Textbook v.2.1

THE FINANCIAL
SYSTEM AND
THE ECONOMY
PRINCIPLES OF MONEY AND BANKING
Éric Tymoigne
THE FINANCIAL
SYSTEM AND THE
ECONOMY
PRINCIPLES OF MONEY AND BANKING
SECOND DRAFT
ÉRIC TYMOIGNE
© August 2018 by Eric Tymoigne, Lewis & Clark College, Portland, OR, USA. All rights reserved.
TABLE OF CONTENTS
PREFACE ..................................................................................................................................................................... VII
PART 1: THE WORLD OF FINANCE ......................................................................................................................................................... 1
CHAPTER 1: BALANCE-SHEET MECHANICS AND FINANCIAL ACCOUNTS OF THE UNITED STATES .................... 1
WHAT IS A BALANCE SHEET? .............................................................................................................................................2
BALANCE SHEET RULES .................................................................................................................................................... 3
CHANGES IN THE BALANCE SHEET .......................................................................................................................................5
Net cash flow ........................................................................................................................................................5
Net addition to assets and liabilities .....................................................................................................................7
Net income ............................................................................................................................................................7
Net capital gain .....................................................................................................................................................7
MACROECONOMIC USE OF BALANCE SHEET: THE FINANCIAL ACCOUNTS OF THE UNITED STATES ....................................................8
CHAPTER 2: FINANCE: A WORLD OF PROMISES ........................................................................................................................... 11
THE FINANCIAL SECTOR: A WORLD OF PROMISES.................................................................................................................12
CREATION AND DESTRUCTION OF FINANCIAL INSTRUMENTS...................................................................................................14
CHARACTERISTICS OF A FINANCIAL INSTRUMENT: TERM TO MATURITY, LIQUIDITY, RISKS, AND OTHER CHARACTERISTICS ....................15
MARKETABLE FINANCIAL INSTRUMENTS: SECURITIES ...........................................................................................................18
Equity instruments .............................................................................................................................................. 18
Debt instruments ................................................................................................................................................ 23
Monetary instruments ........................................................................................................................................32
NON-MARKETABLE FINANCIAL INSTRUMENTS ..................................................................................................................... 37
CONCLUSION ............................................................................................................................................................... 43
CHAPTER 3: FINANCIAL INSTITUTIONS: AN OVERVIEW ........................................................................................................47
MAINTAINING SOLVENCY: PROFITABILITY AND LIQUIDITY ......................................................................................................48
PRIVATE DEPOSITORY INSTITUTIONS: COMMERCIAL BANKS AND THRIFTS.................................................................................. 50
Commercial banks ...............................................................................................................................................50
Thrift institutions .................................................................................................................................................53
Savings institutions ........................................................................................................................................................... 53
Credit unions .................................................................................................................................................................... 55
INSURANCE COMPANIES.................................................................................................................................................57
Life insurance companies ....................................................................................................................................58
Property and casualty insurance companies.......................................................................................................60
FINANCE COMPANIES ....................................................................................................................................................62
FINANCIAL INVESTMENT COMPANIES ................................................................................................................................64
Pension funds ......................................................................................................................................................64
Regulated portfolio management companies: Mutual funds and others ...........................................................66
Lightly regulated portfolio management companies: Hedge funds....................................................................69
Real estate investment trusts .............................................................................................................................70
FINANCIAL MARKET COMPANIES ...................................................................................................................................... 72
Market-services companies: Organized exchanges ............................................................................................72
Investment banks ................................................................................................................................................73
Brokerage Firms: Security Brokers and Dealers and Security Brokers ................................................................74
Securitization vehicles: Special purpose entities .................................................................................................76
GOVERNMENT AND GOVERNMENT-RELATED FINANCIAL AGENCIES ..........................................................................................78
Government-sponsored enterprises ....................................................................................................................78
The Farm Credit System ................................................................................................................................................... 80
The Federal Home Loan Bank System .............................................................................................................................. 84
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Farmer Mac, Fannie Mae, Freddie Mac, and Sallie Mae .................................................................................................. 90
U.S. government agencies...................................................................................................................................90
TRUST BUT VERIFY: ACCOUNTING FIRMS ........................................................................................................................... 95
RECENT TRENDS AMONG FINANCIAL COMPANIES ................................................................................................................97
CONCLUSION ............................................................................................................................................................... 99
CHAPTER 4: LEVERAGE ............................................................................................................................................................................ 103
WHAT IS LEVERAGE? ..................................................................................................................................................104
WHAT ARE THE ADVANTAGES OF LEVERAGE? ...................................................................................................................105
WHAT ARE THE DISADVANTAGES OF LEVERAGE? ...............................................................................................................105
Interest-rate risk ...............................................................................................................................................105
Higher sensitivity of capital to credit and market risks .....................................................................................106
Refinancing risk and margin call risk ................................................................................................................106
Impact on mortgage debt: Refinancing risk ................................................................................................................... 106
Impact on security-based debt: Margin call risk ............................................................................................................ 108
EMBEDDED LEVERAGE .................................................................................................................................................110
BALANCE-SHEET LEVERAGE, SOME DATA .........................................................................................................................111
THE FINANCIALIZATION OF THE ECONOMY .......................................................................................................................112
PART 2: THE FEDERAL RESERVE SYTSEM ..................................................................................................................................... 117
CHAPTER 5: THE FEDERAL RESERVE SYSTEM: AN INSTITUTIONAL OVERVIEW ....................................................... 119
CHAPTER 6: CENTRAL-BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS ................................................. 121
BALANCE SHEET OF THE FEDERAL RESERVE SYSTEM ...........................................................................................................122
FOUR IMPORTANT POINTS ............................................................................................................................................123
Point 1: The Federal Reserve notes are a liability of the Fed ............................................................................123
Point 2: The Fed does not earn any cash flow in USD .......................................................................................124
Point 3: The Fed does not lend reserves and does not rely on the taxpayers ...................................................125
Point 4: Banks cannot do anything with reserve balances unless they are dealing with other Fed account
holders ..............................................................................................................................................................127
CAN THE FED BE INSOLVENT OR ILLIQUID? .......................................................................................................................128
CHAPTER 7: MONETARY BASE, RESERVES AND CENTRAL-BANK BALANCE SHEET ................................................ 131
THE MONETARY BASE AND THE MONEY SUPPLY.................................................................................................................132
RESERVES: REQUIRED, EXCESS, FREE, BORROWED, NON-BORROWED ....................................................................................134
HOW DOES THE MONETARY BASE CHANGE? .....................................................................................................................138
CAN THE FED ISSUE AN INFINITE QUANTITY OF MONETARY BASE? .........................................................................................141
CHAPTER 8: MONETARY-POLICY IMPLEMENTATION ............................................................................................................ 145
WHAT DOES THE FED DO IN TERMS OF MONETARY POLICY AND WHY?...................................................................................146
TARGETING THE FFR PRIOR TO THE 2008 FINANCIAL CRISIS ................................................................................................149
A GRAPHICAL REPRESENTATION OF THE FEDERAL FUNDS MARKET .........................................................................................152
TARGETING FFR AFTER THE GREAT RECESSION.................................................................................................................153
DOES THE FED TARGET/CONTROL/SET THE QUANTITY OF RESERVES AND THE QUANTITY OF MONEY? ...........................................156
TO GO FURTHER: BEYOND THE FED FUNDS MARKET, EURODOLLARS AND REPURCHASE AGREEMENTS ......................................157
CHAPTER 9: TREASURY AND CENTRAL BANK INTERACTIONS....................................................................................... 163
MONETARY POLICY AND THE U.S. TREASURY ...................................................................................................................164
Treasury’s involvement in monetary policy during the 2008 crisis ...................................................................166
Other examples of Treasury’s involvement in monetary policy ........................................................................169
FISCAL POLICY AND THE FED .........................................................................................................................................173
A NECESSARY COORDINATION OF TREASURY AND CENTRAL BANK ACTIVITIES: SOME IMPLICATIONS .............................................175
Independence of the central bank ....................................................................................................................175
TO GO FURTHER: CONSOLIDATION OR NO CONSOLIDATION? THAT IS THE QUESTION ...........................................................175
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TO GO EVEN FURTHER: WHAT ARE THE RELEVANT QUESTIONS TO ASK FOR A MONETARILY SOVEREIGN GOVERNMENT ? .............177
PART 3: PRIVATE BANKING SYSTEM ................................................................................................................................................ 183
CHAPTER 10: THE PRIVATE BANKING BUSINESS ........................................................................................................................ 185
THE BALANCE SHEET OF A BANK .....................................................................................................................................186
WHAT DO BANKS DO? .................................................................................................................................................189
WHAT MAKES A BANK PROFITABLE? ...............................................................................................................................189
RISKS ON THE BANK BALANCE SHEET ...............................................................................................................................192
BANKING ON THE FUTURE ............................................................................................................................................194
EVOLUTION OF BANKING SINCE THE 1980S .....................................................................................................................195
CHAPTER 11: BANKING REGULATION............................................................................................................................................... 201
EXAMPLES OF BANK REGULATIONS .................................................................................................................................202
Reserve requirement ratios ...............................................................................................................................202
Capital adequacy ratios ....................................................................................................................................203
CAMELS rating ..................................................................................................................................................204
Underwriting requirements...............................................................................................................................204
WHY ARE THERE STILL FREQUENT AND SIGNIFICANT FINANCIAL CRISES IF REGULATION IS SO TIGHT ?.............................................205
Deregulation, competition and concentration ..................................................................................................205
Deenforcement and desupervision ...................................................................................................................208
Regulatory arbitrage .........................................................................................................................................209
THEORIES OF BANK CRISES AND BANKING REGULATION: TWO VIEWS .....................................................................................210
Laissez faire, laissez passer: Crises as random events ......................................................................................210
Save capitalism from itself: Crises as internal contradictions ...........................................................................211
CHAPTER 12: MONETARY CREATION BY BANKS ........................................................................................................................ 217
MONETARY CREATION BY BANKS: CREDIT AND PAYMENT SERVICES .......................................................................................218
WHAT CAN WE LEARN FROM THE EXAMPLE ABOVE? ..........................................................................................................222
Point 1: The bank is not lending anything it has: when providing credit services, the bank swaps financial
instruments with its clients ...............................................................................................................................222
Point 2: The bank does not need any reserves to provide credit services .........................................................223
Point 3: The bank is not using “other people’s money”: it is not a financial intermediary between savers and
investors ............................................................................................................................................................223
Point 4: The bank’s financial instrument is in high demand .............................................................................225
HOW DOES A BANK MAKE A PROFIT? MONETARY DESTRUCTION ..........................................................................................225
INTERBANK PAYMENTS, WITHDRAWALS, RESERVE REQUIREMENTS, AND FEDERAL GOVERNMENT OPERATIONS: THE ROLE OF RESERVES
...............................................................................................................................................................................228
WHAT LIMITS THE ABILITY OF A BANK TO PROVIDE CREDIT SERVICES? ....................................................................................230
MOVING IN STEP ........................................................................................................................................................231
LIMITS TO MONETARY CREATION BY THE CENTRAL BANK AND PRIVATE BANKS ..........................................................................231
TO GO FURTHER: A SIDE NOTE ON ALTERNATIVE VIEWS OF BANKING: THE MONEY MULTIPLIER THEORY AND FINANCIAL
INTERMEDIATION........................................................................................................................................................232
PART 4: FINANCIAL MARKETS ............................................................................................................................................................ 237
CHAPTER 13: INSTITUTIONAL ASPECTS OF FINANCIAL MARKETS .................................................................................. 239
CHAPTER 14: PRICING SECURITIES .................................................................................................................................................... 241
A SMALL DETOUR: SAVINGS ACCOUNT AND INTEREST COMPOUNDING ...................................................................................242
BACK TO SECURITIES....................................................................................................................................................242
A simple rate of return: Current yield................................................................................................................242
Adding one complication: Time.........................................................................................................................243
Adding another complication: Capital gains or losses ......................................................................................245
A real world application: QE, deficit and rate on treasuries .............................................................................247
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Conclusion .........................................................................................................................................................247
WHAT IF THERE IS NO COUPON? ZERO-COUPON SECURITIES ...............................................................................................249
DISCOUNT, PAR, PREMIUM AND ARBITRAGE BETWEEN SECURITIES ........................................................................................250
BUBBLES OR NOT: ARE FINANCIAL MARKET EFFICIENT? ......................................................................................................251
TO GO FURTHER: DURATION AND CONVEXITY ..............................................................................................................253
CHAPTER 15: THE INTEREST RATE .................................................................................................................................................... 257
REAL THEORY OF INTEREST RATE: NATURAL INTEREST RATE AND EXPECTED INFLATION ..............................................................258
Gross substitution and indifference condition: Determinant of the nominal interest rate ...............................258
Inflation expectations .......................................................................................................................................259
The natural rate of interest ...............................................................................................................................259
Implications of the theory .................................................................................................................................262
Empirics .............................................................................................................................................................263
MONETARY THEORY OF INTEREST RATES: MONETARY CONDITIONS AND LIQUIDITY PREFERENCE .................................................266
Substitution effect vs. income effect .................................................................................................................266
Liquidity preference theory of interest rate ......................................................................................................268
Money rules the roost .......................................................................................................................................270
Liquidity preference and rates of return ...........................................................................................................271
Implications of the theory .................................................................................................................................273
Empirics .............................................................................................................................................................275
TO GO FURTHER: LIQUIDITY TRAP AND THE SQUARE RULE ...............................................................................................277
CHAPTER 16: INTEREST-RATE STRUCTURE .................................................................................................................................. 281
CHAPTER 17: OFF-BALANCE SHEET OPERATIONS: SECURITIZATION .............................................................................. 283
CHAPTER 18: OFF-BALANCE SHEET OPERATIONS: DERIVATIVES ...................................................................................... 285
PART 5: MONETARY SYSTEMS ............................................................................................................................................................. 287
CHAPTER 19: MECHANICS OF MONETARY SYSTEMS ................................................................................................................. 289
A SPECIFIC FINANCIAL INSTRUMENT: MONETARY INSTRUMENT ............................................................................................290
ACCEPTANCE OF MONETARY INSTRUMENTS .....................................................................................................................291
ACCEPTANCE IN ACTION: AT WHAT PRICE SHOULD A MONETARY INSTRUMENT CIRCULATE AMONG BEARERS? ...............................294
FAIR VALUE AND PURCHASING POWER ............................................................................................................................295
TRUST AND MONETARY SYSTEM: TRUST IN THE ISSUER VS. SOCIETAL TRUST ............................................................................299
WHY ARE MONETARY INSTRUMENTS USED? THE MONETARY FUNCTIONS ...............................................................................300
CASE STUDY: DEMONETIZATION IN INDIA IN 2016 ............................................................................................................302
CHAPTER 20: SOME FAQS ABOUT MONETARY SYSTEMS ........................................................................................................307
Q1: CAN A COMMODITY BE A MONETARY INSTRUMENT? OR, DOES MONEY GROW ON TREES? ..................................................308
Q2: CAN A MONETARY INSTRUMENT BECOME A COMMODITY? ...........................................................................................309
Q3: IS MONEY WHAT MONEY DOES? ..............................................................................................................................310
Q4: ARE CONTEMPORARY GOVERNMENT MONETARY INSTRUMENTS IRREDEEMABLE ? OR, IS THE FAIR VALUE OF CONTEMPORARY
GOVERNMENT MONETARY INSTRUMENTS ZERO?...............................................................................................................312
Q5: IS MONETARY LOGIC CIRCULAR? IS FIAT MONEY A BUBBLE? ..........................................................................................313
Q6: DO ISSUERS OF MONETARY INSTRUMENTS PROMISE A STABLE PURCHASING POWER? .........................................................314
Q7: ARE MONETARY INSTRUMENTS NECESSARILY FINANCIAL IN NATURE? ..............................................................................314
Q8: ARE CREDIT CARDS MONETARY INSTRUMENTS? WHAT ABOUT PIZZA COUPONS? WHAT ABOUT PRETEND-PLAY BANKNOTES AND
COINS? WHAT ABOUT BITCOINS? ..................................................................................................................................314
Q9: WHAT WERE SOME ERRORS MADE IN PAST MONETARY SYSTEMS?..................................................................................316
Q10: DO LEGAL TENDER LAWS DEFINE MONETARY INSTRUMENTS? WHAT ABOUT FIXED PRICE?.................................................317
Q11: IS IT UP TO PEOPLE TO DECIDE WHAT A MONETARY INSTRUMENT IS? WHO DECIDES WHEN SOMETHING IS DEMONETIZED?......317
Q12: CAN ANYBODY CREATE A MONETARY INSTRUMENT? IS A MONETARY INSTRUMENT NECESSARILY WIDELY ACCEPTED BY OTHERS?
HOW DO I CREATE ONE? ..............................................................................................................................................318
Q13: DOES THE FORM THAT SOMETHING TAKES MATTER TO DETERMINE IF IT IS A MONETARY INSTRUMENT? ...............................319
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CHAPTER 21: HISTORY OF MONETARY SYSTEMS ........................................................................................................................ 321
MASSACHUSETTS BAY COLONIES: ANCHORING OF EXPECTATIONS AND INAPPROPRIATE REFLUX MECHANISM.................................322
MEDIEVAL GOLD COINS: FRAUD, DEBASEMENT, CRYING OUT, AND MARKET VALUE OF PRECIOUS METAL ......................................323
TOBACCO LEAVES IN THE AMERICAN COLONIES: LEGAL TENDER LAWS AND SCARCITY OF MONETARY INSTRUMENTS ........................325
SOMALIAN SHILLING: THE DOWNFALL OF THE ISSUER AND CONTINUED CIRCULATION OF ITS MONETARY INSTRUMENT .....................326
THE ABSENCE OF A REDEMPTION MECHANISM .................................................................................................................326
PART 6: FINANCE AND THE ECONOMY .......................................................................................................................................... 329
CHAPTER 22: ECONOMIC GROWTH AND THE FINANCIAL SYSTEM ...................................................................................331
THE REAL EXCHANGE ECONOMY ....................................................................................................................................332
Money supply is a veil .......................................................................................................................................332
Finance and the economy .................................................................................................................................333
Conclusions .......................................................................................................................................................335
THE MONETARY PRODUCTION ECONOMY ........................................................................................................................336
Money is everything ..........................................................................................................................................336
Why monetary incentives matter? what are other implications?.....................................................................337
Finance and the economy .................................................................................................................................339
Beyond incentives: The role of macroeconomic forces .....................................................................................339
Conclusions .......................................................................................................................................................341
CONCLUSION .............................................................................................................................................................341
CHAPTER 23: INFLATION ....................................................................................................................................................................... 345
THE QUANTITY THEORY OF MONEY: MONETARY VIEW OF INFLATION.....................................................................................346
INCOME DISTRIBUTION AND INFLATION: NON-MONETARY VIEW OF INFLATION .......................................................................349
TO GO FURTHER: KALECKI EQUATION OF PROFIT, INTEREST RATE AND INFLATION ................................................................353
CHAPTER 24: BALANCE-SHEET INTERRELATIONS AND THE MACROECONOMY ..................................................... 357
A PRIMER ON CONSOLIDATION ......................................................................................................................................358
THE THREE SECTORS OF THE ECONOMY ...........................................................................................................................359
SOME IMPORTANT IMPLICATIONS ..................................................................................................................................361
Point 1: The beginning of the economic process requires that someone goes into debt ..................................361
Point 2: Not all sectors can record a surplus at the same time .........................................................................363
Point 3: Public debt and domestic private net wealth ......................................................................................366
Point 4: Business cycle and sectoral balances ...................................................................................................368
Point 5: Policy space and self-imposed constraints...........................................................................................370
CONCLUSION .............................................................................................................................................................371
TO GO FURTHER: SECTOR BALANCES FROM THE PERSPECTIVE OF THE NATIONAL INCOME AND PRODUCT ACCOUNTS .................372
TO GO EVEN FURTHER: NIPA AND FA DEFINITIONS OF SAVING ......................................................................................373
CHAPTER 25: FINANCIAL CRISES ........................................................................................................................................................ 377
DEBT DEFLATION ........................................................................................................................................................378
Step 1: Overindebtedness and distress sales.....................................................................................................379
Step 2: Distress sales and deflation, the “Dollar Disease” ................................................................................379
Step 3: Deflation and debt liquidation; the “Debt Disease” ..............................................................................379
Step 4: Prices and profit and net worth, the “Profit Disease” ...........................................................................380
Step 5: The “amplifier effect” ............................................................................................................................380
Step 6: Pessimism ..............................................................................................................................................381
Step 7: Interest-rate spread ..............................................................................................................................382
Conclusion .........................................................................................................................................................383
ORIGINS OF DEBT DEFLATION ........................................................................................................................................384
Real exchange economy: Efficient markets and imperfections.........................................................................384
Monetary production economy: The financial instability hypothesis ...............................................................385
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Financial fragility ............................................................................................................................................................ 385
The Financial instability hypothesis ................................................................................................................................ 387
HOW TO DEAL WITH FINANCIAL CRISES............................................................................................................................388
TO GO FURTHER: PONZI FINANCE AND THE BALANCE SHEET ............................................................................................389
TO GO EVEN FURTHER: MINSKY AND INCOME VS. CASH INFLOW ....................................................................................390
CHAPTER 26: INTERNATIONAL ASPECTS ...................................................................................................................................... 393
EUROCURRENCY .........................................................................................................................................................394
Some historical background ..............................................................................................................................394
Accounting mechanics of eurodollars ...............................................................................................................394
Eurodollar operations with a branch located abroad ..................................................................................................... 395
Eurodollar operation with a foreign bank ...................................................................................................................... 396
eurodollar credit services ..................................................................................................................................397
Payment services...............................................................................................................................................398
Eurobonds .........................................................................................................................................................399
PART 7: POLICY AND THEORY ISSUES ............................................................................................................................................. 401
CHAPTER 27: MONETARY POLICY IN ACTION ........................................................................................................................... 403
GLOSSARY.................................................................................................................................................................405
ABOUT THE AUTHOR ...................................................................................................................................................414
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PREFACE
This text is the preliminary draft for a textbook that embodies of an extensive revision of posts published
on the blog neweconomicperspectives.org. There are three main reasons to write a new money and
banking text when there are already so many available. First, most texts do not have a coherent theme
that runs through them and that ties together all the chapters. Second, the monetary and banking
chapters most often present views that are inapplicable or that are too limited in their presentation of
the topic. Third, the macroeconomic sections tend to 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 accounting mechanics of the balance sheet is central and used to analyze all the
topics presented. Not only are balance sheets relevant to understanding financial mechanics, but they
also 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. All economists should know some basic
accounting to make a proper analysis the financial system and its relation to the rest of the economy.
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. Yet,
this literature that has been mostly ignored until recently but gained to traction following the 2008
financial crisis. In addition, a clear difference is made between the inner workings of an economy with
fixed exchange rate regimes and flexible exchange rate regimes. Gone is the money multiplier theory,
gone is the financial intermediary theory of banks, gone is the idea that the central bank controls
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. Finance is not constrained by the amount of saving.
The chapters dealing with monetary systems are also much more developed than in a typical textbook. As
such, the “money” chapter, usually first in M&B texts, 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
issues of inflation, economic growth, financial crisis and financial interlinkages.
Of course, all this is still a 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. I wish to thank
all my former and current students and readers posts who provided numerous helpful comments and
suggestions. Many thanks to Stavros N. Karageorgis for carefully reading and editing the first draft. Warren
Mosler, Susan Webber and Nick Estes provided valuable comments.
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PART 1:
CHAPTER 1:
After reading this Chapter you should understand:

What a balance sheet is
Why a balance sheet changes
How a balance sheet changes
What the Financial Accounts of the United States are
How the Financial Accounts of the United States work
What the limits of the Financial Accounts are
CHAPTER 1: BALANCE-SHEET MECHANICS AND FINANCIAL ACCOUNTS OF THE UNITED STATES
The core of the financial system consists of financial documents; among them are balance sheets. Balance
sheets provide the foundation upon which most of a 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 sheets. As Hyman P. Minsky noted, 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
1.1).
Figure 1.1 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 1.2. Financial assets are claims on other economic units; nonfinancial
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 1.2 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 nonfinancial assets and $69.1 trillion of financial
2
assets. Their two main liabilities were mortgages ($9.4 trillion) and consumer credit (credit card debts,
student debts, healthcare debts, etc.) ($3.3 trillion).
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
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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.
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 1.3).
Figure 1.3 A simple balance sheet

What is the impact of a bank forgiving $40k of principal on the mortgage? The value of the mortgage went
down by 40k and the value of the net worth went up by 40k so that the accounting equality is preserved
(Figure 1.4)
Figure 1.4 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 $20k and here again the accounting equality is
preserved. (Figure 1.5).
Figure 1.5 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
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opposite changes in two items on the right side of the balance sheet (Figure 1.6), and a change in assets
and net worth by the same amount (Figure 1.7). Of course, these are not the only 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 wonder what the offsetting change is. This has practical implications when
studying how banks and central banks operate.
Household
ΔAssets ΔLiabilities and Net Worth
Mortgage: -$40
Net worth: +$40
Figure 1.6 T-account that records the decline of the mortgage principal
Household
House: +$20 Net worth: +$20
Figure 1.7 T-account that records the higher house value
CHANGES IN THE BALANCE SHEET

One can classify factors that change a balance sheet into 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.
Cash flow, income and expenses, and capital gains and losses 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 1.8).
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Figure 1.8 Balance sheet and cash flow

Going back to the balance sheet of Figure 1.3, 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, Figure 1.9 shows what the cash flow structure looks like.
Figure 1.9 Balance sheet and cash flows, an example

The balance sheet at the beginning of the following year is shown in Figure 1.10 (assuming all cash flows
involve actual cash transfers 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 offsets for these two changes.
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Figure 1.10 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. Over time, assets lose value via depreciation, or destruction, or repayment of principal;
some assets are sold while other 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, so it 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 minus principal reductions) also impacts the balance sheet of their
issuers. It also impacts 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
Figure 1.3 shows the impact of acquiring nonfinancial assets (the house) and incurring new liabilities (the
mortgage). Figure 1.4 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. In the previous example (Figures 1.9
and 1.10), net cash flow and net income are the same thing; however, not all incomes necessarily lead to
cash inflows (see Chapter 4 and Chapter 4). There is a debate about whether or not one should record
capital gains and losses in the income statement. Given the pedagogical 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 have not changed (no net addition). If accounting is done on a “mark-to-market” basis, that
is, by valuing balance-sheet items on the basis of their current market value, these changes are accounted
in the balance sheet on a daily basis. Some assets see their prices go up (capital gains) while other see their
7
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 capital gains of the period
The example of Figure 1.5 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, that is, at the price at which they were acquired minus depreciation. For
financial assets, there are three options to record their value. Level 1-valuation uses the available market
price. Level-2 valuation is used for assets that do not have an active market; a proxy market is used 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
a convenient way to hide major losses of net worth by financial institutions.
MACROECONOMIC USE OF BALANCE SHEET: THE FINANCIAL

ACCOUNTS OF THE UNITED STATES
TO BE WRITTEN
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/capital/equity is the difference between the monetary value of assets and liabilities.
4- A balance sheet must balance, that is, at all times 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, nonfinancial 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
8
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:

What the financial system broadly does
What financial instruments are
What the different types financial instruments are
Who holds and issues different types of financial instruments
How the liability structure influences the asset structure
CHAPTER 2: THE FINANCIAL SYSTEM: A WORLD OF PROMISES
The U.S. financial system is extremely complicated. Figure 2.1 provides an overview of that system that
consists of three main categories: financial markets, financial companies, and regulatory and supervisory
institutions. Chapter 2 emphasizes that the world of finance is a world of promises and it goes through most
of the different sorts of promises that exist. Chapter 3 overviews most of the private and public institutions
involved in the financial industry.
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 2.1 The financial system in the United States
THE FINANCIAL SECTOR: A WORLD OF PROMISES

Anybody can make any kind of promise. “I will pick you up tonight at 8 PM,” “I will complete my homework
assignment tomorrow,” “I will provide you with a free pizza whenever you want,” “I will service my
mortgage every month for the next 30 years.” The hard parts are, first, to convince others of the
genuineness of the promise, so they are willing to accept it and, second, to fulfill the promise once it has
been accepted. If the issuer of a promise is not credible (maybe he has a reputation for being late and lazy,
maybe he defaulted on past debts), there is much less of a chance that the promise will be accepted, or it
will be accepted only at a high cost to the issuer. Thus, all promises involve the credibility of the issuer, that
is, trust in the ability and willingness of the issuer of a promise to fulfill that promise. The world of finance
establishes a framework to record the creation and fulfillment of formal promises that are financial in
12
nature, and to measure the credibility of issuers at any point in time. Finance more or less accurately
measures the credibility of these financial promises by pricing financial instruments (Chapter 14).
Casual promises
Promises Nonfinancial promises
Formal promises
Financial promises (financial instruments)
Figure 2.2 A categorization of promises
Figure 2.3 Some nonfinancial promises

Formal promises are promises that carry the weight of the law through either contractual agreements or
legislation. Such promises can be financial or nonfinancial depending on the nature of the promise made.
A free-pizza coupon is a nonfinancial promise because the reward provided by the issuer is not monetary
in nature. On the contrary, a mortgage note or a monetary instrument merely involves future monetary
13
transfers with the issuer (interest payments, tax payments, among others). This textbook studies financial
promises, which are known as “financial instruments” (Figure 2.2).
Figure 2.3 shows that a formal promise does not have to take a specific shape or to be made of a specific
material. Today, the cheapest means to make a financial instrument are through an electronic entry, but
an issuer may choose to do so by stamping gold or leather, or by printing paper; the object representing
the promise can be very fancy and big or very small and simple. The shape and material are irrelevant to
the existence of a claim. As long as key legal elements described below are included, there is a formal
promise.
CREATION AND DESTRUCTION OF FINANCIAL INSTRUMENTS

The creation (and destruction) of any promise, financial or nonfinancial, involves at least two actors: the
issuer, who makes the promise, and the bearer, who accepts the promise and so chooses to trust the issuer.
There cannot be issuance without a willing bearer, and there be cannot a promise without a willing issuer.
As such, banks cannot create bank accounts if nobody wants to hold them (see Chapter 12), corporations
cannot issue shares if nobody wants to acquire them, etc.
The creation of a financial instrument is a complicated matter that involves lots of legalese explaining in
detail what the promise is, and what happens if the promise is not fulfilled. Lots of time is also spent on
determining how credible the issuer is—its creditworthiness—and the willingness of potential bearers to
hold the issuer’s financial instrument. The legal document that records all the details of a financial
instrument can run for hundreds of pages, and bearers and issuers are supposed to know all the details of
the agreement, which is sometimes not the case.
One may wonder why one may decide to issue a financial instrument and why others are willing to hold it.
People, businesses, governments and other entities issue financial instruments for all sorts of reasons.
Some want to obtain funds to be able to go to school or to buy a car, others want to buy expensive
equipment to expand their productive capacities. Another reason may be to provide meals to poor
households, to maintain and develop the infrastructure of the state, or to manage the overall national
economy. In general, financial instruments are issued because someone, the issuer, does not have enough
funds on its balance sheet to pursue the goal it sets for itself; the issuer has a deficit of funds. By issuing
financial instruments, the issuer asks economic units with a surplus of funds, or with the ability to create
those funds, to trust the issuer. The issuer promises to return the funds later on with some rewards.
Depending on the nature of the reward and the credibility of the issuer, the demand for a financial
instrument varies. When the financial instrument comes due, the issuer repurchases its financial instrument
from bearers by giving back to bearers the funds they provided in the first place.
Figure 2.4 shows the general logic behind financial instruments (here denominated in dollars). At issuance,
the issuer sells a financial instrument to the bearer. The bearer decides to buy the financial instrument of
the issuer at a certain price, say $100. The issuer then uses the $100 for whatever purpose. Until the
financial instrument is returned to the issuer, the bearer periodically receives a monetary reward from the
issuer (e.g., $10 every month or $20 every six months). When the principal is owed (“at maturity”), the $100
is paid back by the issuer to whoever presents the financial instrument. The issuer is effectively buying back
its financial instrument, and he does so at its face value, that is, the monetary sum inscribed on the financial
instrument. Once it has recovered his financial instrument, the issuer destroys it to prevent others from
acquiring it and so having a claim on the issuer.
14
Financial instrument of issuer
$$ (purchased price: fair price) At issuance
Issuer $$ (income) Bearer Until maturity

(Debtor) (Creditor)
$$ (repurchase price: face value) At maturity
Financial instrument of issuer

Figure 2.4 Broad logic behind financial instruments
As illustrated below and explained in Chapter 14, Figure 2.4 does not fit exactly the structure of all financial
instruments because sometimes the income is not paid until maturity (zero-coupon securities), sometimes
the principal is paid bit by bit over time (fully-amortized financial instruments) rather than at once at
maturity (unamortized financial instrument), sometimes the issuer never promises to buy back his financial
instruments and so never has to repay the principal (consols, corporate shares). However, the Figure
illustrates the general point that someone issued a financial instrument, pays a reward, and then fully
redeems its financial instrument at maturity. Chapter 19 shows that this logic applies to monetary
instruments.
CHARACTERISTICS OF A FINANCIAL INSTRUMENT: TERM TO

MATURITY, LIQUIDITY, RISKS, AND OTHER CHARACTERISTICS
Balance sheets contain many types of financial instruments. Some of them are issued by an economic unit
to others who then have a claim on the issuer (financial liabilities). Some of them are held by that same
economic unit who then has claims on others (financial assets). The way a financial instrument is structured
varies widely depending on the needs of their issuers and potential bearers, but common questions that a
promise must answer are the following.
- Who is the issuer? That is, who made the promise? The mark of the issuer (name, head, etc.) is
present on the financial instrument, so bearers know who is supposed to fulfill the promise
contained in the financial instrument.
- What is the unit of account? Financial instruments cannot exist before there is a unit of
measurement for transactions and outstanding assets and liabilities.
- When will the issuer redeem its financial instrument? That is, how long will it take the issuer to
fulfill the promise? There is a term to maturity. At maturity, the issuer buys back the financial
instrument it issued. The term can go from zero (issuer takes back its financial instrument at the
bearer’s discretion) to infinity (issuer takes back its financial instrument at its discretion).
- At what price will the issuer redeem its financial instrument? A face value specifies the number of
units of account the financial instrument carries ($100, $10, $1, 25 cents, etc.) and so the monetary
value of the principal owed.
- How will the issuer redeem its financial instruments? How can bearers redeem the notes? The
expected means that will be used by the issuer to fulfill his promises, also called the “reflux
15
mechanisms/channels” or redemption channels (Chapter 19 shows that the way this question is
answered is crucial for financial stability)
- What is (are) the benefit(s)/reward(s) for those willing to trust the issuer? Income, voting rights,
settle debts owed to issuer, avoid prison, etc.
- Are there any protections for bearers in case the issuer is unable or unwilling to fulfill the promise?
If the issuer defaults on its promises, the bearers are paid by taking ownership of some assets of
the issuer (house for mortgages, etc.). The asset(s) that the issuer uses to secure a financial
instrument are (is) called collateral. If there is no collateral, the financial instrument is said to be
unsecured.
- Is it possible to transfer the financial instrument to another bearer? Financial instruments may be
marketable/transferable/negotiable, that is, 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 and are not endorsable. Some, like checks,
have limited transferability through endorsement.
Depending on how these questions are answered, the name of a financial instrument changes, in the same
way the race of a dog changes depending on its physical characteristics; some are called stocks/shares,
bonds, or mortgages, others are called bills, commercial paper and student debt. While they differ in
characteristics, they all contain a promise made by someone (the issuer) to someone else (the bearer).
Depending on the previous characteristics, a financial instrument is also more or less liquid. Broadly, the
liquidity of an asset means the ability to sell it quickly without incurring major capital losses. A house is
one of the most illiquid assets. If someone decides to buy a house today for $500,000 and wants to sell it
the next day, it will be impossible to resell it at the same price. The owner will either have to wait—days,
weeks, months, or years depending on the popularity of the location of the house and the state of the
economy—to find someone willing to buy it for $500,000, or will have to offer a large discount to sell it
immediately; there are plenty of people willing to buy a house for $100.
One way to check if a financial instrument or any other asset is liquid is to analyze how its nominal price
behaves over time, that is, at what price it circulates over time among bearers. Figure 2.5 shows how the
price of three different financial instruments with the same face value changes over time. Financial
instrument #1 is perfectly liquid in the sense that the price at which it passes among economic agents is
constant; it always trades at face value, and so there is never any capital loss (or gain). Federal Reserve
notes (FRNs) are examples of perfectly liquid financial instruments; a $20 FRN is always accepted at $20.
Financial instrument #3 is highly illiquid because, even though one may be able to record a capital gain by
selling at the right time, its nominal price is highly volatile. Financial instrument #2 is less liquid than financial
instrument #1 but more liquid than financial instrument #3. Indeed, while the initial bearer will always make
a capital loss if he sells, the volatility of the price is low, and so later bearers will have less chance to record
large capital losses if they want to sell quickly.
Note that the notion of liquidity is different from the notion of purchasing power stability. A $20 Federal
Reserve note may circulate at $20 at all times, but the quantity of goods and services that $20 can purchase
varies through time. Chapter 23 and Chapter 19 explain that the mechanics at play in the determination of
liquidity and purchasing power are quite different.
Two main factors determine the liquidity of a financial instrument. One is its financial characteristics
presented above. Another is the existence of a well-organized financial infrastructure that allows for a
smooth trading of financial instruments according to their financial characteristics; in this case, the price at
which the financial instrument circulates reflects well the promise made.
16
Price
Financial instrument #3
Time
Figure 2.5 Liquidity and price volatility
In terms of financial characteristics, the most liquid financial instruments are those that are transferable, of
the shortest term to maturity, and with reflux mechanisms that are reliable and compatible with their term
to maturity (see Chapters 14, 19, and 20). Federal Reserve notes are due on demand, checking accounts are
due on demand, and so both are perfectly liquid given that existing reflux mechanisms do allow bearers to
redeem on demand.
In terms of financial structure, a well-developed deep market will promote liquidity. A deep market means
that the price at which a financial instrument trades is not influenced by major swings in its demand or
supply. If trading in a market is limited and participation is thin (few buyers and sellers at any price point),
the price of a security will be very sensitive to a change in demand or supply of that security. In this case,
there is a high chance to record a capital loss if some participants try to sell the security quickly. On the
contrary, if trading volume is strong and at any price point there are lots of willing buyers (so the price
cannot fall much) and sellers (so the price cannot rise much), a financial instrument will be more liquid given
its financial characteristics.
Once an economic unit has decided what type of financial instrument to issue and assuming some willing
bearers do exist, the difficult part becomes to fulfill what was promised. A bearer may also want to sell the
financial instrument to another bearer but may have difficulties to do so. As such, the bearer of a financial
instrument faces several risks, among which are:
- Credit risk: The issuer is unable or unwilling to fulfill what was promised when it was promised. The
income due is not paid, or only paid partially, or paid fully but not on time. The issuer is not able or
willing to repurchase partially or fully its financial instrument—that is, part, or all, the principal—
when he stated he would. More broadly, credit risk occurs when any part of a promise is not
accomplished in terms of dollar amount and/or timeliness. If credit risk does occur, the issuer is
said to have defaulted/to be in default/to be delinquent. This has important implications for the
creditworthiness of the issuer and for the price of its financial instrument as explained in Chapter
14.
- Prepayment risk: Some clauses in a financial instrument may allow the issuer to repay the principal
due more quickly than the stated term to maturity. For example, a bearer may buy a financial
instrument expecting to earn an income over 10 years, but the issuer may suddenly decide to
repurchase fully his financial instrument after 7 years, which leads to a loss of income for the bearer.
Households usually tend to repay their mortgages more quickly than the original term to maturity
17
(a 30-year mortgage is repaid in 20 years by making accelerated payment of the principal), some
bonds are callable (the issuer can repurchase them earlier than expected).
- Collateral risk: If the issuer defaults, the value of the collateral may not be high enough to recover
all the income, fees, and principal due to the bearer.
- Liquidity risk: If the bearer decides to sell a financial instrument, he may try to sell it to another
bearer (the issuer is under no obligation to buy it back until maturity). Doing so, however, may be
costly if the financial instrument is not liquid as explained above.
- Interest-rate risk: Interest rates may change in a way that negatively impacts the net worth of the
bearer. For example, the price of some financial instruments are more sensitive than others to
changes in interest rates (see Chapter 14), or banks may hold mortgages with fixed interest rates
but issued liabilities with flexible interest rates (Chapter 4).
Many other risks exist for bearers that are more or less pronounced depending on the structure of the
financial instrument (that is depending on what the issuer promised to do), the structure of the balance
sheet of the issuer and of the bearer and the state of the economy. The main point is that accepting to hold
a financial instrument is not without risks, not only because one must trust the issuer, but also because of
potential adverse changes in financial-market conditions and the overall economic situation. Given the
characteristics presented above, one may classify financial instruments into marketable (aka “securities”)
and non-marketable (aka “advances” or “loans”). The following uses the Financial Accounts of the United
States to present an overview of financial instruments. The Accounts measure how much of each
instrument is outstanding, who the issuers are and who the bearers are. Since 1945, a lot has changed in
terms of these elements.
MARKETABLE FINANCIAL INSTRUMENTS: SECURITIES

While some securities are not marketable, most of them are because the promises that they contain can
be fulfilled to anyone who holds the security rather than to a specific person. Three broad types of securities
that are distinguished by their financial characteristics: equity instruments, debt instruments, and monetary
instruments. Monetary instruments are analyzed more carefully in Chapters 20 and 21.
EQUITY INSTRUMENTS
There are different types of equity instruments such as corporate stocks/shares/equities and mutual fund
shares. The main legal aspect of equity instruments is that they represent a residual claim on the business
that issued them. As such, they are paid last and take losses first. The income earned from the equity
instruments—called dividend—is a proportion of the profit. If the business does not make any profit, no
dividend is paid. Put differently, a dividend is paid if there is a residual income after all other creditors have
been paid. Even if there is a profit, a dividend payment is not guaranteed because the board of the company
may decide that it is best to allocate earnings in a different manner, such as the expansion of the business.
Not paying a dividend is, however, a risky strategy because unhappy bearers may decide to sell the stock
leading to a fall in its price. This could make the business subject to potential hostile takeover bids by
competitors who want to take control of the business by acquiring a large quantity of its stocks.
Equity security holders can participate in a vote on the major issues facing a business. Each shareholder has
a vote, and the more shares one owns in a business, the more voting power one has. Some holders of equity
instruments may prefer to give up that right in exchange for a more certain income. This is the main
18
difference between common stocks and preferred stocks, with the latter guaranteeing a dividend as long
as there is some profit, but also not giving a right to vote.
Equity holders are the first to take losses in a bankruptcy procedure. For example, assume a business only
has $100 worth of assets to make payments to thousands of creditors. The overall dollar amount owed in
terms of principal, income, and other claims is $10000 including $1000 worth of equity instruments. The
bankruptcy judge is tasked with distributing the $100 among claimants. One way would be to give 1 cent
per dollar claimed and to call it a day, but that is not how equity instruments are structured. Equity holders
take losses first and so the $1000 they are owed is wiped out first from the claims on the business. The
judge then moves to the next claimants, holders of debt instruments and other claims, to figure out how to
allocate losses.
Finally, the term to maturity of an equity security is infinite, which means that the issuer never promises to
pay back the principal owed; it is not redeemable. Issuers may choose to redeem their equity instruments
at their convenience, but they do not have to do so. For example, if one buys a corporate share with a face
value of $1000 from business X, business X is under no obligation to repay the $1000. If one wishes, one
may try to sell the share to someone else at the prevailing market price (that may be above or below $1000).
Interestingly, the corporate business sector has never used the stock market as a major source of funds.
Since the early 1980s, corporations have used many of their earnings to repurchase the shares they
previously issued. While some corporations have issued large quantities of shares to finance their business
operations—Facebook and Twitter may come to mind—other corporations have repurchased their shares
in quantities that dwarf new issues. Figure 2.6 shows that the net increase in corporate shares (issuances
minus repurchases) has been constantly negative since 1994 and averaged -$231 billion annually from 1994
to 2015.
Figure 2.6 Net issuance in corporate equities, billions of dollars.

