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AND BANKING
INTRODUCTION AND SUMMARY But this does not imply a one-to-one relation-
ship between bank deposits and lending. Other
Money is at the core of modern society, not least customers may increase their deposits as they
due to its role in the many different transactions sell securities to banks, and banks may fund their
made by households and firms every day. The lending through sources other than deposits.
transactions range from small everyday purchases Banks’ composition of funding depends, inter alia,
to large-scale financial transactions. Against this on costs and risk.
backdrop, the money stock, i.e. households’ and The growth in money and credit is influenced
firms’ holdings of money, attracts interest. This by a number of factors, such as demand from
article discusses what money is and what drives households and firms, market conditions, the
the money stock. The development in the money regulatory framework for the financial sector
stock is closely linked to lending by banks and and Danmarks Nationalbank’s monetary policy. A
mortgage banks, which is also considered.1 well-functioning financial sector is crucial for ena-
Money is essentially liquid claims that are bling money and credit to adjust to the demand
stable in value and can also serve as a unit of from households and firms. In this article we use
account. Besides cash, i.e. banknotes and coins, simple empirical models to illustrate some of the
the standard definitions of money also include determinants of money and credit in Denmark.
other liquid claims such as bank deposits. This The need for both money and credit is close-
reflects that deposits can be used as a means ly linked to the transactions of households and
of payment alongside cash. In practice, there is firms. Consequently, it is not surprising that
not one overall monetary aggregate, just as the domestic demand, which reflects the volume of
relevant definition of money has been amended transactions, can contribute to explaining the de-
over time. Prior to last century’s increasing use of velopment in both the money stock and lending.
bank deposits and cheque payments, money was Property prices also play a role in the demand
equivalent to cash. for and access to money and credit, and so do
While banknotes and coins are issued by Dan- interest rates.
marks Nationalbank, the remainder of the money Generally, banks determine interest rates and
stock is the result of transactions between actors other conditions for their deposits with a view
in the private sector. For example, when a house- to achieving the highest possible return, taking
hold or firm raises a bank loan, this transaction into account the associated risks. Ultimately, the
will often, in the first instance, lead to higher bank private sector’s demand for money is determined
deposits and thus an increase in the money stock. by the current monetary policy. The reason is that
monetary policy determines the level of interest
rates, which has a direct impact on the costs of
1 See also McLeay et al. (2014a and 2014b) for a thorough introduction
to money and banking in a modern economy. raising a loan. Monetary policy also influences
10,000,000
1,000,000
100,000
10,000
1,000
100
1922 1927 1932 1937 1942 1947 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012
Banknotes and coins Banknotes and coins and bank deposits (M2)
Note: The curve for banknotes and coins also includes the holdings of banks, mortgage banks and the central government, which are not
included in the official definitions of the money stock. Annual data for banknotes and coins and quarterly data for M2.
Source: Abildgren (2006 and 2012) and Danmarks Nationalbank.
Per cent
14
12
10
0
82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14
which everybody agrees to use. Money is such a relevant definition of money has evolved over time.
means of payment. For example, last century’s increased use of bank
Confidence in Danish kroner reflects confi- deposits and cheques led to a broadening of the
dence in Danmarks Nationalbank. The population relevant monetary aggregate, which had previous-
expects Danmarks Nationalbank to ensure, via ly comprised only cash. Today, households most
its monetary policy, that the value of the krone is often make payments by credit transfer from the
stable over time. Inflation has been very stable buyer’s to the seller’s bank, e.g. using the Dankort,
over a long period, cf. Chart 2. This is the result of and demand deposits at the banks have the three
maintaining a fixed exchange rate of the krone vis- basic characteristics of money alongside cash.
