In the past I’ve argued that monetary policy mostly consists of Federal Reserve changes in the currency stock. Yes, the monetary base also includes “member bank deposits” at the Fed, but prior to 2008 that was only about 5% of the base. And even that tiny share was mostly a disguised tax on banks, in the form of required reserves. If we took that requirement away (as we should) then the base would be more than 99% currency (including coins) in normal times.
Several people sent me a link to a recent discussion of the recent big increase in $100 bills in circulation. Another link shows that the currency stock is currently about 75% composed of $100 bills, and that that share is rising rapidly. Because these bills are used only rarely in transactions, and because during normal times their rate of return is dominated by equally risk-free FDIC-insured bank accounts, the demand for “Benjamins” is mostly attributed to tax evaders, drug dealers and foreigners. Let’s call these people “TDFs.” Also note that this demand has little to do with the famous “equation of exchange,” as most $100 bills are not used in US transactions during a given year, and most transactions do not involve currency. Instead let’s use the Cambridge equation (M = k*PY) and think in terms of the total demand for Benjamins as a share of US GDP.
Now let’s explain what caused a recession to begin in December 2007. Between July of 2007 and May of 2008 growth in both the monetary base and the stock of currency in circulation suddenly halted. In previous years they had been increasing at a fairly steady rate of about 5% per year. If the Cambridge k had fallen at this time, this would not have been a problem. But the TDF’s thirst for Benjamins did not suddenly end in late 2007 and early 2008. So when the Fed refused to meet that demand, and k did not fall sharply, NGDP growth had to slow dramatically. The actual and prospective slowdown in growth in the currency stock tipped the economy into a recession in December 2007.
As the economy slowed sharply, market interest rates declined. This reduced the opportunity cost of holding Benjamins, and after mid-2008 the k ratio began rising. Now the Fed saw its mistake, and began increasing the supply of Benjamins more rapidly. But not fast enough, and as a result the recession got even worse. But this time the culprit was a rising k ratio.
What about the claim that monetary policy is about the control of short term interest rates? I’d prefer to put it this way; most central banks like to target short term interest rates, and do so by (mostly) adjusting the current and expected future supply of Benjamins. And I would add that the “expected future supply” is especially important, as economists like Woodford like to emphasize. (Actually he emphasizes expected future interest rates, but in any case it’s future monetary policy that matters.) So even if the injections of new base money initially go into banks, during normal times 95% of that extra base money spills out into currency within a few days. It’s all about the Benjamins.
In normal times the demand for Benjamins by TDFs tends to trend upward at around 5% per year, or even more. If the Fed refuses to meet that demand, you’ll get a recession, regardless of what they do or don’t do to interest rates, reserve requirements, IOR and all their other policy instruments. It’s all about the Benjamins.
And remember that Benjamins are rarely used in transactions, so this model isn’t much different from Fama’s famous “spaceship” model, where the medium of account was permits to operate a spaceship. Fed policy in 2007 mostly consisted of adjusting the quantity of a medium of account that wasn’t even primarily a medium of exchange; it was mostly a store of value. It really doesn’t matter what you make the medium of account, just make sure that its value falls at a steady 5% per year, where “value” is defined as the share of NGDP that can be purchased with each unit.
PS. It might be objected that the Fed can no longer control the stock of Benjamins, once rates hit zero. Extra cash simply goes into bank ERs. Maybe, but the same objection could be made about M2. And no one thinks it weird when monetarists talk about control of M2 as the essence of Fed policy. In fact, the Fed can control the stock of currency even at the zero bound. The question is whether or not they want to. And if they went back to the pre-1914 system where the base was 100% currency, then monetary policy would be nothing more than currency control.
Instead, we are headed for a cashless society (however despite pleas by Miles Kimball–it’s at least 50 years away) where the Fed will control policy by adjusting IOR–interest on reserves. Finally the Keynesians will be right. And when they are, they’ll (wrongly) insist that they were right all along. The bad news for Keynesians is that once that happens no one will be able to claim a role for fiscal policy. And that WAS true all along.
HT: Chuck E, et al.