Do monetary frictions matter?

In some cases, maybe. But not in understanding the effect of conventional monetary policy, at least to any significant degree.

First things first: To be clear about these issues, we need to be specific about the type of “money” and “frictions” we’re discussing. There are, after all, many assets that are sometimes labeled “money”. First, there’s “base money”, the paper currency and electronic reserves issued by the Fed. Then there are all the different kinds of “money” created by banks, both traditional and shadow: transactions accounts, saving accounts, money market funds, repo, and so on. And if that’s not enough, the Treasury creates “money” too: Treasury Bills are so liquid and bereft of nominal risk that they’re essentially as good as bank money. (Often they’re held in money market funds, which add an additional layer of convenience, but Treasury does all the heavy lifting in creating short-term liquidity.)

When all these assets are given the blanket title of “money”, you can’t have any sensible discussion. The properties distinguishing $1000 in cash from $1000 in a money market fund are very different from the properties that, in turn, distinguish $1000 in the money market fund from $1000 in an S&P index fund. So let’s confine our discussion to the narrowest possible definition of money: currency and reserves issued by the Fed.

Does this restrict us to some kind of meaningless special case? Not at all. In normal times, the Fed implements monetary policy by adjusting the federal funds rate (and its expected path). This is the spread between the interest rate on currency (zero) and loans in the federal funds market—in addition to T-bills, commercial paper, and many other assets that end up with essentially the same rate. In other words, it’s the spread between base money and a much broader set of money-like instruments. If monetary frictions matter in understanding the impact of a certain shift in the federal funds rate, their effect must boil down to the difference between base money and “money” more broadly. Base money must be useful in addressing monetary frictions in a way that “money” in general is not, and this usefulness must have nontrivial macroeconomic consequences.

Does it? I find that exceedingly hard to believe. Paper currency, which in normal times comprises the vast majority of base money, simply isn’t that important to the macroeconomy—at least not at the current margin. (Quick question: can you think of any cash transactions you would stop making if interest rates went up to 4%, which makes you lose $4 a year for every $100 in your pocket? I didn’t think so. Even harder question: are there any transactions you would stop making, period, because of this cost—rather than simply shifting to some non-cash form of payment? Again, I didn’t think so.)

That leaves us with reserves. Before the crisis made reserves costless, required reserves amounted to about $40 billion—that’s 10% of the roughly $400 billion in checking accounts subject to the requirement. That’s compared to $150 trillion in total financial assets—or, if we want to avoid double-counting, $50 trillion in financial assets held by households. The impact of a 1% increase in the federal funds rate is to increase the implicit cost of holding those reserves by 1%—that’s $400 million. But to a first approximation, the 1% increase also changes the expected rate of return on all financial assets by 1%. If we use the household total of $50 trillion, that’s a $500 billion effect. The direct effect of interest rates is over a thousand times as large as the secondary effect of making checking accounts more expensive. In other words, the effect where monetary frictions come into play—because a certain kind of money is made more expensive—is vanishingly small in comparison to the standard effect in New Keynesian models. And if the Fed sets the federal funds rate using interest on reserves,  the former effect disappears entirely.

If this isn’t enough to convince you, consider the following: the role of monetary frictions is key to understanding what matters in monetary policy. Scott Sumner and other market monetarists doggedly insist that the true stance of monetary policy is determined by the expected future path of nominal variables, not just whatever the interest rate or monetary base happens to be today. I completely agree! We use different languages—I think that it’s better to talk about expectations in terms of interest rate rules, while they like to talk about nominal GDP and quantities of money—but we share the fundamental understanding that expectations are more important than current levels.

