The New Monetary Framework

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 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 requirements, and the total deposit liabilities of banks constitute some multiple of balances (that is, vault cash plus deposits at the central bank). The banking system as a whole is thus reserve 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 of reserves available to private banks, then there has to be a corresponding contraction of deposit money. These constraints have historically meant that, for better or worse, monetary authorities have the power to control the nation's supply, and, in so doing, affect economic activity. However, this traditional account no longer holds true. The commercial banking system has ceased to be constrained, and this means that monetary authority actions to change the size of the central bank balance sheet do not affect the nation's supply. Now, instead of being constrained by the amount of reserves supplied by central banks, banking companies are constrained by the of earning assets that are available to them. And it is the 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 expansion. That conclusion reflected the fact that the banking system was constrained, so that increases in the stock of 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 creation has become a function of loan 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 (which would cause inflation), or an excess (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. …