The new monetary framework.

• Author: Jordan, Jerry L.

Do the policy actions of monetary authorities actually affect economic activity? We know that time and other resources are expended, but what can we observe about the results of such efforts?

In answering this question, it is helpful to begin with an account of how monetary authorities in discretionary, fiat currency regimes are traditionally thought to influence economic activity. Here, every college course in intermediate monetary theory tells essentially the same story. A nation's money supply comprises two distinct components: paper currency and deposits at banking organizations. The former was the largest component in earlier times, but the latter has come to dominate in recent decades--at least in most countries. The deposits in banks are subject to minimum reserve requirements, and the total deposit liabilities of banks constitute some multiple of reserve balances (that is, vault cash plus deposits at the central bank). The banking system as a whole is thus "reserve constrained," which means that, unless the central bank provides more reserves, there is an upper limit to the total deposits that may be held by individuals and businesses. By extension, if currency outstanding increases, and the central bank fails to add to the total supply of reserves available to private banks, then there has to be a corresponding contraction of deposit money. These reserve constraints have historically meant that, for better or worse, monetary authorities have the power to control the nation's money supply, and, in so doing, affect economic activity.

However, this traditional account no longer holds true. The commercial banking system has ceased to be reserve constrained, and this means that monetary authority actions to change the size of the central bank balance sheet do not affect the nation's money supply. Now, instead of being constrained by the amount of reserves supplied by central banks, banking companies are constrained by the supply of earning assets that are available to them. And it is the supply of these earning assets that, subject to capital constraints, determines banks' aggregate deposit liabilities.

What implications does this shift have? Brunner and Meltzer (1972: 973) suggested that while it was possible for inflation or deflation to occur without changes in the monetary base, most inflations were, in practice, the result of base money expansion. That conclusion reflected the fact that the banking system was reserve constrained, so that increases in the stock of money were limited in the absence of expansion of the central bank balance sheet. However, in today's world of massive excess reserves in the banking system, the same model used by Brunner and Meltzer suggests that money creation has become a function of loan demand and the securities on offer to banks.

The new college textbook for intermediate monetary theory explaining all this has not yet been written, but when it is, it will not say that the monetary authorities control the "supply of money" and estimate the "demand for money," the objective being to prevent either an excess supply (which would cause inflation), or an excess demand (which would trigger a recession). That theoretical framework is broken--at least for now--in such a way that the monetary authorities can no longer formulate policy actions intended to influence aggregate economic activity by expanding or contracting the central bank balance sheet.

Interest Rates and Monetary Stimulus

The intermediate college course on monetary theory also offers an alternative theoretical avenue for influencing the economy--the level of nominal market interest rates. The basic idea is that when interest rates are lower, people borrow more to consume and invest, and when interest rates are higher, people will borrow less for consumption and investment. The big economic debate--and empirical contest--has been about the degree to which people understand the inflation premium in nominal interest rates, as well as the before- and after-tax interest expense they will bear. The economic argument is that if people think in terms of interest rates that are adjusted for anticipated inflation and/or taxation, observed market interest rates are higher than the "real" interest that affects consumer and investor decisions.

One hypothesis is that central bank "zero-interest-rate-policy" (ZIRP) works by pushing down bond yields so that investors are driven into equities in search of higher returns. Consequently higher valuations in equity markets then create a "wealth effect," wherein stockholders decide to increase consumption spending. Presumably, greater consumption demand will, in turn, give potential investors more confidence to forge ahead with capacity expansions and new projects.

However, this model only makes sense in a closed economy. In an open, global economic system, there is no reason to expect that increased investment and output will be domestic--even if aggregate consumer spending does respond to stock prices. This is especially so in a context of tax and regulatory policies hostile to capital formation. And surely no policymaker would argue that the best way to promote prosperity via monetary policy is to drive the trade deficit ever higher as imports outpace export growth.

Whatever the theoretical arguments, and regardless of the evidence of most of the past century, the near-zero interest rates we have seen in recent years have shown no correlation with domestically produced consumption by households, or with domestic investment activity in the private sector. In fact, an argument can be made that the low interest rate environment has reduced the demand for bank credit while increasing the demand for earning assets by non-bank lenders such as mutual funds, pension funds, and insurance companies (Jordan 2014). Hence, the liabilities of banks (i.e., demand deposits) have grown more slowly than they otherwise might have. In other words, the "low interest rates are expansionary" view conflicts with the "slow money growth is contractionary" view of the channels by which monetary authorities influence the economy.

Central Banks and Economic Growth

Another contribution to this debate about the influence of monetary authorities on the economy comes from the "market monetarists," who argue that central banks should focus their policy actions on achieving a target growth rate for nominal GDP that is consistent with their objectives for inflation and real economic growth. This claim, however, is the "assume we have a can opener" approach to economics. Monetary authorities once had several tools in their policy bag--reserve requirements, discount rates, interest ceilings, open market purchases and sales--that might be employed to achieve any objective they chose. But what tools do they have today to influence the pace of nominal GDP growth? What instructions can the monetary authorities give to their trading desk to achieve a faster or slower growth of nominal GDP? None!

The notions behind monetary and fiscal stimulus are, first, that that economic growth comes from getting consumers to spend or businesses to invest, and, second, that this can be brought about by government actions designed to "stimulate demand." But that is not how growth happens. A couple of hundred years ago, Adam Smith would have laughed at the idea that consumers' wants are satiated and must be "stimulated" by government, or that investors don't foresee opportunities to enhance profit without the government hyping demand for something--and rightly so.

In fact, growth (i.e., rising standards of living) happens when there are opportunities for real cost reductions. Put simply, when innovations cause the information and transactions costs of doing something to decline, people do more of the now-lower-priced thing. The demand was always there. It was never necessary for either monetary or fiscal authorities of government to "promote demand" for something. Wants are insatiable. If the cost of a weekend fly-around-Mars drops dramatically, the amount demanded will rise. The notion that government can or should do something to stimulate demand is, at best, obsolete.

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