The supply curve in the corporate bond market shifts to the right, and the risky interest rate falls to 3% real, from 4% real. At a 3% real borrowing cost, companies have a longer list of profitable investments. Companies borrow and invest more, and economic growth accelerates.
Note once again, the power or lack of power, from this effort, emanates from the interest rate change that QE delivers, not the change in the size of Federal Reserve, or commercial bank balance sheets. Consider 2008-2013 surge in commercial banks excess reserves: Quantitative easing lowered long rates modestly. Most economists believe this caused lending to grow a bit faster than it otherwise would have. That said, the buying of bonds by the CB swelled the Fed s balance sheet and produced a surge in commercial banks excess reserves pictured above. If banks lent all excess reserves, then the Fed could simply buy bonds, pump in reserves, and deliver a booming economy. The excess reserves chart, above, makes it clear that the power of Fed policy operates through interest rates, not reserve levels. The CB, in reality, is quite powerful, but it is a far cry from omnipotent.