Currency matters, even with IOR

Today I’m going to be defending Paul Krugman, who claims that the quantity of money does matter when interest rates are positive.  Steve Waldman recently criticized Krugman in this post:

If Ip and I are right, Paul Krugman is wrong to say

“It’s true that printing money isn’t at all inflationary under current conditions “” that is, with the economy depressed and interest rates up against the zero lower bound. But eventually these conditions will end.”

Printing money will always be exactly as inflationary as issuing short-term debt, because short-term government debt and reserves at the Fed will always be near-perfect substitutes. In the relevant sense, we will always be at the zero lower bound. Yes, there will remain an opportunity cost to holding literally printed money “” bank notes, platinum coins, whatever “” but holders of currency have the right to convert into Fed reserves at will (albeit with the unnecessary intermediation of the quasiprivate banking system), and will only bear that cost when the transactional convenience of dirty paper offsets it. In this brave new world, there is no Fed-created “hot potato”, no commodity the quantity of which is determined by the Fed that private holders seek to shed in order to escape an opportunity cost. It is incoherent to speak, as the market monetarists often do, of “demand for base money” as distinct from “demand for short-term government debt”. What used to be “monetary policy” is necessarily a joint venture of the central bank and the treasury. Both agencies, now and for the indefinite future, emit interchangeable obligations that are in every relevant sense money.

There are several mistakes here, but the most important is to assume that the quantity of base money doesn’t matter in a world of zero rates, or a world of IOR. Let’s suppose the Fed keeps paying IOR permanently.  And during normal times the level of bank reserves is much higher than under the pre-2008 regime (when it was less than 5% of the base.)  More specifically, let’s assume that in the year 2020 the base is $1 trillion, and that represents $800 billion in currency and $200 billion in reserves.  Waldman is appointed to the Fed, and told to use IOR to double the price level.  Or IOR plus fiscal policy.  He can’t use OMOs, because we know that the quantity of base money doesn’t matter, he must use the IOR.  What happens?

One answer is that he cannot double the price level.  Monetary policy is impotent for “Fiscal Theories of the Price Level” reasons. But this is hard to reconcile with the fact that many central banks have been using IOR for quite some time, and seem to have no problem doing regular monetary policy.  The only real question is whether they can do monetary policy without adjusting the quantity of base money, as Waldman asserts.

So let’s say Waldman tries to adjust the IOR until the price level doubles.  What will he have to do to the IOR?  Presumably he cuts the IOR, which reduces the demand for bank reserves, and this reduces the value of bank reserves.  So far so good.  Bank reserves are a medium of account, so if their value falls then the price level rises.  And what is the demand for currency in the new long run equilibrium, once prices have doubled?  Obviously $1600 billion.  So the new equilibrium level of the monetary base is $1600 billion plus the new level of reserves (which will be lower as a share of the base, but might be higher or lower in absolute terms.)

So the base rises by at least 60% in the new equilibrium.  But we assumed no rise in the base, as Waldman said the quantity of base money no longer matters.  So the quantity of base money must matter.  QED.

Astute readers will notice the similarity between this example and the gold standard.  Under the gold standard a $1 bill and 1/20.67 ounces of gold were both MOAs.  Gold could be freely converted into currency, and vice versa, just as Waldman assumes reserves and T-bills and currency are freely convertible. Nonetheless, the quantity of gold mattered, and it mattered a lot, because there was a zero lower bound on central bank gold stocks.  Likewise there is a zero lower bound on bank reserves, and thus currency still matters a lot.

But even if Waldman were right that the quantity of base money didn’t matter, even if IOR was the only tool of monetary policy, he’d still be wrong about the hot potato effect. And that is because T-bills are not “in every relevant sense money.” Indeed they are not money in the only relevant sense.  They are not a medium of account. When the value of T-bills change the nominal price of T-bills change. When the value of money changes the nominal price of money doesn’t change. Instead, all other prices in the economy adjust. That’s why I monomaniacally focus on the base.