Source: Board of Governors of the Federal Reserve System (series Z.1, F.102, line 38)
A central reason behind this trend has been a change in the management strategies of corporations because
of the financialization of the economy (see Chapter 4). For example, business managers have seen a change
in their remuneration structure away from salary and toward stocks and bonuses. This has pushed
19
managers to find means to boost up the short-term trend of stock prices, and one means to do so is to make
the stock of a company scarcer.
For every issuer of a financial instrument there is a bearer, for every creditor there is a debtor. Figure 2.7
and 2.8 illustrate this point by showing the structure of ownership of corporate shares and the structure of
issuers. In 2015, the market value of outstanding corporate stocks was about $36 trillion. Households hold
most of the stocks, either directly or indirectly via money managers (pension funds, mutual funds and
insurance companies). Figure 2.7 shows two trends in the evolution of the structure of ownership. One is
the growing role of money managers—also known as institutional investors—and another is the
internationalization of the ownership. Until the late 1950s, over 90 percent of corporate shares were held
directly by households and non-profit organizations (NPOs). Over time, money managers—especially
pension funds and mutual funds—have owned a greater proportion of corporate shares and, by 2015,
money managers held about 40 percent of all corporate shares, with another 40 percent held directly by
households. The rest of the world has also owned a growing proportion of outstanding corporate stocks in
the United States and today owns about 15 percent of them.
Over 70 percent of corporate shares outstanding are issued by nonfinancial corporations (Figure 2.8). This
proportion is even larger if one includes the shares issued by “captive financial institutions.” They are
financial affiliates of nonfinancial corporations that provide financial services to the customers of the parent
nonfinancial corporations (credit cards issued by retail stores, financing provided by a car dealer to its
customers, among others). Banks chartered in the United States, life insurance companies and non-MMMF
funds (closed-end funds and exchange-traded funds) are most of the other issuers of corporate shares.
Figure 2.9 shows that another major issuer of equity instruments are mutual funds with the market value
of their shares equaling $12 trillion. The evolution of the structure of ownership of mutual funds shares
follows a similar story to corporate shares with 100% of mutual funds shares held directly by households
until the 1960s, followed by a rapid increase of indirect ownership via money managers that today hold
about 40 percent of mutual fund shares. Foreign ownership is less pronounced for corporate shares with
only about 5 percent of mutual funds shares held by the rest of the world.
20
Figure 2.7 Structure of ownership of corporate equities (percent) and market value of outstanding shares
(trillions of dollars)
Source: Board of Governors of the Federal Reserve System (series Z.1, L.223)
Note: “Others” includes monetary authority (common stocks of American International Assurance
Company Ltd. (AIA) and American Life Insurance Company (ALICO) held between December 2009 and
January 2011 via special purpose entities AIA Aurora LLC and ALICO Holdings LLC), the federal government
(preferred shares issued by US banks to Treasury to access emergency injection of capital via the Troubled
Asset Relief Program), private depository institutions, state and local government, closed-end funds,
exchange-traded funds, and security brokers and dealers.
21
Figure 2.8 Structure of issuers of corporate equities (percent)

Figure 2.9 Structure of ownership of mutual fund shares (percent) and market value of outstanding shares
(trillions of dollars)
22
DEBT INSTRUMENTS
Debt instruments are distinct from equity instruments by the fact that they do not represent a residual
claim on the company but rather are an acknowledgment of debt. This acknowledgement by the issuer
comes with a promise to repay the principal and a reward, even if the issuer does not earn any income. The
issuer must sell assets, deplete its savings, or must find other means to pay the income due on debt
instruments. Debt instruments are also provided more protection in case of bankruptcy, the first layer being
provided by equity instruments. However, not all debt instruments are equal in bankruptcy and some may
be subordinated to others, that is, may absorb losses before other debt instruments. Chapter 17 on
securitization will develop this point.
The structure of debt instruments varies greatly to fit the needs of the issuer and bearers. Some pay a
periodical income—called coupon—but others do not, some are secured while others are not, and the
range of the term to maturity varies from one month to decades. A classic example of a short-term debt
security is commercial paper. Some businesses may mostly need extra funds for a short period of time in
order to pay their workers and to buy the raw material needed to start production. Once the production is
completed and the output sold, the businesses repay their debts. A commercial paper is a short-term
financial instrument that fulfill such financial needs. Its term to maturity at issuance is usually less than 270
days and averages 30 days in the United States. About 30 percent of commercial papers are issued by
nonfinancial corporations either to finance inventories (renting space, paying insurance, etc.), or to finance
production (paying wages, electricity, etc.). The rest is issued by financial companies that seek short-term
sources of funds.
Until the 1970s, finance companies were the main issuers of commercial papers with about 50 percent of
outstanding commercial papers issued by them. After the 1970s, captive financial institutions, issuers of
asset-backed securities, and the rest of the world (mostly foreign private financial companies) became
major issuers (Figure 2.11). About 50 to 60 percent of open-market papers is held by funding corporations
and money market mutual funds, in the form of commercial paper, and their outstanding amount peaked
at $2 trillion in 2007 before collapsing to less than $1 trillion in 2015, mostly due to the decline in issuance
of asset-backed commercial paper as explained below (Figure 2.10).
Given that the issuance of commercial papers is tied to economic activity, the outstanding dollar amount
of commercial papers fluctuates with the business cycle: it rises in an expansion and falls in a recession. A
commercial paper does not pay a coupon but rewards its bearer in another fashion explained in Chapter
14. Most commercial papers are unsecured but, with the rise of securitization, a secured form—called asset-
backed commercial papers (ABCP)—became prominent. Figure 2.12 shows that the outstanding volume of
ABCPs peaked at $1.2 trillion in 2007—about 50 percent of all types of commercial paper outstanding—
before collapsing to $240 billion by 2015 or about 25 percent of all types of outstanding commercial papers.
23
Figure 2.10 Structure of ownership of open-market papers (percent) and market value of outstanding
papers (trillions of dollars)
Figure 2.11 Structure of issuers of open-market paper (percent) and proportion of commercial paper in all
open-market papers
Note: Open-market papers include commercial paper and banker’s acceptances
24
Figure 2.12. Proportion of unsecured and secured commercial paper and outstanding dollar amount of
asset-backed commercial paper (trillions of dollars)
Source: Board of Governors of the Federal Reserve System (series “commercial paper”)
Note: There are four categories of commercial paper in the dataset: nonfinancial, financial, ABCPs and
others. “Others” represents an insignificant proportion and are included in commercial paper.
While commercial papers deal with the short-term needs for funds of businesses, corporate bonds deal
with their medium to long-term needs. Bonds pay an interest income. The interest income is called
“coupon” because bonds were formerly made of paper and small coupons were attached to the bond. Each
one had to be cut and redeemed to the issuer in order to receive the interest payment. At maturity, the
issuing corporation buys back the bonds from whoever holds them and pays the face value of the bond.
Figure 2.13 shows an old-fashioned bond with the bonds on the left stating a face value of 100 taels (a unit
of account that prevailed in China) and 18 coupons left on the right. This bond, issued by Tientsin Land
Investment Company has an initial term to maturity of 22 years. An interest income worth 3.5 taels was
due every six months, which means that 44 coupons were initially attached to the bond. Interest income
was paid whenever a coupon was handed to Tientsin and, after 22 years passed, the bond was to be
returned to Tientsin to get 100 taels. Today, all financial instruments, except for cash, take an electronic
form. This form is cheaper to create (it is just a matter of keystroking numbers and letters on a computer;
no need for fancy illustrations and calligraphy and cumbersome printing) and to track (centralized
accounting of dollar amount due and owners, quick crediting and debit of dollar amounts by keystroking on
the computer).
25
Figure 2.13 An old fashion bond

Figure 2.14 shows that a wide variety of economic entities are interested in buying such financial
instruments with an outstanding value of a little less than $12 trillion in 2015. Insurance companies, pension
funds, and, more recently, mutual funds have been major purchasers of corporate bonds and in 2015 held
about 50 percent of all corporate bonds, down from 85 percent in the 1960s. Today, other financial
institutions, such as exchange-traded funds and the rest of the world, have become major holders of
corporate bonds, with the rest of the world owning about 25 percent of outstanding corporate bonds in
2015.
Figure 2.15 shows that issuers of corporate bonds have also diversified considerably since 1945.
Nonfinancial businesses have been major issuers and so have been finance companies, but with the growth
of securitization in the 1980s, special purpose entities (“issuers of asset-backed securities” or ABS issuers)
have become major issuers. By 2007, 40 percent of outstanding corporate and foreign bonds were issued
by them. However, since the Great Recession, the volume of corporate bonds issued by ABS issuers has
diminished considerably. In 2015, only 10 percent of outstanding corporate and foreign bonds were issued
by ABS issuers.
26
Figure 2.14 Structure of ownership of corporate and foreign bonds (percent) and dollar amount
outstanding (trillions of dollars)
Note: “Others” includes money market mutual funds, exchange traded funds, security brokers and
dealers, and federal, state and local governments, among others.
Figure 2.15 Structure of issuers of corporate and foreign bonds, percent

27
A type of corporate bond that was at the center of the 2008 financial crisis is the private-label mortgage-
backed security (PL MBS). Figure 2.16 shows that in six years the dollar amount of PL MBS rose tenfold from
$200 billion in 2001 to over $2 trillion in 2007. In the Financial Accounts, the sector that issues them is called
“issuers of asset-backed securities,” which are special purpose entities created by private depository
institutions to hold mortgages and other financial instruments (see Chapter 17 on securitization). While
most PL MBSs were initially held by depository institutions (they bought the securities issued by the special
purpose entities they created), for reasons explained in the Chapter on securitization, government-
sponsored enterprises, insurance companies and the rest of the world came to hold 90 percent of them by
2000. Insurance companies and the rest of the world were especially eager to buy PL MBSs when their
issuance boomed in the early 2000s.
Figure 2.16 Structure of ownership of private-label mortgage backed securities and other asset-backed
bonds (percent) and dollar amount outstanding (trillions of dollars)
Commercial papers and corporate bonds are two debt instruments that satisfy widely different needs of
corporate businesses, but private companies are not the only issuer. The United States Department of the
Treasury (“the Treasury”) is a major issuer of debt instruments—called Treasuries—with terms to maturity
ranging from 1 month to 30 years. The name of a Treasury security changes depending on its initial term to
maturity. Treasury bills (T-bills) are Treasuries with an initial term to maturity of one year or less, Treasury
notes (T-notes) have an initial term to maturity between 2 and 10 years, and Treasury bonds (T-bonds) have
an initial term to maturity of more than 10 years. Also contrary to T-notes and T-bonds, T-bills do not pay a
coupon, and so the reward to holders comes in a different form, which is presented in Chapter 14. At the
statistical level, when the government compiles the size and structure of the public debt, the government
changes the classification a Treasury security as it gets closer to mature. Treasuries with an initial maturity
of 30 years are first classified as T-bonds, but, once 20 years have passed, they are classified as T-notes. As
explained in Chapter 9 and throughout this book, Treasuries are a cornerstone of the financial system. The
Treasury actively manages the level and structure (that is, proportions) of outstanding Treasuries to meet
the needs of other participants of the financial system and to help promote financial stability.
28
Figure 2.17 shows a similar trend to corporate equities with an internationalization of ownership and a
growing importance of money managers, especially pension funds. In 2015, about 40 percent of the $15
trillion of outstanding Treasuries held by the public were held by foreigners (foreign central banks, foreign
Departments of the Treasury, foreign businesses and households, and other foreign entities), and about 25
percent were held by money managers. A major difference with corporate equities is that the Federal
Reserve (“Fed”) has been a major holder of Treasuries. Since 1945, the Fed has usually held at least 10
percent of outstanding Treasuries. Chapter 7, Chapter 8 and Chapter 9 explain why Treasuries are central
to the operations of the Fed.
While the federal government is a major issuer of debt instruments, states and localities also issue them—
municipals or “munis”—and the issuance of new bonds to fund specific projects is often put on the ballot.
Municipals can be structured in two different ways: revenue bonds are issued to finance a specific project
(a toll bridge, etc.) which revenues will serve to pay the coupon and principal, while general obligation
bonds are issued to finance any project and are paid back with tax revenues. The outstanding dollar amount
of munis reached a little less than $4 trillion in 2015 and ownership has been highly diversified and mostly
domestic since 1945 (Figure 2.18).
Figure 2.17 Structure of ownership of Treasuries (percent) and dollar amount outstanding (trillions of
dollars)
Note: Treasuries held by intra-federal agencies are not included. For example, the United States Social
Security Administration holds a substantial dollar amount of Treasuries in its trust fund.
29
Figure 2.18. Structure of ownership of Municipals (percent) and dollar amount outstanding (trillions of
dollars)
Note: Others include the rest of the world, closed-end funds, exchange-traded funds, security brokers and
dealers, among others.
Other major issuers of debt instruments are federal agencies, government-sponsored enterprises (GSEs)
and the special purpose entities they back, which altogether issue securities called agency securities. Two
prominent GSEs are the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan
Mortgage Corporation (“Freddie Mac”). Their purpose is to promote homeownership, and they finance
their operations by issuing mortgage-backed securities. A federal agency called Government National
Mortgage Association (“Ginnie Mae”) helps further promote homeownership among veterans and low-
income households by guaranteeing payments on their mortgages in case of default and by issuing
securities backed by these mortgages. While not explicit, financial-market participants believe that, in case
of financial difficulties, the federal government will help GSEs—a belief that turned out to be correct as the
2008 financial crisis showed—, so securities issued by GSEs are considered very safe, which leads to a very
high demand for them. Federal agencies are part of the federal government and so their securities are
considered to be without credit risk, like Treasuries.
In 2015, there was about $8 trillion worth of agency securities (“Agency- and GSE-backed securities”),
outstanding and the ownership was highly diversified (Figure 2.19). While private depository institutions
were at first the main holders of agency securities, once again money managers and the rest of the world
have become major holders. Recently, the Federal Reserve has also become a major bearer of agency
securities by holding 20 percent of them following its massive purchases of financial instruments to help
contain the effects of the 2008 financial crisis (see Chapter 7 and Chapter 8). As Figure 2.20 suggests, GSEs
also had to intervene to help the special purpose entities (“mortgage pools”) they backed by buying their
securities and through the issuance of GSE securities backed by the purchased MBS.
30
Figure 2.19 Structure of ownership of Agency- and GSE-backed securities (percent) and dollar amount
outstanding (trillions of dollars).
Note: Agency- and GSE-backed securities include securities guaranteed or issued by US federal agencies
(Tennessee Valley Authority, Ginnie Mae, among others), securities issued by government-sponsored
enterprises (Fannie Mae, Federal Home Loan Bank, among others), and securities issued by special
purpose entities created by Ginnie Mae, Fannie Mae, Freddie Mac, and the Farmers Home Administration
to pool mortgages and mortgage-related securities.
31
Figure 2.20 Structure of issuer of Agency- and GSE-backed securities (percent).

MONETARY INSTRUMENTS
Monetary instruments are the last type of marketable financial instruments. Chapters 19 and 20 are
devoted to their analysis. One of the main characteristics of monetary instruments is that their term to
maturity is instantaneous, that is, they can be returned to the issuer at the will of the bearer—they are
redeemable on demand. In terms of cash, that is physical monetary instruments, the Financial Accounts of
the United States make a difference between currency, Treasury currency, and coins. Coins are not included
in the Accounts, currency refers to cash issued by the Federal Reserve (Federal Reserve notes), and Treasury
currency refers to cash issued by the US Treasury (the Treasury no longer issues any currency, but some of
it still circulates). Unless stated otherwise, the term “currency” will be used to include paper-made
monetary instruments issued by both the Federal Reserve and the Treasury. In 2015, the outstanding dollar
amount of currency was $1.5 trillion, and Figure 2.21 shows that 95 percent of that was held by the
domestic non-federal sectors and the rest of the world. In 2015, about 40 percent of the US-dollar-
denominated currency outstanding was held by the rest of the world, and about 55 percent was held by
the domestic private sector. The ownership structure of Treasury currency outside the Federal Reserve is
not provided by the Financial Accounts, but most of it must be held by the domestic private sector. The
Federal Reserve is a significant holder of Treasury currency although the significance of its holding has
shrunk over time. In 1945, Federal Reserve’s holdings of Treasury currency represented about 10 percent
of outstanding currency, but, by 2015, it represented less than 5 percent of outstanding currency.
32
Figure 2.21 Structure of ownership (percent) and level (trillions of dollars) of US currency and US Treasury
currency
Source: Board of Governors of the Federal Reserve System (series Z.1)
Note: Currency means Federal Reserve notes, Treasury currency includes banknotes no longer issued by
the Treasury but that the Treasury did not demonetize (United States notes, silver certificates, pre-1933
Federal Reserve notes convertible into gold coins at the Treasury, among others)
Beyond currency, another familiar monetary instrument is the checking account (aka checkable deposit)
and its outstanding amount was slightly less than $2.5 trillion in 2015. Checking accounts are held by all
sectors of the economy and, again, the rest of the world has held a growing proportion of US-dollar
denominated checking accounts (Figure 2.22). Following the definition of the Financial Accounts, currency
(Federal Reserve notes) and checkable deposits have been issued by two entities, the private depository
institution (private checking accounts) and the Federal Reserve (currency and checking accounts issued to
the Treasury, government-sponsored enterprise and the rest of the world). Figure 2.23 shows that from
1945 until 1990, the checking account issued by private depository institutions represented 75 percent of
outstanding checkable deposits and currency. Since 1990, the proportion issued by the Federal Reserve has
grown to 40 percent of outstanding currency and checkable deposits in 2015.
If one moves away from the narrow definition of checking accounts used by the Financial Accounts to
include all existing checking accounts and currency outstanding in the Financial Accounts, then one must
include the checking accounts issued by the Federal Reserve and the Federal Home Loan Bank to private
depository institutions. One must also include currency in the vault of private depository institutions.
Figures 2.24 and 2.25 show the implication of including these elements in the statistical analysis. The 2015
outstanding amount of checkable deposits and currency jumps to $6 trillion instead of $4 trillion (see
Chapter 7 for an explanation). The proportion of currency and checking accounts held by banks had been
declining from 1945 until 2008 to less than 10 percent of the outstanding dollar amount, but the financial
crisis led to a jump to 40 percent of all currency and checking accounts. From 1945 until 1990, the Federal
Reserve issued about 30 percent of the outstanding currency and checking account; this proportion rose
slowly in the 1990s and jumped to 60 percent following the 2008 financial crisis.
33
Figure 2.22 Structure of holders (percent) and level (trillions of dollars) of checkable deposits and currency
held by all sectors except private depository institutions
Source: Board of Governors of the Federal Reserve System (series Z1, Table L. 204)
Note: Checkable deposits held by private depository institutions at the Fed (“reserve balances”) are not
included in the Financial Accounts’ definition of checkable deposits. “Private financial businesses” includes
checking accounts issued by private depository institutions that are held by security brokers and dealers,
government-sponsored enterprises, pension funds, insurance companies, finance companies, money
market mutual funds and real estate investment trusts.
34
Figure 2.23 Structure of issuers of checkable deposits and currency held by all sectors except private
depository institutions
Source: Board of Governors of the Federal Reserve System (series Z1, L. 204)
Note: Monetary authority issued checkable deposits to the Federal government, the rest of the world,
and government-sponsored enterprises. Checkable deposits issued by the Federal Home Loan Banks to
private depository institutions are not included in Table L.204, checkable deposits issued by the Federal
Reserve to private depository institutions are also not included.
35
Figure 2.24 Structure of holders (percent) and level (trillions of dollars) of checkable deposits and currency
held by all sectors
Note: “Other private financial businesses” are the same as “private financial businesses” in Figure 2.22.
Figure 2.25 Structure of issuers of checkable deposits and currency held by all sectors, percent.
Source: Board of Governors of the Federal Reserve System (series Z1)
Note: Monetary authority issued checkable deposits to the Federal government, the rest of the world,
and government-sponsored enterprises, and private depository institutions.
36
NON-MARKETABLE FINANCIAL INSTRUMENTS

While many financial instruments can be traded among bearers, a large number of financial instruments do
not have an active market in which they can be traded. Once a bearer has decided to acquire that type of
instrument, it is difficult, if not impossible, for him to part with it. The bearer must wait for the financial
instrument to mature, or a willing issuer to repurchase it before maturity. Chapter 17 will explain how banks
and other financial-market participants have gone around this constraint by securitizing non-marketable
claims.
Maybe the most well known non-marketable financial instrument, especially after the 2008 financial crisis,
are mortgages. Mortgages are medium- to long-term financial instruments that are secured by residential
or commercial real estate (home, apartment building, store, among others). The issuer promises to pay
some interest income on a monthly basis and to repay the principal owed by the time of maturity. If the
mortgagor (the issuer of the mortgage like a household who buys a house) defaults, the mortgagee (the
bearer of the mortgage) can foreclose on the property, that is, the mortgagee can take ownership of the
property, evict the current resident, and sell the property to try to recover any unpaid interest income, fees
and principal owed. Figure 2.26 shows that the percentage of outstanding home mortgages in foreclosure
quadrupled in the late 2000s, with 4.5 percent of outstanding home mortgages in the process of foreclosure
compared to around 1 percent for 20 years prior to the Great Recession. Millions of households lost their
homes and had to find alternative housing. Although home foreclosures are back down today, evictions are
not because renters are now facing threats of eviction following a rapid increase in rent prices after the
financial crisis.
Figure 2.26 Percentage of residential home mortgages in the process of foreclosure, percent
Source: Mortgage Bankers Association (National Delinquency Survey)
Figure 2.28 shows that four main sectors issue, or issued, mortgages. Households are the main issuer with
70 percent of outstanding mortgages issued by them in 2015, followed by nonfinancial noncorporate
businesses (mostly small businesses) that issued 20 percent of outstanding mortgages. The rest of
outstanding mortgages was issued by nonfinancial corporations, the federal government, and real estate
37
investment trusts. The outstanding dollar amount of mortgages in 2015 was around $13 trillion and they
are held by a wide variety of sectors (Figure 2.27). Until the 1970s, households, insurance companies and
private depository institutions together held about 90 percent of all outstanding mortgages. After that, the
rise of securitization led to a change in the structure of ownership of mortgages away from private
depository institutions toward issuers of mortgage-backed securities. Private depository institutions
continued to be the main initial bearer because households and small business companies go to see them
to fund the purchase of real estate property (land, house, commercial building, among others). However,
once private depository institutions have obtained the mortgage note, they may sell it to a government-
sponsored enterprise or to special purpose entities (“Issuers of asset-backed securities”). Government-
sponsored enterprise may also sell the mortgage note to their own special purpose entities (“Agency- and
GSE-backed mortgage pools”). As a consequence, the proportion of mortgages held by special purpose
entities peaked to 45 percent right before the Great Recession. Following the Great Recession, GSEs bought
back from their special purpose entities a large proportion of the mortgages, so the proportion of mortgage
held by GSEs went from 5 percent to 35 percent.
Figure 2.27 Structure of issuers of mortgages, percent.

Source: Board of Governors of the Federal Reserve System (series Z1, L.217)
Note: Between 1957 and 1965, the federal government, via the Department of Defense, issued multi-
family mortgages (that is mortgages backed by dwellings housing multiple families) to build housing for
military families under the 1955 Capehart Housing Act.
38
Figure 2.28 Structure of holders (percent) and level (trillions of dollars) of mortgages.
Mortgages deal with long-term financial needs to purchase expensive physical assets. Households also need
funds for their daily expenses: to go to school, to buy food, to buy a car, among others. The category
“consumer credit” regroups all sorts of secured and unsecured financial instruments issued by households
with short- to medium-terms to maturity that are not marketable; credit card receivables, automobile
debts, student debts, health care debts, among other debts (Figure 2.30). Some of these financial
instruments, such as automobile debts, are secured (if a household defaults, the bearer of the note takes
the car and resells it). All of them promise to pay interest and principal periodically and on time.
Figure 2.29 shows that the outstanding amount of consumer credit has grown rapidly since the early 1990s
to reach $3.6 trillion in 2015. Until 1990, private depository institutions and finance companies were the
main holders of consumer credit. In the 1990s, with the rise of securitization, private depository institutions
sold some of their holdings to ABS issuers that held up to 20 percent of outstanding consumer credit prior
to the 2008 financial crisis. After 2008, private depository institutions repurchased from ABS issuers most
of the consumer debts that they sold to them. The federal government, through student debt, also has
come to hold a large and growing proportion of all consumer credit (25 percent in 2015).
Households and small businesses are not the only ones who issued non-marketable securities. The US
Treasury is a major issuer of such financial instruments. These are not marketable either because they are
issued to a specific person and so are not transferable (US savings bonds are issued to a specific individual
and so the coupon and principal can only be paid to that individual), or are held for internal purpose within
different agencies of the federal government. While US savings bonds (issued to households) used to be
the main type of non-marketable Treasury securities, in 2015 there were $2 trillion of non-marketable
Treasury securities and 90 percent of them were held by various federal government retirement funds
(Figure 2.31).
Other non-marketable financial instruments include pension entitlements and insurance contracts. These
types of financial instruments are contingent, that is, they make payments to the bearers when an
event/contingency occurs (retirement, car crash, etc.). In exchange, bearers have to make a periodic
39
payment to the issuer of these contracts (insurance premium, contributions to retirement accounts, etc.).
Chapter 3 studies them more carefully. For example, the outstanding amount of pension entitlements
(retirement savings plans such as individual retirement accounts and annuities) owed to households was
about $21 trillion in 2015. While the federal government retirement funds used to be the main issuers of
retirement savings plans with 60 percent of outstanding contracts, today that proportion has shrunk to 20
percent. State and local government pension funds and private providers of pension (pension funds and life
insurance companies) are now the main issuer of retirement savings plans (Figure 2.32).
Figure 2.29 Structure of holders (percent) and level (trillions of dollars) of consumer credit.
Notes: Non-profit organization holdings represent student debt originated under the Federal Family
Education Loan Program. Federal government holding includes debt originated by the Department of
Education under the Federal Direct Loan Program and Perkins Loans, as well as Federal Family Education
Loan Program, financial instruments that the government purchased from depository institutions, finance
companies, and nonprofit and educational institutions, and financial instruments in default.
40
Figure 2.30 Types of consumer credit, percent.

Note: Revolving consumer credit includes mostly credit card debt but also other miscellaneous consumer
credit such as overdraft plan on checking accounts (that is the ability to have a negative balance on a bank
account that is renewed as long as it is repaid in due time). Home equity lines of credit are not included in
revolving consumer credit, which are unsecured financial instruments, but are part of outstanding
mortgages.
Note: Prior to Q1 2006, “other student debts” is included in non-revolving consumer credit.
41
Figure 2.31 Type (percent) and outstanding dollar amount (trillions of dollars) of non-marketable
treasuries.
Source: Board of Governors of the Federal Reserve System (series Z.1, part of L.210)
42
Figure 2.32 Structure of issuers (percent) and level (trillions of dollars) of pension entitlements.
Note: Life insurance contracts consist in annuities, private pension funds contracts include unallocated
insurance company contracts beginning 1985:Q4, federal government contracts includes the Thrift
Savings Plan, the National Railroad Retirement Investment Trust, and other federal government
retirement funds.
CONCLUSION
There is a very wide range of financial instruments issued in the United States that vary in terms of term to
maturity, the type of income paid, the protection provided, among others. One may wonder why so many
different types of financial instruments are issued. One of the reasons is that issuers have different needs;
a household does not need, or want, to fund its grocery shopping with a 30-year mortgage. Buying a house
with a credit card, if possible, would be expensive and cumbersome. Another reason is that bearers have
different needs. Given the nature of their own liabilities (presented in Chapter 3), pension funds much
prefer to hold long-term securities that are safe, while money market mutual funds prefer short-term
securities. As such, the US Treasury, one of the main issuers of securities, actively managed the structure
of Treasuries to accommodate the needs of bearers. For example, if bearers want more long-term
treasuries, the US Treasury will consider those needs when it issues new Treasuries.
Not everybody can issue marketable financial instruments because the financial, legal, and administrative
requirements to meet are too high. For example, most individuals and small businesses do not need much
more than a few hundred of thousand of dollars—a few million at best—to buy a house and other assets.
This is not interesting to financial market participants that deal mostly with economic units who want to
raise hundreds of millions, or billions, of dollars. Similarly, the earnings of households and small businesses
are too small to provide an attractive income to financial market participants. Finally, to be able to issue
bonds and keep them listed of an organized exchange (see Chapter 3), one must go through several costly
and cumbersome steps such as releasing quarterly accounting documents (balance sheets and others).
Some celebrities, such as David Bowie, have been able to issue personal bonds (“Bowie bonds”), but they
43
needed tens of millions of dollars ($55 million for David Bowie, a small issuance) and have earnings (such
as music royalty revenue streams) that are large and stable enough to make payments due on the bonds.
The fact that there is such a wide variety of financial instruments that can be issued in the United States
make the financial sector highly accommodative of the financial needs of households, businesses and
governments. This promotes economic activity and financial security as long as the issuance of financial
instrument is done properly, which is not always the case as explained in Chapter 19.
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 (Federal Reserve notes and
checking accounts issued by the Federal Reserve) are at the top of the hierarchy. They are followed by bank
monetary instruments (banknotes, if possible, and bank accounts). Below monetary instruments are
financial instruments traded on an organized exchange. They are issued mostly by governments (U.S
Treasuries, municipal bonds, etc.) and corporations (shares, bonds, notes, bills, etc.); instruments issued by
national government are more easily accepted than other marketable financial instruments. At the bottom
of the hierarchy are all sorts of promises such as local currencies and personal non-marketable financial
instruments. This hierarchy is not fixed and, throughout history, the top monetary instrument was not
always a government monetary instrument. Figure 2.33 shows a classification of the domestic financial
instruments presented above from the most accepted (government monetary instruments) to the least
accepted (non-marketable financial instruments). One may note in passing that Figure 2.33 assumes a
monetarily sovereign government, an issue of great importance as explained in Chapter 9 and Chapter 24.
Gov.
monetary
instruments
Private bank
monetary
instruments
National government
marketable
instruments
Other
marketable
instruments
Non-marketable
instruments and
others
Figure 2.33 Hierarchy of some financial instruments issued in the United States
Figure 2.34 shows the outstanding dollar amount and structure of all the financial instruments presented
above together with a few others. Note that off-balance sheet derivative contracts (see Chapter 18) are not
included, although their outstanding value is around $700 trillion. Other instruments not included are
special drawing rights, US-dollar denominated foreign account (Eurodollars), and other items in the
Financial Accounts such as tax payables and trade payables. In 2015, there was about $160 trillion of
outstanding financial instruments in the United States (all of them valued at book value except equity
44
instruments that are valued at market price). In 2015, 12 percent of them were monetary instruments and
close substitutes (categories 1 to 4) and consisted mostly of time and savings accounts. Another 15 percent
were non-marketable financial instruments, mostly mortgages (categories 5 to 8). About 25 percent were
debt instruments (categories 10 to 14), 30 percent were equity instruments (categories 15 to 18), and 15
percent were contingent financial instruments (life insurance, pension, property insurance contracts)
(Categories 19 to 21). The rest were trade credit that represented about 3 percent of outstanding financial
instruments.
1 Currency and Treasury currency in circulation 12 US Treasuries

2 Checking accounts at Monetary Authority and FHLB (includes reserve balances) 13 Agency securities
3 Checking account at private depository institutions 14 Municipals
4 Time and savings accounts at private depository institutions 15 Corporate equities
5 Consumer credit 16 Closed-end funds and ETF shares
6 Mortgages 17 Mutual funds shares
7 Others advances by private depository institutions 18 MMMFs shares
8 Other advances 19 Life insurance reserves
9 Trade credit 20 Pension entitlements
10 Open market paper 21 Policy payables of property and casualty insurance companies
11 Corporate and foreign bonds
Figure 2.34 Structure (percent) and outstanding dollar amount of most financial instruments included in
the Financial Accounts (trillions of dollars)
Note: Contrary to the Financial Accounts, category 2 includes checking accounts of private depository
institutions (“reserve balances”). Following the Financial Accounts, currency in circulation means currency
outside banks and the federal government plus vault cash. Life insurance reserves represents the
discounted value of expected payments by life insurance.
45

1- Finance is a world of promise, some issue promises, the issuers, others accept the promises, the bearers.
2- Financial promises are different from nonfinancial promises because the former involves monetary
payments.
3- Financial instruments are the formal and legal representation of a financial promise.
4- A wide variety of financial instruments can be issued, and they have different names to reflect their
different financial characteristics.
5- The broader the spectrum of financial instruments that can be issued, the more flexible the financial
system is in its ability to accommodate the needs of issuers and bearers.
6- There are three broad categories of marketable financial instruments: equity instruments, debt
instruments, monetary instruments.
7- In any economy, there is a hierarchy of financial instruments because some are more widely accepted
than others are.
Keywords
Creditworthiness, deficit, surplus, face value, issuer, unit of account, term to maturity, reflux mechanisms,
redemption, collateral, unsecured, secured, marketable, liquid, capital gain/loss, deep market, credit risk,
prepayment risk, default, delinquent, foreclosure, callable, collateral risk, liquidity risk, equity instrument,
debt instrument, monetary instrument, dividend, coupon, common stock, preferred stock, money
manager, institutional investor, subordinated, interest income, Treasuries, T-bill, T-note, T-bond, Treasuries
held by the public, municipals, revenue bond, general obligation bond, agency securities, insurance
premium, monetarily sovereign government.
Review Questions
Q1: What are the broad characteristics of a financial instrument?
Q2: In order for a financial instrument to exist, there must be an issuer and a bearer, why?
Q3: What happens when a financial instrument is issued?
Q4: What happens when a financial instrument is redeemed? When can a financial instrument be
redeemed?
Q5: If someone accepts a financial instrument, what are some of the potential risks?
Q6: How does the price of a liquid financial instrument behave compared to the price of an illiquid financial
instrument?
Q7: What makes a financial instrument liquid?
Q8: Why is it difficult for most individuals to issue securities?
Q9: Why are there financial instruments with different characteristics?
Q10: Who are the two main issuers and the two main bearers of the different types of financial instruments
presented above?
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CHAPTER 3:

What the main concerns of for-profit financial institutions are
How the business purpose influence the structure of the balance sheet
What the different financial companies do and how they do it
Why there is a need for different types of financial companies
That the federal government does not operate with the goal of being
profitable
That the federal government operates smoothly despite a massively negative
net worth
That the federal government heavily manages and subsidizes the U.S.
financial sector
How the financial sector has changed over the past 40 years
CHAPTER 3: FINANCIAL INSTITUTIONS: AN OVERVIEW
Financial companies are involved in creating, buying, selling, and pricing financial instruments. Given the
multitude of financial instruments that carry different sorts of risks and the complexity involved in issuing
and trading financial instruments, financial companies tend to specialize in specific aspects of the financial
sector:
- Activities surrounding marketable financial instruments: the creation and maintenance of a market
in which securities can trade require many resources, and some companies specialize in the
provision of such resources. They set up a trading platform and determine the rules for quoting
securities, trading securities, issuing new securities and many other aspects necessary to make
trading smooth. Other companies focus on ensuring that issuance can be done properly and that
issuers continuously meet the requirements of the platform.
- Providing opportunities to diversify asset portfolios: some financial companies provide
opportunities for economic units with a surplus of funds to pool funds to buy financial and
nonfinancial assets that provide higher rates of return, and, possibility, to use leverage to do so.
- Promoting specific economic activities that are deemed socially beneficial but riskier and/or less
profitable: private companies and government work together to provide low cost sources of funds
to specific economic units.
- Risk management and evaluation: some financial companies provide opinions about the
creditworthiness of issuers of financial instruments to determine which economic activity is viable,
and to guide the asset-portfolio decisions of financial market participants (what to buy, what to
sell).
- Providing and managing a payment system: a smooth economic system requires that payments be
done efficiently and reliably.
The specific functions performed are reflected in the structure of the balance sheet of each financial
institution. Their asset portfolio, that is the type of assets they hold, will contain financial instruments that
are more or less liquid, more or less due in the long term, and more or less secured. The structure of their
liabilities will contain a different proportion of contingent liabilities (claims that are due if an event happens,
such as, an accident or retirement), demand liabilities (claims that are due whenever claimants require it,
such as, withdrawals of cash from checking accounts, or the repurchase of shares on demand), and dated
liabilities (claims that are due after a certain time, such as the requirement to pay an interest periodically).
MAINTAINING SOLVENCY: PROFITABILITY AND LIQUIDITY

All for-profit financial companies ultimately have two core objectives: profitability and liquidity.
Profitability is the ability of a company to generate an income greater than its expenses so that it can
accumulate some net worth over time. Liquidity is about ensuring that enough cash and other liquid assets
are available at any time to meet immediate payments due to creditors. For-profit companies must meet
these two objectives to maintain their solvency, that is, their ability to pay creditors. Put differently solvency
can be judged in two ways:
- Cash-flow solvency: The capacity to acquire positive net cash inflows.
- Balance-sheet solvency: The capacity to generate a positive net worth so that if cash inflows are
insufficient one can repay creditors by selling assets.
For example, if a commercial bank is facing a bank run—many of its customers are lining up at the same
time to cash out their bank accounts—there are several possible outcomes depending on the structure of
the balance sheet of the bank:
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- Case 1: The balance sheet looks like this:

Assets Liabilities
Vault cash = $100 Accounts = $100
There is no net worth, but all the assets are liquid. The bank is liquid today (so it can respond to the
run) but is not profitable. The bank is solvent today but insolvent in the future because the bank
cannot pay its daily expenses such as salaries and electricity.
Assets Liabilities
Illiquid financial
instruments = $90
There is no equity in the bank and most financial instruments are illiquid. The bank is illiquid (it
cannot tackle a run on its own) but it is potentially profitable (illiquid financial instruments pay an
interest income). A run makes the bank insolvent today although the bank is solvent in the future
if it is given some time to operate, because it will receive income and will build equity.
Assets Liabilities
Illiquid financial Capital = $50
instruments = $50
There is some equity and the bank is profitable and has enough liquid assets. The bank can tackle a
bank run on its own and be profitable over time.
The necessity to stay solvent will lead to a different structure of assets given the structure of liabilities. For
example, a financial company will need to keep more liquid assets if it has a high proportion of demand
liabilities and/or highly unpredictable cash outflows. As such, banks that have a high proportion of demand
liabilities, must keep more cash on hand than pension funds that have a high proportion of long-term dated
liabilities and highly predictable cash outflows.
The following sections review the main characteristics of different financial companies and illustrate them
by using mostly the Financial Accounts of the United States. The Financial Accounts aim at measuring the
outstanding, and change in the, dollar value of nonfinancial assets, financial assets, financial liability, and
net worth of many different sectors of the economy. This goal is achieved imperfectly because the dataset
relies on many sources of data that are imperfect, incomplete, and rely on surveys and estimations. The
Financial Accounts also ignores some assets, such as land or coins, and do not capture well what goes on in
some corners of the financial sector because many of these activities are off-balance sheets and/or
unregulated, and so limited or no data is available. The dataset is also constantly changing with some
sectors and some instruments added or removed. Despite its limitations, the Financial Accounts of the
United States provide invaluable information about the financial states of different economic sectors, and
it is a core dataset for economic analysis.
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PRIVATE DEPOSITORY INSTITUTIONS: COMMERCIAL BANKS AND

THRIFTS
Private depository institutions are financial companies in which one can open checking accounts. These
accounts give access to the payment system of private depository institutions—account holders can make
payments to someone else who has an account at any private depository institution—and are convertible
into cash on demand. These financial companies are commonly known as “banks” and they provide the
following financial services:
- Credit services: Evaluate the creditworthiness of deficit-spending economic agents through
screening (i.e. selection) and monitory (i.e. supervision).
- Payment services: Settle debts, transfers of funds, provision of monetary instruments that can be
used on banks’ payment system.
- Retail portfolio-management services: Provide portfolio management opportunities for savers to
earn better interest rate on savings.
In order to operate as a bank, depository institutions must obtain a charter that allows them to operate
either in a state (state bank) or on the entire territory (national bank). Chapter 10 through 13 examine the
operations of banks in more details.
COMMERCIAL BANKS
U.S. Congress gave the first national charter to the Bank of North America in 1781 in Pennsylvania.
Commercial banks specialize mostly in fulfilling the financial needs of small businesses and households.
Figures 3.1 to 3.3 provide details about the volume and structure of the balance sheet of FDIC-insured
commercial banks since 1934. During World War 2, private depository institutions were asked to help
finance the war through large purchases of Treasuries and the Federal Reserve ensured that they had the
means to do so throughout the war (Chapter 9). Consequently, the proportion of Treasuries rose from 20
percent of assets to 55 percent by the end of the war. After WWII, commercial banks returned to fulfilling
the financial needs of private economic units. The proportion of mortgages in the portfolio of banks rose
progressively to peak at 30 percent of assets prior to the Great Recession. Consumer, industrial, and
commercial credit—that is, non-marketable financial instruments that are not mortgages and that are
issued by households and businesses—have also consistently represented about a third of the asset
portfolio of banks.
With the rise of wholesale funding sources (see Chapter 7), federal funds loans and security repurchase
agreements (RPs) have grown as a proportion of the assets of banks and peaked at 15 percent of assets
prior to the Great Recession. The proportion of cash and accounts held by commercial banks (“due from”)
shrank from 25 percent of all assets after World War Two to 5 percent right before the Great Recession,
but represents today about 10 percent of all assets following emergency monetary policy during the Great
Depression. The book value of outstanding assets was worth $15 trillion in 2015. The book value equals the
face value of financial instruments less amortization (repayment of principal) plus the purchased price of
nonfinancial assets less depreciation (an accounting measure of the expenses due to wears and tears). The
book value is different from the market value of assets, the price at which the assets could be sold at any
given time.
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Liabilities of commercial banks consist mostly of accounts due to the private domestic sector, which have
represented at least 60 percent of their liabilities. Accounts issued to domestic governments and foreign
entities used to add another 20 percent to liabilities but since the mid-1980s their importance has shrunk
considerably to about 5 percent of liabilities. In their place, “borrowed funds” have grown in importance
since the 1960s, marking the growth wholesale funding sources for banks. The proportion of demand,
savings, and time accounts have varied widely since 1934 and today savings accounts represent 70 percent
of all accounts out of the $10 trillion outstanding.
Overall, while commercial banks accept long-term illiquid financial instruments (20 percent of their assets
are mortgages), their assets consist mostly of short-to-medium term maturity or relatively liquid financial
instruments (Treasuries, cash, consumer and business credit, fed funds loans). This is necessary given the
nature of their liabilities that are mostly due on demand or on a short-term basis (demand and savings
account, fed funds debt, among others). Commercial banks usually do not have to keep much cash in their
vault because withdrawals in retail bank accounts tend to be highly predictable, but some liquid safe assets
are kept in significant proportion. The greater reliance on wholesale sources of funds has increased the
ability to operate with no or limited reserves and other liquid safe assets but regulators do set minimum
liquidity ratios in the balance sheet of banks.
Figure 3.1 Structure (percent) and level (trillions of dollars) of the assets of FDIC-insured commercial
banks
Source: Federal Deposit Insurance Corporation (Historical Statistics on Banking, Tables CB09 to CB13)
Note: “Other types of credit” include various items that have changed over time such as unplanned
overdrafts and advances to brokers and dealers in securities, any debtor for the purpose of purchasing
and carrying securities, and credit to nonprofit institutions and organizations, real estate investment
trusts, mortgage companies, holding companies of depository institutions, insurance companies, finance
companies, foreign governments and official institutions, churches, among others.
Note: “Other securities” includes corporate bonds, corporate equities, among others.
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Figure 3.2 Structure of liabilities of FDIC-insured commercial banks

Source: Federal Deposit Insurance Corporation (Historical Statistics on Banking, Tables CB14, CB15)
Note: “Other accounts” represents mostly accounts of foreign and domestic financial institutions and
accounts of foreign governments and official institutions.
Note: “Borrowed funds” represents federal funds purchased (that is borrowed), securities sold under
agreements to repurchase, demand notes issued to the US Treasury, mortgage indebtedness, liabilities
under capitalized leases and all other liabilities for borrowed funds. From 1934 to 1968 borrowed funds
does not include mortgage indebtedness, which is netted against bank premises.
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Figure 3.3 Structure (percent) and outstanding dollar amount (trillions of dollars) of bank accounts
Source: Federal Deposit Insurance Corporation (Historical Statistics on Banking, Tables CB14, CB15)
THRIFT INSTITUTIONS
SAVINGS INSTITUTIONS
Savings and Loan associations emerged in the 1830s as “building and loan associations.” The initial business
model of savings institutions consisted in holding mortgages issued by households and businesses, and
encouraging thrift by providing interest-earning bank accounts. Prior to 1980, there were important
differences with commercial banks such as:
- A cap on the interest rate they could pay on savings accounts that was higher than commercial
banks (Regulation Q)
- They could not offer checking accounts
- There were restrictions on the assets they could hold, mostly mortgages and safer assets.
The sector was deregulated in the 1980s following changes in monetary policy practices in the 1970s that
made the initial business model of savings banks unprofitable. Large risk taking and fraudulent activities
followed as savings institutions tried to return to profitability, which led to the Savings and Loan crisis in
the late 1980s. The sector was hit by high credit risk and the value of its financial assets fell by $600 billion
(Figure 3.4). The sector was hit again by the mortgage crisis during the Great Recession, after which the
outstanding value of assets was the same as in 1985 ($1.3 trillion).
Like commercial banks, by the end of WWII, Treasuries represented 50 percent of the financial assets of
savings institutions. With the rise of homeownership after the war, residential mortgages once again
became a large proportion of the asset portfolio of savings institutions, and by 1980 mortgages of all sorts
represented 80 percent of all financial assets. After 1980, agency securities, corporate and foreign bonds
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as well as consumer, industrial and commercial credit grew from about 10 percent of assets to 30 percent
of assets.
Time and savings accounts have always been the overwhelming liabilities of savings institutions, especially
so prior to 1980 when they represented usually over 90 percent of liabilities (Figure 3.5). After 1980,
checking accounts and individual retirement accounts (IRAs) grew in proportion to 10-15 percent of
liabilities. Debts owed to GSEs (Federal Home Loan Banks and Sallie Mae) also became a significant
proportion of the liabilities of savings institutions. Contrary to commercial banks, savings institutions do not
rely much on the federal funds market to borrow funds.
Figure 3.4 Structure (percent) and level (trillions of dollars) of savings institutions
Source: Board of Governors of the Federal Reserve System (Series Z.1, previously L.114)
Note: Savings institutions include state-chartered savings banks, federal savings banks, cooperative banks,
and savings and loan associations. The sector “savings institutions” was discontinued from the Financial
Accounts at the end of 2011 due to filing regulatory changes and was merged with U.S. chartered
depository institutions, which are part of commercial banks.
Note: “Other financial assets” includes corporate equities, checkable deposits, time and savings deposits,
reserves, municipals, commercial paper, among others.
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Figure 3.5 Structure of the liabilities of savings institutions

Source: Board of Governors of the Federal Reserve System (Series Z.1, previously L.114)
Note: “Other liabilities” include taxes payable, bank advances not classified elsewhere, corporate and
foreign bonds, among others.
CREDIT UNIONS
Determining the creditworthiness of a client is costly, especially for those who have never had access to
prior credit and have limited income and assets. In addition, the risk of losses for a bank are intrinsically
greater if the amount of collateral available is limited or non-existent. Consequently, traditional banks are
reluctant to provide credit to poor, small, and rural economic units. Credit unions emerged in the 1910s in
the United States to service the credit needs of economic units that were not served well by commercial
banks.
Credit unions perform similar services as the thrifts and commercial banks but credit unions are local
cooperative, non-profit, tax-exempt associations. Given their non-profit nature, compared to traditional
bank they can offer a slightly higher interest rate on savings account, and a slightly lower interest rate when
granting credit. However, their business model is mostly localized and may not fit the needs of customers
that operate nationally or internationally. In addition, contrary to commercial banks and savings
institutions, not everyone can become a customer of a credit union. The law requires that a credit union
defines a field of membership, that is, that it states what the common bond is between its members. That
common bond can be narrow or broad depending on how the credit union is set up; a common employer,
a church, living in certain local counties, among others, are common criteria.
Figure 3.6 shows that the outstanding value of their assets was $1.2 trillion in 2015. Contrary to savings
institutions, they were not hit by the Great Recession; the non-profit nature of credit unions did not push
them to lower their credit standards to reach a profitability target. While credit unions did buy some
Treasuries during World War 2, this financial instrument never became more than 25 percent of their
financial assets. After the War, the financial assets of credit unions mostly consisted of mortgages, but they
rapidly specialized in providing consumer credit. In the 1990s, home mortgages (single-family housing
55
mortgages and home equity line of credit) grew again as a proportion of financial assets from 10 percent to
over 30 percent. Agency securities also became significant assets during that period to reach about 20
percent of their financial assets. Their main liabilities have been quite similar to savings institutions, with
time and savings accounts as the main liability and individual retirement accounts (IRAs) and checking
accounts gaining in importance in the 1980s. Credit unions have relied on the federal funds market even
less than savings institutions (Figure 3.7).
Figure 3.6 Structure (percent) and level (trillions of dollars) of the assets of credit unions.
Source: Board of Governors of the Federal Reserve System (Series Z.1, L.114)
Note: “Other financial assets” includes federal funds sold and repurchase agreements, municipal
securities, corporate and foreign bonds, and commercial paper, among others.
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Figure 3.7 Structure of the liabilities of credit unions

Note: “Other liabilities” includes federal funds and repurchase agreements, among others.
INSURANCE COMPANIES
Insurance companies issue policies that promise to provide protections against specific contingencies
(probable events) that adversely impact the balance sheet and income of an economic unit. Retirement
leads to a loss of income, an earthquake destroys a house, a car crash leaves someone without a car and
badly injured, the death or illness of a spouse leaves other family members in poverty. Economic units who
want financial protection must pay a periodic premium that is a main source of income for insurance
companies. This business model is profitable as long as contingencies—and so payouts to affected insured
economic units—are not too frequent nor too severe. In order to ensure that this is the case, insurance
companies protect themselves by screening and monitoring policyholders, and by ensuring that customers
have something to lose if they do not behave properly once they are insured. Insurance companies also
insure themselves.
In order to avoid adverse selection, that is, to avoid attracting mostly high-risk customers (sick individuals,
reckless drivers) before a policy contract is signed, insurance companies rely on screening. One must fill up
forms asking questions about age, sex, life habits, marital status, family illness, among others, in order to
determine the probability of occurrence of the contingency against which a client wants protection. The
probability is not established by studying the character of an individual but by relying on statistics. Long-
run data shows that motorcyclist have a much higher chance to get in a fatal crash, young male drivers are
at higher risk to get in a fatal car crash, someone with a history of cancer running in the family has a higher
chance to get cancer, American Indian women have a lower risk of getting breast cancer than white women.
Once the screening is done, an insurance company, either will refuse to insure a potential customer because
the risk is too high, or will adjust the premium to the risk; young single male drivers pay a much higher
premium than middle-aged married males.
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In order to avoid moral hazard, that is, to ensure that insured customers do not become careless once they
are insured—thereby raising the probability of a contingency—insurance companies make sure that its
clients have some stake in limiting risk taking. They do so by making sure that if the contingency does occur,
the client still has to incur some expenses. One way to do so is to set a deductible, that is, a minimum
amount that the client has to pay before reimbursement by the insurance company starts. For example, if
a medical insurance contract states that the annual deductible is $2000, the sum of medical expenses
incurred by an individual for the year has to reach $2000 before reimbursement starts. An insurance
company may also require coinsurance, that is, that the clients cover a percentage of any expense beyond
the deductible, such as 10 percent of medical expenses beyond $2000. Finally, insurance companies may
also require copayments beyond the deductible, that is, payments each time insurance service is requested.
Copayments are not counted toward meeting the deductible, only medical expenses are.
The reader may note that moral hazard and adverse selection are not limited to insurance companies. They
apply to all financial institutions. We will encounter them again in the Chapters on banking (Part 3).
LIFE INSURANCE COMPANIES
They emerged in the early 1800s to provide insurance services against loss of income induced by death,
disability, old age and other health problems. Cash outflows are highly predictable because probabilities
about life expectancy are well established and stable. Therefore, most of the funds earned are placed into
less liquid to illiquid assets. Similar to commercial banks, Treasuries used to represent a large proportion of
the assets of life insurance companies but that changed rapidly after WWII. Figure 3.8 shows that in 2015,
80 percent of their $6.5 trillion assets are corporate securities and mutual fund shares as well as non-
marketable financial instruments. Life insurance reserves (a measure of future payouts to beneficiaries) and
pension entitlements were the main liabilities of insurance companies, with pension entitlement
representing a growing share of liabilities. Since the end of the 1970s, the proportion of corporate shares
has grown in the liabilities of life insurance companies, and now represent about 5 percent of liabilities.
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Figure 3.8 Structure (percent) and level (trillions of dollars) of assets of life insurance companies
Note: “Other financial assets” includes money market mutual funds shares, commercial paper, checking
accounts and currency, security repurchase agreements, among others.
Note: Policy loans are loans made by life insurance companies secured by the cash value of a policy. If
default occurs, the amount of death benefits is reduced accordingly. Syndicated loans are loans made by a
group of creditors to nonfinancial businesses.
59
Figure 3.9 Structure of liabilities of life insurance companies

