This is rather impressive:

“Cash still exists in rather surprising quantity – about a trillion dollars, or more than $3,000 per capita, 77% of it in hundred-dollar bills. But you and I, corporate businesses, and financial markets use trivial amounts of cash. The legal, and especially corporate and financial economies, have moved to electronic, interest-bearing money. Almost all of us pay by credit cards or debit cards, linked to accounts that will, when interest rates rise, pay interest, and are mostly settled by netting between our banks –an essentially electronic accounting system. Cash really is only used in any substantial quantity for illegal transactions, undocumented people, and store of value in foreign mattresses.

For this reason, as a modeling approximation, it seems wiser to think of cash holdings as disconnected from nominal (legal) GDP, than to found control of nominal GDP on control of cash balances not used for most of GDP. Empirically, cash holdings just trundle with little apparent connection to the economy and, especially, the financial system. Unredeemed coupons, unused subway cards, sock-drawer change, that stack of receipts you’ve been putting off submitting for reimbursement, and, more seriously, invoices and some trade credit are also non-interest paying claims. But they’re not tightly connected to output or price level determination. Controlling the inventory of unredeemed coupons would not control the price level.

Furthermore, the Fed does not control the quantity of cash, as Fama prescribes. For MV = PY to control PY, the Fed must control the M, as well as V being determined and stable. The Fed allows banks freely to exchange cash for reserves.

For these reasons, it makes more sense, I think, to abstract from cash –along with unredeemed coupons and the rest of my humorous list of non-interest-bearing claims – and think of a monetary system based entirely on interest-paying reserves, and consisting entirely of interest-paying electronic money. Reserves, not cash, are really our fundamental numeraire and means of final payment. We certainly don’t want to embark on the alternative abstraction –that the functioning of monetary policy and the control of inflation centrally revolves around the demand for cash, almost all of which is held for illegal purposes.

More generally, some monetary frictions do remain. There are tiny spreads between treasuries and reserves. There are on-the-run and other small liquidity spreads in treasuries. But I think it would be a mistake to base our basic analysis of big questions of monetary policy – can monetary policy affect GDP and the price level, and if so how – on these ephemeral frictions, using models that, if those frictions were to disappear, would not be able to describe monetary policy and price level determination at all. Instead, it seems more sensible to base our analysis on a theory that is valid in a world with no monetary frictions at all, and then add frictions as necessary to understand second-order effects.

This discussion about money may seem quaint, because our Federal Reserve explicitly targets interest rates rather than monetary aggregates, and obviously will continue to do so. So, the central class of theory needed is a theory that describes how Fed manipulation of interest rate targets, not M, controls the price level.”

The source for the piece just quoted is John Cochrane’s paper “Monetary Policy with Interest on Reserves”, reviewed in this previous post:

John Cochrane’s “Monetary Policy with Interest on Reserves”

The Achilles heel of monetarism is its undifferentiated concept of the monetary base. Leaders of the theory refer to it reverently as “the base”.

The regime of interest paying reserves is one window into this traditional conflation. Cochrane incorporates this perspective as part of the fiscal theory of the price level.

Within the framework of a controversial theory, he offers clarity on several aspects of monetary operations:

a) Interest paying reserves are a form of government debt. That is not new, but it is a foundation for his seamless application of FTPL.

b) Currency is almost irrelevant for any useful version of a monetary theory.

Yes, that’s right.

Read point b) and the quoted piece again.

Useless. He rejects it outright as being helpful to the analysis. Done away with.

Cochrane’s paper is amazing not just for this but for a number of other realistic observations offered as background to the FTPL theme.

But there is a larger point that overarches the subject and the paper.

Which is that understanding the previous (Fed) regime of scarce bank reserve balances that paid an interest rate of zero also required a differentiated analysis of the functions of bank reserve balances and currency.

Deconstructing this traditionally consolidated view of the “base” is essential in understanding monetary operations. But monetarism has never seemed to put much value in such operational details.


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2 years 3 months ago

JKH, your recent work on FTPL looks interesting. Hopefully I can get to it during the holiday time.

2 years 3 months ago

Yes, I definitely took notice of that, and it’s a slightly quirky part of his model.

And I agree that he ignores endogenous money creation by the commercial banking system, or at least leaves it in the background (you can still infer it from his description of the model).

He does take pains to point out that FTPL does not mean monetary policy cannot be effective and he shows that in several model scenarios.

But if you skim through section 5, he is very dismissive of traditional monetarism in several different places and not just because of the cash aspect.

But I agree there’s a bit of a compromise in the way he structured his model. Although for the most part he talks about bonds and not reserves. And that means he’s implying more about velocity than permanent money supply expansion.

2 years 3 months ago

It does seem that mainstream is moving toward a more realistic understanding of how fiscal and monetary policy work. I just think modern macro models have deeper flaws and are going to lead to the wrong answers.

JW Mason has a good post on a Michael Woodford paper that seems to be going in a similar direction as Cochrane.

He has a good paragraph on the budget constraints in these models.

“This is a nice part of the paper, Woodford’s treatment of the “transversality condition.” This, or the equivalent “no-Ponzi” condition, says that the debt of a government — or any other economic unit — must go to zero as time goes to infinity. The reason mainstream models require this condition is that they assume that in any given period, it is possible for anyone to borrow without limit at the prevailing interest rate. This invites the question: why not then consume an infinite amount forever with borrowed funds? The transversality condition says: You just can’t. It is still the case that at any moment, there is no limit on borrowing; but somehow or other, over infinite time net borrowing must come out to zero. This amounts to deal with the fact that one’s assumptions imply absurd conclusions by introducing another assumption, that absurd outcomes can’t happen. Woodford sees clearly that this does not offer a meaningful limit on fiscal policy”

2 years 2 months ago

Interesting – I really never knew the background of the ITGBC. Thought it *must* be something like this, because it just comes out of nowhere when you step through the math.

I had some discussions with Ramanan Iver a while back. There are still constraints on borrowing, but they are hard to define. But in the real world, the constraints do seem to exist. There must be some way to model them.

It seems people had to know this ever since Sargent’s Unpleasant Monetarist Arithmetic.

And hey thats an interesting thought – that households are not required to have a balanced budget either, but rather have a range of balance sheet options open at any given time.

2 years 3 months ago

Cochrane’s view of cash is welcome. I’ve come to think that any short term floating rate liability should be considered money.

But I still think his model is much closer to monetarism, than a proper understanding of endogenous money. You see this a lot with krugman, he has some interesting observations about the actual economy, but his models never follow the implications all the way through.

Take this from appendix 8.1,

“Each evening, the government sells a face value (Bt1) of nominal debt due the next period. Each morning (t) then, the government prints up (Bt1) new dollars to pay off the outstanding debt. Households receive the dollars, sell their endowments (y) for dollars and buy goods (ct) for dollars. At the end of the day, they must pay lump sum taxes less transfers (Ptst) in dollars.” [it is assumed that no cash is held overnight]

As I understand it, this is the crux of the FTPL. The money that the government prints to pay off its debt is the money supply. And the money supply determines the price level. There is a step away from saying the CB controls the money supply, but it is only a small step because through exogenous fiscal policy the government still controls the amount of debt and thus the money supply.