à-vis first the D-mark, then the euro. The European Looking ahead, the relevant definition of mon-
Central Bank, ECB, conducts monetary policy with ey may evolve further in line with innovations in
a view to ensuring price stability in the euro area, the financial sector. The crux of the matter is that
meaning that prices will be stable in Denmark too. the framework for the sector enables households
and firms to allocate their financial assets and lia-
MONEY STOCK bilities appropriately, while taking liquidity, return
The money stock is a measure of households’ and and risk into account.
firms’ holdings of liquid claims. In practice, there is In a data context, three monetary aggregates
not one overall monetary aggregate that can pro- normally apply. M1 comprises banknotes and
vide a clear picture of liquidity conditions in the coins in circulation as well as demand deposits
economy. It is difficult to determine the character- at banks. M2 also includes time deposits with an
istics that distinguish money from other financial original maturity of up to and including 2 years as
assets, since there are no hard-and-fast bounda- well as deposits redeemable at notice up to and
ries between liquidity, stability in value and return including 3 months. Finally, M3 comprises, in addi-
from cash to bonds and e.g. equities. tion, deposits from repo transactions2 and bonds
The liquidity of the individual claims and hence
the composition of what can be characterised as
2 In a repo transaction, securities are sold for cash, and at the same
money is determined by households and firms
time an agreement is concluded on repurchase from the counterpar-
via their transaction patterns. Consequently, the ty at an agreed price at a future time.
Financial claims can be ranked in a hierarchy according to tions whose liquid liabilities are included in the definition of
liquidity and stability in value. Money is characterised by a money. These are banks and mortgage banks and Danmarks
high degree of liquidity and stability in value, and the higher Nationalbank, overall called the MFI sector. The money-hold-
the degree of liquidity and stability in value, the narrower ing sector comprises Danish households and firms (exclud-
the monetary aggregate. The money stock is also limited by ing banks and mortgage banks) as well as local and regional
the sector issuing the claim (the money-issuing sector) and authorities, cf. the chart below. The central government is
the sector holding the claim (the money-holding sector). regarded as neutral in a money context.
The money-issuing sector comprises the financial institu-
Note: The arrow points to the sector on which the money represents a claim.
The table below shows which claims are included in the current account at Danmarks Nationalbank and credited to
various monetary aggregates and provides examples of the mortgage bank’s account.
claims not included in the money stock. The last column in Financial entities other than banks and mortgage banks,
the table indicates where in the chart the claim is shown. e.g. pension companies, are not included in the money-issu-
M1, M2 and M3 consist of the money-holding sector’s claims ing sector, but in the money-holding sector instead. House-
on the money-issuing sector, cf. (1) and (2) in the chart. hold pension savings are offset by the pension companies’
The money stock is determined on the basis of the pension commitments and have no impact on the money
consolidated balance sheet for the MFI sector. This excludes stock.
inter-MFI accounts. Since mortgage banks are part of the The counterparts of the money stock are the items on
money-issuing sector, short-term mortgage bonds held by the consolidated balance sheet of the MFI sector that are
the money-holding sector are included in M3. The status not included in the money stock. Examples are lending by
of mortgage banks as part of the money-issuing sector banks and mortgage banks to non-MFIs, the banks’ securi-
also means that banks’ purchases of mortgage bonds from ties portfolios and their international position. By definition,
mortgage banks have no impact on the money stock. Bonds a change in the money stock will be reflected in its counter-
issued by mortgage banks are offset by banks’ holdings of parts.
these bonds. Similarly, the consolidated balance sheet is not
affected by payments for the bonds debited to the bank’s
3 The MFI sector covers the banks and mortgage banks and Danmarks
Nationalbank. The development in M3 is influenced by the issuance
of short-term bonds for financing of adjustable rate loans, which
may result in substantial fluctuations. For Denmark, the information
content of M3 is thus often modest.
M1 M2 M3 Arrow in chart
Other bonds
Equities
Pension savings
In the monetary base, the money-issuing sector is limited certificates of deposit and banknotes and coins, cf. (3) in
to Danmarks Nationalbank. The monetary base consists the chart. In addition, the money-holding sector’s holdings
of banks’ and mortgage banks’ liquid claims on Danmarks of banknotes and coins are also included in the monetary
Nationalbank in the form of current account deposits, base, cf. (2) in the chart.
4 per cent
2 per cent
10 per cent
Kr. billion
6,000
Assets Liabilities
5,000
4,000
3,000
2,000
1,000
0
2003 2008 2013 2003 2008 2013
Note: The pension portfolio has been calculated before tax. Other securities, etc. include, inter alia, bonds and other accounts receivable/
payable. Debt comprises all household liabilities. End-of-period, seasonally adjusted data. A data break occurred in 2013 due to the
transition to new MFI statistics.
