Thinking about monetary policy in terms of interest rate policy just doesn't work. It doesn't work in theory, and it doesn't work in practice. That's why the Bank of England is having to do QE, and is having to re-introduce the old general theory of monetary policy as a special theory for QE.

The Bank of England has published a lovely clear article (by Michael McLeay, Amar Radia and Ryland Thomas) on "Money Creation in the Modern Economy". Thanks to JKH for the tip-off. (Here is JKH's blog post) . But I disagree with it.

This is the part of the article that most caught my attention:

"Like reductions in Bank Rate, asset purchases are a way in which the MPC can loosen the stance of monetary policy in order to stimulate economic activity and meet its inflation target. But the role of money in the two policies is not the same.

QE involves a shift in the focus of monetary policy to the quantity of money: the central bank purchases a quantity of assets, financed by the creation of broad money and a corresponding increase in the amount of central bank reserves.

The sellers of the assets will be left holding the newly created deposits in place of government bonds. They will be likely to be holding more money than they would like, relative to other assets that they wish to hold. They will therefore want to

rebalance their portfolios, for example by using the new deposits to buy higher-yielding assets such as bonds and shares issued by companies — leading to the ‘hot potato’ effect discussed earlier. This will raise the value of those assets and lower the cost to companies of raising funds in these markets. That, in turn, should lead to higher spending in the economy."

There is nothing wrong, in my eyes, with that second paragraph. Good monetarist hot potato stuff! What is wrong is the sentence that immediately precedes it: "But the role of money in the two policies is not the same."

They have two theories of how monetary policy works. There is one theory for when the Bank of England sets a rate of interest: "And reserves are, in normal times, supplied ‘on demand’ by the Bank of England to commercial banks in

exchange for other assets on their balance sheets." And a second, quite different theory, for when the Bank of England does QE.

I'm sure they are not alone in having two theories: one for "normal times"; and one for QE, which is seen as needing a special theory only applicable in "abnormal times". But it is rather peculiar having two different theories of the same thing.

One theory is better than two.

What is even more peculiar is that their special theory for QE is the same as the general theory taught in first-year textbooks. The central bank buys a bond and the money supply expands, because the seller of the bond now owns the money that the central bank gave him in exchange for the bond.

"Quantitative Easing" is just a silly new name for the "Open Market Operations" that first-year textbooks have always said was the way that central banks normally increase the money supply.

If you spend your life teaching first year economics, like I do nowadays (when I'm not blogging), this here modern world looks very peculiar. My general theory has become their special theory, and they have gone and invented some weird new theory of money creation in what they call "normal times", that they admit doesn't work as a general theory, and they still need my old theory to handle the cases where their weird new theory doesn't work.

Here is my general theory: when the central bank buys something, with central bank money, the money supply expands, because whoever sold them that something now holds extra money. Done. It does not matter whether the central bank buys a bond, or a computer, or whatever. Hell, it could just give the money away to its favourite charity (helicopter money), and the result would be the same.

Why can't my general theory work equally well in "normal times"? Let me repeat that above quote, this time with bold added: "And reserves are, in normal times, supplied ‘on demand’ by the Bank of England to commercial banks in exchange for other assets on their balance sheets." See that bit about "in exchange for other assets"? That means the Bank of England buys something. Just like I said in my general theory. The central bank increases the money supply by buying something. See, it's easy!

Now if the central bank is buying something, and someone else is selling something, there must be some sort of market in which that something is bought and sold. But it really doesn't matter, for money creation, what that "something" is. What matters is that the central bank is selling central bank money. It is supplying central bank money. So we want to know something about the central bank's supply function. And that supply function will depend on what it is the central bank is targeting.

We could assume that the central bank is targeting the stock of its own money, so the supply function is perfectly inelastic with respect to anything. That is a very simple assumption, suitable for a first year textbook. But not very realistic, for most times and places.

We could assume that the central bank is targeting the price of gold, so the supply function is perfectly negatively elastic with respect to the price of gold. Realistic in the past, but not nowadays.

We could assume that the central bank is targeting the stock of M1, so the supply function is perfectly negatively elastic with respect to the stock of M1. Realistic briefly in the past, for Canada, but not nowadays.

We could assume that the central bank is targeting expected CPI inflation, so the supply function is perfectly negatively elastic with respect to the expected rate of change of the price of the CPI basket of goods. That is realistic for many central banks nowadays.

