Last modified: 2016-06-11
Abstract
No satisfactory analysis of the working of modern market economies can be carried out without giving due attention to the actual ways financial markets and the ‘real’ economy are related. The expanding macro-financial literature is facing a number of analytical challenges. An ‘arguably more fundamental’ challenge (Borio 2014) deals with the nature of money supply and hence the theory of bank lending underlying such models. The money multiplier (MM) doctrine represents the conventional take on the way how changes in base money (monetary policy) must be reflected in changes in money supply. This doctrine is based on the understanding of banks as intermediaries of loanable funds (ILF) and lending as transfer of excess reserves. An alternative theory of bank lending (‘financing through money creation’, FMC) suggests that bank lending involves no intermediation at all: when lending, the bank creates its own funding, which is why most of bank deposits do not consist of cash paid in, but of credits borrowed (inside money). According to the ILF theory, bank money is created when banks borrow, and how larger the money supply is than the monetary base critically depends on savers’ willingness to hold bank money, rather than base money, in reserve. According to the FMC theory, money is created when banks lend, and the extent to which the money supply is larger than the monetary base critically depends on investors’ willingness to borrow (‘animal spirits’). We then consider how banks’ active management of risks associated to lending in the two perspectives over banking theory shows up.
JEL codes. E44, E51.
Keywords. Financial Cycle; Money Supply; Inside Money; Liquidity Risk.