Anyone interested in money should check out JP Koning’s excellent blog. In a post discussing the ECB’s decision to stop producing 500-euro banknotes, Koning made this claim:
This highlights an important point that I often mention on this blog. One of the most popular motifs of central banks is that they print cash willy nilly, forcing it onto an unsuspecting and virginal economy. This wildly misses the mark. Central banks do not push banknotes into the economy. Rather, the public pulls banknotes out of the central bank into the economy and pushes them back to the central bank.
I understand the point he is making here, and it has some validity. But I don’t agree that the alternative view “wildly misses the mark”. There are different ways of viewing the process of money creation, and “forcing it onto an unsuspecting and virginal economy” is a perfectly respectable way of envisioning the process. Here are a couple plausible claims:
1. The Fed targets interest rates and accommodates the public’s demand for currency at the interest rate target.
2. The Fed targets inflation and accommodates the public’s demand for currency at a 2% inflation target.
I don’t think the first view is particularly useful, as the Fed frequently adjusts its interest rate target as required to stabilize inflation. So interest rates are mostly endogenous, much like currency.
The second claim is more useful, but raises another question. How does the Fed create 2% inflation, on average? That sort of trend inflation rate is not normal; indeed it’s extremely abnormal. Throughout human history, trend inflation has mostly been close to zero, with occasional spikes during wartime, etc. So how does the Fed create 2% inflation?
Between 1990 and 2008, they did so by “forcing extra base money onto an unsuspecting and virginal economy”. They printed just enough money to push prices higher at the desired rate. Prior to 1990, they didn’t even target inflation, and therefore inflation often greatly exceeded 2%.
Between 1960 and 2007 the Fed increased the monetary base from $50 billion to $837 billion, by forcing $787 billion in new base money onto an unsuspecting and virginal US economy. And doing so caused a lot of inflation and a big rise in NGDP.
The monetary base is not identical to currency. But prior to 2008, the base was more than 98% currency. So it would be 98% accurate to describe the process as forcing extra currency onto the public.
Today, things are different. Currency is still a substantial portion of the base, but a far smaller share than prior to 2008. The rest is commercial bank deposits at the Fed. The Fed still does rely to some extent on money printing as a way of boosting prices, but less so than prior to 2008. Instead, they often adjust the interest rate on bank reserves.
You can think of a cut in the interest rate on bank reserves as being equivalent to an open market purchase of bonds. Before 2008, they forced currency onto the public by purchasing Treasury bonds with new base money. More than 98% of the new base money went out into the economy as currency. Now they cut the IOR, which discourages banks from holding reserves. Banks then try to get rid of these unwanted reserves, which flow out into the economy as currency. The extra currency drives up prices, just as with an open market purchase. Instead of the Fed injecting cash, the Fed is incentivizing commercial banks to inject cash. Either way, it pushes up the price level.
At its most basic level, monetary economics is quite simple. The price level is the inverse of the value of money. The central bank controls the price level (i.e., the value of money) by adjusting the supply and demand for base money. They can raise prices by adding to the supply of base money or reduce base demand with a cut in IOR. Or that can reduce the price level by reducing the supply of base money or increasing the demand for base money by raising IOR. It’s basic supply and demand, nothing more.
Prior to 1913, the base was 100% currency. As late as 2007, the base was still more than 98% currency. Thus for most of our history, changes in the base were almost identical to changes in the currency stock. If the Fed wishes to create 2% inflation, they’d print more currency than the public would wish to hold if inflation were 0%. Then they would force it into an “unsuspecting and virginal economy”.
It’s not a question of Koning being right or wrong, or me being right or wrong. The issue is which description of the process is more useful. For some purposes, Koning’s description is more useful. For other purposes, my description of the process is more useful.
Here’s an analogy. A new gold mine opens and the owners sell 20 tons of gold on the international gold market. Is that gold being “forced” on the public? Yes and no. No in the sense that people are free to not buy the new gold. Yes in the sense that the mine is determined to sell the gold, even though the extra gold is not wanted or needed at the pre-existing gold price. The mine sells the gold for whatever people are willing to pay. This forces the price of gold down until people willingly buy the new gold.
Central banks add currency whether people want the money or not. But people are not going to throw away this new money. Instead, prices rise until people willing hold the extra currency.
READER COMMENTS
Market Fiscalist
Oct 29 2023 at 9:54pm
‘Between 1990 and 2008, they did so by “forcing extra base money onto an unsuspecting and virginal economy”.’
In that era the fed did a pretty good job of setting everyone’s expectation for 2% inflation. Wouldn’t it be more accurate to say the fed “delivered the expected extra base money to an informed economy” ?
