An economic historian builds a macroeconomic model to help her understand the gold standard. Her model says the central bank sets the dollar price of gold, and the stock of base money is demand-determined. If the central bank raises the dollar price of gold, her model says this will cause an increase in the general price level, and an increase in the stock of money.
She thinks about the monetary transmission mechanism in her model, how an increase in the dollar price of gold will affect the demand and supply of gold, the demands and supplies of close substitutes to gold, radiating out to the demands and supplies of all other goods.
Then the economic historian decides to study the debate between advocates of the gold standard and advocates of the silver standard. She builds a new model to help her understand this debate. Her new model contains both the price of gold and the price of silver. Under the gold standard, the central bank sets the price of gold, and the price of silver is an endogenous variable. Under the silver standard, the central bank sets the price of silver, and the price of gold is an endogenous variable.
Under the gold standard, if the central bank raises the price of gold, that will cause a rise in the price of silver. Under the silver standard, if the central bank raises the price of silver, that will cause a rise in the price of gold.
How many monetary transmission mechanisms does her model contain?
It is tempting to answer "two". There is one monetary transmission mechanism under the gold standard, which explains how changes in the price of gold affect the price of silver and other endogenous variables. And a second monetary transmission mechanism under the silver standard, which explains how changes in the price of silver affect the price of gold and other endogenous variables.
But then consider:
If the central bank wanted to, and if it responded quickly enough to shocks, the central bank could adjust the price of gold to hit any desired target for the price of silver.
If the central bank wanted to, and if it responded quickly enough to shocks, the central bank could adjust the price of silver to hit any desired target for the price of gold.
How could an outside observer even tell the difference? Is the central bank adjusting the price of gold to get the price of silver where it wants it to be? Or is it adjusting the price of silver to get the price of gold where it wants it to be? Which price is the instrument, and which price is the target? Would it make any difference to any individual agent in the economy which of those two things the central bank is doing?
If the two monetary policy transmission mechanisms are observationally equivalent, and if the two monetary policy transmission mechanisms make no difference to any individual agent in the economy, does it make any sense to say there are two different monetary policy transmission mechanisms in her model?
If, despite this, you say that her model contains two different monetary transmission mechanisms, one from the price of gold, and a second from the price of silver, and that the central bank can choose to use either one, then consider:
There are millions of different goods in a real world economy. There is the price of gold, the price of silver, and the millions of other prices of all the millions of other goods too. If the economic historian's model contains two different monetary transmission mechanisms, then the real world must contain millions of different monetary transmission mechanisms.
So why are so many monetary economists fixated on just one of the millions of possible monetary transmission mechanisms? One which starts from the nominal rate of interest on very short term loans between banks? Aren't they being just a little narrow-minded by looking only at one, when there are millions?
You want concrete steps? I will give you a million different flights of concrete steps.
For example, like Lars Christensen, lets talk about the monetary transmission mechanism where the central bank adjusts the stock price index, rather than a short term nominal interest rate. No zero lower bound problem there.
(This post is a reflection on Josh Hendrickson's recent post.)
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Really, the transmission mechanism is the same in both scenarios; the difference lies in the starting point of the transmission—the initial action by the monetary authority that has to be transmitted to the broader economy. In the gold-standard scenario, the monetary authority’s initial action is to buy or sell gold, not silver, and also to announce its peg for gold, not for silver. In the silver-standard scenario, it is the reverse. (Of course, when the authority is pegging the price of gold, and doesn’t care about the price of silver, the price of gold will be steady while the price of silver fluctuates randomly; when the authority is pegging the price of silver, it is the reverse.) The difference between the two scenarios—between the gold standard and the silver standard—is not a difference in mechanism.
J.V. Dubois, it is not silly and not non-sense. One dollar might not be able to move rates that much but only because daily “mistakes” of banks in aggregate are much larger. That is why there are always excess reserves. But if you, the central bank, exceed the tolerance level of commercial banks for “mistakes” in their liquidity management with your reserve operations, then rates will go down. And they will go down until the tolerance of banks for mistakes will reconcile with your new reserve injection. If you inject 1 trln then that it is sure way to push rates all the way down to zero.
Finally, to change the rate all the central bank has to do is to announce it. And it is done. No OMOs are required for this. Liquidity optimization of banks does not really depend on the level of interest rates but it depends on spreads.
JV- would you rather incur a cost of 0% (i.e. not holding onto the excess reserves now and borrowing it when rates go to 0%) or incur an opportunity cost of something above 0% (i.e. holding onto the excess reserves instead of lending them out at some rate above 0%)?
