Wednesday, November 8, 2023

How would a cash-only central bank conduct monetary policy?

What role do changes in the supply of banknotes play in contributing to a central bank's ability to carry out monetary policy? Put differently, to what degree does "printing," or creating new physical currency and issuing it into the economy, contribute to generating a central bank's desired inflation rate of 2-3%?

In a recent blog post at Econlog, Scott Sumner suggests that printing physical cash and "forcing" or "injecting" it into the economy has been an important part of central banks hitting their inflation targets, albeit less so now than in times past. I'm not so sure.

Having imbibed Scott's blog posts for more than a decade, I think I'm 99% on the same page as he is when it comes to thinking about monetary policy. We both agree that a central bank must either reduce the interest rate that it pays on the monetary base, or inject more monetary base into the economy, in order to push up prices. Using either of these two methods, the central bank sets off a hot potato effect in which a long chain of market participants do their best to unload their excess money balances, a process that only comes to an end when all prices have risen to a new and higher equilibrium such that no one feels any additional urge to spend away their extra money. Scott once described the hot potato effect as the the "sine qua non of monetary economics."

The monetary base is comprised of two central bank financial instruments: physical banknotes (a.k.a. cash) and digital clearing balances, sometimes known as reserves, a type of money used by banks.

Reading through Scott's post, I think the one spot where we may disagree is on the relative role played by the two types of base money in the hot potato process.

For my part, I don't think that cash has ever had much of a primary role to play in setting off a hot potato effect. All of the initial uumph necessary for driving prices towards target has typically been provided by reserves, either via a change in the interest rate on reserves or a change in their quantity. Once that initial uumph has been delivered, a whole host of other money types  physical currency, bank deposits, checks, money market funds, and PayPal balances  helps convey the forces originally unleashed by reserves to all corners of the economy.

An example of the hot potato effect in action may help illustrate.

Let's start with a central bank that needs to push inflation up to target. It reduces the interest rates on reserves. The first reaction to lower rates is a flight out of reserves into other assets, say shares.

As a result, share prices quickly rise. Those existing shareholders who realized their gains by selling at the new and higher price now find themselves with a hot potato on their hands; they have too many monetary balances in their possession and not enough non-monetary things.

Some of these ex-shareholders may choose to spend their excess deposits to go on, say, a vacation. As a result, airline ticket prices rise. Others transfer their extra money to their PayPal account in order to send it to friends and family, who may in turn make purchases, pushing up the prices of whatever they buy. Another group of ex-shareholders decides to buy used cars. They withdraw banknotes, their banks in turn asking the Fed to print new banknotes and ship them over. Used car prices rise.

The point is, the initial uumph is delivered by the change in reserves, and this gets conveyed to all prices by a daisy-chain of spenders offloading an array of different types of excess money.

In this story, note that cash isn't being actively "injected" into the economy by central banks, nor by commercial banks. Rather, people are choosing to draw cash out as their preferred method for getting rid of unwanted money, in response to a set of forces initiated by reserves. Reserves are the central bank's lever for change; cash is merely responsive.

Consider too that in a world where cash no longer exists, and has been replaced by digital payments options, monetary policy is still effective. In this world, the response to a reduction in the interest rate on reserves gets conducted to all the economy's nooks and crannies via non-cash types of monies, like fintech balances and bank deposits. (I'd be curious to hear if Scott is of the same opinion about monetary policy in a world without cash.)

Here's an interesting thought experiment. Would it be possible to redesign cash and reserves in such a way that cash takes over the initiatory role in monetary policy from reserves? That is, can we turn cash into the active part of the monetary base, the one that drives changes in monetary policy, and relegate reserves to the passive role?  

One step we could take is to pay interest on cash. This may sound odd, but it's possible to do so by setting up a serial note lottery to pay, say, 3% per year to holders of cash. (I wrote about this idea here and here.) Simultaneously, reserves would be rendered less important by no longer paying interest on them.

Now when a central bank needs to raise consumer prices in order to hit its targets, it reduces the interest rate on cash from 3% to 2%. This ignites the hot potato process as the entire economy suddenly tries to offload its unwanted $20 and $100 bills, which at 2% just aren't as lucrative as before.

Another change we could enact would be to modify the mechanism by which central banks inject base money into the economy. As it stands now, central banks inject base money by purchasing assets with new reserves. Since reserves are digital, they are a lot more convenient for making billion dollar asset purchases than physical money. These extra reserves become hot potatoes in the hands of asset sellers, which sets off the process of price adjustments described in previous paragraphs. If central banks were to buy assets with cash rather than reserves, that would put cash in the driver's seat, albeit at the expense of convenience.

It's an interesting thought experiment, but in the end I don't think it's very helpful to get bogged down over which type of base money has more monetary significance. As Scott says, the key point is that the central bank controls the price level via its control over base money in general. They can raise prices by either adding to the supply of base money, or by reducing the demand for base money with a cut in the interest rate paid on reserves. "It's basic supply and demand, nothing more." 


  1. It is highly debatable whether the "trickle down" effect, which you describe, has anly long term impact on the consumer price level. QE is merely shifting assets: instead of bonds the public now holds reserves - this was Fama's argument at the beginning of QE and there have been numerous acedemic papers which show a limited effect (on the CPI, not on asset prices ofc).
    Only when that the supply of assets has been increasing at an alarming rate (read: budget deficit) has CPI started to move...
    The way our monetary system operates (by stimulating credit) it is not entirely clear how the price level is impacted in the long run. What would happen to P, if the US starts consolidating its budget? (We know what happens if it doesnt consolidate the budget and restarts QE)

    1. I broadly agree that QE had almost no effect. The hot potato effect set off by changes in the quantity of reserves stops working once the world has become flooded with reserves. It only really works in environments like pre-2008 when reserves were kept incredibly scarce, and thus the settlement services they provided were highly valued, and so changes in their quantity were meaningfull.

