Pushing On A String - Monetary Policy

Monetary Policy

Further information: Monetary policy

"Pushing on a string" is particularly used to illustrate limitations of monetary policy, particularly that the money multiplier is an inequality, a limit on money creation, not an equality.

In modern economies with fractional-reserve banking, money creation follows a two stage process. First, a central bank introduces new base money into the economy (termed 'expansionary monetary policy') by purchasing financial assets from or lending money to financial institutions. Second, the new money introduced by the central bank is multiplied by commercial banks through fractional reserve banking; this expands the amount of broad money (i.e. cash plus demand deposits) in the economy so that it is a multiple (known as the money multiplier) of the amount originally created by the central bank. Money is in essence pushed from central banks to commercial banks, and then to borrowers. This is the crux of the "pushing on a string" metaphor – that money cannot be pushed from the central bank to borrowers if they do not wish to borrow.

Alternatively, the process can be seen as borrowers demanding credit from commercial banks, who then borrow base money to provide reserves to back the new bank money: demand for credit pulls base money from central banks. This presentation is particularly associated with, and seen as support for, endogenous money theory, such as monetary circuit theory, in that money supply is not determined by an exogenous (external) force (central bank policy), but rather a combination of central bank policy and endogenous (internal) business reasons.

Commercial banks extend loans, and borrowers take out loans, for commercial reasons – because they expect to benefit from them: banks profit by charging interest on the loan higher than they must pay on their debts (the "spread"), while borrowers may for instance invest the money (hire workers, build a factory), speculate with it, or use it for consumption. These loans must in turn be backed by reserves – this is a legal requirement, otherwise banks could print unlimited quantities of money – and banks are allowed to extend as loans some multiple of reserves: in a fractional-reserve banking system banks are allowed to extend more loans than they have reserves (the ratio is called the money multiplier, and is greater than 1), while in a full-reserve banking loans must be precisely backed by reserves and the money multiplier is 1. The distinction between fractional-reserve and full-reserve is not significant in this context – the important point is that in both systems, loans must be backed by reserves.

Crucially, central banks can limit money creation by either limiting the amount of base money extended, thus denying reserves and preventing commercial banks from extending further loans, or by raising the price of base money extended by increasing interest rates and thus making loans less profitable for the bank (raising the hurdle rate), and while relaxing these constraints can encourage money creation, central banks cannot force commercial banks to extend credit – monetary policy can pull but not push.

By increasing the volume of their government securities and loans and by lowering Member Bank legal reserve requirements, the Reserve Banks can encourage an increase in the supply of money and bank deposits. They can encourage but, without taking drastic action, they cannot compel. For in the middle of a deep depression just when we want Reserve policy to be most effective, the Member Banks are likely to be timid about buying new investments or making loans. If the Reserve authorities buy government bonds in the open market and thereby swell bank reserves, the banks will not put these funds to work but will simply hold reserves. Result: no 5 for 1, "no nothing," simply a substitution on the bank's balance sheet of idle cash for old government bonds. —(Samuelson 1948, pp. 353–354)

If there is unmet demand for credit money, then credit money is pulling and monetary policy can be effective, by being more or less restrictive, just as if a dog or horse is pulling on a leash or bridle its speed can be regulated by reining it in or letting it loose – one says that the reserve requirement constraint is binding. If, conversely, all demand for credit money is being met, either because banks do not wish to lend (finding it too risky or unprofitable) or borrowers do not wish to borrow (having no use for added debt, such as due to lack of business opportunities), then the string is slack, the reserve constraint is not binding, and monetary policy is ineffective: monetary policy allows reining in a horse, but does not allow whipping it on.

The breakdown in monetary policy is particularly damaging because it often occurs in financial crises such as the Great Depression and the Financial crisis of 2007–2010: in the midst of a crisis, banks will be more cautious about lending money due to higher risk of default, and borrowers will be more cautious about borrowing money because of lack of investment and speculation opportunities: if demand is dropping, new investment is unlikely to be profitable, and if asset prices are dropping (following the bursting of a speculative bubble), speculation on rising asset prices is unlikely to prove profitable.