Sergei: “If you inject 1 trln then that it is sure way to push rates all the way down to zero.”
This is utter nonsense. Imagine an economy with inflation of 2% and nominal interest rate of 6% – so the real interest rate is 4%. Now CB announces that it increases the inflation target to 100% they will buy whatever it takes by newly printed money to make it so. So if I am correct, you say that CB flooding commercial banks with cash causes nominal interest rates to fall to 0% because “that is how the banking sector operates”. So just like that CB will lower the real interest rate from +4% to -100%. And in the meantime all owner of assets that CB decided to buy – for instance pension funds formerly holding government bonds – will be happy swapping these assets for quickly detoriating currency.
Come on guys, this is just plain stupid. Go read something about Fisher Effect.
What if banks collectively know that lowering interest rate will cause inflation to shoot up, which in turn will cause people willing to hold more cash in their wallets, which means that people will demand more paper cash as opposed to money on the reserves, which will in turn make some bank to just hold that one dollar of “excess” reserve to meet this demand.
Why would banks “know” something that isn’t true?
What a bank knows is that is has $1 of excess reserves earning 0 interest. Regardless of what economic theory you happen to believe, $1 of reserves that you don’t need, earning 0 interest, is inferior to a $1 overnight loan earning positive interest. Any positive interest above zero is preferable.
Therefore the bank will lend that dollar. Now, another bank has an extra dollar. It will also prefer to lend the dollar, etc.
This is pure profit maximization.
Now CB announces that it increases the inflation target to 100% they will buy whatever it takes by newly printed money to make it so.
There are laws that prevent the CB from purchasing “whatever it takes”. Of course, if the CB agreed to purchase everyone’s labor for $1000/hour, many would quit their jobs and work for the CB, and I guarantee you that inflation would shoot up. That is fiscal policy. But inflation would shoot up because you’ve increased everyone’s income, not because you’ve increased the quantity of reserves.
Given the universe of things that the CB is allowed to buy — government guaranteed assets — the CB cannot credibly commit to targeting something that it can’t control. And while the CB certainly has influence over inflation, it does not precisely control it, as can be seen from our own experience, or the experience of Japan.
wh10: No, what I say is that if printing money in whatever amounts causes nominal interest rates to go down, then there would be queues of people before banks willing to lend for this 0% buying whatever real assets they can and then repay the debt it later when the inflation hits and pocket the profits.And banks also know it, suddenly there is plenty of high quality potential lenders who may make huge profits. Not only that, there will be a huge number of people attacking banks and changing their deposits for cash because they will not be satisfied by 0% interest when they can get rich by buying real assets. We could end up with bank runs. If banks don’t want to lose all deposits they will have to increase their interest rate on deposits in line with expected inflation.
J.V.,
I am confused by your above paragraph — did you mean to replace “lenders” with “borrowers”? How are people going to attack banks — you mean violence against banks, the threat of which will prevent banks from lending too much or too little?
But yes, the general idea is that lower interest rates cause people to borrow more and invest more and this causes an increase in the price level.
If we call this the Wicksell channel, then what I and others believe is that this is the only operative channel available to the CB, and that the quantity channel is a null op.
Some nations, such as Canada, have a zero reserve system, so they are clearly able to control interest rates while keeping reserves (quantity) fixed at zero (actually, it is something like $50 million due to the “frictions” that Sergei talked about).
We know that, at the ZLB, increasing the CBs balance sheet merely causes reserves to go up, it does not cause inside money to change at all, nor does it cause the quantity of currency to change, or the quantity borrowed to change, or NGDP change, etc.
There are many papers out there (I referenced one) describing how these institutions operate and how rates are set, and we have the practical experience of Japan and the U.S. as well.
J.V. Dubois, your depiction of banking is very strange. Bank liquidity is generally a scarce asset. Central bank makes it so but running its monetary policy. That is central bank generally regulates the cost of liquidity. That is the whole point of monetary policy. In different systems central banks use different tools. In developed countries this tool is price of liquidity, i.e. some tenor on interbank yield curve. In the USA it is O/N, in eurozone it is 2 weeks, in Switzerland it is 3 months and so on. Central bank does not set the market rate at this tenor on the yield curve. It rather declares its desired level. And if market forces move the market rate from the targeted level, then central bank has to intervene. What you effectively call non-sense is that if central bank intervenes into the market by the tune of 1 trln dollars, this intervention will have no effect on the market. Well, what you say is generally non-sense though I can imagine a situation (like Sep-Nov 2008) where even 1 trln would not make the trick.
