7 - Central Banking and Monetary Policy

7
Central banking and

monetary policy
Louis-Philippe Rochon and Sergio Rossi
OVERVIEW
This chapter:
• explains the essential role of a central bank, which is the settlement

institution for banks that, together with the central bank, form a
banking system, that is, a system characterized by money homogeneity
and payment finality for all its members;
• shows that the central bank, like any bank, is both a money and a credit
provider, as it issues a means of final payment and provides credit to the
banking sector, which needs both to avoid financial crises;
• presents monetary policy strategies, instruments and transmission

mechanisms in an endogenous money framework, characterized by the
fact that money supply is credit-driven and demand-determined;
• argues that monetary policy goals should go beyond price stability, to

include also financial stability and macroeconomic stabilization, with
regard to both economic sustainability and employment levels.
These points are relevant to understanding the scope and limits of mone-
tary policy, and to critically discussing both contemporary monetary policies
and the regulatory reforms carried out at national and international levels
in the aftermath of the global financial crisis that erupted in 2007–08.
KEYWORDS
• Bubble: A steady increase in asset prices on financial and/or real estate

markets that cannot be explained by the economic performance of a
country, but results from some forms of speculation induced by banks’
behaviour in providing credit.
M4921-ROCHON & ROSSI (2nd edn)_Text.indd 200 25/02/2021 08:09

Central banking and monetary policy · 201
• Final payment: A payment as a result of which the payer settles their

debt against the payee, who has thereby no further claims on the payer.
This provides for monetary order and is a necessary, though not sufficient,
condition for financial stability.
• Monetary targeting: A monetary policy strategy targeting a publicly
announced rate of growth for a given monetary aggregate, in order to
make sure that the price level is stable over the long run.
• Money multiplier: The ratio between the total money supply and central
bank money, which orthodox economists believe exists due to their view
of the supposed exogenous supply of the monetary base.
• Quantitative easing: A monetary policy intervention whereby the
central bank buys a very large volume of financial assets (corporate bonds,
government bonds, and so on), in order to lower rates of interest and
thereby support economic growth.
• Taylor rule: A stylized rule that central banks might use when setting
their policy rates of interest, considering inflation and output gaps
according to their reaction function against the current or expected
macroeconomic situation.
Why are these topics important?

This chapter is important to understanding the role of the central bank in a
monetary economy of production as well as the scope and limits of monetary
policy-making in such a framework. The large majority of the academic litera-
ture and of monetary policy interventions fail to consider the particular nature
of money and the actual working of a monetary production economy, with the
result that not only are these interventions unable to deliver the results that are
expected, but they may also in fact make the economic situation worse.
This chapter will offer a deep criticism of mainstream monetary policy, and
in doing so will discuss the so-called impotence of monetary policy, a topic
that has been revived of late by Lawrence Summers, the former United States
Treasury Secretary and Chief Economist of the World Bank, though the
notion goes as far back as Keynes, who once claimed, ‘[i]t is to the theory of
a generalised monetary economy, i.e. of an economy in which, through the
fault or the inaction or the impotence of the monetary authority . . . that this
book will attempt to make a contribution’ (Keynes, 1979, pp. 67–8). This
chapter is written in this spirit.
Further, this chapter provides a systemic view of money and banking, enabling
us to understand the monetary–structural origins of the global financial crisis
that erupted in 2007–08, particularly after the demise of Lehman Brothers
in the United States. It thereby offers an explanation of this crisis based on

202 · An introduction to macroeconomics
s tructural rather than behavioural factors, which the regulatory reforms put into
practice at national as well as international levels do not and cannot address.
This chapter thus highlights the largely ignored fact that a monetary–structural
reform of domestic payments systems is required in order to eradicate the factors
of systemic crises, which are the hallmark of a monetary disorder affecting the
working of our national economies. As a result, the objectives of monetary
policy should go much beyond price stability, contributing to re-establishing
monetary order and guaranteeing financial stability at systemic level.
To summarize, this chapter will consider: (1) monetary policy and its trans-
mission mechanism from a mainstream and a post-Keynesian perspective;
and (2) the architecture of monetary policy.
The mainstream perspective

The mainstream approach to central banking and monetary policy focuses
on the relationship between monetary policy and inflation. In its original
form, this meant that there existed a direct relationship between the growth
of the money supply and the rate of inflation. This rested on the notion
that central banks could effectively control changes in the money supply,
which American economist Milton Friedman likened to ‘helicopter money’
(Friedman, 1969, pp. 4–5), and that in turn these changes would impact
upon the price level. This statement carries many implications. For instance,
it means that the central bank is in a position to steer and determine the total
amount of money within the economic system, either directly or indirectly.
Directly as regards the so-called ‘high-powered money’ (see Friedman,
1969), which is the monetary base issued by the central bank (Box 7.1). Or
indirectly, via the so-called ‘money multiplier’, that is, the relationship that
orthodox economists believe exists between the monetary base and the total
amount of money within the system, through bank lending (Box 7.2).
This mainstream view gave rise to specific policies of monetary-targeting

strategies by a number of central banks following the collapse of the Bretton
BOX 7.1
THE MONETARY BASE

The monetary base includes cash in circula- reserves. It is assumed that central banks
tion as well as the deposits of commercial can effectively control the monetary base,
banks at the central bank, also known as increasing or decreasing it at will.

BOX 7.2
THE MONEY MULTIPLIER

This theory is closely linked to the central increase lending to the private sector, which
bank control over the monetary base, and then creates money. Moreover, this multi-
sees a relationship between the monetary plier is assumed constant, so that whenever
base and overall money supply in the the central bank increases the monetary
economy, through the lending activities of base, it translates into a predictable and
commercial banks. In essence, the money proportionate increase in the money supply.
supply is a ‘multiple’ of the monetary base. Since the central bank is said to control the
When central banks increase the reserves of monetary base, it is further assumed that it
commercial banks (an exogenous action), can also control the growth of the money
the latter could then use these reserves and supply.
BOX 7.3
THE BRETTON WOODS REGIME

Established in 1944, the Bretton Woods in particular their exchange rates, that is,
Agreement, so called because the meetings the relative price of the currencies between
were held in Bretton Woods, a small town countries, which had to keep the value of
in New Hampshire in the United States, their respective currencies stable relative to
was meant to establish the rules governing the price of gold.
monetary relations between countries, and
Woods regime in the early 1970s (Box 7.3). Indeed, in the 1980s and 1990s,
the majority of central banks implemented their monetary policy with a view
to reaching some previously announced target for the rate of growth of a
given monetary aggregate; as M0, that is, central bank money, or as M3, that
is, the total sum of bank deposits across the banking system, including both
the central bank and the set of commercial banks (Box 7.4).
This assumed control over the money supply is at the heart of the original
mainstream monetary model, which was based on the so-called ‘quantity
theory of money’, which further assumed a direct influence of the money
supply on inflation (Box 7.5).
In other words, according to this view, central banks could effectively influence
inflation directly via a proportional relationship that this theory establishes