Now let’s suppose we have a cashless economy, just interest-bearing reserves. The base is one trillion dollars and NGDP is $20 trillion.  People prefer to hold base money equal to 5% of NGDP.  Now the Fed wants to double NGDP, to $40 trillion.  How do they do this?  They could adjust the quantity of base money.  But let’s rule that out.  We’ll have them adjust the demand for base money by changing the IOR.  So let’s say they cut IOR until the public prefers to hold reserves equal to 2.5% of NGDP.  If the stock of reserves is unchanged, there will be an excess supply of reserves at the new IOR.  The hot potato effect will take over, and raise prices and output until NGDP has doubled.  Then we will be in equilibrium again.  So the hot potato effect refers to changes in both the supply and the demand for base money.  There is nothing particularly “monetarist” about the hot potato effect.

Contrary to Waldman’s claim, market monetarists have grappled with a world of IOR.  Indeed my very first blog post (after the intro) advocated negative IOR as a way of boosting NGDP.

PS.  Peter Ireland did a paper that made some very similar points using a formal model.  He showed that money continues to be neutral in the long run, even with positive IOR.

PPS.  This thought experiment also demonstrates why Fama was right to focus on currency, not the base.  Currency is the part of the base that really matters.

HT:  Tim Duy

Update:  After I wrote this I noticed that Krugman did a similar post.

Update:  David Beckworth has an excellent explanation of IOER.


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32 Responses to “Currency matters, even with IOR”

  1. Gravatar of Bill Woolsey Bill Woolsey
    15. January 2013 at 08:15

    I think Waldman goes with the– lets suppose the central bank pays an IOR exactly equal to the yield on government bonds. (He explicitly says they pay the same amount as the overnight interbank loan rate.

    Clearly, you can have interest on IOR less than the interest rates on government bonds. It has happened many times. Positive interest rate on government bonds and zero IOR. If the interest rate on T-bills is 5% and the interest rate on reserves .2%, while the demand for reserves would be higher than with an interest rate of zero, it would hardly make them perfect substitutes with T-bills. They aren’t close.

    Instead, suppose that if the interest rate on government bonds is 5%, the Fed sets the interest rate on reserves at 5%.

    Or, suppose the interest rate on reserves was 1% and the interest rate on T-bills was 5%, and the Fed raises the interest rate on reserves to 6%. It seems likely to me that the interest rate on T-bills would rise to 6% too.

    So, the interest rate on government bonds can be greater than or equal to the interest rate on reserves.

    Now, suppose the Fed initially sets the IOR reserves at 6% and the interest rate on T-bills is aslo 6%. It could be that open market purchases of T-bills would have no effect. Open market sales might not have much effect on the margin, but enough of them would raise T-bill rates above 6%. Say they rise to 7%. Of course, the Fed could have done that by just raising the interest rate it pays on reserves to that same level.

    Seems to me that if we assume that the interest rate on reserves is always set at or above the equilibrium interest rate on T-bills, then open market operations using T-bills have no effect.

    I favor setting the interest rate on reserves below the interest rate on T-bills and shifting it when T-bill rates change. Open market operations work always, though when the yield on reserves gets too low, you get a currency drain. And that is what the zero nominal bound is about. Pretty soon reserve balances disappear, and open market operations just impact the quantity of currency, which is a perfect substitute for T-bills on the margin because the currency would be held as a store of wealth, on the margin, and the yield is the same.

  2. Gravatar of ssumner ssumner
    15. January 2013 at 09:06

    Bill, I agree that the Fed could set IOR below T-bill yields, and policy would work as usual. I was giving Steve the benefit of the doubt. But Steve needs to consider why the Fed would want to give up control over monetary policy, when they could keep control by maintaining an IOR slightly below the T-bill yield.

    I oppose IOR, and would rather get rid of reserve requirements.

  3. Gravatar of Andreas Andreas
    15. January 2013 at 09:34

    Scott, I am convinced that people still don’t get what Steve is getting at here. He basically agrees with the premise that the monetary base will matter again as soon as the intrest rate rises back to ‘normal’ levels. But his point is, I think, that the intrest rate will be at, or very close to the zero lower bound for a very long time to come. This graph strengthens his position: http://www.interfluidity.com/files/FEDFUNDS-from-1980.png

  4. Gravatar of Saturos Saturos
    15. January 2013 at 09:48

    I’m not sure how Scott’s “logical argument” works, but if we’re assuming no change in the base then the conclusion would have to be that the price level won’t rise. The Fed can always physically hold the base constant, after all, then cutting IOR just pushes reserves out as currency, right? Change in base composition, but not much change in NGDP.

