There's more than one kind of money demand

We are used to money demand diagrams that look like this:

If the money supply is fixed, the demand for money reduces as the interest rate rises. This is because investors substitute interest-bearing assets for zero-interest money. As the interest rate falls toward zero, investors become indifferent between other assets and money, and demand for money rises.

In this sort of model we talk about investors being willing to "hold" money in preference to other assets. This is, of course, stock thinking. It says nothing at all about the flow of money. Indeed in the quantity of money equation MV = PY, V (the velocity of money) is often assumed to be constant. Yet we know that the velocity of money reduces as economic activity slows, and increasing the stock of money does not necessarily increase its velocity. Indeed, it could be argued that providing investors with all the money they want to hold itself tends to slow velocity. If money is hoarded, it is not spent - and it is spending that increases the velocity of money.

But investors are not the only people who demand money. Borrowers do, too. And their demand for money ALSO falls as the interest rate rises, and rises as the interest rate falls. However, it is not the interest rate on equivalent assets that they might "hold" that determines their demand for money, but the interest rate (or discount rate) on the assets that they must supply in order to obtain money.

As borrowers usually spend the money they borrow, borrowing tends to increase the velocity of money. So we might expect that a falling interest rate would encourage borrowers to borrow more, thus increasing the velocity of money and offsetting the stagnating effect of investors hoarding money. Increasing the stock of money reduces the interest rate, encouraging borrowing and helping to maintain money velocity.

If only it worked like that in reality. The problem is that falling interest rates on alternative assets for investors don't necessarily translate into falling discount rates on loan assets supplied by borrowers. Changes in borrower creditworthiness - whether real or perceived - mean that banks and markets may offer far higher discount rates than borrowers are prepared to accept. Even if banks and markets maintain low discount rates, borrowers themselves may be less willing or able to offer loan assets at those rates, because of falling net worth and/or falling real incomes.

So in a debt-deflationary slump, not only do investors hoard money, reducing the amount of money in circulation and slowing its velocity: borrowing reduces too, and the supply of money falls (because banks create money when they lend). Rather than money hoarding by investors being offset by increased spending by borrowers, the two combine to depress not only the amount of money in circulation but also its velocity. The fall in money velocity in the US since 2008 is staggering:

Efforts by monetary authorities to raise the velocity of money tend to focus almost entirely on reducing interest rates to investors and increasing their stocks of money in the hope that this will encourage them to spend. But this only addresses one side of the problem. While banks - encouraged by regulators - continue to demand high discount rates on loan assets, and households and corporations continue to offer much lower rates (if they offer them at all), borrowing will remain depressed, the money supply will be smaller than it should be and the velocity of money will be on the floor.

Belatedly, monetary authorities are beginning to understand that reducing policy rates and flooding banks and markets with money isn't sufficient. Unless money reaches those households and corporations whose ability to supply loan assets has been impaired, the velocity of money does not recover and the economy remains stagnant.

Governments have exhorted, cajoled, bribed and kicked banks to try to make them lend, but the reality is that damaged banks under pressure from regulators to repair their balance sheets only want to lend money to people who don't need it, not those who do. The much-maligned Help to Buy scheme is at least an attempt to reduce the very high discount rates faced by certain kinds of borrower. And it does work: there is increased activity in the housing market across the whole of the UK, not just in London and the South East where inflows of foreign money are pumping up prices. The trouble is that it also pushes up house prices, making the UK's housing affordability problem worse.

The UK's Funding for Lending scheme was less effective because it provided banks with cheap money rather than improving the creditworthiness of borrowers. Banks used the money mainly to refinance existing portfolios and offer lower interest rates to people they would have lent to anyway. But despite this less than encouraging response,the ECB has now joined the Funding for Lending party with its Targeted LTROs. It is hard to see that these will make much difference to the credit bifurcation in the Eurozone:

(chart courtesy of

Real discount rates on loan assets in Italy and Spain are far higher than those in France or Germany, partly because of lower inflation but partly also because of higher perceived risk. As the Italian and Spanish sovereigns themselves are perceived as higher risk than Germany or France, sovereign loan guarantees are likely to be of limited effectiveness. Some form of ECB guarantee for SME lending in those countries seems likely to be necessary if the ECB is serious about ending credit bifurcation.

But government or central bank guarantees for the loan assets of high-risk borrowers won't be enough to end the deep-rooted depression in the Eurozone. Renewed spending does not have to come solely from bank borrowing. It can also come from higher wages, lower taxes, more benefits, increased government capital investment. All of these are impaired in the Eurozone. Because of ridiculous political restrictions, Eurozone sovereigns cannot borrow to invest in their economies even though yields on sovereign bonds are historically low and falling rapidly. They cannot put together a New Deal to support the people and businesses that are being hurt by this depression.  They cannot reflate their economies with helicopter drops to businesses and households, bypassing damaged banks. Nor can they write down excessive debts. Even increasing the money stock to meet investor demand is politically suspect, because it involves buying other assets. Just about everything that might help appears to be verboten.