Note: “Other liabilities” include security repurchase agreements, taxes payable, among others.
PROPERTY AND CASUALTY INSURANCE COMPANIES
In response to blazes that burned down large cities such as London, several steps were taken to reduce the
scope of personal financial losses and to protect physical properties. Fire brigades were organized, building
codes were created, and fire insurance companies emerged. In the US, the first fire brigade was created in
1653 in Boston and the first fire insurance companies emerged around 1750s. Today, property and casualty
insurance companies protect against a wide variety of events, from accident, to theft, to natural disasters.
The cash outflows of this business model are less predictable because, even though there are statistical
regularities, unexpected adverse events like natural disasters can happen. As such, property and casualty
insurance companies hold more liquid assets than life insurance companies do. In 2015, their assets were
worth $2 trillion and were composed mostly of safer securities (Treasuries, agency securities and
municipals) (Figure 3.10). Their main liability is the claims customers have on existing policies (Figure 3.11).
Corporate shares peaked at 40 percent of liabilities from the mid-1990s to the mid-2000s, but since 2008
they have represented about 20 percent of liabilities.
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Figure 3.10 Structure (percent) and level (trillions of dollars) assets of property and casualty insurance
companies
Note: “Other financial assets” includes commercial paper, mutual funds shares, money market mutual
funds shares, commercial mortgages, security repurchase agreements, among others.
Figure 3.11 Structure of liabilities of property and casualty insurance companies

Note: “Other liabilities” includes advances from Federal Home Loan Banks, taxes payable, among others.
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FINANCE COMPANIES
They first specialized in providing credit to customers with a low creditworthiness, but now provide credit
to all types of customers. One can put finance companies in three categories:
- Sale finance companies: They are owned by nonfinancial companies, such as car dealers or
department stores, and provide credit to customers.
- Consumer finance companies: They provide credit to individuals with poor creditworthiness
(payday loan companies, car title loan companies, subprime mortgage companies, among others).
- Business finance companies: They lease equipment (airplanes, machines) to businesses and provide
credit for inventory financing, among others
Most of the assets of finance companies consist of non-marketable financial instruments issued by
households and nonfinancial businesses for consumption purpose (“consumer credit”) and business
purpose (“nonfinancial business credit”). Mortgages gained in importance in the 2000s, as mortgage
companies increased the volume of subprime mortgages they accepted, and peaked at 20 percent of
financial assets before collapsing to 5 percent of financial assets because of heavy losses during the Great
Recession. Corporate and foreign bonds also grew as a share of financial assets in the mid-1990s, and early
2000s to reach 15 percent of financial assets, but fell during the Great Recession, which reflects heavy losses
on mortgage-backed securities and related financial instruments (Figure 3.12). Losses on mortgages and
related securities led to a fall of the value of financial assets by $400 billion and, in 2015, they were worth
$1.5 trillion. Liabilities have been quite diverse given the wide range of activities in which finance companies
are involved, but since the late 1980s, the structure of liabilities has moved toward longer-term to maturity.
Corporate and foreign bonds have grown in proportion whereas commercial paper and advances from
banks have shrunk from 40 percent to 20 percent of liabilities (Figure 3.13).
62
Figure 3.12 Structure (percent) and level (trillions of dollars) of the assets of finance companies
Note: The sector includes retail captive finance companies and mortgage companies. Residential
mortgages include, home mortgages, home equity lines of credit and multifamily mortgages.
Figure 3.13 Structure of the liabilities of finance companies

Note: “Other liabilities” includes advances by the Federal Home Loan Banks, taxes payable, among others.
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FINANCIAL INVESTMENT COMPANIES

A wide variety of financial companies proposes to pool and manage funds saved by economic units in order
to buy income-earning and capital-gain-making assets. They vary in terms of the assets they buy, in terms
of the liabilities they issue, in terms of their tax status, among others. Pooling funds is beneficial because:
- Small savers may not be able to afford to buy securities in financial markets on their own.
- The absolute return obtained by pooling money together is higher.
- Pooling reduces the cost of financial placements and increases the diversification of portfolios.
For example, bonds usually have a market value close to $1000 so people with a small amount of savings
may not be able to afford to buy many of them unless they pool their funds together into a mutual fund.
Say Mr. Y has $100 and Mr. X has $900. Alone, none of them can buy a bond, but they can if they pool their
funds into a mutual fund. Interest received on the bond will be distributed to X and Y in proportion of the
amount of funds provided to the mutual fund. For example, if the interest income received on the bond is
$100, Y will receive $10 and Mr. X will receive $90, minus fees paid to the mutual fund.
PENSION FUNDS
Pension funds are tax-exempt institutions that promise to provide an income—called pension—to replace
partially or fully the loss of income induced by retirement. Individuals usually get access to a pension fund
through their employers, who are the sponsor of the fund. The employers match the contributions
employees make to the fund, and provide some financial backing to the fund. Individuals have to make
contributions that are used by the fund managers to buy earning assets. The contributions are tax-exempts,
that is, no income tax is paid for any part of gross income that is allocated to a pension fund. For example,
if an individual’s gross salary is $50,000 and she chooses to put $10,000 in a pension fund, the individual’s
income tax will be based on $40,000. The vesting period is the length of time over which one must
contribute to a pension fund before one can get a pension (usually 5 years in the US).
In the US, the first pension fund was established by New York City for its police force in 1857. There are two
forms of pension funds and both can be created by private and government economic units; defined-
contribution plans (401(k) plan, 403(b) plan, among others) and defined-benefit plans (Social Security and
the California Public Employees’ Retirement System (CalPERS) are the most well known).
In a defined-contribution plan, the pension received depends on the overall contribution of an individual
and the performance of the assets in the pension fund. For example, if by the time someone retires,
someone has contributed $1,000,000 to a pension fund and the assets purchased by the fund yield a 5
percent annual rate of return, the annual pension is $50,000. However, the rate of return (and so the
pension) is not fixed, it depends on what happens to the assets purchased by the pension funds. Most of
those assets are financial assets, and Chapter 2 showed that they are risks involved with them. Some issuers
may default, some financial instruments may be illiquid, economic and financial conditions may negatively
impact the value of securities. As such, as some retirees learned during the Great Recession, the pension
from a defined-contribution plan can dwindle to nothing. Finally, in order for this type of plan to be
beneficial, income earners must be able and willing to save during their working years. Many Americans do
not have the ability or willingness to do so in a significant fashion.
Defined-benefit plans guarantee a pension that is calculated based on years of work, age of retirement,
final salary, among other. For example, if one must work 40 years to get full benefits but merely worked 30
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years, and if the salary on the final year is $50,000, the annual retirement benefit will be $37,500 (3/4 of
$50,000). One of the main risk involved in such plan is a funding risk, that is, the pension fund and its sponsor
may become insolvent. This is a risk for pension funds that are sponsored by entities that are not monetarily
sovereign (state and local government pension funds, private pension funds, pension funds of non-
sovereign federal governments). The reader probably heard that Social Security will be insolvent soon and
so today’s youth should not rely on it (and should in fact be against it). This is not the case given that the
US government is monetarily sovereign so finding dollars to pay Social Security benefits is not a problem
(see Chapter 9). As shown below, the U.S. government’s net worth is massively negative but this does not
impact its ability to operate smoothly.
Given that defined-benefit plans are more costly and more risky to employers, most private businesses and
state and local governments have moved away from sponsoring defined-benefit plans. As such, the funding
risk of retirement has been shifted away from employers onto employees. The timing of the cash outflow
is well established and the liability is a long-term liability so most of the assets owned are less-liquid long-
term assets. In 2015, corporate securities and mutual fund shares represented about 60 percent of the
assets of pension funds, and Treasuries have consistently represented about 10 percent of assets since
1945. Early on, 80 percent of the funding of pension funds came from the sponsor’s payments to the funds
but today pension funds are much more autonomous and claims on sponsors represent about 20 percent
of assets (Figure 3.14). This reflects the move away from defined-benefit plans to defined-contribution
plans. The liability of pension funds is called pension funds reserves, which is a function of expected
pensions to be paid and must be matched by some assets.
Figure 3.14 Structure (percent) and level (trillions of dollars) of the assets of pension funds
Note: “Other assets” includes nonfinancial assets, checking accounts, time and savings accounts, money
market mutual funds shares, mortgages, commercial paper, among others.
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REGULATED PORTFOLIO MANAGEMENT COMPANIES: MUTUAL FUNDS AND

OTHERS
Portfolio management companies provide a wide variety of placement opportunities to economic units
with spare funds who do not want to, or cannot, directly buy securities or other assets. There are three
broad types of portfolio management companies: mutual funds, closed-end funds, and unit investment
trusts (UITs). One of the main differences between them is the characteristics of the shares they issue in
terms of marketability and the ability to redeem them. Mutual fund shares are nonmarketable and
redeemable on demand, closed-end fund shares are marketable and irredeemable, and UIT shares are
marketable and redeemable on demand. Closed-end funds and UITs do not continuously offer their shares
for sale. Rather, they sell a fixed number of shares in an initial public offering, after which the shares
typically trade on a secondary market such as the New York Stock Exchange or through the sponsor (for
UIT). The price of closed-end funds is determined in the market. Another main difference is the type of
asset they are allowed to acquire, with closed-end funds allowed to buy more illiquid assets than mutual
funds.
Within each of these three broad categories, there is a wide variety of funds in terms of the assets they
purchase, the placement strategies, and the means of issuance and redemption of shares (cash redemption
or security redemption). This wide variety of funds accommodates the financial preferences of most
shareholders. For example, some like risks and others do not; some like stocks others prefer bonds; some
want stable fund share prices others want to be able to make capital gains (while risking to make a loss).
They also have different level of minimum financial contribution to cater to different wealth groups. The
following focuses on mutual funds, which are the most common type of portfolio management companies.
Mutual funds became popular in the U.S. in the 1920s, but have existed since the 19 th century. They issue
shares to whoever wants to join, and use the proceeds to buy earning assets for the benefits of the
members. As shown in Chapter 2, 80 percent of mutual funds shares are held directly or indirectly (via
pension funds) by households. Mutual funds are open-end companies, that is, the outstanding number of
shares is allowed to change on a daily basis. The shares of mutual funds are not tradable and are
redeemable on demand, which is quite different from corporate shares that are tradable and irredeemable.
Economic units who want to place some funds in a mutual fund must purchase shares from the mutual fund
itself, not from other bearers. When economic units wish to retrieve their funds, they can redeem them—
that is, sale them back to the mutual fund—for a fee.
The price that an economic unit pays for mutual fund shares is approximately the net asset value (NAV) per
share. The NAV is the net worth of the fund (assets net of liabilities). For example, if a mutual fund has $100
of assets and $10 of liabilities, NAV is $90. The NAV is calculated on a daily basis by recording the market
value of assets and liabilities at the end of each day. The price at which a share can be bought and redeemed
is the NAV per share, and this price varies on a daily basis because of daily changes in the NAV and in the
outstanding number of shares. Thus, if the NAV is $90 and there are 100 shares outstanding, the price of a
mutual fund share is 90 cents that day.
In the mid-1970, money market mutual funds (MMMFs) emerged to bypass regulation Q. They purchase
mostly short-term, safe securities. MMMFs try to keep their NAV per share stable at $1 and the dividend
paid on MMMF shares closely follows short-term interest rates. Given these financial characteristics and
the fact that MMMF share are redeemable on demand, financial market participants consider MMMF
shares to be close substitutes to savings accounts.
Most assets of mutual funds are composed of corporate shares except for the decade 1985-1995 during
which Treasuries, agency securities, and municipals grew to represent 40 percent of the financial assets of
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mutual funds. Today, these types of securities only represent 15 percent of the $12.6 trillion of financial
assets held by mutual funds, while corporate shares represent 65 percent of the financial assets. As the
stock market plunged during the Great Recession, mutual funds recorded a $3-trillion decline in the value
of their assets, but they recovered their losses quickly as the stock market boomed again (Figure 3.15). Their
liabilities is composed mostly of their shares, but also of individual retirement accounts (IRAs) that have
grown to represent 20 percent of liabilities (Figure 3.16).
The assets of MMMFs are composed mostly of safe to safer assets that are of short-to-medium term
maturity, such as commercial paper, T-bills, agency securities, Treasuries, time and savings accounts, and
repurchase agreements (Figure 3.17). Prior to the crisis, MMMFs bought a lot of asset-backed commercial
paper because it looked safe. During the crisis, some MMMFs recorded large losses on asset-backed
commercial paper and the value of their assets fell by $1 trillion to $2.8 trillion. This led the NAV per share
to fall below $1 for some MMMFs; customers could not recover 100 percent of the principal they put in the
fund, in the same way one could not recover 100 percent of the funds in a savings account. As the NAV per
shares fell below $1, a run on MMMFs began—many customers tried to recover their funds by redeeming
their MMMFs shares at the same time, forcing MMMFs to sell assets quickly—that compounded the decline
in the value of MMMF shares, and the Federal Reserve intervened to help contain the run.
Figure 3.15 Structure (percent) and level (trillions of dollars) of the assets of mutual funds
Note: The Financial Accounts assume that all funds received are immediately put to work. The allocation
of funds is based on econometric analysis or discretionary decisions of the analyst.
Note: “Other financial assets” includes commercial paper, syndicated loans to nonfinancial businesses and
security repurchase agreements
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Figure 3.16 Structure of liabilities of mutual funds

Source: Board of Governors of the Federal Reserve System (Series Z.1, L.122 and L.227)
Figure 3.17 Structure (percent) and outstanding dollar amount (trillions of dollars) of the assets of money
market mutual funds
Note: “Other financial assets” includes checkable deposits, private foreign deposits, among others.
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Figure 3.18 Structure of liabilities of money market mutual funds

LIGHTLY REGULATED PORTFOLIO MANAGEMENT COMPANIES: HEDGE

FUNDS
Hedge funds emerged in the 1950s. Like mutual funds, hedge funds pool funds to buy return-earning assets
but, unlike mutual funds, they frequently use riskier balance-sheet strategies, such as leverage (see Chapter
4) and short selling, to achieve the rate of return they promise to their clients. Hedge funds are also more
lightly regulated and may not have to file full financial statements with regulatory agencies, although the
2010 Dodd-Frank Act increased the regulatory filing requirement. Finally, they cater to wealthy individuals.
Some hedge funds try to make a profit under whatever market conditions by implementing “market neutral
strategies.” This means that they speculate on the price direction of two assets by taking an opposite
position in each asset. For example, assume that the stocks of companies X and Y are worth respectively
$100 and $90. Hedge fund Alpha expects that the price of both stocks to be $95 in one week (Figure 3.19).
Week 1 Week2
X $100
$95
Y $90
Figure 3.19. Expectations of hedge fund Alpha about the price direction of two stocks
The hedge funds does two things to profit from this expectation:
- Take a short position in X shares: Borrow X stocks from a broker for a week and sell them
immediately at current market price ($100), and buy them back at $95 next week to repay the
broker. A capital gain of $5 per share is expected.
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- Take a long position in Y shares: Buy Y stocks today for $90 and sell them in Week 2 at $95: Expected
capital gain of $5 per share.
This placement strategy allows Alpha to “hedge” its portfolio position because it can avoid losses, to a
certain extent, if its expectations turn out to be incorrect. For example, assume that both stock prices
decreases by $10, in that case, the funds loses $10 on its long positions in share Y but gains $10 on its short
positions in share X (Figure 3.20). Of course, if X stock go up or go down by less than Y shares, then Alpha
will record a loss. Short positions are inherently more risky than long positions because the price of financial
assets cannot be negative so potential gains are limited by how much price can fall ($100 for stock X) while
potential losses are unlimited (the price of stock X can go up to infinity).
Week 1 Week2
X $100
$90
Y $90
$80
Figure 3.20 Actual price direction of two stocks
REAL ESTATE INVESTMENT TRUSTS
They were created in the 1960s to provide opportunities to take a position in real estate. They hold about
$500 billion in assets tied to the real estate in the form of actual real estate properties or financial
instruments linked to real estate (mortgages, agency securities, mortgage-backed securities) (Figure 3.21).
REITs also issue mortgages that, together with bonds, usually represent over half of the liabilities they issue.
Their short-term debts are in the form of reserve repurchase agreements and advances from private
depository institutions (Figure 3.22).
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Figure 3.21 Structure (percent) and level (trillions of dollars) of real estate investment trust
Source: Board of Governors of Federal Reserve System (Series Z.1, L.129)
Note: Nonfinancial assets have a negative value from 1968 to 1974 and from 1984 to 1989. This is due to
statistical discrepancies and errors because their value is measured indirectly as the difference between
liabilities and financial assets. The value is set at zero for those years.
Note: “Other financial assets” includes multifamily mortgages and other financial assets.
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Figure 3.22 Structure of liabilities of real estate investment trust

Source: Board of Governors of Federal Reserve System (Series Z.1, L.129)
Note: “Other liabilities” include advances by the Federal Home Loan Banks, commercial paper, among
others.
FINANCIAL MARKET COMPANIES
MARKET-SERVICES COMPANIES: ORGANIZED EXCHANGES
Securities do not trade themselves; there needs to be a platform that is reliable and standardized so trading
can be done smoothly and at low cost. Some businesses specialize is setting up such a platform, called an
organized exchange. An organized exchange sets up trading rules, quotation methods, methods of buying
and selling securities, and provides smooth means to transfer of securities among parties. It also provides
other market services such as extensive market data and trading services.
The most well known organized exchanges are the New York Stock Exchange (NYSE) and the NASDAQ.
NASDAQ used to be the acronym of "National Association of Securities Dealers Automated Quotations”
until the company became independent from the National Association of Securities Dealers in 2006.
Created in 1971, NASDAQ was the first organized exchange to provide automated trading of securities and
competitors followed.
Organized exchanges used to be a noisy place where many individuals were on the phone taking sell/buy
orders from clients and “talking” (more yelling) to each other to match buy and sell orders. The place was
actually so noisy that individuals working on the floor of the market had to develop some hand signals to
be able to carry their trading operations. Today, most organized exchange are very quiet places except for
a few markets that have not been automated. The NASDAQ is fully automated and its physical place is a
room with a giant digital screen on Time Square.
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Once an exchange has been set up, some businesses specialize in provide specific market services; issuing
securities, ensuring the continuous quotation of securities, redeeming securities, trading securities, among
others.
INVESTMENT BANKS
Investment banks complement commercial banks by focusing on the needs of medium to large businesses,
governments and other economic units with large needs for funds (think at least tens of millions of dollars).
When a client X needs a large sum of funds to acquire an expensive illiquid long-term asset with an uncertain
profitability—railroad, industrial plant, nuclear plant, Channel tunnel between the UK and France—a
commercial bank is not willing to take X’s financial instrument. Indeed, such a very large single financial
asset on the bank’s balance sheet that would greatly negatively impact the bank’s net worth in case of
problems (see Chapter 11). A bank is even more reluctant that complex industrial projects usually run into
delays, record significantly larger expenses than budgeted, and take decades to break even.
One solution is to share that risk through syndicated credit in which several commercial banks and other
financial institutions join to meet the financial needs of the client. However, even in that case, banks usually
do not want to keep all their share of financial instruments of X on their balance sheet and gauge the ability
to sell some of them before agreeing to provide credit to client X. Figure 3.23 shows that syndicated credit
to nonfinancial businesses boomed in 2004 to reach $550 billion. Major bearers are special purpose entities
(“issuers of ABSs”), mutual funds, security brokers and dealers, life insurance companies, and funding
corporations.
Figure 3.23 Syndicated credit to nonfinancial businesses

Source: Board of Governors of Federal Reserve System (Series Z.1, part of L.216)
While syndicated credit has become more popular, its outstanding volume is still small, especially compared
to alternative wholesale funding methods. Indeed, beyond syndicated credit, another solution to spread
the risk is to issue many marketable financial instruments. If client X needs $100,000,000, one way to obtain
that sum is to issue 100,000 bonds with a face value of $1,000. Each bearer takes on its balance some credit
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risk for up to the dollar amount of bonds each bought, which is much more limited than if a commercial
bank had to bear a single non-marketable financial instrument worth $100,000,000. In addition, bonds can
be traded—at least this is the hope—so if some of the initial bearers no longer want hold the bonds, they
can sell them to willing buyers.
While they may issue securities on their own, economic units who seek funds by issuing marketable financial
instruments may ask for the help of an investment bank in order to maximize the dollar amount raised by
the offering. Investment banks assist issuers of securities by determining which type of securities will be
the cheapest to issue, evaluating the creditworthiness of the issuer, and providing economic and financial
research to financial market participants. Investment banks design, market and underwrite securities in the
primary market:
- “Design” means to:
o Determine which type and what quantity of securities should be issued in order to raise as
much funds as possible at the lowest cost: if stock markets are booming, then issuing shares
is a better option, whereas issuing bonds is best if interest rates are low and profit
expectations of the issuer are high.
o Help meet filing requirement with the Securities and Exchange Commission
o Help get a rating from credit rating agencies by making sure that the issuer complies with
all the necessary requirements.
- “Market” means to determine the expected sale price of securities and to sell them:
o Initial public offering (IPO): For shares, investment banks must figure out what is the fair
price for the shares of a company that enters the stock market for the first time. For bond,
pricing is easier and based on the price of bonds of comparable risk and term to maturity.
o Seasoned offering: Pricing is based on current existing securities but the investment bank
must figure out how the new issue will affect the price of existing securities.
- “Underwrite:” Investment banks usually take some responsibility for the price at which they expect
the securities will sell, that is, they sign a contract with the issuer that guarantees that the issuer
will be able to raise a given dollar amount. If the securities sell above the contracted price, the
investment bank makes a capital gain. If the securities sell below, the investment bank may stop
selling securities for a while and hold the securities on their balance sheet.
BROKERAGE FIRMS: SECURITY BROKERS AND DEALERS AND SECURITY

BROKERS
Brokerage firms provide two types of market services:

- Brokering: To buy and sell securities for clients for a fee. The rise of automated trading and online
brokerage accounts has significantly reduce the fees that brokers can charge.
- Dealing: To buy and sell securities for one’s own account. Dealers usually play an important role of
market makers to promote market liquidity. They have specialists on the floor of the platform who
act as buffer between the demand and supply of securities. If there is a surplus, specialists buy for
their own account some securities to close the surplus; if there is a shortage, specialists sale
securities they own to close the shortage. With the emergence of automated trading, the need for
specialists has diminished considerably. Some dealers may choose to become primary dealers,
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which entail them to have a direct working relationship with the Federal Reserve to help implement
monetary policy (Chapter 7) and fiscal policy (Chapter 9).
The balance sheet of security brokers and dealers reflects the fact that they deal in securities (Figure 3.24).
Margin credit—advance provided to clients to buy securities on credit (see Chapter 4)—use to represent
up to 60 percent of their assets. From the 1970s, security repurchase agreements (RPs) have substituted
margin credit as their main assets. Clients seeking funds sell securities to brokers and dealers, and promise
to buy them back later at a price that will provide an income to security brokers and dealers. This is a form
of secured credit. Chapter 7 explains how security repurchase agreement are used to implement monetary
policy. The value of the assets held by security brokers and dealers peaked in 2008 at $4.6 trillion and has
been falling since to reach $3 trillion in 2015. Since the late 1980s, a great proportion of the business
operations of dealers and brokers has been to lend the securities they own. Claims on borrowers of
securities have represented at least 20 percent of their balance sheet.
The structure of liabilities reflects the shift in assets (Figure 3.25). Security brokers and dealers used to be
indebted to private depository institutions that provided the funds to clients requiring margin credit.
Brokers and dealers would make a profit on the interest rate differential between the interest rate charged
on margin credit and the interest rate charged on the credit that broker and dealers obtained from
depository institutions. Since the 1970s, repurchase agreements, in the form of reverse repurchase
agreements, have become the main liability of security brokers and dealers. They obtain funds by selling
securities and by promising to buy them back later at a price that rewards the seller.
Figure 3.24 Structure (percent) and level (trillions of dollars) of the assets of security brokers and dealers
Note: At times, the outstanding value of US Treasuries is negative, reflecting the fact that security dealers
had an overdraft on their Treasuries account at the Fed; they were borrowers of Treasuries.
Note: “Other financial assets” includes commercial paper, agency securities, municipals, syndicated
advances to nonfinancial business, among others.
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Figure 3.25 Structure of liabilities and equity of security brokers and dealers
Note: “Other liabilities” includes corporate shares, corporate and foreign bonds, various advances, trade
payable, taxes payable, among others.
SECURITIZATION VEHICLES: SPECIAL PURPOSE ENTITIES
Securitization is discussed in Chapter 17 but the following Figures together with the ones presented in this
Chapter and in Chapter 2, should convince the readers that companies involved in securitization have
become major participants in the financial sector. Figure 3.26 and 3.27 show the financial assets held by
issuers of asset-backed securities and issuers of mortgage-backed securities backed by federal agencies and
GSEs. Together, they held up to $8.5 trillion of financial instruments of all sorts in 2008, after which the
outstanding value of their financial assets felt to reach $3 trillion, half of the fall in the value is due to the
sale of $3-trillion worth of mortgages to government-sponsored enterprises. Since early 2000s, mortgages
have replaced consumer credit and agency securities are the main assets of issuers of asset-backed
securities.
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Figure 3.26 Structure (percent) and level (trillions of dollars) of the assets of mortgage pools backed by
federal agencies and government-sponsored enterprises
Figure 3.27 Structure (percent) and level (trillions of dollars) of the issuers of asset-backed securities.
Note: “Other financial assets” include funding agreement backing the ABS issuers and Treasuries.
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GOVERNMENT AND GOVERNMENT-RELATED FINANCIAL

AGENCIES
Government and government-related financial agencies include some federal budget agencies and some
for-profit companies chartered by the U.S. Congress. Their goal is to promote, through financial means,
specific economic activities that are deemed socially beneficial but that are underserved by the traditional
private financial sector because of their riskiness or low profitability.
GOVERNMENT-SPONSORED ENTERPRISES
Government-sponsored enterprises (GSEs) are private for-profit companies created by US Congress. They
help to promote specific economic activities by buying and/or insuring illiquid and risky financial
instruments that financial companies have on their balance sheet. By doing so they remove the credit risk—
and liquidity risk if they buy the financial instrument—from the balance sheet of the seller. This encourages
private financial companies to provide credit at more affordable terms (lower interest rate, longer term to
maturity) to specific economic units. Put differently, the point of GSEs is to intervene in the financial sector
to reduce the volatility, and to bring down the level, of interest rates on specific financial instruments, and
to raise the volume of issuance of such financial instruments. GSEs do so because these financial
instruments are issued to perform economic activities that U.S. Congress deems socially beneficial.
A point of entry in the world of GSEs are the Financial Accounts (Figures 3.28 and 3.29). From 1945 until the
mid-1980s, advances from the Farm Credit System and the Federal Home Loan Bank System, Farm
mortgages (that is mortgages backed by a farm excluding the farm dwelling), and home mortgages
represented about 80 percent of the assets of GSEs. After the mid-1980s, the promotion of farming shrunk
considerably in relative terms, with farm mortgages and Farm Credit System advances representing about
5 percent of the financial assets of GSEs in 2015. Agency securities, federal funds sold and corporate bonds
gained in importance. The financial crisis led to an enormous increase in the balance sheet of GSEs because
Fannie Mae and Freddie Mac purchased over $3 trillion of mortgage-backed securities from the special
purpose entities (“mortgage pools”) they back. MBSs from these pools now represent 60 percent of the
assets of GSEs. Most of the liabilities of GSEs consist of securities and securitized securities, and the
purchase of $3 trillion of MBSs by Fannie Mae and Freddie Mac was done by issuing bonds backed by them.
The following sections provide a more detailed presentation of some GSEs.
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Figure 3.28 Structure (percent) and level (trillions of dollars) of the financial assets of government-
sponsored enterprises.
Note: The GSE sector includes the following enterprises: Federal Home Loan Banks, Fannie Mae, Freddie
Mac, Farmer Mac, Farm Credit System, the Financing Corporation, and the Resolution Funding
Corporation and the Student Loan Marketing Association (Sallie Mae) until 2004:Q4. Mortgage pools
backed by GSEs are not included.
Note: Others financial assets include Sallie Mae financial assets, commercial paper, checking, savings and
time accounts, currency, among others.
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Figure 3.29 Structure of liabilities and equity of government-sponsored enterprises

Note: “Other liabilities” include federal funds purchased and reverse repurchase agreements, loans of U.S.
government to Sallie Mae, among others.
THE FARM CREDIT SYSTEM
The Federal Loan Act of July 1916 created the first government-sponsored enterprise; the Farm Credit
System (FCS). Its organization is based on the template provided by the Federal Reserve System created in
December 1913. The goal of the FCS is to help the agricultural sector and rural communities by providing a
stable and affordable source of funds to Agricultural Credit Associations (ACAs) and agricultural
cooperatives that compete with private banks.
ACAs provide credit and leasing services to rural providers of critical infrastructure (communication
services, power supply, water supply, among others), rural households seeking to become homeowners,
and farmers, ranchers, and other agribusinesses (to stock seeds, to buy capital equipment, to build barns,
among others). Contrary to traditional banks, an ACA does not issue bank accounts to their clients; it merely
accepts their financial instrument and makes payment on their behalf by using the payment system of
private banks. For example, if farmer F1 is granted a credit of $100 to buy a $100 tractor, the following
happens: The ACA makes the payment to the tractor company on behalf of farmer F1, and F1 will repay the
ACA bit by bit by servicing its financial instrument.
ACA
Financial instrument of Farmer F1: +$100
Bank account of ACA: -$100
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Farmer F1
Tractor: +$100 Financial instrument issued to ACA:
+$100
Tractor company
Tractor: -$100
Bank account of company: +$100
Each ACA is part of a district. The System is composed of four districts, each overseen by a Farm Credit
System Bank that is owned by the ACAs (Figure 3.30). There are four Farm Credit System Banks (FCS Banks);
three Farm Credit Banks (FCBs) and one Agricultural Credit Bank (ACB). FCS Banks issues Farm Credit System
debt instruments (FCS securities) via a funding corporation (the Federal Farm Credit Banks Funding
Corporation) that acts as fiscal agent for the four banks. The funding corporation determines the amount
and terms of FCS securities, issues them and handles their servicing. The term to maturity of FCS securities
varies from overnight to 30 years. The funds obtained from the issuance of securities are lent to ACAs and
cooperatives who then lend to rural communities. Beyond obtaining funds from the issuance of FCS
securities, ACAs also borrow funds from, and lend funds to, each other.
The Farm Credit System Insurance Corporation—established in 1987 when farmers were defaulting en
masse—ensures the timely servicing of FCS securities. It is an insurance plan in which each ACA pays a
premium and gets help in case of difficulty. The overall system is overseen by the Farm Credit
Administration (Figure 3.31).
Table 3.1 shows the unconsolidated balance sheet of the four FCS Banks. Their main assets are securities
(mostly Treasuries, federally-backed debts and GSE securities, but also federal funds sold, commercial paper
and negotiable certificates of deposit) and financial instruments issued by residents of rural communities
and ACAs (“Loan, notes, sales contracts, and leases”). Figure 3.32 shows that in 2016 about two-third of the
$220 billion of credit provided by FCS Banks goes to ACAs, while the rest is direct credit to rural communities
mostly for production, for agricultural cooperatives, and for infrastructure. Their main liabilities are $259
billion of FCS securities. Similar to Treasuries, FCS securities are generally recorded, and transferred, via
electronic entries at the Federal Reserve. FCS Banks have accounts at the Federal Reserve and they use this
payment system to make payments to private banks, service debt on their securities, among others.
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Figure 3.30 Districts of the Farm Credit System

Source: Farm Credit Administration
Figure 3.31 The institutional components of the Farm Credit System

Source: Federal Farm Credit Banks Funding Corporation
82
Farm Credit System Banks (Unconsolidated)

(Dollar Amounts in Millions)
ASSETS LIABILITIES AND NET WORTH
Cash 1,033 Systemwide notes and bonds outstanding 258,977
Securities 58,388 Subordinated notes and bonds 499
Accounts receivable 162 Other interest-bearing debt 1,928
Loans, notes, sales contracts, and leases 220,031 Accrued interest payable on 678
Accrued interest receivable 892 Accounts payable 420
Equity investments in other FC institutions 273 Other liabilities 848
Premises and other fixed assets 147
Other assets 633 Net worth 18,207
Total assets 281,558 Total liabilities and net worth 281,558
Table 3.1 The unconsolidated balance sheet of the four Farm Credit System Banks, 2016
Source: Farm Credit Administration
Note: There are four System Banks: AgFirst FCB in Columbia, SC; AgriBank, FCB in St. Paul, MN; CoBank,
ACB in Denver, CO; and FCB of Texas in Austin, TX.
Note: “Cash” includes actual cash but also, checks in the process of collection, accounts due from
domestic and foreign private depository institutions, and account “balances of all types, and for all
purposes, due from Federal Reserve banks (e.g., funds held at Federal Reserve banks for payment of
interest on consolidated and Systemwide bonds, purchase of securities, redemption of called
consolidated and Systemwide bonds, clearing and working balances, etc.).”
Source: Farm Credit Administration (View FCS Institutions)
Figure 3.32 Type of credit provided by the Farm Credit System Banks, unconsolidated, 2016
Source: Farm Credit Administration (View FCS Institutions)
Note: Credit for agricultural production includes real estate mortgages issued to finance productive
capacities (to purchase farm real estate, to refinance existing mortgages, or to construct various facilities
used in operations), as well as credit obtained to buy equipment and for business operations.
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THE FEDERAL HOME LOAN BANK SYSTEM
The Federal Home Loan Bank System (FHLBS) is also organized on similar premises as the Federal Reserve
System. It is much more similar to the Federal Reserve System than the FCS because the FHLBS issues
monetary instruments and has its own payment system. It was established by the Federal Home Loan Bank
Act of 1932 with the goal of promoting homeownership and community development. FHLBS is composed
of eleven Federal Home Loan Banks (FHL Banks) that each oversees a district (Figure 3.33). FHL Banks are
for-profit companies that are owned by members of the System. This System was first set up for Saving and
Loans Institutions but, since 1989, all federally-insured depository institutions (thrift institutions,
commercial banks and credit unions), insurance companies, and a few others (such as real estate
investment trusts and finance companies) can join if they wish.
Today, over 80 percent of members are commercial banks and credit unions, and 90 percent of all
commercial banks are members of the System (Table 3.2). Membership is voluntary and requires the
purchase of stocks of the FHL Bank of the district in which the financial institution operates. The stocks are
not tradable, cannot be pledge as collateral, must be held at face value, pay a dividend, and provide a voting
right to elect the director of the FHL Bank of the district. The Office of Finance is the fiscal agent of the
System. It does the accounting and oversees the issuance, redemption and servicing of FHLB securities. The
system is regulated and supervised by the Federal Housing Financing Agency.
The purpose of the FHLBS is to provide its member a stable and low-cost source of funds. The way this is
done can be understood by studying the consolidated balance sheet of the FHL Banks (Table 3.3). The main
asset is “advances” that were worth $705 billion. Advances represent financial instruments issued by
members to the FHL Banks. In exchange, FHL Banks provide credit and payment services in the same way
private banks and the Federal Reserve do (See Chapter 7 and Chapter 12).
FHL Banks compete among each other and with other financial institutions to provide credit to its members,
so each FHL Bank try to accommodate the financial needs of their members as much as possible. FHL banks
do so by accepting financial instruments with widely different financial characteristics. Advances can vary
in terms of term to maturity (overnight to 30 years), interest rate (fixed or variable), collateral, among
others. About 40 percent of advances have to be repaid within one year, and slightly more than half of all
advances have to be repaid within two years (Figure 3.34). Revolving lines of credit can also be open—think
credit card—that allow a member to continuously get access to FHLB credit.
The FHL Banks only accept the financial instruments of their members if they are secured by collateral that
is consistent with the mission of the FHLBS. The Federal Home Loan Bank Act limits the type of collateral
FHL Banks can accept to certain securities, residential mortgage loans, cash, deposits with the FHL Banks,
and other eligible real estate-related assets. Community development financial institutions may also pledge
secured financial instruments issued to them by small businesses, small farm, and small agri-business.
Figure 3.35 shows the type of collateral accepted by the FHL Bank of New York. In addition to a collateral
requirement, federally-insured members must at least have 10 percent of their assets in the form of
residential mortgages to be granted credit by FHL Banks. Put differently, before getting credit from a FHL
Bank, members have to show that they have granted credit to fund economic activities that are consistent
with the mission of the FHLBS.
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Percent of
Percentage
each type of
Number of total
financial
members
institutions
Commercial banks 4,520 63.5% 89.8%
Credit unions 1,389 19.5% 23.1%
Thrifts 778 10.9% N/A
Insurance companies 393 5.5% 6.6%
Community development
45 0.6% N/A
financial institutions
Total 7,125 100% -
Table 3.2 Members of the Federal Home Loan Bank System, 2016
Source: Office of Finance of the Federal Home Loan Bank System (Federal Home Loan Banks, Combined
Financial Report for the Year Ended December 31, 2016), Federal Reserve Bank of St. Louis (FRED), and
Credit Union National Association (Credit Union Reports), Insurance Information Institute.
Figure 3.33 The Federal Home Loan Bank System as of May 2017
Source: Federal Housing Financing Agency
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Federal Home Loan Banks Combined Statement Of Condition, 2016

(Millions of Dollars)
ASSETS LIABILITIES AND CAPITAL
Cash and due from banks 7,441 Total accounts 8,089
Interest-bearing accounts 2,878 Demand and overnight accounts 7,268
Securities purchased under agreements to resell 52,771 Term accounts 634
Federal funds sold 48,633 Other accounts 187
Total securities 187,735 Discount notes 409,815
Total non-mortgage-backed securities 49,085 Bonds 578,927
Certificate of deposits 3,050 Other liabilities 7,422
U.S. Treasuries 1,606
GSE and TVA securities 28,406
Other agency securities 6,249 Capital 52,459
State or local housing agency obligations 3,848
Federal Family Education Loan Program ABS 4,572
Others 1,354
Total mortgage-backed securities 138,650
GSE MBS 112,801
Agency MBS 14,658
Private-label MBS 10,951
Others 240
Advances 705,225
Mortgages 48,476
Other assets 3,553
Total assets 1,056,712 Total liabilities and capital 1,056,712
Table 3.3 Federal Home Loan Banks consolidated balance sheet
Source: Office of Finance of the Federal Home Loan Bank System (Federal Home Loan Banks, Combined
Financial Report, for the year ended December 31, 2016)
Note: “Cash and due from” represent cash, accounts at commercial banks, and accounts at the Federal
Reserve Banks.
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Figure 3.34 Outstanding advances (trillions of dollars) and term-to-maturity structure (percent)
Note: Overdrafts on demand accounts held by members at FHL Banks automatically lead to an advance
Figure 3.35 Types of collateral accepted by the Federal Home Loan Bank of New York
Source: Federal Home Loan Bank of New York
To fund its operations, that is to obtain the funds it needs to settle payments with other financial institutions
and with its members (see Chapter 12 on interbank payments and reserve requirement for an application
to the banking system), FHL Banks must obtain either federal funds or, if the institutions to whom they
must transfer funds do not have an account at the Federal Reserve, funds on a private bank account. To
obtain these funds the FHL Banks issue financial instruments.
For example, a FHL Bank can attract federal funds when other FHL Banks, commercial banks and
government institutions deposit federal funds (monetary assets of the FHL Bank go up) and get credited the
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equivalent dollar amount on a FHLB account (liabilities of the FHL Bank go up). FHLB accounts can be
demand accounts or term accounts, and overdraft is possible on demand accounts and lead to an automatic
advance to replenish the account. FHLB accounts can be used to make payments among members, that is,
the System has its own payment system that is an alternative to the Federal Reserve payment system and
the payment system of private depository institutions. Most FHLB accounts are overnight or demand
accounts so the FHL Banks are required to keep an equivalent dollar amount—$8 billion in 2016—of short
to medium term to maturity financial assets to avoid liquidity problems. These assets can be cash, federal
funds, demand accounts at private banks or FHL Banks, short-term repurchase agreements, Treasuries and
agency securities that mature in less than 3 years, among others.
Deposits are, however, a marginal funding source. The two main means to obtain funds are short-term FHLB
securities (“discount notes”) and long-term FHLB securities (“bonds”) that together amount to almost $1
trillion. FHL Banks issue these securities in domestic and global financial markets, and compete with the
U.S. Treasury, other GSEs, corporations and other issuers of debt instruments to find willing bearers. Figure
3.36 shows how the FHLB operates within the financial system. “Lenders” refers to FHLBS members (see
Table 3.2) that accept mortgages from “borrowers” (households and businesses) who purchase real estate.
Once they have accepted mortgages, FHLB members have illiquid long-term assets (mortgages) on their
balance sheet, while they have immediate needs for federal funds to make payments to their creditors
Chapter 12 shows that they are many means to obtain these federal funds and the FHL Banks are one of
them. FHL Banks themselves obtain federal funds by issuing securities.
Figure 3.36 How the Federal Home Loan Bank System works
Source: Federal Housing Financing Agency
Figure 3.36 may be potentially misleading in several ways to the reader of this text. It may seem that the
whole system is an intermediation between “investors” and “borrowers,” with the investors (the buyers of
FHLB securities) being the source of the funds that are then lent to the borrowers (households and
businesses) via the help of FHL Banks and “lenders” (FHLB members). This is not the case. As explained in
details in Chapter 12, there is no intermediation at play. Borrowers do not receive cash from investors, in
fact they never see any funds, and banks (the “lenders”) do not lend cash. Banks also do not wait for funds
obtained by the FHL Banks from investors to accept mortgages from households and businesses. In fact,
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banks must accept mortgages first before they can get access to FHLB refinancing channel. The point of
FHLB is not to provide credit to households and businesses; it is merely to provide an alternative source of
federal funds for its members, and a convenient means to make payments among its members.
Commercial banks have other means to obtain federal funds, so one may wonder why they would come to
the FHLBS. Given their size and given the implicit backing of the federal government, there is a high demand
for FHLB securities and so FHL Banks are able to issue securities at relatively lower cost. As such, the interest
rate FHL Banks pay on their liabilities is lower than that of their members. Given their cooperative structure,
FHL Banks pass the lower cost of their liabilities to their members, by granting credit are a lower cost than
what members may be able to get if they tried to get credit on their own. The interest rate charged on
advances is slightly higher than the interest rate on US Treasuries of similar maturity, and interest rates on
Treasuries are among the lowest at a given time for a given maturity.
Figure 3.37 FHLB advances (trillions of dollars)

Source: Board of Governors of the Federal Reserve System (series Z.1, part of L.216)
Note: In 2012, the “savings institutions” sector was merged with U.S.-chartered depository institutions
This is important especially in time of crises because interest rates on private financial instruments tend to
rise steeply as the number of potential bearers dwindle and the demand for safe assets, such as Treasuries,
rises. For FHLBS members, revolving advances have proven to be a reliable substitute to federal funds
market and security repurchase agreements to obtain federal funds, and, in times of stresses, advances
from the FHLB tend to be a preferred means to obtain funds. During the savings and loans crisis of the mid-
1980s, advances to thrifts peaked at $150 billion in 1988 (Figure 3.37). During the Great Recession, advances
to members peaked almost at $1 trillion in 2007 and 2008, with commercial banks asking for the bulk of
the $600 billion obtained by U.S. chartered depository institutions in 2008.
Thus, members can obtain loans of federal funds from a FHL Bank, or get an advance from a FHL Bank to
pay other members, at a more stable and lower cost than would otherwise have been the case. They can
also obtained those funds for a much longer period than alternative wholesale sources. This helps members
to lower the interest rates they charge to their customers: homebuyers, small businesses, farmers and
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others. Lowering the cost of getting credit for homeownership and community development helps to
promote these economic activities; precisely the goal of the FHLB.
FARMER MAC, FANNIE MAE, FREDDIE MAC, AND SALLIE MAE
This section closes the presentation of government-sponsored enterprise with a quick look at other GSEs.
They work in a similar fashion to the FCS, by issuing securities and using the proceeds to buy or back illiquid
financial instruments held by financial institutions. The goal is once again to lower the level and volatility of
interest rates on specific financial instruments, and to encourage credit for specific economic activities.
A GSE that is formally part of the FCS but independent from it is the Federal Agricultural Mortgage
Corporation (Farmer Mac). Farmer Mac issues its own securities and use the proceeds to purchase
mortgages from financial institutions that help fulfill the mission of the FCS. Farmer Mac also provides
guarantees against the mortgage-backed securities issued by its special purpose entities, and provides
advances that are secured by agricultural real estate and loans guaranteed by the US Department of
Agriculture, among others.
Fannie Mae (Federal National Mortgage Association) was a government agency created in 1938 to purchase
from banks mortgages insured by the Federal Housing Administration (FHA) and the Department of Veteran
Affairs (VA). Until the 1966 financial crisis, Fannie Mae remained a minor player in the secondary market
for mortgages, but the crisis led Fannie Mae to enlarge its purchases to conventional mortgages and it
became the largest participant in the secondary mortgage market. Heavy government involvement in
private affairs (here conventional mortgages) is never seen with a good eye in the United States, and this
involvement required larger spending than the U.S. Congress was willing to provide on a continuous basis.
Therefore, in 1968, the U.S. Congress split Fannie Mae into Ginnie Mae (Government National Mortgage
Association)—a government agency taking the role of Fannie Mae. Fannie Mae became a private
corporation that deals in conventional mortgages and related securities, that conform to specific criteria
set by Fannie Mae. Freddie Mac (Federal Home Loan Mortgage Corporation) was created by act of U.S.
Congress in 1970 to compete with Fannie Mae in the conventional mortgage market. The FHLBS also
competes with Fannie Mae and Freddie Mac to purchase mortgages. Both Fannie Mae and Freddie Mac
have created special purpose entities that pool mortgages, mostly conforming mortgages, and issue
mortgage-backed securities insured by Fannie and Freddie.
While most GSEs currently deal with residential and non-residential mortgages, from 1972 to 2004, Sallie
Mae (Student Loan Marketing Association) used to promote college education. The goal was to encourage
financial institutions to grant credit to students at affordable terms although students usually have no or
poor creditworthiness. In exchange of the payment of a premium, Sallie Mae guaranteed the timely
payment of the student debts to financial institutions. In 2004, Sallie Mae lost its congressional charter—it
became a normal private business—and began to provide credit to students.
U.S. GOVERNMENT AGENCIES
Like GSEs, the U.S. government is also involved in providing credit to, and protecting private financial
institutions against the default of, specific economic units for economic activities that are deemed socially
beneficial. Government financial programs cover housing, education, small businesses, agriculture and
others. These programs ensure that credit at preferential conditions (lower interest rate and/or longer term
to maturity and/or lower downpayment and/or lower credit score threshold, among others), to specific
economic units. Such economic units include low-to-moderate income households, veterans, students,
small businesses, small farms, households with low credit score, among others. Private financial institutions
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would normally, either refuse to grant credit to them, or do so only at high cost because of higher credit
risk. Given that these financial programs aim at delinking partly or fully credit risk from the terms of the
financial instruments, the financial instruments issued under these programs are unconventional and do
tend to record a higher delinquency rate.
Government indirectly provides credit through institutions such as the Federal Housing Administration
(created in 1934), the Veteran Affairs (created in 1930), the Small Business Administration (created in 1953),
and Ginnie Mae (Government National Mortgage Association). These Administrations provide protections
to the bearers of unconventional financial instruments by insuring or guaranteeing their servicing. For
example, FHA mortgages are mortgages issued by households and by held private financial institutions that
are insured by FHA. Households must pay a mortgage insurance premium every month and FHA ensures
the timely servicing of mortgages if households default. The VA also ensures timely servicing but merely by
providing its partial backing, that is, it ensures timely payment on a portion of the debt service due without
asking households to pay an insurance premium. SBA does something similar for the financial instruments
issued by small businesses. Ginnie Mae guarantees the timely payment on mortgage-backed securities
(MBSs) backed mostly by mortgages insured by FHA and guaranteed by the VA. This allows commercial
banks to sell these MBSs at a better price, and so to remove FHA and VA mortgages from their balance
sheet at a lower cost (see Chapter on securitization).
FHA mortgages have an average default rate of over 10 percent—well above the average of all mortgages
(Figure 3.38)—and so carry a higher interest rate. However, the default rate on these mortgages is also very
stable. This can be contrasted with subprime mortgages that have a volatile default rate and defaulted at a
much higher rate in 2009 and 2010, when one quarter of subprime mortgages were in default. Even the
default rate on prime mortgages tripled during that time from 2.5 percent to 7.5 percent. Chapter 19
explains that this had a lot to do with changes in underwriting requirements in the private financial sector.
Figure 3.38 Percentage of mortgages past due by type

