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Most people try to visualize monetary economics at the micro level. What would I do if the Fed gave me some money? What would I do if the Fed sold me some money for a T-bond? But that approach simply won’t work, as these thought experiments are subject to the fallacy of composition:

1. We all think that we control our own personal quantity of base money. And we do.

2. We think the Fed controls the total monetary base. And it does.

3. So what if the Fed increases the base, and we don’t want to hold any more money? What happens? The answer is that our attempt to get rid of this money causes a change in the macroeconomy (higher NGDP), which eventually causes us to want to hold on to the extra money created by the Fed. That is the essence of monetary theory, the very core of (non-MMT) monetary economics, not changes in interest rates that may or may not make people want to invest more.

Len Rosenthal and Brito sent me a New York Fed piece by Antinolfi and Keister that seems to fall prey to the fallacy of composition:

In other words, the size of the monetary base is determined by the amount of assets held by the Fed, which is decided by the Federal Open Market Committee as part of its monetary policy. It’s now becoming clear where our story’s going. Because lowering the interest rate paid on reserves wouldn’t change the quantity of assets held by the Fed, it must not change the total size of the monetary base either. Moreover, lowering this interest rate to zero (or even slightly below zero) is unlikely to induce banks, firms, or households to start holding large quantities of currency. It follows, therefore, that lowering the interest rate paid on excess reserves will not have any meaningful effect on the quantity of balances banks hold on deposit at the Fed.

The passage is literally true, but in a deeper sense is misleading in a very revealing way. It relies on a “micro approach” to monetary economics, ignoring the fallacy of composition.

A lower IOER will obviously reduce the total bank demand for ERs. That’s supply and demand 101. And Antinolfi and Keister are correct that it will not change the size of the monetary base. Nor will it directly make people want to hold a single dollar more in currency. So what gives?

This attempt to get rid of ERs is essentially a OMO by the banking system. When they reduce their collective demand for ERs, the money will literally be forced out into the economy. There are several ways this might occur. A pessimistic Keynesian would say that interest rates on bank deposits would fall until people wanted to hoard more cash. An optimistic monetarist would say that the monetary injection would boost NGDP enough so that people would want to hold more cash, in order to make a larger volume of purchases. In practice, it depends on all sorts of things, most importantly on expectations of future monetary policy. What sort of signal would be sent by the lower IOER?

Even in the optimistic case, the effect on the stock of ERs would be tiny. Thus suppose ERs are $2 trillion and cash is $1 trillion. Also suppose the lower IOER boosts NGDP by 2% (an optimistic assumption.) In that case currency demand might (and I emphasize might) rise by 2%, to $1.02 trillion. And that means ERs would fall by $20 billion, to $1.98 trillion. So they are right that ERs are not significantly affected. But the macroeconomy might nonetheless be very strongly affected.

Later on they indicate that the lowering of IOER might have macroeconomic effects. So I’m not trying to say their article is factually incorrect, or that they don’t understand the fallacy of composition. Rather I’m claiming that 99% of readers would interpret the passage I cited in exactly the same way that I did. That is, they’d assume that Antinolfi and Keister were trying to show that lower IOER would not do much good, because the level of ERs would not be significantly affected. They are right that the level of ERs would not be greatly affected, but they are wrong if they are trying to imply that this means the policy would not do much good. That question can only be answered by evaluating the signalling aspect of lower IOER.

PS. Later they speculate that a negative IOER would cause banks to hoard currency. Despite the fact that I was the first to publish a paper advocating negative IOER, I’m not really a big fan of the idea. But if the Fed did go ahead with negative IOER, it would be absolutely idiotic to exempt ERs held in the form of currency.

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This entry was posted on August 27th, 2012 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.



