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Wednesday, March 14, 2012

Liquidity Trap and Unconventional Monetary Tools

Given the reasons mentioned in the last post, conventional economic models conclude that monetary policy is preferred to fiscal policy, unless the economy is still in serious trouble when interest rates are close to zero.

In this post, we explore what happens when interest rates are near zero. A key question is whether monetary policy works in such conditions.

The Zero Bound Constraint on Nominal Interest Rates

Since people can always choose to hold cash and receive zero returns, they will not invest in anything that pays negative returns. Hence, interest rate must be non-negative, which is referred to as the zero lower bound constraint. When deflation occurs, a nominal interest rate that is close to zero may actually be high in real terms. This is when the open market operations do not work as usual. 

This situation occurred in the Great Depression. Monetary expansion and the low nominal interest rate didn’t work because the economy was in deflation (at a rate of 10% per year in 1931 and 1932). The real interest rate rose to about 15%, and was a major reasons why the economy took a long time to recover. For more information, you can refer to these PowerPoint slides from the Federal Reserve Bank of St. Louis, which offers a nice economic analysis of the Great Depression.

The Role of Monetary Policy in a Liquidity Trap 

Liquidity trap refers to the situation where interest rates are close to zero. It wasn’t an important topic in economics, since in most countries the nominal interest rates were consistently well above zero from the end of World War II to the 1980s. However, after Japan’s deep recession in the 1990s and the recent financial crisis, the subject now attracts a lot more attention. For a more detailed treatment on liquidity trap, please refer to this article written by Nobel Prize winner Paul Krugman.

The conventional wisdom of Keynesian economics is that the monetary policy could do little to boost output in a liquidity trap, because it’s not possible to lower the interest rate even further.

But new research shows monetary policy can still be effective in a liquidity trap. A study by two renowned economists explains that even in a severe liquidity trap that is expected to last, open market operations can improve welfare by lowering the real value of public debt and thereby reducing the future tax burden on debt. This implies open market purchases are beneficial even if they have no immediate effect on interest rates and output.

Furthermore, the same study concludes that a permanent monetary expansion (i.e. the increase in money supply aren’t expected to be reversed in the future) increases current prices. With less than fully flexible prices, this increases output as well.

Indeed, when the short-term interest rates are near zero, a central bank can use unconventional tools such as quantitative easing and operation twist to stimulate the economy. These tools work via the asset price channel and the credit channel instead of the traditional interest rate channel.

Quantitative Easing and Operation Twist 

Even when interest rates can’t be lowered any further, a central bank can conduct quantitative easing, i.e. to buy assets from the market and expand its balance sheet, in order to increase the money supply. The central bank further injects liquidity into the market because it wants to promote bank lending, inflate asset prices and reduce real interest rates, all of which can stimulate economic activity. This policy was implemented in Japan in the early 2000s and the United States in the Great Recession.

In operation twist, the central bank sells short-term and buys long-term government bonds. This pushes down the price of short-term bonds (i.e. increases its yields), and increases the price of long-term bonds (i.e. lowers its yields). Operation twist aims to lower the long-term interest rates so as to reduce the cost of mortgage and corporate financing. Hopefully, this can stimulate investment and ease the burden of homeowners who are struggling to pay their mortgages.

As we can see, monetary policy can adapt to an environment of low interest rates, which is why it can still be effective at a near-zero interest rate. Still, it isn’t sufficient to adopt monetary policy alone in a severe financial crisis. The reasons will be explained in the next entry. 

(Entry 3 of 4 in the An Introduction to Monetary Policy series) 

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