BOX 7.4
MEASUREMENTS OF MONEY SUPPLY

Economists have designed several aggre- • M3: this is an even broader definition than
gates through which they aim at measuring M2, and includes less liquid assets, and as
the money supply. Here is a short list, along such sees money more as a store of value.
with what they measure:
Central banks and economists have at
• M0: total bank reserves; it is also referred various times used any of these definitions
to as ‘narrow money’ or the monetary of monetary aggregates to see whether
base. they contained any information regarding
• M1: currency, travellers’ cheques, bank possible measures of inflation. M3 in par-
accounts such as sight and demand ticular was used for many years for such a
deposits, and other checkable deposits; purpose. Today, central banks have largely
it excludes reserves, bonds and savings abandoned M3 in favour of another defini-
accounts. tion of money, called MZM (money zero
• M2: this is a broader definition than maturity), which measures money’s liquidity
M1, and also includes savings d eposits, in the economy. It includes cash (bills and
money market securities, mutual funds bank notes), chequing and saving accounts,
and other types of time deposits. as well as money market accounts.
BOX 7.5
THE QUANTITY THEORY OF MONEY

According to the quantity theory of money, much money chasing too few goods’.
the price level in the economy is directly Dating as far back as the sixteenth century,
related to the amount of money in circu- this theory became an important compo-
lation, or the money supply. Hence, any nent of conservative British philosopher
increases in the money supply would lead David Hume. The theory was later revived
to an increase in prices (inflation), because by Milton Friedman.
there would now be a situation of ‘too
between (changes in) the money supply (M) and (changes in) the general
price level (P), according to the following so-called ‘equation of exchange’:
MV ; PQ(7.1)
where V represents the so-called ‘velocity of circulation’ of money (the number

of times that a unit of money is supposed to be used in payments across the

economic system during a given period, say a calendar year) and Q is physi-
cal output (the bulk of goods and services produced during the same period
of time). This equation of exchange states that the value of money times its
velocity (left-hand side) is equal to the value of output (right-hand side). This
suggests therefore that the money supply and the price level are connected.
Though developed very early in the nineteenth century, the equation of

exchange was revived in the 1960s by Milton Friedman of the University of
Chicago, who insisted on reading into it a causality from the left-hand side
to the right-hand side. In doing so, Friedman suggested that money caused
prices or, in terms of changes, a change in the money supply caused a change
in the price level, that is, inflation. This led Friedman (1987, p. 17) to pro-
nounce his famous saying: ‘inflation is always and everywhere a monetary phe-
nomenon’. This was the mantra of the monetarist school (Box 7.6).
BOX 7.6
MONETARISM
Monetarism is a school of thought devel- of money was zero, so that changes in the
oped by Milton Friedman, as a direct money supply caused changes in the price
challenge to Keynesian economics, of output. Over the long run, it is possible
which rested on the use of fiscal policies. to find a so-called natural rate of economic
Friedman developed these views in par- growth. This being the case, if central
ticular in a monumental book, co-written banks wanted an inflation rate of, say,
with Anna Schwartz, entitled Monetary zero, the proper policy would be to allow
History of the United States 1867–1960. the money supply to grow at the same
In this book, Friedman and Schwartz rate as long-run economic growth (fixed
(1963) argued that, historically, excessive monetary rule), thereby eliminating ‘excess’
growth of the money supply contributed money growth. This is why the assump-
to periods of high inflation. An adversary tion of exogenous money or control over
of Keynesian economic policies, Friedman the growth of the money supply by the
rejected the importance of fiscal policy central bank is paramount: it was impera-
and instead favoured the use of mon- tive for Friedman to assume it in order to
etary policy. Monetarism emphasizes that undermine Keynesian economics. As the
changes in the money supply have a direct authors of this book explain, however,
and predictable impact on inflation. This money is endogenous, which undermines
approach is based on the quantity theory the essence of monetarism. This said, one
of money, which stipulates that MV ; PQ. does not need central bank control over the
Rewriting this equation in terms of growth monetary base to justify inflation targeting
# #
rates, we have M ; p 1 g 2 V. Monetarists policies inspired by monetarism.
assumed that the growth of the velocity

Rearranging the terms of equation (7.1) and expressing it in growth rates

form, this determines the factors affecting the rate of growth of the money
supply, as in equation (7.2):
# #
M ; p 1 g 2 V(7.2)
where a dot over a variable indicates its rate of change over time, π is the
measured rate of inflation on the goods market, and g represents the growth
rate of produced output. Box 7.6 gives a summary of this view.
Equation (7.2) has been used to set up and justify monetary-targeting strat-
egies, once the central bank was in a position to determine the three vari-
ables on the right-hand side of that equation (see Box 7.6). The German
Bundesbank, for instance, was implementing this strategy in the 25 years that
preceded its adoption of the euro on 1 January 1999 (Table 7.1).
The Bundesbank decided the targeted growth rate of the relevant monetary
aggregate (∆M*), applying equation (7.3):
DM* ; pnormative 1 gpotential 2 DV(7.3)
where πnormative is the desired rate of inflation, gpotential is the rate of growth
of potential output, and ∆V is the rate of change in money’s ‘velocity of
circulation’.
Provided the central bank controls the monetary base and we assume a
constant relationship between that base and the money supply, monetar-
ism thus believed in the ability of central banks to target a specific rate of
inflation.
While monetarism has today been abandoned by central banks – that is,
the notion that central banks control the money supply – the spirit of this
approach remains very much entrenched in policy circles. While many or
most central banks have now recognized their inability to control the money
supply (Box 7.7), they have now favoured an approach that focuses on their
ability to control the rate of interest, something post-Keynesians have been
saying for several decades now.
Yet, the mainstream version of this interest rate procedure is much differ-
ent. First developed by American economist John Taylor in a 1993 paper,
it stipulates that central banks should now set the interest rate at a level that
generates an inflation rate consistent with their targeted inflation rate, or

Table 7.1 The monetary-targeting strategy of the German Bundesbank, 1975–98
Year pnormative (%) +gpotential (%) – DV = DM* (%)
1975 5.0–6.0 – – 8.0

1976 4.0–5.0 2.0 Increasing 8.0
1977 # 4.0 3.0 Increasing 8.0
1978 3.0 3.0 – 8.0
1979 Moderate ≈ 1978 Declining 6.0–9.0
1980 3.5–4.0 3.0 Declining 5.0–8.0
1981 3.5 2.5 Increasing 4.0–7.0
1982 3.5 1.5–2.0 – 4.0–7.0
1983 3.0 1.5–2.0 – 4.0–7.0
1984 2.0 2.0 – 4.0–6.0
1985 2.0 2.0 – 3.0–5.0
1986 2.0 2.5 – 3.5–5.5
1987 2.0 2.5 – 3.0–6.0
1988 2.0 2.0 –0.5 3.0–6.0
1989 2.0 2.0–2.5 –0.5 5.0
1990 2.0 2.5 –0.5 4.0–6.0
1991 2.0 2.5 –0.5 3.0–5.0
1992 2.0 2.75 –0.5 3.5–5.5
1993 2.0 3.0 –1.0 4.5–6.5
1994 2.0 2.5 –1.0 4.0–6.0
1995 2.0 2.75 –1.0 4.0–6.0
1996 2.0 2.5 –1.0 4.0–7.0
1997 1.5–2.0 2.25 –1.0 3.5–6.5
1998 1.5–2.0 2.0 –1.0 3.0–6.0
Source: Bofinger (2001, p. 251).
BOX 7.7
THE COLLAPSE OF MONETARISM

In the late 1970s and in the 1980s, mon- 1980, and interest rates (federal funds rate)
etarism was practiced by central banks to 19.83 per cent on 29 June 1981, and
around the world. But following the oil the prime interest rate rose to 21.5 per cent
shocks of 1973 and 1979, inflation rates in June 1982. The monetarist experiment
increased to unprecedented levels. For proved to be a disaster, and was aban-
instance, inflation in the United States doned, though its fundamental message
climbed as high as 14.76 per cent in April remains.

