A handbook of alternative monetary economics

Endogenous money

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Keynes inspires another interest rate impact in this market. The other two impacts of the credit channel occur in the credit market; on the one hand, households borrow to consume and a higher credit price reduces this sort of borrowing, pressing effective demand downwards. Likewise, firms borrow working capital, and an increase in the rate of interest modifies their costs, cash flows and, as a result, profits.

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The third transmission mechanism of the interest rate is the wealth channel. So, it depends on the degree that households use this changed price to finance their consumption. The more the latter is financed in this way, the larger is the effect of this transmission channel. The fourth transmission channel operates in open economies.

It is the effect of interest rate changes through the exchange rate. Besides the expected variation in the exchange rate, external investors seek the differential between domestic and foreign interest rates when deciding on the contents of their portfolios. Hence, modifications of the local interest rate in relation to the world one, change capital flows and the exchange rate. This movement impacts the cost of inputs, foreign attractiveness of domestic production, and the financial stance of firms with external liabilities. Moreover, capital flows have another relevant effect for which monetary policy needs to account.

Every external capital flow changes the money market liquidity, as it requires the conversion of foreign currency into domestic money. Consequently, the financial system yield-curve is affected in view of liquidity changes that emanate from external flows. Whether the economy faces external flows that are either volatile or susceptible to fast reversal in their direction, open market operations need to offset the possible effects of these flows on the money market. The last interest rate transmission channel is expectations.

This diversity of expectations and liquidity preference motivate agents to negotiate debt contracts, guided by their wish to profit by betting on the future interest rates. While agents negotiate in the financial system, there is room for monetary policy to sell and buy public debt with which it makes open market operations. Furthermore, as credibility is a condition for the success of monetary policy, to keep expectations stable the central bank also has to acquaint the agents with the action it takes to bring monetary policy to a successful end.

Nevertheless, diversity of individual expectations only happens if the central bank is sufficiently credible, and able to maintain a trustworthy state of expectations. Otherwise, if the central bank fails to build a positive state of expectations concerning how it guides its policy, the relevant state of the financial markets would be disorganised, driving expectations to a high degree of liquidity preference. Under such circumstances open market operations have no space to influence the speculative demand for money and monetary policy would be less effective.

Finally, it is worth highlighting the relation amongst open market operations, interest rate transmission channels and the financial system yield-curve. Open market operations are normally undertaken in the sovereign market, where the central bank and banks transact on public debt.

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The effects of monetary policy via interest rate changes are thereby transmitted to the other financial markets - namely credit, capital and foreign exchange markets. This process terminates in a new financial system yield-curve. Concomitantly, these same expectations and portfolio channels also drive new comparisons between the new yield-curve and the marginal efficiency of capital, driving agents to rearrange their portfolio towards financial or capital assets, what culminates in a new level of investment.

This process goes on through the other channels, eventually influencing effective demand. It also alters the price that firms pay to borrow working capital, affecting their production costs. In the capital market, shifts in interest rates produce two outcomes, the new conditions for agents seeking to borrow money in order to buy securities, and the cost of funding that firms borrow to finance their investment plans.

There is also the link between the foreign exchange market and the other financial markets. Depending on the gap between the local and international interest rates and the expected shift in the exchange rate, external capital flows into or out of the economy. Just after that it goes to the credit and capital markets. In the case when foreign capital leaves the country, the opposite process prevails.

Still, external flows pass into the money market and are capable of changing its liquidity level, thus provoking monetary policy action to smooth its impacts on the yield-curve. Another idea Keynes , advances, and Tily , reminds us of, is that the monetary authorities should use public debt with different maturities in their monetary operations. As discussed above, it is the long-term interest rates that compete with the acquisition of capital goods.

As Keynes proposes, debt management can deal with this kind of operation. Based on Keynes op. In other words, public debt with various maturities - that is, short-, intermediate- and long-term 7 - is issued, each type with a diverse interest rate. Debt management works as a tool for interest rate administration because public debt is the benchmark for private financial assets.

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In terms of its operation, following Keynes , debt management is very much similar to the purchase and sale of bills undertaken in open market operations. Meanwhile, debt management accounts for the medium- and long-term sections of the yield-curve, by means of the complex of the interest rates of public debt. In order to undertake proper debt management, a strong and accessible bond market is needed. Otherwise, debt management is directed to administer the financial system yield-curve, getting it as most prone-to-investment as possible.

If these operations were undertaken in the same market, the financial institutions could start an arbitrage process, receiving long-term deposits directed to buy bonds, selling them in the secondary market and using the resources to buy short- or intermediate-term bonds. The general objective of the central bank in gaining influence throughout the yield-curve is to push the long end of the yield-curve down, administering it around the level compatible with the average scale of the marginal efficiency of capital.

