Monetary Policy in a World Without Money

Against fears that electronic money will erode central banks’ monopoly over a monetary base and so undermine their power to control inflation, Woodford argues that monetary policy works through control of a short-term nominal interest rate, not through a stable link between the size of the monetary base and nominal spending, and that even a complete disappearance of demand for central-bank money would leave interest-rate control – and hence price-level control – intact, especially under the “channel” systems already used in Canada, Australia and New Zealand. Responding directly to alarmed essays by Benjamin Friedman and Mervyn King about the “New Economy” threat to central banking, Woodford identifies three misconceptions in the conventional quantity-theoretic worry: that monetary control requires a stable relationship between the monetary base and nominal spending, that the transactional use of currency is essential to the transmission mechanism, and that a central bank must be able to ration bank reserves (creating a scarcity-driven interest-rate spread) in order to move interest rates. Drawing on the theoretical “cashless limit” of his own earlier work, Woodford shows that as the demand for base money used in transactions shrinks toward zero, the price-level path implied by a given interest-rate policy is essentially unaffected, so long as the central bank retains some ability to vary the spread between the return on base money and other assets; and he shows that even where that ability itself might be lost, a central bank can still control short-term rates directly by varying the interest paid on its own liabilities – a method already implemented in the “channel” or “corridor” systems used by Canada, Australia, and New Zealand, in which standing lending and deposit facilities bracket a target rate so tightly that only trivial quantities of reserves need change hands. Only in the extreme and, in his view, implausible case of a “fully frictionless economy” in which demand for every component of the monetary base collapses to exactly zero at any positive interest-rate differential would today’s methods genuinely fail – and even there, Woodford argues, the central bank’s continuing role in defining the unit of account used in contracts would preserve its influence over the exchange value of its currency, so long as anyone continues to contract in it.

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Monetary Policy in a World Without Money