Source: Danmarks Nationalbank.
300 900
200 600
100 300
0 0
92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
its at Danmarks Nationalbank rose considerably An increase in the monetary base may also reflect
from the onset of the financial turmoil in the changes in items of central banks’ balance sheets
summer of 2007 to the autumn of 2008, cf. Chart other than monetary policy lending. Items other
5, while monetary policy lending increased. The than monetary policy lending and deposits are
growth in monetary policy lending and deposits denoted the autonomous factors. On the assets
was attributable to an increase in certificates of side, these include e.g. the foreign exchange re-
deposit, which constitutes a liquidity buffer that serve and the central bank’s portfolio of domestic
the banks may use for raising liquidity in Dan- securities. An example on the liabilities side is the
marks Nationalbank’s open market operations. central government’s account at the central bank.
Any change in the monetary base is mirrored For example, the increase in the US monetary
by changes in other items on a central bank base is primarily attributable to the large-scale
balance sheet. By definition, more central bank asset purchases by the Federal Reserve. The Fed
lending will be reflected in larger deposits at the buys assets from the banks, resulting in a rise in
central bank, if the other items remain unchanged. the banks’ deposits at the Fed.
As a result, the central bank cannot provide net In Denmark, the fluctuations in the monetary
funding to the banks overall by increasing its base since the onset of the financial crisis are very
lending. Individual banks may increase net bor- much attributable to fluctuations in the foreign ex-
rowing from the central bank, but this will be change reserve, cf. Dam and Risbjerg (2009). The
offset by other banks’ reduction of their net loans monetary base dived in late 2008 in connection
from the central bank. with considerable intervention sales of foreign
However, enhanced access to monetary policy exchange in October.6 It then rose as the foreign
loans, which will increase central bank lending exchange reserve grew. When Danmarks Nation-
and deposits, may support the banks’ lending to albank buys foreign exchange from the banks, the
households and firms. This will be effected partly
through greater certainty for the banks about
their liquidity situation and partly by ensuring 6 The central government’s issuance of a 30-year bond in December
2008 also reduced bank deposits at Danmarks Nationalbank in con-
funding access for banks that find it difficult to
nection with an increase in the balance of the central government’s
borrow in the market. account at Danmarks Nationalbank.
7 Cf. Jørgensen and Risbjerg (2013). 11 The ability of the monetary base to predict the development in
the money stock and bank lending has been examined specifically
8 Cf. Jørgensen and Risbjerg (2012).
via Granger causality tests. These tests seek to explain changes in,
9 Borio and Disyatat (2009) refer to this view, but dismiss the existence respectively, bank deposits that are included in the money stock, and
of such a close link. bank lending by the banks’ own lagged changes and changes in their
deposits at Danmarks Nationalbank. The hypothesis that changes
10 The model is reviewed in Mishkin (2004). in bank deposits at Danmarks Nationalbank do not contribute to
predicting changes in deposits and lending, respectively, cannot be
rejected.
Kr. billion
Assets Liabilities
5,000
4,000
3,000
2,000
1,000
0
2003 2008 2013 2003 2008 2013
Lending to non-MFIs Lending to MFIs Securities Other assets
Deposits from non-MFIs Deposits from MFIs Capital and reserves Other liabilities
Note: End-of-period data. A data break occurred in 2013 due to the transition to new MFI statistics. Securities include bonds, equities, deriva-
tives and certificates of deposit issued by Danmarks Nationalbank. Lending to and deposits from MFIs include e.g. accounts with MFIs'
foreign units and central banks except purchases of certificates of deposit from Danmarks Nationalbank. Other assets include e.g. cash
in hand. Other liabilities include, inter alia, debt instruments issued and derivatives. The balance sheet is not consolidated.
Source: Danmarks Nationalbank.
