Money is Interest Bearing With A Possibly Low Opportunity Cost

A central quandary of modern economics in general, and monetary theory in particular, is this: today, in advanced industrial economies, most money—certainly money at the margin—is interest bearing, and the difference between the interest paid on money in, say, a cash management account15 and a T-bill is determined not by monetary policy, but by transactions costs. In effect, with modern technology, individuals can use T-bills for transactions. There is no opportunity cost, at the margin, in holding “money.” (To be sure, there is an opportunity cost in holding currency, but there are few economists who use currency in their regressions attempting to explain inflation or output).

The monetary economics developed over the last three quarters of a century is based on a money demand equation in which there is an opportunity cost for holding money. Standard monetary theories argue that monetary policy exerts its effects through changing the supply of money, which changes the interest rate; and changes in the (real) interest rates affect (real) economic behavior. Reducing the money supply increases the “price” of money—the interest rate—and that in turn reduces investment, reducing aggregate demand. In an open economy, there is one more channel through which monetary policy exercises its influence.

The increase in the interest rate makes it more attractive for foreigners to put their money into the country (and less attractive for those within the country to invest their money abroad.) The induced movement of capital into the country drives up the exchange rate, reducing demand for exports and increasing demand for imports.

The model was a useful one for policymakers, because at least some of the key relationships were stable. While the investment function was presumed unstable—shifting to the left in an economic slump—the money demand functions were presumed stable. Even with a variable level of investment, so long as the elasticity of response of investment to interest rate changes was stable, the government could easily predict the consequences of changes in policy. In many circumstances, the model did extremely well, but at other times—particularly in economic downturns associated with financial sector crises, such as that in the United States in 1991 and in East Asia in 1997-1998— the model performed quite inadequately, and policies based on that model failed to deliver the right medicine in a timely way.

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