MONETARY TACTICS AND MONETARY TARGETS: A GUIDE TO POST-CAMPBELL MONETARY POLICY*

by KEVIN DAVIS and MERVYN LEWIS, University of Adelaide

Introduction In a recent lecture, Friedman (1982) noted that the theory of monetary

policy consists of two parts: what to aim for (targets) and how to get there (tactics). On both issues, the prevailing (monetarist-inspired) orthodoxy is quite clear. The principal objective of monetary policy should be price stability, a sentiment echoed in the Final Report of the Campbell Inquiry: “Monetary policy . . . should have, as one of its principal objectives, the maintenance of long-term price stability” (3.3).

But how is this objective to be achieved? Friedman lists three possi- bili ties:

. . . first, using what are called euphemistically money market conditions, which really means interest rates, both as a target and also as an instrument; second, using monetary aggregates as a target, but money market conditions or interest rates as an instrument for achieving that target; third, using monetary aggregates as a target and control over the monetary base, that is, the obligations of the monetary authority, as the instrument.

His choice amongst these is unequivocal, citing “wide agreement” for using the money supply as the proximate target of monetary policy and the monetary base as the instrument. Viewed in this light, the Campbell Inquiry’s other major recommendation for the conduct of monetary policy, that “the authorities should formulate, announce and seek to achieve a monetary target . , ,” (3.27) appears uncontroversial.

In our view, however, the value of monetary targeting in the type of deregulated financial system proposed by the Campbell Report has yet to be established. Apart from a general exhortation that open market opera- tions be the conduct through which monetary policy operates, the Report is also remarkably silent on tactics. Since a number of significant changes (including abdition) are proposed for previously popular policy instruments, this is a major omission from the Report’s otherwise wide- ranging review of the Australian financial system.

Advocacy of “market-oriented’’ tactics is by no means new in Aus- tralia. For over two decades, the authorities have espoused (if not always acted in accordance with) the merits of such tactics vis-a-vis the alter- native use of direct controls. Among the latter group of policy instruments are the SRD/LGS mechanism, quantitative lending controls, and interest

* Revised version of paper presented at the Conference on the Campbell Report, 18-19 June 1982.

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rate controls, all recommended for abolition or radical surgery in the Report. We focus initially upon the role of the SRDlLGS mechanism because of its prominence in the past development of Australian mone- tary policy. Following that, we investigate the effects which removal of restrictions on bank deposit interest rates has on the role of money and thus for monetary policy. The final section returns to the question of tactics and targets, focusing particularly upon issues surrounding the choice of a monetary target and the means available to achieve it in the proposed environment.

The Future of SRDs and LGS In both Australia and the United Kingdom, the monetary authorities in

the post-Radcliffean years (1960s and early 1970s) used interest rates as intermediate targets of policy with open market operations and manipula- tion of bank portfolios as policy instruments. In the British case the open market operations were concentrated in the discount market via the Treasury bill tender and supplemented by control of bank liquidity through calls to Special Deposits interacting against the reserve assets ratio and forcing banks to sell off investments. In Australia, the market operations were in longer-term securities and the SRD/LGS mechanism was used for additional control over bank balance sheets, thereby effecting (or avoiding) bank sales of securities.

Elements of these tactics have persisted after the switch in the mid-1970s to money supply targets. Interest rates remain a concern of policy and the transition to the money supply as the intermediate target has been handled by an additional step being grafted on to the policy process, whereby interest rates have become the operational target for achieving a monetary target. In this way implementation procedures and administrative arrangements devised over many years have been retained.

The LGS convention, for example, dates back to 1956. It was designed, according to its architect, Dr. H. C. Coombs (1971), with two purposes in mind. One was to ensure that a t least some of the impact of a reduction in banks’ liquidity would fall upon advances. In the absence of the conyen- tion, banks responded to a loss of reserves by running down their other earning assets, mainly government securities. That continued to be their first reaction, but the convention sought to ensure that advances would eventually be constrained. This aim accorded with the belief that a money supply reduction engineered by a restriction of advances has more impact upon final expenditures than one brought about by the sale of. government securities. Such ideas are pass6 in monetarist thinking, although still an influence on policy formulation.

The other purpose of the LGS convention, then the minor one, was “a protection to depositors”. Now, under the Committee’s recommendations, that is seen as the major function. They propose, on prudential grounds, a constant minimum liquidity ratio. Assets suggested as eligible for satisfy-

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ing this requirement are those of short term and high quality, such as government debt with less than 12 months to maturity, deposits with the official dealers, and (possibly) certain net investments with other banks. Since eligible deposits with the official dealers seem to be those backed by government securities, this recommendation must be interpreted as a modification of the existing LGS convention. The modifications are: a slight widening in the range of assets: a substantial decrease in the maturity range; a change in the base used for calculating the ratio: and, presumably, a lower value for the ratio.