    2. it only works to the extent that reserves are scarce, i.e. holding back lending and then only cyclically as are all credit effects. Debatable whether this was the case even pre GFC.
      As Adam smith observed a long time ago: the proliferation of Scottish banks did not have a meaningful long-term impact on the overall price level...The hot potato effect is in effect among asset holders (those people who hold assets at the outset and profit from the distributional effects of the fed). their marginally propensity to consume is probably lower, they merely recycle their savings - marginal CPI impact.

    3. "it only works to the extent that reserves are scarce, i.e. holding back lending and then only cyclically as are all credit effects. Debatable whether this was the case even pre GFC."

      Reserves were by definition scarce pre-2008 because the federal funds rate was positive. The only way to get a positive federal funds rate (without paying interest on reserves, which before 2008 the Fed didn't offer) is to keep reserves scarce, and special, and thus something that banks will offer an interest rate carrot in order to borrow.

    4. right, i was being unprecise. what I meant was they were not holding back lending to a significant extent, i.e. natural rate way above i. ofc, you could argue that an even lower (relative) interest rate might have led to even more rapid bank expansion- the main point ist the cyclical part!

  2. Thanks, JP! In my last post I wrote "Who else misses the good old days when JP Koning wrote mostly about actual, not fake money" (fake=cryptos) -- it seems the good old days are back! If this doesn't create nearly as many "clicks", I hope you can see it as a contribution to the advancement of monetary theory.

    How has currency been forced onto the public? I have no idea how Sumner can see this happen. Don't the commercial banks need to request more currency from the Fed for it to be printed? And the commercial banks won't buy stuff with it, so the demand has to come from their customers. I also wonder when was the last time the Fed bought bonds and handed over currency to the seller?

    When it comes to the general "hot potato effect" you describe, I have always wondered who is the seller of the bonds who suddenly holds "too much" M0 or M1 (the former in case of a bank)? I would think the sale is not forced - rather the seller wants to hold M0/M1, if only for a while. From the seller's point of view, I don't see how it matters who the buyer is (Fed or a fellow investor).

    1. Yep, it was time to do some regular monetary policy stuff.

      "When it comes to the general 'hot potato effect' you describe, I have always wondered who is the seller of the bonds who suddenly holds "too much" M0 or M1 (the former in case of a bank)? I would think the sale is not forced - rather the seller wants to hold M0/M1, if only for a while. From the seller's point of view, I don't see how it matters who the buyer is (Fed or a fellow investor)."

      If you want to get into the specifics, the central bank creates new reserves in order to buy bonds from a primary dealer, a large investment firm that acts as a permanent counterparty to central banks. Those reserves get credited to the investment firm's bank. At the end of the day this bank will find itself with more reserves than it intended, and so it'll try to get rid of them hot-potato-like by spending them, lending them out, etc. But other banks' demand for reserves is already satiated at the old level of reserves, too, so the new level of reserves is in excess of the entire banking system's needs. The only path for adjustment is for prices to be driven up and interest rates driven down until the new reserves are willingly held by banks.

    2. Sorry, I'm late with my answer.

      Thanks for the explanation! I can see how the hot potato effect works on bank reserves (M0). The daily change in reserves of an individual bank are partly out of its control, and the total amount of reserves in the system is controlled by the central bank.

      What I can't see is how the non-bank seller of the bond would suddenly be holding more M1 than he/she/it wants to. If you decide to sell a bond, then you do want to hold more cash (for a moment at least; unless your account was overdrawn to start with). So at that moment, although total M1 has increased, no one is holding excess M1 because of this increase? And if the seller of the bond then buys another bond or shares, the next seller will be holding as much M1 as he wants. This of course applies to any increase in M1, that can be caused by a bank extending any type of credit to its customers - not just by central bank purchases.

      So it seems to me that the hot potato effect is mainly confined in the M0 realm, affecting mainly the prices of credit instruments (-> interest rates). And all this depends on the IOR. Right?

      I can, though, see how the hot potato effect could escape the "bank sphere". I only need to think of Weimar. If the government issues a huge amount of 0 % notes by making purchases / paying wages, then these will become a hot potato in an inflationary environment. (This is why a hyperinflation might not be as easy to create in a cashless society, assuming interest rates on bank accounts follow inflation at least to some extent.)

    3. "What I can't see is how the non-bank seller of the bond would suddenly be holding more M1 than he/she/it wants to."

      You're right, they aren't holding a hot potato. It's their banker that is holding it, in the form of excess reserves.

      "And all this depends on the IOR. Right?"

      It can depend on IOR, interest on reserves. But recall that many central banks didn't have IOR prior to the 2000s, so the hot potato effect could only be set off by changes in the quantity of reserves.

    4. Snailmail correspondence continues...

      So, we agree that M1 is rarely a hot potato? Apart from Weimar and other situations where one is required to accept & hold credits ("money") that don't come even close to compensating for inflation. No one likes to give up a banana today and sit with a record which next week will imply that you gave up only half a banana (and so are due to receive half a banana from someone else).

      I agree that the total quantity of reserves was decisive when they were relatively scarce. You need IOR if you want to avoid a serious hot potato problem when the quantity of reserves is excessive (due to QE) and other risk-free rates are well above zero.

      Based on all this, it is just very hard to see how an increase in M0 and M1 would affect the general price level in any linear way.