If you think that frictions are essential to understanding the effects of monetary policy, on the other hand, you have to think that the present matters much more. Why? The extent to which frictions are a tax on economic activity is determined by the current cost of holding money rather than less liquid assets. (After all, if money pays as much as all other assets for the next few weeks, you can hold all your wealth as money, and frictions won’t be much of a problem in the near-term!)  Yes, it’s possible that the future trajectory of monetary policy will affect your capital investment decisions—if extreme frictions in 5 years will make it difficult to sell your products, you won’t want to build the factory today—but the current cost of money (and therefore the current burden of frictions) has a vastly disproportionate influence on your actions.

This result pops out of virtually any model where there is no nominal rigidity and the only impact of money comes through frictions. For instance, if you parse Proposition 2 in Chari, Christiano, and Kehoe 1991, you’ll see that the proof for optimality of the Friedman Rule comes entirely through static considerations—setting R=1 so that a certain first-order condition is satisfied at each point in time. Admittedly, if you’re deviating from this “optimum” and setting R > 1, the future trajectory of policy matters, but in strange ways that don’t do a very good job of matching intuition: tight monetary policy in the future depresses capital investment today, yet all else equal it actually increases current consumption. (Tight future policy makes investing in capital less worthwhile, so you choose to consume more today instead.) I don’t think this is what market monetarists have in mind, to say the least.

Bottom line: if you say that expectations rather than current levels matter in monetary policy, you can’t think that monetary frictions are very important. This isn’t an argument against monetary frictions, of course—the model should drive policy conclusions, not the other way around—but it is a useful check for mental consistency.

To a large extent, I think this issue is confusing because under conventional policy, monetary frictions must matter to some degree—otherwise, the Fed couldn’t convince anyone to earn a lesser rate on money than other assets, and it wouldn’t be able to manage interest rates using open-market operations. But “some degree” can be extremely small in practice, and the details of how the Fed manages rates aren’t necessarily relevant to the effects of those rates, in much the same way that the mechanics of your gas pedal are peripheral to the consequences of driving quickly. Meanwhile, the Fed can implement policy when there are no frictions at all. Even when the market is saturated with money, it can set rates by adjusting interest on reserves. (In fact, it’s doing that right now.)

All in all, I see very little practical role for monetary frictions in understanding the impact of conventional monetary policy. The slight changes in cost of holding paper currency or maintaining a checking account simply don’t have serious macroeconomic consequences. The notion that we need a comprehensive model of these frictions to understand monetary policy is the kind of idea that’s plausible in theory but dead wrong in practice—just like the Friedman rule.

(Unconventional policy like QE is a different story, but let’s save that for another post.)

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12 Comments

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12 responses to “Do monetary frictions matter?

  1. JKH

    This is a very sensible, practical interpretation of how the monetary system works. You’ve looked at the numbers. In fact, you’re closer to how the MMT group analyses monetary system mechanics than you may want to believe.

    • wh10

      My thoughts exactly, and this is quite often the case here at mattrognlie.com. Hope you don’t mind us saying so, Matt :).

    • Thanks to both of you for the kind words! They are much appreciated, and I’m glad you liked the post.

      • Matt,

        While I agree entirely with the content of the post, I don’t think you want to be too close to MMT and in fact you aren’t.

        MMT, or at least Scott Fulwiler’s take on it, completely denies any effect of interest rates on economic activity. Obviously that is not at all consistent with your point in this post.

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  3. JKH

    A key point of the post as I read it is that monetary policy today is implemented by the pervasive dissemination of an originating interest rate effect, rather than a quantity of “money” effect. I think that description is consistent with how MMT (including Scott Fullwiler) analyzes the nature of today’s monetary system.

    An MMT view beyond that is that monetary policy as implemented today is not particularly effective. E.g. the aggregate demand effect of interest rate adjustment is ambiguous in their view – lower interest rates diminish the income on “net financial assets” held by non government, and are not necessarily stimulative for that reason. But that is a view of policy effectiveness, rather than policy mechanics. And it is for that reason that MMT moves on to fiscal/monetary policy fusion through such proposals as permanently zero interest rates combined with taxation as a key lever for aggregate demand management. There I would expect considerable difference between your views and theirs.