Such a prudential requirement can make banks safer only if the ratio leads the public to think that they are safer. Like all reserve ratios, a liquidity requirement suffers from a fundamental fault-Harrod’s (1969) “cab-rank fallacy”:

The kind authorities might think it desirable that citizens should always be able to find a cab on a recognised cab rank when they wish for one, and accordingly make a regulation that there shall never be less than two cabs on the rank at any one time. But if the citizen finds two cabs there, he cannot take one, because that would be in contravention of the regulation. Accordingly, in practice, if the citizen is to be convenienced, there will have always to be at least three cabs on the rank. All systems requiring a percentage ratio are of this character.

Apparently mindful of this fault, the Committee recommends, vaguely, that the ratio apply on an averaging basis over some period. It might have been better if the Committee had recommended the abolition of the Iiquidity convention, as we suggested in 1980 (Davis and Lewis (1980) p. 320). For one thing, the averaging procedure may slow down banks’ portfolio adjustments to reserve pressure. For another, the presence of the requirement may help to bring about a pattern of interest rates which inhibits monetary control.

Faced with a reserve shortage induced by policy, the banks have the choice, on the asset side of their portfolios, of selling short-term government debt, long-term government debt, or reducing advances, while on the liabilities side they can bid interbank for funds or seek interest-bearing deposits from wholesale or retail money markets. Insofar as asset management is concerned, the liquidity requirement seems likely to act similarly to the LGS requirement, with the banks holding assets in excess of the requirement as a buffer against reserve flows (although this does depend on how the averaging procedure operates). But if banks practise liability management their normal reaction may be to bid for deposits in an attempt to buy in additional reserve assets. This response may not succeed in relieving the reserve shortage, but could result in a pattern of interest rates as between bank deposits and short- term government debt such that yields on the latter fall absolutely or relatively compared to other rates, so inhibiting open market sales of short-term debt and encouraging the non-bank public to switch into bank deposits during periods of restrictive policy!

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Changes in reserves can be instituted either by means of market techniques or by alterations to the SRD ratio. This ratio has an even longer history than the LGS ratio, and can be traced back to the war and immediate post-war years when the thinness of the bond market pre- cluded open market operations-the reason reserve ratio changes are still used in many European countries. Later, when market operations were possible, the Reserve Bank’s portfolio proved inadequate on occasions for the desired scale of explicit open market sales. By making calls to SRDs, the desired sales could be effected, but from the banks’ portfolios.

On neither of these counts is the Reserve Bank forced to use SRDs nowadays. It is perhaps not surprising, then, that the Campbell Com- mittee suggests that the utilisation of this policy instrument be down- played (indeed, little need is seen for it after the transitional period to deregulation is over), and recommends significant changes in its characteristics. Before examining these recommendations, we enquire into the present and possible future role of the SRD ratio.

One possible reason for retaining the ratio is to provide additional leverage over the level and structure of interest rates. It is a familiar result of monetary theory that the “equilibrium” rate of interest responds differently to changes in a cash reserve ratio [which is all the SRD ratio is) and to open market operations, The result comes about either because there is an alteration to wealth (in the Metzler framework) or to the insideloutside money ratio (in Gurley and Shaw, or Patinkin). With respect to the structure of interest rates, Davis (1981) shows that open market operations and reserve ratio changes which bring about equiva- lent changes in the money stock can have differing effects on the relative yields of private and government debt. The explanation for this result lies in the different pattern of effects which the two policy weapons have upon the relative supplies and demands for the two (imperfectly substitutable) assets. Changes in the SRD ratio exert a larger impact on private interest rates than do open market operations, which concentrate the effect upon government rates. If the responsiveness of expenditure decisions to changes in private and government interest rates differs, the two instruments will then have different “real” effects for any given change in the money supply-a difference which may be reinforced by the greater announcement effects of SRD changes.

While the Committee acknowledged the possibility of such differential effects, its suggestion that SRD changes be eschewed was based on the (untested) view that the empirical significance of such differences would, in the proposed deregulated environment, be slight. But why then propose that a required cash reserve ratio be a part of the policy armoury-par- ticularly since Harrod’s cab-rank fallacy is as applicable here as to the proposed liquidity requirement?

A likely explanation stems from the role of the SRD ratio in ensuring that banks maintain some holdings of cash reserves-amounts sufficient

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to meet current and prospective calls. This has two important implica- tions in the light of the Report’s recommendations: one concerning a possible transition towards monetary base control, the other with respect to the deregulation of bank deposit rates. We discuss each in turn.

As a result of alterations to Loan Council arrangements and the introduction of the tender system, yields on government securities a re being determined much more by market forces. These moves should reduce, or more correctly reduce further, the degree of substitutability between cash and bonds in bank portfolios. In a cash-based system of money supply control, the function of the LGS convention is one of determining the division of banks’ earning assets [i.e., non-cash assets) between advances and government securities. The total of earning assets, and thus banks’ maximum balance sheet, is controlled by the amount of cash reserves available to the banking system in relation to their cash reserve ratio. The latter serves as the fulcrum for a system of monetary base control. By conscripting a specified minimum holding of cash- which is what the SRD ratio does-the authorities may feel that they thereby have a firmer datum point on which to operate.