    And that is because T-bills are not “in every relevant sense money”… They are not a medium of account.”

    And also, crucially, they are not a medium of exchange. As Scott himself has pointed out, you can’t use T-bills to make purchases at Wal-Mart.

    Is Waldman actually suggesting that buying all the assets on earth outside the ZLB would not create inflation, as base money is a perfect portfolio substitute? Come on.

    P.S. I love Krugman so much for that post title. But surely you don’t agree that the use of currency is what constrains the money multiplier? Banks would hold reserves even if no cash withdrawals were made, because they need to settle payments with each other with base money.

    Also: “Everyone sensible (a group containing nobody on the political right)…”

    It’s because he says things like this so regularly that we can’t tell the rhetoric from the fervent belief that a lot of us get so pissed off at Krugman from time to time.

  5. Gravatar of Peter N Peter N
    15. January 2013 at 10:39

    I think theory would say that moneyness is a linear function of opportunity cost utility. That is, you have to consider both the difference in interest rates and the convenience of holding legal tender. Viewed this way the difference is clear.

    An interesting corollary would seem to be that for sufficiently large sums, T-bills may be a better form of money, since there are restrictions on large cash transactions, and deposit insurance is limited to $250,000. This creates a counterparty bankruptcy risk with deposits. Repos are protected against counterparty risk under bankruptcy law, while deposits aren’t, so deposits lose the risk adjusted opportunity cost comparison.

    BTW the change in BK law was a major change to the financial system that would seem to make comparisons of events before and events after more problematic.

  6. Gravatar of Peter N Peter N
    15. January 2013 at 10:58

    Saturos,

    You can use T-bills at Wal-Mart. While standing in the checkout line, you log on to your brokerage account with your cell phone, sell a T-bill, and either transfer the money to your checking account or pay with a check on your brokerage account. Ain’t technology grand.

    You also have to consider the effects of things like sweep accounts.

    I prefer to think of there being different kinds of money which vary in their ability to substitute for base money. At the limit, if you had a form of security that you could turn into a bank deposit by waving a magic wand, it would be base money regardless of origin. The closer you get to the magic wand, the more like base money a security is.

    Given perfect fungibility and 0 transaction overhead (which is obviously extraordinarily unlikely), I don’t think the interest rate difference signifies.

  7. Gravatar of Luis Luis
    15. January 2013 at 11:06

    I think that if they were perfect substitutes, Fed would be redundant.

  8. Gravatar of Saturos Saturos
    15. January 2013 at 11:30

    Peter N, you’re not actually paying with the T-bills then, you’re liquididating them and then paying with the medium of exchange. If you could buy your groceries with T-bills then they would be media of exchange too (and probably also media of account), and would have to be counted in some measure of the money supply.

    “I prefer to think of there being different kinds of money which vary in their ability to substitute for base money.”

    Also known as liquidity?

  9. Gravatar of Mike Sax Mike Sax
    15. January 2013 at 13:30

    Andreas, as I read Steve it’s not just that he thinks the liqiudity trap-may or may not-go on “forever” or at least a long time.

    He really thinks that post-IOR we are in a totallly new monetary regime

    “What I am fairly sure won’t happen, even if interest rates are positive, is that “cash and government debt will no[] longer be perfect substitutes.” Cash and (short-term) government debt will continue to be near-perfect substitutes because, I expect, the Fed will continue to pay interest on reserves very close to the Federal Funds rate. (I’d be willing to make a Bryan-Caplan-style bet on that.) This represents a huge change from past practice “” prior to 2008, the rate of interest paid on reserves was precisely zero, and the spread between the Federal Funds rate and zero was usually several hundred basis points. I believe that the Fed has moved permanently to a “floor” system (ht Aaron Krowne), under which there will always be substantial excess reserves in the banking system, on which interest will always be paid (while the Federal Funds target rate is positive).”