Source: Mortgage Bankers Association
Beyond backing private financial instruments through insurance or guarantee, government also directly
provides credit. For example, students reading this book probably heard of the Perkins loan program, the
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Small Business Administration also directly provides disaster assistance loans to small businesses for
repairs, and the Farm Service Agency provides loans to farmers temporary unable to obtain credit through
private institutions.
Table 3.4 shows the balance sheet of Ginnie Mae in 2007. The two main assets among the $13 billion
outstanding are funds with the Treasury and Treasuries. Like many other federal government agencies,
Ginnie Mae has accounts at the Treasury and all receipts and expenses of Ginnie Mae are processed by the
U.S. Treasury. Its main liability amounts to $536 million related to loss reserves for its mortgage-backed
securities, that is, Ginnie Mae records a liability for the expected payments it will have to make to ensure
the timely payment of MBSs it guarantees. Loss reserves go down with actual losses and go up with
recovered funds (mostly obtained for servicing fees it charges on the payments that it makes to MBS
bearers). Ginnie Mae does not have capital; instead, the U.S. Government covers any discrepancy between
assets and liabilities by committing to make payments due by Ginnie Mae. In 2007, this discrepancy was
worth $12.6 billion and it represents mostly commitments made by Ginnie Mae to insure mortgage-backed
securities.
Government National Mortgage Association
(Dollars in Millions)
ASSETS LIABILITIES AND INVESTMENT OF U.S. GOV
Funds with the U.S. Treasury 4,433 Reserve for loss on MBS Program 536
U.S. Government securities 8,736 Other liabilities 554
Mortgages held for sale, net 19
Commitments and contingencies:
Properties held for sale 3 Investment of U.S. Government 12,621
Other assets 520
Total assets 13,711 Total liabilities and Investment of U.S. Gov. 13,711
Table 3.4. Balance sheet of Ginnie Mae for fiscal year 2007
Source: Government National Mortgage Association
Finally, one may look at the overall balance sheet of the U.S. Government to get a broad picture of its
involvement in the financial system (Table 3.5). The U.S. Treasury funds most of the operations of the U.S.
government, and maintains a record of incomes and outlays for all the Departments and Agencies. There
were $465 billion of monetary assets held by the U.S. government. The U.S. government counts as monetary
instruments unminted gold and silver that back gold certificates and silver certificates (the certificates are
included in other liabilities). There was $11 billion worth of gold (valued at the official price of $42.2222 per
fine troy ounces) to back the $11 billion worth of gold certificates still outstanding. The two other main
assets of the U.S. government are physical assets (building, land, furniture’s, among others), valued at $980
billion, and loans. Most loans are made by the Department of Education with a net outstanding amount of
over $1 trillion, followed by loans from the Department of Agriculture with net outstanding loans of $69
billion.
The main liability is Treasuries held by the public, that is, Treasuries held by economic units other than
federal agencies such as the Social Security Administration. The outstanding value of Treasuries held by the
public was $14.1 trillion. The second main liability, worth $7.2 trillion, is benefits to be paid to veterans and
federal employees (pensions, healthcare coverage, and burial services, among others).
One may note that the value of liabilities is far superior to the value of assets with a net worth valued at -
$19 trillion. The U.S. government is massively insolvent in terms of balance sheet (and cash flow given that
it usually records a deficit), if one thinks of the U.S. government in the same way as a private business. Of
course that is not the case, the U.S. government can make all payments due on its liabilities in a timely
fashion because its fiscal agent, the Federal Reserve System, is monetarily sovereign. The Federal Reserve
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System shares that sovereignty with the U.S. government, through a comprehensive coordination with the
U.S. Treasury to accommodate the financial needs of the U.S. government (see Chapter 9).
United States Government
(In billions of dollars)
ASSETS LIABILITIES
Monetary assets 465 Accounts payable 62
Total cash 381 Department of Defense 18.3
Unrestricted: Cash held by 347
Treasury for government-wide
operations Department of Veterans Affairs 4.8
Unrestricted: Other 11.6 Department of Justice 6.2
Restricted 22.4 Department of the Treasury 4.4
International monetary assets 59.6 Department of Education 4
Gold and silver 11.1 Department of Energy 3.6
Foreign currency 12.9 Department of State 2.5
Accounts and taxes receivable, net 133 Department of Homeland Security 2
Loans receivable, net 1,278 General Services Administration 2.4
Federal Direct Student Loans -
Education 958.9 Department of Agriculture 1.9
Federal Family Education Loans -
Education 114.9 U.S. Postal Service 1.8
Electric Loans - USDA 45.2 U.S. Agency for International Development 1.7
Rural Housing Services - USDA 23.1 Tennessee Valley Authority 1.5
Export-Import Bank Loans 23.7 National Aeronautics and Space Administration 1.3
Housing and Urban Development
Loans 16.7 Department of the Interior 0.7
Water and Environmental Loans -
USDA 12.5 All other 5.3
International Monetary Fund
Federal debt securities held by the public 14,221
Program - Treasury 8.6
All other programs 74 U.S. Treasuries 14,139.6
Inventories and related property, net 314 Agency securities: TVA 23.8
Property, plant and equipment, net 980 Agency securities: Others 0.2
Debt and equity securities 48 Accrued interest payable 57.5
Investments in GSEs 109 Federal employee and veteran benefits payable 7,209
Other assets 144 Environmental and disposal liabilities 447
Benefits due and payable 218
Insurance and guarantee program liabilities 122
Loan guarantee liabilities 18
Other liabilities 465
Capital (19,292)
Total assets 3,471 Total liabilities and Capital 3,471
Table 3.5. Balance sheet of the United States Government
Source: Bureau of Fiscal Service (2016 Financial Statements)
One can get an idea of how the balance sheet of the U.S. Government has changed over time by studying
the data of the Financial Accounts. The Accounts do not provide the same number as Table 3.5 because
they do not include all of its aspects. Notwithstanding, the Accounts show a massive negative net worth
with assets worth $5.4 trillion and liabilities worth $18 trillion (Figures 3.39 and 3.40). Financial assets
represent about 30 percent of total assets, and non-marketable financial instruments (mortgages, student
debts, and others) are the main financial assets. Financial liabilities are mostly composed of Treasuries and
retirement entitlement liabilities (claims of federal pension funds on the U.S. government and retiree health
care funds) although the relative importance of Treasuries has grown since the mid-1970s.
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Figure 3.39 Assets of the federal government

Note: Land is not included in nonfinancial assets.
Figure 3.40 Financial assets of the federal government

Note: “Other financial assets” includes equity in GSEs, trade receivables, nonofficial foreign currencies,
equity in the funding corporation set up for the Public–Private Investment Program created during the
Great Recession, among others.
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Figure 3.41 Structure of liabilities of the federal government

Note: “Other liabilities” includes budget agency securities, trade payables, multifamily residential
mortgages, special drawing rights, among others.
TRUST BUT VERIFY: ACCOUNTING FIRMS

In this and the previous Chapter, a lot has been said and shown about the balance sheet and the functions
of different sectors of the financial system, but a vital part of the system was left aside: accounting firms.
Accounting is tedious, unglamorous and relegated to the “back office,” but, without it, there cannot be a
financial sector. Accounting is about providing a record of transactions and outstanding balances to give
managers, and outside analysts, an idea of the financial state of an economic unit. Money is the blood of
finance, trust is its heart, and accounting is its backbone. Without accounting, one cannot draw a balance
sheet statement, income statement, or cash flow statement; finance becomes a black box and one can trust
but not verify. One should always verify, especially when money is at stake.
However, accounting rules are not absolute, they can be bent, they are subject to interpretations, and they
can be evaded. All economic units use accounting rules to their benefits and financial companies—that deal
with accounting on a daily basis—can be especially creative. Indeed, given that accounting is about giving a
picture of the financial state of an economic unit, and given that trust is central to finance, economic units
aim a giving the best financial picture to external analysts; especially in times of financial difficulties. Martin
Mayer, a famous commentator about Wall Street notes:
The fact is that large American banks keep four sets of books: one for the internal
management information system, which hopes to keep the bosses informed of what’s
happening; one for the regulators; one for the Internal Revenue Service; and one for the
stockholders. (Mayer 2001, 308)
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Accounting can be arcane and can be manipulated to one’s favors, and it is also the most effective tool to
create a fraudulent financial scheme. Fraud is about creating trust and subverting that trust for personal
gain; it is about deceiving others for personal gains. A fraudulent scheme cannot continue for long unless
one can subordinate accounting to the need of the scheme. Indeed cases of financial frauds have been
numerous, even since the beginning of the 21st century: Mortgage fraud, LIBOR fraud, securities fraud,
Fannie Mae accounting fraud, among others.
There are also conflicts and debates about the proper accounting standards. For example, one may wonder:
- How should the value of assets be measured? Shall one use their current market value, that is, the
value at which they can be sold now? Shall one use the value at which they were purchased minus
depreciation and if so how does one measure depreciation? Shall another method be used?
- How should the value of income and cash flow be measured? Shall we use an accrual basis or shall
we use a cash basis? Shall interest incomes due be recorded as incomes even if they have not been
paid (accrual accounting) or shall one wait for the actual payment to be made (cash accounting)?
- How should capital be measured? Can some bonds be included in capital? Are common stocks the
only financial instrument that can be counted as capital? What is a proper amount of capital?
Major financial stakes are at play depending on how these questions are answered. For example,
Countrywide reported $295 million in deferred interest revenues for the twelve months ending June 2006,
vs. $5.9 million in the previous twelve months. For other mortgage bearers, deferred interest represented
up to 67 percent of their pre-tax profit. Accrual accounting has its uses—most businesses and all
governments are required to use accrual accounting—but it can be easily abused.
Another example, occurred in 2009, the financial industry pushed for a relaxation of accounting rules in
order to avoid reporting major losses on securitized financial instruments. Major financial institutions
wanted to be allowed to use level-3 valuation (in-house model) instead of level-1 valuation (market value)
or level-2 valuation (proxy market) of their assets. They argued that the prevailing large discounts on
securitized financial instruments were the result of a liquidity crisis (and so temporary) instead of a solvency
crisis (and so permanent) so mark-to-market valuation (level 1) should be relaxed for a while. Both the
Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) resisted
the push to modify the reporting of financial information, and instead argued that government policies
should be used to help the economy. Mr. Hertz, Chairman of FASB, made the following statement:
We also agree with the SEC that suspending or eliminating existing fair value requirements
would not be advisable for the role of accounting and reporting standards is to help the
investing public in the capital markets with sound, unbiased financial information on
companies. Its purpose is not to determine regulatory capital or capital adequacy. [. . .]
Thus, to the extent there are valid concerns relating to procyclicality, I believe these are
more appropriately and more effectively addressed through regulatory mechanisms and
via fiscal and monetary policy than by trying to alter the financial information reported to
investors. (Herz in U.S. House of Representative 2009)
However, in a congressional hearing legislators from both sides, lobbied by the American Bankers
Association, demanded the FASB to act and lift the requirement to use level-1 valuation. Therefore, banks
could record higher profits and net worth by assuming that securities were worth much more than what
market participants were willing to pay for them.
Finally, major accounting firms (Ernst & Young, KPMG, among others) are subject to competitive pressures
and, combined with internal incentives, may give a “clean opinion” (that is put a stamp of approval on
financial documents they audited) when there are actually problems. Chief financial officers only last on
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average for two or three years, and so they have the incentive try to maximize short-term accounting gains.
Employees in the firm are happy because profitability targets are reached and so bonuses are paid. Some
accountants and others inside the firm may come to realize that something is amiss, but they are subject
to tremendous pressure not to say anything or are fired if they become whistleblowers. Matthew Lee at
Lehman Brothers, Carmen Segarra at the New-York Fed, are examples of such remarkable individuals.
RECENT TRENDS AMONG FINANCIAL COMPANIES

Since the 1970s, there has been major changes in the financial sector that can be categorized in terms of:
- Increased competition.
- Increased concentration and the emergence of financial conglomerate: financial holding
companies.
- The rise of off-balance sheet financial operations.
- The rise of money managers.
- The declining relative importance of private depository institutions.
- The internationalization of the financial system.
- The rise of quants and computer trading.
This Chapter presents briefly these different trends and some are developed more fully in other Chapters.
Since the 1970s, the extensive deregulation of the financial sector (see Chapter 11) has increased
competition by removing interest-rate ceilings on savings accounts, by allowing a greater diversification of
financial assets that could be held by each financial institution, and by removing branching restrictions.
Most of these regulations had emerged after the Great Depression to try to deal with the issues of the time.
These regulations progressively became outdated and bypassed as explained in Chapter 10 and Chapter 11.
Today, the U.S. banking industry is highly concentrated (Figure 3.42) and a few large financial holding
companies dominate the industry. Eighty percent of the assets of the banking industry are concentrated in
the 595 largest banks that account for about 10 percent of FDIC-insured banks. While there has been a
concentration of assets among banks, there has also been a concentration off-balance sheet activities.
Figure 3.42 and Table 3.6 show the recent data about derivative holding concentration among FDIC-insured
institutions; the seven biggest institutions hold 97 percent of derivative contracts held by FDIC-insured
institutions, worth almost $170 trillion notionally. Derivatives bring forward the rise of off-balance sheet
financial entities and instruments that will be studied in another Chapter. From the 1980s, because of
monetary policy and regulatory reasons, off-balance sheets operations became a core component of the
financial system.
The high concentration of the industry means that if one of the banks fails, it may have a major impact on
the financial system because it has many creditors. Banks may become “too big to fail,” and so must be
saved even though they are not economically viable. This may promote moral hazard—banks take more
risks than they would have otherwise because they know the government will rescue them—and so may
increase financial instability over time.
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Figure 3.42 Concentration of the banking industry

Source: Federal Deposit Insurance Corporation (Graph Book)
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
Table 3.6 Concentration of derivatives notional amounts

Source: Federal Deposit Insurance Corporation (Graph Book)
Beyond concentration, there has also been a diversification of the activities of financial institutions. While
the 1930s regulations had compartmentalized the financial system, this was not the case by the 1990s and
a financial holding company (all the major “banks” in the United States: Bank of America, Wells Fargo,
Goldman Sachs, among others) owns multiple companies that are involved in commercial banking,
insurance, investment banking, and money managing.
Figure 3.43 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 them fell dramatically from 50 percent of all financial assets held by the financial industry to about 20
percent; this share has been a stable since 2000. Instead, money managers (mutual funds, pension funds,
etc.) have gained in importance as did financial institutions related to securitization, which together held
about 55 percent of the financial assets held by the financial industry in 2015. Moneylenders (payday loan
companies and others) have also grown in proportion since the mid-1960s.
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Figure 3.43 Allocation of financial assets within the financial sector

Note: Savings institutions were merged with other private depository institutions in 2011.
Finally, a more recent change has been the rapid growth of computer trading and quants. Computers can
execute thousands of sales and purchases of financial instruments in a blink of an eye, and they focus on
millisecond (or less) changes in the prices of those financial instruments. The rise of computer means a
growing need for empirics and mathematics among firms involved in trading, and so the rise of individuals
with quantitative skills (quants). When previously one would use intuitions and back of the envelop analysis,
together with some qualitative analysis, quants use empirics and mathematics to develop formal trading
rules that can be plugged into computers. Nuclear physicists and others mathematical whizzes with no
finance backgrounds have been hired to create complex financial instruments and trading algorithms.
CONCLUSION
This overall presentation of the US financial system shows that it is complex and vast. Still, this Chapter left
out most the multitude of private and government regulators and supervisors that are part of that system.
It also left out credit rating agencies.
Financial companies take promises and make promises of all sorts to accommodate the needs of economic
units that need funds to pursue economic operations of all sorts: production, consumption, investment,
speculation, management of inventories, and protection against all sorts of contingencies that could
negatively influence financial well-being.
Over the past few decades, the complexity and vastness of the financial system has increased tremendously,
with a few giant financial holding companies with revenues as large as the gross domestic product of some
countries having a large influence on the system. Another very large influence on the financial system is the
U.S. government, either directly through its agencies or indirectly through GSEs. The Federal Reserve
System analyzed in Chapters 4 through 9 also has a very large influence, in fact an overwhelming influence,
in the financial sector in terms of interest rates, reliable payment systems, and the economic impact of
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financial crises. The financial sector is heavily controlled and subsidized to keep interest rate stables, to
reduce interest-rate spreads on specific economic activities, and to ensure that smooth and reliable
refinancing channels are available to private financial institutions. Finance is a public-private partnership.
Private depository institutions used to be the only institutions to have access to these government channels
given their crucial role in the payment system (if they close most payments freeze and economic activity
stops because most private economy units use private banks to make payments). The recent financial crisis
required extending access to safe refinancing channels to other institutions. This heavy involvement of the
government comes with heavy regulation and supervision, but, as explained in Chapter 11, the will to
enforce regulation may not be there.
1- A wide variety of different financial companies that specialize in specific aspects of the financial industry.
2- For-profit financial companies are concerned about staying solvent, which requires that they stay
profitable and liquid. The liquidity concern is the strongest for financial companies that issue demand
liabilities.
3- The federal government is involved in many different ways in the inner workings of the financial sectors
through the sponsoring of private companies (government-sponsored enterprises), through direct and
indirect provision of credit, through guarantees to ordinary for-profit companies, and through the Federal
Reserve System.
4- The federal government is able to operate smoothly even though it usually deficit spends and has a
negative net worth. This is possible and sustainable because the federal government does not operate on
a for-profit basis and because it is monetarily sovereign.
5- Over the past 40 years, the financial sector has become more concentrated, more competitive and more
internationalized. Money managers have gained in importance while private depository institutions have
lost ground in terms of holdings of financial assets.
Keywords
Portfolio, profitability, liquid, solvency, bank run, charter, state bank, national bank, wholesale funding
sources, retail funding sources, federal funds, federal funds market, repurchase agreements, book value,
market value, amortization, depreciation, Regulation Q, credit standards, insurance premium, adverse
selection, moral hazard, copayment, coinsurance, deductible, vesting period, defined-contribution plan,
defined-benefit plan, placement, primary market, secondary market, cash redemption, security
redemption, net asset value, net asset value per share, speculation, position, short position, long position,
capital gain, syndicated credit, offering, initial public offering, seasoned offering, fair price, broker, dealer,
market maker, specialist, primary dealer, margin credit, conventional mortgage, conforming mortgages,
loss reserves, Treasuries held by the public, fraud, mark-to-market valuation, too big too fail, money
manager, institutional investors, pension fund, mutual fund.
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Review Questions
Q1: Explain what the following financial companies do: commercial bank, savings bank, insurance company,
pension fund, mutual fund, hedge fund, market service company, Federal Home Loan Bank System, Farm
Credit System, Fannie Mae.
Q2: Is the financial system more or less concentrated than it in the past? How do we know?
Q3: Why is it possible for the federal government to continue to operate with a negative net worth?
Q4: What happens to bank that holds a FHA mortgage in the case the homeowner defaults?
Q5: Why would a commercial bank prefer to obtain credit from the FHLB rather than the federal funds
market?
Q6: The FHLB system exist to promote homeownership, how does it do so?
Q7: Financial companies are subject to potential adverse selection and moral hazard. Explain how these can
negatively impact profitability and how financial companies protect themselves.
Q8: How is it possible to make a capital gain by taking a short position in an asset?
Q9: Why are defined-benefit plans more costly for a sponsor than defined-contribution plans?
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CHAPTER 4:

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 4: 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 4.1). The balance sheet looks like this:
Figure 4.1 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 4.2).
Figure 4.2 Another balance sheet without leverage

What is the leverage? Leverage = A/E = $100/$100 = 1. There is 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 4.3). 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.
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Figure 4.3 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)
o No leverage: interest/bond = $10/$100 = 10%
o 10x leverage: net interest/bond = ($100 - $9)/$1000 = 9.1%
- Return on equity (ROE)
o No leverage: interest/equity = $10/$100 = 10% = ROA
o 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
What if the interest rate on bank debt goes up to 12% in the previous example?
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- 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 4.4).
- 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 11 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 4.4 Impact on capital of a 10% decline in the value of bonds under no leverage and 10x leverage
REFINANCING RISK AND MARGIN CALL RISK
IMPACT ON MORTGAGE DEBT: REFINANCING RISK
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:
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0.8*50000 = $40000
For the same house, the bank is willing to provide less of an advance.
Table 4.1 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 4.1 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 mortgagee 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 4.5). Pay-option mortgages allow
debtors to pay only part of the interest due.
The selling point offered by mortgage brokers was that IO mortgages 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 cannot make the additional $1264 payment. What can be done? One option
is to 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. Therefore, the household goes to a bank with the intention
to get a credit of $80000. Unfortunately, the bank states it can only provide $40000, that is, 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. Instead of granting an advance of up 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.
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Figure 4.5 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
Similar issues are at play with any other form of purchase of assets by using debt. In the balance of Figure
4.3, the outstanding amount of bonds is 10 times as large as the value of equity. The debt that funds the
position in bonds usually comes from a broker and, like for a mortgage transaction, there is a loan-to-value
ratio that determines the maximum dollar amount of funds a broker will provide to buy bonds and other
financial assets. In Figure 4.3, the loan-to-value ratio is 90%.
There are, however, a few differences relative to a mortgage transaction in terms of mechanics, vocabulary
used, and perspective (with an emphasis on the equity component instead of the debt component). First,
brokers require that whoever gets an advance from them open an account with them. This account is called
the margin account and it serves as equity in the financing of the asset position. In Figure 4.3, the economic
units had to deposit $100 in a broker account, which was used to finance a tenth of the bond position. Thus,
the equity-to-value ratio is 10%; 1 – LTV. The minimum equity-to-value ratio that ought to prevail at the
time of the broker participates in the funding of asset positions is called the initial margin requirement and
is regulated by the Federal Reserve System. Currently, the Federal Reserve sets the initial requirement at
50%, which means that at the maximum a client can only acquire twice as many assets as what the dollar
value of its margin account allows. Brokerage firms may choose to have a higher initial margin requirement,
that is, may choose to reduce the ability of their customer to use leverage. Thus, if an economic unit
deposits $500 in a margin account, it can acquire up to $1000 of bonds because the broker will provide up
to $500 more. Assuming an economic unit uses the funds that a broker is willing to provide, the balance
sheet for this transaction is shown in Figure 4.6. One must note that this balance sheet does not represent
the overall balance sheet of an economic unit, it only represents the funding of the bond holdings.
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Figure 4.6 Acquisition of bonds with maximum leverage allowed

Second, once the asset has been acquired, the value of the assets purchased is revalued every day according
to the prevailing market price and resulting equity-to-value ratio is calculated. The Federal Reserve again
regulates the minimum value that the equity-to-value ratio must have as a client continues to hold the
assets acquired on margin. This minimum value is called the maintenance requirement and is currently set
at 25% of the value of assets. In the case of Figure 4.6, the value of bonds would have to fall by $250 to
reach the maintenance requirement. If the market value of bonds falls to $600 then the balance sheet of
Figure 4.7 holds. The value of bonds fell by 40% while the value of net worth fell by 80%, which is the result
of using a 2X leverage.
Figure 4.7 Undermargined bond position

The equity to value ratio is now 17% which is below the 25%; the economic unit is under margined in terms
of its holdings of bonds financed with the help of a broker. In order to bring back the equity to value ratio
to the maintenance requirement, the economic unit must either add more bonds to the balance sheet
(perhaps from its overall balance sheet), or increase the net worth of the balance sheet. Assume that the
economic unit decides to add to the net worth, which must be $150 to represent 15% of $600. To add $50
to the net worth, the economic units adds $50 to its margin account for a total of $550.
Things may get more complicated for the economic unit because in times of crises, brokers usually raise the
initial and maintenance requirements, that is, they lower the allowed loan-to-value ratio and time of
acquisition of assets and holding of assets. For example, if the maintenance margin goes up to 40%, in the
previous situation the net worth ought to be $240 (0.4*600). This means that the economic units has to
come up with $140 to add to its margin account. If the economic units cannot come up with the $140, the
broker is allowed to sell some of the bond to repay some of the debt owed so that the maintenance margin
is once again met.
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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 4.8 presents a “simple” case of embedded 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 4.8 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 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, that is looking at SPE3 alone, AAA CDO 2s 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 CDO 2s 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.
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- CDO2 become worthless much faster. If the mezzanine CDOs are worthless then CDO 2 are worthless.
Mezzanine CDOs are worthless after a 1.2% decline in the value of subprime mortgages (5% x 24%)!
Suddenly 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 CDO 2 relative to
AAA corporate bonds, together with the 40% buffer against loss provided by other CDO 2.
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 nonfinancial 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 4.1 only presents
preliminary data that seems to pass the smell test. Chapter 10 presents official leverage data in the banking
sector.
Figures 10.9 and 10.10 give a broad idea of the relative leverage across sectors and of the trend in leverage.
Clearly, the nonfinancial sector is less leveraged than the financial sector with households being the least
leveraged of all sectors. Overall, leverage in the nonfinancial sector grew relatively smoothly until the Great
Recession, especially so for households. Leverage in the financial sector is much more volatile.
Figure 4.9 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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Figure 4.10 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 units 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. The rise of money managers (pension funds, hedge funds, mutual funds, among
others) also has led to changes in the managerial structures of financial institutions. Money managers are
under extreme pressure to perform and compare their performance on the quarterly basis with large
movement of funds toward the better performing money managers in the quarter. While this focus on
short-term performance is understandable for hedge funds, it also prevails in pension funds and mutual
funds with a long-term maturity. Given the large sum of funds they control, money managers have been
able to influence the decisions of the board of directors of the companies in which they had a significant
stake. Given that money managers are heavily focused on short-term capital gains, companies had to watch
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more carefully changes in the value of their stocks and short-term business performances. This move
toward shareholder value also led to a change in the incentive structure of management with more
emphasis on stock-options, which is believed to help align the incentives of managers and money managers.
Prior to the 1990s, the compensation of chief executive officers (CEO) was based overwhelmingly on salary.
By 1992 the proportion of salary in CEO compensation had declined to 42 percent in 1992 and by 2008 it
represented only 17 percent of CEO compensation. Instead, stocks, stock options, and bonuses became
dominant means to remunerate CEOs, and the first two means exploded in the 1990s.3 Money managers
also have pushed for more involvement in financial activities by nonfinancial companies because of the
higher rates of return. Some of them, like Ford or GE (until recently), have a financial branch that provides
more cash balances than their core nonfinancial activity (Figure 4.13) 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 4.11). 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 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 4.12). 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 4.11 Distribution of U.S. financial assets among the different macroeconomic sectors.
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Figure 4.12 Proportion of national income earned by the financial sector.

Sources: BEA, Historical statistics of the United States
Figure 4.13 Percent of cash balance coming from financial activities

Source: SEC (10K statements)
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1- To leverage is to go 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 nonfinancial 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 nonfinancial 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 imply the debtization of the economy?
Suggested readings
Chapter 1 of Guns, Traders and Money by Satyajit Das relates personal recollections surrounding leverage
in a very clear and funny way and presents 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/

3 Frydman, C. and Jenter, D. (2010) CEO Compensation, Annual Review of Financial Economics, 2, 75-102.
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PART 2:
CHAPTER 5:

CHAPTER 6: THE FEDERAL RESERVE SYSTEM: AN INSTITUTIONAL OVERVIEW
TO BE WRITTEN
1 For detail see Section 7 of Federal Reserve Act.

CHAPTER 6:

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 tax revenues to spend
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 6: 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; 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 6.1 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 6.1 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, which 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.
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
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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 the net income of the
Fed.
Any leftover net income is transferred to the U.S. Treasury. The Secretary of the Treasury can use the
funds only to increase the Treasury’s gold stock or to reduce the outstanding amount of Treasuries. 1
For analytical purposes, it is best to rearrange the balance sheet of the Fed according to Figure 6.1.
Throughout this book, a lot will be done with L1, L2 and L3 as well as A1 and A2 because they are all central
to understanding domestic monetary policy operations. In addition, L1 only contains the FRNs held by
banks, the domestic public and foreigners. 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”), the Federal Reserve banks and 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’ financial
instruments L2: Reserve balances (Checking Account
due to banks)
A3: Foreign-denominated financial
instruments L3: Treasury’s account and Federal
Notes Held by Treasury
A4: Coins and Treasury currency
L4: Account due to Foreigners and
A5: Other assets (buildings,
others
furniture, etc.)
L5: Other liabilities (including equity
capital)
Figure 6.1 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 dollars. 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 a coin dealer on behalf
of the Treasury.2 The 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. A gold certificate account (first line under assets) is just an electronic
entry to record the safekeeping 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).
What the U.S. population considers “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 promises
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something to the holders of the FRNs. Chapter 19 studies what is promised. FRNs are secured by some of
the assets of the Federal Reserve banks, most of them are Treasuries (Figure 6.2).
Figure 6.2 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; 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 with a 10% interest and repayable the next day. Today the following is recorded:
Fed
Financial instruments of banks: +$100 Reserve balances: +$100
Someone at 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 that 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
Financial instruments of banks: -$100 Reserve balances: -$100
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 the net worth of private banks):
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Fed
Reserve balances: -$10
Net worth: +$10
These two T-accounts are normally consolidated into one:
Fed
Financial instruments 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 and the Treasury gained 10 points.
POINT 3: THE FED DOES NOT LEND RESERVES AND DOES NOT RELY ON THE
TAXPAYERS
In Table 6.1, there is a line labeled “loan” on the asset side. One will often hear and read—even in Fed
documents—that the Fed lends reserves to banks. In fact, the use of this terminology is pervasive in the
financial industry. The trick is that the words “loan,” “lender,” “borrower,” “lending,” “borrowing,” are
given a specific meaning that is different from the common understanding.
The word “lend” (and so “borrow”) is a misnomer that has the potential of confusing—and actually does
confuse—people about what banks do. In the common sense, “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
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 the gambler’s legs (or worse!).
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“To lend” is 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 banks its own financial instrument (reserve balances), and banks give the Fed their
own financial instruments. The Fed swaps/exchanges claims with banks. This is one way for banks to
obtain reserves. Chapter 6 and Chapter 12 explain why banks are so interested in the Fed’s financial
instrument and how they obtain reserves. Figure 6.3 shows what the banks’ financial instrument looks
like.
Figure 6.3 Template of the financial instrument issued by banks to the Discount Window
Source: Federal Reserve Bank Services (Operating circular No. 10)
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, it credited the bank’s reserve balance. The bank promises
to comply with the terms of the contract that details the timetable 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 6.1) 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
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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 simply credits the accounts of banks by
keystroking amounts. Chapter 12 shows that the same logic applies to private banks; “lending” in banking
is just a matter of crediting accounts through keystrokes.
To avoid confusing the reader, this textbook will not use the words “loan,” “lender,” “borrower,”
“lending,” “borrowing,” when analyzing banks (private or Fed) and their credit operations. Banks do not
lend money in the common sense of the term. They are not money lenders, and customers do not borrow
money from banks. Words like “advance,” “credit,” “creditor,” “debtor,” are more appropriate words to
describe what goes on in banking operations. However, the reader must work on a fine line because most
participants in the financial industry will use the word “loan” to describe their credit operations. Once the
reader understand how the words are used, she should feel free to use the terms, but the text will
deliberately avoid using them to make sure banking operations are properly understood. In the balance
sheet of Figure 6.1, there is no “loan” but instead there is “A2: Domestic private banks’ financial
instruments.”
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:
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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 keeping score 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 to buy something from someone in the domestic economy with Fed currency, they first
would have to get more vault cash (case 1 above). Chapter 12 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 from a down payment. 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 mortgagee. If the downpayment 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. The
Fed can meet all payments due denominated in USD at any time, no matter how big they are; it is just a
matter of keystrokes on a computer terminal.
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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 are Treasury securities.
3- Lending means temporarily giving up an asset; 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 financial instruments
with them.
5- To obtain an advance from the Fed, private banks must provide collateral to back their financial
instrument.
6- Paying interest to the Fed increases its net worth and debits the Fed accounts of whoever is paying the
interest. There is no cash flow gain, that is, 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. Similarly,
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.
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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 6. 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 6.
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. “The gold certificate account reflects the receipts issued to the Reserve Banks by the Treasury
against its gold holdings. In return, the Reserve Banks issue an equal value of credits to the general account of the Treasury,
computed at the statutory price of $42.22 per troy ounce. Because nearly all of the gold held by the Treasury has been monetized
in this fashion, the Federal Reserve Banks' gold certificate account of $11 billion represents the nation's entire official gold stock.”
(Board of Governors of the Federal Reserve System (US), Assets: Gold Certificate Account [WGCAL], retrieved from FRED, Federal
Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WGCAL, October 1, 2016.)
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.
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CHAPTER 7:

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 7: 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. This Chapter studies the difference between monetary base and money supply, and 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.
The Financial Accounts prefer a narrower definition by defining currency in circulation as currency held by
the non-federal sectors. Economists prefer an even narrower definition, and the book uses it. Currency in
circulation is any currency outside vaults of private banks (“vault cash”), the Treasury, and the Fed—what
is held by “the public” (abroad or in the domestic economy).
Figure 6.1 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 refer to 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
statistical and does not have any analytical power. Chapter 19 shows that the material of which something
is made is irrelevant to determine if it is a monetary instrument. Unless stated otherwise, this book uses
the word cash and currency interchangeably.
To simplify, the U.S. monetary base can be reduced to (see Figure 6.1 for meanings of L1 and L2):
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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 has grown
steadily to almost $1.4 trillion today, most of which are FRNs.2 Between one-half and two-thirds of the value
of currency in circulation is held abroad.3 The global financial crisis led to a large increase in reserve balances
from about $24 billion on average from January 19B59 to August 2008 to about $2.5 trillion today (Figure
6.1).
Figure 6.2 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 excluding the Treasury and other official foreign institutions. There are
several ways to measure that, and monetary aggregate M1 is the narrowest (Figure 6.2):
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 have represented
a growing proportion of the monetary base (Figure 6.2), 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; it 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 component of the money supply. As a result of Quantitative Easing,
the growth rate of M1 increased in 2009.
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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 interview,4 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 has been 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. Chapter 6 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. This section studies a bit
more carefully the reserve side of the monetary base. Total quantity of reserves is:
Total reserves = Reserve balances + applied vault cash = L2 + part of L1
Applied vault cash is 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 up 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, reserve balances have been, by far, the main component of total reserves (Figure 6.3).
It is possible for reserve balances (L2) to be negative, that is, the Fed allows banks to have an overdraft.
During the day, banks process trillions of dollars of transactions on a daily basis while only holding a few
billions of dollars of reserve balances. The Federal Reserve accommodates the needs of banks by providing
daylight overdraft. In exchange, it charges a small fee and may ask for collateral.5 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 an overnight overdraft is a form of uncollateralized advance, contrary to Discount
Window advances. If the overnight overdraft persists, the Fed may take a closer look at how the bank runs
its business.
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Figure 6.3 Decomposition of total reserves in terms of forms, billions of dollars

Total reserves can be decomposed into categories other 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 them:
- Discount Window operations: The Fed advances funds by swapping financial instruments with
banks (see Chapter 6). This is recorded as “borrowed reserves.”
- Open-market operations: The Fed buys some financial assets from banks either permanently
(“outright purchases”) or temporarily (“repurchase agreements”). This is recorded as “non-
borrowed reserves.”
Total reserves = borrowed reserves + non-borrowed reserves
Non-borrowed reserves have been the main source of reserves for banks (Figure 6.4) 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 very strong. 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 were negative during most of 2008 and bottomed at about -$330 billion in October
2008, just about at the same time as borrowed reserves reached their peak value (Figure 6.5). Non-
borrowed reserves are measured by the difference between total reserves and borrowed reserves.
Borrowed reserves are measured by A2 in Figure 6.1. For reasons related to monetary developments
discussed in Chapter 7, total reserves became smaller than A2 during the 2008 financial crisis. The central
bank provided a lot of advances but removed most of the reserve injection that resulted from them.
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Figure 6.4 Decomposition of total reserves in terms of sources, billions of dollars

Figure 6.5 Borrowed and non-borrowed reserves during the 2008 financial crisis
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:
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- Required reserves: The quantity of reserves banks must hold in proportion to 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 6.6). Excess reserves
were virtually zero (Chapter 7 explains why). Up until the crisis, the dollar amount of reserves was also
relatively stable over decades and averaged $40 billion (Figure 6.7).
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 6.6 Decomposition of total reserves in terms of uses, billions of dollars

137
Figure 6.7 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 6.1):
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
o Higher A1: Buying securities (T-bills, T-bonds, etc.)
o Higher A2: Advances of Federal Funds
o Higher A3: Buying foreign currency from private banks
o 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:
o Lower L3: Treasury spends
o Lower L4: Government-sponsored enterprises buy mortgages from banks
o Lower L5: Fed pays dividends to member banks
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. The following presents two examples:
- Case 1: The Federal Reserve buys T-Bills worth $100 from banks
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Fed
ΔA1: +$100 ΔL2: +$100
Banks
T-bills: -$100
Reserve balances: +$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 for 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 9). 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 has to go to the Treasury. Given
that we assume 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 is transferred (which
would be the second step if TT&Ls were included in the analysis):
Fed
However, 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. 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
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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 the 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 7.
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, that is,
if the Treasury held some tax receivables against Dr. T. In that case, instead of net worth, tax receivables
that would go down by $1000.
Figure 6.8 provides a graphical representation of how the reserve component of the monetary base has
changed after 2003. Until 2008, assets and liabilities that influence reserve balance were almost equal so
reserve balances were almost nonexistent (Figure 6.7 shows that they averaged $40 billion). After the late
2008, reserve balances exploded because the Fed acquired large sums of assets during the financial crisis.
While early in the crisis liabilities did go up to offset the purchase of assets (see Chapter 9), most reserves
were not drained November 2008. Since 2014, the acquisition of assets has stabilized and the Fed now
wants to “normalize” its balance sheet by progressively bringing L2 to its pre-crisis level.
Figure 6.8 Balance sheet of the Fed and reserve balances, trillions of dollars
Source: Board of Governors of the Federal Reserve System (Series H.4.1)
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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 7 shows that, unless it changes its operational procedures, the central bank cannot reach its
interest rate target if it issues reserves regardless of the needs of banks.
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 financial instruments 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.
The language of the preamble of the 1913 Federal Reserve 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 in response to the needs of the economy. However, until 1932, the Fed operated under the Real
Bills Doctrine (RBD). What that meant was that the Fed ought to accept only securities that “self liquidate”
in A1 and as collateral for A2 (see Figure 6.1). Self-liquidating securities are those that are issued and
destroyed in relation to economic activity. Firms issue securities to produce (see Chapter 12) and repay
them when firms sell their production. The monetary base (and so money supply as the thought of the
time—erroneously—went) would grow in-sync with production. The RBD doctrine grew out of a fear that
the elastic currency would lead to the Fed to over issue currency, which would be inflationary and would
threaten the gold reserve of the country. Given that US dollar was convertible into gold on demand,
monetary authority took step to ensure that not too many US dollars were issued relative to the quantity
of gold available. This helped to maintain the confidence of the public in the ability to convert on demand
and so limited demand to convert the currency into gold.
In practice, RBD never worked out well for both theoretical and practical reasons. WWI led to large holdings
of Treasuries by the Fed. The Great Depression led to the elimination of the doctrine, and the 1932 Banking
Act dramatically widened the types of securities the Fed could accept if needed (Table 6.1).
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Table 6.1 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 relies on private indebtedness (issuances of securities by companies
to finance production, “real bills”) for monetary policy to work. During a recession, banks do not have
enough real bills to sell or pledge to the Fed because private issuance plunges given that economic activity
is moribund. This is problematic because the scarcity of real bills limits the ability of banks to obtain
reserves, just at the time when banks desperately need additional reserves to counter bank runs (people
running to banks to ask for cash) and make interbank payments. This scarcity was created by design to
maintain the confidence in the convertibility of the currency into gold, but ended up conflicting with the
need to preserve the financial stability of the economy.
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 Reserve System. It was also a
reaction to the opaqueness and questionable use of the Discount Window operations during the crisis.
The Fed needs to be able to fight panics and the ensuing liquidity crisis when everybody (including all 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 variety 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. Consequently, 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 encapsulate.
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- 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
19).
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, are reserves 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?
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
5 More details can be found in The Evolution of the Federal Reserve's Intraday Credit Policies by Stacy Panigay Coleman, Federal
Reserve Bulletin, February 2002.
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CHAPTER 8:

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 8: MONETARY POLICY IMPLEMENTATION
Chapter 6 examined the balance sheet of the Fed and Chapter 6 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 increased 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 $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 a 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 6.1). Holders of these accounts include private banks, the U.S. Treasury, government-
sponsored enterprises, the International Monetary Fund, and 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 in the form of unsecured loans of fed funds.
Figure 8.1 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. The Fed wants to make sure that the
FFR prevailing in the market does not deviate too much from the FFR desired by the Fed (the FFR target)
(Figure 8.1). Most of the time the Fed targets a specific number but sometimes it targets a range. In July
2018, the target range is 1.75-2.00%. From the late 1970s until 1991, the Fed had a range that was as high
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as 16%-22%, and as wide as 13%-20% in early 1980 (Figure 8.2). 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 12 for further
explanation):
- Cash withdrawals by customers: people get cash from banks.
- Reserve requirements: regulators require that banks keep a certain dollar amount of reserves.
- Interbank debt settlements: paying debts due to other banks.
- Payments to other Fed account holders: tax payments drain reserves.
Figure 8.2 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
By far, the largest day-to-day need for reserves is interbank settlements. Banks that do not have enough
reserves to make the necessary payments must get reserves to avoid default. They may get them from
other banks, other fed funds holders, or from 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 8.3).
In terms of portfolio choices, assume 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
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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 8.3). 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 is to influence inflation and employment. For example, if the Fed
thinks that inflationary pressures are building up, the reasoning goes as 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 23). There are many 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.
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Figure 8.3 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
used not to earn any interest. Chapter 6 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 excess reserves to avoid the
overnight-overdraft penalty rate (Chapter 6 explains that reserve balances can be negative).
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What happens if banks cannot get enough fed funds for their needs by going to the Fed funds market?
During the day, this is not an issue because the Fed automatically grants an overdraft to banks that need
more fed funds, and the Fed provides that overdraft at a low cost. At the end of the day, however, if banks
cannot close the overdraft, they are subject to a steep interest rate. Banks cannot create more reserves
than what is available, only the Fed can. If the Fed does not add more fed funds, the FFR rises steeply toward
the overdraft penalty rate because bank must have the reserves they need. A higher FFR does not
incentivize banks to demand fewer fed funds; their demand for reserves is inelastic and mostly non-
discretionary.
What happens if banks have too many 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 fewer fed funds.
To minimize fluctuations in the FFR and keep it around the target, the Fed intervenes daily to add or remove
fed funds. This is done 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 for T-bills
with banks (Figure 8.4):
- 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
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) depending on the expectation of the Federal Reserve regarding
the future state of the market. If the Fed expects that extra reserves will be needed for a while to avoid a
shortage, the Fed does an outright purchase of treasuries, whereas if the Fed expects that a shortage will
exist only for a few days it will perform repurchase agreements. For banks to agree to trade with the Fed
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instead of putting reserves in the market—or for banks to get reserves from the Fed instead of 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 lend the funds in the
market? One way is to do something similar to the following: the Fed sells 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 8.4 Targeting the FFR: Open-market operations

The Fed could do this all day long and FFR would be on target all the time, but 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 6.1).
The Fed is 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 reserves to reach the target. The FFR will move
quickly around the target following the announcement of a change.4
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Another way to understand this is to 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 will offer reserves at a higher FFRT, banks
with a surplus of reserves also raise the rate at which they offer to lend reserves to deficit banks. 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 8.5).
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 6, banks
cannot do much with them.
Figure 8.5 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 the overdraft penalty rate.
Thus, while the Fed performs the injection and ejections of reserves, the Fed adds or removes only on a
defensive basis to keep the FFR on target.
What monetary policy is all about is setting the price of reserves and letting the quantity of reserves 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.
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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 8.1) and, from early 2008, to provide significant quantities of emergency funds to the financial
system (Figure 8.6). 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 8.6). 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 6.1 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
8.1). Emergency advances by the Discount Window led to an 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 9 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 8.1).
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) (Figure 8.6, Table 8.1). It did so without
neutralizing the impact on reserves so reserve balances increased rapidly beyond the needs of banks (see
Chapter 6). 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.
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Figure 8.6 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 8.1 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 when the FFR goes below the interest rate
on reserve balances (IOR).
The Fed and other central banks now operate under a “corridor” framework (Figure 8.7). In theory, the FFR
can only fluctuate between the IOR and the discount window rate (DWR). The FFR target is set in the middle
of the corridor and the three rates (IOR, FFRT and DWR) move together. There is a horizontal band instead
154
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 8.7 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, 6
were a major source of excess supply of fed funds. Since the end of 2015, the Fed has solved this problem 7
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 a 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 8.8). 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.
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Figure 8.8 Corridor of ECB

Source: Kahn’s Monetary Policy under a Corridor Operating Framework
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 times and in times of panic. 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 if it merely transact with banks. 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, that is, FRNs cannot be “helicopter dropped” via traditional
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 and to bring them to banks. Banks would have more reserves, the FFR
would fall, and the Fed would remove excess reserves to bring the 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.
If the central bank deals with economic units that do not hold a central-bank account. For example, during
the period of quantitative easing, the Fed bought large quantity of securities from non-bank. In order to do
the Fed works through banks and the following occurs:
Fed
Securities: +$100 Reserve balances: +$100
Banks of sellers of securities
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Reserve balances: +$100 Account of sellers: +$100
Sellers of securities
Account of sellers: +$100
Securities: -$100
The money supply (and reserve balances) goes up by $100 when “account of sellers” increases by $100 (but
it does not if only reserve balances go up by $100).
TO GO FURTHER: BEYOND THE FED FUNDS MARKET,

EURODOLLARS AND REPURCHASE AGREEMENTS
There are three main overnight sources of federal funds for banks with a US charter: the federal funds
market, the overnight Eurodollar market and the overnight repurchase agreement market (repo market).
Federal funds market involves unsecured loans, Eurodollar market involves deals with foreign banks, and
repurchase agreement market involves secured loans. All three are close substitutes and the choice
between them is a matter of convenience, accessibility, and preference. For example, borrowing reserves
through the repo market involves pledging an asset as collateral. Treasuries, agency mortgage backed
securities are the most common securities used as collateral. Some banks may not be willing or able to do
so. In addition, most small to medium banks rely on the federal funds market and only large banks that
operate internationally have access to reserves indirectly via the Eurodollar market.
The substitutability of the three overnight markets is reflected in the spread between the federal funds rate
and the rates of the two other markets. In the Eurodollar market, the interest rate that serves as a
benchmark is the London interbank offered rate (LIBOR). LIBOR is quoted every day for several currencies
(US dollars, euros, Swiss franc, among others) and several maturities (overnight to 12 months). The spread
between the FFR and the overnight LIBOR is very small and averages 7.5 basis point from 2001 to 2016 but
has been 0 since 2012. Some larger spreads did occur during times of crisis (Great Recession and especially
in September 2008 with the bankruptcy of Lehman Brothers) or heightened uncertainty (September 2001
collapse of Twin Towers that hosted major financial institutions) when the LIBOR goes significantly above
the FFR (Figure 8.9). The Treasury repo rate is also closely aligned with the FFR but tends to be below the
latter by an average 2.7 basis points from 2005 to 2015. The relatively lower repo rate reflects the fact that
a collateral is involved in the loan of reserves and so it is a safer loan.
While the federal funds market is the core of the overnight refinancing market, it is not the main source of
reserves for banks. The Eurodollar market and securities repurchase agreement are alternative sources of
federal funds.
157
Figure 8.9 Spread between the LIBOR and FFR, percentage points
Source: FRED economic data, DTCC
Note: Overnight repo rate is the rate on General Collateral Finance overnight repurchase agreements
involving U.S. Treasury securities. It is available from 2005 to 2015
Given that the LIBOR is a major source of funding cost for large banks and given that large banks hold most
of US bank assets (see Chapter 10), the LIBOR is used instead of the FFR to influence a whole range of
financial contracts with a variable interest rate, notably a large proportion of mortgages. The interest rate
on an adjustable rate mortgage will be calculated as the sum of LIBOR plus a fixed spread. So, for example,
if the LIBOR moves from 2% to 3% a mortgage rate equal to LIBOR + 200 basis points will move from 4% to
5 %. In practice, it makes little difference most of the time if the FFR or the LIBOR is used given that they
are highly correlated and almost equal at all time.
How do banks with a need for reserves obtain them through the repo market? They do it by selling a security
to market participants with fed funds to lend, which can be another bank, a security dealer, GSE, among
others. The next day banks must buy back the security and give back the reserves they borrowed.
How do banks obtain reserves in the Eurodollar market? Suppose that a French company does a lot of
business in the US and has an account at bank AUS. Suddenly, the account of the company is transferred to
a bank located in a foreign country, bank F. Why? One reason may be that Bank F is a branch of Bank A US
abroad; in order to avoid reserves requirements on the bank account at bank AUS, bank AUS sweeps accounts
by transferring to its branch. Another reason may be that the French company would like to transfer the
funds into its account into a certificate of deposits in order to earn an interest but the interest paid by bank
F is higher than the one that bank A can offer. Yet another reason may be that the French company wants
to shelter its US-dollars savings from seizure by the US because it is afraid political tensions between France
and the US. Chapter 23 explains that all these reasons have played a role in the transfer of funds from bank
AUS to bank F, the point is now that bank F receives funds from the French company. If we assume that bank
F as an account at bank AUS, the offsetting entry is an increase in the bank account of bank F at bank AUS.
The account of the French company is called a Eurodollar deposit.
158
Bank F
Account at Bank A: -$100 CD of French Company: $100
Say another bank located in the US, bank BUS, wants to obtain $100 worth of reserves from bank AUS. One
way is to go through the Eurodollar market by issuing a US-denominated financial instrument to bank F.
Bank F pays for the financial instrument by using its account at bank A US.
Bank F
Financial instrument of Bank B: +$100
Account at Bank A: -$100
Bank AUS
Reserves: -$100 Account of Bank F: -$100
Bank BUS
Reserves: +$100 Financial instrument: +$100
The form the financial instrument takes varies but interbank liabilities in the Eurodollar market takes usually
the form of time deposits with maturity of overnight to several months.
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 keep 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.
8- Banks may go through other overnight markets than the federal funds market to obtain more reserves,
but interest rates in other overnight markets are strongly influenced by the FFR.
159
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.
Review Questions
Q1: If the Fed supplies more reserves than banks want, what happens to the FFR? What if it supplies less?
What will the Fed do to keep the FFR on target?
Q2: What does a horizontal supply of reserves mean 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 Handbook
of Alternative Monetary Economics, 17-34, Northampton: Edward Elgar.
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.
160
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.
6 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

