Front Page Titles (by Subject) 5: Changes in the Demand for Inside Money - The Theory of Free Banking: Money Supply under Competitive Note Issue
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5: Changes in the Demand for Inside Money - George A. Selgin, The Theory of Free Banking: Money Supply under Competitive Note Issue 
The Theory of Free Banking: Money Supply under Competitive Note Issue (Lanham, MD.: Rowman & Littlefield, 1988).
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Changes in the Demand for Inside Money
Except in Chapter 2, where account was taken of the effects from a lowering of the exchange value of commodity money in response to fiduciary substitution, this study has assumed a demand for money balances fixed in both real and nominal terms. We must now consider how a free banking system responds to changes in the demand for money. Would a free banking system accommodate an increase in the demand for money? Would it automatically reduce the supply of money in response to a fall in the demand for it? Would it, in short, continue to maintain monetary equilibrium?
A change in the demand for money—meaning real demand to hold inside money—can be due to a change in the number of bank liability holders, a change in the holdings of the same individuals, or a combination of both. It does not necessarily involve any redistribution of existing demands among various banks. References to an increasing or decreasing demand in this chapter will mean changes in aggregate or total demand. Thus when the demand to hold the liabilities of one bank increases, it is assumed, unless otherwise stated, that there is no change in the demand to hold liabilities of other banks.
Increased Money Demand
Suppose then that there is a growth in the total demand for inside money that takes the form of a growth in demand for the liabilities (notes and deposit balances) of one bank. How can this increased demand be satisfied? We have seen that, in a mature system where there is no more outside money in circulation to be deposited, all fresh sums of inside money make their first appearance through new loans and investments. In general such newly issued liabilities do not at first come into the hands of those persons who happen to desire to hold more of them. There is an exception to this, though, which also provides the simplest example of how a bank may profitably expand its liabilities (with a fixed supply of reserves) in response to the increased money demands of its clients. This exception involves so-called compensating balances. These are balances held by bank borrower-customers as part of their loan agreement. A person or firm that holds compensating balances is simultaneously a borrower and a lender of the sum in question: in accepting a loan the person or firm becomes a debtor to the bank, but to the extent that borrowed funds are willingly held (rather than spent) the borrower is also a creditor. The bank has issued claims to commodity money, but these claims are not going to be redeemed by anyone. Some of the commodity money that has been “borrowed” is, in effect, never taken from the bank. Hence the bank can lend it to someone else.
When a bank borrower explicitly agrees to keep a compensating balance, the banker knows in advance that the balance will be held rather than spent and that it will therefore not become a source of adverse clearings like other loan-created deposits. A bank’s compensating-balance liabilities are one of its most reliable sources of credit.
The holders of compensating balances, in turn, also benefit by holding them so long as their borrowed holdings do not exceed their ordinary demands for money balances. The benefit is due to the fact that loan rates are generally lower for loans involving compensating balance agreements, which reflects the banker’s preference for having his liabilities outstanding in a form not likely to contribute to unanticipated clearing losses.1
That banks can accommodate the fluctuating money demands of their borrower customers by means of changes in compensating balances is obvious enough. But how might they satisfy the increased demands of would-be note and deposit holders who are not among their borrower customers? Recall that every day a certain number of a bank’s notes and checks enter the clearing apparatus and become a source of debits against it. If the bank is in equilibrium vis-à-vis its rivals, it will on average have clearing credits equal to its clearing debits, and so it can maintain its outstanding liabilities, replacing its earning assets as they mature. Now suppose that some of the bank’s depositor customers write fewer checks on their balances (without increasing the average size of their checks), or that more individuals who come into possession of the bank’s notes hold on to them instead of spending them. The result will be a reduced flow of the bank’s liabilities into the clearing mechanism—a reduction in adverse clearings against it—much like the reduction that would occur if borrower customers elected to increase the portion of their borrowings represented by compensating balances.
A metaphorical description of the process of demand expansion may be helpful. The outstanding supply of inside money may be thought of as flowing through the economy in a stream of money income and expenditures. Along this stream are pockets or “reservoirs” representing individuals’ and firms’ holdings of inside-money balances. When the demand for money increases, either the number of reservoirs increases (as when the number of firms or people that want to hold money increases), or existing reservoirs deepen (as when demands of existing money holders become more intense). Either case results in a withdrawal of funds from the income stream. When the increased demand is for the liabilities of one particular bank, then that bank’s liabilities are removed from the flow of spending and income. Instead of being cancelled by the clearing mechanism, they become lodged in the reservoirs of demand.
