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Monetary Policy: Why Money Matters and Interest Rates Don,T (2012)

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Monetary Policy: Why Money Matters and Interest Rates Don,T (2012) ECONOMIC RESEARCH FEDERAL RESERVE BANK OF ST. LOUIS WORKING PAPER SERIES Monetary Policy: Why Money Matters, and Interest Rates Don’t Authors Daniel L. Thornton Working Paper Number 2012-020A Creation Date October 2012 Citable Link https://doi.org/10.20955/wp.2012.020 Thornton, D.L., 2012; Monetary Policy: Why Money Matters, and Interest Rates Suggested Citation Don’t, Federal Reserve Bank of St. Louis Working Paper 2012-020. URL https://doi.org/10.20955/wp.2012.020 Published In Journal of Macroeconomics Publisher Link https://doi.org/10.1016/j.jmacro.2013.12.005 Federal Reserve Bank of St. Louis, Research Division, P.O. Box 442, St. Louis, MO 63166 The views expressed in this paper are those of the author(s) and do not necessarily reflect the views of the Federal Reserve System, the Board of Governors, or the regional Federal Reserve Banks. Federal Reserve Bank of St. Louis Working Papers are preliminary materials circulated to stimulate discussion and critical comment. Monetary Policy: Why Money Matters and Interest Rates Don’t Daniel L. Thornton Federal Reserve Bank of St. Louis Phone (314) 444-8582 FAX (314) 444-8731 Email Address: [email protected] October 23, 2012 Abstract Since the late 1980s the Fed has implemented monetary policy by adjusting its target for the overnight federal funds rate. Money’s role in monetary policy has been tertiary, at best. Indeed, several influential economists suggest that money is irrelevant for monetary policy: Central banks effect economic activity and inflation by a) controlling a very short- term nominal interest rate and b) by influencing financial market participants’ expectation of the future policy rate. I offer an alternative perspective: namely, that money is essential for the central bank’s control over the price level and that the monetary authority’s ability to control interest rates is greatly exaggerated. JEL Codes: E41, E43, E52 Key Words: money, medium of exchange, monetary policy, federal funds target, structure of interest rates, inflation The views expressed here are the author’s and do not necessarily reflect the views of the Board of Governors of the Federal Reserve System or the Federal Reserve Bank of St. Louis. I would like to thank John Leahy and Yi Wen for comments and Aditya Gummadavelli, Bryan Noeth, and Elise Marifian for valuable research assistance. We’d always thought that if you wanted to cripple the U.S. economy, you’d take out the payment system…Businesses would resort to barter and IOUs; the level of economic activity across the country could drop like a rock.—Alan Greenspan, The Age of Turbulence: Adventures in a New World, p. 2. 1.0 Introduction Today “monetary policy” should be more aptly named “interest rate policy” because policymakers pay virtually no attention to money.1 Prominent monetary/macroeconomic economists such as Woodford (2000, 2003, and 2008), Friedman (1999) and King (1999) have suggested the possibility of a moneyless economy: Friedman and King argue that the absence of money would severely limit the effectiveness of monetary policy; Woodford argues that it would not. In a similar vein, Svensson (2008) suggests that over the past 50 years monetary theorists and policymakers have learned that “monetary aggregates matter little, or even not at all, for monetary policy.”2 Given the prominence of these economists and the lack of interest in money by central bankers around the world, one might think it foolish to assert that money is essential for economic activity and monetary policy. It will no doubt seem even more foolish to suggest that monetary policymakers’ ability to influence interest rates, especially those that matter for the efficacy of monetary policy, is greatly exaggerated. This paper is an attempt to motivate discussion and debate about the essence of monetary policy. It is often fruitful to have such debates. It may be particularly useful now because the Federal Reserve and most other central banks ignore money and are pursuing unconventional monetary policies in an effort to enhance the effectiveness of countercyclical policy. Challenging orthodoxy is useful even if it only serves to solidify one’s belief in it. 1 This is true of virtually every central bank; however, the focus here is on the Federal Reserve. 2 Svensson (2008), p. 4. 1 The remainder of the paper is as follows. Section 2 argues that money is essential for economic activity and is critical for determining the price level. Section 3 suggests several reasons why money’s critical role for economic activity and monetary policy, as discussed in Section 2, is not reflected in modern macroeconomic models. Section 4 analyzes several reasons to be skeptical of the extent to which the Federal Reserve affects interest rates.3 Section 5 concludes. 