Over at Cato Unbound, Lawrence H. White explains the reason why the Federal Reserve's monetary policy was too accommodative in the early-to-mid 2000s was that if failed to stabilize nominal spending:
How do we judge whether the Fed expanded more than it should have? One venerable norm for making fiat central bank policy as neutral as possible toward the financial market is to aim for stability (zero growth) in the volume of nominal expenditure. [2] Second-best would be a predictably low and steady growth rate of nominal expenditure. A useful measure of nominal expenditure is the dollar volume of final sales to domestic purchasers (GDP less net exports and the change in business inventories). During the two years from the start of 2001 to the end of 2002, final sales to domestic purchasers grew at a compound annual rate of 3.6 percent. During 2003, the Fed’s acceleration of credit began to show up: the growth rate jumped to 6.5 percent. For the next two years, from the start 2004 to the end of 2005, the growth rate was even higher at 7.1 percent, nearly a doubling of the initial rate. It then backed off, to 4.3 percent per annum, from the start of 2006 to the start of 2008. But the damage from an unusually rapid expansion of nominal demand had been done.A key implication is that had there been a nominal income targeting rule, monetary policy during this time would have been more stabilizing. I am a big fan of nominal income targeting and hope some day it becomes as popular as inflation targeting has been over the past few decades. For more discussion on why a nominal income targeting rule would have made a difference in the early-to-mid 2000s see my posts here and here. Also see this classic paper on nominal income targeting for a good overview.
Assume that there were no legal restrictions that required banks to hold deposits at Federal Reserve Banks. Would the ability of the Federal Reserve Banks to generate their own earnings be affected? The answer is no. To implement its monetary policy objectives, the Federal Reserve would still buy and sell Government securities. Its holdings of Government securities would still represent the primary source of the “base” under bank deposits. The Federal Reserve would pay for the securities just as it does now, with a check written on itself. Commercial banks would then be “paid.”
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