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Does Monetary Policy Have a Future?
By David Cronin and Kevin Dowd
Introduction
Central bank or base money lies at the heart of modern monetary systems. Unlike other money, it does not confer on its holder a claim to another type of money, but is instead the ultimate settlement asset in monetary exchange. This property makes base money a natural medium of account, and so it is no accident that prices in all developed economies are expressed in terms of its units. Of course, modern base money has no intrinsic value—except perhaps for papering walls—and has had no fixed exchange value against goods and services since the abandonment of the gold standard. Instead, its value (and, hence, the price level) is determined by the central bank's supply of it, on the one hand, and the public's demand for it, on the other. Other things being equal, as the demand for it rises, its value rises and the price level falls; and as the demand for it falls, its value falls and prices rise. Any factors that affect its demand could therefore have consequences—and potentially serious ones—for price and monetary stability.
This paper suggests that there is a very real prospect of such instability in the not-too-distant future. We argue that the demand for central bank money will not only drastically fall, but also probably disappear altogether, over a foreseeable horizon. Prospective technological progress with electronic payments and settlements systems is likely to combine with ongoing institutional changes—such as shifts toward private-sector settlements systems— to eliminate the demand for central bank money. Given that the price level depends on that demand, these developments carry the seeds of a profound monetary policy problem emerging in the future. If central banks do not reduce the supply of their own money, a falling demand for it will produce rising inflation and eventual hyperinflation. To avert such an outcome, central banks would need to reduce the monetary base in line with the falling demand for it. Unfortunately, such a policy is difficult to implement and would impose large—and potentially crippling—financial costs on central banks. Furthermore, as the demand for base money continued to fall, the price level would become increasingly volatile in the face of shocks, and there is a clear danger that our current discretionary monetary policy regime would, if continued, lead to escalating monetary instability.
This paper is laid out as follows. We begin by outlining the role and importance of the monetary base in the monetary system, and in so doing highlight its pivotal role as the lever on which monetary policy operates. We then look at the development of new payments media that compete with central bank currency and examine prospects for the other component of base money: commercial bank deposits at the central bank. The implications of a falling demand for base money for central banks and their ability to conduct discretionary monetary policy are then discussed. We next evaluate the likelihood that the demand for base money will disappear entirely, and discuss the implications of a zero demand for base money. Finally, we address possible policy responses and assess central banks' prospects. Our conclusions are that discretionary monetary policy is unsustainable, and that the future of central banking looks bleak.
Full Text (PDF, 18 pages, 83 KB)