7 More details about the reverse repurchase agreement operations is available here:
https://www.newyorkfed.org/markets/rrp_faq.html
161
CHAPTER 9: FAQs ABOUT CENTRAL BANKING
162
CHAPTER 9:

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 9: TREASURY AND CENTRAL BANK INTERACTIONS
This Chapter concludes the study of central banking. 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 the Treasury spends, the Fed debits the TGA and credits reserve balances. Simultaneously, private
banks credit the account of private economic units. If 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
Taxpayer
Account of taxpayer: -$25 Net worth: -$25
164
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 lend
everything in the Fed Funds market and the FFR will fall rapidly to 0% (see Chapter 7). 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 6.1) 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 9.1).
Cash flows of the TGA are very erratic throughout the day so a perfect targeting is difficult and, sometimes,
the outstanding value of the TGA deviates substantially from the target for a brief period of time. 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. Assume that spending occurs first (payment to
a paper company):
Bank
Reserve balances: +$2 Account of company: +$2
Fed
TGA: -$2
The injection of reserves is removed by calling funds from TT&Ls:
Bank
Reserve balances: -$2 TT&Ls: -$2
165
Fed
TGA: +$2
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 9.1 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 Brother’s collapse in September 2008 led to a large injection of reserves via emergency Discount
Window advances. 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 9.2). The cause of the increase was a
massive cash and debt 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, the 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 9.3).
166
Figure 9.2 Balance sheet of the Federal Reserve, trillions of dollars

Why did the Treasury do this? It did it to help drain reserves in order to keep the FFR on target. The FFR
target was positive until December 2008, so reserves had to be drained in order to keep the FFR around the
non-zero target. Chapter 7 explains that the Fed had been neutralizing the impact of emergency programs
on reserves since December 2007. It had been doing so by selling 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 (that is bank that could not access fed funds
through the fed funds market), the Treasury was simultaneously draining them (Figure 9.4). This
coordinated operation allowed the Fed to tackle simultaneously problems regarding financial stability
(some banks desperately needed reserves) and monetary policy (keep the FFR on target).
167
Figure 9.3 Treasury’s accounts at the Fed, billions of dollars

Figure 9.4 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 This is incorrect because the
Fed does not need cash from anybody; it creates cash.
168
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, the Treasury used to be able to have an intraday overdraft on its TGA; it was unlimited
from 1914 to 1935 and up to $5 billion from 1942 until 1979 (Table 9.1).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.4 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))
The previous two quotes can be illustrated by using balance sheets. To simplify, we assume that banks do
not hold reserves and are fine with that (their demand for reserves is zero), that the TGA is at zero, and that
the Fed needs to spend $20 every day:
Banks
Reserves: $0 Bank accounts: $150
Other Assets: $300 TT&Ls: $50
Net Worth: $100
Fed
Assets: $100 Reserves: $0
TGA: $0
Net Worth: $100
169
At the moment, the FFR is on target given demand for and supply of reserves are equal. Although the
Treasury has funds in its TT&Ls ($50) it is not possible for the funds to be transferred to the TGA because
banks have no reserves. While overdrafts are possible on reserves, they are subject to a penalty rate and
non-monetary cost so banks will want to avoid that situation by trying to borrow reserves in the fed funds
market. This means that the FFR will move above the FFR target. In order not to disturb the state of the fed
funds market, the Treasury asks the Fed for a credit of $20. The Fed credits the TGA by $20 and in exchange
takes a financial instrument from the Treasury called “certificate of indebtedness” (see Figure 9.5).
Fed
Certificates of indebtedness: $20 Reserves: $0
Other assets: $100 TGA: $20
Net Worth: $100
Now the Treasury spends:
Fed
Certificates of indebtedness: $20 Reserves: $20
Other assets: $100 TGA: $0
Net Worth: $100
Following, Treasury’s spending banks have now $20 of reserves, the Treasury then calls $20 out of its TT&Ls,
which drains $20 of reserves and credits $20 to the TGA. The Treasury uses the funds to repay the Fed (TGA
goes down by $20 and the dollar amount of certificates of indebtedness held by the Fed goes by $20).
Figure 9.5 Sample of a Treasury’s certificate of indebtedness issued to the Fed

Source: “Amendment of Section 14(B) of the Federal Reserve Act”, Hearing before the Committee on
Banking and Currency, House of Representatives 58th Congress, 2nd Session, on H.R. 12586, June 12, 1958.
Since 1981, direct financing of the Treasury by the Fed is forbidden. As such, the Treasury and the Fed had
to find another way to coordinate to make sure that tax seasons did not have major influence on the fed
funds market. Before the 2008 financial crisis, the Treasury aims at keeping the amount of funds in the TGA
around $5 billion, which ensures that the Treasury has a buffer of funds against unpredicted spending. This
also simplifies the daily monetary policy of the Fed by limiting the volatility of the monetary base that comes
from L3.
170
Another example occurred throughout most of World War 2. At that time, the Fed was targeting the entire
yield curve (that is, all the interest rates on Treasuries) and Treasury helped through debt management
(Figure 9.6). 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:
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 24-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.
171
(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 9.1 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)
Figure 9.6 U.S. Interest rates in the 1930s, 1940s and 1950s, percent.
Sources: NBER, Board of Governors of the Federal Reserve System
Note: Grey area represents the official involvement of the United States in World War 2.
172
There have been other cash and debt management techniques used by the Treasury, but those above
should give the reader 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 the Treasury and central bank is needed for monetary-
policy operations to work properly.
FISCAL POLICY AND THE FED

For a government that is monetarily sovereign, 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.” However, the $5 billion limit was 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 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 be 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 implement the transfer of funds from TT&Ls to TGA.
In addition, the Fed also has been heavily involved in treasury auctions5 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
173
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.
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 2 (see Figure 9.7 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.
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Figure 9.7 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: SOME IMPLICATIONS
INDEPENDENCE OF THE CENTRAL BANK
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:
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). These funds cannot exist
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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 operations. One is that the Fed directly finances the Treasury:
Fed
Treasuries: +$100 TGA: +$100
Another is that other Fed accounts are drained by the settlement of taxes or 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 7). 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.
Some economists following Modern Money Theory (MMT) have used these conclusions and noted that no
analytical insight is gained from making a distinction between the Treasury and the central bank when
dealing with a monetarily sovereign government. We might as well consolidate them into one economic
unit, the government. The use of consolidation is actually quite frequent among economists and
commentators who note that the “United States” issues the dollar.6 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
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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: ΔL 1 > 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 back its currency to the government (ΔL1 < 0). This is exactly what was said in the previous sections.
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.
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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. Maybe the individual asking this question is defining too
narrowly 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 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 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 a project, it is funded. If it is
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,
“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 peacetime, the economy is usually below full
employment so to produce more one just needs to employ more. 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
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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.
The 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 peacetime. 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 many resources and may not export enough to obtain the 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 a net injection of reserves, which 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 over time 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 2.
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
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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 techniques 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.
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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 “Under the present authority, Treasury borrowings have taken the form of special certificates of indebtedness which are issued
to the Federal Reserve. These borrowings have provided the Treasury with an immediate source of funds to meet unforeseen
developments which generally occur within a day or two when there is insufficient time to raise funds through the issuance of
securities in the market. They can be redeemed as soon as the events which necessitated their use are corrected or when market
financing can be accomplished. Also, they do not have to be issued until the Treasury's cash balance with the Federal Reserve
actually becomes negative. In such a case immediately available funds can be credited to the Treasury very late in the day.”
(Altman 1979, 19)
5 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
6 Below are two examples of how consolidation is used:
“As the sole manufacturer of dollars, whose debt is denominated in dollars, the U.S. government can never become insolvent,
that is,, unable to pay its bills. In this sense, the government is not dependent on credit markets to remain operational. Moreover,
there will always be a market for U.S. government debt at home because the U.S. government has the only means of creating
risk-free dollar-denominated assets.” (Fawley and Juvenal 2011)
“The United States is a very special place, no questions about it, and we will pay our debt in the end. It is not like if we don’t pay,
we can’t pay. We've got the right to print our own money, that's the key. Greece lost the power to print their money. If they
could print drachmas they’d have other problems, but they would not have a debt problem. And seventeen countries in Europe
gave up the right to print their own money. That’s enormously important. And we’ve got the right to print our own money, so
our credit is good." Warren Buffet on July 8, 2011 speaking with Betty Liu on Bloomberg Television's "In the Loop"
https://www.youtube.com/watch?v=2hUid81aK-U
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PART 3:
CHAPTER 10:

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 10: 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 10.1 depicts the balance sheet of a commercial bank. Financial instruments issued by others include
any kind of agreement between the bank and an economic unit that promised to pay some monetary
amount(s) to the bank. That economic unit can be a domestic or foreign household (mortgage note or any
other customer notes), company (business credit, corporate securities), or government (Treasuries,
municipals). Financial instruments 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 6 and
Chapter 12 explain that the word “loan” is inappropriate). Chapter 6 studied reserves, which are themselves
a financial instrument as explained in Chapter 19, but are singled out for analytical purposes. Nonfinancial
assets include real estate, computers, and goodwill, among others.

Reserve balances and vault cash Financial instruments issued by the bank
Financial instruments issued by others (accounts, CDs, bonds, etc.)
(“loans and leases”, “securities”) Net worth/Equity/Capital
Nonfinancial assets
Figure 10.1 Balance sheet of a typical commercial bank

Financial instruments 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 6, is to protect the
creditors of the bank, that is, those who hold the financial instruments issued by the bank (you and I for the
accounts, CD holders, etc.).
Figures 11.2 and 11.3 show how the composition of financial assets and liabilities of US banks has changed
since 1945 (quantity of nonfinancial 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, in terms of percentage, 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: they represented about 55% of the liabilities of banks in
2010. Figure 10.2 also clearly shows the rise of the federal funds market from the 1960s (see Chapter 7).
Figure 10.2 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 10.4 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 assets 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. Moneylenders (pay-day loans, etc.) have
also recorded an increase in the proportion of financial assets they hold since the 1970s.
Figure 10.2 Financial assets of US-chartered commercial banks

Note: Other securities includes corporate and foreign bonds, mutual funds shares, corporate shares, and
open-market papers.
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Figure 10.3 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 10.4 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 financial instruments 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 financial instruments issued by banks have a
shorter term to maturity than the financial instruments on their asset side. Banks are involved in maturity
transformation. They accept financial instruments from their customers for which the principal will not be
repaid for a long time. In exchange, they give their customers some financial instruments 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 4) that comes with this balance-sheet
structure, a central bank that provides stable low-cost refinancing channels is crucial.
Some of the financial instruments that banks issue have another interesting property for potential clients.
Chapter 19 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 set up properly. Today, transfers between bank
accounts are done at par, conversions into Federal Reserve note are done at par, 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 financial instruments 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 careful 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 incomes – Other expenses than interest
payments
Net capital gains are 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 (or net interest margin) is the difference
between interest earned on bank assets and interest paid on bank liabilities. Other incomes include fees
and other charges imposed on customers. Net interest income 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
189
80% from about the mid-1940s to the early 1980s (Figure 10.5). Net interest income is the lowest proportion
of profit for the largest banks.
Figure 10.5 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 4 explains that this ratio can
be decomposed into the return on assets (ROA) and leverage (Figure 10.6). 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 10.7). The larger the bank, the higher the leverage (Figure
10.8), 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 an 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 4 explores the concept
of leverage more carefully in terms of its advantages and risks. Chapter 11 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 10.6 ROA, ROE, leverage of all FDIC-insured institutions

Source: FDIC Graph Book
Figure 10.7 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.
191
Figure 10.8 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 financial instruments (credit risk): households,
businesses, and governments may not be able to service their financial instruments, 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 slow down, then one may expect that layoffs will rise and so that
some debtors will have problems servicing their debts. Chapter 7 explains how expected monetary policy
impacts current asset prices and refinancing cost.
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
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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 10.9 shows the impact of credit and market risks. The value of financial instruments 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 11 (in the example a 15% loss on financial instruments 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 10.10 shows the value of non-tradable financial instruments 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
financial instruments of their clients. In general, the larger the banks the worse the performance, that is,
the larger the bank, the higher the proportion of past due loans. This can be explained by looking at Figure
10.7. 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 10.9 Impact of default and/or capital losses
Figure 10.10 Noncurrent loans & leases as a percent of tier-1 capital plus loan-loss reserves
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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 their
profitability and liquidity. 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 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 financial instrument (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 the 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%?
- 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 flexibility 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 comfortable with 40%. The mortgage
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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 “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 expanding 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 financial instruments accepted instead of
the quality of financial instruments. 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 11) and a monetary policy focused on fine-tuning the economy (see Chapter 7), have pushed
banks to move away from a business model that promotes careful underwriting and toward market-share
growth. Figure 10.4 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 first is the loan-officer desk, whose task is to judge the
quality of the projects proposed by potential clients and to tame optimism. The second is the position-
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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’ financial
instruments 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. The Volcker 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 issue financial instruments with more attractive rates. This ultimately
led to the savings and loan (S&L) crisis when savings and loan institutions 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 Volcker experiment, and widespread fraud by top bank managers followed
deregulation.5 Other banks were not immune from the crisis and recorded large defaults (Figure 10.10). The
S&L crisis marks the end of the originate-and-hold banking model.
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Figure 10.11 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 10.5). 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. Financial instruments of customers are packaged and sold to special
purpose entities that fund the purchase by issuing bonds (mortgage-backed securities, collateralized debt
obligations, etc.). Banks make a profit from the fees that come from passing the debt service to the SPEs.
They have been more involved in trading activities, especially top banks that currently get between 6% and
9% of their gross revenue from trading (Figure 10.11).
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1- The main assets of commercial banks are mortgages, consumer credit and other financial instruments 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 tighten sharply during a recession.
9- Banks have moved away from a business structure that involves acquiring non-tradable financial
instruments and keeping them until they mature. Much more emphasis is put on trading securities.
Keywords
Bank profit, financial instrument, 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
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 financial
instruments?
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 a bank is more conservative than its competitors are? Less conservative than them?
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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 11 of the General Theory. Available at https://www.marxists.org/reference/subject/economics/keynes/general-
theory/ch12.htm
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CHAPTER 11:

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 11: 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.
Below are four examples of regulations that must be followed by banks.
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 6). Table 11.1 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.
Requirement
Liability Type
% of liabilities Effective date
Net transaction accounts 1
$0 to $15.2 million2 0 1-21-16

3
More than $15.2 million to $110.2 million 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 11.1 Reserve requirement ratios for the United States.
Source: Board of Governors of the Federal Reserve System
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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 as a buffer for account holders against losses on assets, that is, 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 the 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 have uniform capital regulation across the
world. Table 11.2 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 11.2 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 11.1):

Mortgage notes = $40 (100%) Bank accounts = $104
Municipal bonds = $30 (80%) Capital = $6
U.S. Treasuries = $30 (0%)
Reserves = $10 (0%)
Figure 11.1 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. Thus, 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).
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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 to
improve its 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.
UNDERWRITING REQUIREMENTS
One would think that banks carefully check the creditworthiness of a customer before they accept her
financial instrument. 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 10, 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 blacklist 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. Thus, it turned out regulations had to be put in place to tell bankers what they
are supposed to do!
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This is included in Title 14 of the Dodd-Frank act. It forces mortgagees to determine the capacity to pay off
mortgagors on the basis of other means than the expected refinancing sources and expected equity in the
house. It also forces mortgagees 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 financial instruments should 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
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 11.3 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 11.2
shows that the stability of the banking from 1940 to 1980 also stands out.
Chapter 10 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 rates 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 11.3) and a few large financial holding
companies dominate the industry. 80% of the assets of the banking industry are concentrated in the 595
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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 11.4 shows the recent data about derivative holding
concentration among FDIC-insured institutions; the seven biggest institutions hold 97% of derivative
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.
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 11.3 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
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Figure 11.2 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.
Figure 11.3 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)
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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
December All Other
$4.7 3% 1,400 $105.5
Table 11.4. 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. They
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 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 concerns 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, “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 Congress made large cuts to the
budget of the GAO. These cuts were estimated to reduce the staff of the GAO by 850 employees (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 11.4).
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
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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
11,000 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 regulatory
arbitrage is 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 compete to get the most banks under their wings because
regulators are funded partly through the fees they charge for supervision.
Figure 11.4 Number of employees at the Federal Deposit Insurance Corporation.

Source: FDIC.
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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 4). 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 4), and
of a “black-swan” 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-2000s 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:
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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. In addition, the government also does not have much to say about
the way banks should be managed, the proper underwriting procedures, and the types of assets that banks
should be allowed to hold. Bankers know best.
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 10, 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 non-investment grade securities) in order to reach 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.
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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 10 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 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 19).
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 10).
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 19 studies this categorization more carefully. The main point is that indebtedness is much
less likely to lead to financial instability if it is underwritten on the basis of income (income-based credit).
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 10, 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). Thus must be so 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
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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, and 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 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 11.5).
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, limiting
access to pay-option mortgages to households with enough cash buffer and income, not allowing financial
institutions to create Ponzi-generating financial innovations, and closely regulating 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 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 10).
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Figure 11.5 Homeownership rate in the U.S. (Percent).

Source: U.S. Census Bureau

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 be 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, either the bank is 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. A period of deregulation, desupervision, and deenforcement that has
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.
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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?
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
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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 12:

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 12: MONETARY CREATION BY BANKS
The last two 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. In order to do so,
go back to the balance sheet of banks presented in Figure 10.1. Some of the financial instruments issued by
banks are banks accounts (checking account, savings accounts and others). The following focuses on
checking accounts and the mechanics of creation and destruction of checking accounts. Figure 12.1 shows
a simplified version of the balance sheet of banks.

Reserves Checking accounts
Financial instruments issued by others Other liabilities and equity
Nonfinancial assets
Figure 12.1 Balance sheets of banks
Balance sheet rules provide us a simple way of how banks create and destroy bank accounts:
Checking accounts = Assets – Other liabilities
As such monetary creation will come from banks buying something from non-bank agents, either financial
instruments (mortgage notes, securities, etc.) or physical assets, or paying their non-bank creditors
(payment of salaries of bank employees, payment if interest on savings accounts and other liabilities, etc.).
Monetary destruction will come from banks selling assets to non-bank agents and non-bank agents
servicing their debts to banks. The following explores these ideas in turn and studies some of their
implications.
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 downpayment #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 12.2 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% downpayment), 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
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note that the bank will accept is $417,000 unless the household is able to provide a 20%
downpayment.
#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 10) and is either approved or not.
Figure 12.2 Example of types of mortgage note a bank will accept

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 from what market participants want. The bond will trade at a discount or a premium in that
case (see Chapter 14). 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.
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Unfortunately for #1, there is no active market for its financial instruments, 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 financial
instruments over securities; the issuer is completely bound by what potential bearers require in terms of
the characteristics of the financial instrument (interest rate, term to maturity, etc.).
Figure 12.3 shows what a mortgage note looks like. This legal document 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.” Over the next 30 years, the household promises to pay an annual interest
representing 7.5% of the outstanding note value, and promises 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.
Figure 12.3 A mortgage note
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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
financial instrument, 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:
Bank A
30-year 5% mortgage note of #1: +$100 Bank account of #1: +$100
#1 then pays #2 and, for the moment, 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 T-accounts show 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, the first step occurs when A directly
credits the account of #2:
Bank A
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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 financial instrument of the bank called “bank account” is one type of monetary instrument as explained
in Chapter 19.
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 FINANCIAL INSTRUMENTS 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 6, when studying central banking, “lending” means giving up an asset
temporarily, “I lend you my pen for a minute.” This is clearly not what is happening. Banks are not in the
business of allowing customers to use temporarily 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 during the credit operation is this (as
shown above this operation is in practice combined with a payment operation):
Bank A
One may wonder if there is an indirect lending of reserves. 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 directly or indirectly between A and #1. What a bank does do is
to swap financial instruments with economic units and to make payments for them. Reserves may enter
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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 financial
instruments:
- 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 financial instrument 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 they issue financial instruments. That is the point of finance; it is about banking on the future (see
Chapter 10).
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, that is, at the will of solvent banks, so banks never worry about being unable to get
reserves (see Chapter 7). 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). In addition, 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, bank A
never does this:
Bank A
Bank account of #2: -$100
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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.
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 financial
instruments is unrelated to the quantity of reserves on its balance sheet because a bank pays for them by
issuing its own financial instruments.
There is one case where a bank does need reserves to acquire a financial instrument: 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 9), but it no longer does since 1989.
- If it buys financial instruments from another bank.
In the first case, the balance sheet changes as follows (this assumes 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 9 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.
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POINT 4: THE BANK’S FINANCIAL INSTRUMENT IS IN HIGH DEMAND
Why did #1 enter in an agreement with A? Because nobody else would accept #1’s financial instrument and
a large number of economic units accepts A’s financial instrument (if someone does not, A offers conversion
into cash that most economic units accept in payments). Chapter 19 explains why bank monetary
instruments are widely accepted.
If #2 had been willing to accept #1’s financial instrument then none of the previous agreement would have
been needed. The problems with #1’s financial instrument are twofold:
- There is a credit risk: #2 is not sure that it will be paid the interest due and that it will be able to
make payments to #1 by giving back to #1 its financial instrument. 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 financial instrument for the payment of the house.
Later #2 could use #1’s financial instrument to pay debts owed to #1.
- There is a liquidity risk: the financial instrument 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 a financial instrument that
nobody else will accept.
Bank A’s financial instrument 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 financial instrument can always be converted into Federal
Reserve notes at par, and that the (nominal) value of A’s financial instrument will not fall even if A goes
bankrupt. All this makes the A’s financial instrument free of credit risk and perfectly liquid.
HOW DOES A BANK MAKE A PROFIT? MONETARY DESTRUCTION

Banks are dealers of financial instruments: banks take non-bank non-federal financial instruments and in
exchange give their own financial instrument. Banks make a profit by taking back their own financial
instruments. 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?
#1 can paid this dollar amount via two different means; 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 financial instrument: Bank
A promised to take back its financial instrument 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. 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
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How can household #1 get funds credited to its account?

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 9 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,
and 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.
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
Alternatively, 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
Again, as in the case of a central bank presented in Chapter 6, the bank is not gaining any cash flow from
the transaction. Its profit does not increase the quantity of reserves on the asset side. Profit raises the net
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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. The servicing of debts owed to banks
destroys 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 develop further its credit service because it can now create more
financial instruments because it has more capital to protect its creditors.
The following presents 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 pursue further the provision of credit services. It also
allows a bank to pay its own employees without further lowering its capital position. Thus, if A has one
employee (household #3) who receives a monthly salary of 20 cents, the following is recorded:
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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 6. 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).
Go back to the point where #1 pays #2 and now assume 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
Financial instrument: $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 asset because A cannot operate without it, and the mortgage
note of #1 is not tradable.
2- Getting reserves from a wholesale funding source: borrow fed funds via the fed funds market, via
repurchase agreements, via advances from a FHL Bank, among others (see Chapter 6 for FHL Bank,
and Chapter 7 for the fed funds market and the repurchase agreement market).
3- Getting reserves from the Fed: swap financial instrument with Fed via the Discount Window
4- Recording an overnight overdraft on its reserve balance.
Over time, there will be other means for A to get reserves because:
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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 or will open an account at A
to transfer funds from an account at a competitor
7- The government will make payments to economic units with accounts at bank A (see case 1 above).
However, 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. During the
day, Bank A is automatically granted an overdraft 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
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
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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 9 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 automatically 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 7). 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 6, 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 7, 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 10, by offering to accept financial
instruments 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.
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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 accepts many pay-option mortgages from non-prime
economic units, these units will 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 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 financial instruments:
- The credit standards: if A considers that #1 does not meet the 3Cs of credit analysis, A will not
accept #1 financial instrument 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 11).
MOVING IN STEP
As noted in Chapter 10, 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 other 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 over time. However, as explained in a Chapter 10, things may get out of hand if
most banks aggressively pursue growth in market shares and search for yield.
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:
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- For the central bank: under normal circumstances (see Chapter 7), the main limit to the reserve
creation process is the need to keep 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.
Figure 12.4, 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. Demand for credit by businesses is
very insensitive to interest-rate conditions.
Figure 12.4 The market for bank credit
TO GO FURTHER: A SIDE NOTE ON ALTERNATIVE VIEWS OF

BANKING: THE MONEY MULTIPLIER THEORY AND FINANCIAL
INTERMEDIATION.
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.
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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 7): any unwanted excess
reserves are drained out of the banking system to prevent a fall of FFR to zero. Chapter 6 notes that
banks have very little need for reserves. The Volcker experiment in the late 1970s and early 1980s
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 and is not
constrained, or improved, by the availability of reserves. Bank A had to wait for #1 to show up
before anything could happen. 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:
o 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 7).
o 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.
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- Savers can deposit cash, but savers are not the source of cash, cash comes from the Fed. The Fed
creates cash at the demand of banks so saving does not constrain credit.
1- Banks are not moneylenders because their monetary instruments are their liability not their assets. One
cannot lend one’s own debt.
2- Banks are financial instrument dealers. They take non-bank financial instruments and in exchange give
their own financial instruments. Contrary to most non-bank financial instruments, bank financial
instruments are widely accepted and perfectly liquid.
3- If customers’ default on their financial instruments, 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 financial instruments 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’ financial instrument
because banks think that their customers are involved in activities that are profitable. As such, monetary
creation moves in accord 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 have
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 financial instruments 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, financial instruments, 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: Show the accounting side of a credit operation.
Q2: If a customer comes to ask for a bank credit, what will the bank do? Why?
Q3: When customers service their financial instruments 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?
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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/qb14q1prereleasemo
neycreation.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 Handbook of
Alternative Monetary Economics, 35-51, Northampton: Edward Elgar.
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 Handbook
of Alternative Monetary Economics, 17-34, Northampton: Edward Elgar.
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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PART 4:
CHAPTER 13:

CHAPTER 13: INSTITUTIONAL ASPECTS OF FINANCIAL MARKETS
TO BE WRITTEN
CHAPTER 14:

What influences the pricing of securities
Why pricing securities is about developing a view about the future
How economics can be used to make a pricing decision
That there is more than economics and logics involved in pricing securities
How the interest rate and the price of a security are inversely related
What determines the rate of return
How the sensitivity of balance sheets to changes in interest rates is calculated
The different viewpoints among economists about the efficiency of financial
markets
CHAPTER 14: PRICING SECURITIES
Much has been said about the assets on a balance sheet and about how changes in their value influence
the net worth. It is time to study more carefully how the price of securities are determined, and more
broadly, what influences the valuation of securities. In doing so, the Chapter will illustrate how finance is
about guessing the future through many different means.
A SMALL DETOUR: SAVINGS ACCOUNT AND INTEREST

COMPOUNDING
The typical way to think about interest rates is studying how a savings account works. Suppose Mr. X puts
$1000 in a savings account that provides a one percent annual interest rate. In that case, X will get at the
end of:
- Year 1: $1010 = $1000(1 + 0.01)
- Year 2: $1020.1 = $1010(1 + 0.01) = $1000(1.01)2
- …
- Year 5: $1051.01 = $1000(1.01)5
Several things are worth noticing:
- The rate of return is fixed by the issuer of the account (1%)
- Principal rises over time: The longer X keeps the funds in his saving account, the greater the total
amount of principal due by a bank when X chooses to withdraw all its funds.
- Income rises over time: Interest income earned is automatically added to the outstanding amount
of funds ($1000, $1010, etc.) so income earned changes every year as more funds are accumulated:
$10 the first year, $10.1 the second year, $10.2 the third year…
Most securities work quite differently.
BACK TO SECURITIES
Many securities are standardized financial contracts with the following characteristics:
- Income earned is either fixed (coupon) or unrelated (dividend) to the amount paid to acquire the
security: X earns $10 every year on a bond, X earns $10 of dividend if a profit exists.
- Principal due by issuer at maturity is fixed; it is the face value (typically $1000 for bonds).
Thus, buying a security is equivalent to buying a given future stream of cash flows (income and principal).
The problem becomes figuring out how much one is willing to pay today to get access to these future cash
flows. The answer is that it depends on the rate of return one wants to receive. Contrary to a savings
account, the rate of return can be changed according to the desires of bearers. The following sections work
first with bonds and then generalize the analysis.
A SIMPLE RATE OF RETURN: CURRENT YIELD
At its core, the rate of return measures the reward obtained relative to the effort necessary to get that
reward:
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Rate of return = what you get/what you paid to get it

Therefore, in terms of securities the rate of return is:
Rate of return = monetary benefits provided by a security/price paid for a security
To simplify, one may reduce the benefits to a single coupon earned; this type of rate of return is called the
current yield:
𝐶
𝑖 =
𝑃
For example, if Eric wants to borrow funds from you by issuing a bond with a face value of $1000 that pays
an annual 1% coupon rate for 5 years—a 1% 5-year bond—it means that:
- Each year Eric pays you a coupon worth $10 (= coupon rate*face value = 0.01*$1000)
- At the end of the fifth year, Eric gives you $1000.
Are you willing to give Eric $1000 for the bond?
- If yes, it is means that a 1% reward is high enough for you: you paid $1000 to get $10
- If no, how could you raise the reward without changing the term of the bond (coupon rate, term to
maturity, face value cannot be changed)? Answer: Pay fewer dollars for the bond. If you wish to
have a:
o 4% rate of return, you should pay $250 for the bond to receive $10 every year: $10/$250 =
4%.
o 5% rate of return, you should pay $200
o 10% rate of return, you should pay $100
As you may note, the less you pay the higher the rate of return. The price P paid for the bond at any given
time is positively related to a fixed coupon C, and inversely related to the desired rate of return i that
prevails at any given time:
𝐶
𝑃 =
𝑖
This inverse relationship between the price of a bond and its rate of return holds in cases that are more
complicated and is an important point to remember.
ADDING ONE COMPLICATION: TIME
The previous section studies the pricing of securities from the point of view of one income. Several coupons
may be paid over time and the principal is paid at maturity. Going back to Eric’s bond the stream of cash
flow is:
Year 0 1 2 3 4 5
Cash flow P $10 $10 $10 $10 $1,010
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What should you pay for that stream of cash flows? Again, the answer depends on the rate of return you
want for each cash flow. Assume you are fine with a 1% rate of return, then to get that rate of return on
the cash flow of:
- Year 1, you must pay today approximately $9.9 because $9.9 placed over one year at 1% gives $10:
$9.9(1.01) = $10.
- Year 2, you must pay today approximately $9.8 because $9.8 placed over two years at 1% gives $10:
$9.8(1.01)2 = $10.
- …
- Year 5, you must pay today $960.98 because $960.98 placed over five years at 1% gives $1010:
$951.57(1.01)5 = $1010
One may note that, in order to find the proper amount to pay today for a specific future cash flow, one
must work backward with the rate of return desired. Indeed, given that the future cash flows are known,
the point becomes to figure out what each of these flows are worth today given the desired rate of return.
This is called discounting cash flows, and the discount rate is the desired rate of return. The sum of all the
discounted cash flows until maturity is called the present value, or fair price, of Eric’s bond.
Year 0 1 2 3 4 5
Cash flow P $10 $10 $10 $10 $1,010
10/1.01 = 9.9
+
10/(1.01)2 = 9.8
+
Discounted
cash flows 10/(1.01)3 = 9.7
+
10/(1.01)4 = 9.6
+
1010/(1.01)5 = 961.0
Sum = P = $1000
This is the price that you ought to pay, if a 1% rate of return is satisfactory and you plan to hold the bond
until maturity. Note that, for a desired rate of return of 1%, the fair price equals the face value of the bond.
This is consistent with what was found in the section about the current yield. If you desire a higher rate of
return, you will want to pay less for the bond. For example, if you desire a rate of return of 5%, you should
pay $826.82 (just replace 1.01 by 1.05 in the previous sum).
The rate of return obtained by holding a bond to maturity is called the yield to maturity. Put in
mathematical form:
𝐶 𝐹𝑉
𝑃 = +
(1 + 𝑖 ) (1 + 𝑖 )
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With P the fair price, C the coupon received at time n, N the term to maturity, FV the face value, and i the
yield to maturity. Once again, one may note that a higher interest rate (yield to maturity) leads to a lower
fair price. This can be seen even more clearly for consols or perpetuities, which are irredeemable bonds
(term to maturity is infinite: N tends toward infinity) that pay a fixed coupon. In that case, the fair price of
a consol is:
𝐶
𝑃 =
𝑖
This is similar to what the previous section concluded by using the current yield.
The yield to maturity can be approximated by calculating the total rate of return, that is, the rate of return
that accounts for all the incomes earned, for interest incomes earned on incomes (reinvestment income),
and for capital gains/losses. Using the logic presented in savings accounts, if someone puts $1000 in a
savings account and gets $1050 after 5 years, one gets:
$1050 = $1000(1 + i)5
Solving for i we get:
i = (1050/1000)1/5 – 1 ≈ 1%
Similarly, if a bearer paid $827 to get $1050 after 5 years the rate of return is:
i = (1050/827)1/5 – 1 ≈ 5%
More generally, the total rate of return for n years of placement can be calculated as follows:
Total sum received after selling security

𝑖= −1
Total sum paid to buy security
ADDING ANOTHER COMPLICATION: CAPITAL GAINS OR LOSSES
The previous section assumed that someone decided to hold Eric’s bond until maturity, what if someone
does not plan to do so. What should a bearer pay Eric at issuance to get the bond? Once again, it is all about
calculating a fair price by using the discounted value of cash flows. The first step is to figure out what those
future cash flows are. Assume a bearer plans to hold Eric’s bond for only three years. He will earn three
coupons and then sell the bond at the end of year 3, so the bearer studies the following stream of cash
flows:
Year 0 1 2 3 4 5
Cash flow P $10 $10 $10 + E(P) $10 $1,010
There is a new element that enters into the cash flow stream, the expected resale price E(P). The bearer is
not interested in earning the last two cash flows, although, as shown in a moment, she must care about
them to calculate what she ought to pay for the bond.
Given that E(P) is part of the cash flow stream, the bearer must now formulate a precise expectation to
calculate the fair price. One may wonder how the bearer can formulate this expectation. Should she just
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make up something, or is there a more systematic way to formulate an expectation? As you may have
guessed, the second answer is correct.
At any time, the market price of a bond follows its fair price and the fair price is the discounted value of
future cash flows. At the end of year 3, Eric’s bond will be a two-year bond with two cash flows left to be
paid—$10 and $1010—so the expected resale price should account for these known elements. The problem
becomes to discount these two cash flows. The bearer should use what she currently (year 0) expects other
market participants will desire in terms of rate of return in year 3, E0(i3):
10 1010
𝐸 (𝑃 ) = +
(1 + 𝐸 (𝑖 )) (1 + 𝐸 (𝑖 ))
Thus, the current expectation of the bearer regarding the resale price in three years (E0(P3)) must depend
on her current expectation about the interest rate demanded on Eric’s bond by other market participants
in three years. How can the bearer know what this interest rate will be? She cannot—and she knows her
expectation will most probably turn out to be wrong to some degrees, and she hopes not to be completely
wrong. However, to make an informed decision regarding what price she is willing to pay for the bond, she
must make a guess by using her intuition, some economic analysis, and/or other methods. The following
section shows a real world example.
Once a bearer is armed with the cash flow stream, the only thing left to do is to compute the discounted
value using her desired rate of return. Therefore, if the bearer wants a 1% rate of return over three years
and expects that market participants will want a rate of return of 5% in three years on Eric’s bond, the
bearer makes following calculation:
Year 0 1 2 3 4 5
Cash flow P $10 $10 $10 + E(P) $10 $1,010
10/1.01 = 9.9
+
10/(1.01)2 = 9.8
+
10/(1.01)3 = 9.7
10/(1.05)
+
1010/(1.05)2
E(P) = 925.6
+
925.6/(1.01)3 = 898.4
P = $927.8
At issuance, the bearer should offer to pay $927.8 for Eric’s bond given her expectation about the resale
price and so her expectation about the future interest rate on Eric’s bond. This provides the bearer an
expected rate of return of 1% over three years. She will get $30 of coupons plus the expected $925.6 by the
end of year 3, and will have paid $927.8 to receive that these cash flows: (955.6/927.8) 1/3 – 1 ≈ 1%.
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As noted earlier, expectations rarely turn out to be correct. While the trend might have been guessed
correctly, one rarely gets to make an accurate prediction of the timing or the actual value of a variable. The
bearer assumed that interest rate on Eric’s bond would rise from 1% to 5%. What if at the end of year 3:
- The interest rate went up but only to 3%. In that case, the resale price of the bond is higher than
expected ($990) and the total rate of return is higher than expected.
- The interest rate went up more than expected, say 10%. In that case, the resale price is lower than
expected ($926.44) and so the total rate of return does not reach the desired 1%.
- The interest rate went down to 1%. In that case, the bond can be sold for $1000 instead of the
expected $925. Total rate of return is much improved.
A REAL WORLD APPLICATION: QE, DEFICIT AND RATE ON TREASURIES
As explained in the previous section, unless one plans to hold a security until maturity, one must make some
expectations about the price at which a bond can be sold. The Great Recession led to large injections of
reserves (see Chapter 6) and to the rise of the fiscal deficit to historical highs for the post-WWII period. A
common view among bond-market participants and others was that these monetary and fiscal policy trends
would generate a rise in the interest rate on Treasuries. The economic logic was based on the money
multiplier (see Appendix to Chapter 12), the quantity theory of money (see Chapter 23) and the crowding
out effect (see Chapter 15), which led market participants to conclude that inflation risk and fiscal risk had
risen and so interest rates on treasuries would rise in the future. This means that they expected bond prices
to fall.
Armed with this logic and a set of expectations some decided to anticipate the rise in Treasuries rate. They
did so by implementing a portfolio strategy that involved selling their treasuries, to avoid capital losses,
and/or taking a short position (see Chapter 3) on Treasuries, to profit from the expected fall in the price of
Treasuries. Unfortunately for them, interest rates on Treasuries fell overall afterward and inflation never
materialized. They forgo capital gains (if they sold their Treasuries) or recorded potential capital losses (if
they took a short position on Treasuries). As explained in Chapter 7, Chapter 9, Chapter 12 and Chapter 23
and Chapter 24, their economic argumentation was unsound. Not only are inflation and interest rate loosely
related, but also nominal interest rates on Treasuries are largely driven by the monetary policy stand not
by the fiscal stand. As explained below, however, one must be careful to think that a sound economic
argumentation can always provide a winning portfolio strategy because many other factors influence what
goes on in financial markets.
CONCLUSION
There are two direct ways to obtain a reward from taking a position in a security. First, financial instruments
embody a promise to make future monetary payments in terms of income and repayment of the principal.
Second, one may also be able to make a capital gain by reselling the security before it matures. Thus, before
someone decides if taking a position in a security is worthwhile, one may ask several questions such as:
- Will the issuer be able and willing to fulfill his promise? One may want to judge carefully the
creditworthiness of the issuer, especially if one plans to buy and hold the security for a long time
so that income payments are the main reward. If the creditworthiness of the issuer is shaky, one
will ask for a higher rate of return, which lowers the price of the securities issued by the issuer.
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- Will it be possible to make a capital gain? How big will it be? One may be more interested in
speculating, that is, to bet about the direction of the price of a marketable financial instrument in
order to make a capital gain. As explained in Chapter 3, this can be done by taking a short position
(if one bets that price will fall) or a long position (if one expects that price will rise).
- How long am I willing to hold a given financial instrument (either to speculate or to hold)?
- What is the rate of return on asset that I want to get? As noted above this is a crucial question and
as explained in Chapter 4, this question can be combined with a decision about the proper amount
of leverage to use to get a desired rate of return on equity.
By answering some or all these questions, one can determine at what price a financial instrument should
be bought. The general formula for the fair price of a financial instrument is:
𝐸 (𝑌 ) 𝐸 (𝐹𝑉 )
𝑃 = +
(1 + 𝑖 ) (1 + 𝑖 )
Where the subscript t indicates the present time, Pt is the current fair price, 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, it is the current discount rate imposed by bearers, N is the time
lapse until maturity (n = 0 is the issuance time). A wide variety of financial instruments uses this formula.
One can classify financial instruments according to the term to maturity (Figure 14.1).
Figure 14.1 Financial instruments and term to maturity

Note: C is the coupon
At one extreme are modern government monetary instruments that provide no income (Y = 0), have a zero
term to maturity (N = 0, they can be redeemed instantaneously), and are universally expected to be taken
back by the government at their initial face value at any time, Pt = FV0 (see Chapter 19). At the other extreme
are consols that pay a given coupon and have an infinite term to maturity, Pt = C/it. At the other extreme
are also stocks. Assuming that a stock pays an initial dividend D0 that grows over time at a given rate g, the
fair price of the stock is:
𝐷 (1 + 𝑔)
𝑃 =
(𝑖 − 𝑔)
If a collateral exists, in case of default, the fair value depends on the expected ability of the creditors to
recover some of the unpaid dues embedded in a promise. Thus, in case of default, the maximum fair value
is equal to the expected value of the collateral and available recourse.
Note that the fair price is only the price at which a financial instrument ought to trade; it is may not be the
price at which a financial instrument trades—the market price. A discrepancy between the market price
and the fair price can emerge because of the financial infrastructure in place to trade securities is not well
developed, or, for example, because market participants do not have all the information needed to make
an informed decision. A discrepancy may also exist because of the simplifying assumptions made to get a
neat mathematical expression of the fair price. For example, the previous formula for the fair price of stocks
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assumed that the growth rate of dividends is forever constant. Finally, a discrepancy will exist because what
is fair to pay depends on the holding period and desired interest rate, and not all market participants have
the same holding period and desired interest rate.
The central point that this formula brings forward is that expectations about the future are central to
determine what financial market participants are willing to pay for a security. If speculative behaviors
dominate, E(P) is what financial market participants focus on to determine P; guess the future mood and
view of market participants. If an entrepreneur approach to portfolio choice dominates, E(Y) is the main
focus of market participants: buy-and-hold strategy to earn income over long run.
The i, E(Y), E(P) are impacted by credit risk, liquidity risk, solvency risk, inflation risk, tax risk, recession risk,
monetary-policy risk, and many other risks—real or imagined—perceived by market participants. As such,
P can fluctuate widely and changes frequently as views about i, E(Y), and E(P) change constantly. In markets
where traders are very active, P will fluctuate with the mood of the time, technical problems (if automated
trading is dominant), and many other non-economic reasons including the proportion of speculators and
the proportion of income-seeking participants.
What this suggests is that it is impossible to predict P (and so i) on a specific security. While one may use
sound economic and financial arguments to make a prediction, most market participants may not agree
with that argument, or may have a different argument that involves an opposite prediction. In that case, P
will tend to be influenced by the dominant view, which may not be the correct view in terms of intellectual
soundness. While financial market participants who used a sound economic and financial logic to make
their portfolio choice will usually end up being vindicated, it may take years for that to happen if they are
not the dominant view in a market. As the saying goes, the market can stay irrational longer than one can
stay liquid and solvent.
As such, some market participants may not be interested in brainstorming about fair prices, and may prefer
to use pattern recognition to try to determine if they should buy, hold, or sell a financial instrument. The
chartist approach is such view. Followers of this approach study charts of past price behaviors to determine
how the price will behave in the future. Certain patterns are supposed to be clear predictor of an upcoming
sharp change in the price; one just needs to recognize the pattern in time. In the end, financial market
participants use all sorts of strategies and methods to implement their portfolio strategies, and they have
all sorts of opinions about the different risks at play.
WHAT IF THERE IS NO COUPON? ZERO-COUPON SECURITIES

Some securities, such as T-bills or commercial paper, do not pay any coupon. In that case, the valuation of
the fair price is done purely with the discounted face value of the security:
𝐹𝑉
𝑃 =
(1 + 𝑖 )
As long as the interest rate is positive, the fair price will be below the face value. The fair price converges
toward the face value as the term to maturity gets closer to zero. Bearers are rewarded by making a capital
gain that is bigger the closer to issuance they buy the security.
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DISCOUNT, PAR, PREMIUM AND ARBITRAGE BETWEEN

SECURITIES
The face value is the price at which the issuer will redeem its financial instrument when it matures. It is
usually inscribed on the face of the financial instrument but not always as explained in Chapter 19. The
market price of a security—the price at which it circulates among bearers—is usually different from the
face value. If, to simplify, one assumes that the fair price and market price are the same, then three
situations are possible:
- If P > FV: A security trades “at a premium.”
- If P = FV: A security trades “at par” or “at parity.”
- If P < FV: A security trades “at a discount.”
One may wonder why a security would sell at a premium. That is, why would someone be willing to pay
more today than the principal that will be received at maturity? Someone may pay $1200 for a bond with
a face value of $1000. One reason is that coupon rate on the bond is higher than current interest rate (which
is the currently desired rate of return), so market participants are willing to pay more for the bond. Another
reason is that the central bank intervenes to ensure that capital gains can be made by others, and is willing
to record capital losses at maturity.
For example, assume that all bonds have a face value of $1000 and all bonds carry the same credit risk. In
January 2017, Corporation X issues 10% 5-year bonds, that is the coupon rate is 10% (and so the coupon is
$100) and the term to maturity is 5 years. At that time, the interest rate on bonds is also 10% so X is be able
to sell its bonds at par ($1000) and bearers get a 10% rate of return, just what they desired. After January
2017, the corporate bond rate falls to reach 5% by January 2018, so corporations now issue bonds that pay
a lower coupon rate (say 5% and so $50 of coupon). While the desired rate of return has fallen, the coupon
rate on the bonds issued by X in 2017 is still 10%. As such, there is a high demand for them, which raises
their price. The question becomes to figure out by how much the price will rise.
The general answer is that the price will rise until financial market participants are indifferent between
buying the 10% bond and a 5% bond. Remember that the rate of return is what you get for what you paid.
Thus, a quick dirty answer to the question can be provided by using the current yield: the price of the 10%
bond will have to rise to $2000 because getting $100 for $2000 is equivalent to getting $50 for $1000. This
is, of course, a simplification because one needs to calculate the fair price to get a full answer that accounts
for time. In January 2018, the bond issued by X in January 2017 is now a four-year bond, which means that
its fair price, if held to maturity, is:
100 1000
𝑃 = + = $1,127.30
(1 + 0.05) (1 + 0.05)
The January 2017 10% bond issued by X sells for $1127 in January 2018. This provides a rate of return (as
calculated by the yield to maturity) of 5%.
The act of buying and selling securities in order to equalize rate of return is called “arbitraging.” Arbitrage
is an important portfolio strategy for market participants who are always on a look out for securities with a
price that is inconsistent with the desired rate of return of the moment. With computers, this kind of activity
involved millisecond (or less!) price deviations and thousands of trades in the blink of an eye.
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BUBBLES OR NOT: ARE FINANCIAL MARKET EFFICIENT?

