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Money, net wealth, and the real-balance effect
DANIEL L. THORNTON Federal
Reserve Bank of St. Louis
Bank Money, Net Wealth, and the Real-BalanceEffect* Tlas paper deals with two important questious in monetary economics: Is competitively produced resource-using bank money part of society’s net wealth? IS such money part of the base relevant for the operation of the real-balance effect? We argue that the answer to the first question depends critically on the nature of the asset and not on the market structure of the industry, In particular, we argue that perfect competition in the banking industry is a necessary but not sufficient conditious for excluding bank money from society’s net wealth. Furthermore, we argue that resource-using bank money is part of the base relevant for the operation of the real-balance effect, regardless of whether or not it is part of society’s net wealth.
1. Introduction Over a decade ago, Pesek and Saving (P-S) attacked the conventional wisdom that bank money is, ipso facto, the debt of issuing banks. They argued that bank money is part of society’s net wealth and, hence, part of the base relevant for the operation of the real-balance effect. While making this point, they attacked other aspects of monetary theory and, as a result, provoked a number of responses.’ While many of their critics argued to varying degrees against the proposition that bank money is net wealth and, hence, a vehicle for the real-balance effect, the most rigorous and forceful attack came from Patinkin (1969, 1972). In his analysis of P-S, Patinkin presented the following proposition:
*I would like to thank Alan Nichols, Boris Pesek, Ron Ratti, Basil Zimmer, Jr., and the anonymous referees for helpful comments on an earlier draft of this paper. They are absolved of responsibility for any errors. The views expressed here do not necessarily represent those of the Federal Reserve Bank of St. Louis or the Federal Reserve System. ‘For the more important responses to P-S’s work, see: Buchanan (1969), Johnson (1969), Laidler (1969), Smith (1970), Patinkin (1969, 1972), and Marty (1969). Journal of Macroeconomics, Winter 1983, Vol. 5, No. 1, pp. Copyright 0 1983 by Wayne State University Press.
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Daniel L. Thornton for the purpose of measuring net wealth-the really relevant distinction between types of money is not between the “inside” and “outside” varieties, but between money which has no costs of production-or, more generally, whose marginal cost is less than its marginal value (and this has implicitly been assumed to be the case for government fiat paper money) and money whose marginal cost of production equals its marginal value. [(1969), p. 11521 Thus, for Patinkin, competitively produced resource-using bank money is not net wealth and, hence, not part of the base relevant for the operation of the real-balance effect. So complete was Patinkin’s rebuttal that it appeared that PS’s conclusion was in articulo mortis. However, a recent article by Pesek (1976), comments by Dean (1977) and Mayer (1977), and replies by Pesek (1977a, 197713) have reopened the question. As a result of this most recent debate, it is now recognized that Patinkin abstracted from the labor and capital devoted to banking and, thus, ignored the value added of the banking industry in his critique of P-S. Mayer, however, argued that this omission was of little analytical significance, and that Patinkin’s criticism of P-S’s analysis emerges unrefuted [see Mayer (1977), p. 1921. It is the purpose of this note to demonstrate that the above proposition is incorrect. This will be accomplished by first showing that competition in banking is a necessary but not sufficient condition for excluding resource-using bank money from net wealth and, second, by showing that resource-using bank money is part of the base relevant for the operation of the real-balance effect, regardless of whether it is part of society’s net wealth.’
2. Bank Money and Net Wealth Patinkin argues that P-S’s inclusion of money as part of net wealth is based on two fundamental analytical errors: The first is ‘There is a tendency in the literature to treat two different types of resourceusing money as being characteristically the same. For example, it has long been recognized that noninterest-bearing commodity money is net wealth. However, this does not necessarily imply that bank money is net wealth to the extent that it is resource-costing as Dean (1977, p. 921) implies. Dean’s contention is true only if resource costs are current, as this comment shows. Thus, Patinkin’s conclusion is not necessarily incorrect, given his implicit assumption about the nature of the resource costs associated with bank money. Thus, Mayer, Dean, and Pesek appear to have criticized Patinkin too severely. 196
Bank Money and the Real-Balance
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their failure to recognize that it is not the production of bank money that is the source of net wealth to the banking sector and, hence, to bank money, but the monopoly rights that banks receive from the government. The second is their assumption that bank money is costless to produce, and the companion assumption that the banking industry is not competitive. First, he assumes, as do P-S, that individuals are granted monopoly rights to produce a fixed quantity of bank money that exchanges for fiat money at a fixed one-to-one ratio. He argues that the extension of these rights immediately increases society’s net wealth via an increase in the net worth of the banking sector by the amount of these rights. Thus, production of bank money equal to the present value of the monopoly rights does not in and of itself increase the net wealth of the banking sector. The production and sale of bank money is merely the balance sheet reflection of the increase in the banking system’s net wealth, which has already taken place. Patinkin next extends the analysis to permit banks to produce bank money beyond some fixed quantity. Specifically, he assumes that society has some fixed stocks of real nonfinancial wealth and government fiat money that combine to constitute society’s stock d wealth. Banks then commence operation and produce bank moneyi He further assumes that banks operate in a perfectly competitive environment and that banks are free to produce all of the bank money they desire subject to the restrictions implied by P-S’s “instant repurchase clause. lr3 Specifically, Patinkin assumes that banks begin operation by using fiat money which they obtain from the sale of common stock (in his example, $5,000). He th en allows banks to produce bank money up to the point where marginal revenue equals marginal cost. He restricts the net worth of the banking industry, however, to its original investment of $5,000. He does this on the assumption that investors, having perfect foresight, realize their expectations [(EM%), p. 11481. Patinkin argues that the expansion of bank money from a below-competitive-equilibrium level (due to governmental restrictions) to a competitive-equilibrium level creates liabilities equal to the difference between bank money outstanding and banks’ reserves of fiat money. He is quick to note, however, that his analysis does 3The repurchase clause requires money producers to stand ready to redeem money with fiat money [see Pesek and Saving (1967), pp. 84-851.
