TJP

According to some economists, the new consensus in macroeconomics (NCM), introduced two decades ago, is one of the greatest achievements of modern monetary economics. They argue that it rejects the classical quantity theory of money and proclaims short-term interest rates and not monetary aggregates as the central bank’s control variable.

The recent worldwide recession, however, casts doubt on the achievements of the NCM. Moreover, it validates Milton Friedman’s dismissal of interest rates as a policy instrument. Friedman noted that experience has demonstrated that it is not feasible for monetary authorities to use interest rates as a target or as an effective policy instrument.

The NCM rejects the quantity theory of monetary framework and embraces the Wicksellian framework. In the Wicksellian “pure credit economy,” the banking system grants loans to entrepreneurs to pay for inputs of the production process, such as wages of workers. And, workers use their wages to buy commodities and services from businesses; thus, creating effective demand. Businesses use monies received from workers to buy commodities from entrepreneurs and a portion of the monies received by entrepreneurs is used to repay bank loans, closing the circle.

The Wicksellian approach assumes an economy at full employment. Accordingly, the economic system is in balance when the interest rate on loan (r) is equal to the so-called natural interest rate (r), which is the real return to production. However, in the Wicksellian framework the natural interest rate is unknown. Thus, Wicksell noted that it is only by chance that the banking system is able to set the interest rate on loan equal to the natural rate.

The clear implication is that targeting interest rate would, more often than not, lead to a disequilibrium condition; where r would be higher or lower than r. If higher, savings (S) would exceed investment (I) and if lower investment would exceed savings, since I – S = v (r - r).

For over a year, interest rates on loans (r) have been historically low. However, low interest rates have not spurred investments. Therefore, if the Wicksellian framework, and hence the central bank’s policy, is valid then the interest on loan (r) is still too high.

My take all along is that the Federal Reserve (Fed) policy of inflation targeting has no merit and was a principal contributor to the current economic problems.

The Fed reaction, in mid-September of 2008, where it began creating money at a rapid pace demonstrated that it was keenly aware that targeting interest rate to control inflation restricted the money supply, and hence adversely affected aggregate demand and the economy.

In October of 2008, Congress provided an incentive for banks to hoard the increase in reserves created by the Fed. It authorized the Fed to pay interest on reserves (IOR) on the more than a trillion dollars of reserves supplied to banks. The policy of paying IOR provided a disincentive for banks to provide loans and hence expand the money supply.

The appropriate policy should have been to charge banks a fee for holding excess reserves, rather than paying IOR, and raising Federal funds rate; prompting banks to loan rather hoard excess reserves.

Banks’ choice of reserve ratio is contingent on required reserve (r_R); uncertainty of net deposit flow (u_D); cost of borrowing, which is the discount rate (i_D); the interest forgone by hoarding excess reserves (i); and the interest on reserves (i_R). Therefore, we can express the bank’s reserve deposit ratio as: R = R(i, i_R, i_D, r_R, u_D ).

An increase in the interest rate on earning assets, i, decreases the reserve ratio; it makes reserves more costly to hold. An increase in interest paid on reserves, i_R, increases the reserve ratio; it makes reserves less costly to hold. An increase in the discount rate, i_D, increases the reserve ratio; it makes it more costly to be short on reserves. Higher reserve requirements and uncertainty of deposits also increases the reserve ratio.

It is unambiguously clear that the bank’s reserve ratio is a function of interest rates. Therefore, when the Fed increased monetary aggregates, as it did in the fourth quarter of 2008, it should have also set short-term interest rate at a level conducive to reasonable banks’ profits. Additionally, it should have not paid interest on reserves, rather imposed a fee on excess reserves.

These steps would have forced money into the economy, expanding the money supply at the Main Street level and radically reduced foreclosures, boost the production process and hence employment. These steps are still available and if implemented expeditiously would rapidly increase demand, production, and employment.

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