Deep-Dive Understanding of Re-distributive Monetary Policy

This is the third part of the Diabolic System of Money in Banking article series. In recap, under part one, we studied how a financial econo...

This is the third part of the Diabolic System of Money in Banking article series. In recap, under part one, we studied how a financial economy works and how banks create money. And part two, we'll learn how an adverse shock is endogenously amplified through the liquidity spiral and the disinflation spiral. Now in part three, we introduce monetary policy and macro Prudential policy.

Re-distributive Monetary Policy
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The role of monetary policy in this framework is to limit the systemic risk that is endogenously created by the system. Hence, monetary policy will also reduce the wealth redistribution generated by systemic risk. There are different views about monetary policy. The money view focuses on restoring a broad measure of the total money supply to credit you focus on restoring credit by switching off the disinflationary spiral and the liquidity spiral.

The objective of the money view is to restore the total money supply. The central bank can vary the supply of outside money to indicate the passion interest 1930s the total money supply shrank. Many banks went bankrupt and the amount of demand deposits dropped. Inside Money, Frank Friedman and Schwartz concluded in their seminal work that the central bank failed to expand out that money as insert money was declining. Picture the increase in outside money supply as a helicopter drop of cash. But suppose the helicopter drops new money only to save us and not to the banks. As inside money shrinks outside money expands to questions arise.

 First, will this fully undo the dis-inflationary spiral and calm, Consequently, the central bank will meet its inflation target. The answer is No. Inflation will still understood. So, unless, even though the money supply is fully restored, it is important to note that money demand also rises. This is because as banks diversify away less, it is credit risk and people have to bear it. People like to hold my money.

 The second question is who actually benefits from the helicopter drop to the savers? Paradoxically, the banks are better capitalized, even though the money was dropped exclusively to the savers. Why are the banks benefiting from our money drop to the savers? Recall that savers would benefit from disinflation if the economy were not to tank. The extra outward money dropped on the same as high ever switches off this benefit. It reduces the value of the outside money. And inside money as the value of insert money declines, bank's liabilities decline in value.

This recapitalizes the bank somewhat, in which by the way also stabilizes the whole economy. In some, the money view makes a case to replace the reduction inside money due to the adverse shock. With an increase in outside money, the emphasis is on the liability side of the bank's balance sheet.

 In contrast, the credit view focuses on restoring healthy credit. Proponents of the credit view, focus on the asset side of the bank's balance sheet, in particular, the credit supply of banks. The focus should be on healthy credit, not credit from Zombie banks.

The Banks, which are under-capitalized and have negative equity. Not credit from Vampire Banks, which offer high interest on demand deposits in order to attract more funding even though they are insolvent. So the question stands, how can one promote healthy credit? Let's see what happens when we give out money to the banks directly. Now suddenly banks have more assets than liabilities to what's the safest state is same. To balance the balance sheet and then the equity rises banks are recapitalized.
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Suppose we give the bank's exactly the same amount they have lost from the initial adverse shock. And there's no reason for them to extend less credit to the real economy or to issue less inside money. We have switched off both the dis-inflationary spiral into a liquidity spiral, no fire sales, no dis-inflationary pressure, etc. all the adverse effects are switched off. Of course, there is also a difference, Now all claims towards the Central Bank. Monetary policy in reality does not occur through a helicopter drop of money. The recapitalization of the banking system might occur in more subtle ways to what we call stealth recapitalization. Monetary Policy occurs by influencing prices and interest rates.

For example, through interest rate policy in open market operations, or through the outer purchase of bank loans. When the central bank buys loans directly, let's focus on interest rate policy. For this, we now assume that the central bank pays a nominal interest rate on reserves financed simply by printing new money to see the effect of monetary policy through interest rate changes. We have to introduce in addition to the outside money, a long term bond it shows up on the liability side of the government's balance sheet, we will assume that the bond pays a fixed interest rate, there is no default, and we will assume that the banks hold these bonds.

Now on the bank's balance sheets, we have in addition to the credit extended to the end pauses. So long term bonds, which is credit extended to the government. Note that the value of long term bonds rises when short term interest rates for. In addition, the pure existence of long term bonds increases the supply of assets that can be used as a store of value.

As before, let's study the impact of a small permanent adverse shock to the end powers. The initial direct impact is that it lowers the value of the loans extended by the banks. If at the same time as the value of the bank's asset decline, the central bank cuts shorter interest rates, then the value of the long term bond increases.

Monetary policy can compensate the bank's losses with capital gains on the long term government bonds. Hence, it switches off the liquidity spiral and the disinflationary spiral. In a sense, a helicopter prop to the banks was conducted through the interest rate policy, in a subtle way, a stealthy capitalization of the levered sector, which suffered from adverse shocks occurred. This stealth recapitalization of banks can be viewed as exposed redistribution of wealth, two important qualifiers need to be made.

Ideally, monetary policy should simply limit the redistribution caused by the endogenously generated systemic risk. Second, undoing this redistribution is not a zero-sum game. It creates overall welfare gains, sometimes even everyone can be better off. Instead of looking at exposed to the distribution, let's look at the ex-ante monetary policy rule.

Before we know whether there will be a positive or negative shock, and optimal ex-ante monetary policy rule cuts interest rates after negative shock and raises interest rates after positive shock. It acts like an insurance arrangement. Whenever there's a negative shock, the central bank creates capital gains for the banks by lowering the interest rates. Whenever there's a positive shock, it creates wealth losses by increasing the interest rates.

The optimal monetary policy calls for clear rule variables that show that the financial sector is undercapitalized like credit interest rate spreads should be part of such a rule. In a sense, we add to the money versus credit view a third perspective. So risk view, monetary policy can assume and redistribute tail risk and risks that occur in Nigeria tail events. This risk transfer stabilizes the economy by reducing amplification effects and endogenous risk.

However, as people in the economy anticipate the Central Bank's reaction, they also change the ex-ante behavior. And insurance arrangement comes with a moral hazard problem. If you provide the banks with full insurance against the negative shock, they will take on more risk-taking more leverage, arguably more than the economy can bear. So monetary policy has to be complemented with strict rules that limit pain and risk-taking. In other words, cannot separate monetary policy rules from macro Prudential rules like a loan to value ratios, haircut roles, and so forth that limit banks and others risk-taking behavior.

With the appropriate macro Prudential Regulation in place, monetary policy can assume a more forceful role as an insurer of aggregate risk market potential regulation in the largest set of implementable monetary policy rules.

In other words, market potential regulation in monetary policy, complementing each other. Again, one cannot separate price stability from financial stability. We now have a better understanding of the interaction between financial stability and monetary policy.

However, notice that although monetary policy can be a powerful tool that can ease a shock if properly applied, Its power is not limitless. By intervening in the government and the central bank pay-off the risk that can potentially put the whole nation into jeopardy (danger of loss, harm, or failure). To understand it better, we now need to consider our final stability concept, the government debt sustainability.

 To sum up, in part three of this video series, we stress the stabilizing and re-distributive role of monetary policy. We contrast it, the money view with the credit view. And you also learned that monetary policy can be more effective if macro Prudential policy limits to this taking. Click on Part Four, to learn about the three stability concepts and what happens if government debt might default. 



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Beyond Narrative | Blog Where Every Single Word Matters: Deep-Dive Understanding of Re-distributive Monetary Policy
Deep-Dive Understanding of Re-distributive Monetary Policy
Beyond Narrative | Blog Where Every Single Word Matters
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