their
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Daniel L. Thornton not imply that bank money per se is a liability. Nevertheless, it is clear that he feels these deposits are in some sense liabilities of the producing bank: Note the phrasing of this conclusion: It is not necessarily bank money per se (whatever that may mean) which is a liability; instead, all that has been established by our formal argument is that there must be a liability equal in value to that of bank money. The economic interpretation of this conclusion is that bank money represents a future flow of services which the banks have obligated themselves to provide; the annual (imputed) market value of these services to the individuals who hold the bank money is the interest foregone; and the present value of this future stream is precisely $300,000 . . . the market value of the aforementioned services . . . [(1969), p. 1149, second emphasis added]. The implication is that these “services” are the contractual obligations of the banks and that the value of the bank money outstanding represents the present value of this stream. It is clear that Patinkin’s statement is not so much a conclusion as it is an assumption. He first assumes that society has some fixed stock of wealth composed of fixed quantities of nonfinancial wealth and a fixed quantity of fiat money. Part of this wsalth is transferred to the banking industry through the sale of common stock. Banks are then permitted to produce all the bank money they desire conditional on the restrictions stated above. Since he restricts the stock of wealth and the net worth of the banking sector to be unchanged, his conclusion is straightforward and obvious-indeed, it has been assumed. Given these restrictions, the conclusion would be the same for any commodity, not only money. What then is the basis for his conclusion? It is his implicit assumption that all costs of bank money production are future (i.e., the promise to supply certain services at a future date).4 Given this ‘We define real future costs as the resources that banks have pledged themselves to provide. Future costs in this sense, therefore, represent the obligations of banks to holders of bank money. We note that these costs may be distinct from the “tirture costs” society incurs in keeping the stock of any asset (including resource-costing bank money) constant, i.e., depreciation. Commodities that require future costs in the former sense are excluded from society’s stock of net wealth, while commodities that require future costs in the latter sense are not necessarily excluded. The latter group of commodities will only be excluded if they depreciate 108
Bank Money and the Real-Balance
Ejy
assumption and competition in the banking industry, the equill rium value of the stock of bank money outstanding will be eqr to the present value of these future costs. Thus, it would be : correct to count as part of society’s net wealth both the stock bank money and the resources pledged to maintain it. Rank man is not part of society’s net wealth.5 While this may be a preferable way to view the “producti costs of bank money,” Patinkin is wrong to imply that it is a m essary consequence of competition in the banking industry alor The distribution of real production costs between present and 1 ture is a function of the nature of the asset, not of the mark structure of the industry.6 Like any other asset, the flow of curre services used to produce or maintain the stock has nothing to with whether the stock is net wealth. The stock of a commodity net wealth if it produces a positive income stream for its hold and a smaller negative income stream for its nonholder. Compe tion in the banking industry implies only that if bank money is asset such that the positive income stream to the holder of ha money is offset by a corresponding negative income stream to t banks, then the present value of the negative streams will be t actly equal to the value of the stock, and bank money will not part of society’s net wealth.’
rapidly enough-from a purely theoretical point of view, instantaneously! Patinki failure to adequately distinguish between these two concepts of future costs n have contributed to the confusion about the net wealth character of resource-IISI bank money [see Patinkin (1969), p. 11521. Buchanan (1969) has made a simi point, but along different lines. ‘Thus, the distribution between interest-payments-in-kind and interest-p; ments-in-money, which Pesek (1976) g oes to some length to establish, is irrelev: in determining whether bank money is net wealth. Interest-payments-in-kind : merely future costs of bank money production and hence Patinkin was quite rii in treating both types of interest payments as synonymous for the purpose of ma suring society’s net wealth. The type of interest payment is not relevant for t real-balance effect, as this comment shows. % is common, for example, in the case of highly sophisticated capital asse that the price (or rental rate) include a provision for rendering future services. a perfect capital market, the price of the asset woidd reflect the expected val of these services. In this case, it would be wrong to count as net wealth both t full market value of these assets and the present value of the future services o\ which they are a claim. ‘In fairness to Patinkin, it should be noted that if marginal real social costs z less than marginal real social benefits, then bank money will be net wealth ir welfare sense.
Daniel L. Thornton 3. Bank Money and the Real-Balance Effect In this section, the claim that competitively produced bank money is not part of the base relevant for the real-balance effect is considered. Since it was demonstrated in the previous section that bank money is net wealth depending on whether production (or maintenance) costs are present or future, it will be desirable to discuss the question of the real-balance effect separately for each possibility. (A derivation of the major conclusions of this section appears in the appendix.) In considering the relationship between bank money and the real-balance effect, Patinkin considers two possibilities: one in which the real production costs are independent of the price level and a second in which they are inversely proportional to a price level change. In the first case, an exogenous fall in the price level gives rise to economic profits in the banking industry. Thus, for Patinkin, there is a real-balance effect. He argues that its effect is likely to be temporary, however, since industry competition will eliminate these economic profits [see Patinkin (1969, p. 1154) and (1971, p. 275)]. In the second case, there is no real-balance effect, even temporarily, since the real net worth of the banking system is unaffected .
