Unformatted text preview: e but, as we
shall see, not at all the only line of defense.
So far, I have been talking about market makers as a reactive bunch who respond to fluctuations
in the natural hierarchy that are outside their control. I have also been implicitly assuming that
their behavior is driven by the dictates of profit maximization. The whole idea of monetary
policy however is to intervene actively with some objective in mind other than profit
maximization. We can understand monetary policy as an attempt to manage the natural
fluctuation of the system for the general good, rather than for the profit of the central bank.
So for example at a time when the natural hierarchy is flattening, instead of waiting for a
financial crisis to reassert the scarcity of money, the monetary authorities might try themselves to
reassert the scarcity by raising the Fed Funds rate (“taking away the punch bowl” in the immortal
words of William McChesney Martin). Or, at a time when the natural hierarchy is very steep,
the monetary authorities might try to reassert elasticity by lowering the Fed Funds rate (“pushing
on a string” in the immortal words of John Maynard Keynes). Mehrling 9/14/2009 8 Note here that the main policy instrument of the central bank is the overnight borrowing rate.
There can be considerable slippage between that rate and the longer term interest rates on which
important investment and spending decisions depend. One of the purposes of this course will be
get a better sense of the sources of that slippage. I’ve said that the central bank intervenes for the general good. What does it mean, “the general
good”? In this regard the ambitions of the monetary authority have shifted over time. The very
first central banks focused their attention simply on “managing the hierarchy” to protect par and
the exchange rate. If ordinary banks were having difficulty defending par, the central bank could
help them out by providing additional reserves—this is the essence of the classic “lender of last
resort” function. On the other hand, if the central bank itself was having difficulty defending the
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This document was uploaded on 02/16/2014.
- Fall '14