Essays in the Tradition of Jane D'Arista
Edited by Gerald A. Epstein, Tom Schlesinger and Matías Vernengo
Chapter 13: Liquidity, leverage, and financial instability
As inflation rose in the 1970s monetarist economists argued that it was solely a monetary phenomenon and thus could simply be contained if the central bank curtailed the money supply. Post Keynesian economists challenged this view by correctly arguing that the central bank could not possibly control the money supply the way monetarist economists alleged. While the central bank had considerable discretion in setting the policy interest rate it had next to none over the money supply, which they argued lagged overall bank credit. The loans commercial banks issued to meet the credit demand from businesses returned to the banking system in the form new deposits, a process which the central bank was powerless to check unless it put at risk the very integrity of the payments system. Thus, Post Keynesians argued, the influence of the central bank over the economy rested not on its ability to control the money supply as such but instead in its ability to set interest rates that impacted businesses’ willingness to borrow. For some this also meant that interest rates were mainly impervious to market forces. Others thought that the point was overdone, for they recognized that the central bank policy influenced banks’ ability and willingness to make loans as well and emphasized the role of financial innovations and market forces in the determination of interest rates.
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