On the liabilities side, banks can fund their lending will first be credited to the borrower’s bank
by using deposits, but also by borrowing funds in account. This means that lending will initially be
the money and capital markets. The banks used offset by a corresponding deposit and thus by an
the latter option to a considerable extent up to increase in the money stock. After that, there are
2008, when growth in deposits lagged behind several possibilities as regards the deposit.
lending growth. The result was a substantial cus- One possibility is for it to remain unchanged,
tomer funding gap in the Danish banking sector resulting in a permanent effect on the money
overall, which was funded via borrowing abroad. stock. Alternatively, it can be used to repay other
The customer funding gap has subsequently been debt to the banking sector, generating a short-
reversed to a customer funding surplus. lived increase in the money stock. Loans are often
The composition of the banks’ funding depends raised to pay for products, services or invest-
on such factors as costs and risk. For example, ment goods. This typically means transferring
banks can increase their funding via deposits by the amount to an account belonging to another
raising the deposit rate and thus induce house- household or firm.
holds and firms to make more deposits. In gener- If the loan proceeds are used for payment
al, banks’ deposits are determined by the demand purposes, the payee will, in some cases, take the
from households and firms for transaction money opportunity to redeem its own bank debt. This
and by the return on deposits compared with the reduces the money stock again. The payee may
return on investment in other financial claims. also choose to leave the money as a deposit in
On the assets side, lending is determined by the his own bank account or to spend it. The further
demand for loans and by the banks’ assessment effects on the money stock depend on what the
of return against risk on lending. next money recipient decides to do.
The money stock is not only affected by lend-
BANK LENDING AND THE STOCK OF MONEY ing. Deposits, and hence the money stock, are
Given the structure of the banking system, lending affected every time a household or firm buys or
normally generates deposits. When a bank grants sells financial assets, which are not included in
a loan to a household or firm, the loan proceeds the monetary aggregates, from or to the bank-
13 Money demand in Denmark was previously estimated by Christensen 14 See Risbjerg (2006) for a discussion of the link between the money
and Jensen (1987), Hansen (1996) and Andersen (2004). stock and housing loans.
15 For similar estimations for other countries, see e.g. Calza, Manrique
and Sousa (2006), Gerlach and Peng (2005), Hofmann (2003 and
2004) and Addison-Smyth, McQuinn and O’Reilly (2009).
The demand for money and loans is estimated using two level of either 1 per cent or 5 per cent. There are indications
error correction models, estimated separately. It is thus not of error correction in the model, in that money demand will
one overall portfolio model, but individual models for two tend to return to its long-run level after being hit by a shock.
of the most important assets and liabilities of households The results indicate that any deviation between actual mon-
and firms. The models can be written as: ey demand and its long-run level narrows by approximately
𝑘 10 per cent per quarter.
The estimate on domestic demand indicates that the
Δ𝑦𝑡 � α𝑥𝑡-1 + �β𝑖Δ𝑥𝑡-𝑖 � ω𝑡 (1)
elasticity of money demand as regards transaction volume
𝑖=1
is close to 1. This means that money demand moves along
The left-hand variable 𝑦𝑡 is the money stock in one model with the transaction need in the long run, which is in accord-
and lending by banks and mortgage banks to households ance with previous analyses of money demand in Denmark.
and non-financial corporations in the other. The first term The deposit rate is strongly significant, and the estimate
after the equal sign, α𝑥𝑡-1, consists of a vector of adjustment shows an increase of approximately 5.5 per cent in money
coefficients α and the model vector of variables 𝑥𝑡 and demand if the deposit rate rises by 1 percentage point.
expresses the model’s long-run relationship. The next term As regards the alternative interest rate, the 30-year
after the equal sign contains the short-run dynamics, where mortgage yield, 𝑅𝑡𝑅𝐼30, has the best properties for the model.
𝑘 is the number of lags. The last term, ω𝑡, denotes the resid- The widespread use of mortgage credit in Denmark enables
uals, which are assumed to be identical and independently households to either buy mortgage bonds or service their
normally distributed. The following data vectors have been mortgages rather than place funds in their deposit accounts,
applied to the demand for loans and money, respectively: if mortgage yields go up. This causes money demand to
fall. Finally, household property wealth also turns out to be
𝑥'𝑡 = (𝑚2𝑡, 𝑦𝑡𝑟𝑡 , 𝑅𝑡𝑑𝑒𝑝, 𝑅𝑡𝑎𝑙𝑡, 𝑤ℎ𝑡)
significant with a coefficient of 0.30. This implies that money
demand will rise by 0.30 per cent if property wealth increas-
𝑥'𝑡 = (𝑙𝑒𝑛𝑑𝑖𝑛𝑔𝑡 , 𝑦𝑡𝑟𝑡 , 𝑅𝑡𝑙𝑒𝑛𝑑, 𝑤𝑒𝑡) es by 1 per cent.
