Economic agents’ balance sheets hold the key to understanding monetary policy

We begin with the balance sheet of private economic agents (using the euro zone as an example). They hold real estate, corporate capital (in the form of listed and unlisted equities), corporate and public sector bonds and money. They decide how to distribute their wealth between these different asset classes. An expansionary monetary policy consists in replacing bonds with money in the portfolio s of private economic agents. It therefore only has an effect if money and bonds are not perfectly substitutable. If this is the case, economic agents will try to rebalance their portfolios by using the excess money they have to buy other assets. At equilibrium, the prices of these assets will rise (increase in real estate and share prices; fall in long-term interest rates, credit spreads, etc.). A constantly expansionary fiscal policy financed by debt leads to a continuous increase in the stock of bonds that private economic agents have to hold. Because the weight of bonds in these economic agents’ portfolios is limited (by their asset diversification choices), if fiscal policy remains expansionary, then at equilibrium there will inevitably be a rise in long-term interest rates to lower the value of outstanding bonds. If the constantly expansionary fiscal policy is financed by money creation (as advocated by “modern monetary theory”), the quantity of money that economic agents have to hold must constantly rise, which will only be possible if the value of the other assets they hold increases (to meet the desired weight of money in portfolios), i.e. t he prices of all the other assets (bonds, equities, real estate, etc.) increase. We then arrive at a continuous rise in the value of their wealth relative to their income, which is obviously destabilising.