Saturday, February 15, 2014

An old monetarist interpretation of interest on money (money isn’t credit)

We can imagine a world where all central bank money is electronic money, and the central bank can alter both the quantity of money and the interest rate paid on that money, and can make Rm and Rb move by different amounts, or even in different directions, if it wants to.
To my monetarist mind, an increase in Rm increases the demand for money, and that causes an excess demand for money, just like a reduction in the supply of money causes an excess demand for money. An excess demand for money, or an excess supply of money, has macroeconomic consequences. Any change in Rb is just one symptom of those macroeconomic consequences. We would get roughly the same macroeconomic consequences even if Rb was fixed by law, or if lending money at interest was tabu.
Let’s begin by looking at this from an old monetarist perspective.  They would argue that “the money supply” is some sort of aggregate, such as M1 or M2.  Here are four ways of reducing the supply of that aggregate:
A.  Reduce the supply of base money:
1.  Do open market sales
2.  Raise the discount rate to reduce discount loans
B.  Raise the demand for base money:
3.  Raise reserve requirements
4.  Raise the interest rate paid on base money
The first two policies reduce the supply of base money, and the second two reduce the money multiplier.  All four policies reduce the monetary aggregates such as M1 and M2.  Milton Friedman would regard all four as essentially the same policy, a reduction in the supply of money.
[Because I regard money as "the base," I regard the first two as a lower supply of money and the second two as a larger demand for money.  But this is pure semantics; nothing of importance hangs on the difference between how I define 'money' and the definition used by old monetarists like Friedman.]
The interesting thing about interest on money is that it can be controlled even in a completely flexible price economy.  Recall that the only reason that changes in the monetary base lead to changes in market interest rates is that wages and prices and debt contracts are sticky.  If prices are completely flexible, as in a currency reform, a change in the money supply has no effect on interest rates. Indeed that’s even roughly true of a change in the aggregates caused by a change in the demand for base money (ignoring small “superneutrality” effect from a change in real base balances.)
A one time decrease in the money supply leads to a temporary rise in interest rates, but then when the price level adjusts interest rates fall back to their original level.
A one time increase in the interest rate on money causes a one time increase in market interest rates on bonds, but only because prices are sticky. In the long run the interest rate on money stays at its new and higher level, whereas the interest rate on bonds returns to its equilibrium level (consistent with money neutrality.)
Sticky prices make it seem like interest on money and interest on bonds are related, but that’s a cognitive illusion.  At a fundamental level a change in the interest on money is a change in the demand for the medium of account, and is a profoundly monetarist policy.  It is no different from changing the supply of base money.  In contrast, a change in the discount rate does have a direct effect on the cost of credit, and hence is a more “Keynesian” policy.  Unlike a change in the interest rate on money, which can be permanent, a change in the discount rate would lead to hyperinflation or hyperdeflation if permanent.  There is a long run Wicksellian equilibrium discount rate, whereas there is no long run Wicksellian equilibrium rate of interest on money.  The central bank is the monopoly supplier of base money and can attach any (reasonable) tax or subsidy it wishes, even in the long run.
Money is not credit.  That’s the whole point of this post.
Update:  Obviously the interest on money should not exceed the interest on bonds

No comments:

Post a Comment