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As usual, Paul Krugman gets right the the essence of the problem:

Actually, Tobin-Brainard is to many of the controversies that swirl around banks and money as IS-LM is to controversies about interest-rate determination. When we ask, “Are interest rates determined by the supply and demand of loanable funds, or are they determined by the tradeoff between liquidity and return?”, the correct answer is “Yes” “” it’s a simultaneous system. Similarly, if we ask, “Is the volume of bank lending determined by the amount the public chooses to deposit in banks, or is the amount deposited in banks determined by the amount banks choose to lend?”, the answer is once again “Yes”; financial prices adjust to make those choices consistent. Now, think about what happens when the Fed makes an open-market purchase of securities from banks. This unbalances the banks’ portfolio “” they’re holding fewer securities and more reserve “” and they will proceed to try to rebalance, buying more securities, and in the process will induce the public to hold both more currency and more deposits. That’s all that I mean when I say that the banks lend out the newly created reserves; you may consider this shorthand way of describing the process misleading, but I at least am not confused about the nature of the adjustment.

Yup, that’s all it means. Krugman begins the post by acknowledging that there is a group with very different views:

I’m actually kind of reluctant to even get into this, because any discussion of these issue brings out the people who believe that they have discovered the hidden secrets of the monetary universe, somehow missed by generations of economists. But here goes anyway.

I get lots of commenters coming over here breathlessly telling me the wonderful news—it’s been discovered that banks don’t actually loan out reserves! How does one even respond to that sort of ferver? Now I have a simple answer; “it’s a simultaneous system.” I can stop wasting so much time in the comment section.

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This entry was posted on August 17th, 2013 and is filed under Monetary Theory. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