At the same time, the authorities can control the interest rate paid on the conscripted funds and hence bank earnings. SRDs currently pay a rate of 5% [previously 2.5% and before that 0.75% per annum). Consequently, the SRD requirement can be viewed as a tax on bank intermediation, with the size of the tax bill being given by

In this expression, where rA represents the yield which would have been otherwise obtained on the frozen funds [e.g., on advances and other earning assets) and r, is the interest rate paid on SRDs, the tax base is deposits, D, and the tax rate is s[rA - rs). Clearly the extent of the tax varies with market interest rates. A move to restrictive policy typically increases both s and the margin [rA - r,). Banks’ cost of intermediation is raised and they are prevented from profitably matching movements in market rates.

The first of the Campbell Committee’s two recommendations about the SRD ratio concerns the “tax base”. Instead of trading bank deposits, it is recommended that the “appropriate liabilities” of banking groups be treated as consolidated units. Here the implication is that the new ratio apply also to the non-deposit liabilities of the trading banks, and to the deposit and other liabilities of their savings bank, finance company and other subsidiaries. Neither extension is argued out in detail in the Report, although application of SRDs to trading bank total liabilities would be a return to the situation before the 1953 Banking legislation when Special Accounts were applied to the banks’ total assets, and gains significance when seen in the light of bank behaviour in 1981, when the banks used bill transactions to inflate total liabilities by 17.5% while deposits increased by 11.2%. Inclusion of the banks’ holding company operations accords with our own recommendations [Davis and Lewis [1982a)), but the a p p m

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T = [rA - rs) SD.

priate treatment of non-bank intermediaries which are only partially owned by the bank appears not to have been considered (although see Final Report, p. 316, n. 32). Interestingly, much of what we would perceive to be the need for the change is removed if the Committee's second recommended alteration to SRDs is implemented.

The second recommended change concerns the interest rate paid on required reserve holdings. A near-market rate is proposed, implying that in the earlier expression (rA - r,) be close to zero. The idea is for required reserves to no longer constitute a tax on bank intermediation, whatever the level of s. Indeed if, a s the Report suggests, the rate paid on required reserves is tied to the Treasury note rate, banks may actually gain during periods of restrictive policy if short rates rise relative to long rates.

Obviously the latter proposal, if implemented, would greatly enhance the capacity of the banks to adjust deposit rates in line with the earnings on their loan and bill portfolio. In the next section we explore the implications which follow from this for the demand for bank deposits. These results apply under the present regime, but gain force if the banking system is further deregulated.

In the final section of the paper the role of a required reserve ratio is examined in the context of monetary base control, which the Committee suggests should be seriously investigated. As a contribution to that investigation, we question the notion that the payment of a market rate on required reserves solves the "problem" of the funds conscripted into SRDs. While the required reserve ratio may not be a tax, as we have defined it, we cannot agree that it is non-discriminatory, for banks may not choose to hold the cash without the compulsion. After all, a conscript, even if adequately rewarded, is not a volunteer, and may act differently. Yet, in the absence of a required ratio, banks' holdings of cash reserves may not provide the reliable fulcrum which monetary base control requires. We take up these issues below.

Flexible Bank Deposit Rates To jump right to the end, our conclusion is that a move from fixed to

market-determined interest rates on bank deposits, as recommended in the Report and as proceeding apace in the marketplace, involves a substantial change in the role of money in the macroeconomic process. Underlying our argument is the now generally accepted proposition (except in the textbooks) that relative and not absolute interest rates influence asset demands (and supplies) and that it is the relative rates which must adjust to restore asset market equilibrium following a change in market conditions. When bank interest rates are regulated, relative interest rates between bank deposits and other assets can be readily altered. With deregulation, it becomes a matter of how bank deposit rates are determined.

Consider the following representation of the market for bank deposits: D(rD, PA, rK) w = DS

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in which DS is the supply of deposits, and in which the demand for deposits, D, as a propoi.tion of private sector wealth, W, depends on rD, the banks’ deposit rate, r A , the yield on “securities”, and r K , the yield on capital assets. Conventional price theory would presumably see the yield on deposits as determined by the interaction of demand and supply in the market for deposits. If so, an excess supply of deposits would to some extent be “bottled up” in the deposit market via an equilibrating reduction in the bank deposit rates. On similar reasoning, Tobin (1963, 1969) saw flexibility of the interest rate on “money” as destroying the potential for discretionary monetary )olicy.

Our argument proceeds along diff xent lines. Payment of interest on bank deposits is possible due to the intermediation activities of banks whereby bank deposits are used to finance holdings of other assets. These other assets are themselves substitutes for bank deposits in the portfolios of the non-bank sector. The demand for bank deposits then will depend upon the yield on deposits (rD) and these other assets (rA, rK), while com- petition among banks will necessitate that the deposit yield offered will depend upon the yields available on these assets held in the banks’ portfolios. Such responses pose a question about the independence of the demand and supply curves in these circumstances, and focus attention upon the behaviour of market rates.

