This archived content originally appeared at, the predecessor site to, and does not carry the sponsorship of the Cato Institute.

What’s old, continued: the New Monetary Economics

At Marginal Revolution, Tyler Cowen has a post on the New Monetary Economics. He says,

If you’re looking for a definition of the NME, I would say it is the study of unusual monetary arrangements involving either explicit prices for monetary media of exchange (i.e., separating money’s medium of exchange function from its medium of account function), and/or paying interest on currency or bank reserves held at the Fed.

If you are ever tempted to call something “the New X,” remember that eventually it will cease to be new. The New Monetary Economics now qualifies under “what’s old,” as I defined it in an earlier post, that is, something those who are interested in the subject have known about for at least 15 years.

Work on free banking since Lawrence H. White’s Free Banking in Britain (first edition 1984) has been strongly influenced by historical cases of the system, in which the three textbook functions of money as medium of exchange, unit of account, and store of value have been combined into one. As White discussed in another 1984 publication (“Competitive Payments Systems and the Unit of Account” – JSTOR, requires subscription), the combination is quite powerful and durable. That is why, to my knowledge, all historical cases sometimes adduced as being examples of what the New Monetary Economics talks about have been at the edge of conventional finance — LETS (local exchange trading systems) and the like — rather than at the center, like the commercial banks in historical free banking systems.

Even so, the New Monetary Economics helps to imagine one possible path for the future. Several economists, including Kevin Dowd, Tyler Cowen, Randall Kroszner, and Leland Yeager, have contributed both to it and to research on free banking.

Cowen mentions, without endorsing it, the idea of the late Fischer Black that paying interest on deposit reserves that commercial banks hold at the Fed could cause the Fed to lose control of the price level. I fail to see why; the Fed could always switch from paying interest to charging a fee (negative interest), as Sweden's central bank did in 2009-10.


  1. Suppose the Fed did pay interest on reserves. Assume the Fed has issued $300 of reserves, against which it holds 100 oz of silver plus bonds worth 200 oz. (yielding the assumed market interest rate of 6%). At the start of the year, each dollar would be worth 300 oz/$300=1 oz./$. If the Fed pays 4% on reserves, then at the end of the year it will receive 12 oz. of interest on its bonds, which it would pay to the holders of its reserves. The Fed once again has total assets of 300 oz backing total liabilities of $300, and the price level remains at 1 oz./$. Paying interest does not cause the fed to lose control of the price level.

  2. Kurt:

    If you recollect, Cowen's (and Krozner's) contributions–abstract units of account, were pretty idiosyncratic.

    I have no difficulty imagining the end of hand-to-hand currency and the replacement with electronic signals. Even so, I find it difficult to conceive of an organized payments system using either paper or electronic checks to be anything other than monetary. You are earning $1000 a week in wages and spending $75 dollars for groceries. You aren't bartering labor for the particular assets in some security account and then bartering those securities for groceries.

    How do people obtain these securities? Buy them? At what price?

    That isn't to say that such systems are impossible or undesirable. It is just that they are monetary orders with all of the benefits and problems.

    Black had some interesting scenarios, particularly the one where a credit/debit card is provided to everyone and receipts increase balances and expenditures decrease them. Interest is paid on postivie balances and interst charged to negative balances. At first pass, he considered the scenario where negative balacnes are the sole source of finance. And postive balances would be the sole avenue for saving (other than direct real investment, I guess.)

    Personally, I don't find this kind of system particularly puzzling. That Black did always suggested something about Black's understanding of basic monetary economics. With interest rate targeting, the price level is indeterminant. And if the interest rates are wrong, there is a Wicksellian cumulative process. The sum of the positive balances is the quantity of money. Controlling it is inconsistent with letting people run up credit card bills as they will at a given interest rate. But if you do control it, the price level is determinant.

    Anyway, as interesting as those scenarios are, paying interest on central bank reserves is a far cry. The real demand for reserves is negatively related to the interest rate paid. Given that real demand, and the nominal quantity for base money, the price level adjusts to bring the real quantity into equilibrium with the demand. What view of monetary economics causes someone to be puzzled by the implication that a given nominal quantity of base money is consistent with a variety of different price levels–if different interest rates are paid on reserve balances?

    The "problem" with paying flexible market interest rates on reserves (and other money) is with interest rate targeting, not price level determinacy.

    Finally, Cowen is correct that Sumner's index futures targeting does have at least some roots in the "new" monetary economics. Of course, schemes that combine index futures convertibility with free banking (like what Dowd has sometimes proposed) are very close.

Comments are closed.