Thus, as a rule for managing debt over time Keynes , pp. Debt management has indirect and direct transmission channels to effective demand. Its indirect effects stem from the channels of transmission of the interest rate, which are enhanced by debt management as long as it grants to monetary policy a broader influence over the yield-curve. In the presence of debt management, even if the short-term interest rate bears some volatility, the medium- and long ends of the yield-curve are under greater stability because the monetary authority operates on all of its segments.

Given that, monetary policy has more room to counteract the trend in the liquidity preference of agents.

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Furthermore, debt management also influences the exchange rate stability, due to the better control central banks exert upon the difference of the local and the world interest rates. Debt management is also capable of directly affecting some of the immediate goals of monetary policy, namely price, liquidity, and financial stability.

In accordance to the circumstances and given that no harsh and frequent movements are taken on the interest rate, debt management can be used by monetary policy to tackle conjectural problems, helping to stabilize expectations and counteract the economic cycle. For instance, open market operations can bring the short-term interest rate up to face inflation by means of the credit channel; however due to debt management the long-term interest rate may continue favouring investment, improving the overall production capacity and avoiding inflationary supply constrains.

The USA central bank used the proceeds of short-term bills to buy long-term bonds, furnishing liquidity to this segment of the financial market and bringing the long end of the yield-curve down. Furthermore, debt management spreads public debt through the financial system, widening the capacity of the central bank to control liquidity in all the financial markets. This improves monetary policy in its handling of liquidity and helps in its efforts to guaranteeing financial stability.

Still, regarding financial stability, a widespread use of public debt makes the financial system more robust, due to the opportunity of the public debt being offered as better quality collateral in loans. Hence, the overall liquidity preference can be kept more stable over time because agents have, on their need for liquid assets, the chance to acquire public debt. When the flight-to-liquidity is overcome, the monetary authority can repay bonds of different maturities, even by issuing money, rendering liquidity and stability to the financial system.

Figure 1 presents the case of how debt management operates as a monetary policy tool. In this Figure, the vertical axis shows the two main rates of return taken into consideration by entrepreneur financial assets and the marginal efficiency of capital. The horizontal axis shows time and risk of the overall assets. The upward slope in both the financial system yield-curve and public debt yield-curve, accounts for the higher gain sought by investors as uncertainty increases and investments become riskier over time. In turn, point I in Figure 1 reports the exactly higher level of the long-term interest rate below which investments are not undertaken; beneath this point, it is better to buy financial assets rather than capital goods.

In this context, if monetary policy is acting to stimulate investment towards full employment, it should make all the required effort to keep the long end of the yield-curve at least equivalent to the marginal efficiency of capital. Without debt management, Figure 1 would not have the public debt yield-curve guiding the financial system yield-curve.

In fact, this is the way in which monetary policy has been performed as central banks undertake open market operations to keep stable the short-term interest rate they set. Still, even in this case the intention of the monetary authority is to influence the yield-curve throughout, although acting only at its short-term. In this case, agents and financial institutions would largely act freely to define the long-term interest rate, so that central banks have less power to set a long-term interest rate that does not perform a high opportunity cost to investment.

Debt management implies that monetary policy operates with various maturities of public debt; for it tries to create the benchmark interest rate to the private debt and because of that, it can influence the yield-curve on its entire extension, making it easier to set a long-term interest rate that enables investment levels to be undertaken - as per point I in Figure 1. For instance, if the long-term interest rate is increasing due to expectations of inflation or exchange rate devaluation, central banks can concomitantly increase the short-term interest rate of the bills they use in open-market operations and keep stable the interest rate of their long-term bonds.

While doing that, monetary authorities act both at the short- and the long-ends of the yield-curve. So, they do not attempt to establish some long-term interest rate by only working with short-term maturity debt. Figure 1 presents this process by means of debt management influencing the financial system yield-curve throughout up to point I. Finally, in the case where debt management is not undertaken, the only way to influence the long-term segment of the yield-curve would be fiscal policy.

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By means of the bonds the Treasury issues to finance budget disequilibrium, fiscal policy could try to exert some influence on the long-term interest rate. Nevertheless, the aim of the Post Keynesian fiscal policy, as Arestis et al. That is why we argue that debt management should be a monetary policy tool, as it is the task of the monetary administration to manage all the complexities of the interest rates of the financial system. Therefore, debt management as a monetary policy instrument requires close coordination between fiscal and monetary policies, so that the closer this coordination is, the better is the use of the public debt by these two policies; and, also, the greater is the influence of the economic policy over the finance system yield-curve.

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Monetary policy in developing countries Jeffrey Frankel Harvard University paper presentation updates. Discussant: Allan Drazen University of Maryland discussion. Discussant: Petra Geraats University of Cambridge discussion.

Monetary policy regimes and economic performance: the historical record, Charles Goodhart London School of Economics with Luca Benati European Central Bank paper presentation. Inflation targeting Lars E. Coffee 4. Twitter facebook linkedin Whatsapp email. Our website uses cookies We are always working to improve this website for our users. Learn more about how we use cookies I understand and I accept the use of cookies I do not accept the use of cookies.

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