Here a special factor comes from the “moneyness” of bank deposits. Because of the use of bank deposits as money, destruction of an excess supply or their creation to meet an excess demand cannot occur readily for the economy in aggregate, except via transactions in the markets for particular assets (e.g., bank advances, government securities, or over- seas securities) under specified conditions (pegged exchange rate, etc.). Without these, the market for deposits may be characterised by “mone- tary disequilibria” with deposits being accepted but not willingly held, except as a temporary abode of purchasing power. In such circumstances it is difficult to see how an excess supply or demand for bank deposits is “signalled” directly in the market for bank deposits. Suppose that bank lending creates an excess supply of bank deposits which individuals attempt to remove by purchases of goods. The resulting increases in nominal income and wealth raise the demand for deposits, but unless the yield on bank asset portfolios increases, there is no scope for higher deposit yields to constitute part of the equilibrating mechanism.

Adjustment to deposit rates seems more likely if disequilibrium is worked out in other asset markets. Such transactions may alter both the yield on non-monetary assets and, in certain circumstances, the quantity of money. For example, if an excess supply of money (deposits) leads to attempts by the non-bank sector to purchase government debt, the yield on government debt will tend to fall and some of this demand may be met by sales of government securities by the banking sector, resulting in a destruction of bank deposits. Both effects, the reduction in the stock of bank deposits and lower yields on competing assets, would tend to restore

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equilibrium, but other factors intervene. The rearrangement of bank portfolios involving a higher cash reserve ratio caused by security sales may lead banks to expand advances, thereby returning deposits towards the original level and, in the process, lowering yields on private sector debt, This may in turn impinge upon bank deposit yields, for while the yield per dollar of assets is extensively predetermined by past portfolio decisions in the short run, with flexi-rate loans some downward move- ment in deposit yields is to be expected, also partially offsetting the restoration of equilibrium.

Our earlier analysis (Davis and Lewis (1982b)) avoided some of these complications by adopting a number of simplifying assumptions. We assumed that the stock of bank deposits was, effectively, exogenous through the maintenance by banks of a constant cash reserve ratio in the face of a fixed aggregate supply of reserves. We concentrated upon asset market adjustments alone. We also assumed that bank deposit rates were linked closely to current market rates through competition and, by excluding capital assets from banks’ portfolios, ensured that equilibrium in the deposit market would occur.

An alternative description is provided here. When the authorities engineer a reduction in the money supply (via open market sales or reserve ratio increases, etc.), a process of asset readjustment eventuates which raises the yield on the non-monetary (financial and physical) assets. When the interest rate on money (bank deposits plus currency) is pegged, this absolute increase on competing yields is also a relative one

FIGURE 1 MONETARY EQUILIBRIUM AND INTEREST RATES

\ E

45 O

\

\ \ \ \

\

__

\

R S T O M‘ M M”

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and, for some increase in absolute yields, portfolio equilibrium will be re- established. In Figure 1, adapted from Miller [1981), the yield differential (used to represent relative yields) between market yields (rA) and that on bank deposits [rD) must widen from ( rA - rD)o to ( rA - rD)1 following a reduction (MM’) in the money supply. On the left hand panel, this increase in the yield differential translates into an equal-sized increase in market rates (from R to Q) along the 45O line.

When the yield on bank deposits is instead competitively determined there is no longer a one-for-one relationship between market rates and the differential rate. This is because the return on banks’ asset portfolios will increase with market rates and, under competitive conditions, the higher return will be passed on to depositors, thereby narrowing the yield differential. Thus, to achieve a particular change in relative yields, necessary for portfolio equilibrium, a larger change in the absolute level of interest rates is necessary. Suppose that the transition from pegged to flexible deposit rates occurs at position A in Figure 1. Suppose also, for the time being, that the same interest differential [rA - rD)o gives money market equilibrium with the money stock OM. When the money stock is again restricted to OM‘, market rates rise as before but this time they are chased by bank rates. A larger change in r A is needed to produce the same result in the differential [ rA - rD), and this relationship is depicted by the 45O line pivoting a t A to the line BC. Movements up and down the demand for money schedule [shown as from A) give rise to larger absolute fluctuations in market rates (from P to T as compared to movements before from Q to S).

Not only are interest rates likely to be more variable when bank deposit rates are flexible, they are likely to be higher on average. This conclusion comes about because the relevant change in practice [a process which began in December 1980) is from an interest rate ceiling (now applying to only a part of banks’ asset portfolio) to removal of that ceiling. When the ceiling operates, bank rates can follow market rates downwards but can- not do so in an upwards direction above the ceiling. Removal of the ceiling would thus imply more flexible bank interest rates, but only in one direc- tion. To the extent that this is the case, the response of market rates to monetary disequilibria with the ceiling on is given by the kinked line DAC, with rates varying from Q to T. With the ceiling off, rates vary from P to T. Under the specified conditions, rates will overall be at a higher average level compared with the position before deregulation.