  4. Good post as always, Matt.

    But the thought that comes to my mind is: if monetary frictions didn’t matter, the unemployed would just barter their way back to full employment.

    And I need to reconcile my intuition with yours.

    • Good objection.

      I suspect that we’re thinking about different concepts when we discuss “monetary frictions”. As I understand it, your point here is that in a world without “monetary frictions”, markets would be cleared by some kind of barter system or Walrasian auctioneer, and it would be impossible to have the gains left on the table that we see in a New Keynesian model. I agree from a theoretical perspective. I think, however, that this case is so unrealistic that we don’t need to spend much time contemplating it when thinking about optimal policy: there is simply no way that barter will ever be practical for the vast majority of activity taking place in a modern economy.

      In thinking about monetary policy, I take for granted the fact that we will not have direct exchanges of goods and services, and that instead goods and services will be traded for financial assets. Some assets will be more liquid and more useful in transactions than others; the more such assets that people have, the less relevant monetary frictions will be. Portfolio allocation between liquid, money-like assets and other assets will be determined by the yield spread between the two. If the marginal cost of foregone yield needed to obtain liquid assets and overcome monetary frictions is low, I say that “monetary frictions” don’t matter very much–because in virtually any model, they will not be substantially distorting real decisions (relative to plausible alternative scenarios; not barter).

      Let me illustrate this way of thinking with an example. Imagine a world where everyone holds virtually all their wealth in an optimal, diversified portfolio of equities, bonds, etc., with all the risk-return characteristics that finance professors dream about. When someone needs to spend money, he swipes his credit card or writes a check and, bam, part of his optimal portfolio is liquidated costlessly and the proceeds are transferred to the seller, who immediately (and costlessly) enlarges his optimally balanced portfolio. In this world, all assets are liquid, and there is very little need for “money” of any kind—at most, there is an extremely small demand for clearing balances at the Fed for the rare transactions that can’t be netted out at the bank level or cleared with some alternative asset. To me, this seems like the ultimate example of a world where “monetary frictions” are virtually irrelevant.

      Yet according to your way of thinking, monetary frictions would still be deeply important here, since a New Keynesian recession can still emerge—after all, pure barter is still not possible. There’s nothing conceptually wrong with this, but I don’t think it’s a very policy-relevant way of thinking about the importance of monetary frictions, which will always be pretty much equally “important” in this view as long as barter does not prevail. (which is to say always)

  5. Nick Rowe

    Thanks Matt. I only just found this today.
    (K: maybe I’m still thinking ;) )
    In the world you just described, I would be tempted to say that all (financial) assets have become monetised. It’s like I have a demand deposit (nearly) as big as my portfolio.

    (I added the word “nearly” because you would need some margin for error in case the stock market crashed before your cheque cleared).

    In my vision, there’s a whole spectrum of assets, from the least liquid at one end, to the most liquid at the other. But there’s something very special about the asset at the most liquid end of the spectrum. It’s sort of a “winner takes all” game, where the winner in the liquidity race becomes the medium of exchange, and all other assets, even the ones nearly as liquid, are traded via the medium of exchange.

    I’m still thinking about this.

  6. K

    Nick: I’m glad you said that because it’s something you’ve said before and it only later occurred to me that you are making a mistake. If I take a loan at the risk free rate against all my capital assets and hold that money at zero interest, I’m losing the risk free rate on the value of my assets. That’s why in the ideal world that Matt describes you don’t have to hold any money. What we want is a world of instant 24/7 settlements for both goods and securities. Then there’d be no money. And we’d all be happy.

  7. K

    Nick: Or maybe I don’t understand what you mean by “monetized”. But I assume you mean that we’d have a lot of non-interest bearing money around, which I think is exactly wrong. We’d have none. If you merely mean that all our liquid capital assets would serve the role of the medium of exchange I’d agree. But it would be interest bearing and there’d be no role for LM in determining equilibrium.

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