Scott Sumner
Oct 29 2023 at 11:54pm
That’s sort of a question of terminology. The way they did that expected 2% inflation was by injecting more cash than people wanted to hold if inflation had been 0%.
Mike Hammock
Oct 30 2023 at 12:31pm
Thank you. This was extremely helpful for me as I try to figure out how to teach the Ample Reserves Framework to students. The Fed seems to be trying to argue (in its educational material) that only interest rates matter in this new model, and that the focus should be on that, not money supply–but I’m unwilling to accept that the recent inflation is due to interest rates alone, with no role for money supply. Thinking of a cut in the IORB rate as leading to an increase in money holdings squares that circle.
Market Fiscalist
Oct 30 2023 at 12:56pm
When one is specifically discussing paper money (as the Moneyness post appears to be doing) isn’t it correct to say that whatever the ongoing change in the total monetary base may be the CB will always adjust the amount of paper money in circulation to match demand so will never “force” extra notes on them ?
Scott Sumner
Oct 30 2023 at 7:05pm
Sure, but what if the base is 100% currency, as before 1913? Or 98% currency (as it was up to 2008.). Then that’s not a particularly important distinction.
Market Fiscalist
Nov 2 2023 at 3:56pm
I think this point is directly relevant to the point being made by Moneyness. Prior to 2008 even while the fed was “forcing extra base money onto an unsuspecting…economy” if the public had wanted to hold 97% or 99% of the base as currency then the fed would have met this requirement. They may have been forced to accept the extra base – but they could choose how much to hold as paper currency.
I think this is what Moneyness is saying in the bit you quote:
‘This wildly misses the mark. Central banks do not push banknotes into the economy. Rather, the public pulls banknotes out of the central bank into the economy and pushes them back to the central bank’
Scott Sumner
Nov 6 2023 at 10:06am
I think people understand that point, even when they speak of the central bank “printing” more money and pushing it out into the economy. Technically this is the monetary base, but during many periods of time that’s almost synonymous with currency.
spencer
Oct 30 2023 at 1:15pm
We have a managed currency. The quantity of our currency is determined by the “needs of trade” (cash drain factor). The volume issued may be influenced by the size of a federal deficit, but it is not determined in any way by the government’s needs for revenue. The collective demands of the public determine the absolute volume of currency held.
The volume of currency held by the public needs no specific regulation since it is impossible for the public to acquire more of a given type of currency without giving up other types of currency, or else bank deposits. I.e., it is impossible for the public to add to the total money supply consequent to increasing its holdings of currency.
vince
Oct 30 2023 at 3:51pm
“The central bank controls the price level (i.e., the value of money) by adjusting the supply and demand for base money.”
What about the role of reflux?
Scott Sumner
Oct 30 2023 at 7:06pm
Not a factor under fiat money regimes.
vince
Oct 30 2023 at 4:02pm
I recall the Fed struggling to meet its 2 percent inflation target after 2008. After the GFC, for years 2011 through 2020, the PCE averaged less than 1.5 percent. If the Fed–if it could have–forced 2 percent inflation on the economy, would the economy have been worse off?
More and more, I question whether anyone including the Fed is qualified to say what monetary policy should be. Money doesn’t even have a clearly defined measure!
Don Geddis
Oct 30 2023 at 4:40pm
The economy would have been much, much, much better off after 2008, if the Fed had correctly achieved its promised 2% target. The lack of that achievement was one of the largest central bank errors in all of economic history.
“Money” has many possible measures, each useful for a different purpose. For monetary policy, the “monetary base” is generally the most useful measure. It is perfectly clearly defined (currency + commercial bank reserves at the central bank), and the exact value is known, tracked, and published within a week or so: https://fred.stlouisfed.org/series/BOGMBASE
vince
Oct 30 2023 at 4:51pm
“The lack of that achievement was one of the largest central bank errors in all of economic history.”
What do you base that claim on? How would we know?
Matthias
Nov 3 2023 at 12:37am
Have a look at the posts on Scott Sumner’s blog (and here) throughout the 2010s.
vince
Oct 30 2023 at 5:20pm
” the “monetary base” is generally the most useful measure.”
Most useful doesn’t necessarily mean it’s useful …
The Fed in 2015 says this:
Over recent decades, however, the relationships between various measures of the money supply and variables such as GDP growth and inflation in the United States have been quite unstable. As a result, the importance of the money supply as a guide for the conduct of monetary policy in the United States has diminished over time.