some targeted monetary aggregate that in turn would deliver a desired rate of
inflation. In this sense, the money supply rule advocated by Milton Friedman
was replaced with an interest rate rule. Yet, the core idea of monetarism, that
inflation is influenced by central bank policies, remains in practice. With the
Taylor rule, inflation becomes ‘always and everywhere’ a monetary policy
phenomenon.
Monetary-targeting strategies have usually been operationalized via an

implicit interest rate rule, which can be written as follows:
it = it–1 + a (mt – m*)(7.4)
where i represents the policy rate of interest set and controlled by the central
bank during the relevant period represented by t, a is a positive parameter, mt
is the observed growth rate of the targeted monetary aggregate, and m* is the
targeted rate of growth for that monetary aggregate. We can also assume that
central banks target a specific rate of inflation; a strategy that has been called
inflation targeting. In this sense, the above equation simply becomes:
it = it–1 + a (πt – π*) (7.5)
In equation (7.5), the central bank is now targeting a specific rate of infla-
tion, say 2 per cent. Accordingly, if the rate of inflation is above its target
level, or similarly if the monetary aggregate is above its targeted level (as in
equation 7.4), the rule dictates that the central bank should increase the rate
of interest.
Note that, in both instances, this shows that monetary-targeting central

banks have been well aware, in general, of the fact that they cannot steer the
relevant monetary aggregate through the ‘quantity theory of money’ channel.
In its stead, they operated through interest rate channels, that is, a mecha-
nism centred on the indirect relation between interest rates and demand on
the market for produced goods and services, which in the end affects the
price level assuming a full-employment situation.
The question then becomes obvious: how do changes in interest rates

filter through and deliver on a targeted inflation rate? In other words, what
is the transmission mechanism of monetary policy? The causal chain in
this approach is actually a two-step process, in what has been called New
Consensus Macroeconomics, that runs like this:
ci 1 TC, TI 1 TTD

BOX 7.8
THE PHILLIPS CURVE

In 1958, A.W. Phillips published a paper in argued that there existed a short-run trade-
which he observed an empirical relationship off between fighting either unemployment
between the rate of unemployment and or inflation, such that fiscal or monetary
the increase in nominal wages in the United policies could not deliver low unemploy-
Kingdom, between 1851 and 1957. In their ment and low inflation simultaneously.
interpretation of this article, Keynesians
In the first instance, central banks will change their interest rate (i) as
described above, whenever observed or actual values of inflation are above
the targeted rate. Specifically, they will increase the rate of interest. Then, in
a first instance, this should translate into lower consumption (C) and invest-
ment (I).
Second, this drop in total demand (TD) should translate into an increase in
unemployment rates (U), which in turn lowers the inflation rate (P):
TTD 1 cU 1 TP
This second step is crucial for monetary policy, and is known as the Phillips
curve (Box 7.8): a theory that describes the short-run inverse relationship
between the unemployment rate and the rate of inflation. As unemployment
increases, inflation comes down, and vice versa.
Today, monetary policy depends on this two-step process to achieve price

stability: increases in the rate of interest should therefore bring inflation
rates back down to their targeted level. As suggested above, while this newer
version abandons the idea that central banks control the money supply, it
retains the idea that inflation is related to monetary policy, and that central
banks have an important role to play in achieving price stability.
The above discussion can also be extended in the context of an open economy,
that is, an economy that considers both imports and exports, but also the
exchange rate. If one considers such an economy, one should expand on this
interest rate view by including the effects on total demand and the price level
that stem from an exchange rate depreciation (appreciation) induced by a
reduction (increase) in the policy rates of interest administered by the central
bank. Indeed, it is assumed that if central banks increase the domestic rate

of interest above the world rate, this increases the demand for the domestic
currency as investors move their funds into the domestic economy to take
advantage of higher returns, thereby pushing up the demand for the domes-
tic currency and hence its value. The inverse applies when domestic rates of
interest are below the world rate.
This exchange rate pass-through may be particularly important for small

open economies whose output is often more focused on a limited variety of
products, rather than large open economies, whose domestic magnitudes,
like the rate of inflation, are less sensitive to the exchange rate channel.
Further, the interest rate channel as described above also affects an economic
system’s financial stability, as it could generate an asset bubble on either finan-
cial or real estate markets (in the absence of the proper macroprudential reg-
ulations), when the policy rates of interest are kept too low for too long. This
induces debtors as well as creditors to increase the volume of credit in order
for both to profit, in one way or another, from the inflating credit bubble (see
Chapter 6 for analytical elaboration). In this perspective, the mainstream
explanation of the subprime bubble and ensuing crisis observed across the
US housing market during the late 1990s and early 2000s is based basi-
cally on a too-generous monetary policy by the United States (US) Federal
Reserve in the aftermath of the so-called ‘dot.com’ bubble. The bursting of
this bubble led the US monetary authority to dramatically reduce policy
rates of interest in an attempt to kick-start the domestic economy, which was
also negatively affected by the terrorist attacks of 11 September 2001.
In this light, mainstream economists believe that the policy rates of interest
decided by central banks, when used in a countercyclical manner, are a pow-
erful instrument with which to fine-tune economic activity and affect total
demand and, hence, have an impact on the price level in order to guarantee
price stability across the economy. The spending behaviour of both con-
sumers and businesses would thus be determined by a variable – the rate of
interest – that central banks could influence, if not control, through a reduc-
tion or an increase in their own policy rates of interest. This is particularly
so with respect to their credit lines: if a central bank (say) reduces its policy
rates of interest, banks will reduce (although not one-to-one) their own rates
of interest, thereby inducing more consumers and businesses to borrow from
the banking sector in order to expand production when the economic system
is affected by a recession (such as in the aftermath of a financial crisis).
However, as explained by Keynes, reducing the policy rate of interest (to

close to zero) may not be enough in order to spur economic growth: it is

akin to pushing on a string. As regards firms in particular, their propensity

to invest could be impaired by the economic prospects and the high level of
uncertainty regarding the expected profitability of their investment, which,
in the case of a deep recession elicited by a global financial crisis, may be so
dreadful that firms are unwilling to borrow from banks to finance investment
even though the borrowing rate of interest is very low. These firms consider
that they would not be able to sell the newly produced output because of the
bad economic situation as well as its likely evolution over the relevant time
horizon (see Chapters 4 and 9).
Once low or near-zero interest rates failed to stimulate economic activity, the
mainstream perspective induced a number of central banks, and in particular
the US Federal Reserve System in the aftermath of the global financial crisis
that erupted in 2007–08, to try to support economic growth with so-called
unconventional policies, in particular quantitative easing (QE); that is, an
expansionary monetary policy aimed at making sure that banks lend to cred-
itworthy non-financial businesses (private sector firms), in order for these
businesses to carry out their investment projects and thus expand economic
activity, thereby increasing the level of employment.
Quantitative easing may take different forms, including the purchase by

the central bank of government bonds on the primary market (where these
bonds are issued to finance government spending) and the easing of credit
standards that banks must fulfil in order to borrow from the central bank
(with or without a collateral, that is, a series of eligible assets used as a repay-
ment guarantee for a central bank’s loans). Be that as it may, quantitative
easing increases the volume of central bank money (reserves) that banks
could spend on the interbank market. The aim of this policy, according to the
mainstream, is that the increase in reserves would translate into higher bank
lending and credit to non-financial businesses.
There are several problems with this reasoning. First, banks do not need
reserves to lend (see Chapter 5), and as such, more reserves do not lead to
more lending. Banks do not lend reserves to the private sector, as it is not
their function. So, in that sense, increasing reserves serves no purpose with
respect to bank lending. That is the meaning of endogenous money. Banks
were never constrained in their ability to lend. This was essentially the con-
clusion of a Bank of England report, which stated that: ‘As a by-product of
QE, new central bank reserves are created. But these are not an important
part of the transmission mechanism . . . these reserves cannot be multiplied
into more loans and deposits and . . . these reserves do not represent “free
money” for banks’ (McLeay et al., 2014, p. 1).