When Costs Are Future Now consider the effect of a fall in the price level for each of Patinkin’s assumptions about real production costs, starting with the case (which Patinkin favors) in which real costs are inversely proportional to the price level. Assume the banking system is in a long-run equilibrium, and banks are just maintaining the profitmaximizing stock of bank money. Now assume there is a parametric decrease in the price level. The fall in prices produces no new economic profits in the banking industry and, hence, there is no incentive to expand the nominal stock of bank money. The real net wealth of society does not increase, even initially; therefore, there is no traditional real-balance effect. However, the real stock of bank money increases. Moreover, since long-run competitive equilibrium requires that the present value of the future services that banks have obligated themselves to provide equal the real value of the stock of bank money, total real production costs must also increase. Banks will find it necessary to acquire larger quantities of resources to supply the larger flow of services associated with the larger real money 110
Bank Money and the Real-Balance
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stock.” Resources are drawn into the maintenance of a larger stoc of real bank money. Thus, the lower price level results in an ir crease in the level of employment in the banking industry ant hence, produces forces which cause the price level to change, i.e there is a real-balance effect. Consider now the case in which costs are independent of tk price level. Here, the lower price level increases the wealth of tl private sector as the profitability of the banking industry increaser This will have the immediate effect of: 1) increasing the demar for goods and services via a traditional real-balance effect, as P tinkin suggests, and 2) expanding the nominal stock of bank mom as the output of the competitive banking industry increases. As tE output expands, resources will be drawn into the production of bal money. Eventually (assuming the system is stable), a new equili rium will be established. Thus, the decline in prices will increase the nominal stock bank money and, hence, the employment required to maintain tl larger stock. The increase in aggregate demand via the traditior real-balance effect and via the increase in the nominal stock of mono as the banking industry responds, undoubtedly will mitigate t: original movement in prices. Whether the final equilibrium outp
*It should be noted that Saving (1970) distinguished between “production cos and “maintenance costs” of bank money. Implicitly, he was treating maintcnar costs as future and production costs as current (see the discussion on pS 95, pecially footnote 10). Unfortunately, Saving erroneously concluded that chaugc:s the price level that leave the banking system’s profits unaffected produce no rc balance effect; although, in a reply to Patinkin, he came close to seeing the s nificance of any resource costs for the real-balance effect [Saving (1971), pp. 27 80, footnotes 11 and 141. @This can be demonstrated easily in a balance sheet framework in which I private sector is divided into the banks and the nonbank private sector. -Is assc banks hold fiat money, real assets, and fixed money-denominated 1.O.U.s of 1 nonbank private sector. The nonbank private sector holds fiat and bank money : real assets not included in banking. As liabilities, banks have the present value the future services they are obligated to provide, while the nonbank privat<* see has fixed money denominated 1.O.U.s. Under conditions of perfect cuxqctition the banking industry, the present value of the future services equals the stock bank money outstanding. Hence, the net wealth of the private sector is qll:ll its fixed capital and fiat money. When the price level falls, the fixed moneynominated 1.O.U.s increase in value as does the stock of money (fiat s!lcl IMI but under the assumption that real costs of production are independent of the pl level, the present value of the real flow of services which banks are obliga~c~ provide, remains unchanged. In net, and ignoring all distribution cffectb, bocie net wealth has increased. See Patinkin (1969, p. 1153).
Daniel L. Thornton of real bank money will be larger or smaller than its initial level cannot be deduced, a priori, from this or Patinkin’s model. Nevertheless, the final equilibrium will be influenced by the banking industry’s response. After all, this is the quintessence of the realbalance effect. When the system is thrown into disequilibrium, forces come into play to help restore equilibrium. These forces include not only an increase in demand for goods via a traditional real-balance effect, but an increase in demand for factors as a result of the response of the banking industry. It is clear from the above paradigm that Patinkin is wrong in asserting that the shorter the time needed for the banks to adjust, the better the approximation of defining net wealth in terms of fiat money for the purpose of the real-balance effect [see Patinkin (1969, p. 1154)]. Patinkin should not be criticized severely, however, since the part of the real-balance effect described here is new and is not part of the standard analysis. In the Pigouvian real-balance effect, individuals temporarily forego current consumption to acquire wealth in the form of real money balances when the price level rises.” In the present analysis banks alter their supply of real services in response to changes in the price level.
When Costs Are Current In order to head off any potential misunderstanding of this section, understand that we do not mean to imply that all costs of producing bank money are current. We are merely following up on the previously demonstrated result that there is nothing in Patinkin’s analysis (or, for that matter, in P-S’s) that suggests what proportion of real production costs are present or future.” When all real costs of bank money production are current, the results are much the same as the above, but with an interesting difference. If real production costs are independent of prices, a fall in the level of prices increases society’s net wealth independent of the increase in the profits of the banking system. Real wealth increases as a direct consequence of the fact that the resources embodied in bank money are now worth more to society at the margin-bank money is like gold. In addition, the falling price level “For an excellent discussion of the traditional real-balance effect, see Hynes (1974). “In fairness to P-S we should note that at one point in their text they stated an awareness of this fact; P-S (1969, pp. 192-197, especially the second paragraph on page 197). 112
Bank Money and the Real-Balance
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gives rise to an initial increase in bank profits and produces a I balance effect, just as in the case in which costs are future. On the other hand, if the current real production cost: money are inversely proportional to the price level, a fall in pr only brings about an increase in the existing stock of society’s wealth via an increase in the value of bank money. The value the outstanding stock of bank money increases while the pro bility of the banking industry remains unchanged. There is no dency for the stock of nominal bank money to expand-the r balance effect is the traditional one.
4. Conclusions No attempt has been made to offer empirical evidence a: which assumption about the nature of bank money is true. 0 priori grounds, we are inclined to favor Patinkin’s intuition. Her if perfect competition prevails, we would accept Patinkin’s con1 sion that bank money is not part of society’s net wealth. We wa argue, however, that a fall in the price level would bring a1)011t equilibrating response from the banking industry and the en economy, regardless of whether real costs of producing bank mol are inversely proportionate to the price level. Anything that than the value of the real money stock produces an effect on resell employment in the banking industry and, ipso facto, income ; employment in general. This result seems so basic one wonders why it was igno. for so long. Certainly not because its impact was considered inct sequential. The same was long thought true of the real-balance feet, yet it was hardly ignored. Perhaps it was because econom have viewed bank money production as costless. A good exam of this is found in the following quote of Paul Davidson: Since the creation of private debt by financial institutions does not by itself require the use of resources, jobs are not created merely by the process of increasing certain forms of private debt such as bank money [(1978), p. 155, emphasis added]. Clearly Davidson believes that there will be no employmt effect associated with changes in the stock of bank money btlc.;u the production (and/or maintenance) of bank money requires resources. Yet even a casual observation of the amount of (capi and labor devoted to banking should immediately rentle~. such
Daniel L. Thornton conclusion suspect. buked for permitting facts.
