In response to a query about the “Pushing-On-A-String” post, I thought it would be helpful to post some pictures clarifying the elasticity argument.
Recall that we are discussing supply and demand for bonds. The central question is whether CB bond purchases can force households to hold more deposits. My contention was that this would be ineffectual, as households would push the (bulk of the) excess deposits back onto the financial sector. There is no “hot potato” effect with deposits in a modern economy.
Essentially this is an elasticity argument — recall that anyone who holds a bond is a potential supplier, and anyone who may want to purchase a bond is a potential demander.
Imagine three sectors: “FG” = (non-financial) firms + government. “F” = finance. “H” = households. All three sectors are both potential suppliers and demanders of bonds, although generally speaking FG will be a net supplier, H will be a net demander, and “F” will be somewhere in between.
We can make this more precise by picturing the excess demand function for all three sectors, the sum of which is the total excess demand function for bonds:
As pictured, the household sector ends up being a net consumer of bonds in equilibrium, firms + government are net suppliers of bonds in equilibrium, and the financial sector is a small net consumer. The sum of all positions is zero.
What is meant by the elasticity argument is that the slope of the Finance excess demand function is much more steep than the slope of the other functions (in this diagram, quantity is on the vertical axis, so this corresponds to a “highly elastic” excess demand curve with respect to the interest rate). The reason for this is leverage — a small change in yields creates a much greater return opportunity for the financial sector than the corresponding increase in consumption or investment opportunities of the non-financial sector. The financial sector is more sensitive to changes in interest rates.
As a result of this steepness, what happens when the Central Bank intervenes, to buy up bonds? Effectively, the excess demand function for the “FG” sector in our model shifts upward, but this creates a much smaller shift in the total excess demand function:
The new excess demand function shifts only slightly. The household sector’s equilibrium bond holdings are basically unchanged (they do change slightly), and the financial sector’s equilibrium bond holdings swings to a near zero position to offset the change in bond supply coming from the central bank (“FG”).
In this sense, transactions between the central bank and the rest of the economy are effectively transactions between the central bank and the financial sector. That is, on the margin, the financial sector is the one making almost all of the adjustments.
This follows because of the increased sensitivity of interest rates of this sector, which follows because this sector is leveraged whereas the other sectors are not. And the more the financial sector is leveraged, the more ineffective central bank bond purchases are at forcing households to hold more than the level of deposits that they demand.