The inclusion of property wealth is decisive for the stabil-
In the top vector, 𝑚2𝑡 denotes the money stock, 𝑦𝑡𝑟𝑡 is
ity of the model after 2002. If the model is estimated up to
domestic demand, 𝑅𝑡𝑑𝑒𝑝 is the banks’ deposit rate, 𝑅𝑡𝑎𝑙𝑡 is the
the 3rd quarter of 2013 without including property wealth,
alternative return to placing funds in deposit accounts, while
the estimate on the coefficient on domestic demand is con-
𝑤ℎ𝑡 denotes household property wealth. In the bottom vec- siderably higher. Moreover, if property wealth is excluded,
tor, 𝑙𝑒𝑛𝑑𝑖𝑛𝑔𝑡 denotes total lending by banks and mortgage
the alternative interest rate becomes insignificant. Both
banks to households and non-financial corporations. 𝑅𝑡𝑙𝑒𝑛𝑑 is
factors indicate that if property wealth is not included, the
the banks’ and mortgage banks’ weighted lending rate, and
model is not well specified.
𝑤𝑒𝑡 is property wealth compiled as the sum of household The model’s explanatory power, measured as 𝑅2, is 0.42.
property wealth and the market value of commercial prop-
Consequently, it is unable to explain a substantial part of
erties.
the variation in money demand. Most statistical assump-
Lowercase letters denote variables in logarithms. The
tions are met, including the absence of autocorrelation and
estimation period is Q1 1981-Q3 2013, and all series except
heteroskedasticity. However, there are problems with the
interest rates are seasonally adjusted and included in
normality assumption, which can be attributed to a few
nominal terms. This is in accordance with the analysis in An-
large residuals, cf. the chart below. This problem can be
dersen (2004). Basically, we use four lags for the first order
eliminated by including dummy variables for the quarters
differences as the data is quarterly data. Variables are then
with the largest residuals. In general, the model estimate of
removed from the relation on the basis of statistical criteria.
the development in the money stock is lower than the actual
development from 2004 to end-2007. Consequently, the rise
Money demand
in the money stock in that period cannot be explained by
Estimation of error correction model (1) leads to the follow-
soaring house prices alone..
ing long-run relationship for money demand:
- 3,54**𝑅𝑡𝑅𝐼30 + 0,30**𝑤ℎ𝑡
14 8
12 6
10 4
8 2
6 0
4 -2
2 -4
0 -6
-2 -8
-4 -10
-6 -12
82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12
Residuals (right-hand axis) Actual Estimated
Demand for loans either domestic demand or the lending rate and one with
With a view to focus on the description of the relationship both variables.
between the demand for loans and the real economy, The coefficient on domestic demand also depends
corporate lending is restricted to non-financial corporations. on which measure of property wealth is included in the
Borrowing decisions e.g. by insurance companies and other model. If only household property wealth is included, the
financial intermediaries may be based on financial consider- explanatory power of domestic demand is weakened, and
ations, which can lead to stronger fluctuations in lending to the positive residuals in 2005-07 tend to be smaller. The
the financial sector, cf. e.g. ECB (2014). coefficient on property wealth is significant at a level of 1
Estimation of error correction model (1) leads to the per cent. All else equal, an increase in property wealth of 1
following long-run relation for the demand for loans: per cent increases lending by 0.8 per cent. The model shows
signs of heteroskedasticity in the residuals. Apart from
𝑙𝑒𝑛𝑑𝑖𝑛𝑔𝑡 = α + 0,33*𝑦𝑡𝑟𝑡 - 1,33*𝑅𝑡𝑙𝑒𝑛𝑑 + 0,82***𝑤𝑒𝑡 that, the model is generally well specified on the basis of
standard misspecification tests. Dummy variables have been
The coefficients on the variables have the expected signs. included in Q4 1985, Q4 2001 and Q1 2002 to ensure normal
There are indications of error correction in the model, in distribution of the residuals. Overall, the model captures
that lending will tend to return to its long-run level after lending fluctuations well, and its explanatory power meas-
being hit by a shock. The results indicate that any deviation ured as R^2 is 0.85. The residuals are predominantly positive
between actual lending and its long-run level narrows by in 2005-07. As is also the case for the money stock, the
approximately 6 per cent per quarter. considerable growth in lending in the run-up to the financial
Both domestic demand and the lending rate are included crisis cannot be explained by soaring property prices alone.