The withdrawn liabilities thus cease to contribute to their bank’s reserve demand: the reserves held by their issuer—formerly just adequate to sustain its liabilities—become excessive as positive net clearings accumulate. To maximize its profits, the bank whose liabilities are in greater demand expands credit. This newly expanded credit is transfer credit, because it is issued in response to the desire of certain people to hold more of the liabilities of the bank that grants it. Hence it does not lead to any forced savings or upward pressure on prices. It allows the bank to recover its equilibrium vis-à-vis other banks in the system.
It should be noted that, as far as the maintenance of monetary equilibrium is concerned, the specific point of the injection of new liabilities is not crucial: the bank can be expected to make new credits available to borrowers in a way that satisfies the principle of equimarginal returns.2 All that matters is that the bank recognizes the decision to save made by holders of inside money.
Now consider the consequences of an increased general demand for inside money, one that confronts all banks at once. No bank in this case witnesses any improvement in its circumstance relative to other banks, that is, any positive net average clearings. Nevertheless each bank will have fewer gross clearings than before, insofar as the banks considered as a group do not respond to the increased demand, and this will reduce each bank’s need for (precautionary) reserves relative to its actual reserve supply. Thus the banks will find it profitable to expand until their total gross clearings are such as to again raise the demand for reserves to the level of available supply. A more complete explanation of this requires a discussion of the economic determinants of reserve demand, which is deferred until the next chapter.
To summarize, a general increase in the demand for inside money is equivalent to a general decline in the rate of turnover of inside money. Bank notes change hands less frequently, and holders of demand deposits write fewer (or perhaps smaller) checks. As a result, bank liabilities pass less frequently into the hands of persons or rival issuers who return them to their points of origin for redemption. The reduction in turnover of liabilities leads directly to a fall in the volume of bank clearings. When this happens banks find they have excess reserves relative to the existing level of their liabilities, and so they are able to increase their holdings of interest-earning assets, which they do by expanding the supply of inside money in a manner that accommodates the growth in demand for it. In standard textbook terminology, there is an increase in the reserve multiplier. Liability expansion continues so long as there are unfilled reservoirs of demand. Any issues in excess of demand, however, will lead to additions to the stream of payments, causing an increase in bank clearings and reserve requirements.
Yet another way to put the argument is to speak in terms of velocity rather than turnover. Then free banks can be said to accommodate a fall in the velocity of inside money with an increase in its supply. Regardless of how one phrases it, the actions of the banks are precisely the ones required for the maintenance of monetary equilibrium. For reasons that will be made clear later on, this cannot generally be the case for central-banking systems or for otherwise unregulated systems lacking freedom of note issue.
An issue arises at this point concerning the relative maturity structures of bank assets and liabilities. Individual money-holders’ offerings of credit to their banks are, generally speaking, of much shorter (as well as more uncertain) duration than the banks’ resulting offerings to their borrower customers. Hence the bankers must be able to transform short-term credits of unknown duration into longer-term loans and investments. They do so by taking advantage of the law of large numbers in the same way as goldsmith bankers took advantage of it in making the first loans based on fiduciary media (see above, chapter 2). The actions of large numbers of independently motivated users of inside money will largely offset one another in the day to day course of things. One person spends his deposit balance previously held at Bank A, thereby ceasing to be one of its creditors. Another simultaneously adds to his deposit account at Bank A. The same kind of largely offsetting transactions occur at all other banks. As a result, the sum of short-lived, individual demands for inside money can be treated by the banks as a fund suitable for investing in a portfolio of earning assets the average maturity of which significantly exceeds the average turnover period of individual notes or deposit credits. The maturity structure and quantity of a bank’s loans and investments therefore depends on the expected behavior of the aggregate demand for its liabilities, and not on changes in the composition of individual demands from which the aggregate is derived.
