Scott Sumner on Finance and Monetary Economics

I'm often frustrated by the conflation of finance and monetary economics. I understand its occurrence in the lay-public (not hating, just saying), but most economists themselves fall into this trap. It occurs because the signaling mechanism central banks use is short term interest rates, but they could theoretically pick anything. Where interest rates are used, policy is still just about changing the money supply to target a nominal variable. The conflation presents all sorts of cognitive problems, such as thinking the “real problem” is the the financial system, so monetary policy can’t work, to thinking monetary policy is used up because interest rates are at 0%.

Anyway, here is Bently economist Scott Sumner on just how baseless this conflation is:

"…monetary policy consists of changing the supply of cash relative to demand. The nominal size of the entire banking system and all its components; capital, loans, reserves, deposits, etc., is determined endogenously, just like the nominal size of the plastic surgery industry, or nominal size of the ice cream industry. Normally, a permanent 20% increase in the [monetary] base[1] would be expected to increase the nominal size of the banking, plastic surgery, and ice cream industries by 20%. But other things are often not equal. 

Banking is only special a few cases. For instance, government regulation of banks might create a large and time varying demand for base money. Or the public may hoard cash because they fear a banking collapse. Otherwise, banking is of no interest to monetary economics. If the Fed abolished reserve requirements, insured bank deposits, and targeted NGDP growth expectations at 5%, then you might as well drop banking out of monetary textbooks."

1. The monetary base is currency plus reserve accounts at the Fed