Base money is just as special as it ever was. Technology changes and post-crisis monetary policy are making financial assets and money indistinguishable. Central banks now need to work in partnership with fiscal authorities. Several economists at the Lindau meeting were severely critical of central banks’ conduct of monetary policy in the light of continuing depression in the US, Japan and much of Europe, and called for greater use of fiscal policy to bring about recovery.
Among the most critical was Christopher Sims, who gave a trenchant presentation on “Inflation, Fear of Inflation and Public Debt”. He started by announcing the death of the quantity theory of money, MV=PY. Due to interest on reserves and near-zero interest rates, “money” can no longer be clearly distinguished from other financial assets. This is a fundamental point which requires some explanation. These days, nearly all forms of money bear interest, which makes them indistinguishable from interest-bearing assets. For Sims, the paying of interest on bank reserves, coupled with the decline of physical currency, all but eliminates the distinction between interest-bearing safe assets such as Treasury bills and what we traditionally call “money”.
All assets can be regarded as “money” to a greater or lesser extent: the extent to which assets have “moneyness” is really a matter of liquidity. Sometimes words can get in the way of meaning. There is no point in arguing about what the term “money” really means, it obviously means different things to different people. But the term “base money” still has a pretty clear meaning; currency in circulation and bank deposits at the Fed. The Fed happens to have a complete monopoly on the (US$) monetary base. Prior to 2008 it could determine the supply of base money through OMOs and discount loans, and it could influence the demand for base money through changes in reserve requirements.
After 2008, a 4th tool was added—interest on reserves, which also impacts the demand for base money. With these four tools the Fed can push the value of the dollar (in terms of euros) to anywhere between zero and infinity. That’s a lot of power. Nothing fundamental has changed, at least nothing relating to the validity of the quantity theory of money. A few other points:
1. The quantity theory of money has NOTHING to do with the equation of exchange. That equation is best viewed as a definition of velocity, nothing more. Definitions are not theories.
2. Currency is not “declining.” The currency stock is growing faster than GDP. It is also becoming a steadily larger share of the monetary aggregates