    It’s not about the liquiity trap he thinks the Fed has switched to a new monetary regime he calls “the floor system.” It’s not just that he’s more bearish than Krugman or anyone else about the economy.

    Luis, there are people that claim it is in fact redundant-and should be absorbed into the Treasury

    Not saying whether they’re right or wrong just that this is the claim of the MMTers.

  10. Gravatar of flow5 flow5
    15. January 2013 at 13:32

    “I oppose IOR, and would rather get rid of reserve requirements”

    I only read non-fiction. The only tool at the disposal of the monetary authority in a free capitalistic system through which the volume of money can be controlled is legal reserves & reserve ratios.

    The shortage of safe assets initially developed as the Fed tentatively introduced its Credit & Liquidity Funding Programs & Facilities. As the Fed defined its eligible collateral requirements, terms, RESERVE IMPACT, etc., it set the tone for liquidity (risk aversion) in the money markets (what’s safe for the lender of last resort “is good for the gander”).

    See:

    http://bit.ly/P1wSQS

    The CB system’s lack of security & loan demand was the direct result of transforming excess reserves (IBDDs) from cash (or non-earning assets), into earning assets via the remuneration rate.

    IBDDs now serve as “close substitutes” for Treasury bills in terms of safety & return. The payment of interest on excess reserve balances today is analogous to the rate differential that existed in favor of the CBs during the 1966 credit crunch crisis (the shadow banking system today represents the S&L’s & MSB’s of yesteryear).

    Commercial banks need clearing balances to lend (from an individual bank’s perspective), but these “reserves” are either re-deposited within the same institution, or shifted to (clear thru) other CBs (reflecting the distribution of reserves from the system’s perspective). I.e., they are either derivative or primary inter-bank demand deposits (IBDDs) to member banks, but just a change in the composition of (IBDDs) for the system. Even with CB credit expansion, total reserves remain the same, but their form may change if excess “or precautionary?” reserves need to be converted to legally “required” reserves.

    Thus IBDDs are indeed “lent” from the standpoint of an individual bank (have reserve velocity) but are not destroyed from a system’s perspecitve (unless Federal Reserve Bank credit on the BOG’s balance sheet changes).

    Excess reserves may be depleted (if not offset by the “trading desk”), as “factors that affect reserve balances change” (as currency is issued or as System Open Market Account securities are sold or “run off”, etc).

    “Base money is what’s left over after all assets & liabilities cancel out. It is, in other words, the system’s tangible equity. Or the equity of the system” – Izabella Kaminska

    Note: the unregulated, prudential reserve, E-D bank lending (credit creation) is based on the velocity of collateral (not deposits).

  11. Gravatar of Andy Harless Andy Harless
    15. January 2013 at 14:35

    When the value of T-bills change the nominal price of T-bills change. When the value of money changes the nominal price of money doesn’t change.

    This is just because of the conventions of how T-bills and reserves are priced. It’s convenient because T-bills have a long enough maturity to make a secondary market useful, so it’s easier to price them at a discount to maturity value rather than having to re-adjust the interest rate every time one is resold. But suppose the government issued non-transferable overnight T-bills, and suppose it sold them at par and paid interest (a “coupon” if you will, where the auction would determine the size of the coupon) instead of selling them at a discount. Those would be just like base money in the respect that you state above. Yet they would be obligations auctioned by the Treasury and eligible to be held by non-banks, just as actual T-bills are now. So I don’t think you’ve made the case that reserves are special in this respect.

    Your other argument is valid: reserves do put an upper bound on the quantity of currency that could be issued. However, if the Fed operates as I expect, then we’re not likely to be near that upper bound at any time, so it will be a non-binding constraint. For practical purposes, when the Fed makes a decision to change NGDP from what it was otherwise expected to be, it will implement that decision by changing IOR. The Fed will use reserves to maintain the liquidity of the banking system, and if the change in macro policy is large enough, then it will ultimately call forth a change in reserves, as the change in IOR will alter the liquidity of the banking system, and the Fed will offset this. But I expect it will do so rather passively, not viewing it as a policy decision.

  12. Gravatar of Peter N Peter N
    15. January 2013 at 14:57

    Saturos,

    Liquidity as I understand it means convertibility to money, not ease of substitution for money.

