A Communication from Your Central Bank

By Dan Kervick

Nick Rowe recently argued that there can be certain types of products for which the market might allow multiple equilibria.  This can happen because the willingness of an individual to buy some product might depend on how many other people buy that product.  The upshot, Rowe suggests, is an unusual, non-functional shape to the demand curve characterizing the market for the product in question, resulting in two distinct equilibrium demand quantities corresponding to the same price.

Rowe applies this model to cases in which the supply of a product is determined by a monopoly supplier.  Rowe says that in most cases it does not matter, for theoretical purposes, whether we think of a monopolist as setting the optimum output level and then letting the price go to the equilibrium determined by the intersection of the demand curve with that output level, or as setting the optimum price and then supplying output until it reaches the level the market demands at that price.  In each case, we get the same result.  But if a non-functional demand curve describes the market for some product, then it does make a difference, he claims, whether the monopolist targets a price or targets an output level, because there might be multiple equilibrium output quantities for some prices, but only one equilibrium price for each output quantity.

The kind of case Rowe is discussing, which he illustrates with an example of a hypothetical electronic communications device – a “gizmo”, is theoretically interesting in itself.  But what I want to focus on is an application he makes of it, an application which appears to be his main reason for offering the model in the first place.   Appealing to some 1970 work by William Poole, Rowe applies the multiple equilibrium model to the central bank, which they view as a monopolist setting either the “price” for money – an interest rate – or the quantity of money.  The monopolist in this case is constrained by a “money demand” relation that might be non-functional in the manner described above.

Rowe then says this:

Should we economists think about central banks setting a nominal rate of interest or a target for NGDP? Should central banks think of themselves as setting a nominal rate of interest or a target for NGDP? How should we best communicate to the public what it is that central banks do? It matters.

“NGDP” stands here for nominal gross domestic product, the total amount of spending in the domestic economy, measured in current dollars.  Rowe and others have argued that the central bank should set a desired growth rate for NGDP as their primary policy target, and should carry out monetary policies mainly aimed at hitting that target rate.  They also argue that the central bank should practice level targeting of NGDP growth, which essentially means that if the target is not hit in a given period, the bank should aim for an NGDP growth rate in the immediately subsequent periods that brings the overall NGDP growth trend to the target level.

But Rowe’s question about how economists should think about NGDP targeting seems to come out of the blue following the previous discussion about multiple equilibria.  Even if we think of the central bank as the monopoly producer of money, with the ability to target either the price or quantity of money, why should think that this power extends to the ability to target not just the amount of money in the economy, but the amount of spending of that money?

And in fact, the central bank is not the monopoly producer of money.  The central bank produces only one form of money – the narrow form of money in the monetary base: mainly the reserves in which banks conduct their own business among themselves, and the decreasingly important vault cash that banks order from the central bank to meet customer needs that those banks have identified and developed.  And as research by MMT economists like Scott Fullwiler and others has increasingly shown, the quantity of broad money in the economy is endogenously determined by a host of factors.  There is no technique by which the central bank can reliably target the supply of broad money through its control over the monetary base.  Instead of driving the process of broad money creation, the central bank is constrained to react to changes in broad money by adjusting the monetary base to support its primary operational target: the interest rate on interbank lending.

So it’s like Rowe has told a story about the monopolist who produces gizmos, and then followed that story up by asking, “Should we think of the gizmo producer as setting the nominal price of Christmas trees, or as targeting the total volume of exchanges involving Christmas trees?” The fact that the gizmo producer is a gizmo monopolist doesn’t mean the gizmo producer can monopolize other, non-gizmo markets like the market for Christmas trees.  Similarly, there is no reason to think that the central bank can target the quantity of broad money, much less that it can target the actual level of total dollar spending in the economy.

But Rowe is right that the message a central bank communicates to the public is important.  That message does matter.  So what should that message be?  This is the kind of message I personally think would be best:


“Dear citizens:

“We are the central bank, which means our job is to serve as a bank for bankers, and to regulate and stabilize the banking system.   We do not run the whole national economy, or even set the main macroeconomic parameters for the whole economy.   Despite the existence of some strangely popular macroeconomic theories to the contrary, we cannot determine the level of aggregate demand, the level of employment, or even the general level of prices.

“Money exists in different forms.  The broadest form of money is the kind used by ordinary households and companies to transact business of all kinds, and consists predominantly of balances in commercial bank deposit accounts.  It can be thought of as points on a scorecard.   These points are exchanged in the economy for real goods and services, often without ever being reduced to the physical form of old-fashioned paper currency and coins.   A narrower form of money is used by commercial banks to transact business among themselves, and can also be thought of as points on a scorecard.   Just as individuals, households and firms have accounts at commercial banks which they use for transacting business of all kinds, commercial banks have accounts at the central bank for transacting business among themselves.