Perhaps monetary their assumptions
economists should be reto be so at odds with the
Receioed: ]anuaq, 1982 Final version received: September, 1982
References Buchanan, J.M. “An Outside Economist’s Defense of Pesek and Saving. ” Journal of Economic Literature 7 (September 1969): 81214. Davidson, P. Money and the Real World. New York: John Wiley and Sons, 1978. Dean, J.W. “Professor Pesek Returns.” Journal of Economic Literature 15 (September 1977): 920-24. Hynes, J.A. “On the Theory of the Iteal Balance Effects.” Journal of Money, Credit and Banking 6 (February 1974): 65-84. Johnson, H.G. “Inside Money, Outside Money, Income, Wealth and Welfare in Monetary Theory.” Journal of Money, Credit and Banking 1 (February 1969): 30-45. Laidler, D. “The Definition of Money.” Journal of Money, Credit and Banking 1 (August 1969): 508-25. Marty, A.L. “Inside Money, Outside Money and the We$th Effect.” Journal of Money, Credit and Banking 1 (February 1969): 101-11. Mayer, T. “Professor Pesek’s Criticism of Monetary Theory: A Comment. ” Journal of Economic Literature 15 (September 1977): 908 -14. Patinkin, D. Money, Interest and Prices. 2nd Ed. New York: Harper and Row, 1965. -. “Money and Wealth: A Review Article. ” Journal of Economic Literature 7 (December 1969): 1140-56. -. “Inside Money, Monopoly Bank Profits, and the Real-Balance Effect: A Comment. ” Journal of Money, Credit and Banking 3 (May 1971): 271-75. -. “Money and Wealth. ” In Studies in Monetary Economics. Don Patinkin, ed. New York: Harper and Row, 1972, 168-94. Pesek, B.P. “Monetary Theory in the Post-Robertson ‘Alice in Wonderland’ Era.” Journal of Economic Literature 14 (September 1976): 856-84. -. “Professor Pesek’s Criticism of Monetary Theory: A Re114
Bank Money and the Real-Balance
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joinder. ” Journal of Economic Literature 15 (September 1977 914-20. -. “Reply to Professor Dean. ” Journal of Economic Literatzl 15 (September 1977b): 924-27. and Saving, T.R. Money, Wealth, and Theory. New YOI Macmillan, 1967. Saving, T.R. “Outside Money, Inside Money, and the Real-Balan Effect.” Journal of Money, Credit and Banking 2 (February 197 83-99. p. “Inside Money, Short-Run Rents, and The Real-Balance I feet: A Reply.” Journal of Money, Credit and Banking 3 (M 1971): 276-80. Smith, W.L. “On Some Current Issues in Monetary Economics: 1 Interpretation.” Journal of Economic Literature 8 (Septemb 1970): 767-83.
Appendix It is possible to obtain the conclusions concerning bank mom and the real-balance effect with a simple reformulation of Patinkir arguments. Consider Patinkin’s model within the following fram work. Patinkin assumes that banks engage in some number of re transactions (T) per unit of nominal money. He further assumes th each transaction requires a certain quantity of labor and capit: That is, transactions are produced via the following transformatic curve: T = T(N,K);
TN > 0, TK > 0,
where N and K denote the physical quantity of labor and capit required to produce a volume of ,transactions, T. (It is assr1111c~lill K is fixed for simplicity.) The stock of bank money is equal to tt number of transactions times the number of nominal units of n~om per transaction. That is, M = T(N, K) * (M/T)
.
(
Patinkin then considers two cases, one where the number of trau actions per unit of nominal money is independent of the price leve . respect tc; P: T!:o! P, and a second where (M/T) is umt’ elastic’ with cases can be conveniently summarized by
Daniel L. Thornton (M/T)
= A(P); A’ I 0 .
(2)
Patinkin’s two cases can be represented by A’ = 0 and h’(P/A) = - 1, respectively. Substituting Equation (2) into (l), the following production function for nominal money is obtained: M = T(N,K) A(P) .
(3)
If banks are profit-maximizers, they will produce nominal money up to the point where the real marginal cost of the last unit is equal to the marginal revenue of the last unit produced, or where:
where W and r denote the nominal wage rate and the interest rate, respectively. The term on the 1.h.s. of (4) represents a banks real marginal cost (RMC). The change in RMC for a change in price is given by:
am ap
-W
-=
(5) $
PA (P)
It is clear that (5) is negative if A' = 0. Thus, a fall in the price level raises both real marginal revenue and real marginal costs. Furthermore, the changes are proportional so that the profit-maximizing condition in (4) is unaffected by a change in P. Firms do not expand their output of nominal bank money; however, their real marginal costs are higher. If A’(P/A) = -1, then a fall in price leaves real marginal costs unaffected, and short-run bank profits increase. Banks respond by expanding their output of nominal bank money until (4) is satisfied again. Thus, under this condition, a fall in the price level raises bank profits and banks respond by increasing the nominal stock of bank money. Equation (4) can be also used to obtain the banks demand for labor by rewriting it as: 116
Bank Money and the Real-Balance
W +&(P). The term on the r.h.s. of (6) represents the banks labor de as a function of the real wage rate. The derivative of labor de with respect to P is given by:
a(w/P) r I)T =jaN v--xO,i= = hi (r, P, N);
Mi,. > 0, Mp zs 0 1,2 ,.,.,
m;
h, > 0, hip < 0, hi, > 0, i = 1, 2,. . . , m .
Up to this point, it has been assumed only that indiv banks are profit-maximizers; however, Patinkin assumes that t operate in a competitive market. If we impose this additiona striction, long-run competitive equilibrium requires real mar revenue to equal real average total costs. Thus, total costs, TC, TC = r(M/P)
.
In other words, the real supply of bank money is equal tc present value of the total real costs of production per unit of t Hence, long-run competitive equilibrium requires banks to SII real not nominal money. This conclusion holds regardless of value of A’.