    “Peter N, you’re not actually paying with the T-bills then, you’re liquidating them and then paying with the medium of exchange. If you could buy your groceries with T-bills then they would be media of exchange too (and probably also media of account), and would have to be counted in some measure of the money supply.”

    I believe that they are counted in a measure of the money supply – M4.

    In my model given a time delta there exists an epsilon < delta which is the time for which I actually have to hold the medium of exchange. At all other times someone else can use the medium of exchange which should increase the velocity. There are also sorts of financial transactions for which I would use T-bills rather than dollars.

    They're in M4 for a reason. You might want to look at the last 10 years of Divisia M4 for the US. It's quite interesting.

    Money isn't so easy. For instance how do you account for internal settlement. I already mentioned sweep accounts.

    It's misleading to apply textbook models to the real financial system. It has a lot of interesting counter-intuitive quirks. You can't really model the economy without a realistic range of financial services.

  13. Gravatar of Max Max
    15. January 2013 at 16:23

    “Is Waldman actually suggesting that buying all the assets on earth outside the ZLB would not create inflation, as base money is a perfect portfolio substitute? Come on.”

    At some point the central bank would be forced to raise interest on reserves above the yield on its portfolio, and this would end the buying spree (without generating inflation).

  14. Gravatar of Max Max
    15. January 2013 at 16:27

    …but if purely hypothetically a central bank could *profitably* buy everything, then it would not be inflationary.

  15. Gravatar of dtoh dtoh
    15. January 2013 at 17:04

    Scott,
    You make this overly complex. At the ZLB money becomes dual purpose: medium of exchange and store of value (financial asset). If you increase the real price (1/expected real return) of the financial asset (excess reserves) by lowering the interest rate on reserves, this triggers an increased exchange of financial assets for real goods and services (i.e. increase in AD). It’s very simple.

  16. Gravatar of Fed Up Fed Up
    15. January 2013 at 21:16

    “Now let’s suppose we have a cashless economy, just interest-bearing reserves. The base is one trillion dollars and NGDP is $20 trillion. People prefer to hold base money equal to 5% of NGDP.”

    Let’s assume people don’t want any currency, but it is available. People don’t hold (central bank) reserves, the demand deposits of the central bank. Banks do. People hold demand deposits of a commercial bank in a checking account. IOR = .25%. Checking account yields .01%. Take IOR negative, and banks start charging for checking accounts. People redeem all their commercial bank demand deposits for currency and hold them/it. They still hold 5% of NGDP.

  17. Gravatar of Fed Up Fed Up
    15. January 2013 at 21:22

    “And that is because T-bills are not “in every relevant sense money.” Indeed they are not money in the only relevant sense. They are not a medium of account. When the value of T-bills change the nominal price of T-bills change. When the value of money changes the nominal price of money doesn’t change. Instead, all other prices in the economy adjust.”

    OK, I actually agree with that.

  18. Gravatar of Fed Up Fed Up
    15. January 2013 at 21:27

    “(central) Bank reserves are a medium of account, so if their value falls then the price level rises.”

    And, “… Instead, all other prices in the economy adjust. That’s why I monomaniacally focus on the base.”

    I disagree that (central) bank reserves are a medium of account. With no gold standard or no other commodity standard, MOA = MOE = currency plus demand deposits. (central) Bank reserves don’t circulate in the real economy.

  19. Gravatar of Ron Ronson Ron Ronson
    15. January 2013 at 21:59

    Is the following a correct understanding of how the alleged new fed policy will work ?

    If the fed uses IOR as its main tool then there will be 2 parts to monetary policy: Controlling the size of the base via OMO and controlling the price level (and interest rates) via IOR.

    So if doubling the price level needs an increase to the base then OMO will be needed for this. But this increase in the base will have no effect until IOR is reduced because banks will have no reason to lend these extra reserves out. When IORs are reduced and banks start to increase lending then the price level will start to rise via the hot potato effect.

  20. Gravatar of Shining Raven Shining Raven
    16. January 2013 at 02:46

    @ Ron Ronsen: I think you are correct.