Decreased Money Demand
Now consider what happens when the demand for inside money falls. Supposing once more that the fall affects the liabilities of one bank only, it means the shrinking or disappearance of reservoirs in which that bank’s liabilities were formerly lodged. The liabilities return to the stream of money income, where they pass into the clearing mechanism and become debits to their issuer. To adjust its position vis-à-vis its competitors the bank, experiencing reduced demand for its liabilities, calls back some of its loans and liquidates some investments or at least ceases to renew some existing loans as they mature. Thus, just as the supply of inside money is increased through the expansion of credit, it may be reduced through the absorption of credit, that is, by the retirement of loans and investments.3
It is even possible for unwanted liabilities to be directly returned to their points of origin by way of the repayment of loans. Suppose, for example, that the surplus liabilities no longer wanted in money balances are paid over to someone who happens to be indebted to their issuer, and that the individual in question uses them to repay his loan. What is the overall result of this transaction? The bank suffers no clearing loss and no change in the volume of clearings against it.4 Yet the sum of its outstanding liabilities has fallen, assuming that the bank does not make any new loans or investments. If, on the other hand, the bank attempts to restore its assets and liabilities to their previous level by new extensions of credit it will suffer adverse clearings approximately equal to the new issues. Presumably the bank had no excess reserves to begin with (i.e., before the demand for its liabilities fell and before one of its loans was repaid). Since nothing has happened since to supply it with excess reserves, the bank cannot sustain further adverse clearings, and so it must ultimately accept a reduction in its business.
Similar consequences follow if the liabilities of one bank, the demand for which has fallen, are used to repay loans at another bank. What happens here is best understood as a two-step process. First imagine that Y, who is indebted to Bank B, receives inside money from X, who in making the payment in question permanently reduces his holdings at Bank A. Suppose furthermore that Y at first deposits the sum received from X at Bank B. Then Bank A will, other things being equal, suffer an adverse clearing equal to the amount of the payment made by X to Y. In response to this loss Bank A has to contract its liabilities. On the other hand, Bank B has become a recipient of new, excess reserves, and so it can expand its liabilities. The overall result so far is a zero net change in the supply of inside money, since Y’s increased holdings precisely offset the reduction of demand on the part of X.
Now, however, we must consider the second step of the loan repayment process, in which Y withdraws his new deposit by writing a check to his bank in repayment of a loan that was previously granted to him. This is identical to what happens when unwanted liabilities are used directly to repay loans from their original issuer. It leads to the extinction of the liabilities, with no possibility for offsetting expansion by the bank to which they are repaid. Thus when unwanted liabilities from Bank A are used to repay loans from Bank B, the overall result is an extinction of Bank A’s liabilities to the extent of the fall in demand with no offsetting increase (of any significant duration) in the supply of liabilities from Bank B or from any other bank.
The processes described here can once again be generalized for the case of an all-around reduction in the demand for inside money. In this case there is an increase in the rate of turnover (or velocity) of bank liabilities, which means that bank clearing assets have to “turn over” more rapidly as well. In other words, the liquidity needs of the banking system increase, and an existing volume of reserves can no longer support the same amount of inside money. Therefore assets and liabilities must contract, and the reserve multiplier falls. Once again the explanation of reserve demands involved in this generalization must wait until the next chapter.
Thus the capacity of free banks to maintain equilibrium applies also to conditions where the demand for inside money is changing. This result is just an extension of the static rule of excess reserves since it rests on the demonstration, to be completed in the next chapter, that the overall availability of excess reserves (or conversely the overall excess demand for reserves) is a function of the aggregate demand for inside money. It does not apply to systems with monopolized currency issue: adjustments in the money supply in such systems have to be achieved, assuming they can be achieved at all, by deliberate policy. The possibilities for controlling the money supply by means of central banking will be critically examined in chapters 7 and 8. Prior to this, though, it is necessary to examine certain common ideas concerning reserve requirements that might cast doubt upon the conclusions just arrived at.
[1.] See Richard G. Davis and Jack M. Guttentag (1962), who describe compensating balances as a way for banks to guarantee that their borrower-customers will hold their working balances with them rather than elsewhere. They also note (123fn) that in many instances the requirements, rather than being based on “hard and fast agreements,” take the form of informal understandings.
[2.] See Harold Barger (1935, 441). Barger, however, believes that monetary equilibrium can be maintained only if credits are restricted to producer (and not consumer) loans. His position seems to be based on the view that “non-productive” loans will not generate interest necessary for their repayment. This view overlooks the fact that consumer-borrowers can pay interest out of their future income even if this involves a reduction in wealth. Thus, banks’ granting of loans to consumers, although it does not necessarily contribute to capital accumulation, is still consistent with the preservation of monetary equilibrium.
[3.] The process of inside-money absorption is discussed in Shotaro Kojima (1943, 17-18).
[4.] It is assumed that before being paid-in the liabilities were strictly “idle,” so that they were not a cause of any bank clearings.