Reserve Bank of St. Louis
Bank Money, Net Wealth, and the Real-BalanceEffect* Tlas paper deals with two important questious in monetary economics: Is competitively produced resource-using bank money part of society’s net wealth? IS such money part of the base relevant for the operation of the real-balance effect? We argue that the answer to the first question depends critically on the nature of the asset and not on the market structure of the industry, In particular, we argue that perfect competition in the banking industry is a necessary but not sufficient conditious for excluding bank money from society’s net wealth. Furthermore, we argue that resource-using bank money is part of the base relevant for the operation of the real-balance effect, regardless of whether or not it is part of society’s net wealth.
1. Introduction Over a decade ago, Pesek and Saving (P-S) attacked the conventional wisdom that bank money is, ipso facto, the debt of issuing banks. They argued that bank money is part of society’s net wealth and, hence, part of the base relevant for the operation of the real-balance effect. While making this point, they attacked other aspects of monetary theory and, as a result, provoked a number of responses.’ While many of their critics argued to varying degrees against the proposition that bank money is net wealth and, hence, a vehicle for the real-balance effect, the most rigorous and forceful attack came from Patinkin (1969, 1972). In his analysis of P-S, Patinkin presented the following proposition:
*I would like to thank Alan Nichols, Boris Pesek, Ron Ratti, Basil Zimmer, Jr., and the anonymous referees for helpful comments on an earlier draft of this paper. They are absolved of responsibility for any errors. The views expressed here do not necessarily represent those of the Federal Reserve Bank of St. Louis or the Federal Reserve System. ‘For the more important responses to P-S’s work, see: Buchanan (1969), Johnson (1969), Laidler (1969), Smith (1970), Patinkin (1969, 1972), and Marty (1969). Journal of Macroeconomics, Winter 1983, Vol. 5, No. 1, pp. Copyright 0 1983 by Wayne State University Press.
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Daniel L. Thornton for the purpose of measuring net wealth-the really relevant distinction between types of money is not between the “inside” and “outside” varieties, but between money which has no costs of production-or, more generally, whose marginal cost is less than its marginal value (and this has implicitly been assumed to be the case for government fiat paper money) and money whose marginal cost of production equals its marginal value. [(1969), p. 11521 Thus, for Patinkin, competitively produced resource-using bank money is not net wealth and, hence, not part of the base relevant for the operation of the real-balance effect. So complete was Patinkin’s rebuttal that it appeared that PS’s conclusion was in articulo mortis. However, a recent article by Pesek (1976), comments by Dean (1977) and Mayer (1977), and replies by Pesek (1977a, 197713) have reopened the question. As a result of this most recent debate, it is now recognized that Patinkin abstracted from the labor and capital devoted to banking and, thus, ignored the value added of the banking industry in his critique of P-S. Mayer, however, argued that this omission was of little analytical significance, and that Patinkin’s criticism of P-S’s analysis emerges unrefuted [see Mayer (1977), p. 1921. It is the purpose of this note to demonstrate that the above proposition is incorrect. This will be accomplished by first showing that competition in banking is a necessary but not sufficient condition for excluding resource-using bank money from net wealth and, second, by showing that resource-using bank money is part of the base relevant for the operation of the real-balance effect, regardless of whether it is part of society’s net wealth.’
2. Bank Money and Net Wealth Patinkin argues that P-S’s inclusion of money as part of net wealth is based on two fundamental analytical errors: The first is ‘There is a tendency in the literature to treat two different types of resourceusing money as being characteristically the same. For example, it has long been recognized that noninterest-bearing commodity money is net wealth. However, this does not necessarily imply that bank money is net wealth to the extent that it is resource-costing as Dean (1977, p. 921) implies. Dean’s contention is true only if resource costs are current, as this comment shows. Thus, Patinkin’s conclusion is not necessarily incorrect, given his implicit assumption about the nature of the resource costs associated with bank money. Thus, Mayer, Dean, and Pesek appear to have criticized Patinkin too severely. 196
Bank Money and the Real-Balance
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their failure to recognize that it is not the production of bank money that is the source of net wealth to the banking sector and, hence, to bank money, but the monopoly rights that banks receive from the government. The second is their assumption that bank money is costless to produce, and the companion assumption that the banking industry is not competitive. First, he assumes, as do P-S, that individuals are granted monopoly rights to produce a fixed quantity of bank money that exchanges for fiat money at a fixed one-to-one ratio. He argues that the extension of these rights immediately increases society’s net wealth via an increase in the net worth of the banking sector by the amount of these rights. Thus, production of bank money equal to the present value of the monopoly rights does not in and of itself increase the net wealth of the banking sector. The production and sale of bank money is merely the balance sheet reflection of the increase in the banking system’s net wealth, which has already taken place. Patinkin next extends the analysis to permit banks to produce bank money beyond some fixed quantity. Specifically, he assumes that society has some fixed stocks of real nonfinancial wealth and government fiat money that combine to constitute society’s stock d wealth. Banks then commence operation and produce bank moneyi He further assumes that banks operate in a perfectly competitive environment and that banks are free to produce all of the bank money they desire subject to the restrictions implied by P-S’s “instant repurchase clause. lr3 Specifically, Patinkin assumes that banks begin operation by using fiat money which they obtain from the sale of common stock (in his example, $5,000). He th en allows banks to produce bank money up to the point where marginal revenue equals marginal cost. He restricts the net worth of the banking industry, however, to its original investment of $5,000. He does this on the assumption that investors, having perfect foresight, realize their expectations [(EM%), p. 11481. Patinkin argues that the expansion of bank money from a below-competitive-equilibrium level (due to governmental restrictions) to a competitive-equilibrium level creates liabilities equal to the difference between bank money outstanding and banks’ reserves of fiat money. He is quick to note, however, that his analysis does 3The repurchase clause requires money producers to stand ready to redeem money with fiat money [see Pesek and Saving (1967), pp. 84-851.