    The point is that the control of the short-term interest rate is now decoupled from the absolute size of the monetary base. Under the previous system, which purely relied on OMOs, this was necessarily coupled. The Fed funds rate falls to zero if there are excess reserves in the system.

    I recommend to read Todd Keister, Antoine Martin, and James McAndrews: “Divorcing Money from Monetary Policy”

    http://www.newyorkfed.org/research/epr/08v14n2/0809keis.pdf

    Usually, the demand for reserves is extremely inelastic, and the Fed has to hit the demand for reserves exactly in order to achieve its target interest rate for Fed funds.

    The point is now that if you set the target rate for Fed funds equal to the deposit rate at the deposit facility (“IOR”), the demand curve becomes completely flat, and the Fed can achieve the target rate and set the size of the monetary base at the same time.

    Exhibit 3 in the above-linked paper makes clear how this works.

    Unfortunately this blows simple monetarist ideas on a direct link between monetary base and actual “money” in circulation (including demand deposits, which people of course use to effect transactions) right out of the water. I guess this is why Scott does not like the policy.

    For all intents and purposes of monetary policy (setting the short-term interest rate and hence controlling the creation of loans and actually circulating money), things work exactly the same in the new regime as before. Only the technical means of achieving the target interest rate have changed.

  21. Gravatar of Shining Raven Shining Raven
    16. January 2013 at 02:51

    @Ron Ronson: “So if doubling the price level needs an increase to the base then OMO will be needed for this. But this increase in the base will have no effect until IOR is reduced because banks will have no reason to lend these extra reserves out.”

    This is of course exactly correct (except that banks do not lend out reserves, they create deposits in the act of extending a loan and thus create the actually circulating “money”, which is only partially backed by reserves). But this also means that the simple monetarist story about the price level does not work here anymore. Obviously, excess reserves have exploded with quantitative easing, but there is no effect of comparable magnitude on the price level, as you state. To me, this seems to be a problem for the simple picture of the quantity theory of money.

  22. Gravatar of Shining Raven Shining Raven
    16. January 2013 at 02:56

    (Above, I should have said more precisely, “banks do not lend out reserves to non-banks, only to other banks on the Fed funds market”)

  23. Gravatar of ssumner ssumner
    16. January 2013 at 06:23

    Andreas, I think he did clearly intend to argue that base doesn’t matter, even at positive rates.

    Andy. You said;

    “For practical purposes, when the Fed makes a decision to change NGDP from what it was otherwise expected to be, it will implement that decision by changing IOR.”

    If you are claiming this for the year 2020, when T-bill rates are again positive, then I strongly disagree. The Fed will change both the base and IOR. The IOR change may come first (just as the fed funds target now changes before the base.) But it will use both. Lots of people made the same argument about the gold standard. They said gold didn’t matter because the Fed had lots of excess gold. But it did matter because the Fed WANTED lots of excess gold.

    If T-bills were changed in the way that you descibe, then they would become identical to interest-bearing reserves. In that case they would be interest bearing reserves. They would be part of the base. My point was that right now T-bills are not a MOA. I certainly would not deny that right now they are awfully close substitutes. Of course the bigger problem with Steve’s argument is he seems to claim that the Fed will sabotage itself, so it can’t do an independent monetary policy. But why would it do that? It could even pay IOR, as long as the rate was slightly below T-bill yields, and keep full control over monetary policy. As long as there is a large amount of non-interest-bearing currency, control of the base will be an important part of monetary policy.

    Max, A FTPLer with the courage of his convictions!

    dtoh, If the real price of ERs rises, then AD must fall.

    Fed Up, Yes, if there is no demand for currency my example doesn’t hold. You are wrong about reserves, a MOA does not have to circulate in the real economy.

    Ron, No, it’s much more complicated. An increase in the base is inflationary, even with stable IOR. I’d check out Peter Ireland’s paper. Money is still neutral.

    Shining Raven, I’ve criticized the policy because it is currently contractionary. I don’t favor targeting any monetary aggregate, so I have no objection to IOR on money multiplier grounds. I even once proposed negative IOR.

  24. Gravatar of Shining Raven Shining Raven
    16. January 2013 at 07:24

    Scott: I really do not quite understand the objection. So do you think that the current Fed funds target is to high? This is what IOR essentially fixes.