Second, as a matter of fact, lenders and/or borrowers may have a ‘liquidity

preference’, which means that they decide to abstain from lending or bor-
rowing in light of their own expectations about the future. Indeed, if the eco-
nomic situation is bad and its expected evolution is similar, banks and their
potential borrowers are likely to postpone any expansion of credit activities,
thus making quantitative easing ineffective in supporting economic growth.
In this sense, banks were never constrained in lending, although they may
have been unwilling to do so.
Third, rather than an inflationary pressure, quantitative easing could contrib-

ute to deflation, as agents think or observe that such an expansionary monetary
policy has no positive effect on prices, which can fall as a result of agents’ absten-
tion from both consumption and investment across the economic system.
Further, reducing the policy rates of interest to zero (or even to the negative
domain) may not be enough to reduce banks’ own rates of interest, particu-
larly on the interbank market. Shortly after the collapse of Lehman Brothers
in the United States on 15 September 2008, the US monetary authority
reduced the federal funds rate of interest close to zero, but in fact the inter-
bank market rate of interest increased, since banks were reluctant to lend on
this market because of their higher uncertainty (notice again the importance
of uncertainty) about the actual financial situation of their counterparts on
that market. Indeed, the interest rate channel may not work as monetary
authorities expect, although a long period of very low policy rates of interest
can have various problematic effects in the financial sector and beyond it, in
the absence of a properly designed regulatory framework.
For instance, banks could be induced to borrow from the central bank in
order for them to inflate a financial bubble, through a sustained increase in
the purchase of financial assets, particularly those assets whose high risks may
lead many financial institutions to buy them with the expectation of earning
high yields. Also, banks and non-bank financial institutions could inflate a
real estate bubble, particularly as a number of middle-class individuals may
be attracted by favourable borrowing terms in order to become homeowners.
As shown by the subprime bubble that inflated during the 1995–2005 period
and burst in 2006, spurring a series of systemic effects in the United States
and beyond it, a number of non-performing loans can increase banks’ finan-
cial fragility to a point where several financial institutions become bankrupt.
In particular, those financial institutions that are ‘too big to fail’ – individually
or as a group – will require an intervention by the public sector, which must
bail them out to avoid a systemic financial crisis that will induce a deep reces-
sion, if not a depression (like the Great Depression of the 1930s).

This state of affairs has induced many regulatory reforms at national and
international levels, such as the so-called Basel Agreements signed within the
framework of the Basel Committee on Banking Supervision, at the Bank for
International Settlements. The large majority of these reforms aim to affect
the banks’ behaviour, to limit their risk-taking attitude and provide them
with a cushion of safety that should be solid enough to avert a systemic crisis
in the case of financial or real estate turmoil.
In fact, however, these regulatory reforms do not and cannot avoid a sys-
temic crisis, as this is the result of a structural disorder affecting the payments
system, rather than stemming merely from agents’ behaviour. The main-
stream perspective is not in a position to detect and explain such a systemic
crisis, because it considers that any economic system is merely the result of
a series of demand and supply forces that the set of economic agents exert
on any kinds of market. In this view, therefore, it all boils down to individual
behaviour, so that the working of the system as a whole is studied (and can
be studied appropriately) with a system of equations that allow to establish
the system’s ‘equilibrium’, provided that the public sector does not intervene
in the ‘market mechanism’, because this intervention would be a matter of
hindrance and not a macroeconomic stabilizing factor.
The heterodox perspective

The above discussion of the mainstream views on monetary policy is open
to severe criticism. Before turning our attention to the post-Keynesian or
heterodox alternative, let us consider some of these criticisms.
Assuming inflation is above its target, current monetary policy is based on a

two-step process: (1) increases in the rate of interest should lead to a decrease
in investment and consumption; which (2) should lead to an increase in
unemployment and a decrease in inflation (the Phillips curve), back to target.
Yet, there is empirical evidence that shows this process is severally limited.
First, regarding the relationship between changes in the rate of interest and
their impact on consumption and investment, there is evidence that shows
the latter two magnitudes are not very interest-sensitive, as explained by the
following quotation:
The transmission mechanism from monetary policy to aggregate spending in

new consensus models relies on the interest sensitivity of consumption. It is
difficult, however, to find empirical evidence that households do indeed raise or
lower consumption by a significant amount when interest rates change. Some

authors have generalized the link to include business investments (see Fazzari,
Ferri, and Greenberg, 2010 and the references provided therein) but a robust
interest elasticity of investment has also been difficult to demonstrate empirically.
(Cynamon et al., 2013, p. 13)
Even the US Federal Reserve is sceptical, as argued in the following quota-

tion: ‘A large body of empirical research offers mixed evidence, at best, for
substantial interest-rate effects on investment. [Our research works] find that
most firms claim their investment plans to be quite insensitive to decreases in
interest rates, and only somewhat more responsive to interest rate increases’
(Sharpe and Suarez, 2014, p. 1). In this connection, Nobel laureate Paul
Krugman stated that ‘[a]ny direct effect on business investment is so small
that it’s hard even to see it in the data’ (Krugman, 2018).
This would suggest therefore that attempts by central banks to manipulate

aggregate demand may not work or, at the very least, are ineffective. If these
statements are not devastating enough, it is the second relationship, the
Phillips curve, that bears even more criticism.
Claudio Borio (2017, p. 2), Chief Economist at the Bank for International
Settlements, was quite candid: ‘the response of inflation to a measure of
labour market slack has tended to decline and become statistically indistin-
guishable from zero. In other words, inflation no longer appears to be suffi-
ciently responsive to tightness in labour markets.’ In other words, the inverse
relationship between unemployment and inflation has disappeared. This is
a devastating conclusion. Without these two relationships, monetary policy
has lost its essence, and it begs for a complete rethinking of what monetary
policy is and what it does. To better understand this, it is to post-Keynesian
economists that we must turn our attention.
Monetary policy from a post-Keynesian perspective I

The post-Keynesian (and heterodox) perspective on central banking and
monetary policy-making is widely different from the mainstream view.
The differences stem from a series of different conceptions at both the
positive and the normative levels. On the one hand, the nature and role
of money and interest rates are essentially different from the mainstream
perspective. On the other hand, monetary policy-making has an important
influence on both income and wealth distribution according to the het-
erodox perspective, but its actual impact on the price level should not be
overestimated. Hence, interest rate policies should consider their effects
on income and wealth distribution, rather than focusing on the stability