their
107
Daniel L. Thornton not imply that bank money per se is a liability. Nevertheless, it is clear that he feels these deposits are in some sense liabilities of the producing bank: Note the phrasing of this conclusion: It is not necessarily bank money per se (whatever that may mean) which is a liability; instead, all that has been established by our formal argument is that there must be a liability equal in value to that of bank money. The economic interpretation of this conclusion is that bank money represents a future flow of services which the banks have obligated themselves to provide; the annual (imputed) market value of these services to the individuals who hold the bank money is the interest foregone; and the present value of this future stream is precisely $300,000 . . . the market value of the aforementioned services . . . [(1969), p. 1149, second emphasis added]. The implication is that these “services” are the contractual obligations of the banks and that the value of the bank money outstanding represents the present value of this stream. It is clear that Patinkin’s statement is not so much a conclusion as it is an assumption. He first assumes that society has some fixed stock of wealth composed of fixed quantities of nonfinancial wealth and a fixed quantity of fiat money. Part of this wsalth is transferred to the banking industry through the sale of common stock. Banks are then permitted to produce all the bank money they desire conditional on the restrictions stated above. Since he restricts the stock of wealth and the net worth of the banking sector to be unchanged, his conclusion is straightforward and obvious-indeed, it has been assumed. Given these restrictions, the conclusion would be the same for any commodity, not only money. What then is the basis for his conclusion? It is his implicit assumption that all costs of bank money production are future (i.e., the promise to supply certain services at a future date).4 Given this ‘We define real future costs as the resources that banks have pledged themselves to provide. Future costs in this sense, therefore, represent the obligations of banks to holders of bank money. We note that these costs may be distinct from the “tirture costs” society incurs in keeping the stock of any asset (including resource-costing bank money) constant, i.e., depreciation. Commodities that require future costs in the former sense are excluded from society’s stock of net wealth, while commodities that require future costs in the latter sense are not necessarily excluded. The latter group of commodities will only be excluded if they depreciate 108
Bank Money and the Real-Balance
Ejy
assumption and competition in the banking industry, the equill rium value of the stock of bank money outstanding will be eqr to the present value of these future costs. Thus, it would be : correct to count as part of society’s net wealth both the stock bank money and the resources pledged to maintain it. Rank man is not part of society’s net wealth.5 While this may be a preferable way to view the “producti costs of bank money,” Patinkin is wrong to imply that it is a m essary consequence of competition in the banking industry alor The distribution of real production costs between present and 1 ture is a function of the nature of the asset, not of the mark structure of the industry.6 Like any other asset, the flow of curre services used to produce or maintain the stock has nothing to with whether the stock is net wealth. The stock of a commodity net wealth if it produces a positive income stream for its hold and a smaller negative income stream for its nonholder. Compe tion in the banking industry implies only that if bank money is asset such that the positive income stream to the holder of ha money is offset by a corresponding negative income stream to t banks, then the present value of the negative streams will be t actly equal to the value of the stock, and bank money will not part of society’s net wealth.’
rapidly enough-from a purely theoretical point of view, instantaneously! Patinki failure to adequately distinguish between these two concepts of future costs n have contributed to the confusion about the net wealth character of resource-IISI bank money [see Patinkin (1969), p. 11521. Buchanan (1969) has made a simi point, but along different lines. ‘Thus, the distribution between interest-payments-in-kind and interest-p; ments-in-money, which Pesek (1976) g oes to some length to establish, is irrelev: in determining whether bank money is net wealth. Interest-payments-in-kind : merely future costs of bank money production and hence Patinkin was quite rii in treating both types of interest payments as synonymous for the purpose of ma suring society’s net wealth. The type of interest payment is not relevant for t real-balance effect, as this comment shows. % is common, for example, in the case of highly sophisticated capital asse that the price (or rental rate) include a provision for rendering future services. a perfect capital market, the price of the asset woidd reflect the expected val of these services. In this case, it would be wrong to count as net wealth both t full market value of these assets and the present value of the future services o\ which they are a claim. ‘In fairness to Patinkin, it should be noted that if marginal real social costs z less than marginal real social benefits, then bank money will be net wealth ir welfare sense.
Daniel L. Thornton 3. Bank Money and the Real-Balance Effect In this section, the claim that competitively produced bank money is not part of the base relevant for the real-balance effect is considered. Since it was demonstrated in the previous section that bank money is net wealth depending on whether production (or maintenance) costs are present or future, it will be desirable to discuss the question of the real-balance effect separately for each possibility. (A derivation of the major conclusions of this section appears in the appendix.) In considering the relationship between bank money and the real-balance effect, Patinkin considers two possibilities: one in which the real production costs are independent of the price level and a second in which they are inversely proportional to a price level change. In the first case, an exogenous fall in the price level gives rise to economic profits in the banking industry. Thus, for Patinkin, there is a real-balance effect. He argues that its effect is likely to be temporary, however, since industry competition will eliminate these economic profits [see Patinkin (1969, p. 1154) and (1971, p. 275)]. In the second case, there is no real-balance effect, even temporarily, since the real net worth of the banking system is unaffected .