If the overriding need is to get the economy out of a slump, does it really matter how the money is provided, provided it gets to people who will spend it rather than sitting on it? I speak here of the Eurozone, because it is by far the worst offender: if present political restrictions remain, this depression will never end. But in reality no country has paid enough attention to repairing the net worth of borrowers and improving their incomes so that they can start spending again. And because of this, recovery from the financial crisis has taken far longer and been far more painful than it needed to be.

As Willem Buiter says, debt-deflation driven stagnation is a policy choice. It doesn't have to be like this.

Related reading:

Sacred cows and the demand for loans

Draghi's Latest Announcement is a Big Nothing - Capitalism and Freedom

Helicopter money: why it works - always - Willem Buiter

Can labour markets be too flexible? - Pieria

House of Debt - Mian & Sufi (book)


  1. if the money supply is fixed [ vertical red line ] , then the demand for money reduces
    as the interest rate rises [ sloping blue line ] .
    I have never , ever seen this type of modelling before .
    drawing a demand curve , based on the shape of the supply curve .
    its ground breaking stuff .
    and against conventional economic modelling wisdom .
    if anyone has done this before , could you post a link .
    I am not saying you are wrong .
    just its very , very different .

  2. Frances, I quite agree. What you advocate is very much what Modern Monetary Theory advocates, which in turn is much the same as what Positive Money advocates: two groups I've supported for some time.

  3. "But in reality no country has paid enough attention to repairing the net worth of borrowers and improving their incomes so that they can start spending again. "

    Direct money issuance would be an effective proposal:

  4. Money is where money goes. You may have some control, more or less, as to what money is. But it is likely that you will have very limited control, if any, as to where it goes.

  5. Milton Friedman's income velocity Vi is a contrived figure (Vi = Nominal GDP/M). To the Keynesians, aggregate monetary demand is nominal-GDP, the demand for services (human) and final goods. This concept excludes the common sense conclusion that the inflation process begins at the beginning (with raw material prices and processing costs at all stages of production) and continues through to the end.

    To ignore the aggregate effect of money flows on prices is to ignore the inflation process. And to dismiss the concept of Vt by saying it is meaningless (that people can only spend their income once), is to ignore the fact that Vt is a function of three factors: (1) the number of transactions; (2) the prices of goods and services; (3) the volume of M.

    Inflation analysis cannot be limited to the volume of wages and salaries spent. To do so is to overlook the principal "engine" of inflation - which is of course, the volume of credit (new money) created by the Reserve and the commercial banks, plus the expenditure rate (velocity) of these funds. Also overlooked is the effect of the expenditure of the savings of the non-bank public on prices.

    Vt (the transactions velocity of money), at times, moves in the opposite direction of Vi.

  6. The non-banks are the customers of the commercial banks. Thus all the NB's demand drafts also clear thru the CB system. Bank reserves are largely driven by bank payments (debits). Reserves are based on transaction type deposit classifications 30 days prior.

    See: SEE: Member Bank Reserve Requirements -- Analysis of Committee Proposal, February 27, 1938 - declassified on March 23, 1983
    In 1931 this committee recommended a radical change in the method of computing reserve requirements, the most important features of which were:

    (2) "Requirements against debits to deposits"

    (5)"the committee proposed that reserve requirements be based upon the turnover of deposits"

  7. The Fed's not "accommodative". Unless the money stock is expanded at about twice the historical rates-of-change, gDp & employment growth rates will remain subpar (i.e., the money supply can never be managed by any attempt to control the cost of credit, e.g., ZIRP).

    Because voluntary savings have been impounded within the commercial banking system by the Fed's remuneration rate, economic growth has slowed. I.e., the ratio of non-bank lending/investing (where S=I), to commercial bank lending/investing (where new money is created), has fallen drastically since Bankrupt U Bernanke wiped out the NB's carry trade.

    Unless there's an outlet for savings (as evidenced by a corresponding increase in the transactions velocity of money), the economy will remain depressed. And since the Fed has emasculated its "open market power", there will likely continue to be a shortfall in money stock growth for some extended time.

  8. Unused or unspent savings are a leakage in Keynesian National Income Accounting. Voluntary savings can only be "put to work" by the non-bank financial institutions. Never are the commercial banks intermediaries in the savings-investment process. The CBs do not loan out existing deposits (saved or otherwise).

    I.e., the welfare of the CBs is dependent upon the welfare of the NBs. As Bankrupt U Bernanke destroyed non-bank lending/investing by introducing the payment of interest on excess reserve balances, economic growth rates will continue to remain depressed.

  9. It is great that we have a better appreciation for the mechanism of credit/lending and its importance to monetary policy. But, my takeaway from these last two posts is that we seem confused about the problem we are trying to solve. These posts focus on loan growth as a solution. However, the real solution is increasing and broadening income growth. Substituting loan growth for income growth is a cyclical, not secular, solution. If we cannot get income growth to grow at the pace we want, then the potential growth rate is lower, period. Any attempt to substitute loan growth for income growth will provide just a temporary solution. Monetary policy seems to only be a solution in the narrow case where income growth is specifically constrained by monetary policy tightness.

    1. "These posts focus on loan growth as a solution."

      Er, no they don't. They focus on income support to reduce need for loans.

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