JP poses this question in yet another thought-provoking post.
I’ll offer one thought, from the standard New Keynesian model of money, interest and prices. In this model, the fact that money confers liquidity services is captured, rather crudely, by assuming that we are all like coin collectors and get pleasure from holding real money balances. JP’s thought experiment is undertaken in this model by wondering what happens if you slowly reduce the amount of pleasure all of us coin collectors get.
Woodford explains the title of his textbook ‘interest and prices’, in particular, the virtual absence of money, in his opening salvos, by pointing out that central bank control over interest rates, and thereby over the whole economy, does not depend on this ‘pleasure’ being of a certain magnitude. In fact, the simple version of the model he studies is one in which this pleasure is conjectured to be infinitely small. Monetary policy’s leverage here depends on money’s role as a unit of account.
Looked at this way, the tendency for the economy to get stuck in a liquidity trap in response to shocks to the natural rate of interest (for example) should not depend on the liquidity convenience (pleasure!) we get from money.
Another way we can interpret JP’s question, though is this.
Suppose that a shock to the natural rate comes along, requiring an extended period of interest rates at the zero bound [and perhaps other stimulus too], to return inflation slowly to target. But then on top of that there is some monetary innovation lowering the liquidity services to money. [Apple Pay?!] What would happen then? Looked at through this model, nothing at all. Because the fact that interest rates are already at zero shows that these liquidity service benefits have already long been exhausted.
Here I have assumed that the monetary reform does not change the asymptote of these liquidity service benefits as real balances get very very large. All that happens is that the monetary reform changes the profile of those marginal service benefits at finite values of real balances.
What if the reform that happens mid-way through responding to the natural rate shock did change the asymptote, however? For example, what if the reform involved abolishing higher denomination notes, which increases the costs of managing cash? I’m not absolutely sure here, without actually doing this properly, but I hazard this guess. Nothing happens, much, if central banks hold interest rates where they are, except that they have to allow real balances to decline via a reduction in nominal money quantities. The reform, however, will create an opportunity for the central bank to lower rates if it wants to, in case the old floor to rates [previously zero, now lowered] implied an amount of stimulus that was less than optimal.
The more interesting question – in fact the question that JP Koning actually posed – is what happens in the real world, of course. But you’ll have to go elsewhere for answers to questions like that.
longandvariable 
“stuck in a liquidity trap in response to shocks to the natural rate of interest ”
There is your problem right there.
The attempts to “estimate” are basically alchemy (or philosophy.)
There is no “natural rate of interest.” Or if there is one it is zero – since that is the “natural” rate that results when no bonds or interest on reserves are paid.
http://bilbo.economicoutlook.net/blog/?p=4656
The natural rate of interest is zero.
“The idea of a neutral rate is relevant because it reflects the belief in the primacy of monetary policy as the preferred counter-stabilisation tool. Accordingly, almost all economists these days (not me!) believe that the central bank can maximise real economic growth by achieving price stability. Consistent with this view is the belief that when the central bank target interest rate is below the “neutral rate of interest”, inflation will break out (eventually) and vice versa.
So the neutral rate is sometimes called the equilibrium interest rate. It has a direct analogue in the labour market in the concept of the natural rate of unemployment – another neo-liberal smokescreen.
Where did this construction come from? We can initially see the idea in the writings of Classical British economist Henry Thornton (1760-1815) but the best known exposition is found in the 1898 book by Swedish monetary theorist Knut Wicksell (1851-1926). Wicksellian thinking is very influential among central bankers.
In his classic book – Interest and Prices (1936 edition published by Macmillan and Co) – Wicksell defined a “natural interest rate” as follows (page 102):
There is a certain rate of interest on loans which is neutral in respect to commodity prices, and tend neither to raise nor to lower them. This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods. It comes to much the same thing to describe it as the current value of the natural rate of interest on capital (emphasis in original).
So consistent with the view held in those times that the loanable funds market brought savers together with investors, the natural rate of interest is that rate where the real demand for investment funds equals the real supply of savings.
Wicksell also differentiated the interest rate in financial markets which is determined by the demand and supply of money and the interest rate that would mediate “real intertemporal transfers” in a world without money. So this meant that “money” had no impact on the “natural interest rate” which reflects only real (not nominal) factors.