2.0 Why Money Matters The fundamental importance of money for economic activity and welfare is most easily seen by first considering an autarkic economy. Everyone is self-sufficient so there is no trade and, hence, money would not exist. Individuals get utility from consumption and leisure, where leisure is the amount of time not spent in the production of consumption goods. Individuals produce consumption goods using their share, δδii, 0<< 1,iN = 1,2,..., , (where N is the size of the population) of an aggregate economy-wide resource, R . The economic welfare of such a society is presented in Figure 1, where U is an index of the maximum ordinal utilities of each individual at each possible level of the resource. U * denotes society’s economic welfare when the quantity of society’s resource is R* . The effect of trade using barter as the sole means of exchange is illustrated in Figure 2. Economic welfare increases from U * to U *′ as society goes from autarky to an exchange economy. The upward shift in the utility contour is due to Ricardo’s principle of comparative advantage—everyone who trades is better off, while those who don’t are no worse off. Because exchange is costly, society’s welfare gain is less 3 See Bernanke and Gertler (1995) and Thornton (2012b) for a discussion of other reasons to be skeptical of the efficacy of the interest rate channel. 2 than the vertical shift from U to U′ at R* . The difference represents the fact that some of society’s resource is used in trade. The fact that barter is costly means that society could be better off if there were a more efficient method of exchange. The only alternatives are credit and money. Credit is where one individual obtains a quantity of a commodity from another by promising to pay that individual a quantity of the same or a different commodity at a future date: Credit is inter-temporal barter. Credit will tend to be less efficient than contemporaneous barter because of the addition waiting time. Moreover, unlike barter, credit is accompanied by the default risk. Money, on the other hand, is a commodity that is chosen to be a general medium of exchange: All goods (including credit contracts) are exchanged for money: That is, money is a social contrivance that significantly reduces the transactions costs associated with barter (or credit). Figure 3 shows the effect of moving from barter to money. The upward shift in the utility contour is due to the fact that more trade takes place because money reduces the cost of exchange. The volume of trade could also increase because the use of money increases the range of relative prices over which transactions can occur, which increases the likelihood that an exchange will occur (Thornton, 2000). Of course, increased trade leads to increased specialization and more trade. By reducing exchange costs, money frees up resources for production (or leisure). The net effect of the social invention of money is a marked rise in economic welfare.4 However, because the stock of money is costly to produce and maintain, there is some welfare loss relative to a world where either trade or money is costless.5 4 Thornton (2000) shows why money cannot be a private good. 5 Thornton (2000) speculates that such costs contributed to the evolution to fiat money systems. 3 Economic welfare depends enormously on trade, and the use of money increases both the efficiency and volume of trade. Therefore, money is crucial for the functioning of markets for the simple reason that, of the three possible means of exchange—barter, credit, and money, money is far and away the most efficient.6 Barter has the property that it guarantees final payment—a good that one does not want is exchanged for the desired good, the trade is complete. Money also guarantees final payment. A good that one does not want is traded for money which can be easily traded for the desired good. While the use of money requires an additional transaction, the trade is effectively complete when the good is exchanged for money; the use of money essentially guarantees that no more than two transactions will be required to exchange something you don’t what for something you want. It is money’s property of guaranteeing final payment that enables it to serve as a generalized medium of exchange. Because of the widespread use of credit to make transactions in modern economies it is important to understand that the predominance of credit is due to the existence of money. In a world without money the use of credit would be severely limited for two reasons. First, of the three means of exchange—barter, credit, and money—credit is far and away the least efficient: A credit transaction would require the exchange of a good for the promise to receive a larger quantity of the same good or a other quantity of another good at a future date, when the good received would be exchanged for the desired good.7 Clearly credit is inferior to barter in facilitating exchange.
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