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Cash and the Zero Lower Bound

March 22, 2017

This is the fourth (and, perhaps, final) post on Ken Rogoff’s The Curse of Cash. As summarized in an earlier post, Rogoff argues that the benefits of banning cash (e.g., preventing crime, enabling effective monetary policy) exceed the costs (e.g., a reduction in financial privacy). He does not attempt to estimate the benefits and costs of banning cash. Rather, Rogoff suggests that the benefits are so large (especially given the costs) that more precise estimates are unwarranted. My approach has been to argue that the supposed benefits are not as large as Rogoff suggests. In my last post, I considered the benefits of eliminating crime. In this post, I’ll look at the benefits of eliminating the zero lower bound.

Monetary Policy and the Zero Lower Bound

Rogoff offers a relatively simple model of monetary policy. In effect, he assumes that the monetary authority sets the interest rate. If the monetary authority believes the economy is producing too much, it raises interest rates to discourage consumption and investment. If the monetary authority believes the economy is producing too little, it lowers interest rates to encourage consumption and investment. According to Rogoff, the monetary authority can raise and lower interest rates as it sees fit in normal times. But, since individuals can exchange their deposits for cash, the monetary authority might not be able to lower rates enough to bring about the desired amount of consumption and investment when interest rates are sufficiently low (i.e., close to zero).

To illustrate, consider a case where interest rates are at zero and the monetary authority thinks the economy is producing too little. It would then like to lower rates into negative territory—effectively taxing those with money in the bank—to spur individuals to spend more money on consumption and investment. But negative rates would encourage individuals to convert deposit balances to cash. And, since no interest is paid (or, in this case, charged) on cash, the monetary authority would not be able to bring about its desired amount of consumption and investment. Or, so the argument goes.

Problems with Rogoff’s View of Monetary Policy

I have some serious concerns with Rogoff’s view of monetary policy. To be sure, Rogoff’s view is consistent with the standard New Keynesian model. But that model omits some important features of the real world. For example, the idea that the monetary authority has control of interest rates is not quite right. As regular readers of this blog know, the Federal Reserve does not set the federal funds rate, it targets it. Moreover, there are a host of other interest rates in the economy that the Fed has little control over. Therefore, it is probably more appropriate to think of the monetary authority as adjusting the supply of money in circulation—but money is conspicuously absent in the New Keynesian model.

There are also some problems with thinking in terms of interest rates more generally. Lowering interest rates could be expansionary, as Rogoff suggests. Or, it could be contractionary—indicating that the monetary authority is committed to keeping inflation low in the future by slowing the growth rate of money. It’s hard to tell which is which. Likewise, falling rates could indicate that the supply of loanable funds has increased—meaning more investment spending. Or, it could indicate that the demand for loanable funds has fallen—meaning less investment spending. For this reason, Scott Sumner quite sensibly advises against reasoning from a price change.

Are There Benefits of Banning Cash at the Zero Lower Bound?

The benefits of banning cash at the zero lower bound are only positive if the monetary authority is truly out of ammunition when interest rates enter negative territory and individuals move to cash. But that depends on a faulty view of monetary policy as controlling interest rates and working primarily through the interest rate channel.

I maintain that the monetary authority can generate greater spending on consumption and investment so long as it can increase the supply of highly liquid assets. Indeed, I would maintain that if the monetary authority were committed to adjusting the money supply to maintain a target path of nominal spending, we would be unlikely to get into a situation where the economy is producing too little. And, if the economy were producing too little, the most straightforward monetary policy response would be to purchase assets with newly created money to increase nominal spending.

Can the monetary authority purchase assets when interest rates are at or below the zero lower bound? Absolutely. Therefore, the zero lower bound does not prevent the monetary authority from conducting effective monetary policy.

Of course, if the zero lower bound does not prevent the monetary authority from conducting effective monetary policy, then there are no benefits to banning cash on those grounds. With or without cash, the monetary authority can conduct monetary policy appropriately—provided that it is not blinded by silly interest rate policies and, instead, focuses on targeting nominal spending.