Figure 7.1 The Bank

triangular nature of
money
Household or Payer Firm or Payee

–$x +$x
of the level of consumer prices, which they cannot influence as claimed by

the mainstream.
The nature of money

First, the nature of money, hence also of central bank money, cannot be
reduced to a particular commodity or financial asset, whose supply and
demand depend on the ‘market mechanism’ leading to an ‘equilibrium’ price
(or rate of interest, in the case of money). Money is not a commodity or
a financial asset, but the means of final payment in the sense that it allows
agents to finally pay (extinguish) their debts on any markets. Each bank in
fact issues money in a triangular operation that involves the payer and the
payee, as a result of which the latter has no further claim on the former, since
they obtain the right to dispose of a bank deposit.
So assume you purchase (consume) a good from a store; you are now in debt
vis-à-vis the store, which you extinguish by using cash (bank money), or your
bank account. In this sense, your payment is finally settled through the bank
(Figure 7.1).
Contrary to the conventional wisdom, however, the bank deposit does not
stem from pre-existing saving, the origin of which would remain mysterious
(as it cannot be explained logically). All bank deposits result, in fact, from a
bank loan, and this is why a central bank must exist, to avoid banks moving
‘forward in step’ (Keynes, 1930/1971, p. 23) without any endogenous limit
to money creation, because this would be a major factor of financial crises
(Box 7.9 and Figure 7.2; see Chapter 4 on the monetary circuit). Indeed,
the existence of a central bank closely depends on the book-entry nature of
money (see Rochon and Rossi, 2013). Its role is to make sure that all pay-
ments on the interbank market are final rather than just promised, as would

BOX 7.9
BOOK-ENTRY NATURE OF MONEY

Mainstream theory assumes that money agents, and is closely tied to their produc-
is exogenous and can be dropped from a tion and investment needs. When a bank
helicopter and imposed on the economic agrees to grant a loan, provided the bor-
system. Post-Keynesians, however, see rower is deemed creditworthy, the loan is
money as the result of a prior loan and as registered on the assets side of the bank’s
endogenous to the needs of the economic balance sheet, while a deposit simultane-
system: the supply of money depends ously appears on the liabilities side of the
on the borrowing needs of private sector same balance sheet (Figure 7.2).
Figure 7.2 The

balance sheet of a Assets Liabilities
commercial bank Loan Deposit
occur if banks would be allowed to pay simply by issuing their own acknowl-
edgement of debt.
The triangular nature of money, as described above between a household

and a firm using bank money, also applies to banks in their relationship with
the central bank. To be sure, Figure 7.1 assumed that the payment was made
between a household and a firm using the same bank, whereas in reality two
different banks are most likely involved. So, when a consumer purchases a
good, there are in fact two debts being created: the debt between the house-
hold and the firm, which is extinguished when the payment is settled through
the bank, and a second debt involving the bank of the household and the
bank of the firm. This debt, unlike the other, is settled only using central
bank money (reserves), as shown in Figure 7.3.
As a result of the book-entry nature of money, the central bank intervenes

always and everywhere when there is a payment to be settled between any
two particular banks. It is therefore a matter of routine for a central bank to
issue its own acknowledgement of debt in order for a payer bank to settle its
debt against any other bank on the interbank market. This final payment at
the interbank level may also involve the central bank as a financial intermedi-
ary, in the sense that the latter provides both money and credit to the paying
bank. In particular, the central bank can lend to any bank participating in a
domestic payments system the funds that this bank needs in order to settle

Figure 7.3 The Central bank

triangular nature of
money with a central
bank
Commercial bank of Commercial bank

household of firm
its debt to a third party. This may occur against collateral (that is, a series of
financial assets that the paying bank provides to the central bank as a guaran-
tee of repayment), or it might also occur without collateral (in an emergency
situation, particularly when the paying bank is ‘too big to fail’ without pro-
voking a number of negative outcomes across the domestic or global finan-
cial system). When the central bank intervenes in this regard, it plays the role
of a lender of last resort, as nobody else is willing to lend to the bank in need
of funding its own payments. The central bank may charge a rate of interest
to the borrowing bank, which is usually higher than the interbank market
rate of interest, as a penalty for the bank not being able to raise funds on that
market. This suffices to induce banks to manage their own business in order
to limit the number of instances where they need to turn to the central bank
as a lender of last resort.
The intervention of the central bank as a lender of last resort confirms that
the amount of central bank money is not set by the monetary authority
(exogenously), but actually depends on the needs of the set of banks par-
ticipating in the domestic payments system (endogenously). The ‘helicop-
ter view’ of money, hence the money multiplier, therefore cannot account
for the working of a monetary economy, thus invalidating the orthodox
perspective on factual grounds. The rate of interest set by the central bank
is indeed an exogenous magnitude, and does not depend on the market
rates of interest; rather, it influences them (although not by a one-to-one
relationship and with variable time lags, also depending on the size, type,
and private or public ownership of each bank participating in the domestic
payments system).
This empirical evidence against the orthodox perspective is also a critique

of the alleged influence that monetary policy can exert on the general price
level, hence the doubt about the capacity of a central bank to guarantee price

stability through its own rates of interest, as explained above. The ortho-
dox argument that an interest rate hike reduces demand on the market for
produced goods and services, thereby lowering inflationary pressures, can
be questioned with regard to the likely impact of monetary policy tightening
on banks’ own rates of interest. If firms have to pay higher rates of interest
because the central bank has raised its own interest rates for banks borrowing
from it, then the firms’ output will be sold at a higher price (hence an increase
in the price level) owing to higher production costs due to bank lending.
The income distributive nature of monetary policy

This chapter has argued that monetary policy has failed in its intended
purpose. The underlying theory regarding monetary policy and its transmis-
sion mechanism simply do not find empirical support, with the result that
the conduct of monetary policy must now rely on luck rather than theory.
This is not to say that monetary policy has no role to play in impacting eco-
nomic activity, but rather, the transmission mechanism from changes in the
rate of interest to economic activity is different than what mainstream econo-
mists believe. Indeed, rather than impacting on the price level as claimed
by orthodox economists, post-Keynesians argue that a central bank’s inter-
est rate policy can actually affect income and wealth distribution, making it
more concentrated at the top of the relevant pyramid.
There are two ways in which monetary policy can affect income distribution:
through (1) the income channel; and (2) the wealth channel, as depicted in
Figure 7.4.
The income channel can be divided further into a direct and an indirect
mechanism, the first of which concerns the impact of changes in the rate
of interest directly on the income of individuals: rentiers and workers. This
works through the bond market and on bond holders, or rentiers as we call
them: individuals whose income arises not from work, but from simply
owning a class of assets. When interest rates increase, say the rate of interest
on a ten-year bond, the higher rate translates into a higher return for bond
holders. In this sense, lower rates will tend to reduce the income flow to
rentiers. In this context, the rate of interest itself is an income distributive
variable; a central conclusion of post-Keynesian economics.
The second, albeit indirect, mechanism works through the labour market.
Changes in the rate of interest may have effects on labour markets, unem-
ployment, and thus the income of workers. For instance, as the rate of inter-
est falls in a recession, this may encourage the hiring of workers, a drop in

Direct mechanism: the rate of

interest is a revenue for bond
holders
The
income
channel Indirect mechanism: the rate of
Changes in interest may impact upon labour
the rate of markets and unemployment
interest
The Low interest rates, in the absence of

wealth proper regulations, will generate an
channel asset bubble
Figure 7.4 The income distributive effects of monetary policy
unemployment, and thus an increase in total wages, not to mention that as

unemployment falls, workers may also be able to demand higher wages.
As for the wealth channel, consider, for instance, when policy rates of inter-
est diminish, as in the aftermath of the global financial crisis that erupted in
2007–08, with the aim of supporting economic activity and employment
levels. In fact, as already pointed out, neither firms nor households will be
induced to increase their borrowing from the banking sector if they fear being
unable to repay their debt (and the relevant interest) when it matures. Rather,
this reduction of interest rates will spur financial transactions, thus inflating
an asset price bubble that is further reinforced by the so-called ‘wealth effect’,
which consists in feeling richer when one’s assets are priced higher on the rel-
evant market. Clearly, wealthy individuals whose assets are priced higher as a
result of a reduction in policy rates of interest will not increase their spending
to buy a series of consumption goods, thereby supporting economic activity,
but rather increase their spending on real estate and financial markets, thus
increasing the relevant asset prices. Holders of these assets will thereby feel
richer, giving rise to an upward spiral that could inflate a bubble, threatening
the financial stability of the whole system.