When Costs Are Future Now consider the effect of a fall in the price level for each of Patinkin’s assumptions about real production costs, starting with the case (which Patinkin favors) in which real costs are inversely proportional to the price level. Assume the banking system is in a long-run equilibrium, and banks are just maintaining the profitmaximizing stock of bank money. Now assume there is a parametric decrease in the price level. The fall in prices produces no new economic profits in the banking industry and, hence, there is no incentive to expand the nominal stock of bank money. The real net wealth of society does not increase, even initially; therefore, there is no traditional real-balance effect. However, the real stock of bank money increases. Moreover, since long-run competitive equilibrium requires that the present value of the future services that banks have obligated themselves to provide equal the real value of the stock of bank money, total real production costs must also increase. Banks will find it necessary to acquire larger quantities of resources to supply the larger flow of services associated with the larger real money 110
Bank Money and the Real-Balance
Effea
stock.” Resources are drawn into the maintenance of a larger stoc of real bank money. Thus, the lower price level results in an ir crease in the level of employment in the banking industry ant hence, produces forces which cause the price level to change, i.e there is a real-balance effect. Consider now the case in which costs are independent of tk price level. Here, the lower price level increases the wealth of tl private sector as the profitability of the banking industry increaser This will have the immediate effect of: 1) increasing the demar for goods and services via a traditional real-balance effect, as P tinkin suggests, and 2) expanding the nominal stock of bank mom as the output of the competitive banking industry increases. As tE output expands, resources will be drawn into the production of bal money. Eventually (assuming the system is stable), a new equili rium will be established. Thus, the decline in prices will increase the nominal stock bank money and, hence, the employment required to maintain tl larger stock. The increase in aggregate demand via the traditior real-balance effect and via the increase in the nominal stock of mono as the banking industry responds, undoubtedly will mitigate t: original movement in prices. Whether the final equilibrium outp
*It should be noted that Saving (1970) distinguished between “production cos and “maintenance costs” of bank money. Implicitly, he was treating maintcnar costs as future and production costs as current (see the discussion on pS 95, pecially footnote 10). Unfortunately, Saving erroneously concluded that chaugc:s the price level that leave the banking system’s profits unaffected produce no rc balance effect; although, in a reply to Patinkin, he came close to seeing the s nificance of any resource costs for the real-balance effect [Saving (1971), pp. 27 80, footnotes 11 and 141. @This can be demonstrated easily in a balance sheet framework in which I private sector is divided into the banks and the nonbank private sector. -Is assc banks hold fiat money, real assets, and fixed money-denominated 1.O.U.s of 1 nonbank private sector. The nonbank private sector holds fiat and bank money : real assets not included in banking. As liabilities, banks have the present value the future services they are obligated to provide, while the nonbank privat<* see has fixed money denominated 1.O.U.s. Under conditions of perfect cuxqctition the banking industry, the present value of the future services equals the stock bank money outstanding. Hence, the net wealth of the private sector is qll:ll its fixed capital and fiat money. When the price level falls, the fixed moneynominated 1.O.U.s increase in value as does the stock of money (fiat s!lcl IMI but under the assumption that real costs of production are independent of the pl level, the present value of the real flow of services which banks are obliga~c~ provide, remains unchanged. In net, and ignoring all distribution cffectb, bocie net wealth has increased. See Patinkin (1969, p. 1153).
Daniel L. Thornton of real bank money will be larger or smaller than its initial level cannot be deduced, a priori, from this or Patinkin’s model. Nevertheless, the final equilibrium will be influenced by the banking industry’s response. After all, this is the quintessence of the realbalance effect. When the system is thrown into disequilibrium, forces come into play to help restore equilibrium. These forces include not only an increase in demand for goods via a traditional real-balance effect, but an increase in demand for factors as a result of the response of the banking industry. It is clear from the above paradigm that Patinkin is wrong in asserting that the shorter the time needed for the banks to adjust, the better the approximation of defining net wealth in terms of fiat money for the purpose of the real-balance effect [see Patinkin (1969, p. 1154)]. Patinkin should not be criticized severely, however, since the part of the real-balance effect described here is new and is not part of the standard analysis. In the Pigouvian real-balance effect, individuals temporarily forego current consumption to acquire wealth in the form of real money balances when the price level rises.” In the present analysis banks alter their supply of real services in response to changes in the price level.
When Costs Are Current In order to head off any potential misunderstanding of this section, understand that we do not mean to imply that all costs of producing bank money are current. We are merely following up on the previously demonstrated result that there is nothing in Patinkin’s analysis (or, for that matter, in P-S’s) that suggests what proportion of real production costs are present or future.” When all real costs of bank money production are current, the results are much the same as the above, but with an interesting difference. If real production costs are independent of prices, a fall in the level of prices increases society’s net wealth independent of the increase in the profits of the banking system. Real wealth increases as a direct consequence of the fact that the resources embodied in bank money are now worth more to society at the margin-bank money is like gold. In addition, the falling price level “For an excellent discussion of the traditional real-balance effect, see Hynes (1974). “In fairness to P-S we should note that at one point in their text they stated an awareness of this fact; P-S (1969, pp. 192-197, especially the second paragraph on page 197). 112
Bank Money and the Real-Balance
E,
gives rise to an initial increase in bank profits and produces a I balance effect, just as in the case in which costs are future. On the other hand, if the current real production cost: money are inversely proportional to the price level, a fall in pr only brings about an increase in the existing stock of society’s wealth via an increase in the value of bank money. The value the outstanding stock of bank money increases while the pro bility of the banking industry remains unchanged. There is no dency for the stock of nominal bank money to expand-the r balance effect is the traditional one.
4. Conclusions No attempt has been made to offer empirical evidence a: which assumption about the nature of bank money is true. 0 priori grounds, we are inclined to favor Patinkin’s intuition. Her if perfect competition prevails, we would accept Patinkin’s con1 sion that bank money is not part of society’s net wealth. We wa argue, however, that a fall in the price level would bring a1)011t equilibrating response from the banking industry and the en economy, regardless of whether real costs of producing bank mol are inversely proportionate to the price level. Anything that than the value of the real money stock produces an effect on resell employment in the banking industry and, ipso facto, income ; employment in general. This result seems so basic one wonders why it was igno. for so long. Certainly not because its impact was considered inct sequential. The same was long thought true of the real-balance feet, yet it was hardly ignored. Perhaps it was because econom have viewed bank money production as costless. A good exam of this is found in the following quote of Paul Davidson: Since the creation of private debt by financial institutions does not by itself require the use of resources, jobs are not created merely by the process of increasing certain forms of private debt such as bank money [(1978), p. 155, emphasis added]. Clearly Davidson believes that there will be no employmt effect associated with changes in the stock of bank money btlc.;u the production (and/or maintenance) of bank money requires resources. Yet even a casual observation of the amount of (capi and labor devoted to banking should immediately rentle~. such
Daniel L. Thornton conclusion suspect. buked for permitting facts.
