Central banks pursue a policy of money neutrality. Except when they are seeking a monetary policy to steer the economy. Money neutrality means money has no impact on the workings of supply and demand in the real sector. That is, money is just a veil or a cloak. Money’s influence and function are to serve as a medium of exchange to calculate and facilitate natural market prices and forces.
The way central banks pursue their stated goal of money neutrality is to harmonize the Fed Fund’s rate with the Natural rate of interest. Let us say for simplicity the Natural Rate is the rate of interest, which brings savings and investment in equilibrium ex-ante (it is always in balance ex-post).
However, it is not that simple. When you are referring to a large aggregate macroeconomy, it is not simply setting the market rate equal to the natural rate of interest. Here is why.
Money cannot be Neutral
The following are a summary of arguments of why money can not be neutral. To date there is no central banker or academic that can refute this in its totality. The reason we have a central bank is political rather than having a positive effect on the macro economy.
1. How you define the natural Rate of interest
Definitions of the natural rate vary and how you define it will change your model. For example, in natura marginal productivity on real mobile capital, price stability, I=S ex-ante also modern interpretations such as Woodford’s past, present and future flexible prices in contrast to the world of rigidities, Austrian time preference theory of interest. If you can not define it how can you target it?
Three posts on the natural rate of interest:
- Natural rate of interest in a barter economy
- Natural rate of interest I=S
- Natural rate of interest based on price stability
2. Empirical estimates are problematic
There exists multiple models and estimates, Holston-Laubach-Williams, and other competing models. Each one has a claim to a number, what the rate is at a point in time. How can they all be right? If you steer a ship and you are off a few degrees you will end up somewhere else dending on your model’s output.
However, more important a neutral rate of interest is paradoxically impossibility because of money’s influence is ubiquitous., on par with traveling faster than the speed of light.
Money is about real markets and real market prices than empirics. Money and real factors are intertwined so you can not have money neutrality or estimate this empirically. The natural rate is in a very real sense and fairy-tale. Therefore, estimates are not meaningful.
Econometrically it is challenging to estimate the natural rate of interest. It is beyond the scope of this post. However, Central banks believe that with the right formula’s and complicated equations, R-Star is a reasonably accurate measure of the natural rate of interest. I am skeptical for reasons laid out here: R-Star.
Therefore they target something that does not exist, except for at universities on backboards and books that win awards . However, and equilibrium rate of interest is not something in the world of real markets.
3. Multiple rates of interest
However, even if Central banks could estimate the natural rate of interest, there is the problem of the existence of multiple natural rates of interest. Again that is not within the scope of this discussion. (Pierro Straffa, 1932). Here is a further discussion on:
4. Interventions create a feedback loop
Each intervention creates an imbalance in a dynamic economy. Money/purchasing power enters the macro-economy in a specific path, which distorts the market and creates feedback.
Frequently interventions create a more complicated situation with estimating a neutral rate of interest. Even if they could pinpoint a rate that brings neutrality, they still have to maintain it and it is a moving target.
Interest is not neutral buoyancy like a bubble in a quiet pool of water but rather in a dynamic economy that has forces that go up or down simultaneously and instantly and simply trying to move the water influences the bubbles path. This is not neutrality.
Money is not injected to everyone equality
When money is pumped through the system it is not injected equality. Rather, there are first and last receivers.
Therefore, the point that I want to focus on is that money cannot be neutral because when the central bank decides it needs to expand or contract money or purchasing power in the economy, it does not do this by dropping money on people’s doorsteps by helicopters, or in modern speak drones.
Instead, monetary expansion occurs via the banking system. The central bank in the United States pumps money by lowing the Fed Funds rate (hypothetically in relation to the natural rate of interest).
The Fed Funds interest rate which banks lend reserve balances to each other overnight. This seems like a convoluted way to control the supply of purchasing power, however, it effectively increases or decreases the amount of purchasing power in circulation.
The issue here is the opportunity cost of holding money is different for those who are rich and those who are poor. The rich benefit first, as well as those closer to the money expansion process.
Time preference theory of interest
The time preference theory of interest states that the opportunity cost of saving money is lower for the wealthy. This is because they can make their monthly payments easier than those living on a minimal income. To save money for a poorer person is a much more difficult task.
Therefore, first receivers have more money and their time preference will be lower.
The last receivers or no receivers become poorer. The opportunity cost for them is higher.
This is a transfer of wealth, a wealth redistribution. This is not a neutral policy.
Therefore, if you inject money there will be winners and losers. This again is not a neutral rate policy.
If rates go up the first recipients will lose money and there will be a business cycle.
Any policy is not neutral as it involves a redistribution of wealth.
Therefore, the only way you can have a neutral money policy is if you have free markets.
Historical context of money neutrality
The conversation in modern thought originates with David Hume, but became predominate after Knut Wicksell’s work Interest and Price (1898), and Mises’s Money and Credit (1912) development of his theories. Hayek and Keynes discussed and further popularized the economic concept. Robert Lucas also had a discussion but within the context of the Phillips curve. Michael Woodford, does not discuss it in his 800 page book on Interest and Prices (2003) but rather he assumes it with his flexible price equilibrium. The Federal Reserve combines this with their FRB/US econometric model and the Taylor rule .
It is only the Austrian economists of today that directly and repeatedly challenge this concept, such as Murry Rothbard, Frank Shostak, Robert Murphy, William Butos, Steven Horowitz or Lawrence White.
Free banking is the only money neutrality
That is free banking where supply and demand for purchasing power are determined by the market rather than by a central authority. Here is a discussion on:
Can money be neutral? Not with the existence of the Federal Reserve. Central banks exacerbate the trade cycle by insuring the money is not neutral in the short or long run. In contrast, a free market combined with free banking which allows for the organic nature of money to evolve and operate can be neutral. A classic gold standard is a close proxy also but free banking is almost synonymous with neutral money. With this the economy would have a high growth path, lessen the Gini coefficient and have a money macro equilibrium path.