One question that has kept some economists busy for a few decades is whether financial markets are
efficient. The Bank of Sweden recently decided to award its prize to economists with very different views
on the question: Eugene Fama (who argues that they are) and Robert Shiller (who argues they are not). This
question is especially important for economists who work in the framework of a real exchange economy
that sees markets as the central mechanism to allocate correctly scarce resources (see Chapter 22). If
markets are efficient, they are able to collect all the relevant information to price securities, and so market
participants are able to make informed portfolio decisions. In the process funds are transferred from savers
to investors, and economic activities that are the most efficient (that is the ones are able to produce a given
amount of output with the least amount of inputs) receive funds. Non-efficient economic activities do not
receive funds and market processes weed them out.
The efficient market hypothesis (EMH) comes in different forms. The strong form argues that all private
(confidential information that only the managers of a firm know) and public information are included in the
pricing mechanism. The semi-strong hypothesis argues that only publicly available information is included.
The weak form focuses on a subset of publicly available information—namely past prices of securities—and
argues that markets are efficient if the prices of securities cannot be predicted in the short-run by using
past prices. Prices of securities move in a random fashion as information arrives randomly. Fama argues
that evidence for the weak and semi-strong hypotheses are mostly favorable. Shiller argues that this is not
the case.
An implication of the efficient market hypothesis is that the price of a security cannot deviate at all (for the
strong hypothesis) or for a long time (for the weak hypothesis) from its fundamental value. Another
implication is that it is impossible to predict the price of securities by using past prices because past and
future prices are independent from each other. This is quite the opposite conclusion to the chartist
approach that sees all sorts of patterns in past prices that indicate future price trend.
The fundamental value is the one that reflects all the relevant information necessary to price a security—
dividends for stocks, coupons for bonds. Even capital gain expectations are only a reflection of future
income payments, so one can assume that the fair price is just a discounted sum of future incomes, and the
fundamental value V is:
𝑌
𝑉 =
(1 + 𝑖 )
There is, however, a deeper reason why this is called the fundamental value. The incomes (Y) are supposedly
driven by what economists of the real exchange economy framework see as fundamental economic forces,
technology, time preference, and the amount and allocation of resources. Market prices reflect the “true”
supply-side economic conditions of an economy, and so provide a clear means to allocate scarce resources.
Markets allocate correctly resources as long as market prices equal their fundamental value.
This fundamental value is supposed to be a strong attractor for the fair price (P moves toward V). While
bubbles—deviation of the fair price from the fundamental value—are possible at least in the weak form of
the EMH, they do not last and are marginal. Markets tend to self-correct quickly because of arbitrages by
speculators. Speculators are a stabilizing force as Friedman (1953: 175) argued: “People who argue that
speculation is generally destabilizing seldom realize that this is largely equivalent to saying that speculators
lose money, since speculation can be destabilizing in general only if speculators on the average sell when
the [security] is low in price and buy when it is high”. Speculation corrects price misalignments because
well-informed speculators are supposed to be rational agents who act upon the information available to
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calculate the fundamental value of an asset. If P > V speculators expect that the price will go back to its
fundamental value; therefore, they anticipate capital losses by selling the assets for which this is the case.
This decreases the market price and brings it back to its fundamental value. Inversely, when P < V,
speculators anticipate capital gains by buying the assets concerned, which increases P and brings it back to
V. Thus, well-informed speculators complement market participants seeking to keep securities in their
portfolio, which help to speed up the adjustment process in imperfect markets. Speculators that do not act
on that basis are eliminated by market mechanism as they record losses.
As discussed in Chapter 22, quite a few economists have disagreed, not only with the characterization of
economics as the study of allocation of scarce resources, but also with the view of an economy driven by
supply-side factors that are supposed to be independent from demand factors. The fundamental value is
not a strong anchor and can be influenced by current price conditions (V moves toward P). They have also
disagreed with the role that this view gives to financial markets and how participants operate in that
market.
John Maynard Keynes, who was an economist and a financial manager, among other things, summarized
his own view on the topic by using the analogy of a beauty contest. In a traditional beauty contest, each
judge is asked to select the most beautiful woman according to his/her own opinion. This is equivalent to
financial market participants trying to pick the securities based on fundamentals. One must evaluate
carefully the creditworthiness of an issuer by working through accounting documents, by getting a grasp of
the competence and character of the managers (perhaps by meeting them or by reading about them), by
understanding the business model and potential competitors, among others. Then, one needs to wait
patiently for years to earn accumulate some incomes. Put differently, buying and holding securities for the
long run makes someone equivalent to an entrepreneur, because the financial success of that person
depends on the success of the business.
Keynes argues that most financial market participants do not behave that way when they make portfolio
choices (although Keynes himself apparently did follow that type of decision-making process). Most people
do not want, or do not have the time and knowledge, to do that. There are three reasons for this. First is
human nature, second is competition, and third is the existence of liquidity. In terms of human nature, not
only is it tedious and time consuming to evaluate the creditworthiness of issuers, but also most humans are
driven by the thrill of speculation and the quick results that gambling can provide. These quick results, if
positive and large, may create envy and remorse from those who preferred to wait patiently, and may drive
them to change strategy and become speculators rather than entrepreneurs.
Second, competition is strong among financial market participants, those that record the highest short-
term rate of return will gain clients, while those that are behind will lose clients. If speculative behaviors
provide the highest short-term rate of return, as they tend to do in good times, financial market participants
will adopt them. Portfolio managers (pension funds, mutual funds, etc.) do see large movement of funds in
and out of their firm depending on quarterly results, even if their placement strategy is based on long-term
results. Warren Buffet provides another example of the pressure of competition and search for quick
results. In the late 1990s, the price of the dot.com stocks (Amazon, etc.) was growing very rapidly allowing
holders to make huge capital gains. Mr. Buffet refused to buy stocks of dot.com companies on the ground
that they were not making any profit and the business model was not well established. The share of his
business conglomerate, Berkshire Hathaway, fell during that period as shareholders left to find portfolio
managers that would place funds in dot.com companies. Mr. Buffet did not mind, his business has the
financial strength to sustain short-term swings in financial moods, and the dot.com bubble burst proved
him right; but he had to forego massive potential capital gains during the boom years, which most market
participants are unwilling or unable to ignore.
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Finally, beyond human nature and competition, it is risky to follow an entrepreneur-like portfolio strategy.
The liquidity of securities helps lessen that entrepreneurial risk (one can sell quickly if not satisfied with the
performance of a security), but the existence of that liquidity ends up influencing portfolio choices. One
reason is that liquid market promote speculative behaviors because it is easier to make quick capital gains.
Another is because of the uncertainty of the future and the liquidity risk that exists from holding securities.
For example, one may be willing to wait patiently but suddenly may need to sell securities to meet
unexpected expenses. If, at that time, prices of securities are very low (for reasons that may or may not be
related to the performance of their issuers), it may be difficult, if not impossible, to meet expenses and one
may become insolvent. Thus, individuals must account for expected short-term price direction even if they
do not make portfolio decisions mostly based on that criterion. They do so because, unlike Warren Buffet,
they usually do not have the financial means to wait for the price to go back up; their savings are too small
so they must sell at a loss.
Thus, for all these reasons, Keynes notes that financial markets do not behave like a traditional beauty
contest, and it is rational for them not to behave that way. In Keynes’s beauty contest—which encapsulates
his view about how financial market participants behave—each judge is asked to figure out what the
average opinion of the other judges is about the most beautiful woman. This is quite similar to the chartist
approach that wants to predict future prices (and so future average opinion) out of past prices. Keynes
notes that some market participants may even be concerned with guessing what the average opinion thinks
the future average opinion will be, and so on. It is quite a self-referential behavior, far removed from the
painstaking and cold analysis of the issuer’s creditworthiness. Thus, speculation is a destabilizing force that
is not eliminated by market mechanisms but rather promoted by them. Keynes concluded, “Speculators
may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise
becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a
by-product of the activities of a casino, the job is likely to be ill-done” (Keynes 1936, 159). Activities in
financial markets may become only remotely related to what goes on in terms of economic activity
(production, consumption, investment), and financial markets may become a giant gambling machine. The
financialization of the economy further reinforces this disconnection, and Chapter 2 showed that the stock
market in the United States is not a net provider of funds to businesses.
TO GO FURTHER: DURATION AND CONVEXITY

This Chapter explains what the price level of a security ought to be and what influences that price level.
While this is a central concern of financial market participants, an equal concern is to figure out how
sensitive the price of a security is to changes in interest rates. The Chapter shows that if the desired rate of
return of market participant changes, there is some implications for the pricing of securities and some of
them may end up trading at a premium, while others may end up trading at a bigger discount. Market
participants who want to hold securities, and those looking to make capital gains, want to get an idea of
how much the price will change.
More broadly, financial institutions are interested in knowing how the net worth of their balance sheet will
change if interest rates change because securities on the asset and liability side of their balance sheet may
be marked to market. For example, if interest rates go up the market price of securities will fall, and so the
value of assets and liabilities will fall. Depending on how sensitive the value of securities held (assets) is
compared to the value of securities issued (liabilities), net worth may go up, down or stay unchanged.
To calculate this sensitivity, one needs the duration on a bond. Start with the fair price formula:
253
𝐶 𝐹𝑉
𝑃= +
(1 + 𝑖) (1 + 𝑖)
Take the first partial derivative:
𝜕𝑃 −𝑛𝐶 −𝑁 × 𝐹𝑉
= +
𝜕𝑖 (1 + 𝑖) (1 + 𝑖)
Factorize by 1/(1 + i):
𝜕𝑃 1 −𝑛𝐶 −𝑁 × 𝐹𝑉
= +
𝜕𝑖 (1 + 𝑖) (1 + 𝑖) (1 + 𝑖)
The (Macaulay) duration DUR is the ratio of the time weighted discounted cash flow and the discounted
cash flow:
𝑛𝐶 𝑁 × 𝐹𝑉
∑ +
(1 + 𝑖) (1 + 𝑖)
𝐷𝑈𝑅 =
𝑃
The ratio measures a number of years. One may note that for zero-coupon bond (C = 0), the duration is the
term to maturity (N).
Taking the formula of duration and substituting in the first-order derivative, it follows that:
𝜕𝑃 1
=− × 𝑃 × 𝐷𝑈𝑅
𝜕𝑖 (1 + 𝑖)
Alternatively:
𝜕𝑃/𝑃 1 + 𝑖 1+𝑖
𝐷𝑈𝑅 = × =𝑒 / ×
𝜕𝑖/𝑖 𝑖 𝑖
Thus, the duration reflects the elasticity of price to interest rate.
If one wants to know by how much percentage wise the price of a security changes following a change in
the interest, someone calculates:
𝜕𝑃 𝐷𝑈𝑅
=− × 𝜕𝑖
𝑃 (1 + 𝑖)
is called the modified duration and is used to measure percentage changes in the price following a
( )
one percentage point (100 basis points) change in the interest rate (∆i = 0.01).
If someone wants to know approximately by how much the price level of a security changes following a
change in the interest rate, one calculates:
𝐷𝑈𝑅
[𝜕𝑃] =− × 𝑃 × 𝜕𝑖
(1 + 𝑖)
× 𝑃 is called the dollar duration, it measures the absolute changes in the price following a 1 percentage
( )
point change in the interest rate. It is the product of the modified duration and the price level of the bond.
For example if the 1% 5-year bond is currently trading at parity and the interest rate rises by 50 basis points,
then one can calculate the approximate impact on the price of the bond as follows:
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- Interest rate went from 1% to 1.5% so ∆i = 0.005

- P = $1,000
- i = 0.01 so 1 + i = 1.01
- The sum of time weighted discounted cash flow is 4,901.97:
𝑛 × 10 5 × 1000
+ = 4,901.97
(1 + 0.01) (1 + 0.01)
- DUR = 4,901.97/1,000 = 4.90197 years

- Modified DUR = 4.90197/1.01 = 4.85, that is, a 1 percentage point change in the interest rate leads
to a fall in the price of the bond by 4.85%.
- Dollar DUR = -4.90197/1.01 x 1,000 = -$4,853.46, that is, a 1 percentage point change in the interest
rate leads to a fall in the price of the bond by $48.53.
So the price of the security falls by ∆P = -$4,853.46 x 0.005 = -$24.27, which represents a 2.4 percent fall in
the price of the security, following an increase in the interest rate by 50 basis points. Quite a dramatic fall
for such a small change in the interest rate. For larger changes in the interest rate (derivatives deal with
infinitely small changes) and longer maturity (which increases the convexity of the hyperbola linking P and
i), a better approximation of the change in the price of a bond can be obtained by calculating the convexity
of the bond. The convexity involves the second-order derivative of the price relative to the interest rate.
Adding the duration and convexity provides a better measure of how the price of a financial instrument
responds to change in interest rates.
Thus, if the duration of liabilities and the duration of assets are different, a balance sheet is subject to an
interest-rate risk, that is, a rise in interest rate may negatively impact net worth. Some economic units may
want to make sure that the price of the securities they hold and the price of the securities they issued are
approximately equally sensitive, which ensures that net worth does not change significantly with changes
in interest rates. Matching the duration of assets and liabilities, or at least mitigating their difference, is an
additional concern of financial institutions to matching the liquidity of assets and liabilities and matching
the term to maturity of assets and liabilities.
1- A typical security pays a given income periodically and the principal is repaid at once at maturity.
2- To change the rate of return on a security, bearers change the prince they pay for the security.
3- The rate of return is what you get for what you paid. What you get is fixed so changing the rate of return
involves changing what you pay.
4- The desired rate of return on securities that prevails in the market is called the interest rate.
5- The price of a security moves inversely with the interest rate.
6- The fair price is influenced directly by expectations regarding income payment and the price of the
security, as well as by changes in the desired rate of return. Expectations and desired rate of return change
with changes in views about the economy, change in the mood of market participants, and other factors
that may or may not be related to economic events.
7- Some economists argue that financial markets are efficient while other argue that they are not.
8- To measure how the net worth is impacted by a change in the interest rate, one can calculate the duration
of a security.
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Keywords
Current yield, yield to maturity, fair price, discount rate, present value, total rate of return, rate of return
on asset, rate of return on equity, chartist approach, bubble, efficient market, zero-coupon security,
discount bond, premium bond, arbitrage, fundamental value, duration, interest-rate risk.
Review Questions
Q1: Why is the rate of return inversely related to the price of a security?
Q2: Finance is always trying to guess the future, explain how this applies to the valuation of securities.
Q3: How does default risk impact the valuation of securities?
Q4: If interest rates are expected to fall in the future, will the price of a security issued at a coupon rate
consistent with today’s interest rate rise or fall? Explain your answer.
Q5: Why is the efficient market hypothesis important for the real exchange framework?
Q6: Is speculation stabilizing or destabilizing?
Q7: Why would market participants prefer to speculate instead of buying and holding securities?
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CHAPTER 15:

That there are competing theories about what determines the nominal
interest rate
The role of monetary policy in influencing the nominal interest rate
The impact of fiscal policy on the nominal interest rate
The role of monetary and real factors in determining the nominal interest rate
Why having a central bank that stabilize interest rates can be beneficial
CHAPTER 15: THE INTEREST RATE
In Chapter 14, a lot is said about the role that the rate of return on financial instruments—the interest
rate—plays on the pricing on securities, but little is said about what determines that rate of return. Two
competing theoretical frameworks explain what influences the interest rate, one of them emphasizes the
role of real factors and the other emphasizes monetary factors.
REAL THEORY OF INTEREST RATE: NATURAL INTEREST RATE AND

EXPECTED INFLATION
GROSS SUBSTITUTION AND INDIFFERENCE CONDITION: DETERMINANT OF

THE NOMINAL INTEREST RATE
The real exchange framework (Chapter 22) emphasizes the role played by real variables in the decision-
making process of any rational economic unit. People are not fooled by mere improvement in monetary
income because they only care about improvement in purchasing power given that only consumption
provides utility. Monetary instruments have no other purpose than to smooth market transactions, and
preoccupation about the liquidity of balance sheets and monetary outcomes are irrelevant. Capitalism is
equivalent to a barter economy that uses monetary instruments.
In the early 1900s, Irving Fisher provided a theory of the interest rate that is consistent with that framework.
The theory starts with each economic unit maximizing its intertemporal utility by modifying its
intertemporal real income to fit its preference in terms of intertemporal consumption. An economic unit
does so by trading assets that earn a return while they are held. An economic unit buys assets that provide
the highest rate of return and sells others. This arbitrage leads to an equalization of rates of return, at which
point an economic unit is indifferent about holding any asset and so stops trading them.
A central hypothesis is that all assets are perfect substitutes, so economic units are merely concerned with
acquiring assets that provide the highest rate of return. The liquidity of assets is of no concern because
there is no uncertainty. There exists a market for all potential future contingencies, including default, and
so an economic unit can optimize its portfolio position in order to account for them. As such, assets like
household appliances, houses, furniture, clothes and other goods and services are as reliable means to store
value as financial instruments.
This microeconomic logic is generalized to the macroeconomic level. At that level, there are only two assets:
a monetary asset and a non-monetary asset called aggregate income (think of “potato”). The monetary
asset provides a rate of return when it is lent. Aggregate income provides a rate of return when it is invested,
that is, used to grow productive capacities (plant the potatoes). The rate of return on aggregate income
comes in the form of additional aggregate income (more potatoes). In order to be able to compare the rate
of return on both assets, one must use a common unit by calculating the nominal rate of return on real
aggregate income. Once the two monetary rates of return are known, economic units perform an arbitrage
between these two assets. The arbitrage continues until economic units are indifferent between monetary
and non-monetary assets, which occurs when the nominal rates of return on both assets are equal:
it = rt* + Et(gP)
The rate of return on monetary assets is the nominal interest rate i. r* is the real rate of return on aggregate
income, also called equilibrium real interest rate or the natural interest rate. Et(gP) is the current expectation
about future inflation (gP is the growth rate of output price). rt* + Et(gP) is the expected monetary rate of
return on aggregate income. One may note that the nominal rate of return on aggregate income does not
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include capital gains but merely the monetary reward of physical income. This is consistent with the
framework of the efficient market hypothesis and its focus on fundamental value (see Chapter 14).
If i is lower than rt* + Et(gP), it means that the cost of credit is lower than the nominal return on physical
assets. In that case, deficit-spending economic units have an incentive to invest by borrowing monetary
assets from savers (banks are merely intermediaries between savers and investors, see Chapter 12). The
increase in spending leads to inflation, which pushes up the interest rate until it is equal to the expected
monetary rate of return on real aggregate income. If i > rt* + Et(gP), borrowing falls, inflation falls, and so i
falls until both rates of return are equal (Figure 15.1). Thus, in this theoretical framework, i adjusts to rt* +
Et(gP) ; it is a real theory of interest rate. The following studies how each component of the monetary rate
of return on aggregate income is determined.
i
i
i > r* + E(gP)
r* + E(gP)
i < r* + E(gP)
I1 I* I2 I
Figure 15.1 Adjustment mechanism in the real exchange economy framework
INFLATION EXPECTATIONS
In terms of expected inflation, the theory of inflation associated with the real exchange economy
framework is the quantity theory of money (Chapter 23):
gP = gM – gQfe
If the central bank loosens its policy—either through a higher reserves growth rate (see money multiplier
theory in Chapter 12) or by lowering its interest rate—the growth rate of the money supply rises (gM goes
up) and so inflation rises (gP goes up) because economic growth stays at its natural growth rate (gQfe). In
short, too much money chasing too few goods causes inflation. As such, expected inflation depends on
expected future monetary conditions and, if the central bank injects large amounts of excess reserves
(Chapter 6), one can expect higher inflation and so higher interest rates:
E(gP) = E(gM) – gQfe
THE NATURAL RATE OF INTEREST
The natural rate of interest is the interest rate that keeps prices stable; in other words, it is the interest rate
that leads to no inflation or deflation (gP = 0%). The natural rate of interest is set in the loanable funds
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market (Figure 15.2). According to the real exchange economy framework, the loanable funds market
approximates financial markets. As explained in Chapters 14 and 22, in the real exchange economy
framework, one can study capitalist economies as if they are barter economies, and financial markets are
just a means to perform intertemporal barter in order to adjust intertemporal consumption according to
someone’s preferences. Financial markets are just a means for economic units with a surplus of
commodities (the savers) to lend them to economic units with a deficit of commodities (the investors).
While all transactions are done in monetary forms, what is transferred is purchasing power and so
ultimately goods and services. Savers give up present consumption so that some goods and services can be
allocated to increase the future production of goods and services (investment). Savers are rewarded for
their patience with more consumption in the future and so saving is merely a signal of future consumption,
which encourages firms to invest today to meet that future consumption. The role of financial markets is
to find the equilibrium interest rate that ensures that saving equals investment, that is, that to ensure that
output grows enough to satisfy desired future consumption. To see this more clearly, the following studies
each curve in more detail.
r S
r*
S, I
Figure 15.2 The loanable funds market
On the supply side are savers. Economic units receive an income, and have to decide if they should consume
now or later. In order to decide about the mix of present and future consumption, economic units do not
make a random decision. Their aim is to find the optimal mix, that is, the mix that maximizes their utility
(happiness) over time. Economic units do so by comparing the reward they can get from saving one more
dollar, to the pain induced by saving that additional dollar (delaying consumption is painful). They do this
calculation for each dollar. The reward for saving one more dollar is the real interest rate r, some additional
consumption in the future that is worth a certain amount of utils. The pain of saving one more dollar is the
marginal disutility of waiting, which depends on the patience of each economic unit: individuals who are
spendthrifts feel greater pain and their pain rises faster than individuals who are frugal. The supply of saving
is upward sloping because the pain increases as more saving is done so the reward for saving more must be
increased. The supply curve is also convex, which reflects the acceleration in the pain felt.
On the demand side, there are investors who, to simplify, are considered to be businesses. Remember that
investment in macroeconomics means building productive capacities (buying machines, increasing human
capital by getting an education). Investing is expensive so economic units who want to do so need to borrow
funds from savers. These borrowed funds allow investors to buy the commodities that savers agree to let
go at the present time. Once again, there is a calculation to perform in order to find the optimal level of
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investment, which is the level that maximizes the real profit of firms. Businesses do so by comparing the
benefit of investing one more dollar to the cost of investing that additional dollar. The reward is more
output and this additional output is called the marginal product of capital, which is the output produced by
one additional machine. The cost of investing one more dollar is the real interest rate; investors must give
away some of the additional output produced in order to pay the interest income due to savers. Debt
payments are measured in real terms and potentially performed in real terms (Chapter 22). The demand
curve is downward sloping because the marginal product of capital falls as investment increases so the
interest rate must decrease to make an additional investment profitable. The demand curve is also concave
to reflect the fact that the marginal product falls more rapidly as investment increases.
From this presentation, one can conclude that two main factors influence the natural interest rate, time
preference (patience of individuals) and technology (marginal product of capital). Monetary conditions
have no influence on the natural rate. If individuals become less patient, they save less for each level of
interest, that is, one must reward individuals more to save the same amount (Figure 15.3). The natural rate
of interest rate increases with lower patience (higher preference for present consumption). If the marginal
product of capital rises, the investment curve shifts higher because each level of investment provides a
higher real benefit and so is more profitable in real terms. A higher marginal product of capital leads to a
higher natural rate.
r S1 S
r1*
r*
S, I
Figure 15.3 Impact of a higher impatience (higher preference for present consumption)
Beyond variables related to the decision-making process of private economic units, another factor that
influences the natural rate of interest is fiscal policy. When the government deficit spends, it needs to
borrow some of the available saving and so enters into competition with the demand for funds by investors.
This pushes up the natural rate of interest and so discourages private investment (Figure 15.4). The
crowding out of private investment reduces economic growth (see Chapter 22).
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S
r1*
∆r > 0
r*
I + DEF
I1* I* = S* S1* = I1* + DEF

∆I < 0
Figure 15.4 Crowding Out Effect
IMPLICATIONS OF THE THEORY
The real theory of interest rate has several implications in terms of the regulation of financial markets, the
role of monetary policy, the conduct of fiscal policy, and the promotion of economic growth.
In terms of deregulation, the government should not be involved in setting interest rates. Chapter 3 and
Chapter 7 have explained that the government is heavily involved in managing interest rates, by setting
them or by lowering them. Economists of the real exchange framework see this involvement as a direct
cause of financial instability. For example, according to them, the central bank and government-sponsored
enterprises were major drivers of the early-2000s credit boom that translated into a housing boom. The
Federal Reserve kept its policy rates too low for too long, Fannie Mae and Freddie Mac (Chapter 3) helped
keep mortgage rates artificially low. Both have encouraged investment well beyond the amount of saving
available for housing purpose. Market forces should be left alone to determine interest rates. Economic
units should be left alone to make a rational calculation to figure out if it is worth investing in a business, in
education, among others. Does the marginal benefit outweigh the marginal cost? If this is not the case,
rational economic units will be contented not to own a house or not to go to college because it is not
beneficial given the interest rate. They are better off renting and working (or taking leisure time if the wage
rate is too low). Markets are there to provide a price signal that is included in the rational decision-making
processes; government intervention distorts that signal and leads economic units to make incorrect
decisions, which leads to financial crises.
In terms of monetary policy, it would be best for the central bank not to intervene by setting interest rates;
instead, the central bank should target the quantity of reserves to manage the money supply and so keep
inflation stable (See Chapter 23). If a central bank decides to manage interest rates, it should set the nominal
interest rate in a way that is consistent with the monetary rate of return of aggregate income. If the interest
rate is set too low, monetary policy will promote a credit boom and inflation, if the interest rate is set too
high, monetary policy will generate a recession and deflation (see Chapter 27). Therefore, it is crucial to
have an estimate of the natural rate and inflation expectations so that the optimal interest rate (the one
that promotes price stability) is found. Central bankers have come to see the management of inflation
expectations as a main role of monetary-policy making.
262
Another implication is that monetary policy is a central tool to be used to solve economic crisis. In case of
a recession, central bankers should reflate the economy, that is, they should raise inflation so that inflation
expectations rise which will raise the monetary rate of return on aggregate income and so encourage
investment.
In terms of fiscal policy, a government should avoid deficit spending. While there is some room for fiscal
intervention in the short-run, it should be temporary, quick and targeted in order to help put the economy
back on its natural path more quickly. There should not be permanent deficits, and a central policy goal of
a government should be to aim for a balanced budget. Some economists in that framework have gone as
far as promoting a balanced-budget amendment to the U.S. Constitution so that federal finances work in
the same fashion as state finances.
Finally, in terms of economic growth, a government should find ways to promote thriftiness, which will
bring down interest rates, encourage investment and so promote economic growth. Rather than working
through government programs that artificially lower interest rates, the goal of policymaking should be to
change incentives so that individuals make a rational decision to save more. This will allow more resources
to be allocated to investment. Financial repression—keeping interest rates artificially low relative to what
the market demands—not only promotes financial instability and inflation, but also discourages saving and
economic growth. The biggest savers are high-income and high-wealth earners so policies should cater to
these individuals, who will then have the incentive to use their wealth and income for the benefit of society
by investing in the economy; this is called the trickledown effect. Broader policies, such as tax incentives
to save for retirement, can incentivize everybody to save. As explained in Chapter 3, pension funds work by
deferring and reducing tax payments, which may encourage households to save. Thus, from the viewpoint
of the real exchange economist, the growth of money managers and the financialization of the economy is
positive, because they have promoted thriftiness and so increased the availability of funds for investment.
EMPIRICS
The empirical work surrounding the theory studies if nominal interest rates respond to expected
inflation/deflation, if fiscal deficits impact the natural interest rate (and so nominal interest rates), and what
the level of the natural interest rate is and how it changes over time.
Starting with Irving Fisher, there has been quite extensive empirical testing of the relationship between
interest rates and inflation (expected and actual) in the United States and at the international level.
Unfortunately for the theory, the relation has been either non-existent or much weaker than expected.
Figure 15.5 shows that, in the United States, there is no relation between inflation measured by the
consumer price index (CPI) and interest rates until the mid-1950s. Before 1953, the correlation is zero or
negative, which is quite striking given that financial markets were highly deregulated prior to the 1930s so
savers could have synced interest rates to inflation more easily if that was a major concern. After 1953, the
correlation is moderately high especially for short-term interest rates, 0.79 for short-term rates, and 0.66
for long-term rates.
Some economists have argued that this change means that financial-market participants have now
assimilated Fisher’s framework of analysis, but others note that this change in the relationship between
interest rate and inflation has much more to do with a change in monetary policy strategy following the
Treasury Accord of 1951. By 1953, the Fed had freed itself completely from any obligations toward ensuring
the perfect liquidity of Treasuries by targeting the entire yield curve (see Chapter 9). By that time, the need
to fine tune the economy with policy tools was seen as necessary. Given the growing concerns about
inflation and the renewal of Monetarist ideas, the central bank progressively oriented its policy toward
263
fighting inflation. It now raises and lowers its policy rates with changes in expected inflation. One of the
immediate implications is that the other rates also have become more correlated with inflation. Thus, the
higher correlation does not reflect the fact that market participants suddenly have become more
preoccupied with inflation, only the Federal Reserve did.
Figure 15.5 Inflation and interest rates

Sources: Board of Governors of the Federal Reserve System (Series H.15), National Bureau of Economic
Research (Macrohistory Database), Bureau of Labor Statistics
Empirical tests of the existence or not of a crowding out effect have also been quite extensive and are again
inconclusive. Following the theory, one would expect that a higher fiscal deficit would lead to a higher
natural rate and so a higher nominal interest rate, and that if the fiscal position moves toward a surplus
interest rates would fall. Figure 15.6 shows that, for the United States, the relationship between nominal
interest rates and the fiscal position of the government is very weak to non-existent. Figure 15.7 shows a
similar lack of relationship if one takes estimates of the natural rate of interest. In the end, for the United
States, one cannot conclude that a fiscal deficit will lead to higher interest rates. Chapter 9 provides an
explanation of why: the Federal Reserve System and Treasury work hand in hand to ensure that fiscal
264
operations have no, to very limited, impacts on interest rates. This is a feature of monetarily sovereign
countries.
A final empirical endeavor of the theory has been to measure the natural interest rate. This variable is not
observable so it must be estimated out of supply conditions in the economic system, such as productivity
of capital, the natural growth rate of the economy, demographic trends, among others. There is a debate
among economists following that framework about the reliability of available estimates and their
usefulness for policy purpose. Estimates are model-dependent (depending on the hypotheses made, the
estimate can be significantly different) and time-dependent (the natural rate changes over time) and there
is large uncertainty around the mean. These econometric difficulties are similar to the ones applying to
measures of the natural growth rate and the natural unemployment rate. Still economists following that
framework are hopeful that better model specifications, better estimation techniques and refined data will
bring a reliable measure of the natural rate of interest.
Figure 15.6 Fiscal position and interest rates

Sources: National Bureau of Economic Research (Macrohistory Database, Tables from "The American
Business Cycle"), Treasury Bulletin (via FRASER), Bureau of Fiscal Service (Monthly Receipts, Outlays, and
Deficit or Surplus, Fiscal Years 1981-2017)
Note: Quarterly data, Q1 1880 to Q4 2016 for fiscal position and commercial paper, Q1 1900 to Q4 2016
for high-grade bonds.
265
Figure 15.7 Fiscal position and natural interest rate

Sources: National Bureau of Economic Research (Tables from "The American Business Cycle"), Treasury
Bulletin (via FRASER), Bureau of Fiscal Service (Monthly Receipts, Outlays, and Deficit or Surplus, Fiscal
Years 1981-2017), “Calculating the Natural Rate of Interest: A Comparison of Two Alternative
Approaches” by Thomas A. Lubik and Christian Matthew.
MONETARY THEORY OF INTEREST RATES: MONETARY

CONDITIONS AND LIQUIDITY PREFERENCE
Economists using the monetary production economy framework do not find the previous theory satisfying
for multiple theoretical and empirical reasons. The empirical aspects have been presented above. In
theoretical terms, one can reduce the problem to two issues, one is the over-reliance on the role of relative
prices and substitution effects, and the other is the lack of recognition of the central role of monetary
aspects in decision-making processes. Economic units are deeply concerned about staying liquid and judge
economic results in nominal terms, as such, the interest rate is impacted by these concerns. In the 1930s,
John Maynard Keynes proposed a theory of interest rate that addresses these issues.
SUBSTITUTION EFFECT VS. INCOME EFFECT
The loanable funds theory relies on the smooth working of relative price mechanisms to reach a stable
equilibrium; if there is a surplus relative price falls, if there is a shortage relative price rises. Production
involves two inputs, labor and capital, and firms are indifferent between the two inputs so they use the
cheapest. The price of labor is the real wage (w), the price of capital is the real interest rate (r), and so the
relative price of capital is r/w. In the loanable funds theory, a fall in r encourages investment because r/w
falls and so firms substitute capital for labor. Similarly, the fiscal impact of deficits is only judged from the
point of view of its substitution effect; a deficit raises r and so r/w, which encourages firms to substitute
labor for capital; investment falls.
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Two issues come up with this logic. First, there has been a long recognition that there is no reason to assume
that relative-price adjustments work in a smooth fashion (rapid changes in relative prices create instability)
or bring a market to equilibrium (the equilibrium is unstable). In general, a downward sloping investment
curve (or demand curve more generally) does not apply, and a decrease in r/w can be associated with a
decline, a rise or no change in investment. The “Cambridge Controversy”—a theoretical debate that
occurred in the 1960s between scholars located Cambridge, MA, USA and Cambridge in the UK—is the
latest example of such conclusion. Thus, one cannot rely on relative price adjustments to reach an
equilibrium. This criticism can also be applied to what is presented below (and anytime there is a supply-
demand graph).
Another issue is that a fiscal stimulus, via deficit spending, also generates an income effect. For example,
the Kalecki equation of profit presented in Chapter 22 shows that:
U = I + DEF + NX
With U aggregate profit, I private domestic investment, DEF the government deficit, and NX net exports.
When government deficit spends, the private sector receives an injection of income—firms sell more and
so record higher profits. This, in turn, encourages investment because higher profits boost the confidence
of entrepreneurs and their profit expectations. Thus, assuming that the substitution effect is valid, there
are two impacts from a government deficit (Y is aggregate income):
∆i > 0  ∆I < 0  ∆Y < 0: SUBSTITUTION EFFECT

DEF
∆U > 0  E(U) > 0  ∆I > 0  ∆Y > 0: INCOME EFFECT
The problem becomes to figure out which of the two effects dominates. Economists following the monetary
production economy framework argue the substitution effect is empirically marginal, if not false, in addition
to being theoretically unsound. Firms do not care much about the cost of credit when they invest,
expectations of future cash flows dominate the decision to invest.
The inclusion of income effects has another vexing implication for the loanable funds theory, because the
saving and investment curves are no longer independent. At the aggregate level, the amount of saving
depends on the level of income, but that level of income depends on the level of spending such as
investment. Thus, there is no unique natural rate of interest rate but an infinity of them, because the natural
rate depends on the level of economic activity, so it is influenced by demand conditions and not merely
supply conditions.
Again, the Kalecki equation of profit makes that clear; if investment goes up so does profit (the saving of
firms), and if firms earn more, they employ more individuals who in turn earn an income and so can save.
The ultimate impact on the natural interest rate is undetermined because higher aggregate investment
leads to higher aggregate saving. A shift in the demand curve (via investment or government deficit) can
lead to higher, lower, or unchanged r* depending on the slope of each curve and depending the size of the
shift in the saving curve. Figure 15.8 shows a case where the natural rate is unchanged.
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②
r S S1
r1* = r*
I I1
①
S, I
Figure 15.8 Income effect in the loanable funds market
LIQUIDITY PREFERENCE THEORY OF INTEREST RATE
Given all these issues, economists working in the monetary production economy framework have used an
alternative theory of interest rate that was first presented by Keynes. Capitalist economies are monetary
economies. Contrary to a barter economy that merely uses monetary instruments to transact, in a monetary
economy monetary outcomes influence incentives and decisions. Economic units compete among each
other and judge results in monetary terms not in real terms because all contracts and obligations are written
in nominal terms not real terms (Chapter 22). Such an economy is subject to uncertainty, that is, nobody
knows what the future holds in terms of monetary outcomes, and probabilities are either non-existent or
not a reliable means to judge the future. Such an economy is driven by demand conditions (expected sales
of output), and no market exists to smooth aggregate income over time and to make intertemporal
decisions about aggregate income. Indeed, current spending determines current income and if spending
fall (saving rises) income falls (Chapter 22) because there is no certainty if, nor when, current saving will be
consumed in the future. Saving is not equivalent to future consumption and so a decline in present
consumption (a rise in saving) discourages investment, which lowers aggregate income even further.
Given this institutional context, economic units care about financial solvency, so they care about monetary
profitability and liquidity in addition to purchasing power. Liquidity helps to stay solvent but limits
profitability, and economic units aim at finding the proper mix of assets in their balance sheets given their
liquidity preference.
From this starting point, Keynes makes four points about the lack of substitution among assets, about what
the interest rate rewards, about the overwhelming impact of the stock of financial instruments on the
interest rate, and about the importance of capital gains in the calculation of the rate of return.
First, the liquidity of a balance sheet impacts solvency, so liquidity is a central concern of economic units.
Economic units are not indifferent between holding liquid assets and illiquid assets. In normal times, when
the monetary system works properly, only liquid assets provide a reliable means to store value through
time so there is no gross substitution among all assets. Economic units prefer to hold liquid assets. If an
asset is less liquid, holding it carries some risk and so economic units will require a higher rate of return that
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reflects their concerns and preference for liquidity. The higher their preference for liquidity, the higher the
reward they will demand to buy an illiquid asset.
Second, if someone earns $100 and decides to save $20 in cash, cash does not provide any interest. Thus,
the interest rate is not a reward for merely saving some income; it is a reward for moving the asset portfolio
into illiquid positions. For example, say Mr. X earns $100 every month and has to decide if he should save
some of it. According to Keynes, the interest rate is not playing much of any role in that decision; the
consumption-saving decision is mostly based on habits of consumption and uncertainty about the future (if
X expects to be unemployed in the near future he saves more now); the marginal propensity to consume
(mpc) determines the split of income. Where the interest rate plays a role is in the decision about the
distribution of assets in the balance sheet, and how satisfied economic units are with that distribution. Say
that over the years, X has saved $10,000 in a checking account and the checking account is his only asset,
how should X place that $10,000? Should X hoard all of it in a checking account, should X buy stocks or
bonds? Should X buy a home to rent it and/or for speculative purposes? What proportion of the $10,000
should stay in the checking account? The nominal rate of return on each asset helps X decide which asset
is worth holding given his liquidity preference (Figure 15.9).
Figure 15.9 The role of the interest rate in two theories

Third, the emphasis on flow variables in the determination of interest rates is misguided. Stock variables
play an overwhelming role on the price of assets because stocks are much larger than flows. Flow variables
∆S (net addition to an outstanding amount; think of water flowing into a bathtub) adds to stock variables S
outstanding (the amount of water in the bathtub):
St = St-1 + ∆St
In the loanable funds theory, the net increase in the demand for securities is the amount of saving, while
the net addition to the stock of securities is the offering made by firms that want to invest. For Keynes,
these net increases in supply and demand are too small of a magnitude to have much of an impact on the
price of securities and so the interest rate; instead, it is the outstanding quantity of securities and the
demand for that outstanding quantity (the willingness to hold these securities) that matters to set interest
rates. Do people want to hoard the monetary assets they have? That is, is the demand for monetary
instruments (willingness to hoard) equal to the available quantity of monetary instruments? (Figure 15.10).
Put in accounting terms, the interest rate is determined by balance sheet considerations (willingness to
hold the assets owned) not by income considerations (willingness to save some income).
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iA ∆AD (or S) iA AS AD
iA* iA*
∆AS (or I)
∆A A
Figure 15.10 Flow equilibrium (loanable funds theory) versus stock equilibrium (liquidity preference
theory)
Some economists tried for decades to show that a flow analysis leads to the same equilibrium interest rate
as a stock analysis. However, this conclusion holds only under perfect foresight, or rational expectations,
which is not compatible with the framework used by Keynes and economists operating in the monetary
production economy framework. In case of perfect foresight, liquidity concerns are no longer important
and one is back to the real exchange economy framework.
Fourth, contrary to the Fisherian approach and the Efficient Market Hypothesis, one cannot consider that
the monetary return on an asset (financial or nonfinancial) solely depends on income (r in the previous
theory). To maintain their liquidity and to boost nominal returns, economic units do care about the direction
of the price of a securities, and so care about the future nominal interest rates when making portfolio
decisions. If expectations of a rise in interest rates are such that economic units think that capital losses will
more than offset income gains, they will stay in liquid assets even if the current interest rate on illiquid
assets is positive. This situation is called a liquidity trap.
MONEY RULES THE ROOST
Similar to Fisher, Keynes argues that economic units will choose to hold whatever asset pays the most and
they will arbitrage among assets. This arbitrage will continue until all rates of return are equal. Differently
from Fisher, Keynes argues that it is the rate of return on financial instruments—the interest rate—that is
the anchor of the system. The rate of return on financial instruments sets the minimum monetary rate of
return that nonfinancial instruments must achieve. Again, at the aggregate level, one can reduce the
arbitrage to one between capital equipment and monetary instrument (Figure 15.11).
The rate of return on capital equipment is called the marginal efficiency of capital (mek) and the rate of
return on lending monetary instruments is the interest rate i. If mek > i, firms issue debts to obtain monetary
instruments and use the proceeds to buy capital assets. If they buy new capital assets, aggregate investment
occurs. As more machines are produced, the mek falls because it becomes more difficult to sell output at a
given price as markets become saturated (there is only a limited number of customers for a given product).
If mek < i, firms decrease their investment level. The problem becomes to figure out what determines the
interest rate.
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mek > i
i*
mek < i
mek
I1 I* I2 I
Figure 15.11 Adjustment mechanism in the monetary production economy framework
LIQUIDITY PREFERENCE AND RATES OF RETURN
The expected monetary rate of return z of asset j depends on the following factor:
zj = qj – cj + ℓj + aj
That is, the expected rate of return on any asset depends:
- Positively on the yield q, the expected income earned from holding the asset. If that asset is a
nonfinancial asset, q represents the rate of return earned from the sale of production. If it is a
financial asset, q is earned from monetary payments received in the form of interest payments or
dividends.
- Negatively on the carrying cost c, the expected expenses incurred to take position in an asset. These
expenses include maintenance expenses, insurance, interest payments if debts are issued to
finance asset positions, among others.
- Positively on the expected capital gain (a > 0) or loss (a < 0) from selling the asset.
- Positively on the liquidity premium ℓ, the reward to pay on illiquid assets to incentivize someone
to give up a liquid asset. The higher the perceived liquidity of an asset, the higher ℓ. Note that ℓj is
not rewarded directly by asset j; it is not earned by holding asset j (qj) nor is it earned by selling
asset j (aj). It is a reward obtained on asset j by giving it up for another asset that is less liquid. Put
differently, the more asset j is liquid, the more one is able to bid down the price of other assets to
buy them with asset j. For example, monetary instruments do not pay any interest and always trade
at parity, but they can be used to bid down the price of other financial instruments, which raises
the interest rate (see Chapter 14).
This nominal rate of return can be adjusted via q to account for inflation, but expected inflation and income
are not the only things that matter and, as explained in Chapter 14, economic units may pay much more
attention to staying liquid and speculating. Depending on the assets, some of the components are more
important:
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- Asset 1: Output-producing nonfinancial assets (capital equipment). These assets are illiquid so the
reward obtained from parting with them can be considered nil (ℓ1 = 0%); they cannot be used to
bid down the price of other assets. The rate of return is influenced by expected profit earned from
selling the output produced by the equipment, and the expected capital gain/loss from reselling
the asset: z1 = q1 – c1 + a1.
- Asset 2: Unproductive nonfinancial assets (commodities): These assets are mostly illiquid because
the price of commodities is highly volatile (ℓ2 = 0%), and they do not directly produce any output
that can be sold (q2 = 0%). However, they can provide a return from reselling them at a higher price
(a2). While they are held, one must cover some expenses for stocking them, insuring them, among
others (c2). The rate of return is: z2 = a2 – c2.
- Asset 3: Financial instruments other than monetary instruments: There may or may not be a more
or less active market to trade them, so the degree of liquidity will vary from illiquid (mortgage
notes) to very liquid (Treasuries). The rate of return on financial instruments, the interest rate, is z3
(= i) = q3 – c3 + ℓ3 + a3.
- Asset 4: Monetary instruments: They are perfectly liquid so ℓ4 is the highest of all assets, that is,
bearers want to be rewarded to part with monetary instruments. Given that they are perfectly
liquid they always trade at face value (a4 = 0%). They also do not provide any income (q4 = 0%) and
the carrying cost is marginal (c4 = 0%) unless monetary instruments were obtained through credit.
The rate of return is: z4 = ℓ4. ℓ 4 represents the minimum rate of return that must be provided by
less liquid assets to incentivize bearers of monetary instruments to buy them.
If economic units become pessimistic, their liquidity preference goes up and they will ask for a higher
reward to go illiquid: ℓ4 and ℓ3 go up. This means that the price of less liquid assets falls—and so the rate of
return they provide rises—and it has to fall enough to give an incentive to holders of liquid assets to part
with them (Figure 15.12).
i A3S A3D1 A3D
i1*
∆ℓ4 > 0
i*
A3
2
Figure 15.12 Effect of an increase in liquidity preference on the demand of less liquid assets
To show the central role that monetary considerations play in the determination of the interest rate, the
effect of a change in liquidity preference is usually represented in terms of the demand for monetary
instruments. An increase in the demand for illiquid assets is equivalent to a decrease in the demand for
liquid assets. As such, the demand for monetary instruments moves inversely with the interest rate paid by
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financial instruments; a higher interest rate leads to a lower demand for monetary instruments (a lower
willingness to hoard the outstanding stock of monetary instruments). The demand for monetary
instruments flattens as the interest rate falls because of the liquidity trap. A higher liquidity preference
increases the willingness to hoard the existing stock of monetary instruments at any given interest rate, so
the equilibrium interest rate rises (Figure 15.13).
MD MD1
i MS
i1*
∆ℓ4 > 0
i*
M
Figure 15.13 Impact of liquidity preference on the interest rate on an asset
Figure 15.13 assumes that neither the central bank nor private banks purchase illiquid assets from those
who want to sell. If they do, the supply of monetary instruments rises to accommodate exactly the desire
for additional monetary instruments, and the interest rate stays unchanged. The supply of monetary
instruments is horizontal in that case.
IMPLICATIONS OF THE THEORY
The main implications are that monetary conditions influence the nominal interest rate through more direct
channels than expected inflation, that the crowding out effect is not automatic, that lender-of-last-resort
policies are crucial and monetary policy should be about targeting interest rates, that supply-side factors
have only an indirect and limited impact on interest rates, that promoting thriftiness discourages
investment and may encourage speculation.
First, monetary conditions (quantity of liquid assets, policy rate of the central bank and liquidity preference)
play a central role in determining the nominal interest rate and this influence is direct, it does not go
through inflation. Under normal economic conditions (below full employment and in a smoothly working
monetary system), the immediate impact of a change in monetary conditions is not to change output prices
(inflation) but to change financial-asset prices (interest rates). Output prices are determined by costs and
the state of the economy (Chapter 23). In addition, contrary to the real theory of interest rates, the impact
of a loosening in monetary conditions is to lower interest rates. If the supply of monetary instruments goes
up, or if the supply of reserves goes up, or if the interest-rate target falls, or if the confidence of economic
units increases, then the demand for illiquid assets rises and the demand for liquid asset falls; economic
units want to have a less liquid balance sheet. As they buy less liquid financial instruments, the interest rate
falls. Given that monetary conditions are paramount to determine nominal interest rates, and given that
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the central bank controls some key interest rates on a daily basis (Chapter 7), daily monetary policy has an
overwhelming influence on nominal interest rates.
Second, given the centrality of monetary conditions, an increase in the demand for funds—for investment
purposes or to fund a fiscal deficit—does not have to lead to a rise in interest rates. It depends on how
monetary conditions adapt to the increased need for funds. If liquidity preference falls enough, economic
units with monetary assets are more willing to part with them and the interest rate does not change. If the
supply of monetary instruments rises enough, which it usually tends to do because the money supply moves
endogenously with productive needs (see Chapter 22), the impact on the interest rate is nil. Thus, the
crowding out effect is not automatic. In addition, if the interest rate on a financial instrument is fully or
partially controlled, like the interest rate on federal funds debts or the interest rate on Treasuries, the fiscal
position will have no or limited influence on interest rates. Only changes in the interest rate target (iT) will
have a significant impact (Chapter 7 and Chapter 9) (Figure 15.14).
iT
MS
MD
M* M
Figure 15.14 Interest rate targeting and liquidity preference
Third, it is essential to have an economic unit that is willing to help stabilize interest rates. When views of
the future change for the worse, interest rates rise sharply because economic units try to sell illiquid assets
and to hoard more liquid assets. This volatility occurs because those who seek to change the composition
of their balance sheet cannot change the supply of both assets. Banks cannot create reserves, households
and nonfinancial firms cannot create the monetary instruments they desire to hoard. A sharp rise in interest
rates has an adverse impact, on the net worth of economic units that own a high proportion of less liquid
long term assets (duration is larger for long-term assets, see Chapter 14), on the ability to refinance existing
debts (Chapter 4), on the ability to service debts with a variable interest rate. To counter the fetish for
liquidity that emerges in period of heightened uncertainty, an economic unit should stand ready to provide
liquid assets to satisfy that fetish. A central bank should respond to the willingness of other economic units
to increase their proportion of liquid assets in their portfolio. It can do so by being ready to buy less liquid
assets on demand at a low stable interest rate, or to provide credit on demand against such less liquid
assets. The central bank should act as lender of last resort. More broadly, the central bank should be
involved in smoothing the variability of interest rates on a daily basis; monetary policy is about setting at
least one interest rate, it is not about setting the amount of reserves.
Fourth, the emphasis on productivity, time preference and other supply-side aspects is unwarranted. What
matters for the rate of return on capital equipment is the ability to sell the output (q) not merely the ability
to produce it (marginal product), and there is nothing that ensures that what is produced will be sold even
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if prices fall. Say’s law does not apply in a monetary economy (Chapter 22) and debt deflation prevents a
smooth clearing of market surpluses (Chapter 23). In addition, capital-gain expectations play a crucial role
in determining rates of return, and this is all the more so if the asset is marketable. In this case, market
participants may not want to raise interest rates in sync with inflation because, while raising the interest
rates may protect income against inflation, significant capital losses may materialize.
Fifth, promoting liquid markets and giving incentives to put wealth into less liquid form assets may not
promote aggregate investment. Economic units arbitrage among all assets and buy those that provide the
highest return over the holding period they prefer. Instead of buying new capital equipment—investing—
they may buy old capital equipment or they may buy commodities and financial assets. Chapter 14
explained that financial-market participants tend to have a short holding period and to have a speculative
mentality (bet on price direction) rather than an investment mentality (buy and hold to wait patiently for
income). Nonfinancial companies may also prefer to buy financial assets instead of nonfinancial assets, and
this has been a trend in their balance sheets (Chapter 4). Chapter 2 showed that the stock market is not a
net contributor of funds, and that nonfinancial companies have been buying back their stocks to boost their
prices. Thus, promoting thriftiness not only discourages investment, but also may promote speculation if
liquid financial instruments are available.
EMPIRICS
Empirical evidence clearly shows that interest rates on long-term and short-term securities move with
monetary policy decisions; this is especially so for short-term rates that have a correlation coefficient of
0.99 with the federal funds rate. Long-term rates have “only” a correlation coefficient of 0.88, which leaves
some influence for other factors, such as expected inflation, expected fiscal position, expected monetary
policy decision, concerns about credit risk, among others (Figure 15.15). The impact of monetary policy on
long-term rates will be all the stronger if financial-market participants do not expect the policy to be
reversed for a while, that is, if they believe that the central bank will keep doing the same thing (rising,
lowering, or not changing its policy rates) for a while. Chapter 16 on the interest-rate structure will develop
that point.
So nominal interest rates are low because the central bank sets a low policy rate and they will stay low as
long as the central bank does not raise the rate, even if inflation expectations rise, even if the government
deficit spends is large, and even if the natural rate of interest rises. Interest rates will stay low even if
liquidity preference increases as long as the central bank is willing to intervene enough to stabilize rates it
does not normally stabilize directly. An extreme version of this influence of monetary policy is when the
central bank decides to set both short-term rates and long-term rates, like it did for Treasuries during World
War Two (Chapter 9).
275
Figure 15.15 Monetary policy and interest rates

