Daniel Kruppa, 24 December, 2014
At present monetary policy (MP) is performed by major central banks by means of policy instruments such as fixing or targeting of a specific short term interest rate, asset purchases and sales, exchange rate management, interest on reserves and forward guidance. The current tools have their limitations which limit the effectiveness of policy-making.
Altering the cost or quantity of money and purchasing assets from the marketplace can potentially affect spending primarily through changes in funding costs, increases in the supply of money and wealth effects through portfolio re-balancing (Bank of England 2011).
Interest rate targeting is one of the principle tools employed by central banks in monetary policy. The effectiveness of a reduction in interbank interest rates in generating spending is dependent upon people’s willingness to borrow and bank’s capacity to make loans or investments. Factors such as debt to GDP levels and balance sheets of debtors and creditors can severely hamper the effectiveness of interest rate targeting as a policy tool.The limited direct reach of this instrument is one of its main shortfalls. Adjusting interest rates only directly affects entities which are currently indebted and others who wish to borrow. Interest rate targeting will also be ineffective in instances where the demand for credit is low or in circumstances of disintermediation. Issues of inequality may also arise because direct counter-parties to central banks usually have access to lower borrowing costs than the rest of the marketplace.
The wealth effect as a result of portfolio re-balancing which is generated through asset purchases and interest rate targeting only reaches existing asset holders and because asset ownership is heavily concentrated most of the wealth effect is experienced by the most wealthy while people with few or no assets experience little to no wealth effect. The richest may also have a lower marginal propensity to consume than people on average, therefore the impact on spending as a result of the wealth effect is reduced. It is also a manifestation of inequality that monetary policy seeks to create wealth increases but these increases in wealth mainly go to richer people. Inequality of asset holdings can be observed in the US where over 90% of stocks are owned by the wealthiest 20% while the bottom 60% own approximately 2.5% of stocks (Wolff, 2012). Approximately 65% home ownership rate leaves approximately one third of households not experiencing the wealth effect of house price increases (US Census Bureau).
The effectiveness of policies which expand the money supply such as quantitative easing or open market operations depend on the money demand of central bank counter-parties. Interacting with entities which have a money demand which fluctuates greatly makes its harder for the central bank to attain its targets. For example If the monetary authority expands money to entities which have a very elevated demand for money at the zero lower bound expansions of liquidity will have a diminished effect on growth and inflation. Consequently the central bank will have to resort to large expansions of the monetary base or unconventional policies which increase the difficulty of attaining its goals.
A more effective monetary policy toolkit
The central bank should bring into effect new tools so it can more effectively allow attain its economic targets such as GDP growth or inflation while minimizing inequality.
Fortunately options exist to incorporate new tools which can address the shortfalls of the of existing policy instruments. The instrument with the most potential to increase policy effectiveness and equality is the helicopter drop of e-money.
This form of helicopter drop is superior to interest rate targeting in terms of efficiency because it will directly affect all people regardless of whether they are in debt or not, without being reliant on credit markets or bank intermediation to operate.
Helicopter drops will generate a more balanced wealth effect by increasing money balances of all people. Policy needs generate a direct wealth effect to all people instead of only existing asset holders to improve economic outcomes.
Money demand amongst the general public is more stable when compared to the current counter-parties at the zero lower bound (ZLB). This is because at the ZLB central bank counter-parties have very little or no opportunity cost when holding money due to low investment returns. The overall public on average have a higher opportunity cost when holding money at the ZLB due to foregone utility from consumption or other spending. Banks are oriented towards realizing profits from investing and inter-mediating whereas people gain greater relative utility from consuming. Individuals which are unemployed or of low wealth have very stable and low speculative money demand. Therefore expansions of funds to people broadly would more effectively create inflation and spending growth at the ZLB and simplify policymaking.
The money supply to the broader economy could increase without necessitating an increase in debt if the central bank expands the monetary base directly to people. Under the current system expansions of broader money generally require more borrowing because commercial banks usually increase the quantity of deposits through lending. If the money supply can increase while maintaining lower debt to GDP levels greater financial stability should prevail because historically credit booms raise the odds of a financial crisis (Jordá et al. 2014).
