December 22, 2015 Reading Time: 3 minutes

The purchasing power of money over time depends on its relative abundance or scarcity. People choose to hold money balances for a variety of reasons, all of which economists lump together as “the demand for money.” It is crucially important that this is understood to be a desire to hold on to, rather than spend, some amount of money. While the money holdings of individuals increase and decrease with some frequency, there is an average amount that individuals, households, businesses and the entire population tend to hold. If the aggregate amount everyone wants to hold is roughly predictable, the people responsible for conducting monetary policy find that to be useful information.

The other factor influencing the purchasing power of money over time is changes in the total supply of money balances—either in the form of currency or deposit balances in banks. When a monetary authority, such as a central bank, has the tools and techniques to closely control the availability of money in an economy, they have to potential to match the amount demanded with the amount supplied and thus maintain the purchasing power of money.

At least, that is the textbook version of standard monetary theory. If there is neither an excess supply of money balances nor an excess demand to hold more money, there is no reason for the purchasing power to be falling (inflation) or rising (deflation).

When the monetary authorities make big announcements about changes in their policies—as did the US Federal Reserve on December 16, 2015—it is useful to ask, “In what ways will the actions announced affect the amount of money supplied to the economy, or possibly influence the amounts that people want to hold on average?” That is, will either an excess supply of money or an excess demand for money be caused by the policy actions that were announced?

The set of announcements include several components. The headline announcement was that the monetary authorities raised the target overnight interest rate that some banks pay when they borrow from other banks. For several years now, the US monetary authorities have had no policy tools to directly affect this interbank rate, so the sense in which it can be considered a target is not at all clear. That reality focuses attention to the companion announcements last Wednesday—an increase in the interest rate Reserve Banks pay to depositing commercial banks for their ‘reserve’ balances (IOR), and more aggressive use of an intervention called “reverse repurchase agreements (RRP).

Raising the IOR by 1/4 percentage point is great for banks that hold deposits at Federal Reserve Banks (FRBs), but comes at the expense of taxpayers because the FRBs will now have less interest income to return to the Treasury (essentially a 100% excess profits tax on FRBs net interest income). The indirect effect of the higher IOR on the effective FF rate is that borrowers in the interbank market can afford to pay more for other banks’ excess cash and get a higher arbitrage yield on deposits at FRBs.

The companion announcement—that both the rate paid on RRPs and the volume of such transactions—also reduces net interest income of FRBs (and payment to the Treasury) and expands the list of recipients. Government Sponsored Enterprises (GSEs) and a long list of domestic and foreign money market mutual funds (MMMF) are not permitted to receive interest from FRBs for excess cash, but they can lend to the FRBs via the RRP program. Previously, some GSEs such as Federal Home Loan Banks (FHLB) were frequent sellers of excess cash in the FF market because of limitations on participation in the RRP transactions. Under the expanded RRP program, the supply of excess cash offered in the FF market may decline, thus supporting a higher effective interest rate.

After all this detail about the policy announcement by the monetary authorities, a perfectly reasonable question is, “What does any of this have to do with the purchasing power of money?” The answer depends on whether any of this changes the supply of money in the economy (not at all obvious) or has any effects on the average amounts of money that households and businesses want to hold (not at all obvious). These are new policy tools and techniques; there is no historical experience to learn from. It is simply impossible to say anything with confidence about whether—or in which direction—the purchasing power of the US dollar will be influenced.

Jerry L. Jordan


Jerry L. Jordan is a Senior Fellow with the Fraser Institute and an Adjunct Scholar with the Cato Institute. He was President of the Federal Reserve Bank of Cleveland, a member of President Reagan’s Council of Economic Advisors, Dean and Professor of Economics at the University of New Mexico, and Chief Economist for two commercial banks. He has also served as Sr. Vice President and Director of Research at the Federal Reserve Bank of St. Louis and as a consultant to the Deutsche Bundesbank in Frankfurt, W. Germany.

Jordan earned his Ph.D. in Economics at the University of California, Los Angeles and his B.A. in Economics at California State University, Northridge. He holds honorary doctorates from Denison University, Capital University and Universidad Francisco Marroquin.

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