Sources: National Bureau of Economic Research (Macrohistory Database)
Note: Monthly data from January 1919 to December 2015
The fact that monetary policy plays a central role in determining the interest rate does not mean that the
central bank fully controls all interest rates. As the correlation coefficient above suggests, there is some role
for other factors to play in the determination of long-term interest rates. For example, Figure 15.16 shows
that Quantitative Easing, which resulted in large injection of reserves and an increase in the money supply
(Chapter 7), did not lead to a fall in long-term Treasuries. In fact, long-term Treasuries rates had a tendency
to rise during the period of Quantitative Easing and to fall once it ended. The central bank did not do enough
to control long-term rates. Although it bought a large quantity of them, it did not do so with a specific target
rate in mind like during World War 2. Targeting an interest rate involves buying, or selling, whatever dollar
amount is necessary at a price consistent with the interest rate target (Chapter 7). Quantitative Easing
involved buying a predetermined monthly dollar amount ($75 billion worth of Treasuries each month for
QE2, $40 billion worth of mortgage-backed securities each month for QE3) at whatever price the market
would bear.
276
Figure 15.16 Quantitative Easing (Dark-grey bars), Operation Twist (Light-grey bars), Federal funds rate
and interest rates
Source: Board of Governors of the Federal Reserve System (Series H. 15) and Wikipedia (History of Federal
Open Market Committee actions)
Note: Quantitative Easing (formally known as Large-Scale Asset Purchase Program) involved buying and
holding large quantities of long-term securities, which resulted in trillions of dollars of injections of
reserves. Operation Twist involved changing the composition of the balance sheet of the central bank by
simultaneously selling short-term Treasuries and buying long-term Treasuries, with the goal of lowering
long-term rates while avoiding any net injection of reserves.
TO GO FURTHER: LIQUIDITY TRAP AND THE SQUARE RULE

The liquidity trap was introduced by Keynes in the following way:
[E]very fall in i reduces the current earnings from illiquidity, which are available as a sort of
insurance premium to offset the risk of loss on capital account, by an amount equal to the
difference between the squares of the old rate of interest and the new. For example, if the
rate of interest on a long-term debt is 4 per cent., it is preferable to sacrifice liquidity unless
on balance of probabilities it is feared that the long-term rate of interest may rise faster
than by 4 per cent. of itself per annum, that is, by an amount greater than 0.16 per cent.
per annum. (Keynes 1936a: 202)
This “square rule” implies that someone who expects the level of the rate of interest to go up by more than
its square should increase his preference for monetary instruments. To see this more clearly, assume that
an individual can choose between keeping his monetary assets, or buying a perpetual bond and selling it
after one coupon period. The expected nominal return obtained on the perpetual is the sum of the coupon
and expected capital gain/loss:
R = C + E(ΔP)
Which, knowing that the fair price of a perpetual bond is P = C/i, is equal to:
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𝐶
𝑅=𝐶− 𝐸(∆𝑖)
𝑖
Consistent with Keynes’s liquidity preference theory in which money “rules the roost,” one placement
strategy involves determining what change in the nominal bond rate is expected to lead to a nil nominal
return (E(R) = 0):
𝐶
𝐶− 𝐸(∆𝑖) = 0 → 𝐸(∆𝑖) = 𝑖
𝑖
Thus, for a perpetual bond, the short-term breakeven point (the point at which coupon earned offset capital
loss so that the dollar return is zero) is reached when the level of the rate of interest varies by its square
(when it grows by the level of itself). Therefore, if i is expected to increase and E(Δi) < i2, the short-term
holding a perpetual bond provides a net dollar gain. The capital loss is expected to be inferior to the coupon
and the individual should lower his demand for monetary instruments (should buy the bond).
Keynes called the case E(Δi) > i2 a liquidity trap, that is a situation at which the central bank loses its capacity
to influence nominal long-term rates, because the demand for monetary instrument rise infinitely from that
interest rate; the demand for monetary instrument becomes horizontal (see Figure 15.13). Keynes stated
that this kind of condition is rare, if ever observed. However, the previous condition was obtained by
assuming that the targeted dollar return over the period was zero, and by only looking at placement
strategies over one coupon period.
If one of these strict conditions is removed, the liquidity trap has much more chance to appear. For example,
it is highly probable that financial-market participants have a positive rate of return in mind that makes
them indifferent. Assume that a person, at time 0, could buy a bond for a sum M0. In addition, assume that
this person has a targeted nominal sum, MT, that he would like to receive after one coupon period. His
targeted rate of return over the coupon period is zT = MT/M0 – 1, which generates a targeted nominal return
of zTM0 over the coupon period. A person, therefore, will be indifferent between bond and money if:
𝐶
𝐶− 𝐸(∆𝑖) = 𝑧 𝑀
𝑖
Thus, the expected change in the market rate that leaves the person indifferent is:
𝑧 𝑀
𝐸(∆𝑖) = 𝑖 1−
𝐶
The higher the targeted sum at the end of the coupon period, the smaller the change in interest rates
tolerated will be before parting with a perpetual bond. Given that S0 is the current fair price P (the person
holds only one bond) and that FV is the par value of a bond so that C = cFV, and c is the coupon rate, we
have the following indifference condition for a perpetual bond (p = P/FV):
𝑧
𝐸(∆𝑖) = 𝑖 1− 𝑝
𝑐
The higher the targeted return relative to the coupon rate, and the higher the fair price relative to its par
value, the smaller the change in interest rate tolerated by actual and potential financial-market participants,
and the more the liquidity trap has a chance to emerge. For a high enough targeted yield, an expected
decline in the interest rate is necessary not to affect adversely financial positions.
While Keynes presents the liquidity trap with perpetual bonds, the logic of the argument can be generalized
to all long-term financial instruments. The point is that long-term nominal interest rate, i, may become
insensitive to monetary policy when policy rates become low and are expected to rise again soon.
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The real theory of interest rate argues that:
1- The natural interest rate and inflation expectation determine the nominal interest rate.
2- Monetary policy indirectly impacts the interest rate through its effect on inflation expectations, and fiscal
policy directly impacts the interest rate by raising the natural rate of interest.
3- Supply side factors are central determinant of the interest rate by setting the natural rate of interest
4- The interest rate should not be manipulated by the government because this manipulation leads to
inflation, slow economic growth and financial instability
5- To promote economic growth and financial stability, financial markets should be deregulated so
resources can be efficiently allocated, and government should put in place policies that incentivize
thriftiness.
6- The interest rate is a reward for saving and investment is very sensitive to changes in the interest rate.
7- Economic units are indifferent between holding liquid or illiquid assets, they hold whatever provides the
highest inflation-adjusted rate of return to meet their preference in terms of future consumption.
The monetary theory of interest rate argues that:
1- Having a liquid balance sheet is a main concern of economic units so they prefer liquid assets to illiquid
assets.
2- Monetary conditions determine the interest rate; a rise in the money supply, a decrease in liquidity
preference and a decline in the policy rate directly lowers the interest rate. Interest rate is low because
monetary policy sets the interest rate low and because liquidity preference is low.
3- Given everything else, the impact of a rise in the money supply on inflation is indirect (it depends on state
of the economy) while the impact on the interest rate is direct (it falls). A rise in the money supply raises
the price of financial assets and it might raise the price of output indirectly.
4- The natural interest rate depends on demand conditions because aggregate saving is generated by
aggregate income and aggregate spending generates by aggregate income, investment determines saving.
There is an infinite number of natural rates.
5- The interest rate sets the minimum rate of return on non-monetary assets. The marginal efficiency of
capital converges toward the interest rate.
6- The government should be involved in setting the interest rate because a volatile interest rate can
negatively influence net worth, and the ability to refinance and service debts.
7- The central bank should be involved as lender of last resort by providing monetary instruments at a set
interest rate.
Keywords
Financial repression, trickledown effect, natural interest rate, liquidity preference, liquidity trap, lender of
last resort, Say’s law
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Review Questions
Q1: Why would individuals want to raise the nominal interest rate if they expect inflation? Why would they
not?
Q2: Explain the crowding out effect in terms of its logical argument and policy implications.
Q3: According to the monetary theory of interest rate, a fiscal deficit may not negatively impact investment.
Provide three reasons related to income effects, monetary factors and sensitivity to the interest rate.
Q4: Does an increase in thriftiness promote or discourages investment? What can be done to promote
investment in each case?
Q5: Is the interest rate a reward for saving or a reward for having an illiquid asset portfolio?
Q6: If liquidity preference goes up what happens to investment? Provide an answer for both theories.
Q7: Should a central bank target interest rates?
Q8: What are the benefit of a lender of last resort policy?
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CHAPTER 16:

CHAPTER 16: INTEREST-RATE STRUCTURE
TO BE WRITTEN
282
CHAPTER 17:
After reading this Chapter you understand:

CHAPTER 17: OFF-BALANCE SHEET OPERATIONS: SECURITIZATION
TO BE WRITTEN
284
CHAPTER 18:

CHAPTER 18: OFF-BALANCE SHEET OPERATIONS: DERIVATIVES
TO BE WRITTEN
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PART 5:
CHAPTER 19:

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 19: MECHANICS OF 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 study 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 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.
A SPECIFIC FINANCIAL INSTRUMENT: MONETARY INSTRUMENT

Chapter 2 explains what financial instruments are and this section applies that to monetary instruments.
Some issuers make the following promise to bearers:
- I will redeem my financial instrument whenever you want me to do so: Term to maturity is
instantaneous/zero.
- I will redeem my financial instrument 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 redeem my financial instrument at par in payment of debts owed me: By handing to me my
financial instruments, 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 9 and Chapter 12).
The promise may contain two additional clauses:
- I will exchange my financial instrument 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 financial instrument: the financial instrument
is secured. In the same way a house is collateral for a mortgage, gold may be collateral for a coin.
These types of financial instruments are monetary instruments. Like 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.
Thus, a monetary instrument is just a financial instrument with specific financial characteristics in the same
way a pizza-coupon is a financial instrument with specific nonfinancial characteristics. A pizza coupon
promises to their bearers a pizza at any time, a monetary instrument promises to bearers the ability to
reduce debt owed to the issuer at any time by the face value of the monetary instrument. It may also
promise something in exchange like pizza coupons.
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ACCEPTANCE OF MONETARY INSTRUMENTS

As long as someone makes a promise that is structured in the way described above it is a monetary
instruments; anybody can create monetary instruments. Many websites that allow anyone to do so, and
Figure 15.1 shows a monetary instrument that I created. It is called a 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 strange 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,1
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).2 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 that piece of paper in payments of debts or goods and
services? The answer depends on two central questions that potential bearers asked themselves:
- How credible is my promise? When will bearers have the opportunity to hand it back to me? If
potential bearers never see any opportunity to give the financial instrument back to me, either
directly or via another bearer, then they will not accept it.
- How beneficial is it to accept my promise? If the reward for doing so is negligible, they will not
accept the note in payment even if it is highly credible promise.
As such, there are three ways to make bearers realize that my promise is credible and beneficial:
- Forced acceptance: I will kill you/cut your hands/put you in prison/(fill in the blank with any other
miserable things I could 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 redeem the note, I will give you some gold
worth 5 cities. That will help to widen acceptance if 5 cities worth of gold is significant, and
if others believe I have the means to get the gold I promised.
- 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 the impact of doing so will have on the final grade.
For example, if redeeming a certain number of notes counts for 100% of the grade, then
the demand for E.T. notes will be high, if it only counts for 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).3
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
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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.
Figure 19.1 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 22 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 financial instruments with their customers (see Chapter
12). 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
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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).
Figure 19.2 shows the financial logic behind monetary instruments, which is a subset of the financial logic
presented in Figure 2.4. The issuer creates a financial instrument called “monetary instrument” (cash,
checkable account) either to buy something from bearers (See Chapter 9) or to grant credit to bearers by
accepting their financial instrument (See Chapter 12). At maturity, that is at any time, bearers may return
monetary instruments to their issuer and may ask, if available, for conversion of the monetary instrument
into something else or they can make payment owed to the issuer (debt service, tax payments). As
explained below, the existence of adequate means to return a monetary instrument to its issuer is central
to maintain the fair price, and so liquidity, of that monetary instrument.
Monetary instrument
At issuance
Goods and services or (Influx/Injection of
Bearer’s non-monetary monetary instruments)
financial instruments
Issuer of Bearer of
monetary monetary
instrument instrument
Bearer’s non-monetary
At maturity
financial instruments or
Asset from conversion
(Reflux/Redemption of
monetary instruments)
Monetary instrument
Figure 19.2 The financial logic behind monetary instruments
To conclude, in the broadest terms, the greater the credibility of the issuer, the greater its ability to find
people willing to hold its financial instruments. 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. As such, a monetary instrument may not be widely
accepted if the credibility of the issuer is low.
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. A coupon for a free pizza issued by me may be more or less widely accepted depending
on the credibility of that promise (can Eric make pizzas and will he do it whenever I want?) and the benefits
it provides to the bearers (do I like pizzas?).
Beyond this core reason to accept financial instruments, 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 financial instrument, these other reasons to hold a monetary instrument do not
maintain its fair value.
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ACCEPTANCE IN ACTION: AT WHAT PRICE SHOULD A MONETARY

INSTRUMENT CIRCULATE AMONG BEARERS?
The value of a promise is as good as the credibility of the economic unit who makes that promises and the
benefits it provides to bearers. As such, the valuation of any financial instrument will depend on the
expected ability and willingness of the issuer of the note to fulfill what it promised to do. If the issuer has
no credibility, the value of his financial instrument will be zero. For financial instruments, the promise takes
the form of future monetary commitments and the point of finance is to determine the current value of
these future monetary commitments.
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:
𝐸 (𝑌 ) 𝐸 (𝐹𝑉 )
𝑃 = +
(1 + 𝑑 ) (1 + 𝑑 )
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 of bearers about income and face value of time n, 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”).
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
𝑃= + + +
(1 + 𝑑 ) (1 + 𝑑 ) (1 + 𝑑 ) (1 + 𝑑 )
There is a missing element that prevents the determination of the fair price: what is the value of dt today?
dt represents the interest rate that market participants want at a point in time (the current 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 7, 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.
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For a $20 unconvertible Federal Reserve note, the government does not promise any coupon and promises
to redeem the FRNs at any time at $20, so:
20
𝑃= = 20
(1 + 𝑑 )
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 either the $100 coupon payments or 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
𝑃= + + +
(1 + 𝑑 ) (1 + 𝑑 ) (1 + 𝑑 ) (1 + 𝑑 )
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 notes and other monetary instruments. Say that the government
announces it only accepts $20 FRNs for $10 at any time, that is, a $20 FRN only redeems $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 depositor, and repaying bank debts with a
$20 FRN only clears $10 of bank debts. At time of the default, 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 frequently as explained in Chapter 22. Until the late 19 th century, private
bank notes were applied a discount that varied over time in part because of the changing creditworthiness
of private banks.
FAIR VALUE AND PURCHASING POWER

There are situations in which the prices of financial instruments change relative to the prices 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 23). 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 unconvertible currency has become common and its supply
made elastic.
To make this more concrete, take the case of a $50 Federal Reserve notes. There are two ways that note
can end up having a value of $0. The first case is one of hyperinflation when yesterday a $50 note used to
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buy 10 loafs of bread and today it buys none. In this case, the note will still circulate at $50 given that it has
not been demonetized by the US government (and so $50 worth of dues owed to government can be paid
with them) but to buy anything with them one will need to transport bags of them in a wheelbarrow. The
classic example is the hyperinflation in Germany and Hungary (Figure 19.4) but Zimbabwe recently only had
hyperinflation and the government issued a note with a 100 trillion dollar denomination prompting
Zimbabwean to note that they were starving billionaires (see Figure 19.3). The second case is one of
demonetization when suddenly the government decides that the $50 is no longer redeemable for payment
of public and private debts. In this case, the note will stop circulating. A recent example is the
demonetization of the 500 and 1000 rupees note on November 2016. Government refused them in
payments and provided a period of conversion into other notes for a small period of time.
Figure 19.3 Hyperinflation in Zimbabwe in 2008
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Figure 19.4 Hyperinflation in Hungary in the mid-1940s and Germany in the early 1920s: Men sweeping
banknotes left on the street and a one-million mark note.
One major debate of monetary history wonders 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. Assume 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 because there
has been an inflationary trend since the end of World War 2. Governments around the world have been
unwilling to let deflationary forces develop following the horrible experience of the Great Depression
(Figure 19.5).
Nominalism has prevailed over time. As such, financial instruments cannot be considered 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 19.5 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 find the underlying causes of the problem. Political,
technological and natural causes are usually underpinning problems because inflation is usually not a
monetary issue (see Chapter 23). 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 1
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.4 Table 19.1 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 19.1 Examples of hyperinflation
Source: Studies in the Quantity Theory of Money
To conclude, the financial characteristics of monetary instruments lead to a stable nominal value (parity) in
the proper financial environment (see Chapter 20 for improper financial environments). This stable nominal
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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.”
TRUST AND MONETARY SYSTEM: TRUST IN THE ISSUER VS.

SOCIETAL TRUST
Acceptance introduces the central role of trust for a well-functioning monetary system. Whenever there is
promise, there is trust. However, 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.” The problem with this answer
(beyond the fact that this answer is circular) is that a promise to do something is only as credibility as the
economic unit who makes that promise. As such, acceptance of a promise must have something to do with
the perception that others have about the expected ability and willingness of the originator of the promise
to fulfill that promise. Even acceptance of a promise as trivial as “I promise to pick you up tonight” requires
that the person to whom the promise is made perceived that promise as credible; otherwise, the person
will refuse and call a cab instead.
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. 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, one, banks will convert at par
into government monetary instruments at any time, and, two, that bearers 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 unconvertible financial instrument falls to zero. As one may expect, Chapter 22
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 19.6 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
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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 19.6 A 50 French franc note

In the Middle Ages, coins did not have any face value marked on them. Bearers of the coins would have to
listen periodically to royal proclamations in public spaces to know at what value the King would take his
coins in payments, that is, to know the face value. Chapter 22 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 no bearer think about the ability to pay the issuer at face value with its monetary instruments when
she accepts 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:
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- 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 20), 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 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 24, 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 9).
- Two, the government advances (ΔFLG > 0) more funds than what refluxes to the government (ΔFLG
< 0). That is, the government must acquire more financial instruments 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-
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government sector (financial liabilities stay the same) (see Chapter 9 and Chapter18). 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
This point is very well illustrated by the Massachusetts Bay colonies that issued unconvertible, 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 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 24 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.
CASE STUDY: DEMONETIZATION IN INDIA IN 2016

The Indian economy is highly reliant on cash to perform petty economic transactions. Up until November
2016, the Reserve Bank of India (RBI) issued notes with the following denomination (₹ is the sign for Indian
rupee): ₹1000, ₹500, ₹100, ₹50, ₹20, ₹10 and ₹5. On November 9, the Indian government abruptly
demonetized the ₹1000, ₹500 in order to fight the widespread counterfeiting of these notes and their use
for illegal activities. In an unscheduled live televised address to the nation Narendra Modi, the Prime
Minister of India, declared invalid the use of all ₹500 and ₹1000 banknotes of the Mahatma Gandhi Series
from midnight of the same day. The ₹1000, ₹500 notes could be converted into others notes until
November 24 at the counter of RBI branches and private bank branches. Mr. Modi also announced the
issuance of new ₹500 and ₹2000 banknotes of the Mahatma Gandhi New Series. After November 24, ₹1000,
₹500 notes were no longer convertible at banks but could be used until December 15 in the following ways:
- “All government schools will accept old Rs 500 notes as academic fees up to a limit of Rs 2,000 per
student.
- Central or state government colleges will also accept fees in cash in old currency notes.
- Citizens can now recharge their pre-paid mobile phones in old currency up to a limit of Rs 500 per
top-up.
- Consumer cooperative stores will also accept old Rs 500 notes, however, there will be a limit of Rs
5,000 at a time.
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- Individuals and households can pay current bills and arrear dues in old currency for water and
electricity only.
- The toll charges remain suspended till the 2 December and thereafter payment can be made in old
Rs 500 notes.”5
That is, the notes could only be used in a limited way in economic transactions; mostly to purchase some
services provided by specific government entities.
This abrupt announcement took the Indian population by surprise and many were left with very little means
to perform basic economic transactions unless they could exchange their old notes. This is all the more so
that about 90 percent of transactions involved cash payments, from grocery shopping to the purchase of
expensive jewelries. Now, shops, hospital and other businesses would refuse the notes. People spent hours
in lines to exchange their note as millions of Indians tried to convert their notes at the same time.
Conversion was limited to ₹4000 per day per person so this had to be repeated every day in order to convert
savings into valid notes. For example, a wedding requires saving piles of cash as florists, caterers, and others
all need to be paid in cash. An individual had saved about ₹350000 mostly in ₹1000, ₹500 notes and so
needed to stand in line for 87 days to convert his savings. This was not possible given that conversion was
only available for two weeks so he had to spread the cash among relatives who went to stand in line. Some
with medical conditions died waiting in line.
In order to avoid the large cost involved in conversion, some individuals agreed to purchase some goods
and services from street vendors who would accept the note at a discount. The discount would reflect the
reward to the vendor for doing the chore of going to exchange the notes.
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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 redeem 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 promise a conversion of its monetary instrument into something else. The
same logic applies to any other issuer.
3- Anybody can issue monetary instruments, that is, 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 financial instrument 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 economic units other 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 to become worthless. One, it circulates at par but its
purchasing power is poor (hyperinflation). Two, there is no inflation but it circulates 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.
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 is 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?
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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 See “Origins of currencies: from jagged edges to flowers” http://blog.oxforddictionaries.com/2014/02/origins-currencies/

2 Olivecrona, K. (1957) The Problem of the Monetary Unit. New York: Macmillan.
3 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
4 See Bill Mitchell’s “Zimbabwe for hyperventilators 101” http://bilbo.economicoutlook.net/blog/?p=3773
5 From “Note ban: Rs 500, Rs 1,000 notes exchange ends tonight; exemptions stay till 15 December” Firstpost, November 24.
http://www.firstpost.com/india/note-ban-rs-500-rs-1000-exchange-ends-tonight-exemption-stay-till-15-december-3123108.html
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CHAPTER 20:

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 unconvertible.
What errors have been made in the past when setting up monetary systems
CHAPTER 20: SOME FAQs ABOUT MONETARY SYSTEMS
The following answers a few questions in order to illustrate Chapter 19 and to develop certain points.
Q1: CAN A COMMODITY BE A MONETARY INSTRUMENT? OR,

DOES MONEY GROW ON TREES?
One often hear 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 20.1).
Gold ingots 2009 $50 American buffalo gold coin

Figure 20.1 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 redeem at any time the gold nuggets in payments at
the stated face value.
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 include convincingly “money” in models,
and pushes to ignore the financial side of the economy (see Chapter 12 and 19) and the role of nominal
aspects (see Chapter 22).
Q2: CAN A MONETARY INSTRUMENT BECOME A COMMODITY?

Yes. Numismatists are specialists at treating current and former 3 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 20.2 was worth $1200 in 2016 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 20.2 A $1 FRN issued in 2003 and worth $1200 in 2016 as a collectible item
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 22). 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, 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 22)
and who focus on the function of medium of exchange. In order to avoid the problem 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
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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
example, by relying on the words of an Arab merchant and an Arab historian of the 9 th 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 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 to 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
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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 19). 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.
Therefore, 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 19). 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 redemption 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 redemption 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 14):
P = C/i
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.
Not all this seems 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)
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This confuses irredeemable and unconvertible. The monetary base is redeemable, that is, it can be returned
to the issuer at face value at any time. This point of view also raises other problems:
- Remember that balance sheets are interrelated (see Chapter 24) 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? No benefit is
provided 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? IS FIAT MONEY A BUBBLE?

No. As with any other financial instrument, the acceptance of a monetary instrument by anybody ultimately
rests on the confidence in the issuer’s willingness and ability to fulfill what was promised, not on the
confidence that other potential bearers will accept it.
For a monetary instrument, the most common promise made by the issuer is that he will accept his
monetary instrument at face value at any time to reduce any outstanding debt owed to him. Governments
promise to accept their monetary instruments from those who need to pay their tax liability, banks promise
to accept their monetary instrument from those who need to service debts owed to banks. The credibility
of this promise is what is at the foundation of the demand for monetary instrument and their circulation at
face value among bearers. Today, the credibility of this promise is so strong that monetary instruments
usually circulate at their fair price at all time (face value); there never any bubble monetary instrument (see
Chapter 14 for an explanation of what a bubble is), there are the most boring financial assets for would-be
speculators.
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 of issuer is not crucial
for acceptance. While none of us think of the need to pay taxes when we accept Federal Reserve note at
par, if the government demonetizes its monetary instruments—that is, refuses them in payments—then
fair price is zero and they will circulate at that price among bearers. In normal time, we just expect that the
nominal value of monetary instruments stays constant at face value and that is why we hold them. The
credibility of the issuer is central to the certainty of that expectation.
The same goes on with other financial instruments albeit in that case bearers usually expect, and want,
their fair price to change in a beneficial way. For example, most trading of stocks is done just for the sake
of trading by humans or by computers focused on millisecond price movements. The goal is to make a
capital gain from the change in the price of stocks and most of us do not check carefully, or at all, the books
of a company before buying its stocks. This does not neglect the central role of the creditworthiness of the
firm that issued the stocks in sustaining the fair price of the stock. Financial mechanics cannot be denied
although most of us pay little attention to them in normal times.
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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 2 (see Chapter 19). 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 weak to non-existent.
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 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 an object. 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 financial instrument (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 out 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
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balance sheet up to $1000 of #1’s financial instruments without asking again to check #1’s creditworthiness.
Chapter 12 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.
Figure 20.3 shows a set of play notes. 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 20.3 Pretend-play monetary instruments
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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 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 19 when that
is not the case) and can be used as a reliable medium of exchange (see Chapter 23 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, fraud, 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.
o 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)
o What is the problem? Kings legalized counterfeiting. Anybody with gold could issue a debt
of the king, that is, 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 redemption clause: There is no way to return to the issuer its monetary instruments
o What is the problem? Fair price is zero unless there is a collateral or a recourse.
- There is a redemption clause but no actual means to implement it because no payment is due to
the issuer (Chapter 22 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).
o 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)
o What is the problem? if ∆Pg > 0 => PgG > FV => coins disappear from circulation (melted into
ingots or exported as commodities)
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- 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.
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.7 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. In fact, until recently, federal income taxes could not be paid with Federal Reserve notes
because the Internal Revenue Services did not accept cash payments and requires we paid our taxes
through the banking system for tractability and convenience reasons (in 2017 tax payments in cash were
allowed for tax debt smaller than $1500). Bank then makes the payment to the Treasury for us (see Chapter
9). Other government agencies do accept in person cash payment for taxes and dues, which sometimes
create great inconvenience for them. Indeed, now and then, some people are actually so mad at the DMV
that they decide to pay with pennies. Recently a made came to pay with five wheelbarrow containing
300,000 pennies to pay his DMV taxes. It took DMV staff over seven hours to count the pennies. 8
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
22 develops the case of tobacco leaves in the United States, which came about because of a shortage of
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 leaves, 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
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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? IS A

MONETARY INSTRUMENT NECESSARILY WIDELY ACCEPTED BY
OTHERS? HOW DO I CREATE ONE?
To answer all these questions, it may be easier to start form pizza coupons. Pizza coupons are nonfinancial
instruments; their issuer formally promises a pizza on demand. Who can issue pizza coupons? Anybody,
one just has to promise to give a pizza. One can make the coupon fancy (color printed on high quality paper)
or just write it on a piece paper with a pencil. Will others accept it? It depends on two things from the
viewpoints of bearers. First, they have to believe that you are credible: can you make and deliver pizzas?
Second, they have to see a benefit in accepting the coupon: do they like pizzas? The more credible you are,
and the more people like pizza, the more your pizza coupon will be accepted. If at one point, you cannot
delivered the promised pizza—you defaulted on your promise—your coupons will no longer be accepted.
The same logic applies to monetary instruments and any other financial instruments. In the same way
anybody can create a pizza coupon, anybody can create monetary instruments as long as one does not
counterfeit existing monetary instruments.9 One should then have a monopoly over the issuance of such
an instrument in the same way Pizza Hut should have a monopoly over the issuance of pizza coupon that
promise a Pizza-Hut pizza.
A monetary instrument is a promise, just like a pizza coupon is a promise. Contrary to pizza coupon, the
promise is financial in nature. How to create a monetary instrument?
1- On a piece of paper write $1, your name and "I promise to take this piece of paper from anybody
at any time for $1."
2- Write how you will take it back for $1 at any time (enforcement mechanism). Remember it has to
be a promise that is financial in nature so the enforcement mechanism for must be financial: "I will
take in payments of debt owed to me". You may want to add a nonfinancial promise: "I will convert
in to gold (or pizza)."
You are done. The problem is now to figure out if you can issue them: Will others accept it? Like the pizza
coupon (or any other promise), acceptance depends on the bearers’ view about your credibility and about
how beneficial it is to accept it. If other believe they will be indebted to you in a significant way, or, if not,
if they believe that they can get gold from you (if you promised that), your monetary instrument will be
widely accepted. If few see that promise as credible or beneficial, your monetary instrument will not be
widely accepted. The more you can make other indebted to you or the more you can provide others
something of value, the more widely your financial instrument will circulate.
To conclude, a pizza coupon promises to their bearers a pizza at any time. A monetary instrument promises
at least to bearers the ability to reduce debts owed to the issuer at any time and by the face value of the
monetary instruments. A monetary instrument may also promise something valuable (pizza). If you do not
fulfill the promise, you defaulted and your monetary instrument will be worthless because it nominal value
will be zero.
Good luck getting it accepted!
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Q13: DOES THE FORM THAT SOMETHING TAKES MATTER TO

DETERMINE IF IT IS A MONETARY INSTRUMENT?
No. A bank account is as much a monetary instrument as a gold coin. “Real” monetary instrument are not
necessarily physical. The only thing that matters to determine if something is a monetary instrument is the
character of the promise that is made by the issuer of that thing. If the promise is due at any time, this is an
indication that a monetary instrument may be present. If there is no promise made that thing is a
commodity; a promise-less thing cannot be a monetary instrument.
Again, the case of a pizza coupon may help to answer more clearly that question. A pizza coupon is a pizza
coupon not because it is made of paper. An electronic version of the coupon works just as well, if not better
(less easy to lose, easier to transfer, etc.), and it is just as “real.” What makes a pizza coupon such is the
nature of the promise made.
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, redemption 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 redemption clause?
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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 bitcoin is zero” at http://neweconomicperspectives.org/2013/12/fair-price-bitcoin-zero.html
7 For a detailed analysis of legal tender and its monetary implications see The Legal Qualities of Money by Arthur Kemp.
8 See http://www.bbc.com/news/world-us-canada-38603615
9 For example of proud 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 21:

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 21: HISTORY OF MONETARY SYSTEMS
The goal of this Chapter is 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 public 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 redeem
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.
𝐹𝑉
𝑃 = ( )
(1 + 𝑑 )
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, while also taking them back at a premium to offset the discount.
However, as explained in Chapter 19, 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., 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.
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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 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
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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, 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.
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TOBACCO LEAVES IN THE AMERICAN COLONIES: LEGAL TENDER

LAWS AND SCARCITY OF MONETARY INSTRUMENTS
The case of Virginia and other U.S. colonies in the 17 th 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 leaves 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 leaves 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.
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)
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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 leaves 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 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.
THE ABSENCE OF A REDEMPTION MECHANISM

TO BE WRITTEN
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 leaves were not monetary instruments in the US because nobody issued them, that is, nobody
made promises embedded in the tobacco leaves; they had no issuer.
Keywords
Debasement, legal tender laws, fraud, reflux mechanism
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Review Questions
Q1: How did the inclusion of tobacco leaves 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
create 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
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PART 6:
CHAPTER 22:

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
CHATPER 22: ECONOMIC GROWTH AND THE FINANCIAL SYSTEM
The previous Chapter concludes the study of banking and financial 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 lifeblood 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 financial instruments that can be issued, the more accommodating 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, that is, 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, or 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.
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.
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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)
Imagine a barter economy in which the only product is potatoes and 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—
the marginal product of potatoes—as each potato is a seed that can be used to produce more potatoes.
This marginal product is the foundation of the interest rate earned by the potato savers; their reward is
more potatoes in the future, which means that debt 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 to be received 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”, that is, 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) depends on the
ability to save and the point of finance is to allocate saving—saving drives investment.
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 problem becomes to
figure out if the reward is worth the pain. The graphical way to represent all this is the loanable funds
market (Figure 22.1).
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Figure 22.1 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; that is, 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 this 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 22.2). As the 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 22.1). As the government comes to borrow potatoes (Figure 22.2),
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 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.
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ΔI < 0
Figure 22.2 The crowding out effect
CONCLUSIONS
In the end, finance is a mere intermediary between savers and investors. Finance help to 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). Saving allows the transfer of current output through time; saving is just
delayed/future 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 the government deficit spends, it discourages investment and so discourages the growth of
the economy. The 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, they account for inflation or deflation to maintain
purchasing power constant; Valorism prevails (see Chapter 19)
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) 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.
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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 make 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 19).
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, 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 the sale of more of them, deflation comes
with its own problems given the existence of debts that require fixed monetary payments (see Chapter 19).
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
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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 creating inefficiencies and waste in the production process
(leaving fields idle, letting potatoes rot) in order to maintain an artificial scarcity of potatoes—what Veblen
called the “sabotage of production.” 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
by all means to maintain profitability.
The demand side must also be managed to maintain profitability. People must constantly be aroused to
create new needs and wants (potato chips, French fries, etc.) 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.2 Consumerism is something that needs
to be learned and emulated. In the United States, Edward Bernays was central to the emergence of
consumerism in the early 20th century. He applied the psychoanalysis of Sigmund Freud—his uncle—to the
persuasion of the masses by appealing to their irrational instincts. He first applied these principles
successfully by convincing the US public of the validity of entering World War I. He was approached by
major corporations to apply these principles to times of peace for the benefit of corporations. Paul Mazur,
a leading Wall Street banker working for Lehman Brothers in 1927, noted:
We must shift America from a needs- to a desires-culture. People must be trained to desire,
to want new things, even before the old have been entirely consumed. [...] Man's desires
must overshadow his needs.
Mass production requires mass consumption and Edward Bernays was central in moving consumption
habits away from buying things for their practical use (one buys long-lasting shoes to walk comfortably)
toward buying things for their invidious and fetishist use (one buys a highly desired but uncomfortable pair
of shoes to show off).
As such, scarcity is not a natural state; it is rather a requirement of an economy that is managed by capitalist
businesses through supply and demand management. While abundance is possible, it is not a viable
economic state for capitalism.
WHY MONETARY INCENTIVES MATTER? WHAT ARE OTHER IMPLICATIONS?
Part of the answer is that banks are in the business of dealing with financial instruments that involve
monetary payments instead of 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 the ability to pay based on credit standards set in monetary terms (see Chapter 10): 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 12,
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.”
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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 12); that is it. Again, there
are no savers behind banks asking for their potatoes back with interest (in potatoes).
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 every day of their life.” (Davidson 2002: 78). Say that
workers labor for one hour and earn a wage rate of w = $5, 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 allocate 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 12). 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 24). The
state also imposes tax liabilities that involve future monetary payments (see Chapter 19).
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 price that is high enough 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 19).
7- Current saving does not incentivize current investment; saving discourages investment. Firms will
not invest if current spending (and so sales) is falling. Saving is not delayed/future consumption
because savers are not paid in kind. A fall in sales leads to layoffs and so losses of present income
by economic units.
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.
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FINANCE AND THE ECONOMY
The first phase of the economic process is to ask for credit at banks (the financing phase). The role of banks
is to judge whether or not the expectations of firms are reasonable (see Chapter 10). 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 22.3).
Figure 22.3 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 15 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 economy as a
whole. By relying on conclusions drawn from studying how economic units make decisions in isolation
(microeconomy), one misses the financial interdependencies that exist among economic units. When these
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financial interdependencies 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 that 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 current national income.
When someone spends, that creates incomes for others.
As such, saving cannot be the beginning of the economic process for an economy. Current income allows
current saving, but, at the macroeconomic level, current spending creates current income and so current
spending creates current saving. The Kalecki equation of profit 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, that is, by buying goods and services
for the purpose of maintaining or increasing productive capacities. However, not consuming today
depresses investment. If people consume fewer potatoes, there is no incentive to plant the resulting excess
inventory of potatoes to produce more potatoes.
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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 10).
3- Banks are not intermediaries: they do not lend on behalf of savers. A bank does not lend anything
to non-bank, it is neither a potato lender nor a money lender; it is a dealer in financial instruments
that require monetary payments (see Chapter 12).
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 19).
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 24 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 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 19 and 20 shows that many of these differences can be boiled
down to a different understanding of the nature of monetary instruments: For the REE, monetary
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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, that is, 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 in opinion about how to do economics is old and involves very different paradigms.
Keywords
Crowding out effect, intertemporal output, saving, investment, credit standards, demand-led, supply-led,
financing phase, funding phase
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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. Also Desan’s Making Money: Coin, Currency, and the
Coming of Capitalism (Oxford University Press, 2014).
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 23:

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 23: 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 is due to asset prices, that is, the price of non-
producible commodities and old producible commodities. This Chapter does not study asset-price inflation,
which is about 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 22. 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 to 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 12).
- 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 nil):
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 dollar 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 can adjust to a large
increase in the demand for goods and services is through an increase in prices. Money is “neutral,” it does
not impact production.
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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 money multiplier (see end of Chapter
12), 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 because of the hypotheses and causalities used to reach the
conclusion:
- 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 12 and Chapter 9).
- Interest-rate targeting has only a remote and uncertain effect on the growth of the money supply,
even more so on inflation.
- 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 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 if this theory were correct does not exist, even in the long-run (Figures 17.1 and
17.2). While correlation improves as the length of time increases (one-year correlation is 0.55, five-
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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 23.1 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 23.2 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: 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).
- 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)
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- 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 23.3).
- 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 22). 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. The 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 23.4). 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, while both grew on average.
Wage growth was in the 5-10% range while productivity growth 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 of unions have tamed the ability of wages to outpace productivity,
even in periods of prolonged economic growth.
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Figure 23.3 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 23.4 Unit cost of labor growth rate and PCE inflation, percent
Sources: Bureau of Economic Analysis, Bureau of Labor Statistics
When combined with the explanation of monetary creation presented in Chapter 12, 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
351
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 the 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 reduces the money supply) once production is sold. The money supply moves in part
with the needs of the productive system.
- Federal government spending (that injects monetary instruments) and taxing (that destroys
monetary instruments) 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 rises (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 23.5).
The money supply is not something that falls from the sky, monetary analysis must account for the
endogenous injections and destructions of the money supply in relation to the production process, as well
as the debts incurred by monetary creation (See Chapter 12). If the economy is growing, the 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 23.5 Automatic stabilizers.

Source: Bureau of Economic Analysis.
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. The role of a central bank is to preserve financial stability
through the provision of a stable low cost refinancing source and through regulation.
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TO GO FURTHER: KALECKI EQUATION OF PROFIT, INTEREST RATE

AND INFLATION
For readers who want to know more, this section develops a few more 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.
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 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 23 showed that
UnD = CU – SH + I + DEF + NX
Thus:
gUnD = (gCusCu – gShsSh + gIsI + gGsG – gTsT + gXsX – gJsJ)/sTu
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with 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 make the argument through a FFR-
targeting view.
3- According to some economists, the QTM makes some extreme hypotheses and inaccurately understands
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—an 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
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 rises?
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?
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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 24:

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 24: 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,
the policy goals that are more likely 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 interlinkages.
This is fine as long as one is merely interested in looking at relationship between sectors, but one should be
mindful that this hides some important aspects of the economy.
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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 24.1).