The conclusion to be drawn from this short analysis is that monetary policy
may work first and foremost through income and wealth distribution.
Incremental changes in interest rates affect the distribution of both income
and wealth between rentiers and workers, and between households. Since
we know that poorer individuals spend a greater proportion of their income
than wealthier ones, a policy that redistributes income toward workers is
better. In this sense, a permanent policy of low interest rates is to be consid-
ered. Indeed, this is what Rochon and Setterfield (2007, 2008, 2012) have
advocated in their work on post-Keynesian interest rate rules. Of course, this
policy would then require governments to adopt a proper regulatory frame-
work to prevent financial bubbles.
Yet, the past three decades have shown the fragility of our economic system
when monetary policy is not accommodative to workers. Lavoie and
Seccareccia (1999) and Seccareccia and Lavoie (2016) showed that mone-
tary policy has consistently favoured rentiers, thereby exacerbating an already
unequal distribution of income and wealth. In other words, monetary policy
has acted as an incomes policy that protected rentiers.
These phenomena, in addition to what we discussed above, are also rele-

vant to criticizing the inflation-targeting strategy that has been in fashion at
central bank level and within orthodox circles since the early 1990s, when
an increasing number of monetary authorities abandoned monetary target-
ing in favour of adopting a policy strategy based on an explicit target for
the rate of inflation, thereby considered as the principal (if not unique) goal
of monetary policy until the financial crisis erupted in 2007–08. Indeed,
inflation-targeting strategies and their apparent success in reducing and then
keeping inflation rates at a low and stable level across a variety of countries
since the early 1990s have not been in a position to avoid a major crisis, in
the aftermath of the financial and real estate bubble that burst in the United
States in 2006–07. Quite the contrary: these strategies could have been a
factor of the bubble, and the ensuing crisis, as they led a number of central
banks – first and foremost the US Federal Reserve – to keep their policy
rates of interest too low for too long, thereby inducing several banks as well
as non-bank financial institutions, in the absence of sound macroprudential
regulations, to profit from this policy stance in order to increase both their
lending volumes and their profits in an unsustainable way for the whole eco-
nomic system.
The problem in this regard concerns the theoretical framework support-

ing inflation-targeting strategies. As stated above, based on monetarism,
this framework considers that a monetary authority should guarantee price

stability and nothing else, because this provides the best macroeconomic
environment for other categories of agents to contribute to economic growth
and maximum employment levels. In other words, this approach argues that
stable prices and low inflation are the best economic outcome possible.
The role of rationality and the independence of central banks

The above explanation argues that agents (firms and households) are
equipped with so-called ‘rational’ expectations. Now, this is a very important
assumption: in economics, rational expectations imply that agents possess all
the required information and are able to calculate the most optimal solution,
every time. Moreover, this solution is assumed always correct, since agents
are thought of as knowing with certainly what the ‘correct model’ is, and as
such treat all the newly available information in the right way. This suggests
that the impact of changes in the rate of interest is fully anticipated and as
such has very minor consequences in the long run. In this context, only non-
anticipated changes in the rate of interest aimed at surprising agents can have
an impact (albeit short-lived) on inflation that should support economic
growth via a reduction of real wages and real interest rates (both of which
induce firms to increase investment and employment levels, in the view of
orthodox economists).
These arguments in fact have been instrumental in supporting central bank

independence from any government pressures, arguing that these pressures
(for instance, to ‘monetize’ public debt when a government’s finance minister
is unable to balance the public sector’s budget through tax receipts or f inancial
markets) eventually lead to overshooting the inflation target, without any
positive influence on so-called ‘real magnitudes’ (such as economic growth,
labour productivity and employment levels). As stated above, according to
the mainstream view, agents are rational and have rational expectations, so
they cannot be led astray by surprise inflation, as in that case they anticipate
a rate of inflation higher than the central bank’s publicly announced target
and thus behave ‘as if ’ the rate of inflation were already higher than the one
officially targeted by the central bank (which therefore suffers from being
dependent on the government, as it does not meet its own objective).
This argument has been further reinforced by referring to the so-called ‘sac-
rifice ratio’, that is, the ratio measuring output and employment losses as a
result of a reduction in the rate of inflation. Mainstream literature points out
that these losses are lower when the central bank is independent from the
government, arguing that a central bank’s independence enhances monetary
policy credibility, which is instrumental in making sure that an inflation-

targeting strategy elicits no output and employment losses, as shown by

expression (7.5):
Yt = Y* + b (pt – pe)(7.5)
where Yt is current output, Y* is full employment (or potential) output, b is

a positive parameter, pt is the current rate of inflation, and pe is the rate of
inflation expected by economic agents. A central bank’s credibility would be
instrumental in order to make sure that inflation is on target without generat-
ing output and employment losses (in that case Yt = Y*). As a result, a restric-
tive monetary policy stance aimed at reducing the measured rate of inflation
would give rise to no output and employment losses, if the central bank is
independent of the government, as this is enough to make sure that both the
central bank and its policy stance are credible.
Now, the problem with this reasoning is that agents are not ‘always and every-
where’ rational, as they do not have all the information and the knowledge
required to be rational. Rather, as Keynes pointed out, the future is unknown
and unknowable. Further, there are too many variables and reciprocal influ-
ences among their set to be able to appraise the actual working of the whole
economic system with a particular model or series of models. Hence, the
‘pretense-of-knowledge syndrome’ (Caballero, 2010) that affects main-
stream economics and the ensuing monetary policy-making is a dangerous
factor of financial instability and economic crisis, as it gives a false perception
of security in simply targeting price stability on the goods market by con-
temporary central banks. In fact, as heterodox economists have pointed out,
inflation-targeting central banks have been inflicting an anti-growth bias to
their economic systems, without preserving the latter from financial bubbles
that gave rise to system-wide crises once they burst. A clear example is the
monetary policy stance of the European Central Bank. Before the euro area
crisis erupted towards the end of 2009, the bank’s inflation-targeting strategy
inflated a credit bubble in a variety of so-called peripheral countries across
the euro area, while it hindered economic activities as the monetary policy
rates of interest were not reduced until measured inflation had fallen below
1 per cent, but increased as soon as expected inflation (a virtual magnitude)
was close to 2 per cent, even though measured inflation was much lower than
that (see Chapter 14 for analytical elaboration on this).
Monetary policy from a post-Keynesian perspective II