in the long-run relation shown, but they are only significant The residuals are predominantly negative after 2007. The
at a level of 10 per cent. The two variables take explana- development in credit since the financial crisis has thus been
tory power from each other. This reflects a positive trend slightly weaker than predicted by the model.
in domestic demand and a negative trend in the lending Credit developments can also be influenced by supply
rate over the estimation period. The coefficients on both factors. But empirical studies indicate that supply effects on
demand and interest rate change, and their statistical signif- lending in Denmark are limited, cf. Drejer et al. (2011), Abild-
icance grows, if one variable is included without the other. gren and Kuchler (2013) and Abildgren (2013).
Statistically, there is no big difference between a model with
10 1.5
8 1.0
6 0.5
4 0.0
2 -0.5
0 -1.0
-2 -1.5
82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12
MARKET CONDITIONS IN THE BANKING SECTOR demand deposits, since the depositors demand
Overall, banks determine interest rates and the compensation for binding their money for a cer-
other conditions for their deposits and loans with tain period. Banks may also resort to the money
the aim of obtaining the highest possible return, and capital markets, but these funding sources
while also considering the risk. Individual banks are often regarded as less stable than deposits.
compete in the areas of lending and attracting This was evidenced during the financial crisis,
deposits. A bank can increase its lending by re when foreign banks extensively stopped lending
ducing the lending rate. In order to fund the higher to Danish banks, cf. Jørgensen et al. (2011).
lending, the bank may have to raise its deposits Credit risk reflects the experience that some
rates, thereby eroding its earnings. At some stage borrowers default on their loans. When a bank
a further increase in lending will not be profitable. expands its lending, it may tend to attract riskier
In this way, competition for deposits and lending, customers in the process. During the financial
combined with the banks’ search for profit, serves crisis, the banks that became subject to resolu-
to dampen growth in lending and the money tion were to a high degree those banks that had
stock. experienced strong lending growth in the preced-
The banks must continually consider the risks ing years. Both liquidity risk and credit risk thus
associated with their lending. The risk categories have a dampening effect on lending and deposit
are liquidity risk and credit risk. growth in the financial sector.
Liquidity risk reflects the banks’ maturity trans- When a bank considers return against risk, it
formation. While most deposits can be withdrawn does not necessarily take into account the so-
or moved to another bank at short notice at the cial costs of its potential failure, such as financial
customer’s request, loans usually have longer instability and lower economic growth. Since
maturities. Access to stable funding is important the banks’ liabilities do not extend beyond their
to a bank. Funding sources include deposits equity capital, they may have an incentive to
from households and firms, including fixed term assume greater risks, e.g. on lending, than what is
deposits. Such deposits cost more to attract than desirable for the economy overall. For this reason,
MONETARY POLICY
For most central banks, the money stock does not
play a pivotal role in monetary policy. In an inter-
national context, the most widespread monetary
policy objective is to keep inflation stable at a low
16 See Spange and Toftdahl (2014) for a review of Danmarks National-
level. Consequently, the decisive factor is not the bank’s implementation of monetary policy in Denmark.
amount of money in circulation, but stability in its
17 See Drejer et al. (2011) for an analysis of the pass-through of mone-
purchasing power. tary policy rates to retail rates.
Andersen, Allan Bødskov (2004), Money demand ECB (2014), Extensions to the models for assess-
in Denmark 1980-2002, Danmarks Nationalbank ing money and credit, Monthly Bulletin, February.
Working papers, No. 18.
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surviving: Some international experience, Federal
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cember. housing – evidence for the euro area and the US,
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(2013), Consumption, income and wealth, Dan- in Denmark, Danmarks Nationalbank, Monetary
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Sousa (2006), Credit in the euro area: An empirical Moselund Jensen and Lars Risbjerg (2011), The
investigation using aggregate data, The Quarterly money and foreign-exchange markets during the
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