It occurs to me that, despite the unprecedented flood of writings of all sorts — books, blog-posts, newspaper op-eds, and academic journal articles — addressing just about every monetary policy development during and since the 2008 financial crisis, relatively few attempts have been made to step back from the jumble of details for the sake of getting a better sense of the big picture.
What, exactly, is “monetary policy” about? Why is there such a thing at all? What should we want to accomplish by it — and what should we not try to accomplish? By what means, exactly, are monetary authorities able to perform their duties, and to what extent must they exercise discretion in order to perform them? Finally, what part might private-market institutions play in promoting monetary stability, and how might they be made to play it most effectively?
Although one might write a treatise on any one of these questions, I haven’t time to write a thesis, let alone a bunch of them; and if I did write one, I doubt that policymakers (or anyone else) would read it. No sir: a bare-bones primer is what’s needed, and that’s what I hope to provide.
The specific topics I tentatively propose to cover are the following:
- Money.
- The Demand for Money.
- The Price Level.
- The Supply of Money.
- Monetary Control, Then and Now
- Monetary Policy: Easy, Tight, and Just Right.
- Money and Interest Rates.
- The Abuse of Monetary Policy.
- Rules and Discretion.
- Private vs Official Money.
Because I eventually plan to combine the posts into a booklet, your comments and criticisms, which I’ll be sure to employ in revising these essays, will be even more appreciated than they usually are.
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“The object of monetary policy is responsible management of an economy’s money supply.”
If you aren’t a monetary economist, you will think this a perfectly banal statement. Yet it will raise the hackles of many an expert. That’s because no-one can quite say just what a nation’s “money supply” consists of, let alone how large it is. Experts do generally agree in treating “money” as a name for anything that serves as a generally-accepted means of payment. The rub resides in deciding where to draw a line between what is and what isn’t “generally accepted.” To make matters worse, financial innovation is constantly altering the degree to which various financial assets qualify as money, generally by allowing more and more types of assets to do so. Hence the proliferation of different money supply measures or “monetary aggregates” (M1, M2, M3, MZ, etc.). Hence the difficulty of saying just how much money a nation possesses at any time, let alone how its money stock is changing. Hence the futility of trying to conduct monetary policy by simply tracking and regulating any particular money measure.
For all these reasons many economists and monetary policymakers have tended for some time now to think and speak of monetary policy as if it weren’t about “money” at all. Instead they’ve gotten into the habit of treating monetary policy as a matter of regulating, not the supply of means of exchange, but interest rates. We all know what interest rates are, after all; and we can all easily reach an agreement concerning whether this or that interest rate is rising, falling, or staying put. Why base policy on a conundrum when you can instead tie it to something concrete?
And yet…it seems to me that in insisting that monetary policy is about regulating, not money, but interest rates, that economists and monetary authorities have managed to obscure its true nature, making it appear both more potent and more mysterious than it is in fact. All the talk of central banks “setting” interest rates is, to put it bluntly, to modern central bankers what all the smoke, mirrors, and colored lights were to Hollywood’s Wizard of Oz: a great masquerade, serving to divert attention from the less hocus-pocus reality lurking behind the curtain.
But surely the Fed does influence interest rates. Isn’t that, together with the fact that we can clearly observe what interest rates are doing, not reason enough to think of monetary policy as being “about” interest rates? And doesn’t money’s mutable nature make it inherently mysterious — and therefore ill-suited to serve either as an object of monetary policy, let alone as a concept capable of demystifying that policy?
No, and no again. Although central banks certainly can influence interest rates, they typically do so, not directly (except in the case of the rates they themselves charge in making loans or apply to bank reserves), but indirectly. The main thing that central banks directly control is the size and make up of their own balance sheets, which they adjust by buying or selling assets. When the FOMC elects to “ease” monetary policy, for example, it may speak of setting a lower interest rate “target.” But what that means — or what it almost always meant until quite recently — was that the Fed planned to increase its holdings of U.S. government securities by buying more of them from private (“primary”) dealers. To pay for the purchases, it would wire funds to the dealers’ bank accounts, thereby adding to the total quantity of bank reserves.[1] The greater availability of bank reserves would in turn improve the terms upon which banks with end-of-the-day reserve shortages could borrow reserves from other banks.[2] The “federal funds rate,” which is the average (“effective”) rate that financial institutions pay to borrow reserves from one another overnight, and the rate that the Fed has traditionally “targeted,” would therefore decline, other things being equal.
Because central banks’ liabilities consist either of the reserve credits of banks and the central government, or of circulating currency, and because commercial banks’ holdings of currency and central-bank reserve credits make up the cash reserves upon which their own ability to service deposits of various kinds rests, when a central bank increases the size of its own balance sheet, it necessarily increases the total quantity of money, either indirectly, by increasing the amount of cash reserves available to other money-producing institutions, or indirectly, by placing more currency into circulation.
