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Wednesday, April 6, 2016

What Is Monetary Policy?

One of the more arcane arguments that has resurfaced in recent years is the distinction between monetary and fiscal policy. This is in reference to various unorthodox policy prescriptions that have recently arisen -- helicopter drops, QE, etc. Eric Lonergan has written a fairly concise breakdown of the distinction - "The distinction between monetary and fiscal policy."  I have not had much time to think about his article -- too many charts to prepare -- but I do know whether my preferred definition is covered by his distinction.

Government Policy Matters

This is a debate that is solely for intellectual entertainment; the true answer is what matters is government policy. In the same way we should consolidate the central bank with the Treasury, we need to look at government policies as a coherent whole. A policy like Quantitative Easing is incoherent, and should be avoided; it does not matter whether it is "fiscal" or "monetary."

Furthermore, how do we classify the following hot button issues?
  • Raising the minimum wage to $15.
  • Building a wall along your country's border.
  • Changing welfare state policies, such as eligibility, or the creation of a Job Guarantee Programme.
  • Enforcing tax laws against international trusts.
  • Various "free trade" treaties. 

Simplistic Definitions

If we still want to dig into the definitions of fiscal and monetary policy, I would suggest that the following are entirely reasonable first pass operational definitions.
  • Monetary Policy is what central banks do.
  • Fiscal Policy is what the Treasury (Ministry of Finance) does.
One could argue that these definitions leave a certain amount of room for interpretation. One might ask -- what should central banks be doing?

I do not have a handy answer for fiscal policy, but I would suggest narrowing monetary policy to the following definition.

Monetary Policy should consist of the following activities, which are essentially inter-linked.
  • Administering interest rates (its deposit and lending rate). 
  • Borrowing against or lending against various instruments. (Lending against equities -- why not? It's still structured as a loan.)
  • Buying or selling instruments that normally do not generate regular income (for anyone) when bought or sold, only capital gains. For example, one normally qualifies for a capital gain/loss when selling a bond, but shirt manufacturers generate business revenue when they sell shirts. Therefore, bonds are legitimate under this definition, but shirts are not. Notably, currencies are in this category, so the entire panoply of currency manipulation falls under monetary policy. 
The underlying principle is that monetary policy has no direct impact on income flows in the real economy (other than interest income relating to the central bank's balance sheet). A "helicopter drop" of money creates income for the recipients, hence it is not monetary policy under this definition.

I have thought less about the fiscal policy definition, but it seems that it consists precisely of those policies that directly create income flows in the real economy. All other government policies, such as those ones listed earlier in this article, would have to be classified as "other."

The lack of a direct effect on income (beyond the balance sheet effects) is why I feel it is legitimate for a legislature to delegate monetary policy to the central bank. Acts that affect incomes (fiscal policy, under the definition here) remain the domain of parliament.

Finally, an interesting exclusion to the last case is gold. Since gold miners generate business income when they sell gold, buying or selling gold is not considered a legitimate part of monetary policy. Since I believe that gold should remain de-monetised, I have no problems with this implication.

(c) Brian Romanchuk 2015


  1. Brian,

    I am sure you know at least some of these details, however, I think it is meaningful to discuss operative financial problems and institutional solutions. In the United States the U.S. Congress sets the federal tax, spend, and credit policies. Since it is impossible to match taxes and spending over any short period the Treasury issues securities to cover a deficit and net redeems securities to dispose of a surplus cash flow. This policy, to a first order approximation, means that federal government cash and debt management does not alter levels of bank reserves (issued as central bank liabilities) or levels of bank liabilities. During periods of aggregate bank balance sheet expansion (but not balance sheet contraction) this give the central bank exclusive control over the level of bank reserves, which can be used to control the federal funds interbank interest rate.

    Congress is further concerned to ensure price stability. The central bank (Fed) would do quantitative easing, in the absence of any other authorized price stabilizing mechanism, to prevent a sharp decline in credit formation and an accompanying steep drop in the prices of assets and market price of equities. To stop a credit fueled inflation the central bank would increase the interest rate in money markets to a high level which would bankrupt some of the nonbanks, banks, and financial intermediaries who could not rollover short term liabilities at a profit. So I would identify monetary policy as any measures the central bank or combined government does in an effort to ensure price stability. QE is not incoherent if it actually prevents deflation that would destroy the real economy in a counter-factual world without QE. - Joe.

    1. My understanding of the debate is that it is not about the objectives of policy, it is just what are the policy mechanisms.

      If we want to discuss the institutional factors for the Fed, we end up with my first definition - monetary policy is what the statutes let the Fed do. That does not answer the question of whether that is what the Fed should be doing.

      For example, there is a argument that "helicopter money" is monetary policy. (As I note above, in my view it is fiscal.) The Fed is probably barred from such activities by statute. But the helicopter money advocates would say that the statute is preventing the Fed from implementing a legitimate monetary policy.

  2. The consolidated government (central bank and Treasury) efforts to curb deflation or harmful inflation would be the essence of monetary policy since everything else is a mechanical requirement to issue a float of consolidated government liabilities equal to the sum of past deficit and surplus periods. If the consolidated government is also financing asset purchases under credit policy (central bank QE, direct student loans, direct small business loans, etc.) then it must either collect taxes or float more consolidated government liabilities to finance the assets it holds according to credit policy. If the central bank decides it must purchase assets to prevent deflation via quantitative easing then this is monetary policy in my view since the program is aimed at financial stability and not merely the mechanical finance of fiscal and credit policy.


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