Implied money control theory: Meaning, Criticisms & Real-World Uses

What Is Implied Money Control Theory?

Implied money control theory describes the framework within which a central bank influences the overall availability and cost of money and credit in an economy, primarily through indirect policy tools, rather than directly targeting specific monetary aggregates. This approach falls under the broader umbrella of monetary policy, emphasizing the central bank's ability to affect financial conditions and aggregate economic activity through the manipulation of interest rates and the lending environment. The "implied" aspect refers to the fact that while the central bank may not set explicit targets for the money supply growth, its actions inevitably control the quantity of money circulating in the system.

History and Origin

Historically, many central banks, including the U.S. Federal Reserve, initially focused on directly managing the growth of the money supply as a primary means to achieve economic objectives like price stability. This approach, known as monetary targeting, gained prominence, particularly in the mid-20th century, drawing from the quantity theory of money. However, by the 1980s and 1990s, the relationship between monetary aggregates (like M1 or M2) and key macroeconomic variables such as inflation and economic growth became increasingly unstable due to financial innovations, deregulation, and globalization¹¹, ¹².

This instability led many central banks to gradually de-emphasize direct money supply targeting. Instead, they shifted towards a framework where they primarily use short-term interest rates as their operational target, influencing longer-term rates and overall credit conditions. This evolution meant that control over the money supply became more "implied," an outcome of interest rate decisions rather than a direct objective. For instance, the Federal Reserve Bank of Richmond discusses how the U.S. monetary regime evolved from earlier attempts at managed money to one where short-term interest rates became the instrument of monetary policy¹⁰. The International Monetary Fund also notes that monetary targeting had limited success because the demand for money became unstable⁹.

Key Takeaways

Implied money control theory posits that central banks influence the economy through indirect tools, primarily interest rates, rather than direct money supply targets.
The shift to implied money control reflects the diminishing reliability of the direct relationship between monetary aggregates and economic outcomes.
Central banks aim to manage overall credit conditions and liquidity in the financial system.
This approach underpins modern central banking strategies, including inflation targeting.
It acknowledges that while the quantity of money is affected, it's a consequence of policy actions, not the direct target.

Formula and Calculation

Implied money control theory does not rely on a single, universally applicable formula for direct calculation, unlike some other financial concepts. Instead, it describes a theoretical framework for how central banks operate. The central bank's influence is transmitted through various channels, and its "control" over the money supply is an emergent property of its actions rather than a direct calculation.

For example, when a central bank raises its policy interest rate, such as the federal funds rate in the U.S., it impacts borrowing costs across the economy. While there isn't a direct formula for "implied money control," the central bank's policy rate decisions influence other market rates, which in turn affect the volume of lending and, consequently, the broader money supply. The mechanisms involve changes in commercial bank reserves, interbank lending, and the overall cost of credit for businesses and consumers.

Interpreting the Implied Money Control Theory

Interpreting implied money control theory involves understanding that a central bank's primary objective is often to achieve macroeconomic stability (e.g., controlling inflation and promoting maximum employment) by influencing the cost and availability of credit. Rather than dictating the exact quantity of money in circulation, the central bank influences the conditions under which money is created and exchanged.

For instance, by setting a target for a short-term benchmark interest rate, the central bank encourages or discourages lending and borrowing throughout the financial markets. A lower target rate makes borrowing cheaper, stimulating investment and consumption, which expands the money supply indirectly as commercial banks create new deposits through lending. Conversely, a higher target rate tightens credit conditions, slowing money creation. This indirect approach acknowledges the complex and dynamic nature of money demand and supply in a modern economy, where innovations can rapidly alter the relationship between monetary aggregates and economic activity.

Hypothetical Example

Consider a hypothetical economy where the central bank observes signs of rising inflationary pressures. Under an implied money control theory framework, the central bank would decide to tighten its monetary policy.

Step 1: Policy Rate Adjustment
The central bank's Monetary Policy Committee (MPC) decides to increase its benchmark policy interest rate, for example, from 2.00% to 2.50%. This rate is the overnight lending rate between commercial banks for reserves.

Step 2: Impact on Bank Reserves and Lending
With the higher policy rate, it becomes more expensive for commercial banks to borrow reserves from each other or from the central bank's discount window. Banks, facing higher funding costs, in turn, raise their prime lending rates and other rates offered to customers for loans (e.g., mortgages, business loans).

Step 3: Effect on Borrowing and Spending
Businesses and consumers find it more expensive to borrow. A company planning an expansion might delay or scale down its investment due to higher loan interest. A consumer considering a new car might put off the purchase. This reduces overall aggregate demand in the economy.

Step 4: Implied Money Control
As borrowing decreases, banks create fewer new loans and, consequently, fewer new deposits. This naturally slows the growth of the money supply in the economy, helping to reduce inflationary pressures. The central bank didn't explicitly cap the money supply, but its interest rate adjustment implied a contractionary effect on money growth. This is how the "implied money control" mechanism functions in practice.