Just how much the money supply changes when a central bank grows depends, first of all, on what measure of money one chooses to employ, and also on the extent to which banks and other money-creating financial institutions lend or invest rather than simply hold on to fresh reserves that come their way. Before the recent crisis, for example, every dollar of “base” money (bank reserves plus currency) created by the Federal Reserve itself translated into just under 2 dollars of M1, and into about 8 dollars of M2. (See Figure 1.) Lately those same base-money “multipliers” are just .8 and 3.2, respectively. Besides regulating the available supply of bank reserves, central banks can influence banks’ desired reserve ratios, and hence prevailing money multipliers, by setting minimum required reserve ratios, or by either paying or charging interest on bank reserves, to increase or lower banks’ willingness to hold them. [3]
Figure 1: U.S. M1 and M2 Multipliers
If the money-supply effects of central bank actions aren’t always predictable, the interest rate effects are still less so. Interest rates, excepting those directly administered by central banks themselves, are market rates, the levels of which depend on both the supply of and the demand for financial assets. The federal funds rate, for example, depends on both the supply of “federal funds” (meaning banks’ reserve balances at the Fed) and the demand for overnight loans of the same. The Fed has considerable control over the supply of bank reserves; but while it can also influence banks’ willingness to hold reserves, that influence falls well short of anything like “control.” It’s therefore able to hit its announced federal funds target only imperfectly, if at all. Finally, even though the Fed may, for example, lower the federal funds rate by adding to banks’ reserve balances, if the real demand for reserves hasn’t changed, it can do so only temporarily. That’s so because the new reserves it creates will sponsor a corresponding increase in bank lending, which will in turn lead to an increase in both the quantity of bank deposits and the nominal demand for (borrowed as well as total) bank reserves. As banks’ demand for reserves rises, the federal funds rate, which may initially have fallen, will return to its original level. More often than not, when the Fed appears to succeed in steering market interest rates, it’s really just going along with underlying forces that are themselves tending to make rates change.
I’ll have more to say about monetary policy and interest rates later. But for now I merely want to insist that, despite what some experts would have us think, monetary policy is, first and foremost, “about” money. That is, it is about regulating an economy’s stock of monetary assets, especially by altering the quantity of monetary assets created by the monetary authorities themselves, but also by influencing the extent to which private financial institutions are able to employ central bank deposits and notes to create alternative exchange media, including various sorts of bank deposits.
Thinking of monetary policy in this (admittedly old-fashioned) way, rather than as a means for “setting” interest rates, has a great advantage I haven’t yet mentioned. For it allows us to understand a central bank in relatively mundane (and therefore quite un-wizard-like) terms, as a sort of combination central planning agency and factory. Central banks are, for better or worse, responsible for seeing to it that the economies in which they operate have enough money to operate efficiently, but no more. Shortages of money wastes resources by restricting the flow of payments, making it hard or impossible for people and firms to pay their bills, while both shortages and surpluses of money hamper the correct setting of individual prices, causing some goods and services to be overpriced, and others underpriced, relative to others. Scarce resources, labor included, are squandered either way.
Though they are ultimately responsible for getting their economies’ overall money supply right, central banks’ immediate concern is, as we’ve seen, that of controlling the supply of “base” money, that is, of paper currency and bank reserve credits — the stuff banks themselves employ as means of payment. By limiting the supply of base money, central banks indirectly limit private firms’ ability to create money of other sorts, because private firms are only able to create close substitutes for base money by first getting their hands on some of the real McCoy.
But how much money is enough? That is the million (or trillion) dollar question. The platitudinous answer is that the quantity of money supplied should never fall short of, or exceed, the quantity demanded. The fundamental challenge of monetary policy consists, first of all, of figuring out what the platitude means in practice and, second, of figuring out how to make the money stock adjust in a manner that’s at least roughly consistent with that practical answer.
Next: The Demand for Money.
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1. Although people tend to think of a bank’s reserves as consisting of the currency and coin it actually has on hand, in its cash machines, cashiers’ tills, and vaults, banks also keep reserves in the shape of deposit credits with their district Federal Reserve banks. When the Fed wires funds to a bank customer’s account, the customer’s account balance increases, but so does the bank’s own reserve balance at the Fed. The result is much as if the customer made a deposit of the same amount, using a check drawn on some other bank, except that the reserves that the bank receives, instead of being transferred to it from some other bank, are fresh ones that the Fed has just created.
2. Although amounts that banks owe to one another are kept track of throughout the business day, it is only afterwards that banks that are net debtors must come up with the reserves they need both to settle up and to meet their overnight reserve requirements.
3. The Fed first began paying interest on bank reserves in October 2008. Although some foreign central banks are now charging interest on reserves, the Fed has yet to take that step; nor is it clear whether it has the statutory right to do so.
