Controlling price or quantity of money?

Central banks miss the old days when money supply used to be managed via the funding rate.

As financial crises become a routine of economies due to the piling interconnectedness amid actors, central banks will need prompt intervention tools.

Economic downturns necessitate central banks to improve quantity tools to promptly boost spending. The practices are still infant.

The Monetary Transmission Mechanism: Evolving Beyond Interest Rate Policy

Until the 2008 global financial crisis, central banks primarily managed monetary policy through interest rate manipulation—the "price of money." By adjusting short-term policy rates, they influenced consumption, investment, and aggregate demand. However, the 2008 crisis, followed by the COVID-19 pandemic in 2020, forced central banks into unfamiliar territory: the zero lower bound (ZLB), where nominal interest rates could not fall significantly below zero. This rendered traditional interest rate policies ineffective in stimulating economic activity.

To navigate this constraint, central banks adopted quantitative easing (QE)—a "quantity tool" designed to lower long-term interest rates and inject liquidity into the economy. QE involves large-scale asset purchases, initially of long-term government bonds, with the goal of raising asset prices, lowering yields, and encouraging borrowing and investment.

From Interest Rates to Asset Purchases

Once risk-free rates approached zero, QE expanded to include riskier assets such as mortgage-backed securities (MBS) and corporate bonds. For instance, by mid-2021, the U.S. Federal Reserve held over $2.7 trillion in MBS, up from near zero in 2008 (Federal Reserve, 2021). This marked a structural shift: central banks assumed part of the risk transformation function typically performed by commercial banks.

However, this raises concerns about financial stability. The International Monetary Fund (IMF, 2021) warned that extended QE could concentrate risk in the public sector and reduce the effectiveness of monetary policy over time. Since government balance sheets have limited capacity to absorb credit risk, this approach may not be sustainable. This is echoed in deposit insurance frameworks: for example, the U.S. Federal Deposit Insurance Corporation (FDIC) only insures deposits up to $250,000 per account, highlighting the limits of public sector risk absorption.

Comparative Effectiveness: Quantity vs. Price Tools

Despite these concerns, QE offers several advantages over traditional interest rate policies—particularly under crisis conditions.

First, QE has a more immediate effect. Asset purchases directly raise the money supply and compress long-term interest rates. In contrast, interest rate changes propagate slowly through the economy. Research from the Bank for International Settlements (BIS, 2022) suggests that it can take 12 to 24 months for a rate cut to fully affect inflation and output. During that lag, recessionary dynamics—such as rising unemployment—may escalate. Between 2008 and 2009, U.S. unemployment rose from 5% to 10% in just one year (BLS, 2010), a period during which interest rate cuts failed to prevent mass layoffs.

Second, QE bypasses the banking sector’s credit decisions. In downturns, banks may be reluctant to lend even if funding becomes cheaper. During the early months of the COVID-19 pandemic, despite near-zero policy rates, private-sector credit contracted as banks tightened lending standards (Federal Reserve Senior Loan Officer Survey, Q2 2020). In contrast, QE allows central banks to boost monetary aggregates directly, regardless of bank behavior.

Moreover, QE can be complemented by macroprudential policies. Authorities can mandate increased leverage or capital deployment from banks. For example, in Turkey in 2020, the Banking Regulation and Supervision Agency (BRSA) imposed asset ratio requirements that forced banks to lend or face penalties, which immediately boosted credit flows to households and businesses (CBRT, 2021).

The Future of Monetary Policy

While central banks long for the simpler pre-crisis days when they could steer the economy with a single rate, repeated shocks and systemic crises demand more agile tools. QE and other balance-sheet policies remain relatively blunt instruments, often criticized for fueling asset bubbles or widening inequality.

Looking ahead, more targeted and pass-through monetary tools are likely to emerge. Examples include helicopter money (direct transfers to households), yield curve control (used by the Bank of Japan), and digital central bank currencies that allow more precise liquidity injections. These tools offer the promise of faster, more equitable responses to economic downturns—though they remain in early stages of development.

As global financial systems grow increasingly interconnected, crises will likely occur with greater frequency and complexity. Central banks must continue to refine and expand their arsenal. The shift from price-based to quantity-based tools is not merely a response to recent crises—it may define the new normal in monetary policy.

References

Federal Reserve. (2021). Balance Sheet Developments. https://www.federalreserve.gov

International Monetary Fund (IMF). (2021). Global Financial Stability Report. https://www.imf.org

U.S. Bureau of Labor Statistics (BLS). (2010). Labor Force Statistics. https://www.bls.gov

Bank for International Settlements (BIS). (2022). Transmission of Monetary Policy. https://www.bis.org

Federal Reserve. (2020). Senior Loan Officer Opinion Survey on Bank Lending Practices (Q2). https://www.federalreserve.gov

Central Bank of the Republic of Turkey (CBRT). (2021). Financial Stability Report. https://www.tcmb.gov.tr