    Do you think the current target for the Fed funds rate should be zero?

    In the current environment, setting IOR = 0 means that the Fed funds rate is zero as well. This does not however depend specifically on the IOR policy, which is just a way of ensuring a specific (finite) Fed funds rate.

    You also say above: “The Fed will change both the base and IOR. The IOR change may come first (just as the fed funds target now changes before the base.) But it will use both.”

    I do not understand this at all. IOR is essentially the Fed funds rate. This is what the Fed controls. Under current condition, in the non-standard quantitative easing regime, the base (reserves) can be controlled *independently* of the interest rate, *because IOR means the demand curve is flat at the IOR interest rate*. Without IOR, the Fed funds rate and the quantity of reserves are not independent, because the demand curve for reserves is not flat.

    However, once the QE policy is ended (in the year 2020, as you say), this is probably no longer true: The Fed will then probably once again move on the non-flat part of the curve (Fed funds target above IOR rate), and base or reserve quantity and Fed funds rate are no longer decoupled.

    So what do you mean when you say that base and Fed funds rate are *both* set by the Fed? *Operationally* it only sets the target rate, and the base quantity then adjusts according to the demand!

  25. Gravatar of Ron Ronson Ron Ronson
    16. January 2013 at 08:30

    “Ron, No, it’s much more complicated. An increase in the base is inflationary, even with stable IOR. I’d check out Peter Ireland’s paper. Money is still neutral”

    Thanks Scott, the intro to that paper is a good explanation of how IOR changes monetary policy. In his model the fed has IOR below the FFR and is used to control the level of lending as well as being a floor below which the FFR would be ineffective.

    By manipulating the relationship between IOR and FFR the fed can potentially stimulate lending without changing the level of reserves. However once this additional lending starts to have an effect on the price level then the demand for reserves will increase and if this demand cannot be met even with IOR at zero then the fed will need to use OMO to increase the base.

    So in short: Nothing really changes in the big picture for monetary policy (the change is in the implementation details) , but there will be many subtle changes in the macro-economic side-effects (such as the fact that IOR will allow banks to pay higher rates to depositors) and no-one really knows how this will play out.

    This is probably a big over-simplification but I think that probably the fed wants to use IOR as a way of ensuring it can deal efficiently with bank liquidity in a crisis (by allowing banks to carry large reserves and allowing them to earn interest on them). IOR is then used to “sterilize” some portion of the reserves. Ultimately OMO will still be needed to maintain reserves at a high enough level to allow IOR/FFR to be used together to maintain (from an NGDPT) perspective) the correct level of aggregate demand in the economy.

  26. Gravatar of Lawrence D’Anna Lawrence D'Anna
    16. January 2013 at 18:32

    Great post!

    This is a really, really important point:

    “””And that is because T-bills are not “in every relevant sense money.” Indeed they are not money in the only relevant sense. They are not a medium of account. When the value of T-bills change the nominal price of T-bills change. When the value of money changes the nominal price of money doesn’t change. Instead, all other prices in the economy adjust. That’s why I monomaniacally focus on the base.”””

    You’ve probably said it before in other ways, but I never really got it until just now. Money isn’t money because it’s short term government debt, money is money because it’s medium of account. Sticky wages aren’t denominated in T-bills. Government debt that isn’t money is not money-like either, because the market for other kinds of goverment debt can equlibrate almost instantly, but the market for money can’t.

  27. Gravatar of flow5 flow5
    16. January 2013 at 20:53

    I’d argue that from the standpoint of the Euro-Dollar banking system, Uncle Sam’s debt is “lawful money” (but not “legal tender”). It represents a medium of exchange, a unit of account, a a standard of value, (though not a store of value).

    I.e., the prudential reserves of the money creating E-D banks consist of various U.S. dollar-denominated liquid assets (U.S. Treasury bills, U.S. commercial bank CDs, Repurchase Agreements, etc.) & interbank demand deposits held in U.S. banks. These are liquid balances in the U.S., or any other major currency country. If a bank’s balance is inadequate to meet a specific payment in the E-D system, it borrows in the London money market at or near the LIBOR rate (the London Inter-bank Offering Rate).