“The broader form of money essentially consists of IOUs for the narrower form of money.  Commercial banks introduce and recirculate money in its broadest form into the real economy in response to their own assessments of real economic opportunities for growth and profit.  We have some influence on that process but by no means control it. Our job is to accommodate these commercial bank initiatives by supplying and regulating the more narrow form of money that banks use to settle payments among themselves, while applying brakes if we think the banks are becoming too exuberant in creating the broader form of money.  We can also let off the brakes if we have been applying them too tightly. The commercial banks take the lead and we are bound to follow, regulating the process but not driving the process.

“We control the brakes on the economic car, but not the accelerator.  If the driver is trying to accelerate, and we let off the brakes, the car will go faster.   But if we have released the brakes all the way, and the driver does not want to accelerate, there is nothing we can do to make the car speed up.  The driver is the commercial banking system, and the brakes are the interbank interest rates that we control.  The banks can accelerate lending if there is strong demand for spending on consumption and investment in the real economy.  But, especially in a struggling and indebted economy, the ability of households and firms to generate demand for products leaks out of the economy as these households and firms save substantial portions of their income.  If there is weak demand, banks will not find many profitable opportunities to loan.  And if there are few profitable opportunities to loan, we at the central bank cannot make loans happen.  And, mysterious statements to the contrary notwithstanding, we don’t have any other ways of making spending happen except by influencing the rate of bank lending.

“Again, we don’t run the whole economy.  Our ability to influence general trends in the broad national economy is seriously limited – especially in circumstances in which we have already released the brakes on the interbank lending market as far as they will go. We have no established and approved mechanisms for pouring money directly into the real economy of households and firms outside the banking sector.   We do our work and exert our influence in and through the banking sector.  It would thus be absurd for an institution with our circumscribed powers to profess to “target” total spending in the whole economy, and so we won’t insult your intelligence by professing to aim at such a target. The only target we can sensibly establish and hit is the rate of interest that banks charge other banks in the system we supervise.  So that is the kind of target we’ll stick to.

“If you are dissatisfied with the performance of the national economy, you have two choices: First, you can wait patiently until private economic activity repairs itself, slowly and haltingly, over many years, understanding that there is no reason to think the economy will ever achieve full employment by private sector means alone, or generate the level and scope of national investment necessary to keep the economy from declining over time and falling behind its more aggressively investing neighbors.

“The second choice is less passive: you can demand that the most powerful economic actor in the economy – the national treasury controlled by the legislature that is filled with representatives that you, yourselves elect – is vigorously mobilized to do some significant buying, investing and production of its own. This government activism can restore the economy to full employment in short order, and also accomplish some very important long-term public investment in the process.

“Any schoolchild who has studied the democratic and republican form of government knows that the central bank does not have the “power of the purse.”  We at the central bank cannot invest in new school buildings, hire teachers, build roads and tunnels, build new energy systems and distribution grids, or hire the unemployed in great numbers.  We do not have the unilateral authority to simply give money away to households and firms; nor would any self-respecting democratic country want to give that awesome authority to a secretive panel of unelected bankers.

“But although we cannot initiate such spending ourselves given the constitutional structure of the national government and the central bank’s circumscribed, law-governed role in those institutional arrangements, we guarantee we will accommodate bold economic activism by the national legislature. That is, we will buy up massive quantities of the government’s debt instruments in support of expanded government spending, and roll those debts over indefinitely – making sure the treasury never has to draw on tax revenues to pay it back, effectively just creating money for the government to use at the people’s behest.  We can turn big government debt totals into meaningless bookkeeping figures.   And because the economy is currently running so woefully below capacity, we believe we can assist you in this way without causing damaging inflation.

“It is possible our future successors at the central bank might have a different mindset, and might go into a conservative crouch to battle inflation. But even if our successors don’t have the enlightened attitude we have, it is important that citizens understand their own power in this sphere.  This central bank was created by congressional legislation.  It operates according to rules established by that legislation, and operates under the constitutional money-making authority of the legislature, authority which was only delegated to the central bank.  If some future central bank administrators put the brakes on an economic recovery, or hamstring an energized, mobilized public eager to put the power of the government to work building a brighter future, the public can assert greater control over the central bank.  You and your legislators make the rules.  The so-called “independence” of the central bank is a mere operational practice that you and the legislature have chosen, and that can be modified or reversed any time you decide to choose differently.”

“So there it is.  It’s in your hands.  Organize yourselves, pressure your legislators, and take charge of your own economy, and don’t look superstitiously to magical wizardry from the central bank to control economic events that only the political branches of government can control.

“We are, as ever, your servants,

“The Central Bank”

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