It is not possible collectively to commit to enforce a monetary policy contract with an institution such as a central bank. And, even if we could, we would not want to because that would prevent us from exploiting new knowledge about the world. In essence, I want to argue that the relevant theoretical framework could be described as “public goods meet incomplete contracts”. Institutional design is at the heart of collective decisions in a world of incomplete contracts, and, interestingly, discussion of monetary issues in recent years has focussed on institutional arrangements. I shall illustrate the importance of institutional design for the operation of monetary policy by reference to three case studies: the collapse of exchange rate regimes in Brazil and the United Kingdom; currency arrangements in Iraq and their reform after the war last year; and the relationship between central banks and governments when the zero constraint on nominal interest rates is binding. 1  I am deeply grateful to James Proudman, Jan Vlieghe and Tony Yates for their research collaboration and for many of the ideas in this lecture. They are truly co-authors. I am also grateful to Peter Andrews, Andrew Bailey, John Campbell, Forest Capie, Philip Evans, Niall Ferguson, Charles Goodhart, Simon Gray, Oliver Hart, John Moore, Tom Sargent, Lars Svensson, Greg Thwaites and Geoffrey Wood for their helpful comments. Kath Begley and Ed Bolingbrooke provided valuable research assistance. All errors and omissions are my responsibility.
When the central bank offers to buy illiquid long-term bonds, it increases the average liquidity of the private sector’s portfolio, replacing less liquid with more liquid securities. The private sector will therefore be more willing to hold other illiquid instruments, such as private sector bonds and equities. As a result, liquidity premia fall across a broad category of securities, raising their market value. That will stimulate spending by firms and consumers.17 Such a policy is preferable to conventional open market purchases of short-term bills or bonds because when interest rates are zero such bills become perfect substitutes for cash. Hence purchases of short bonds have no effect on spending or other real variables. It is a short step to show that this argument implies an equivalence proposition between unconventional quantitative operations, on the one hand, and a combination of neutral conventional operations and government debt management, on the other. The purchase of a long-term bond by the central bank is equivalent to a combination of two other operations: a purchase of a short-term bill, followed by an operation that swaps the short-term bill for the long term bond. In either case, the central bank balance sheet ends up with an additional liability in cash, and an additional asset in longterm bonds. The first of these two operations, the purchase of a short-term bill, is neutral in its effect as it replaces one private sector asset, a short-term bill, with another, cash, that is a perfect substitute for it.