Perhaps monetary their assumptions
economists should be reto be so at odds with the
Receioed: ]anuaq, 1982 Final version received: September, 1982
References Buchanan, J.M. “An Outside Economist’s Defense of Pesek and Saving. ” Journal of Economic Literature 7 (September 1969): 81214. Davidson, P. Money and the Real World. New York: John Wiley and Sons, 1978. Dean, J.W. “Professor Pesek Returns.” Journal of Economic Literature 15 (September 1977): 920-24. Hynes, J.A. “On the Theory of the Iteal Balance Effects.” Journal of Money, Credit and Banking 6 (February 1974): 65-84. Johnson, H.G. “Inside Money, Outside Money, Income, Wealth and Welfare in Monetary Theory.” Journal of Money, Credit and Banking 1 (February 1969): 30-45. Laidler, D. “The Definition of Money.” Journal of Money, Credit and Banking 1 (August 1969): 508-25. Marty, A.L. “Inside Money, Outside Money and the We$th Effect.” Journal of Money, Credit and Banking 1 (February 1969): 101-11. Mayer, T. “Professor Pesek’s Criticism of Monetary Theory: A Comment. ” Journal of Economic Literature 15 (September 1977): 908 -14. Patinkin, D. Money, Interest and Prices. 2nd Ed. New York: Harper and Row, 1965. -. “Money and Wealth: A Review Article. ” Journal of Economic Literature 7 (December 1969): 1140-56. -. “Inside Money, Monopoly Bank Profits, and the Real-Balance Effect: A Comment. ” Journal of Money, Credit and Banking 3 (May 1971): 271-75. -. “Money and Wealth. ” In Studies in Monetary Economics. Don Patinkin, ed. New York: Harper and Row, 1972, 168-94. Pesek, B.P. “Monetary Theory in the Post-Robertson ‘Alice in Wonderland’ Era.” Journal of Economic Literature 14 (September 1976): 856-84. -. “Professor Pesek’s Criticism of Monetary Theory: A Re114
Bank Money and the Real-Balance
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joinder. ” Journal of Economic Literature 15 (September 1977 914-20. -. “Reply to Professor Dean. ” Journal of Economic Literatzl 15 (September 1977b): 924-27. and Saving, T.R. Money, Wealth, and Theory. New YOI Macmillan, 1967. Saving, T.R. “Outside Money, Inside Money, and the Real-Balan Effect.” Journal of Money, Credit and Banking 2 (February 197 83-99. p. “Inside Money, Short-Run Rents, and The Real-Balance I feet: A Reply.” Journal of Money, Credit and Banking 3 (M 1971): 276-80. Smith, W.L. “On Some Current Issues in Monetary Economics: 1 Interpretation.” Journal of Economic Literature 8 (Septemb 1970): 767-83.
Appendix It is possible to obtain the conclusions concerning bank mom and the real-balance effect with a simple reformulation of Patinkir arguments. Consider Patinkin’s model within the following fram work. Patinkin assumes that banks engage in some number of re transactions (T) per unit of nominal money. He further assumes th each transaction requires a certain quantity of labor and capit: That is, transactions are produced via the following transformatic curve: T = T(N,K);
TN > 0, TK > 0,
where N and K denote the physical quantity of labor and capit required to produce a volume of ,transactions, T. (It is assr1111c~lill K is fixed for simplicity.) The stock of bank money is equal to tt number of transactions times the number of nominal units of n~om per transaction. That is, M = T(N, K) * (M/T)
.
(
Patinkin then considers two cases, one where the number of trau actions per unit of nominal money is independent of the price leve . respect tc; P: T!:o! P, and a second where (M/T) is umt’ elastic’ with cases can be conveniently summarized by
Daniel L. Thornton (M/T)
= A(P); A’ I 0 .
(2)
Patinkin’s two cases can be represented by A’ = 0 and h’(P/A) = - 1, respectively. Substituting Equation (2) into (l), the following production function for nominal money is obtained: M = T(N,K) A(P) .
(3)
If banks are profit-maximizers, they will produce nominal money up to the point where the real marginal cost of the last unit is equal to the marginal revenue of the last unit produced, or where:
where W and r denote the nominal wage rate and the interest rate, respectively. The term on the 1.h.s. of (4) represents a banks real marginal cost (RMC). The change in RMC for a change in price is given by:
am ap
-W
-=
(5) $
PA (P)
It is clear that (5) is negative if A' = 0. Thus, a fall in the price level raises both real marginal revenue and real marginal costs. Furthermore, the changes are proportional so that the profit-maximizing condition in (4) is unaffected by a change in P. Firms do not expand their output of nominal bank money; however, their real marginal costs are higher. If A’(P/A) = -1, then a fall in price leaves real marginal costs unaffected, and short-run bank profits increase. Banks respond by expanding their output of nominal bank money until (4) is satisfied again. Thus, under this condition, a fall in the price level raises bank profits and banks respond by increasing the nominal stock of bank money. Equation (4) can be also used to obtain the banks demand for labor by rewriting it as: 116
Bank Money and the Real-Balance
W +&(P). The term on the r.h.s. of (6) represents the banks labor de as a function of the real wage rate. The derivative of labor de with respect to P is given by:
a(w/P) r I)T =jaN v--x
Mi,. > 0, Mp zs 0 1,2 ,.,.,
m;
h, > 0, hip < 0, hi, > 0, i = 1, 2,. . . , m .
Up to this point, it has been assumed only that indiv banks are profit-maximizers; however, Patinkin assumes that t operate in a competitive market. If we impose this additiona striction, long-run competitive equilibrium requires real mar revenue to equal real average total costs. Thus, total costs, TC, TC = r(M/P)
.
In other words, the real supply of bank money is equal tc present value of the total real costs of production per unit of t Hence, long-run competitive equilibrium requires banks to SII real not nominal money. This conclusion holds regardless of value of A’.