These results presuppose that asset demand functions remain unaltered in the face of changes like the increased variance of bank deposit yields and increased covariance between bank deposit and other yields-about which more in the next section. The results also assume that bank deposit rates are not already effectively market-determined because of bank competition via the payment of “implicit” interest. When banks are prohibited from paying explicit interest on demand deposits and when ceilings constrain payment of interest on other liabilities, com-

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petition may encourage banks to evade the controls and pay “implicit interest”-by providing transactions services without charge, expanding convenience services, or by granting loans at less than market rates. If this implicit interest equalled the explicit interest paid after deregulation and responded as quickly to market forces, the effect of removing interest rate controls would have more shadow than substance-except that measured interest rates would be higher.

In Australia, implicit interest of about 5% on demand deposits is a figure frequently suggested by the banks and estimates as high as 7% were made by Swan and Harper (1982). Its size is an important issue for the long run demand for money function, for if explicit interest merely replaces implicit interest, the extent of banking re-intermediation which follows deregulation may be less than expected. Monetary expansion which followed the freeing-up of British banking in 1971 was allowed to proceed apace because it was believed, wrongly it would seem, that matching increases in the demand for bank deposits ensued also from the changes (see Artis and Lewis (1981)).

Our analysis above (of the demand for money in the short run) survives so long as the short-run responsiveness of implicit interest rates to movements in market rates is less than that of explicit rates. This seems reasonable. Decisions about branching take time, while frequent revision of service charges is uneconomic. A study by Startz (1979) for US banks found that the implicit interest paid by banks did vary with market rates, but only by a factor in the region of one-third to one-half, so that the short- term variability of bank deposit rates (in total) has been limited by the prohibition of explicit interest rates.

How this might change in the new environment depends much on how the bankerlcustomer relationship evolves. Banks are unlikely to eschew implicit interest payments entirely, if only because under the current tax system they yield a non-taxable benefit to the recipient, whereas explicit interest is taxable. Acquiescence by banks in the tax avoidance will be desired by customers so long as bank pricing policies generate a high degree of correlation between deposit size and the amount of implicit interest received. It is far from obvious that banks or customers would want separate explicit pricing of each and every individual service. Bank demand deposits are characterised by their ready withdrawability and transferability of ownership (as a means of payment), and to provide this package of characteristics banks incur resource costs. Explicit pricing, as an alternative to a “package deal”, itself incurs resource costs, especially in retail activities where economies of scale suggest stan- dardisation of pricing, while services may be a means of full line forcing. Customers’ reaction to piecemeal pricing also needs to be taken into account. They may regard deposits and the services as joint products, preferring to operate in effect a temporal service contract with a bank rather than be involved in a sequence of spot transactions (Thompson and Craven (1980)). Certainly it seems to be the case that the countries which

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offer interest on cheque deposits pay only a low rate and competition via this medium is muted. At the same time, it is also true that there are few examples of deregulated financial systems in which banks do not retain elements of monopoly over the payments mechanism.

Important factors influencing banks' potential to vary interest rates on deposits, as shown in the previous section, are holdings of required reserves and the interest paid by the authorities on them. Assuming that competition leads to banks making only normal profits, the yield on bank deposits (in equilibrium) will be given by

where e is the excess cash reserve ratio; the other symbols are as before, and marginal costs of bank intermediation are ignored. A restriction of bank deposits (say by a reduction of base money) can be expected to increase yields on non-monetary assets. Bank deposit rates will follow them, but the question at issue is by how much. If rs is fixed (below I'A) then the increase in rD will be less than that in rA. Moreover, this retarding effect will be greater the larger is s, and remember that the restriction of deposits can be made alternatively via increases in s (the required reserve ratio). The increase in the "tax" rate of s(rA-rs) retards the rise in bank rates and widens interest margins by increasing the cost of bank intermediation.

On the other hand, if rs is linked to rA (let us say equal to it), it is clear that the required reserve ratio plays no role in retarding the increase in rD relative to rA. With required reserves bearing a market rate of interest, the absence of any tax effect enables bank yields to rise in line with other market rates. Larger changes in the level of interest rates are necessary to bring about the relative rate change needed for equilibrium in the money market. (In Figure 1, the line AB departs farther from the 45O line when SRDs are paid a market or near market rate of interest. Conversely, the line AB lies closer to the 4 5 O line when SRDs bear a below-market rate and when the ratio is increased.)

So far we have couched the argument in terms of partial equilibrium requirements for the money market, but the implications may be more readily appreciated in the context of the familiar IS-LM model. In that framework the argument reduces to the proposition that after deregula- tion, and when SRDs bear a market rate of interest, the LM curve will become less elastic with respect to the absolute level of the interest rate on bonds (and physical capital). Two conclusions follow. First, the effects on economic activity of disturbances in the real sector (such as changes in the expected marginal efficiency of capital or an alteration to fiscal policy) will be moderated to a greater extent by control of the money stock when bank deposit rates are flexible. Second, a given change in the money stock will lead to a larger change in the level of interest rates when bank deposit rates are flexible, and thus exert a larger impact on the level of economic activity. (Similar conclusions are reached by Argy (1982).)