Financial Assets (FA) Financial Liabilities (FL)
Real Assets (RA) Net Worth (NW)
Figure 24.1 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. Alternatively:
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 24.2). 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 9). The
domestic private sector includes domestic households, domestic non-profit organizations, domestic
financial businesses, domestic nonfinancial 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 being 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 24.2 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
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
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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).
Beware that economists may change the names 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.
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.
It is possible to represent this accounting identity in a quadrant. 1 Figure 24.3 includes on the x-axis the
foreign sector balance and on the y-axis the domestic private sector balance. The foreign sector balance is
the opposite of the domestic current account balance so when the foreign sector balance is positive (FB >
0), it implies that the domestic current account balance is negative (CAB < 0). The domestic government
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balance can be found implicitly by noting that the sum of the three balances must be zero. One can draw a
45-degree line that shows where the government balance is zero.
Figure 24.3 A graphical representation of the sectoral identity
SOME IMPORTANT IMPLICATIONS

There 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.2 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 9). There are many other
implications and uses of this framework such as macroeconomic theory, the madness of fiscal austerity,
among others. 3
POINT 1: THE BEGINNING OF THE ECONOMIC PROCESS REQUIRES THAT

SOMEONE GOES INTO DEBT
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
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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 12 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
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 financial instrument
(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 is used to pay interest, dividend and taxes. What is
left after these payments is retained earnings, the saving of the firm. Households will also save some funds.
However, none of that can occur unless someone goes into debt to start production, and for savings to be
bigger, debt must increase.
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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
(Figures 18.4 and 18.5). 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, assume that NFAF =
0:
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 9). 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, the private domestic sector must accumulate the funds
injected.
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—the “golden state.” The green area on Figure 24.5b 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 18.5b and
18.5c). The Great Recession has led most governments to deficit spend and only Norway has been able to
maintain the golden state (Figure 24.5d).
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 constrain
domestic spending by curtailing wage growth, by curtailing government spending and by raising taxes. This
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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).
Figure 24.4 Net financial accumulation in the United States, percent of GDP.
Figure 24.5a Sectoral balances, an international perspective, 1995-2000 average, Percent of GDP
Source: OECD
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Figure 24.5b 2000-2005 average

Source: OECD
Figure 24.5c 2005-2010 averages.
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Figure 24.5d 2010-2014 averages

Note: 2010-2015 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.4 Figure 24.6 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 24.6 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 => FA DP
= 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. 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. However, 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
o If FB < FBd: Domestic exports decline (i.e. foreign imports decline)
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- 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), and 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, that is, 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 9).
- 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
24.4), which made GB > 0 possible. Australia, New Zealand and some European countries
also have recorded a negative domestic private balance (Figures 18.5a, 18.5b, and 18.5c).
However, domestic private sector in deficit is not sustainable because it implies, ultimately,
Ponzi finance (see Chapter 19). 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 24.5d).
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.
An important conclusion is that even though the balances will usually not equal zero, there is no
“imbalance.” A permanent fiscal deficit is not something that ought to be corrected if it is the result of the
desired net financial accumulation of other sectors. A permanent domestic current account deficit is not an
imbalance if it results from the need of the international monetary system.
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POINT 5: POLICY SPACE AND SELF-IMPOSED CONSTRAINTS
The amount of economic flexibility a government has to reach its economic goals is drastically reduced by
the constraints that a government imposes on itself. Such constraints are, for example a maximum deficit-
to-GDP ratio or a fixed-exchange rate. This can be illustrated with the quadrant of sectoral balances.
Suppose a government imposes on itself a maximum deficit-to-GDP ratio. This is the case for Eurozone
countries that are subject to sanction if the deficit-to-GDP ratio goes beyond 3%. In the United States, some
Republicans want federal budgeting to be even stricter by introducing a balance-budget amendment to the
constitution. In the quadrant, this means that a large section of the graph, in gray, is no longer achievable
(Figure 24. 7). This not only constraint the ability to promote economic prosperity, but also limit the ability
to respond to an economic crisis either via policy proposal or through the automatic stabilizers. In addition,
the ability of the domestic private sector to reach a surplus is dramatically reduced and relies heavily on the
ability of the economic to record a domestic current account balance surplus (FB < 0).
If, in addition to a deficit constraint, the government imposes on itself a strict fixed-exchange rate regime,
then it is impossible to devaluate the currency to try to promote a domestic current account surplus. In that
case the ability of the government to help the economy and the ability of the domestic private sector to
reach a surplus is even more reduced (Figure 24.8). This is the prevailing situation in the Eurozone. The
quadrant shows well how limited the policy space of domestic governments is, if they want to promote
sustainable economic prosperity, that is, prosperity that does not increase the financial fragility of the
economy (see Chapter 19).
Figure 24.7 The impact of a maximum deficit rule of 3% on the policy space
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Figure 24.8 Impact of a 3% deficit rule and strict fixed exchange rate on the policy space
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 19)
- A monetarily sovereign federal government usually needs to be in deficit, unless a significant
surplus on the domestic current account 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:
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o If they have limited economic development and resources. In that case, direct foreign aid
instead of private lending is the way to go.
o 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 over time 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
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), and 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
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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. 5 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 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 over time 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
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Integrated Macroeconomic Accounts that aim at integrating the two approaches into one single accounting
framework.
Kenneth Boulding6 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 interdependencies between the sectors
that the model contains.7
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, that is, to record a surplus, another
sector must issue some financial instruments, that is, 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 aggregate balance sheets and their implications 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 examples
in your life 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 6.1 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 or the financial account.
The capital account has less statistical discrepancy.
1Rob Parenteau created that quadrant. He used the domestic current account balance instead of the foreign balance on the x-axis
and calculated DPB as a residual of the two other accounts: DPB = -GB + CAB. See
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http://www.nakedcapitalism.com/2010/03/parenteau-on-fiscal-correctness-and-animal-sacrifices-leading-the-piigs-to-
slaughter-part-1.html
2 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

3 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
4 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

5 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
6 See A Reconstruction of Economics by Kenneth Boulding
7 Watch two lectures by Marc Lavoie on stock-flow modeling at http://neweconomicperspectives.org/tag/stock-flow-consistent-
modeling
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CHAPTER 25:

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 25: 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 11 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
How financial crises are defined vary, with some definitions being broad and all encompassing, and some
being very strict and narrow. Some economists restrict the definition to banking crises; others may use a
statistical definition that requires 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 matters worse.
Figure 25.1 An unstable equilibrium

One way to represent a debt deflation graphically is with the supply and demand diagram of Figure 25.1.
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, that is, price mechanisms
do not bring the market to equilibrium. For example, at P1 there is a surplus of goods and services, leading
to a fall in prices. Deflation decreases the quantity supplied and the quantity demanded so the market
surplus grows, which pushes prices down further. 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. A debt
deflation involves many feedback loops the process starts with some economic units that become
“overindebted.” The following presents Fisher’s argumentation from his 1932 book, Booms and
Depressions.4
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STEP 1: OVERINDEBTEDNESS AND DISTRESS SALES
Some economic units, e.g. (nonfinancial) 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 with too much debt 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 25.2).
Figure 25.2 Distress sales

Note: The “+” sign means that the linked variables are positively correlated: more over-indebtedness
leads to more distress sales (and less over-indebtedness leads to less distress sales).
STEP 2: DISTRESS SALES AND DEFLATION, THE “DOLLAR DISEASE”
The sudden massive amounts of sales of non-monetary assets lead to a decline in their prices. The lower
prices of assets lower the ability of businesses to recover funds from selling assets. Businesses are then
forced to find ways to sell more very quickly, which further pushes down prices. This is the first reinforcing
feedback loop of a debt-deflation.
Figure 25.3 Dollar disease

Note: the sign “-“ means that the linked variables are negatively correlated: 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 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 10).
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Following the quantity theory of money, which Fisher promoted, the decline in the money supply lowers
prices even further. This means that 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 even more
distress sales.
Figure 25.4 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 businesses fall given everything else, which
further increases their over-indebtedness and so feeds back into the dollar and debt diseases. Prices of
assets fall even more.
Figure 25.5 Profit disease
STEP 5: THE “AMPLIFIER EFFECT”
Declines in profit and net worth mean that nonfinancial businesses have an incentive to lay off employees.
Some banks may also have to close because losses from debtors are too large to be sustained by their
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balance sheet (see Chapter 10). Households, who record shrinking 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 writeoffs and decline in the net worth of banks.
Figure 25.6 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 7).
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Figure 25.7 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 (net profit = profit – debt commitments) and so increases over-
indebtedness.
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Figure 25.8 Risk premium disease
CONCLUSION
Overindebtedness and deflation feed on each other through several feedback loops. All of 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, debt deflation only stops 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 lessens the need for distress sales (Figure 25.9). In the process financial and nonfinancial
businesses close, households lose their savings and their economically active members become
unemployed, and resources are wasted. Output, labor power, capital equipment and knowledge are left
unused and quickly decay. 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. 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 10 explains that what has been considered in
hindsight a “bad” or 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,
a rise in unemployment, decreased savings, a decline in confidence, drastic rationing of financing
opportunities, and an overall sharp decline in economic activity. Think of a fire that starts because someone
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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 25.9 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? 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 (See Chapter 14). 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 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, because otherwise bankers
take collateral from defaulting economic units.
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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, leading to a
decrease in 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 22). 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. As a consequence, a market economy is prone to bubbles, herd behavior, cascades of information,
and misallocations 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, that is, 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 the meaning and impact of
“overindebtedness.” He concludes that stability is destabilizing.
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 core activities for companies)
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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 are 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 10
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, that is, 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 11, 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 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.
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The H/S/P categorization does not apply to monetarily sovereign governments, that is, governments that
issue nonconvertible monetary instrument denominated in their own unit of account and that issue public
debt denominated that unit of account. Examples of monetarily sovereign governments are the United
States Federal Government, the Japanese national government, the United Kingdom national government,
and 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 10).
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 on 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 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:
o 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 4 explains that if home prices fall
refinancing may not happen).
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o 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 10).
- Economic causes
o Search for profit and market share, and market saturation: ROE = ROA x leverage (see Chapter
10).
o Inequalities: the need to use debt to sustain a given standard of living has increased (student
debt, healthcare debt, etc.)
o 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:
o Deregulation, desupervision and deenforcement (see Chapter 11): fraud grows and
underwriting worsens.
o 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 23)
and personal savings, and provide cash flows as well as safe financial assets to the private
sector. However, as shown in Chapter 24, government’s desire to reach a surplus, combined
with the automatic stabilizers, means that non-government sectors may be forced to deficit
spend.
o 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
o 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 11).
o 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 10). Therefore, 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, many financial assets that previously
looked safe may now be unsafe because of the lack of confidence and because of poor economic
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prospects. For example, prime mortgagors may default because they lost their jobs. 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.
o 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).
o 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 regulations, 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.
o 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 brink 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.
Leniency 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.
Assume that there is a balance of $100 on a credit card that represents expenses for the month and that
there is $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. Therefore, Ponzi finance implies that the quantity of real assets (RA) falls and/or net financial
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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 24):
ΔNW = ΔRA + NFA
Given everything else, Ponzi finance leads to a fall in net worth. There are two ways to mitigate this decline:
1- Over time 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 10)
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.
TO GO EVEN FURTHER: MINSKY AND INCOME VS. CASH INFLOW

In most presentations 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 22).
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 22, 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 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.
390

1- During a major financial crisis, that is, a debt deflation, several feedback loops may develop to reinforce
the deflationary forces. 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.
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 is 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?
391
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.
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
392
CHAPTER 26:

What Eurodollars are
How Eurodollars transaction operate
How foreign exchange rate are influenced by financial transactions
How balance of payment crises occur
What the different exchange rate regimes are
How an economy operating under a flexible exchange rate regime differ from
one that operate under a fixed exchange rate regime
EUROCURRENCY
SOME HISTORICAL BACKGROUND
Eurocurrency is any bank accounts denominated in a unit of account that is foreign to the account holders.
This account holder—household, a business, a government—does not reside in the country that issues the
currency in which the account is denominated. For example, Eurodollar accounts are any USD-denominated
bank accounts held by non-US residents. While one may think that these bank accounts are held in banks
outside the United States, this is not necessarily the case because U.S. banks are allowed to provide USD-
denominated accounts to non-residents through an International Banking Facility (IBF). An IBF is merely a
separate set of books that a US bank keeps to provide banking services (see Chapter 10) to non-resident
without the burden of some banking and tax regulations that applies to its other books.
Eurocurrency emerged for geopolitical and regulatory reasons. In the 1950s in London when the Soviet
government wanted to prevent the funds in US bank from being frozen by the US government by
transferring them to banks in based in London. In the 1960s and 1970s, bank regulation combined with the
monetary policy of the time, made US bank less competitive in terms of portfolio management services
relative to other domestic financial institutions. Regulation Q put a cap on the interest rate that could be
paid on savings account and certificate of deposits and, rising FFR target led market rates to move above
the cap. As a consequence, banks lost customers who move their funds to financial institutions that could
pay a higher interest rate on financial instruments that were close substitute to savings accounts and
certificate of deposits in terms of liquidity and term to maturity. Regulation D also put some reserve
requirement on certificates of deposits, which made them costly to issue for banks. To respond to this
regulatory constraint, banks innovated and one of this innovation was the use of the Eurodollar market by
transferring customers’ funds to a foreign branch not subject to regulation Q and D. They would do so to
provide an account (in case of regulation Q) or by sweeping excess funds into account not subject to reserve
requirements (in case of regulation D).
While the US dollar was first to be subject to these trends and these trends occurred in Europe, hence the
term “Eurodollar”, other currencies are subject to the same trend all over the world. There is the Euroyen
market, among others, and the prefix “Euro” has stuck even those the accounts are not in Europe.
US banks were reluctant to grant Eurodollar accounts because they saw them as “funny money.” 1 London
banks, who had dealt with international banking activities for a long time because of the central role that
the UK has played in the world economy prior to the World War I, immediately recognized a lucrative
business opportunity and embraced it.
ACCOUNTING MECHANICS OF EURODOLLARS
Like any other bank accounts, Eurodollar accounts can be created either through deposits or via the
provision of advances even though the concept originated at the request of deposit transfers from the
Soviet government. Assume the soviet government has an account at bank A located in the US (Bank A US).
The government decides that it would rather put its funds in a bank located in London. This bank can be a
branch of bank A (bank AUK) or a completely different bank (bank F).
EURODOLLAR OPERATIONS WITH A BRANCH LOCATED ABROAD
If it is a branch of Bank A located abroad (bank AUK) the following occurs. Note that the word “abroad” is
widely defined to mean a branch that is directly involved with non-residents, that branch may actually be
in the United States but classified as an International Banking Facility.
Bank AUS
Account of Soviet gov.: -$100
Due to bank AUK: +$100
Bank AUK
Due from bank AUS: -$100 Account of Soviet gov.: +$100
The record of a due is the offsetting operations to the transfer of funds between accounts and this record
done by entering an entry on the computer. This interbank debt does not be to be settled because it is
internal to bank A. If the soviet government makes a payment of $10 to an economic unit then its account
will be debited by $10. Assuming that the company has an account at Bank AUK the offsetting operation
would be a simple transfer between internal bank accounts:
Bank AUK
Account of economic unit: +$10
If the economic units has an account at Bank AUS the accounting involves a transfer of funds between the
branch and the parent bank:
Bank AUK
Due from bank AUS: -$10 Account of Soviet gov.: -$10
Bank AUS
Account of economic unit.: +$10
Due to bank AUK: -$10
Finally, if the economic unit has an account at another bank located in the US (Bank B US), the change in the
balance sheet of Bank AUK is unchanged but now interbank debts between US banks are created:
Bank AUS
Due to bank AUIK: -$10
Due to bank BUS: +$10
Bank BUS
Due from bank AUS: +$10 Account of economic unit.: +$10
This interbank debt is settled by a transfer of reserves:
395
Bank AUS
Reserve balance: -$10 Due to bank BUS: -$10
Bank BUS
Reserve balance: +$10
Due from bank AUS: -$10
So the net impact of the previous two transactions is:
Bank AUS
Reserve balance: -$10 Due to Bank AUIK: -$10
Bank BUS
Reserve balance: +$10 Account of economic unit.: +$10
The previous started with a deposits at a branch located abroad because of geopolitical concerns. A similar
operation that reduces the dollar value of accounts held at Bank A US could be done to reduce the size of
required reserves. Bank AUS can entice its account holders by rewarding them with interest rate payment
through the transfer of funds into a savings account or a certificate of deposits issued by Bank A UK.
EURODOLLAR OPERATION WITH A FOREIGN BANK
If the Soviet government decides that it prefer to put funds in a bank located in the UK with no ties to any
US banks then the following occurs.
Bank AUS
Due to bank F: +$100
Bank F
Due from bank AUS: -$100 Account of Soviet gov.: +$100
In order to clear the interbank debt, it is not possible to use a transfer of reserves because Bank F does not
have an account at the Federal Reserve. The settlement is done by creating a bank account for bank F at
Bank AUS and by crediting it with the amount due.
Bank AUS
Account of bank F.: +$100
Due to bank F: -$100
Bank F
Account at Bank AUS: +$100
Due from bank AUS: -$100
396
So the net impact of the two previous transaction is:

Bank AUS
Account of bank F.: +$100
Bank F
USD Account at Bank AUS: +$100 USD Account of Soviet gov.: +$100
Now bank F has an account at a US bank that fully backs the USD account of the Soviet government. There
is no exchange rate risk given that both account are in USD and settle at par.
EURODOLLAR CREDIT SERVICES
US banks do not have a monopoly over the issuance of bank accounts denominated in USD and they do not
have a monopsony over the demand of USD-denominated non-bank financial instruments. Any bank in the
world can provide advances denominated in USD if they find that a profitable operations and if domestic
regulation allows it to happen. Given that Bank AUK is now paying interest on a USD denominated liability,
it may want to find a way to earn an income in USD. In order to do so, bank AUK may want to start providing
credit in USD at a rate above the USD interest rate it pays on its Eurodollar liabilities. Similarly, Bank F now
may see a new business opportunity in providing credit and payment services in USD. Doing so is similar to
what was presented in Chapter 12.
Say bank F is ready to provide credit services in USD to anybody who ask for it. Assuming that bank F is
chartered and located only in the UK, its full balance sheet is the following (GBP stands for Great Britain
Pound).
Bank F
GBP assets: £300 GBP accounts: £100
USD Account at Bank AUS: £100 USD Account of Soviet gov.: £100
Net worth: £200
Note that everything is measured in GBP and for the sake of argument it will be assume that GBP and USD
trade on a one-to-one basis (1 USD = 1 GBP). Of course USD-accounts, and any other USD-denominated
assets and liabilities are subject to an exchange-rate risk so if the USD depreciates relative to the dollar this
will be reflected in the balance sheet. For example, if the exchange rate becomes 1USD = 0.5GPB, then the
value of USD assets and liabilities fall to £50.
An international business α (that can be located anywhere in the world) needs to obtain a $120 advance to
buy widgets from business β (also located anywhere in the world). Business α is theoretically indifferent
about who will provide an advance of USD and will go where the cost of the credit is the cheapest. Say that
the business α goes to bank F and they swap financial instruments. The business promises to service its
financial instrument with dollars, bank F promises to accept funds in the USD accounts it issued in payment
of debt owed to the bank. The bank will accept in payment funds in USD accounts of its customers for any
debts owed, USD-denominated or not. Of course, a USD account holder plans to use its USD funds to pay
GBP debt, the holder is subject to an exchange-rate risk; this will be developed later.
Bank F
397

GBP assets: £300 GBP accounts: £100
USD Account at Bank AUS: £100 USD Account of Soviet gov.: £100
USD Financial instrument of business α: USD Account of business α: £120
£120 Net worth: £200
Note that bank F does not have to have any dollar on its asset side in the form of a reserve balance or of an
account at a US bank to be able to do so. Again there is no money multiplier at play (see Chapter 12), bank
F created an account for the business that promises US dollars on demand and that can be used to make
payments, but bank F does not have to have any US dollars in its vault or any other forms to make that
promise. The servicing of the USD financial instrument by business α will lead to similar accounting changes
are those explored in Chapter 12 under monetary destruction. We now turn to payments mechanics
because payments to other banks or withdrawals will lead to a need of USD on the asset side, and that can
be obtained in a similar fashion as a US bank but there are additional complications (see Chapter 12).
PAYMENT SERVICES
As Chapter 12 explains, the previous bold right entry in the balance sheet is a simplification because bank
F will make the payment to business β on behalf of business α. This simplification is necessary to deconstruct
the payment mechanics and settlement that will occur between banks. They are several possibilities that
relate to the location of the bank of business β and the willingness of foreign banks to issue financial
instruments denominated in USD:
- Case 1: Business β has an account at bank F. In that case, when bank F accepts business α’s financial
instrument it simultaneously credits the account of business β and that is it.
- Case 2: Business β has an account at another foreign bank with no relation to any US bank, bank
F2, that is chartered in the same country as bank F: banks will settle their interbank debt in the
same way as presented above when looking at bank AUS and bank BUS: they will use the account
they have at their central bank. Chapter 12 provides more details.
- Case 3: Business β has an account at a US bank or a foreign branch of a US bank. This case is covered
above.
- Case 4: Business β has an account at another foreign bank with no relation to any US bank, bank
F3, that is chartered in another country.
Case 4 would be the following. Bank F3, in Japan receives a USD-denominated payment for business β. The
counterpart will be a claim on bank F (again a one to one dollar-yen exchange rate is assumed).
Bank F3
Due from bank F: +¥120 USD Account of business β: +¥120
There are several ways to settle that claim depending on how bank F3 wants to be paid, but one may assume
that now that it has a USD-denominated liability it will match that with USD-denominated assets to protect
itself against exchange-rate risk. Thus, bank F3 will accept a settlement of its due from bank F by obtaining
a USD denominated account from bank F. Bank F3 can use that account to make payments to account
holders at bank F on behalf of business β.
Bank F3
398

USD account at bank F: +¥120
Due from bank F: -¥120
What if business β wants to withdraw $20 of US currency from its account at bank F3? Assuming that bank
F3 does not have any USD currency on its asset, it is going to have to find way to obtain them. Asking for
bank F will not do because the currency would need to be shipped and bank F does not own any US currency
on its balance sheet. Instead, bank F3 will need to get US currency from a quick source. The Bank of Japan
is the most likely source. This operation would involve debiting the checking account of bank F3 at the Bank
of Japan—the equivalent of reserve balance in the US—and debiting the amount of US currency own by the
Bank of Japan. The US currency would be shipped to the bank F3.
Bank F3
US currency: +¥20
Account at Bank of Japan: -¥20
If the Bank of Japan does not have US currency then bank F3 may find other sources of US currency by
borrowing it or selling assets for it. The source would have to be close enough to allow a rapid shipment of
the currency. If bank F3 cannot find the US currency demanded by business β, bank F3 is in default. In
practice, once business β has obtained a USD account at bank F3, bank F3 will proactively keep some US
currency on its balance sheet to meet potential withdrawals by business β.
EUROBONDS
TO BE WRITTEN
1 Stigum XXXXX
399
PART 7:
CHAPTER 27:
After reading this Chapter you should be able to understand:

CHAPTER 27: MONETARY POLICY AND THE ECONOMY
TO BE WRITTEN
404
GLOSSARY
GLOSSARY
A change its spending or taxation. For Book value: Valuation of an asset based
example, unemployment insurance goes on its purchased price minus
Advance: Funds provided by a bank to a
up automatically in a recession and goes adjustments for depreciation and others.
customer in exchange for the customer’s down automatically during an expansion.
financial instrument. Bond: A security with a relatively long
Similarly, tax revenues fall automatically
term to maturity. It pays a coupon
Adverse selection: Making a choice that during a recession because less income is
periodically.
negatively impacts the viability of a earned by the private sector. Conversely,
business. tax revenues rise automatically during an Borrowed reserves: Reserves obtained
expansion because more income is by going through the Discount Window
Agency securities: Securities issued by
earned by the private sector. (reserves “borrowed” from the Fed).
government-sponsored enterprises and
some federal agencies excluding those B Borrowing: Temporarily using the assets
issued by the Treasury. The Tennessee of someone else.
Balance sheet: An accounting document
Valley Authority issues most of these Broker: A financial institution that trades
that shows what is owned and owed by
securities. securities for the benefits of others.
an economic unit.
Amortization: The act of periodically Bank run: Most of the customers of a Bubble: A discrepancy between the
lowering the outstanding value of a market price and the fundamental value.
bank want to withdraw all of their funds
financial instrument to account for the
at the same time. Customers used to run
servicing of the principal. C
to the bank to be sure they would be the
Applied vault cash: The dollar amount of first in line to receive their cash. If they Callable: The ability of a creditor to
Federal Reserve notes that banks choose were not first in line, there was a risk request the faster repayment of
to use in order to comply with the they would be unable to get their cash. principal.
reserve requirements. Basis point: A one-hundredth of a Call risk: The possibility that a creditor
Arbitrage: The trading of assets to profit percentage point, 0.01%. requests a faster repayment of the
from the mispricing of assets. principal owed. The opposite of
Bearer: An economic unit who holds a
prepayment risk.
Ask price: The price at which someone is financial claim on the issuer. In most
willing to sell a financial instrument. cases, the bearer can sue the issuer if the CAMELS rating: A rating that measures
promise embedded in the claim in not the financial soundness of a bank.
Asset: Anything that is owned by an
fulfilled.
economic unit. Capital: See net worth.
Bid price: The price at which someone is
Asset-based credit (also collateral- Capital gain/loss: A change in the net
willing to buy a financial instrument.
based credit): A financial instrument worth due to a change in the market
underwritten with the expectation that Bid-ask spread: The difference between value in the assets.
the income of the issuer will never be the price at which someone is willing to
Capital requirement: Quantity of capital
enough to service the debt owed. sell (ask price) and the price at which
that a financial institution must keep
someone is will to buy (bid price). The
Asset portfolio: See portfolio. relative to the size and quality of its
wider the difference, the more volatile
assets in order to protect its balance
Asset position: See position. the market price is. The normal case is if
sheet against unexpected losses.
the ask price is above the bid price
Asymmetry of information: A situation Cash flow: Inflow or outflow of monetary
(positive spread), but it does not have to
in which an economic unit knows less instruments.
be the case.
than another economic unit at the time
of a contractual negotiation. Board of Governors: The head institution Cash management: A deliberate change
of the Federal Reserve System. It is of the level and structure of monetary
Automatic stabilizers: Changes in the balances to reach a specific goal.
composed of a maximum of seven
level and growth rate of government
Governors.
spending and taxation that occur Cash redemption: Redeeming a financial
because of changes in economic activity, instrument in exchange for monetary
not from the government decision to instruments.
405
GLOSSARY
Certificate of deposit (CD): A financial Contingent liability: A claim that is due Crying up/down the coinage: The act of
instrument issued by banks with a term when a specific event occurs. increasing/decreasing the face value of
to maturity varying from short to coins by decree.
Conventional mortgage: Any mortgage
medium term. It is equivalent to a
issued by non-government financial D
savings account but funds cannot be
institutions. Unconventional mortgages
withdrawn until maturity. Some CDs are Dated liability: A claim that requires
are those insured by government
negotiable. periodical payments.
agencies (such as the Federal Housing
Charter: Legal document that allows a Administration) and that have Dealer: A financial institution that trades
business to operate as specific financial unconventional characteristics (e.g., low securities for its own benefit.
institution (a bank, etc.). interest rate even though
Debasement: A legal or illegal decrease
creditworthiness of issuer is not good).
Chartist approach: A method of buying, in the quantity of precious metal in a
selling or holding a position that is based Convertible: The ability to hand back to coin.
on reading price charts and making the issuer its financial instrument and to
Debt deflation: An economic situation in
expectations of future prices based on get something else in exchange.
which overindebtedness and prices
the past behavior of prices.
Copayment: The payment of a fee each interact in such a way that it results in
Clipping of coins: The act of cutting out time medical services are requested. deflation, defaults, and a general decline
bits of precious metal out of the edge of in economic activity.
Coupon: The income received from a
a coin. This was quite common in the
bond and other similar securities. It is an Debt instrument: A financial instrument
Middle Ages when the edges of coins was
interest income, that is, its payment is characterized by the requirement to pay
not well defined. Clipping could go
due periodically and represents a a periodical payment of an income to
unnoticed in daily exchanges if done very
proportion of the face value of a bond. creditors, and ability to redeem it after a
moderately.
Bonds used to be made of paper with period of time (principal needs to be
Collateral: Assets held by debtors that small coupons attached to them that repaid by the issuer).
can be taken by creditors in case of needed to be detached and handed
Debt liquidation: The act of reducing the
default. Assets are usually sold to try to backed to the bond issuer to receive the
quantity of outstanding debts either by
recover some of the funds owed. interest payment due.
repaying them or by cancelling them.
Collateral risk: The potential inability to Credit-card receivable: Amount of debt
Debt management: The deliberate
recover funds owed because the value of outstanding on a credit card.
change in the level and structure of
the collateral falls dramatically.
Credit risk: The probability that an outstanding debt to reach a specific goal.
Commercial paper: A security issued by economic unit will default on its promise.
Debtization: The growing use of debt in
private companies with a short term to
Credit standards: Criteria used to daily economic activities. It is the
maturity (one year or less).
determine how creditworthy an counterpart of the financialization of the
Common stock: An equity instrument economic unit is. economy.
that provides a right to vote on some
Creditworthiness: Expected ability of an Deductible: Expenses induced by a
aspect of business management and that
economic unit to service its debts on contingency that are not reimbursed by
may or may not pay a dividend even if a
time in full. the insurance company. Dollar amount
profit exists.
deduced from what an insurance
Currency in circulation: Officially, it is
Conforming mortgage: A mortgage that company will reimburse.
mostly the value of Federal Reserve
has financial characteristics that conform
notes in the hands of economic units Deep market: A market in which there is
to criteria set by Fannie Mae, Freddie
others than the Federal Reserve banks, a large number of willing buyers and
Mac, and Ginnie Mae.
the U.S. Treasury, and banks. sellers at any price.
Consolidation: The act of merging two or Theoretically, coins held by others than
Default: The action of declaring the
more balance sheets into one. the previously cited economic units are
inability or unwillingness to service debts
also included in the definition.
Consumption (also final consumption): according to the previously agreed
The use of goods and service for personal Current yield: The ratio of the income timetable.
enjoyment. earned on a financial instrument to the
Deficit: A budgetary situation for which
price paid for that financial instrument.
spending exceeds income.
406
GLOSSARY
Defined-benefit plan: Pension fund that Efficient market: A market that allocate Federal funds market: A market in which
pays a given pension unrelated to resources toward the most productive participants borrow and lend federal
contributions to the plan. economic activities given the preference funds.
of market participants.
Defined-contribution plan: Pension fund Federal funds rate: The interest rate that
that links contributions to the pension Elastic currency: A currency that can be is paid (received) by an entity that
receive but allow the pension to vary injected and ejected from the economic borrows (lends) federal funds in the
with the rate of return on assets. system as needed. federal funds market.
Delinquent: Not servicing debts on time. Equity: See net worth. Federal funds rate target: The federal
funds rate that the central bank wants to
Demand liability: A claim that is due at Equity instrument: A financial
see in the market.
the will of the bearer. instrument that is a residual claim on a
business. Owners of equity instruments Federal Open Market Committee
Demand deposit: A bank account that
take losses first and are paid last. Some (FOMC): A committee of the Federal
promises conversion into cash on
equity instruments give a right to vote on Reserve System composed of the Board
demand.
some aspect of the business of Governors and the presidents of the
Depreciation: The act of lowering the management. They do not require the Federal Reserve banks. It formulates
outstanding value of a nonfinancial asset periodical payment of an income to monetary policy by meeting every six
to account for its use in the production creditor and have an infinite term to weeks or so and voting on the course of
process. maturity (they are not redeemable). The action in terms of the federal funds rate
claim is residual in the sense that income target. Presidents (except the President
Discount bond: See discount trading.
is paid only after all other creditors are of the New York Federal Reserve bank)
Discount trading: The market price of a paid and if there is any leftover income, rotate their voting power and only five
security is below face value. and in case of bankruptcy holders of out of the 12 can vote at any time.
equity instruments are paid last.
Discount Window: A means for the Federal Reserve Bank: One of the twelve
Federal Reserve System to provide Excess reserves: Quantity of reserves banks that is part of the Federal Reserve
collateralized advances to banks. that is kept by banks beyond what the System.
Fed requires them to hold.
Discount Window operation: The Fed Federal Reserve System (Fed): An
advances reserves to banks. Banks sign a F economic unit created by Congress to
financial instrument and in exchange get provide the currency of the nation, to
Face value: The price at which the issuer
reserves. All financial instruments must facilitate interbank payments, to
promises to redeem its financial
be collateralized so if banks default, the regulate member banks, to promote an
instrument. The outstanding principal
Fed takes the assets banks put as elastic currency, and to manage
due by the issuer.
collateral. economic activity. While it is structured
Fair price (also fair value): The price at with some for-profit features, its
Discount rate: The interest rate used to
which a security ought to trade. It may or activities and goals are oriented toward
calculate the present value of a future
may not be the price at which a security fulfilling the public purpose expressed in
cash flow.
actually trades (the market price). its functions. In addition, the Fed can
Dividend: The income received from a operate without making any profit.
Fannie Mae: A government-sponsored
stock. Its payment is a proportion of the
enterprise that buys conventional and Financial asset: A claim held against
profit of a company. It is not a required
government-insured mortgages from someone that involves contractual
payment.
banks as long as they conform to a set of monetary payments.
Duration: A measure of the sensitivity of standards it sets. It does so in order to
Financial instrument: A promise that
a financial instrument to a change in the encourage them to acquire more
contains some financial commitments.
interest rate. mortgages at more affordable rates. It
buys mortgages by issuing mortgage- Financial repression: Government
E
backed securities. involvements in financial markets that
Economic unit: An economic entity that, bring down the interest rate below its
Federal funds: The dollar value of the
depending on the level of analysis, can be equilibrium value.
accounts at the Federal Reserve banks.
a household, a firm, a government, a
country, or other entity that makes
decisions.
407
GLOSSARY
Financialization: The growing Funds: An outstanding quantity of Income-based credit: A financial

importance that the financial sector monetary instruments. instrument underwritten with the
plays in daily economic activity. expectation that the income of the issuer
G
will be sufficient to service the debt, if
Financing phase: A phase of economic
General obligation bond: Municipal not now at least sometime in the future.
activity in which bank credit is needed to
bond that is serviced with revenues
start production. Income distribution: The distribution of
received by the issuing municipality.
national income among, wage earners
Fine-tuning the economy: Policy
Ginnie Mae: A government-owned and profit earners.
strategy used by the central bank and the
company that guarantees the timely
U.S. Treasury to ensure that an economy Inflation risk: The probability of a
payment of principal and interest on
stays close to full employment with substantial fall in the purchasing power
mortgage-backed securities
stable prices. It involves nudging of future cash flows and outstanding
collateralized by federally insured or
incentives in the private sector and the financial assets
guaranteed mortgages. These mortgages
use of automatic stabilizers to move the
are issued mostly by low-to-moderate Initial public offering (IPO): The first-
economy in a specific direction and to
income households and by veterans. By time offering of a security.
ensure it is neither too hot (inflation
doing this, Ginnie Mae encourages banks
pressures) nor too cold (high Insolvency: Permanent inability to pay
to fund homeownership for veterans and
unemployment). creditors.
the poorer section of American
Fiscal deficit: See deficit. It results in the households. Institutional investors: See money
issuance of new Treasuries. managers.
Government-sponsored enterprise
Fiscal surplus: See surplus. It results in (GSE): A for-profit firm created by Insurance premium: Income due on
the repayment of existing Treasuries. Congress to fulfill a public purpose. Such insurance contracts.
enterprises have been created to
Foreclosure: The legal process necessary Interest: Income due on debt
promote homeownership, education,
to transfer the ownership of real estate instrument. It is due even if the debtor is
the electrification of the country, among
to creditors. It occurs when debtors have not currently able to pay (in which case
other goals that have been deemed
defaulted on debts secured by real unpaid interest is added to the debt
relevant to fulfill the public purpose.
estate. owed and can be claimed during a
They do so by encouraging banks to
bankruptcy process)
Forward guidance: A monetary policy lower the interest rate and underwriting
that involves influencing expectations of requirements on financial instruments Interest on reserves: Interest rate paid
the future path of federal funds rate issued to fulfill the activities that comply on reserve balances.
target through a specific wording of with the public purpose. That is done by
Interest-rate risk: Depending on the
current monetary-policy decisions. buying those financial instruments from
context, it can refer to a specific asset or
banks or by insuring banks against
Fraud: The act of gaining the trust of a to the overall balance sheet. In terms of
defaults on the financial instruments.
person and then abusing that trust. It is an asset, it is the probability that the
the act of deceiving for personal benefit. Fundamental value: The sum of all value of a financial asset will fall
discounted future incomes. drastically when interest rate go up, a
Freddie Mac: A government-sponsored
form of market risk. In terms of balance
enterprise that competes with Fannie H
sheet, it is the probability that interest
Mae.
Hedge finance: A financial situation in rates on liabilities rise above the rate of
Free reserves: Non-borrowed reserves which an economic unit is able now and return on assets.
held beyond what is required. in the future to service its debts with its
Intrinsic value: The market value of
income.
Fully amortized: Financial instrument material (paper for banknotes, gold for
that repays the principal owed bit by bit Household: A person, or group of gold coins, etc.) used to make a
periodically instead of all at once at persons, living in a dwelling. monetary instrument.
maturity.
I Investment: The purchase of goods and
Funding phase: A phase of the economic services to produce goods and services. It
Illiquidity: Temporary inability to pay
process in which finance plays a role for does not include the purchase of
creditors.
the acquisition of what has been financial assets.
produced.
408
GLOSSARY
Irrational behavior: Behavior that Liquid: An asset that can be traded Monetary base: The sum of reserves and
deviates from the standard neoclassical quickly without incurring large losses of cash in circulation.
hypothesis about behaviors capital. An asset with a relatively stable
Monetary instrument: A financial
(maximization and preference ranking). fair price. A perfectly liquid asset has a
instrument that is redeemable on
stable nominal value.
Issuer: An economic unit that created a demand. It may nor may not pay an
financial instrument and gave it to Liquidity preference: Economic units interest income.
others. That economic unit must now prefer to hold liquid assets over non-
Money manager: An economic unit that
fulfill the promise embedded in the liquid assets.
manages funds for other economic units
instrument.
Liquidity risk: The probability that the in order to provide a rate of return. This
J price of an asset will fall substantially include pension funds, mutual funds and
when its owner tries to sell it quickly. others.
Job guarantee program: An economic
policy that provides the opportunities to Liquidity trap: A situation in which long- Money supply: The sum of currency in
work for all persons willing and able to do term interest rate do not fall as monetary circulation and other monetary
so. This helps make a person more policy becomes more accommodative. instruments held by the public.
employable, uses her skills for social
Loss reserves: A buffer of net worth (and Moral hazard: An increase in the risk
purpose, and allows her to gain some
sum of funds on asset side) to protect taking of an economic unit once it knows
training experience. The alternative is to
against expected default. it is protected against specific adverse
be unemployed.
events. The increase in risk taking
M
L increases the probability that such
Margin credit: Credit provided by specific adverse events will occur.
Lease: Lending an asset with the option
brokers to their clients to take a position
of buying it after a period of time. Mortgage: A financial instrument backed
in securities.
by a residential or a commercial
Legal tender laws: Laws that dictate
Mark-to-market valuation: Valuation of property.
what is/are the ultimate means of
assets and liabilities based on their
payment. A creditor cannot pursue Mortgage-backed security (MBS): A
market value at the end of each day.
further legal actions against its debtors if bond that is backed by mortgages. The
it refuses payment in legal tender. Market risk: The probability that the cash flow for the interest and principal
market value will fall drastically. payments for the bond comes from the
Lender of last resort: A policy of the
servicing of mortgages.
central bank that involves providing Market value: Valuation of an asset
liquidity at a stable and low interest rate based on its daily trading price. Municipals: debt instruments issued by
during a financial crisis. state and local governments.
Market maker: A financial institution
Lending: Temporarily parting with an that makes a profit by limiting the Mutual fund: A financial company that
asset. volatility of the price of some securities. pool funds to buy assets that earn a rate
It buys whatever is in excess and sell of return.
Level-1 valuation: Financial instruments
whatever is in shortage.
are valued based on their market price. N
Marketable: A financial instrument that
Level-2 valuation: Financial instruments National bank: A bank that can operate
can be bought and sold in an organized
are valued based on a proxy market, everywhere in the nation.
market.
maybe because there is no readily
Natural growth rate: The growth rate of
available organized market for the Monetarily sovereign government: A
productive capacities induced by a given
instruments. government that issues unconvertible
set of allocation, preference and
monetary instrument denominated in its
Level-3 valuation: Financial instruments technique of production.
own unit of account and issues debt
are valued according to a model created
securities denominated in its own unit of Negotiable: It is possible to trade a
by the economic unit that holds them.
account. financial instrument. The ownership of a
Leverage: A measure of the financial instrument can be transferred
Monetary aggregates: Measures of the
indebtedness of an economic unit. by selling it because no specific
money supply. M1 is the narrowest
beneficiary is named on the note. The
Liability: Anything that is owed by an indicator.
person who will receive the benefits of
economic unit.
409
GLOSSARY
the financial instrument is merely “the debtors should bear the deflation risk. Overdraft: A negative balance in a bank
bearer.” The opposite of valorism. account.
Net acquisition: Acquisition minus Non-borrowed reserves: Reserves Overnight interbank market: The market
reduction in the quantity of assets or obtained through open-market in which banks lend and borrow reserves
liabilities. operations with the Fed or borrowed for the night.
from other banks.
Net asset value: Valuation method based P
on calculating the difference between Nonfinancial asset: Something owned
Par value: See face value.
the market value of assets and the that does not promise contractual
market value of liabilities. monetary payments to its owner. That Parity: See par value.
includes machines, software, and
Net asset value per share: Valuation Placement: The act of taking a position in
goodwill, among others.
method of mutual fund shares. an asset. At the aggregate level,
Normalization: A monetary-policy placement is the same thing as
Net borrowing: The opposite of net
strategy that aims at bringing the FFR investment if a new capital equipment is
lending.
back to more normal levels in an purchased.
Net capital gain: Capital gains minus environment of an abnormally large
Pension fund: A financial institutions
capital losses. quantity of excess reserves. The strategy
that aim at providing a pension to its
also aims at removing most of the excess
Net cash flow: Cash inflow minus cash clients.
reserves in the long run.
outflow.
Percentage point: An increment by one
Natural interest rate: The equilibrium
Net clearing of debts: The act of digit of the percentage, equals 100 basis
interest rate in the loanable funds
acknowledging what two (or more) points. For example, if the interest rate
market.
economic units owe to each other and to goes up from 3% to 4%, it went up by one
calculate the net amount due by one of O percentage point (4% minus 3%) rather
the economic units. For example, X owes than one percent (0.01*3%).
Offering: The act of issuing securities.
$10 to Y, Y owes $3 to X, then X owes $7
Ponzi finance: A financial situation in
to Y. Net clearing simplifies the settling of Open-market operations: The sale or
which an economic unit is not able now
debts by reducing the number of purchases of securities by the central
nor in the future to service its debts with
transfers between debtors and creditors. bank, on a permanent or temporary
its income. It must refinance or sell
basis, respectively to remove or add
Net financial accumulation: See net assets to service the interest and
reserves. The frequency of this market
lending. principal due, at least for a period of
intervention varies depending on the
time.
Net income: Income minus expenses. central bank, with the Federal Reserve
intervening daily and the European Portfolio: The set of assets held on a
Net lending: A positive difference
Central Bank intervenes weekly. balance sheet.
between the change in the volume of
financial assets and the change in the Originate and hold model: Banks acquire Position: The dollar value of a specific
volume of financial liabilities. Over a financial instruments and hold them to asset held on the balance sheet. This
period of time, an economic unit maturity. position can be long (one owns the
acquires more claims on others than specific assets) or short (one borrowed
Originate and distribute model: Banks
others acquire claims on that economic the specific asset).
acquire financial instruments and sell
unit.
them almost immediately. Preferred stock: An equity instrument
Net saving: See net lending. that does not provide a voting right but
Output gap: The difference between the
guarantees the payment of a dividend if
Net worth (also net wealth): The growth rate of aggregate demand and
there is a profit.
difference between the value of assets the growth rate of aggregate supply.
and the value of liabilities. Premium bond: See premium trading.
Outright sales: The action of
Nominalism: A legal view that states that permanently selling a financial asset. This Premium trading: The market price of a
the amount of principal owed should not is done when the Fed expects that some security is above its face value.
be impacted by inflation and deflation. of the reserves available will not be
Prepayment risk: The risk that a debtor
Creditors should bear the inflation risk, needed for an extended period of time.
chooses to repay its debt faster than
what was agreed upon in the debt
410
GLOSSARY
contract. Creditors lose some future Redemption mechanisms: See reflux S

incomes. mechanisms.
Saving: Depending on the context, it can
Present value: The sum of the Reflux mechanisms: The means available be the unconsumed monetary income or
discounted future cash flows. What a to the bearers to give back a financial the positive change in net worth.
future amount is worth today given a instrument to its issuers, that is, the
Say’s law: A theory about the
desired rate of return. existing means of implementing
impossibility to have a general
redemption. For example, taxes for
Primary dealer: A dealer that has a oversupply of goods and services. First
government currency, conversion into
privileged working relationship with the formulated by French economist Jean-
something else for convertible financial
Federal Reserve System. Baptiste Say (1767-1832)
instruments (like gold certificates or
Primary market: Market in which new convertible bonds), or payment of Scarcity: An economic situation in which
securities are offered. principal owed for mortgages. there are limited resources to fulfill
unlimited preferences.
Principal: Outstanding amount of debt Refinance: The act of repaying an old
left to be repaid. debt by issuing a new debt. Seasoned offering: Issuance of
additional securities.
Profitability: Ability to make a profit. Regulation Q: A regulation imposed by
the Federal Reserve System on its Secondary market: Market in which
Public debt: The face value of
members that forbids the payment of securities are traded.
outstanding Treasury securities. It goes
interest on demand deposits and puts a
up with a fiscal deficit and it goes down Secured: Backed by a piece of collateral.
cap on the interest rate that can be paid
when Treasuries are repaid.
on savings accounts and certificate of Security: A financial instrument that is
R deposits. tradable. Depending on its financial
characteristics, a security can take a
Rate of return: A measure of monetary Repurchase agreement: When a party
different name such as stock, bond, or
gains in percentage rather than dollar agrees to sell/to buy something today
commercial paper.
amount. The amount earned relative to and to buy/to sell it back in the future.
the cost of getting access to that earning. Security redemption: A financial
Required reserves: Quantity of reserves
instrument is redeemed by the issuer
Real Bill Doctrine: A view according to that a bank must have.
handing some securities.
which the financial assets of the Fed
Reserves: See total reserves.
should only be composed of self- Settlement of debts: The act of paying
liquidating assets, that is, financial Reserve balances: Accounts of banks at debts.
instruments that are issued and the Federal Reserve.
Solvency: Ability to pay creditors at any
destroyed in relation to economic
Reserve requirements ratio: Proportion time.
activity. Firms issue commercial paper to
of total reserves that a bank must have in
finance production and redeem the Specialist: A broker who only trades
relation to its transaction accounts.
papers when they make a profit. specific securities.
Retail funding sources: Small sums of
Recourse: The ability of creditors to ask Speculation: The act of taking an asset
funds obtained from petty accounts
for more funds from debtors if the sale of position with the view of unwinding it to
(savings accounts, checking accounts,
collateral has not been sufficient to make a capital gain. Buying (long
certificates of deposits)
recover what is owed. position) or borrowing (short position)
Return on asset: The value of monetary an asset, in order to make a capital gain
Redeemable: A financial instrument that
gains relative to the value of assets. by reselling it at a higher price (long
can be returned to its issuer at some
position) or repurchasing it at a lower
point in time through some reflux Return on equity: The value of monetary
price (short position).
mechanisms. gains relative to the value of net worth.
Speculative finance: A financial situation
Redemption: The action of giving back to Revenue bond: A municipal securities
in which an economic unit is not able
the issuer its financial instrument. A that is serviced with the revenue earned
now nor in the future to service its debts
corporation gets back bonds it issued. A on a specific income-earning project.
with its income. It must refinance the
mortgage note is handed back to its
Risk management: Means used to principal due at least for a period of time
issuer at maturity. Currency is handed
protect a balance sheet against expected or must sell assets to service the
back to its issuers. Repayment of the
and unexpected adverse shocks. principal.
principal owed.
411
GLOSSARY
State bank: A bank that can only operate T-note: Treasuries with a term to supplies more the promise of
in a state. maturity of more than 1 year but less convertibility becomes harder to fulfill.
than 10 years
Stock (also equity or share): Security U
that represents a share of the company. Term to maturity: Time left before the
Unamortized: Financial instrument that
The bearer is the owner of the company. principal on a security is due.
repays the principal owed at once at
Common stocks allow the bearers to vote
Time deposit: A bank account from maturity.
on the major strategic decisions of the
which one cannot withdraw funds for a
company. Preferred stocks do not give a Unconvertible: A financial instrument
period of time. Certificates of deposit are
voting right but guarantee the payment that is not convertible.
a form of time deposit.
of a dividend.
Underwriting: The act of determining
Too big to fail: Said of a financial
Subordinated: Financial instrument that the creditworthiness of an economic
institution that market forces would shut
take losses before other financial unit.
down, but that must be saved by the
instruments in case of default.
government because its failure would Unit labor cost: The ratio of wage over
Surplus: The opposite of deficit. cause too much damage to the economy. the productivity of labor.
Surplus vault cash: Federal Reserve Total rate of return: The rate of return Unit of account: The unit in which
notes that banks have in excess of what that is included all the sums earned from transactions and outstanding balances
they use to meet reserve requirements. the time of purchase to the time of sale are measured and recorded.
of a financial instrument. The sum
Sweating coins: The act of shaking coins Unsecured: Financial instrument not
includes income earned, reinvestment
in a bag to remove tiny bits of precious backed by any collateral (e.g., credit
income, and capital gains/losses.
metal. A less easily detectable means of receivables). There may still be some
illegal debasement than clipping. Total reserves: The sum of reserve recourses for bearers.
balances and applied vault cash.
Syndicated credit (also syndicated loan): V
The provision of credit service by a Treasury’s general account (TGA):
Vault cash: The Federal Reserve notes in
consortium of financial institutions. Account of the Treasury at the Federal
the vault of banks.
Reserve that Treasury uses to spend.
T
Valorism: A legal view that argues that
Treasury securities: See Treasuries.
Takeover bid: An offer to buy the stocks the principal owed should be adjusted to
of a company with the goal of taking Treasury’s tax and loan account: maintain its purchasing power constant.
control of it. To be successful, the bid Account of the Treasury at private banks
Vesting period: Number of years
price as to be much higher than the that the Treasury uses to collect funds
someone must contribute to a pension
current market price so that many received from taxes and the issuance of
fund before he can receive a pension.
stockholders are willing to sell to the Treasuries.
economic unit making the bid. Takeover Volcker experiment: A change in
Treasuries: Securities issued by the U.S.
bid can be friendly or hostile (the board monetary policy operations toward a
Department of the Treasury.
of director of the targeted company does looser targeting of the federal funds rate
not agree to the takeover). Treasuries held by the public: Treasuries and a focus on targeting monetary
held by economic other than the federal aggregates.
Tax receivable (or payable): Taxes
government agencies. The “public”
recorded as due but not paid. W
includes the Federal Reserve System,
T-bill: A security issued by the U.S. domestic non-federal economic units, Wholesale funding source: Large sums
Treasury with a term to maturity of at and foreigners. of funds obtained from financial markets
most one-year and that does not provide (large negotiable CDs, federal funds
Trickledown effect: The positive impact
a coupon payment. market, etc.)
on the economy of having policies that
T-bond: A security issued by the U.S. cater to wealthy individuals. Y
Treasury with a term to maturity of more
Triffin dilemma: If a currency is both Yield: See rate of return.
than ten years. More loosely, the term is
convertible and in high demand by the
used to mean any treasuries with a term Yield to maturity: The yield obtained if a
rest of the world, the issuer of that
to maturity greater than one year. security is held until it matures and the
currency must supply enough, but as it
412
GLOSSARY
incomes received while holding the

security are reinvested at that yield.
Z
Zero-coupon security: A security that
does not pay any coupon.
413
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.
414
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THE FINANCIAL

After reading this Chapter you should understand:

WHAT IS A BALANCE SHEET?

Figure 1.1 A balance sheet

Figure 1.2 A simple balance sheet

Table 1.1 Balance sheet of households and NPOs.

BALANCE SHEET RULES

Figure 1.3 A simple balance sheet

Figure 1.4 Effect of forgiving some of the mortgage principal

Figure 1.5 Effect of higher house price

CHANGES IN THE BALANCE SHEET

NET CASH FLOW

Figure 1.8 Balance sheet and cash flow

Figure 1.9 Balance sheet and cash flows, an example

Figure 1.10 Balance sheet after the cash-flow impacts

NET ADDITION TO ASSETS AND LIABILITIES

Net income leads to a change in net worth:

NET CAPITAL GAIN

MACROECONOMIC USE OF BALANCE SHEET: THE FINANCIAL

Summary of Major Points

After reading this Chapter you should understand:

Organized Exchanges (CBOT, CBOE, NASDAQ, NYSE)

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

Figure 2.1 The financial system in the United States

THE FINANCIAL SECTOR: A WORLD OF PROMISES

Figure 2.3 Some nonfinancial promises

CREATION AND DESTRUCTION OF FINANCIAL INSTRUMENTS

Financial instrument of issuer

$$ (purchased price: fair price) At issuance

Issuer $$ (income) Bearer Until maturity

$$ (repurchase price: face value) At maturity

Financial instrument of issuer

CHARACTERISTICS OF A FINANCIAL INSTRUMENT: TERM TO

MARKETABLE FINANCIAL INSTRUMENTS: SECURITIES

Figure 2.6 Net issuance in corporate equities, billions of dollars.

Figure 2.8 Structure of issuers of corporate equities (percent)

Figure 2.13 An old fashion bond

Figure 2.15 Structure of issuers of corporate and foreign bonds, percent

Figure 2.20 Structure of issuer of Agency- and GSE-backed securities (percent).

NON-MARKETABLE FINANCIAL INSTRUMENTS

Figure 2.27 Structure of issuers of mortgages, percent.

Figure 2.30 Types of consumer credit, percent.

1 Currency and Treasury currency in circulation 12 US Treasuries

Summary of Major Points

After reading this Chapter you should understand:

MAINTAINING SOLVENCY: PROFITABILITY AND LIQUIDITY

- Case 1: The balance sheet looks like this:

PRIVATE DEPOSITORY INSTITUTIONS: COMMERCIAL BANKS AND

Figure 3.2 Structure of liabilities of FDIC-insured commercial banks

Figure 3.5 Structure of the liabilities of savings institutions

Figure 3.7 Structure of the liabilities of credit unions

LIFE INSURANCE COMPANIES

Figure 3.9 Structure of liabilities of life insurance companies

PROPERTY AND CASUALTY INSURANCE COMPANIES

Figure 3.11 Structure of liabilities of property and casualty insurance companies

Figure 3.13 Structure of the liabilities of finance companies

FINANCIAL INVESTMENT COMPANIES

REGULATED PORTFOLIO MANAGEMENT COMPANIES: MUTUAL FUNDS AND

Figure 3.16 Structure of liabilities of mutual funds

Figure 3.18 Structure of liabilities of money market mutual funds

LIGHTLY REGULATED PORTFOLIO MANAGEMENT COMPANIES: HEDGE

REAL ESTATE INVESTMENT TRUSTS

Figure 3.22 Structure of liabilities of real estate investment trust

FINANCIAL MARKET COMPANIES