Practical Applications

The implied money control theory underpins the operational framework of most modern central banks, including the U.S. Federal Reserve, the European Central Bank (ECB), and others that employ inflation targeting or similar policy regimes.

Setting Policy Rates: Central banks regularly adjust their key policy interest rates, such as the federal funds rate in the United States, as their primary tool. These adjustments influence a spectrum of other interest rates throughout the economy, thereby affecting borrowing costs for consumers and businesses. This is the most direct application of implied money control, as the control over money and credit is exercised through pricing.
Open Market Operations: Central banks conduct open market operations—buying or selling government securities—to manage the level of reserves in the banking system, which in turn influences short-term interest rates and the overall liquidity. These operations are not about directly controlling the quantity of money, but about influencing the price (interest rate) at which reserves are available, thereby indirectly affecting the money supply.
Unemployment and Economic Stability: Policymakers utilize this framework to navigate economic cycles, easing policy during downturns to stimulate borrowing and spending (thereby fostering job creation and growth) and tightening it during periods of excessive inflation. Th⁷, ⁸e Federal Reserve Board, for example, formalizes its dual mandate of maximum employment and price stability, and its use of policy tools reflects an implied money control approach rather than strict monetary aggregates targeting.
⁶ Crisis Response: During financial crises, central banks might employ unconventional measures like quantitative easing. While these actions directly impact the size of the central bank's balance sheet and the monetary base, their ultimate goal is to influence long-term interest rates and credit availability when traditional policy rates are at their effective lower bound, further demonstrating the focus on implied control over credit conditions.

#⁵# Limitations and Criticisms

Despite its widespread adoption, implied money control theory and its practical application face several limitations and criticisms.

One significant challenge is the unpredictability of money demand and velocity. As noted by economists and institutions like the IMF, the stable relationship between monetary aggregates and economic activity, which was a cornerstone of earlier monetary targeting approaches, has largely broken down. Th³, ⁴is makes it difficult to predict the exact impact of interest rate changes on the broader money supply and, subsequently, on inflation and output. If the demand for money is unstable, a central bank might struggle to achieve its desired level of control, even indirectly.

Another criticism relates to time lags in the transmission of monetary policy. The effects of changes in interest rates can take significant time to propagate through the economy, making it challenging for central banks to fine-tune their policies in real time. Th²is lag can lead to overshooting or undershooting economic targets.

Furthermore, some critics argue that focusing solely on interest rates might overlook other crucial aspects of financial stability, such as the growth of credit in specific sectors or the potential for asset bubbles, which might not be adequately captured by aggregate interest rate movements. The debate over whether reserve requirements or the discount rate should play a more active role in controlling money and credit also arises. Modern Monetary Theory (MMT), for instance, offers a critique by suggesting a different understanding of money creation and the role of taxation as a monetary policy instrument.

#¹# Implied Money Control Theory vs. Monetary Targeting

The core distinction between implied money control theory and monetary targeting lies in the central bank's primary operational focus and intermediate targets.

Monetary targeting involves a central bank explicitly setting and attempting to achieve a specific growth rate for a defined monetary aggregate (e.g., M2, M3). The belief behind this approach is that a stable and predictable relationship exists between the chosen monetary aggregate and macroeconomic variables like inflation and nominal GDP. Central banks using this method would adjust their tools, such as open market operations or reserve requirements, directly to hit the money supply target. The control is direct, with the money quantity being the explicit goal.

In contrast, implied money control theory describes a framework where the central bank primarily influences the economy by setting a short-term benchmark interest rate. While these actions inevitably impact the quantity of money and credit in the economy, the central bank does not set an explicit target for a monetary aggregate. Instead, it aims to manage overall financial conditions—the cost and availability of credit—to achieve broader macroeconomic goals like price stability and full employment. The control over the money supply is therefore "implied" by the interest rate environment the central bank fosters, rather than being a direct, quantified objective. The shift away from monetary targeting to this more indirect approach was largely driven by the instability observed in the relationship between monetary aggregates and economic outcomes.

FAQs

What is the main goal of implied money control theory?

The main goal is to achieve macroeconomic objectives, such as low and stable inflation and maximum employment, by indirectly influencing the availability and cost of money and credit in the economy, primarily through adjustments to key interest rates.

How do central banks implement implied money control?

Central banks primarily implement implied money control by setting a target for a short-term policy interest rate. They use tools like open market operations to influence the supply of bank reserves, which helps ensure that market rates align with their target. These actions then influence broader lending, borrowing, and investment decisions across the economy, thereby affecting the money supply indirectly.

Is implied money control the same as inflation targeting?

Implied money control theory describes how central banks manage money and credit. Inflation targeting is a monetary policy strategy where a central bank publicly announces a specific inflation rate as its primary long-term objective and then uses its tools (operating under implied money control principles) to achieve that target. So, implied money control is the mechanism often used within an inflation targeting framework.

Why did central banks move away from direct money supply targeting?

Central banks moved away from direct money supply targeting because the stable relationship between monetary aggregates and key economic variables became unpredictable due to financial innovations and deregulation. This made it difficult for them to reliably achieve their objectives by targeting the money supply directly.