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.