The new monetary framework

Do the policy actions of monetary authorities actually affect economic activity? We know that time and other resources are expended, but what can we observe about the results of such efforts? In answering this question, it is helpful to begin with an account of how monetary authorities in discretionary, fiat currency regimes are traditionally thought to influence economic activity. Here, every college course in intermediate monetary theory tells essentially the same story.A nation’s money supply comprises two distinct components:paper currency and deposits at banking organizations. The former was the largest component in earlier times, but the latter has come to dominate in recent decades—at least in most countries. The deposits in banks are subject to minimum reserve requirements, and the total deposit liabilities of banks constitute some multiple of reserve balances (that is, vault cash plus deposits at the central bank). The banking system asa whole is thus “reserve constrained,” which means that,unless the central bank provides more reserves, there is an upper limit to the total deposits that may be held by individuals and businesses. By extension, if currency outstanding increases, and the central bank fails to add to the total supply of reserves available to private banks, then there has to be a corresponding contraction of deposit money. These reserve constraints have historically meant that, for better or worse, monetary authorities have the power to control the nation’s money supply, and, in so doing, affect economic activity