In order to conduct e-money helicopter drops the central bank will need to extend the provision of electronic money to all entities not just depository institutions. It is not proposed that private banks cease to be depository institutions or full reserve banking be implemented. If the CB is tasked with providing money it should therefore also provide an efficient electronic means of payments and deposits of the money it creates. The provision of a payment and depository system by the central bank will be beneficial because it will directly be able to interact with people for monetary policy purposes which will remove problems caused by bank disintermediation and the deposits and payment system which is systemic will become risk free. Central bank provision of e-money will continue alongside the provision of physical currency and other forms of broader money issued by banks such as demand deposits.
If the central bank offers depository and payments services through e-money this systemic aspect of the economy will become risk free. Deposit insurance provided by the government for the private sector may no longer be necessary or less of a requirement.
Economies of scale should be realized if the current depository and payments system is unified and streamlined under the central bank instead of being segmented among an array of private banks and clearing houses. As a result the depository and payments system should become simplified and less costly to operate. Efficiencies of scope should also prevail if basic banking functions such as the deposits, payments and monetary policy are integrated. People will have the choice to deposit money with the central bank or private companies serving their own profit interest.
If people participate in monetary policy as counter-parties to the monetary authority they should become more knowledgeable of economics and gain greater confidence in the monetary system and its key institutions which is vital for a healthy economy.
When the CB expands money into the economy without purchasing assets it will not remove safe assets and risk free returns from the private sector which may induce excessive risk taking. Issues relating to collateral shortages, unwinding of asset purchases or other possible adverse effects on asset markets from expanding the CB balance can be avoided.
In a dynamic stochastic general equilibrium model with rational agents maximizing utility over an infinite time horizon subject to inter-temporal budget constraints an increase in net wealth through helicopter drops would cause agents to increase their current and future spending if there are unemployed resources (Bossone, 2013).
How will monetary policy be conducted through the new instruments?
When the monetary authority is pursuing expansionary monetary policy in order to attain its goals related to unemployment, GDP growth or inflation it can affect the target interest rate (if interest rate targeting) by periodically expanding the supply of central bank deposits directly and evenly into all citizen’s accounts while open market operations and other policies are performed when necessary. The rate of growth of e-money helicopter drops will be periodically adjusted by the central bank in order to attain its targets while open market operations or security issuance may be employed in order to fine tune the short term interest rate or contract the monetary base.
When the money supply is expanded to the public it may be directly issued into all people’s accounts on an equal basis at regular intervals such as once a week. The growth rate of the money supply will be adjusted in order to attain the target interest rate, inflation or GDP growth rate. Historically in most of the first world prior to the 2008 financial crisis the growth rate of the monetary base was approximately 5% per anum. If the central bank grows the money base directly to people at 5% per anum and due to liquidity effects is causing the short term interest rate to be too low too the rate of money growth should be slowed and vice versa.
During periods when the central bank needs to contract the money supply this can be done through issuance of securities such as reverse repurchase agreements, term deposit facilities or issuance of liabilities. Historically contractions of the monetary base have been rare and short term, most of the time the MB is increasing. The central bank may also employ temporary open market operations in order to fine tune the interest rate target if necessary as is currently performed.
The people are the central bank’s constituent due to it being a public agency. Therefore issuance of money to people should be recognized as a form of equity on the bank balance sheet. The expansion of money will not deteriorate the balance sheet of the central bank if money is not recognized as a liability. Financial assets or fiat money do not need to be a liability of the issuer and is an asset for its holder (Buiter, 2004), therefore the monetary base through direct public issuance can expand without a corresponding increase in liabilities for the central bank.
Bank of England (2011), “Quantitative easing explained: putting more money into our economy to boost spending”, London: Bank of England.
Bossone, B and A Sarr (2002), “A new financial system for poverty reduction and growth”, IMF Working Paper No. 02/178, October.
Bossone, B (2013), “Unconventional monetary policies revisited (Part II)”, VoxEU.org, 5 October.
Buiter, Willem H (2004), “Helicopter money: irredeemable fiat Money and the liquidity trap”, CEPR Discussion Paper 4202.
Òscar Jordá, Moritz Schularic and Alan M. Taylor (2014), “Private Credit and Public Debt in Financial Crises”, FRBSF Economic Letter, March 10, 2014
Wolff, E. N. (2012), The Asset Price Meltdown and the Wealth of the Middle Class. New York: New York University.