Interest rates? Did I hear you say that modern central banks target interest rates? Well, maybe, but only in the very short run, like maybe the next 8 weeks. Monetary policy for the next 8 weeks isn't very interesting, unless it gives us a clue about what the central bank will be targeting in the years after that. And they say they are targeting things like inflation, not interest rates. But if you insist, the central bank's supply function would be perfectly elastic with respect to whatever interest rate you say it is targeting.

See, it's easy. One general theory to rule them all, that can be modified for whatever it is you want to assume the central bank is targeting, just by changing the central bank's supply function.

But what about commercial banks? They create money too. Commercial banks are much easier. We know what commercial banks are targeting. They target maximum profits. And that means commercial banks, like ordinary profit-maximising firms, and like ordinary utility-maximising people, and unlike central banks, only care about real variables. It is the central bank's job to ensure that nominal variables are determinate, by not doing something daft like trying to target a rate of interest for too long.

Just like central banks, commercial banks create money by buying something, and paying for it with the money they create by buying it. They mostly buy non-monetary IOUs, but it doesn't matter what they buy, or even if they just give their money away to their favourite charity.

How much money commercial banks create to maximise their profits will depend on a lot of things. But what I want to focus on, because this is the key policy question, is how it depends on what the central bank is doing. Let me quote again from the Bank of England article:

"The supply of both reserves and currency (which together make up base money) is determined by banks’ demand for reserves both for the settlement of payments and to meet demand for currency from their customers — demand that the central bank typically accommodates.

This demand for base money is therefore more likely to be a consequence rather than a cause of banks making loans and creating broad money."

First, they don't mean "supply"; they mean "quantity supplied". And as I pedantically tell my first year students, the difference really does matter (sometimes, like here). Yes, the quantity supplied (which is equal to quantity demanded in equilibrium) depends on the demand function, but it depends on the supply function too. Both blades of the Marshallian scissors matter in determining quantity, even if one blade is assumed to be horizontal for the next 8 weeks.

But what matters is their acknowledgement that the demand for base money (central bank money) is a consequence of the amount of broad money commercial banks have created. May I make a small simplifying assumption? May I assume that the demand for base money is proportional to the stock of broad money, other (real) things equal? Because that's the only way we can assume that commercial banks maximise profits and so only care about real things and don't suffer from money illusion. Thanks!

"While the money multiplier theory can be a useful way of introducing money and banking in economic textbooks, it is not an accurate description of how money is created in reality. Rather than controlling the quantity of reserves, central banks today typically implement monetary policy by setting the price of reserves — that is, interest rates."

But hang on! You have just agreed (sort of) that the demand for base money is some proportion r of the stock of broad money. So in equilibrium, when the actual stock of base money is equal to the quantity of base money demanded, the stock of broad money must be a multiple 1/r of the stock of base money. And if the central bank shifts the supply function of base money $1 to the right, that must increase the equilibrium stock of broad money by $(1/r). Just like the first-year textbook says it will!

Now you might object that modern central banks don't care about the stock of base money (except when they are doing QE), and target things like inflation instead (except for 8 week periods when they target an interest rate). OK. But if the central bank wanted a temporary increase in the inflation rate, and so a permanent rise in the price level, it would need to shift the supply function of base money, to create a permanent rise in the monetary base, and a permanent rise in broad money, and the textbook money multiplier would tell us that broad money would increase by 1/r times the increase in base money.

One simple (first-year textbook) general theory to rule them all!

What is the underlying problem here? Why do monetary economists resist this very simple and very general theory of monetary policy? The underlying problem is revealed in this quote:

"Like reductions in Bank Rate, asset purchases are a way in which the MPC can loosen the stance of monetary policy in order to stimulate economic activity and meet its inflation target."

It assumes that interest rates are a measure of the "stance of monetary policy". If interest rates were an adequate measure of the "stance of monetary policy", the Bank of England would not need QE. And you cannot define the stance of monetary policy by taking some sort of average of interest rates and QE. A permanent increase in the target price level would mean a permanent increase in the money base but would have no obvious implications for interest rates. A permanent increase in the inflation target would mean a permanent increase in the growth rate of the money base but would mean higher nominal interest rates. There is no monotonic mapping from loose monetary policy into low interest rates. Thinking about monetary policy in terms of interest rate policy just doesn't work. It doesn't work in theory, and it doesn't work in practice. That's why the Bank of England is doing QE, and having to re-introduce the old general theory as a special theory of how monetary policy works.