Whether people buy assets or not, banks make profits or not, inflation goes through the roof or not, there is a line of borrowers or not, it all does not matter at all. Interbank market does not care about everything you mentioned and much more. It cares only about the rate from today to tomorrow. And when tomorrow comes, it will care about it again. Simples.
And as I said above banks do not care that the level of rates is. Ie. there is no difference to banks whether rate is at 100% or 2%. Banks care only about spreads which are generally defined by the competition. However, when banks make loans, they do care about future rates because it is their risk factor. Which might completely negate the argument you are trying to make regarding profitable borrowers etc.
rsj: Yes, I meant “to borrow” and I may have used the word attack incorrectly. My excuse is that I am not native speaker, while in truth it is just my laziness and that I do not double check what I write every time. Sorry for that. Also, replace “whatever it takes” for “whatever amount of assets CB can legally buy”. The last I recall there is $14 trillion of US public debt, there is plenty of room to go before FED will hit the wall.
Ok, so back to your example: imagine that all banks have the right amount of reserves (or that they fulfill all capital adequacy ratios in countries where reserves are not required). As it happens, there is $1 of excess CB money in the system. My first question is – why should any bank need to borrow this $1 from whatever bank happens to hold it now? What can be their expectations other than lend it to yet another bank at s loss with even lower overnight interest rate?
The only possible impact this $1 of excess reserve has is expectations. All banks know that $1 of excess reserves means that they collectively can make another $10 of loans in the future (if capital adequacy/reserve ratio enforces such money multiplier). But if all people who could get their loans with yesterday’s interest rates already have one, the banks will just need to attract new customers. One way to do it is to offer lower interest rates so that the excess reserves will be absorbed. So the interbank interest rate will not get down to 0. It will fall by whatever amount that equalizes one-day opportunity cost of holding cash without gaining any interest on it with long-term profits for the bank if they will be able to issue $10 debt tomorrow for a given costs of securing it on interbank sector. (ok, they will also need to attract new deposits, but set this aside for the moment as it is not important for this example) The first bank to find such marginal customer in their databases of recent loan applicants will borrow and hold these excess reserves so that they can send the customer a new offer.
Sergei: All the central bank does is that it prints money. Therefore, CB can influence nominal price of whatever they want – if CB credibly commits to it. So your claim that commercial banks do not care about inflation expectations is equal to the claim that commercial banks do not care about monetary policy. Any bank that would care only for today’s interest rate would quickly go out of business.
“However, when banks make loans, they do care about future rates because it is their risk factor. Which might completely negate the argument you are trying to make regarding profitable borrowers etc.”
No, this actually completely supports the argument that I am so painfully trying to make. I will give you yet another example: if nominal interest rate would be 0% and FED would announce that it wants 100% inflation within the year, this would have massive effects on expectations:
1) When banks offer loans, they try to assess the future income of potential lender as well as future price of his collateral. With expectations of 100% inflation and 0% interest rate both these variables would be highly advantageous to lenders. Almost anyone would be eligible for bank loan. Banks could get massive profits even if lenders go bankrupt just by selling the collateral at new inflated price.
2) When bank offer loans they need to take into account the funding. One of the crucial features of banking is that it borrows short and lends long, so they need to be careful with their balance sheet. With 100% inflation and 0% nominal interest rates offered for deposits, banks would face imminent risk of bank runs by depositors. Banks are just facilitators: they are intermediaries between depositors and lenders. So if 1) is true and almost anyone could make profit by such conditions, that invariably means that every depositor is at risk of huge loss.
Combine 1 and 2 and you will find out that for banks to remain in business, to prevent bank runs, they need to substantially increase the interest rate they offer. Despite of CB pumping insane amounts of liquidity to the system, the demand for this liquidity would increase proportionaly. This is the key finding for you: it is not banks that set the interest rate on the market. It is the depositors and lenders that do this. Banks serve only as intermediary, truing to gauge how the future can look like, asses the risk associated with this future and make profit on this.
Both: I know that you are not going to be convinced here. But for your own sake, start thinking about all you say. I know that cognitive dissonance can be very painful to overcome, but the positions you hold are absolutely indefensible. The only way you do it is to constantly mire yourself into mechanics of how banking sector in current operational setup seems to operate trying to extrapolate this into almost insane arguments.