He wrote (page 104):
Now if money is loaned at this same rate of interest, it serves as nothing more than a cloak to cover a procedure which, from the purely formal point of view, could have been carried on equally well without it. The conditions of economic equilibrium are fulfilled in precisely the same manner.
All this reasoning is consistent with the idea that classical idea that money is a “veil over the real economy”, that it only affects the price level. The way in which this occurs in Wicksellian thought is that the deviation between the interest rate determined in the financial markets and the natural rate impacts on the price level.
So when the money interest rate is below the natural rate, investment exceeds saving and aggregate demand exceeds aggregate supply. Bank loans create new money to finance the investment gap and inflation results (and vice versa, for money interest rates above the natural rate).
I could write at length outlining why this conception is inapplicable to a modern monetary economy but that isn’t the purpose of this blog.
With the natural rate of interest an unobservable imaginative construct, Wicksell claimed that the link between price level movements and the gap between the two interest rates provided the clue for policy makers.
He wrote (p.189) that:
This does not mean that the banks ought actually to ascertain the natural rate before fixing their own rates of interest. That would, of course, be impracticable, and would also be quite unnecessary. For the current level of commodity prices provides a reliable test of the agreement of diversion of the two rates. The procedure should rather be simply as follows: So long as prices remain unaltered the banks’ rate of interest is to remain unaltered. If prices rise, the rate of interest is to be raised; and if prices fall, the rate of interest is to be lowered; and the rate of interest is henceforth to be maintained at its new level until a further movement of prices calls for a further change in one direction or the other. (emphasis in original).
So you can see the genesis of the natural rate concept that central bankers still hold onto – but now prefer to refer to it as the “neutral rate of interest”.
In this vein, there was an important speech given by former Federal Reserve Chairman Alan Greenspan in 1993 which elevated this concept back into mainstream policy considerations. Central bankers in the 1980s had been beguiled by Milton Friedman’s view that they needed to control the stock of money if they were to maintain price stability. As a consequence monetary targetting was pursued and soon after turned out to be a total failure.
It was obvious that the stock of money could not be controlled by the central bank given it was endogenously determined by the demand for credit. Modern monetary theory never considered money to be exogenously determined – which is the main presumption in mainstream macroeconomics textbooks.”
If interest rates on central bank money are fixed at 0% (i.e. paper money doesn’t earn interest), then the central bank can’t set seigniorage independently of interest rates. As a side effect of zero rates, seigniorage is also zero. Printing $100 bills is no longer profitable. It would be a welcome coincidence if money demand fell during this unrewarding period.
Thanks for the comment, Tony, I’m sympathetic to Woodford’s view. While I haven’t read his magnum opus, I really liked his paper Monetary Policy in a World Without Money
“Because the fact that interest rates are already at zero shows that these liquidity service benefits have already long been exhausted.”
Since we’re on the topic, here’s something I’ve been thinking about for a while and I’d be curious to hear what you think.
Say that the overnight rate is at zero but risk free rates a few days or weeks out are above zero (I think that’s an accurate description of the current environment). Does a 0% overnight rate mean that all liquidity services have been exhausted? I’m not so sure. A bill in our wallet is expected to yield a stream of liquidity services over the next few days or weeks, not just overnight. This expected flow of pleasure is discounted into the present and sums up to the the total pleasure derived from holding money. About all we can say when the overnight rate is at zero is that overnight liquidity services have been exhausted. Until the 1-week and 1-month risk free rates are also at zero, money’s liquidity services haven’t been exhausted.
So riffing on your post, by creating massive quantities of reserves, a central bank surely reduces current liquidity services to zero. But future marginal liquidity services may still be positive. Something like Apple Pay, a permanent technological improvement, might reduce future liquidity services.
Good point.
I’ll think about it.
I think you are right, but, at least in the NK model, this would not matter for anything! The central bank would decide the optimal trajectory of central bank rates in response to natural rate shocks, and the reduction in liquidity services would simply mean that that rate would translate into a lower demand for money at those interest rates. In a sense, we know this already, because Woodford has already shown what happens when liqudity services become infinitely unvaluable. That’s his baseline model.