Monetary Policy in a World Without Money

Benjamin Friedman’s (1999) widely discussed essay argued it is puzzling that central banks control spending in large economies by controlling a monetary base that is tiny relative to those economies, and that advances in information technology will accelerate an already-decades-long erosion of the role of base money in transactions, leaving the central bank of the future “an army with only a signal corps” – able to signal desired policy but not enforce it. Mervyn King (1999) offered “an even more radical view,” proposing that the twentieth century was “the golden age of central banking” and that electronic money could eliminate central banks’ monopoly position as suppliers of means of payment (Introduction, pp. 1-2). Woodford states plainly that he will argue these concerns “are exaggerated,” not because the underlying technological change is unlikely, but “on the ground that even such radical changes…are unlikely to interfere with the conduct of monetary policy” (p. 5).

“A failure to recognize that a central bank only needs to be able to control the level of short-term nominal interest rates to achieve its stabilization goals” – in practice, an operating target for an overnight interbank rate, which then affects other short-term rates, longer-term rates, and exchange rates, which in turn determine spending and pricing decisions (“Will Money Disappear, and Does it Matter?” section, p. 6). Critically, “there need not be a stable relation between this overnight interest rate and the size of the monetary base in order for the central bank to effectively control overnight interest rates” – innovations in payment technology might complicate the quantity-targeting technique some central banks use to hit their interest-rate target, but that is a technical implementation problem, not a loss of the underlying capacity to control rates.

The assumption “that the use of currency for retail transactions is important for the monetary transmission mechanism.” Woodford notes that while currency demand is indeed the largest component of private-sector demand for the monetary base today, “a large monetary base is in no way essential for effective central-bank control of short-term interest rates,” because the rate a central bank actually targets is determined in the interbank market for bank reserves, and currency demand affects that market only insofar as it affects the supply of reserves – a “relatively minor complication” that an offsetting open-market operation handles. Indeed, “the complete elimination of the use of currency in minor transactions would only make monetary control under current operating procedures easier” (pp. 6-7).

The assumption that to tighten policy the central bank must ration bank reserves, making them scarce enough that the opportunity cost of holding them rises – which “requires a sort of monopoly power on the part of the central bank,” a power that innovations in payment technology might seem to threaten (p. 7). Woodford counters that this conventional method implicitly assumes a zero interest rate on reserves; several countries already raise and lower the interbank rate and the rate paid on reserves “in tandem,” without varying the spread between them at all, so their method of control “does not depend upon bank reserves fulfilling a unique function that gives the central bank monopoly power” (p. 8).

Drawing on Woodford (1998), the paper models an economy with “cash goods” (requiring base money to purchase) and “credit goods” (not requiring it, following Lucas and Stokey 1987); because zero interest on base money makes holding it costly, households substitute toward credit goods, but for any finite interest rate a positive demand for cash goods – and hence base money – always remains, “no matter how small the number of goods that are ‘cash goods’” (“Interest-Rate Control with Zero Interest on Bank Reserves” section). More importantly, Woodford shows the model has a well-defined “cashless limit”: the equilibrium price-level path as a function of the economy’s disturbances “is virtually the same in all cases in which the number of ‘cash’ goods is sufficiently small,” because what matters for the transmission mechanism is how the marginal utility of expenditure varies with real expenditure, a relation that becomes essentially independent of the level of real money balances near this limit. Central banks in this regime still face the genuine, but familiar, judgment problem of tracking the Wicksellian “natural rate of interest” – a difficulty, Woodford stresses, “made no more difficult by the substitution of electronic means of payment for payments using central-bank money.”

Woodford considers a demand schedule for the monetary base that hits exactly zero at some finite interest-rate spread (rather than merely becoming very small), following Bengtsson (2000) and McCallum (2000)’s observation that in a “fully frictionless economy” the earlier cashless-limit method of control would become inapplicable (“Interest-Rate Control without Control of a Rate Spread” section). But he argues this still does not make the central bank powerless: it retains “another instrument,” varying the (potentially non-zero, time-varying) interest rate paid on its own liabilities directly, since “the choice of the nominal rate of interest upon central-bank liabilities is an arbitrary choice of the central bank’s.” This instrument is redundant under current arrangements (where control of the spread already works) but becomes the crucial tool if spread-control is ever lost.

Under a channel system, the central bank sets a target overnight rate (New Zealand’s “Official Cash Rate”) and brackets it with two standing facilities: a lending facility at a fixed rate slightly above target (New Zealand’s Overnight Repo Facility rate, 25 basis points above the OCR) and a deposit facility slightly below target (the “Settlement Cash Rate,” 25 basis points below) (“Interest-Rate Control without Control of a Rate Spread” section, describing the system in place at the Reserve Bank of New Zealand since March 1999). Because both facilities are standing (available on demand, unlike the Fed’s discretionary discount window), “no bank has any reason to pay another bank a higher rate for overnight cash than the rate at which it could borrow from the central bank,” nor to lend below the deposit rate, so market rates stay pinned inside the channel; critically, “the central bank can control overnight interest rates without having to engage in large transactions volumes itself,” since banks’ willingness to use the standing facilities in large volume “largely eliminates any need for it to do so” (citing Brookes and Hampton 2000). Woodford treats the settlement-cash target under such systems as able to be “very small relative to the size of daily transactions flows” and largely unchanged day to day, in sharp contrast to the U.S. Federal Reserve’s reliance on actively adjusting non-borrowed reserves.

Woodford notes that once required reserves are eliminated, aggregate settlement cash held by banks “can vary sharply over short periods of time, in the absence of any notable changes in interest rates,” with New Zealand’s settlement cash briefly spiking to “as much as 50 times the normal level” during two episodes within a year (Y2K-related liquidity demand), even while the overnight rate stayed extremely stable (footnote, “Interest-Rate Control with Zero Interest on Bank Reserves” section). This is offered as direct empirical evidence that a highly unstable or unpredictable demand for the monetary base – exactly the sort of instability electronic-money critics worried new payment technologies would produce – need not translate into interest-rate volatility, provided the central bank uses a channel system rather than a pure quantity target for reserves; Woodford calls the reduction of overnight-rate volatility relative to quantity-targeting “one of [the channel system’s] more obvious advantages.”

He allows, following Hayek (1986), the possibility of “a future in which private entities manage competing monetary standards in terms of which people might choose to contract.” Even in such a world, Woodford argues, “the Fed would still be able to control the exchange value of the U.S. dollar…by adjusting the nominal interest rates paid on the respective central banks’ liabilities” (concluding section). The only genuine open question in that scenario is not whether central banks retain the technical capacity to control the value of their own currency, but “how much the central banks’ monetary policies would matter” – that is, how many people would still choose to contract in a currency the central bank continues to be fully able to control the value of. Woodford’s conclusion is that “central banks that demonstrate both the commitment and the skill required to maintain a stable value for their countries’ currencies should continue to have an important role to serve in the century to come.”

His conclusion is unambiguous: “there is every reason to expect that in the coming century the role of central banks in the control of inflation will be essentially the same as it is now” (following the discussion of interest-rate control without a rate spread). He frames the countries already using channel systems (Canada, Australia, New Zealand) as a working proof of concept that interest-rate-based control does not depend on a large, stable, or even easily forecastable demand for the monetary base – so that “there is no reason to regulate the development of [new payment] means…in order to facilitate this aspect of monetary control.” The paper’s overall stance is that the “New Economy” threat to monetary policy is a misdiagnosis stemming from an outdated, quantity-theoretic model of how monetary policy actually transmits to the economy, not a genuine structural vulnerability.