Here’s older commentary:
From Chicago Fed Letter, No. 100, December 1995
The Monetary Base as an Indicator of Policy
By Robert D. Laurent
… Growth in the monetary base is sometimes used as an indicator of monetary policy. This use appears based on a textbook scenario of the conduct of monetary policy, which assumes that the Federal Reserve implements policy by setting the monetary base, and that reserve requirements are set so as to convert growth in the monetary base into growth in a monetary aggregate related to future economic activity and prices. This article argued that because neither assumption is correct for U.S. monetary policy, the monetary base is not likely to be a good indicator of policy. Furthermore, it appears likely that the performance of the monetary base as an indicator will continue to deteriorate.
Don Geddis
Nov 1 2023 at 5:41pm
Look for the extent of economic damage, compared the counterfactual. Look for a crisis caused by an amenable to monetary policy. (Wars cause economic damage too, but they are supply-side crises, that cannot be fixed by demand-side monetary policy.) Look at the length of the recession after 2008 (a decade?), the depth of the recession (double-digit unemployment), and the cause (completely self-inflicted tight money).
The Great Depression was worse. But it’s hard to find any other central bank error that can compete with 2008.
You give examples of one thing that the monetary base is not useful for. That does not mean the monetary base is not useful. It just means that you chose the wrong application.
The monetary base is not a good substitute for (N)GDP or inflation. If you’re interested in those variables, you should measure them directly. It is foolish to try to guess what their values are, via some hopeless computation from the monetary base. Similarly, the monetary base is a poor guide to the stance of monetary policy (tight vs. loose). For that application, you probably want to measure and track nominal GDP.
But if you’re wondering about the central bank’s direct, concrete actions — aside from communications, from setting expectations — then the monetary base is the best indication of central bank action. And, in particular, it is a response to your previous complaint that “Money doesn’t even have a clearly defined measure!“. You were wrong.
vince
Nov 1 2023 at 6:37pm
Come on, Don. No hand waiving. Sure, slices of money can be defined and measured. Try defining it in a measurable way without slicing it. When does the quality of moneyness make something money? Not so clear.
Don Geddis
Nov 2 2023 at 11:37pm
@vince:
I can do that too. For macroeconomics, it is the Unit of Account function of money which matters. When you take out a mortgage, and promise to pay something back 30 years from now, what is the definition of the thing that the bank agrees to receive 30 years from now? Everything else about the economy might change over three decades, but something needs to be fixed. What is it? What do you and the bank agree on, that determines whether you have properly repaid the final installment at the end of the loan?
Economic chaos, such as recessions and elevated unemployment, or else high inflation, come from central bank mismanagement of the value of the Unit of Account.
Scott Sumner
Oct 30 2023 at 7:08pm
The Fed raised rates in 2015. Does that seem like a central bank “struggling” to raise the rate of inflation.
vince
Oct 30 2023 at 9:20pm
Even more indication the Fed–or anyone–can say with certainty what monetary policy should be. Is 2 percent the stable price target or not?
Andrew_FL
Oct 30 2023 at 7:14pm
This is misleading in that it gives the impression that currency was between 98 and 100% of the base all the time between 1913 and 2007, which is not true.
Scott Sumner
Oct 31 2023 at 7:15pm
Yes, currency was often less than 98% of the base, but in the decades leading up to 2008 it was a very high percentage. So forcing base money into circulation was de facto almost the equivalent of forcing currency into circulation.
Travis Allison
Oct 31 2023 at 5:03pm
Scott, couldn’t lowering IOR increase NGDP even if reserves stay the same? Suppose that the Fed lowers IOR. Bank B doesn’t want to hold as many reserves so it loans $100 to business X by adding $100 to X’s account with bank B. X spends money by buying a good for $100 from business Y, who has an account with bank C. So the money transfers from bank B to bank C. To settle accounts, the Fed deducts $100 from bank B’s account and adds $100 to bank C’s account. Reserves stay the same. Bank C doesn’t want the extra reserves either so bank C loans the money to someone else. If none of the market participants request currency from a bank, then the amount of currency in circulation stays the same. The process repeats until loans rise enough to make banks comfortable with the amount of reserves that they have at the Fed. So what increases in this situation would be loans (and velocity?) and not currency.
Scott Sumner
Oct 31 2023 at 7:18pm
Actually, you don’t necessarily need more currency or more loans, just less real demand for reserves. But yes, loans might well increase.
Travis Allison
Oct 31 2023 at 10:18pm
Do you mean that prices alone could increase without increasing quantities of loans or currency?
Scott Sumner
Nov 1 2023 at 8:30pm
Yes, that’s possible if the demand for currency declined. It happened in 1933 after the devaluation.
JP Koning
Nov 10 2023 at 11:37am
Hi Scott,
Thanks for bringing this up.
I wrote a quick response here:
http://jpkoning.blogspot.com/2023/11/how-would-cash-only-central-bank.html
As I get into in the post, given the important that you place in currency, I’d be curious to hear what you think about monetary policy in a world without cash. Does it still work?
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