Money and Interest--Comment on Sumner

As a small aside in a recent post, Scott Sumner suggested:

BTW, I wish the Fed would stop calling it "base" money; bank reserves are now essentially T-bills. Only currency is still interest-free. And monetary theories of inflation are based on explaining the supply and demand for non-interest-bearing money.

I think this is an error. Bank reserves are not essentially T-bills. And none of my monetary theories of inflation are based upon the supply and demand for non-interest-bearing money. Rather, they apply to the entire spectrum of situations--no money bears interest, some money bears interest and other money does not, and finally, where all money bears interest. When growth rates of the money supply are at issue, the special case where all money pays interest best exhibits the proportionality between money growth and inflation.

First, how are bank reserves different from T-bills? T-bills have a market price. T-bills do not serve as medium of account. While their prices are generally quoted as yields, the dollar price of a $1000 T-bill can and does change depending on supply and demand. While we might quote a price of 1% for a one year T-bill, that means that the dollar price is $990. An increase in demand might increase the price to $995. An increase in supply might reduce that price to $985. (When the price of a $1000 T-bill gets to be $1001 or so, then monetary disequilibrium can be generated because of shortages in the T-bill market.)

A one dollar reserve balance at the Fed is always worth one dollar--by definition. The price of a $1 reserve balance cannot have a price of 99 cents or $1.02. That is because base money--including both currency and reserve balances at the Fed--serves as medium of account.

Second, T-bills do not serve as the medium of exchange. The Treasury and the Fed auction them off to obtain funds to spend. Reserve balances, on the other hand, never have to be sold to obtain funds to make a purchase. They can be spent into existence. The Fed promises to make a payment, and it just credits the funds to the reserve deposit account of the seller's bank. Neither the seller, nor the seller's bank, necessarily wants to hold these funds. Both accept them because it is money--the generally accepted medium of exchange. They may well intend to spend the funds on something else.

Similarly, it is not necessary to "buy" reserve balances. Banks receive them constantly as checks and electronic payments are received by their depositors. By simply refraining from spending them--that is, buying earning assets or making loans--reserve balances are accumulated.

Balances in reserve accounts at the Fed serve as both medium of account and medium of exchange, and nothing changes when the Fed pays interest, other than the demand to hold them. Higher interest results in higher demand. Lower interest results in lower demand. It is exactly like transactions accounts that firms and households keep at banks. Higher interest raises the demand, and lower interest lowers the demand. Still, they are money.

As for monetary theories of inflation, the interest rate paid on money, among other things, determines the real demand for money. If the nominal quantity of money doubles, then the result is an excess supply of money. As that money is spent, it raises the demands for various goods and resources. As the prices of goods and resources rise, the real quantity of money falls. Equilibrium returns when the real quantity of money has returned to the real demand for money.

In response to comments similar to those above, Sumner continued:

I have two points. First, bank reserves, especially excess reserves, aren’t really a medium of exchange. I will admit that there is a derived demand for RR as a result of the demand for checking balances. But the ER number is meaningless. The are just held as assets, like T-bills. the ERs aren’t circulating, and they aren’t even backing DDs.

I think this analysis is much too dependent on the existence of reserve requirements. What would happen if there were no reserve requirements? Since sweep accounts have allowed banks to report however many "DDs" they choose, I am not sure that reserve requirements mean anything today.

Regardless of regulations requiring banks to hold reserves, as explained above, reserves are media of exchange. They can be accumulated by spending less and can be spent into existence by the issuer.

Second, if interest is paid on money, the QTM breaks down. You can no
longer assume if M doubles, P doubles in the long run. Suppose the Fed doubled
M, but paid a higher interest rate on M than alternative assets, that would
actually be contractionary.

The interest rate the Fed pays on reserves (like the interest that banks pay on transactions deposits) simply impacts the real demand to hold money. Yes, if the Fed chooses to pay higher interest on reserves, this raises the real demand for reserves. If banks choose to pay higher interest on transactions accounts, then the real demand for transactions accounts will be higher.

The price level still adjusts so that real quantity of money adjusts to the real demand for money. It is still more or less true that doubling the quantity of money will double the price level. If the nominal quantity of base money doubles and the Fed decides at the same time to pay more interest on reserves (or any number of things happen that simultaneously impact the demand for money or the money supply process) then the price level will not double.

Yes, in a sense you are right, the ERs can be costly converted into a medium of exchange (currency or DDs). But my point wasn’t technical, it was that it’s as if they were like T-bills. If you pay interest on them at a rate higher than on 3 month T-bills, then they don’t have the normal inflationary impact predicted in models. And that’s even true in the long run. Suppose in five years the T-bill yield is 4.5%, but reserves earn 5%; banks will still be hoarding ERs. There are other countries that run monetary policy this way, and they don’t have high inflation.

Private firms, other than banks, and households cannot hold reserve balances at the Fed. So, reserve balances directly serve as medium of exchange only for banks. Even so, payments with transactions accounts involve promises by the firm or household to have their agents, their banks, make payments with reserve balances at the Fed. There is a intimate relationship between the vast majority of payments and the payments banks make with their reserve balances.

If the Fed changes the interest rate it pays on reserves, this will impact the real demand for reserves. Like anything else that impacts the real demand for money, this will impact the equilibrium price level consistent with any nominal quantity of money. I am very uncomfortable with talk about "hoarding ERs." Banks choose to hold reserves. The Fed's responsibility should be to meet that demand for reserves so that nominal expenditure remains on target.

Like Sumner, I think that the Fed's interest rate policy regarding reserves has been a horrible mistake. However, I have no problem with the Fed "paying" interest on reserves. It is just that the appropriate interest rate in October of 2008 was slightly less than zero. I think the most sensible policy is to peg the interest rate on reserves at about 25 basis points below the 4 week T-bill yield.

Also like Sumner, I think that the Fed should keep nominal expenditure on a stable growth path. Paying interest on reserves impacts the nominal quantity of money that the Fed must create to meet that target. Oddly enough, under current circumstances, when a reasonable interest rate on reserves would be slightly less than zero, the quantity of base money and reserves that the Fed needs to create is a bit less than it would be if the interest rate on reserves were fixed at zero. Unfortunately, because the Fed insists on maintaining an interest rate on reserves above the T-bill rate, the quantity of base money it needs to create is larger now than it would be if the interest rate of reserves remained fixed at zero.