Warren Mosler and Phil Armstrong
Published online 24th February 2019
Abstract
With floating exchange rate policies, central banks target policy interest rates – prices – rather than any monetary aggregate. The narrative favoured by central banks and academics is that of the central bank adjusting the quantity of reserves supplied in order to keep market rates in line with their target rate. This implies that, in the US case, for example, the Fed varies the quantity of reserves in order to achieve its interest rate target. However, we argue in favour of a reversed causality vis-à-vis orthodox analysis and contend that rather than adjusting the supply of reserves to meet its policy rate, as the monopoly issuer of reserves in a floating exchange rate regime, the central bank, in practice, acts as the price-setter for the level of reserves demanded by the banking system.
Key terms: Central Banking, Interest Rate Determination
Interest rate adjustments are a very defective instrument because the GDP maximising rate of interest is the FREE MARKET rate. Ergo (as argued by Milton Friedman), interest rates should not be interfered with, exept in emergencies. The best instrument for adjusting demand is simply varying the amount of money the state creates and spends. The latter idea is supported by most MMTers I think, plus others: e.g. the deputy governor of Japan’s central bank and Ben Bernanke, and Positive Money.
What you say about interest rates would be true for fixed exchange rate regimes, such as HK and Bulgaria, but not applicable to floating exchange regimes as in the US.
” loans not only ‘create’ deposits but at the same time ‘create’ associated reserve balances, all as a matter of accounting” [between notes 6 and 7].
I understand the part about creating deposits, but creating the associated reserves escapes me. Anybody?
Hi Mel,
Just noticed this…if a reserve deficiency exists on settlement day it is accounted for as a loan at the CB. Thus the spending of a bank loan necessarily requires the CB to provide the required reserves for interbank settlement to occur.
Best,
Phil