    Therefore I’d also argue that the Shadow Banking System creates lawful money & credit.

  28. Gravatar of ssumner ssumner
    17. January 2013 at 07:29

    Shining Raven, I don’t know if I follow your question. While the ffr is being pegged, the base is endogenous, we all agree about that. It’s also true that the Fed can both target the ffr and control the base. They do so by adjusting the ffr target up and down in order to move the base to the level that produces the amount of inflation they prefer. Is that your question? I distinguish between “pegging” and “targeting.”

    IOR is different. If IOR is below the ffr, then the Fed can adjust both the IOR and the base independently, at least to some extent.

    Ron, That sounds about right.

    Thanks Lawrence.

  29. Gravatar of dtoh dtoh
    17. January 2013 at 13:56

    Scott,
    You said,
    “dtoh, If the real price of ERs rises, then AD must fall.”

    Not true. Consider the dual nature of MB at the ZLB.

    1. It’s a store a value (financial asset). If the real price of a financial asset increases, then there will be an increase exchange of financial assets for real goods and services (higher AD).

    2. It’s a MOE, higher prices means lower return (higher opportunity cost of holding MB) and there is a pick up in V.

  30. Gravatar of interfluidity » A confederacy of dorks interfluidity » A confederacy of dorks
    18. January 2013 at 01:48

    […] Izabella Kaminska, Josh Hendrickson, Merijn Knibbe, Ashwin Parameswaran, Cullen Roche, Nick Rowe, Scott Sumner, and Stephen Williamson are all dorks, albeit of a more articulate variety. I say the most […]

  31. Gravatar of Fed Up Fed Up
    23. January 2013 at 14:07

    “Now let’s suppose we have a cashless economy, just interest-bearing reserves. The base is one trillion dollars and NGDP is $20 trillion. People prefer to hold base money equal to 5% of NGDP.”

    And, “Fed Up, Yes, if there is no demand for currency my example doesn’t hold.”

    I thought cashless would mean no currency (including coins). What do you mean by cashless?

  32. Gravatar of Fed Up Fed Up
    23. January 2013 at 20:58

    My post said: “(central) Bank reserves are a medium of account, so if their value falls then the price level rises.”

    And, “… Instead, all other prices in the economy adjust. That’s why I monomaniacally focus on the base.”

    I disagree that (central) bank reserves are a medium of account. With no gold standard or no other commodity standard, MOA = MOE = currency plus demand deposits. (central) Bank reserves don’t circulate in the real economy.

    Scott’s post said: “Fed Up, Yes, if there is no demand for currency my example doesn’t hold. You are wrong about reserves, a MOA does not have to circulate in the real economy.”

    So it sounds like we agree that (central) bank reserves don’t circulate in the real economy. OK?

    Does a MOA have to circulate in the real economy? No. However, it could.

    I still don’t believe (central) bank reserves are part of the MOA. $1 of currency and $1 of demand deposits both buy the same amount, and there is 1 to 1 convertibility at a bank. That makes MOA = MOE = currency plus demand deposits. Plus, if there is a large demand for currency above the amount of vault cash and (central) bank reserves, the central bank should meet that demand.

    Also, let me try these examples.

    First, $800 billion in currency, $200 billion in (central) bank reserves, and $6.2 trillion in demand deposits. Next, they go to $800 billion in currency, $2.2 trillion in (central) bank reserves, and $3.2 trillion in demand deposits. I believe you would say MOA has gone from $1 trillion to $3 trillion and therefore the price level rises. I say MOA = MOE = currency plus demand deposits has gone from $7 trillion to $4 trillion, and the most likely scenario is that the price level falls.

    Second, $800 billion in currency, $200 billion in (central) bank reserves, and $6.2 trillion in demand deposits. The reserve requirement is zero, and there is no extra demand for currency. Next, they go to $800 billion in currency, $200 billion in (central) bank reserves, and $13.2 trillion in demand deposits. I believe you would say MOA has gone from $1 trillion to $1 trillion and therefore the price level stays the same. I say MOA = MOE = currency plus demand deposits has gone from $7 trillion to $14 trillion, and the most likely scenario is that the price level rises.

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