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r D = s.rS+ (1 - s - e) rA

Both conclusions stem from the likely alteration to the demand for money schedule such that it becomes more inelastic with respect to absolute changes in market yields on securities. But if this is the case, the open market operations needed to institute money supply variations are more difficult to effect. The interest inelasticity of the demand for money with respect to interest rate levels may be mirrored in the demand for securities-a rise in security yields will not necessarily sell more debt if matched by increased bank deposit rates. In effect, “money” and “securities” may be closer substitutes. We now explore the implications for monetary control.

Monetary Control and Base Money

following way: Harry Johnson (1968) put the case for control of the money supply in the

. . . whereas other industries provide real goods and services that the public demands. . . the banking industry provides nominal money. . . while the public demands real balances-stocks of purchasing power. The public can adjust the real value of any given quantity of nominal money balances supplied. . . by changing the price level through its efforts to substitute goods for real balances.

Appealing as this argument is (particularly if the phrase “nominal income” is substituted for “price”-so as to avoid the implicit assumption of full employment), it is deficient in ignoring the process of how deposit money is created, and in failing to explain why this creation is different from an expansion of the liabilities of other intermediaries.

This question has, of course, been asked before, even though for the most part “helicopter money” continues to reign (rain?). Fama (1980) argued that the position of banks in an unregulated environment is, when viewed from a general equilibrium perspective, little different from that of any other intermediary or financial firm. To expand deposits, they must be able to acquire assets on which the deposits are. as “inside” money, an indirect claim. Tobin (1963) had earlier outlined the implications which follow, most notably that the scale of banking, like other intermediation, would (at least in the longer run) be determined as part of a general equilibrium system and that, to a large degree, the importance attached to bank liabilities stemmed from controls over the banking sector.

Although the Report does not adopt the extreme position of no regula- tion, it suggests travelling far enough down the deregulation road to raise the question of what, if anything, should be the object of monetary control. In a general equilibrium framework as Patinkin (1961) has argued, some “important” nominal magnitude needs to be tied down or made in inelastic supply and, since with N assets only N-1 rates of return are independent, some rate of return must be exogenously determined if the system is to have a solution and content given to the unit of account. Typically, the nominal quantity is the fiat issue of money, used as the means of payment, and the interest rate exogenously set is the zero return

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on money, A money supply standard is not essential. The magnitude fixed could be gold, foreign exchange, labour, or even oil. In principle, the questions of which magnitude and which rates are controlled matter little, although there are potential social savings from avoiding a commodity standard. In practice, the choice matters greatly because of controllability and the nature of price determination involved. We confine our analysis to monetary control, and ask what magnitude and rate is to be tied down.

In the usual “inside” money model, financial intermediaries are synonymous with banks, other institutions either being ignored or grouped in the bond market. At the same time, the banks are integrated with the central bank, so that the money supply is bank deposits, determined by central bank mandate. In this Keynesian-type framework, the area of monetary control is large.

A division of this nature is used in the standard IS-LM system assuming flexible wages and prices. Here there are equations for the markets for commodities, money, and bonds, only two of which are independent. Yet there are three variables to be determined: the deposit rate, the bond rate, and the price level. The latter enters because real balances are demanded, but the quantity of money is in nominal terms. One deter- minate solution is when the bank deposit rate is fixed, usually a t zero.

If, in the foregoing system, we substitute for “central bank mandate” the web of controls and suasion exercised over the banks, and substitute for a “zero deposit rate” the price setting practices led by the central bank, we have a not unfair description of many national monetary systems in earlier years. With market forces and deregulation, the area of policy discretion shrinks, a t least a t our simplified conceptual level, to the central banks’ own balance sheet. There are now four equations, covering commodities, bonds, bank deposits, and base money, only three of which are independent. But there are four variables to determine: the price level, the bond rate, the deposit rate, and the rate paid on reserves [or base money). One of these rates must be fixed.

In the financial system envisaged by the Report, the choice of the interest rate to be controlled is quite clear. It is the interest rate on that part of base money which is not held as required reserves by the banking system, i.e., currency plus the banking sector’s excess reserves. From a general equilibrium perspective that, plus control of some nominal magnitude (presumably the quantity of base money), should suffice, but the practical problem remains of whether the chosen interest rate has empirical significance. Unless the supply or demand for some asset is sensitive to the yield on the non-required reserve component of base money, fixing that yield may not help to render the system determinate. More generally (and perhaps more importantly] a low elasticity of asset excess demand functions with respect to this yield may heighten the interest rate responsiveness of the system to random shocks.

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While we expect that currency holdings and banks’ desired excess cash reserves will display some sensitivity to opportunity costs in the deregulated system, both may be relatively low. Niehans (1980) has pointed out that much of the impetus for banks to hold excess reserves stems from a market imperfection which could be driven from the system. If a well-developed interbank market exists in which banks experiencing reserve outflows can borrow reserves from those experiencing inflows, with little spread between borrowing and lending rates, a major cause of interest rate sensitivity of excess reserve holdings is lost. Rather, the level of excess reserves desired will depend upon expectations of the system as a whole experiencing changes in the available stock of reserves of a magnitude large enough to impose costs yet not large enough to threaten stability of the banks and be relieved via last resort loans. It is not obvious that such a rationale for the holding of excess reserves leads to the interest rate on excess reserves affecting asset demands.

