Suppose that we accept two basic arguments:
1. The central bank’s objective is to target the price level or nominal income.
2. The price level/nominal spending is below the optimal time path.
[A quick note: This does not mean that one should accept these arguments. Rather, I want to consider whether expansionary monetary policy can be effective by first assuming that we would find such a policy desirable. This allows us to focus exclusively on the role of monetary policy effectiveness.]
These two points imply that the central bank has a stated objective and is short of that objective. Expansionary monetary policy is necessary. However, even if we accept these basic points, there are other questions that need to be answered:
a. What is the monetary transmission mechanism? According to the New Keynesian model, monetary policy is transmitted through the interest rate. Once the interest rate hits the zero lower bound, monetary policy is relatively ineffective. Recent rounds of quantitative easing have been sold in a similar respect with promises of lower long term interest rates. However, this type of explanation assumes that there is something that prevents arbitrage in the market for government debt (i.e. that people holding long term bonds are different people from those holding short term bonds). This seems a weak reed upon which to rest policy. In the absence of this assumption it is difficult to understand how this policy might be effective in achieving the goal of monetary policy.
An alternative view of the monetary transmission mechanism that the central bank influences economic behavior through the aggregate stock of liquidity. According to this view, it is the aggregate stock of liquidity that determines the price level/nominal GDP.
b. Taking the monetary transmission mechanism in point (a) as given, can open market operations affect the price level/nominal GDP? It would seem that (according to this view) open market operations could be effective if they affect the aggregate stock of liquidity. But under what conditions do open market operations affect the aggregate stock of liquidity?
This brings me to a working paper of mine that examines whether or not open market operations can be effective. Here is the abstract:
Recent rounds of quantitative easing by the Federal Reserve have sparked debate about the effectiveness of such policies. Whether or not such policies can be effective depends on the monetary transmission mechanism. The present paper considers the effectiveness of open market operations when monetary policy is transmitted through the aggregate stock of liquidity. It is shown that monetary policy is effective when the liquidity of money and bonds differs. If bonds and money share the same liquidity properties, however, open market operations are irrelevant. These results hold regardless of whether liquidity is exogenous or endogenous. More generally, monetary policy is most effective when the central bank buys relatively illiquid assets. Even if open market operations are irrelevant, there is an empirical link between the aggregate stock of liquidity and the price level and nominal spending. If money and bonds are perfect substitutes in terms of liquidity, expansionary fiscal policy can influence the price level and nominal spending through its effect on liquidity. When liquidity is endogenous, fiscal policy is irrelevant if money and bonds are imperfect substitutes.
In short, the model shows that open market operations are effective in influencing the price level and nominal spending when money and bonds are not perfect substitutes for liquidity. This is true regardless of whether liquidity is exogenous or endogenous. However, if money and bonds have the same properties in terms of liquidity, open market operations only affects the composition of the aggregate stock of liquidity. As I point out in the paper, it actually seems difficult to empirically test whether or not open market operations affect the aggregate stock of liquidity.
I also consider the implications for fiscal policy, economic welfare, quantitative easing, and also compare the results to similar models in the literature.
The paper is only preliminary, so any and all constructive comments on the paper would be welcome. Hopefully, this can also spur some debate in the blogosphere — in a positive direction — while simultaneously demonstrating the way I have been thinking about monetary policy and why it doesn’t fit with traditional New Keynesian-type analysis.
The Everyday Economist 
The initial reaction of this non-economist is that your conclusion approaches triviality. Also, I do not see the point of leaving it open whether money and bonds have the same liquidity—obviously they don’t. Finally, I think it would still be considered “monetary policy” if the central bank used new money to buy something other than bonds—foreign exchange, stocks, real estate, etc.—where it would be even clearer that the purchased items were less liquid than money.
Philo,
Why is it trivial? Suppose that I am a firm. I am holding a substantial bond position. I need to make a payment (whether it is a debt payment, payroll, etc.), but my income flow is timed to match up with the payment. Even if bonds are not accepted as a medium of exchange, it is possible to use them for this purpose. For example, I could enter into a repurchase agreement where I sell these bonds today and promise to buy them back after I have received the income flow (say tomorrow). In this case, the bonds effectively serve as a medium of exchange. It is of no significance that I was holding bonds rather than money. In this case, money and bonds would clearly be (near?) perfect substitutes in terms of liquidity.
In addition, even if we accept the argument that it is obvious that they have different degrees of liquidity, the degree of liquidity still matters. If bonds or other assets can provide nearly the same amount of liquidity as base money, then the effects of open market operations are likely to be very small.
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Josh,
Are you aware of this Fed paper which concludes:
“Changes in reserves are unrelated to changes in lending, and open market operations do not have a direct impact on lending. We conclude that the textbook treatment of money in the transmission mechanism can be rejected. Specifically, our results indicate that bank loan supply does not respond to changes in monetary policy through a bank lending channel, no matter how we group the banks.”
http://www.federalreserve.gov/pubs/feds/2010/201041/201041pap.pdf (p. 28)
and this Fed paper which concludes:
“the effect of large reserves is contractionary rather than expansionary.”
http://www.newyorkfed.org/research/staff_reports/sr497.pdf (p. 10)
I interpret this as saying OMOs/QEs are (at best) useless, or have the opposite effect of what they’re supposed to do.
There are other “revelations” that have come out from the Fed and NBER in that last couple of years, if you’re interested.