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Let’s review the (alleged) zero bound problem. The nominal interest rate falls to zero. The Fed injects base money, and banks choose to hold it as excess reserves. The Fed could try to force banks to lend it out with negative interest on reserves (IOR), but in that case deposit rates would go slightly negative and the public would pull the money out and hold it as cash. The existence of cash creates an effective zero lower bound on nominal interest rates, or perhaps a lower bound of a few basis points negative, as there are costs of holding cash.

Many Keynesians think that this in some way makes monetary stimulus ineffective. This is wrong, but let’s put that issue aside and consider another issue—does eliminating cash solve the zero bound problem, at least from the perspective of monetary policy ineffectiveness? And the answer is clearly yes. If you eliminate cash then the medium of account is 100 percent bank reserves. If the Fed charges a negative 6 percent rate on bank reserves then the demand for bank reserves would plunge much lower, and AD would soar much higher. What happens to market interest rates in that scenario? I’m not sure, but it doesn’t matter. Eliminate cash and you definitely eliminate the zero bound problem on the policy rate. The Fed can again use interest rates (IOR) as their policy lever.

Tyler Cowen links to a John Cochrane post that discusses the Keynesian argument for eliminating currency. I agree with Cochrane that eliminating cash is a really bad idea, for standard libertarian reasons. But Cochrane misses the point when he argues that people can still earn zero rates of return on other assets, such as stamps, gift cards and prepaid taxes, even if cash were eliminated. Stamps, gift cards and prepaid taxes are not the medium of account, only cash and bank reserves count. If you eliminate cash and charge a strongly negative rare of bank reserves, the hot potato effect kicks in with a vengeance. Monetary policy is all about changes in the supply and demand for the medium of account.

Ironically, despite the fact that Cochrane teaches at the University of Chicago, he uses a strongly interest-rate oriented approach to monetary economics. Milton Friedman used to insist that Keynesians kept making basic mistakes by assuming that monetary policy could be thought of in terms of market interest rates. Friedman was right, focusing on interest rates causes nothing but confusion. (And recall the neo-Fisherian debate, which also got on the wrong track by assuming that changes in fed funds interest rates were “monetary policy.”)

PS. I’m skipping over the dubious assumption that investors would be able to park trillions of dollars in zero interest gift cards in a negative IOR scenario. My point is that even if they could, it would not prevent negative IOR from solving the zero bound “problem,” which of course all market monetarists already know is not actually a problem.

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This entry was posted on January 01st, 2015 and is filed under Monetary Theory. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