A similar question mark hangs over the interest rate sensitivity of currency holdings. Models of the transactions demand for money do suggest a priori reasons for expecting interest rate sensitivity, but it must be asked whether they are applicable to the determination of currency holdings, rather than transactions balances in aggregate. There is, undoubtedly, some level of interest rates a t which currency holdings would be interest-sensitive (such that the return on alternative assets justifies use of cheques in transactions for very small amounts, or thrice daily trips to the bank to withdraw currency to cater for small trans- actions over the next eight hours]. But a t more normal levels of interest rates, we find it not inconceivable that the structure of transactions costs and yield differentials is such as to lead to a “corner solution“ in which currency holdings display no sensitivity to interest rates.

As these comments suggest, control of the interest rate on currency and excess reserves alone may not give the degree of precision needed for medium run stability. While there have been many complaints in the past about the authorities “fixing” too many variables and rendering the system overdetermined (see e.g., Porter (1977)), the Report’s recommen- dations are perhaps open to counter complaints of fixing too little. But fixity of some other rate, say the rediscount rate on short-term government paper, as an independent instrument raises the problem of the control of some nominal magnitude-since base money could not then be regarded as being independently determined. We now take up the issue of which nominal magnitude should be the object of attention.

We have already noted that the financial system envisaged in the Report may make the characteristics of bank deposits in general closer to those of (domestic) “securities”. Certainly, with the exception of cheque accounts, there may be little to distinguish bank liabilities from the liabilities of a wide range of other financial institutions, and a high degree of substitutability may exist between them. In such circumstances, does a bank-based magnitude mean anything?

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A simple example illustrates the point. Suppose the authorities selected (out of the numerous competitive banks) one bank, the quantity of whose liabilities was somehow controlled. Other banks, which were not subject to control, offered liabilities which were perfect substitutes for those of the controlled bank. No one, we suspect, would argue that anything effective had been achieved, unless control over this one bank somehow yielded indirect control over the remaining banks.

In a similar fashion, it is hard to justify control over an aggregate like M3 unless, by so doing, control over the nominal magnitude of close substitutes is thereby achieved. The Report (3.17) clearly indicates that it expects deregulation to enable indirect control of close substitutes to be achieved through control of M3. Although it is not stated, the argument presumably runs as follows. Consider, for example, an exogenous in- crease in the demand for credit by customers of intermediaries. With bank interest rates constrained, other institutions can raise their deposit rates, thereby attracting funds and increasing lending, albeit a t higher interest rates. When bank rates are deregulated, banks respond to these actions by raising their rates. The others must then raise their rates by a larger amount which, provided that the demand for credit is interest elastic (to some degree), reduces the natural limit to expansion.

The argument is incomplete since it fails to distinguish real from nominal magnitudes. There is a contraction of the real demand for credit as (real) interest rates rise, but this contraction could be achieved with any change in the nominal scale of non-bank liabilities, accompanied by appropriate changes in the price level. Unless changes in the price level (or nominal income) induced by financial intermedia tion create a deficiency of real reserves and thus bank deposits, which are tied down in nominal terms, we are still left with a problem of price level indeter- minancy. By our assumption of a high degree of substitutability between financial claims and bank non-chequing deposits, this problem can only be resolved via effects on the quantity of real chequing deposits. It is here that the deficiencies of a n M3 target arise, since a given target provides only minimal constraints on the behaviour of the nominal quantity of M1.

One way for control of M3 to give leverage over other financial aggregates is for the unleashed banks to gradually swallow up their competitors so that M3 with consolidated banks embraces most of the financial system-a not implausible scenario. However, as we make clearer below, this would not necessarily solve the monetary control problems. In terms of existing aggregates, it would seem appropriate for the authorities to focus upon an intermediate objective which is either broader or narrower in scope than M3. In the latter case, there are two main candidates: M1 or base money.

The role of M1 for domestic payments and its immediate convertibility into international means of payment gives this aggregate appeal, although the evolution of alternative domestic payments systems and the ability to hold foreign currencies directly threaten to diminish its uniqueness.

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Moreover, it is far from obvious how control of M1 could be achieved in the new environment. Open market operations may suffice for control of M3 by altering the reserve base of the banking system in conjunction with the required reserve ratio [although the recommendation that banking group liabilities be treated in a consolidated manner raises doubts about this). But while such a mechanism can effect control of the banking sector's total balance sheet, it does not yield control of a subset of it. If it does, the process is an indirect one of interest rates [and nominal income) bringing the demand for M1 into line with the targeted quantity. The mechanism runs from interest rates to nominal expenditures [perhaps via the exchange rate) and hence via the transactions demand for money to M1. Interest rates do the work, not the creation of monetary disequilibria in terms of M1. Rather than being a link in the transmission process, the M1 target is achieved as an outcome. The rationale for such a target is, at best, weak, although appearances can often be important in monetary affairs: "the target" would be met and achievement may bring its own rewards in terms of expectations of inflation and behaviour in exchange rate markets.

