Controlling price or quantity of money?

Central banks miss the old days when money supply used to be managed via the funding rate.

As financial crises become a routine of economies due to the piling interconnectedness amid actors, central banks will need prompt intervention tools.

Economic downturns necessitate central banks to improve quantity tools to promptly boost spending. The practices are still infant.

Monetary transmission mechanism

Until 2008, central banks determined the price of money, the interest rate, while exercising monetary policy. In 2008 and 2020, stuck at the zero lower bound, funding rates of central banks did not boost spending anymore. Instead, central banks employed a quantity tool, quantitative easing.

When the central bank funding rate cannot go way below zero, central banks aimed at lowering long-term interest rates by increasing the demand for long-term assets. For this purpose, they initially bought long-term treasury bonds. Once riskless asset yields approached zero, asset purchases slid to riskier assets. Quantitative easing thereby pushed central banks to perform the risk transformation function of banks. Such a risk transfer is not sustainable as total credit risk exceeds the loss absorption capacity of governments. This is also why governments insure deposits only up to a limit.

Central banks would happily return to their interest rate policies if there were enough room to pull funding rates down. A quantity tool would perform better than an unconstrained interest rate tool, though. Through asset purchases, a central bank can immediately raise the money supply whereas the interest rate tool requires a time taking transmission mechanism. Banks gradually adjust to an interest rate reduction of the central bank. A credit expansion due to a cheaper funding cost would take some time. In the mean time, job losses due to shrinking expenditures would exacerbate delinquencies and deter banks from a credit stimulus.

A second advantage of a quantity tool is its independence from banking decisions. Through asset purchases, central banks can boost money supply even though banks prefer shrinking credits. At the same time, quantity tools can enforce the expansion of money supply via banks. Macroprudential authorities can oblige banks to raise leverages during a recession. Such a practice would immediately yield fruit as opposed to the interest rate tool. Tomorrow, banks would raise credits to households and businesses.

Central banks miss the old days when money supply used to be managed via the funding rate. Nevertheless, crises compel them to improve quantity tools to boost spending. The practices are still infant. As financial crises become a routine of economies due to the piling interconnectedness amid actors, central banks will need prompter intervention tools. In this framework, targeted and pass-through tools will replace the clunky asset purchase programs.