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Interest Rates and Money Growth; Two Types of Central Bank

Summary:
I want to imagine two different types of central bank. The first type of central bank cuts nominal interest rates to increase money growth. The second type of central bank raises nominal interest rates to increase money growth. In both cases the increase in money growth causes Aggregate Demand to start growing, and eventually causes the inflation rate to rise. But the initial change in interest rates is the opposite in the two cases. Here is a simple example of the first type of central bank. It issues currency which pays the holder 0% nominal interest. It sets a rate of interest at which it will freely lend that currency to all (safe) borrowers. If it wants to increase money growth, it cuts that rate of interest, so people borrow more currency from the central bank. Here is a simple

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I want to imagine two different types of central bank. The first type of central bank cuts nominal interest rates to increase money growth. The second type of central bank raises nominal interest rates to increase money growth. In both cases the increase in money growth causes Aggregate Demand to start growing, and eventually causes the inflation rate to rise. But the initial change in interest rates is the opposite in the two cases.

Here is a simple example of the first type of central bank. It issues currency which pays the holder 0% nominal interest. It sets a rate of interest at which it will freely lend that currency to all (safe) borrowers. If it wants to increase money growth, it cuts that rate of interest, so people borrow more currency from the central bank.

Here is a simple example of the second type of central bank. It issues demand deposits (chequing accounts) which pay a rate of interest set by the central bank. The stock of money in those chequing accounts grows at that rate of interest, so if it wants to increase money growth it raises that rate of interest.

Eventually, of course, the first type of central bank will need to raise nominal interest rates, above where they were initially, to match the higher inflation rate, to restore real interest rates to where they were initially, to prevent money growth and inflation spiralling ever-upwards. (The second type of central bank doesn't need to worry abut that.) So they end up in the same place eventually. But the way they get there is very different.

I think that most macroeconomists have something like my simple example of the first type of central bank at the back of their minds. I am unsure what Neo-Fisherians have at the back of their minds, but if it were something like my simple example of the second type of central bank, that would make sense of what they say.

Simple New Keynesian models assume the central bank sets a rate of interest, but are silent on money growth. Or, if they do add a money demand equation, this extra equation has no effect on the rest of the model. Which means that New Keynesian models are ambiguous between an orthodox and Neo-Fisherian interpretation.

Real world central banks are more complicated than either of my two simple examples, but contain elements of both.

The lesson I want you to draw from this post is that thinking of central banks setting a rate of interest and that rate of interest affecting desired investment and desired saving is a very inadequate way of thinking about monetary policy. A better way to think about monetary policy is to think of central banks setting a rate of interest in order to influence money growth. The exact mechanism by which central banks use an administered interest rate to influence money growth can vary, and even the direction of that effect can vary too. The rate of interest set by the central bank matters because, and only because: it affects money growth; it may affect the spread between the interest rate paid on money (if any) and the interest rate (or yield) of other assets, because the velocity of circulation of money will be a positive function of that spread. MV=PT.