Control of M1 in this cosmetic way could be aided by differential reserve ratios or by manipulation of the yield paid on required reserves to alter the structure and level of interest rates. Although we have argued above that the absence of any "tax effect" via required reserve ratios enhances the responsiveness of the level of interest rates to changes in the money supply [appropriately defined), this is not an unmitigated blessing. It does increase the leverage which the authorities can exert with any given action but, by the same token, increases the cost of mistakes and renders the system more inherently interest rate and nomimal income responsive to disturbances emanating in financial markets. These can involve economic costs (bankruptcies, less incentive to engage in maturity mismatching) and, while hedge markets can mitigate them, it is not apparent why the costs should not be tackled at their source. [Why is cure better than prevention?)

The interest rate consequences of monetary base control, recom- mended for consideration by the Report, seem even more pronounced since banks can be expected to compete with the authorities in the market place. Competition for base money among its holders, such as banks, should drive its marginal implicit yield to zero, implying a relationship of the form

Since the demand for bank deposits depends upon a comparison of rA and rD [reflecting the relative costs of direct versus indirect financing), substantial changes in the level of interest rates may be necessary to bring demand into line with the new supply induced by a change in base money. For example, if the demand for bank deposits depends upon the differential [rA - rD), and e is .02, the absolute level of interest rates must

rA(1 - e) = rD.

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rise by 50 percentage points to widen the differential by just one percentage point.

More generally, monetary base control may not be a non-distortive control mechanism, as sought by the Report. It impinges directly upon only those intermediaries-indeed, upon those activities-for which base money is an essential part of the productive process. Wholesale bankers, by contrast, can obviate the need for reserves of base money by employing different production methods such as “maturity matching”. Since a voluntary demand for cash may not exist, an imposed cash reserve ratio conflicts with commercial judgment. Other intermediaries can avoid holding reserves of base money by utilising bank chequing deposits as their liquid reserves-the well-known “pyramiding effect”. Since base control has no direct consequences for the composition of bank deposits, any constraint is, a t best, indirect. Like M3 control, base money control may be of limited use in controlling the nominal scale of financial liabilities which are, or are soon to be, close substitutes for bank non-chequing deposits.

An alternative strategy open to the authorities is to focus upon a financial aggregate broader in scope than M3, its characteristics depend- ing on the theory followed. In Tobin’s (1958) development of liquidity preference, the demand for money dissolves into a demand for all claims with a constant nominal purchasing power. The Bank of England’s new financial aggregates (termed private sector liquidity) have such a basis, embracing sterling M3, non-bank liabilities, and money market paper such as bills. As an alternative basis, the asset theory of exchange rate determination looks to control of all of those short-term claims in the domestic currency which are capable of being readily switched into foreign securities.

Again, however, the question arises of how control of such aggregates is to be achieved. With the imposition of reserve ratios on non-bank institutions ruled out of court by the Report, and with the growth rate of base money only loosely related to the growth of all claims denominated in the domestic currency, the only strategy which seems viable is that of manipulating interest rates (and exchange rates) through open market operations to ensure that spending, output, and price movements lead the demand for this broader nominal aggregate to conform with the targeted magnitude. As in the case of an M1 target, we are left with the target being an outcome of the transmission mechanism rather than a causal link. Inflation is used to control the money supply, when the idea was meant to be the reverse.

If all else fails, fiscal policy can always be used for monetary control, Again, if effective, this reduces the supply of “money” or “liquidity” by reducing expenditures, income, prices, and thus the demand for money first. Not only is this indirect, it cannot be guaranteed to be effective. As explained above, deregulation has a major cost of reducing the impact of fiscal actions upon the economy.

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Conclusion The arguments of the preceding sections indicate that monetary policy

in a deregulated financial sector is not the simple matter that the Campbell Report’s cursory treatment of the subject makes it appear. Monetary targeting, for example, requires much closer scrutiny than it is given, while a major deficiency of the Report is the virtual absence of any discussion of tactics to be pursued by the authorities.

Perhaps these deficiencies were only to be expected given the Com- mittee’s emphasis on matters of efficiency, and, in fairness to them, they have made many useful recommendations in that area. But, we would argue, the emphasis is lopsided. Efficiency in stabilisation policy is important, and failure to achieve macroeconomic objectives can have a more profound impact upon welfare than the narrower concept of efficiency focused upon in the Report would suggest.

Not all of the difficulties we have raised can be laid at the feet of the Campbell Report, nor will refusal to implement its recommendations mean that all of the problems will go away. Deregulation and financial innovation are under way, so that what may be at issue is the speed of change. For policymakers, it involves very much a step into the unknown, in which they cannot be sure that interest rate variability and a possible loss of fiscal policy effectiveness will be compensated for by greater monetary control, except by rather blunt means.

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