Does Discount Rate Control Money Supply?
One of criticism of the real bills doctrine is that supporters claim that the state of business determines the number of bills, and, therefore, the number of bills is independent of bank policies. To the contrary, according to these opponents, the amount lent depends on the discount rate. Banks decide how many bills to discount by the discount rate that they set. A lower discount rate results in banks discounting more bills.
First, banks do not discount bills by lending; they buy bills at a discount. The two actions are entirely different. Second, banks may propose a discount rate, but markets decide the discount rate. A bank that sets a below market rate would not earn an adequate return. If it sets a rate too high, it would not do any business.
True, a lower discount rate normally results in more bills being sold to banks and thus more bank notes and checkbook money being placed in circulation. However, a higher discount rate does not reduce money in circulation. A real bill is commercial money. It can and does, or did, circulate and function as money until it matures. The quantity of commercial money available for discounting determines the discount rate. More commercial money leads to lower discount rates. More productivity results in more commercial money. More consumption causes more productivity. Thus, the discount rate depends on consumption and not banks and savings.
With commercial money in circulation, the economy can function without banks. Banks merely improve the efficiency of the monetary system. With bank notes, they divide commercial money into small uniform pieces that are more easily spent. Also, more people will accept bank notes in payment than bills of exchange because the credit worthiness of a bank is easier to judge.
Under the real bills doctrine, banks do not decide the amount of credit money in circulation. Productivity and consumption decide. Whenever a merchant signs a bill of exchange accepting it, credit money as commercial money is created. Thus, as more goods are produced, commercial money increases. As fewer goods are produced, commercial money decreases. All banks decide is how much commercial money to convert to bank credit, bank notes and checkbook money. (In today’s economy, most would be converted to checkbook money.)
In summary, the discount rate depends on the supply of commercial money, real bills of exchange. However, it does not control the supply. Quite the contrary, the supply of commercial money controls the discount rate. Productivity and consumption control the quantity of commercial money. Therefore, productivity and consumption instead of banks fix the discount rate.
[This article first appeared in The Gold Standard, issue #12, 15 December 2011.]
Copyright © 2011 by Thomas Coley Allen.
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