As noticed above, post-Keynesians and heterodox economists argue in
favour of a very different monetary policy stance: post-Keynesians rank the

well-being of citizens above the need to contain inflation. In their view, this
leads to the policy conclusion that central banks should contribute to output
stabilization and employment maximization, as well as sustainable economic
growth, while also considering the impact of interest rate policy on income
and wealth distribution across the economic system, without neglecting the
fact that a central bank should contribute to financial stability for the system
as a whole. This puts the conventional policy tools used by central banks
(namely, interest rates, open-market operations, repurchase agreements and
reserve requirements) under stress, as they are not appropriate, individu-
ally and as a whole, to ensure that the above set of policy goals are fulfilled
adequately.
Let us revisit briefly the New Consensus Macroeconomics discussed earlier

(equation 7.4), and specifically the interest rate rule, which we wrote as
follows:
it = it–1 + a (mt – m*)(7.4)
We can generalize this rule (many economists write it in different ways), and
end up with a specific rule called the ‘Taylor rule’ (see Taylor, 1999):
it = r + pt + a (pt − p*) + b [(Yt − Y*)/Y*](7.6)
where r is the so-called ‘natural’ (or equilibrium) rate of interest, p* is the

target rate of inflation, and a and b are positive parameters reflecting the
importance of inflation and output gaps respectively in the central bank
policy reaction function, that is, the difference between observed and tar-
geted inflation, and between observed and potential output, respectively (see
Box 7.9).
This policy rule has been criticized on several grounds. First, it integrates
neither exchange rate issues nor the problems stemming from financial insta-
bility, perhaps because it is difficult to determine exchange rate misalign-
ments and to define financial instability. Second, the notion of a ‘natural’
rate of interest is a figment of the imagination (Box 7.10), as it stems from a
dichotomous view of the working of an economic system that is conceived
as made up of a ‘real’ sector and a ‘monetary’ sector that would be separated
from each other.
In the ‘real’ sector, equilibrium would be attained when savings are equal to
the amount of firms’ desired investment, thereby determining the ‘natural’
interest rate. In the monetary sector, by contrast, money supply and money

BOX 7.10
THE NATURAL RATE OF INTEREST

In economics, the natural or neutral rate cannot be calculated. According to Claudio
of interest is the rate at which savings Borio, the Chief Economist at the Bank
equal investment, and is simultaneously for International Settlements, ‘the natural
where inflation is equal to the target rate, rate is an abstract, unobservable, model-
and the economy is growing at its optimal dependent concept’ (Borio, 2017, p. 8). This
level. It is a core principle in the conduct of is yet more evidence of the problems associ-
monetary policy. The only problem is that it ated with mainstream economic thinking.
demand (two separate and independent forces in the orthodox view) would
determine, at equilibrium, the market rate of interest; which may thus differ
from the natural rate, thereby generating an inflationary or deflationary pres-
sure across the whole economic system.
Third, the ‘Taylor rule’ ignores the fact that interest rate policies affect both
income and wealth distribution across this system, which is a major issue for
financial stability as well as for macroeconomic stabilization, as explained
above. In light of all these critiques, the heterodox approach to interest
rate policy offers two alternative views: one that has the merit of including
macroeconomic stabilization in a central bank’s objectives, and another that
focuses on the distributional impact of changing the rates of interest set
by the monetary authority, as discussed above. In the former view, central
banks are important actors in influencing the economic performance of the
relevant countries, as monetary policy is in a position to support or hinder
economic growth not just through its impact on price stability, but also
via output and employment stabilization. In the latter view, by way of con-
trast, monetary policy impacts upon income and wealth distribution via
the setting of interest rates, which tends to favour the owners of financial
capital (the rentiers) in that the targeted rate of inflation is lower (and the
policy rates of interest are higher) than what is needed in order to reduce the
income share of rentiers and to increase the income share of wage earners
with a view to inducing economic growth in a sustainable way for the whole
system.
Conclusion
This chapter aimed at exploring and contrasting various approaches to mon-
etary policy. We argued that the mainstream approach, based on the Taylor

rule and inflation targeting, finds very little empirical support for its theory,
especially given the collapse of the Phillips curve relationship. This suggests
that its fine-tuning approach of incremental changes in interest rates must be
discarded. In its place, post-Keynesians correctly argue that monetary policy
works mainly through income distribution, both directly and indirectly,
through labour markets.
Of course, mainstream economists have not accepted this reality, and instead
continue to rely on counter-cyclical changes in interest rates. Yet, for reasons
explained in this chapter, this approach does not work, and central banks are
forced to increase interest rates several times in an elusive quest to reach a
fictional natural rate of interest. In doing so, interest rates are pushed so high
that in the end they have a negative impact on economic activity, proving that
there is nothing neutral on the road to finding the natural rate of interest. In
the end, monetary policy collapses the economy, and reveals itself at best as
being a blunt tool that causes tremendous harm.
The above discussion shows that monetary policy cannot be considered

merely a technical matter that should be left to ‘technicians’, or perhaps to an
automatic pilot, without any political economy consideration. This echoes
the famous argument already raised in the 1930s by Ralph George Hawtrey,
who wrote that monetary policy is an art rather than a science (Hawtrey,
1932, p. vi). As such, and in light of their socioeconomic consequences, mon-
etary policy decisions should be taken as a result of a systemic appraisal of
their effects and considering the common good, that is, the well-being of the
whole population affected by them.
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A PORTRAIT OF ALFRED S. EICHNER (1937–88)

Born in the United States on 23 March the Journal of Post Keynesian Economics, in
1937, Alfred Eichner was a leading, though the autumn of 1978. In 2011, Richard Holt
considerably undervalued, post-Keynesian and Steve Pressman edited A New Guide
economist who contributed to the advance- to Post Keynesian Economics (strangely
ment of pricing theory, the theory of eco- enough, without a hyphen).
nomic growth and income distribution, and In his Macrodynamics book, Eichner
monetary theory and policy. He is consid- discusses important themes of pricing, eco-
ered by many as one of the founders of the nomic growth and distribution. He rejected
US post-Keynesian school. the neoclassical price theory of supply and
Eichner received his doctorate from demand, and argued instead that prices
Columbia University in New York, and were determined by a mark-up over the
taught at Columbia University; Purchase costs of production, thereby bringing
College, State University of New York together the importance of social classes.
(SUNY); and at Rutgers University, where he Eichner also discusses issues touching on
was lecturing at the time of his death on 10 central banking and monetary policy that
February 1988. were at the time, and still are today, con-
Eichner has written numerous articles siderably innovative and ahead of his time.
and books, but is perhaps best remem- Eichner showed that he had an incredible
bered for two books in particular: his Guide grasp of monetary details that are as rel-
to Post-Keynesian Economics, published evant today as they were at the time (see
in 1979, which offered for the first time Lavoie et al., 2010).
a complete and concise introduction to Eichner was not only an avid author and
various themes within post-Keynesian professor, but also somewhat of an activist,
economics, and The Macrodynamics of having testified numerous times on Capitol
Advanced Market Economies, published Hill before several Congressional and other
in 1987, which contains certainly his most legislative committees.
important insights into the workings of an Among his other books are The
advanced market economy. Megacorp and Oligopoly (1976), which
In his Guide, which contains a fore- explored price setting in an oligopolistic
word by Joan Robinson, Eichner brought setting and how this influences economic
together, for the first time, ten leading post- growth and economic stability, and Toward
Keynesian economists of the time to discuss a New Economics: Essays in Post-Keynesian
topics of great relevance to heterodox and and Institutionalist Theory (1985), in which
critical economics, including a chapter Eichner further develops his ideas on the
on ‘Monetary factors’ by Basil Moore. ‘megacorp’, an approach to labour he
This marked an important first step in the calls anthropogenic, modelling and post-
institutionalization of post-Keynesian eco- Keynesian economics, empirical research,
nomics, and coincided with the creation of and views on social democracy.

