I want to make a minor point to follow up on something important that David Glasner said:
"Nevertheless, our basic mental processes for understanding how central banks can use an interest-rate instrument to control the value of money are carryovers from an earlier epoch when the value of money was determined, most of the time and in most places, by convertibility, either actual or expected, into gold or silver. The interest-rate instrument of central banks was not primarily designed as a method for controlling the value of money; it was the mechanism by which the central bank could control the amount of reserves on its balance sheet and the amount of gold or silver in its vaults. There was only an indirect connection – at least until the 1920s — between a central bank setting its interest-rate instrument to control its balance sheet and the effect on prices and inflation. The rules of monetary policy developed under a gold standard are not necessarily applicable to an economic system in which the value of money is fundamentally indeterminate."
David does not use the word "anachronism", but I think he's saying that central banks' use of an interest rate instrument (and our thinking of monetary policy in this way) is an anachronism. It made sense under the old gold exchange standard, but doesn't make sense now.
But I want to go a little bit further than what (I think) David said. An anachronism is something that's in the wrong time. There must be something equivalent to "anachronism", only in the wrong place. Like a Brit coming to Canada, and continuing to drive on the left. [Update: Brett in comments tells me the word I'm looking for is "anatopism", which is a totally new word for me.] Central banks' using interest rate control is wrong both in time and in place. [It's both an anachronism and an anatopism.] Let me try to explain why those two sorts of wrongness are very similar, in this case.
A central bank on the gold exchange standard issues monetary liabilities that it promises to convert at a fixed exchange rate for gold. It is the central bank's responsibility to conduct its operations to ensure that its promise is credible so its monetary liabilities always have a fixed value in terms of gold.
A commercial bank today issues monetary liabilities that it promises to convert at a fixed exchange rate for central bank notes. It is the commercial bank's responsibility to conduct its operations to ensure that its promise is credible so its monetary liabilities always have a fixed value in terms of central bank notes.
See the similarity between a central bank on yesterday's gold exchange standard and a modern commercial bank? They are both what I call "beta banks". Betas follow alphas. Central banks under the gold exchange standard were beta banks for whom gold was alpha. Commercial banks today are beta banks for whom central bank notes are alpha.
What ultimately determines the value of a beta bank's monetary liabilities is convertibility at a fixed exchange rate. Convertibility at a fixed exchange rate is what creates the nominal anchor. Even if convertibility is temporarily suspended, the expectation that convertibility will eventually be restored pins down the expected future value of a central bank's currency, which plays a large part in limiting movements in its current value. Any interest rate set by a beta bank plays a purely subsidiary role, in helping to ensure it maintains sufficient reserves, or access to sufficient reserves, relative to the size of its monetary liabilities, to ensure it can maintain convertibility.
But modern central banks are alpha banks. They do not promise to redeem their monetary liabilities at a fixed exchange rate to some alpha good.
But when a modern central banker looks back in time to the gold exchange standard, or across in space to commercial banks, it must look very natural to think in terms of interest rate control. Adjusting interest rates is what banks do, and I'm running a bank, so that is what I must do too.
No, you are not running a bank; you are running a gold mine. You are the alpha leader, not a beta follower. The sort of tactics that make sense for a beta follower don't work the same way for you.
When a beta bank adjusts an interest rate, on its loans or deposits, it is not trying to control the value of its monetary liabilities, it is trying to control the size and composition of its balance sheet. Convertibility is what controls the value of its monetary liabilities. When an alpha bank uses only interest rate instruments, it is one instrument short of a full set.