? EXAM QUESTIONS
True or false questions

1. The Taylor rule is used to strengthen fiscal spending rules.
2. Monetary policy works through the income distributive channel.
3. Inflation targeting regimes have been very successful.
4. The natural rate of interest in central to the mainstream approach to monetary policy.
5. Central banks are powerful institutions that intervene on a regular basis as a lender of last
resort.
6. Central banks are always able to set the rate of interest.
7. Monetarism as an economic theory was a failure.
8. Commercial banks always need prior reserves before making loans to the private sector.
9. Because of the book-entry nature of money, the central bank intervenes always and every-
where when there is a payment to be settled between any two particular banks.
10. Fine-tuning monetary policy is an efficient use of monetary policy.
Multiple choice questions

1. The Phillips curve illustrates:
a) the relationship between the money supply and unemployment;
b) the relationship between changes in unemployment rates and the level of economic
activity;
c) the relationship between changes in the price level and unemployment;
d) the impact of money supply growth on inflation.
2. The Taylor rule is:
a) a rule about how much the money supply should be increasing each year;
b) an interest rate rule dependent on a target rate of inflation;
c) a measure of unemployment at less than full-employment equilibrium;
d) a ratio between fiscal deficits and gross domestic product (GDP) growth.
3. The role of lender of last resort suggests:
a) the central bank stands ready to lend to banks if they need liquidity;
b) the government stands ready to inject spending into the economy;
c) the firms are deemed less creditworthy;
d) bank lending to the private sector under proper rules of profit maximization.
4. Changes in the rate of interest affect income distribution through:
a) the income channel and the ratio of imports to GDP;
b) the income channel and the wealth channel;
c) the wealth channel and the lending channel;
d) the elimination of the effect on imports.
5. The concept of rational expectations explains:
a) all agents possess all required information and are thus able to calculate the most optimal
solution, every time;
b) when expectations about the rate of inflation coincide with expectations about the rate of
unemployment;
c) when agents act rationally in deciding whether to increase consumption;
d) agents have less than optimal information, but can still choose optimal solutions when the
economy is growing at full employment.
6. The sacrifice ratio is:

a) the loss in consumption when unemployment remains the same;

b) the personal sacrifices made by consumers in saving for the future;
c) the decrease in inflation when unemployment increases;
d) losses in output and employment as a result of a reduction in the rate of inflation.
7. The natural rate of interest is:
a) a useful guide to monetary policy;
b) equal to the growth rate of GDP;
c) impossible to calculate and therefore not relevant to monetary policy;
d) always equal to the rate of interest on government deposits.
8. The quantity theory of money:
a) considers the relationship between money and its velocity of circulation, on the one side,
and the price of output, on the other side;
b) measures the number of times goods circulate in the economy;
c) examines the triangular relationship of money;
d) measures the value of money and how it grows through policy.
9. The Phillips curve today:
a) remains as relevant as it did three decades ago;
b) is more relevant today for monetary policy than before;
c) has flattened, making it irrelevant for monetary policy today;
d) has transformed into a super Phillips curve.
10. According to Milton Friedman:
a) inflation is the result of too many goods being produced;
b) inflation is always and everywhere a monetary phenomenon;
c) inflation is always and everywhere an income distribution phenomenon;
d) inflation is the result of diminishing fiscal spending.


7 - Central Banking and Monetary Policy

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Central banking and

• explains the essential role of a central bank, which is the settlement

• presents monetary policy strategies, instruments and transmission

• argues that monetary policy goals should go beyond price stability, to

• Bubble: A steady increase in asset prices on financial and/or real estate

M4921-ROCHON & ROSSI (2nd edn)_Text.indd 200 25/02/2021 08:09

• Final payment: A payment as a result of which the payer settles their

Why are these topics important?

M4921-ROCHON & ROSSI (2nd edn)_Text.indd 201 25/02/2021 08:09

The mainstream perspective

This mainstream view gave rise to specific policies of monetary-targeting

THE MONETARY BASE

M4921-ROCHON & ROSSI (2nd edn)_Text.indd 202 25/02/2021 08:09

THE MONEY MULTIPLIER

THE BRETTON WOODS REGIME

M4921-ROCHON & ROSSI (2nd edn)_Text.indd 203 25/02/2021 08:09

MEASUREMENTS OF MONEY SUPPLY

THE QUANTITY THEORY OF MONEY

where V represents the so-called ‘velocity of circulation’ of money (the number

M4921-ROCHON & ROSSI (2nd edn)_Text.indd 204 25/02/2021 08:09

Though developed very early in the nineteenth century, the equation of

M4921-ROCHON & ROSSI (2nd edn)_Text.indd 205 25/02/2021 08:09

Rearranging the terms of equation (7.1) and expressing it in growth rates

DM* ; pnormative 1 gpotential 2 DV(7.3)

M4921-ROCHON & ROSSI (2nd edn)_Text.indd 206 25/02/2021 08:09

Table 7.1 The monetary-targeting strategy of the German Bundesbank, 1975–98

Year pnormative (%) +gpotential (%) – DV = DM* (%)

1975 5.0–6.0 – – 8.0

Source: Bofinger (2001, p. 251).

THE COLLAPSE OF MONETARISM

M4921-ROCHON & ROSSI (2nd edn)_Text.indd 207 25/02/2021 08:09

Monetary-targeting strategies have usually been operationalized via an

it = it–1 + a (mt – m*)(7.4)

it = it–1 + a (πt – π*) (7.5)

Note that, in both instances, this shows that monetary-targeting central

The question then becomes obvious: how do changes in interest rates

M4921-ROCHON & ROSSI (2nd edn)_Text.indd 208 25/02/2021 08:09

THE PHILLIPS CURVE

Today, monetary policy depends on this two-step process to achieve price

M4921-ROCHON & ROSSI (2nd edn)_Text.indd 209 25/02/2021 08:09

This exchange rate pass-through may be particularly important for small

However, as explained by Keynes, reducing the policy rate of interest (to

M4921-ROCHON & ROSSI (2nd edn)_Text.indd 210 25/02/2021 08:09

akin to pushing on a string. As regards firms in particular, their propensity

Quantitative easing may take different forms, including the purchase by

M4921-ROCHON & ROSSI (2nd edn)_Text.indd 211 25/02/2021 08:09

Second, as a matter of fact, lenders and/or borrowers may have a ‘liquidity

Third, rather than an inflationary pressure, quantitative easing could contrib-

M4921-ROCHON & ROSSI (2nd edn)_Text.indd 212 25/02/2021 08:09

The heterodox perspective

Assuming inflation is above its target, current monetary policy is based on a

The transmission mechanism from monetary policy to aggregate spending in

M4921-ROCHON & ROSSI (2nd edn)_Text.indd 213 25/02/2021 08:09

Even the US Federal Reserve is sceptical, as argued in the following quota-

This would suggest therefore that attempts by central banks to manipulate

Monetary policy from a post-Keynesian perspective I

M4921-ROCHON & ROSSI (2nd edn)_Text.indd 214 25/02/2021 08:09

Figure 7.1 The Bank

DM* ; pnormative 1 gpotential 2 DV(7.3)

it = it–1 + a (mt – m*)(7.4)

it = it–1 + a (πt – π*) (7.5)

it = it–1 + a (mt – m*)(7.4)

it = r + pt + a (pt − p) + b [(Yt − Y)/Y*](7.6)