The Insufficiencies of Monetary Policy in a Severe Financial Crisis

As we talked about last time, monetary policy is practical and useful even when interest rates near zero, thanks to unconventional tools such as quantitative easing. But in spite of this, I believe that monetary policy alone isn’t sufficient in the current financial crisis. In this entry, I'll argue that fiscal policy is needed to complement monetary policy due to the following three reasons.

Low Investment due to a Lack of Confidence in Consumer Demand 

First, since consumers are busy paying back debt, firms lack the confidence to employ more staff and expand production even if they have the resources and the ability to do so. Firms need to observe an increase in aggregate demand before they have the confidence to invest.

The situation is similar to the prisoner’s dilemma. A desirable outcome can be attained if all firms invest more when the economy is far below its equilibrium output. However, every firm is waiting for other firms to invest first, and in the end nobody invests and a bad outcome is reached. The only player with the authority to solve this coordination problem is the government. Hence, in a severe financial crisis, public spending restores confidence and stimulates private investment and spending. The crowding out effect is absent. 

The Marked Slowdown in Credit Creation

Second, a financial crisis is different from a typical mild recession, because in a financial crisis the money multiplier falls dramatically. Monetary policy is ineffective because the central bank will find it hard to increase the money supply despite efforts to expand the monetary base.

As Reinhart and Rogoff point out in This Time will be Different: Eight Centuries of Financial Folly, the economy takes longer to recover after a financial crisis because banks have to consolidate their balance sheets. They’ll hold more reserves to maintain financial health and lend out less money. Banks cut lending also because they’re worried about the creditworthiness of borrowers.

For example, as shown in Friedman’s and Schwartz’s The Monetary History of the United States, 1867-1960, while the monetary base was stable in the Great Depression, M1 (a measure of money supply, which includes currency in circulation plus demand deposits) fell by about 30% in the crisis. The culprit for such a drastic fall was a decrease in the money multiplier, and this problem has arisen again in the current financial crisis. In the United States, the monetary base has tripled since the start of the crisis but M2 (a measure of money supply that economists use most often, which includes M1 plus savings deposits and small time deposits) has gone up by 30% only.

In comparison, fiscal policy may be a lot more effective, especially given the lack of empirical evidence for Ricardian equivalence. Besides, tax increases are shown to have a highly contractionary impact on the economy, which suggests fiscal policy is more effective than economists previously thought. 

The Risk of Financial Bubbles

Third, a prolonged zero interest rate and rounds of quantitative easing are likely to fuel speculation and create financial bubbles. Given the drastically lower money multiplier, a lot of the money pumped into the economy is trapped in the investment and commercial banks. When optimism returns to the market and banks start to speculate and make more loans, asset price bubbles will easily follow. Hence, a central bank can’t use monetary expansion for too long because otherwise it risks over-inflating asset prices and causing another bubble before the real economic recovery has come. 

Fiscal Expansion as a Necessary Complement to Monetary Policy 

A low interest rate doesn’t help if consumers have little desire or confidence to spend even at zero interest rate. From Japan’s lost decade, we know that more liquidity doesn’t help if total factor productivity grows too slowly. Monetary policy is powerful, but it alone can’t stimulate economic recovery. 

Governments should boost the economy by taking the lead to spend. Austerity measures aimed to reduce public debt will only further contract the economy. Not only can public spending stimulate investment from the private sector, it benefits the economy by providing the infrastructure and public goods necessary to enhance productivity and growth in the future.

Government spending makes sense especially for countries like the United States, which can finance its public expenditure at a low, sustainable borrowing rate (as shown in the 10-year Treasury note yield, which is at 2%, compared to over 5% for Spanish and Italian bonds of the same maturity). It is a pity for austerity measures to take hold in the United States.

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

 

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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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How Monetary Policy Works and Differs from Fiscal Policy

In the previous post, we've learnt that monetary policy refers to the actions taken by a central bank to change the money supply. Naturally, the next question to ask is how a change in the money supply affects the economy.

This post will answer this question and explain the transmission channels of monetary policy. Afterwards, we'll compare and contrast fiscal and monetary policy, the two broad types of macroeconomic policies.

The Transmission Mechanisms of Monetary Policy 

Monetary policy affects the economy through a number of channels. Here we'll discuss the most important ones. 

(1) The Interest Rate Channel: 

In a recession, the central bank, by increasing the money supply, creates an environment of low real interest rates to lower both the cost of borrowing and the return of savings. In response to these incentives, firms will invest more in capital and consumers will save less and purchase more, which stimulate national output through a multiplier effect. 

(2) The Exchange Rate Channel:

After a monetary expansion, the interest rates are lowered and the return on deposits falls. This motivates people to move deposits abroad. To do so, they first have to sell the domestic currency in exchange for a foreign currency in the forex market. As a result, supply of the domestic currency increases, and the price of the currency falls (i.e. depreciation). Since a currency depreciation promotes exports and discourages imports, monetary expansion raises output under the exchange rate channel. 

(3) Other Transmission Channels: 

Other transmission channels exist too. One channel is through asset prices. Expansionary monetary policy increases the prices of financial assets, creating a wealth effect that increases consumption. Another example is the credit channel. After expansionary monetary policy, more deposits will enter the financial system. To increase profits, banks will lend out more money, which increases investment and output.

How Fiscal Policy Works 

In expansionary fiscal policy, the government increases public expenditure or launches tax cuts and rebates. This stimulates consumer spending and results in a multiplier effect to boost national income. Higher consumer spending means people will hold more money for consumption, which increases the demand for money and raises the real interest rate.

Since public spending results in a higher borrowing cost, it decreases investment in the private sector, a phenomenon known as the crowding out effect. Plus, a higher interest rate leads to an instant appreciation of the currency, which has a negative impact on net exports. 

The Benefits of Monetary Policy over Fiscal Policy 

Comparing the two, we can see that fiscal policy is unfavorable because it crowds out private investment and reduces net exports, while monetary policy facilitates both. Another downside of fiscal expansion is that it often requires borrowing. This may lead to a high level of public debt, which is dangerous since it can cause a range of problems from recession to price instability and a weakening currency.

Plus, economic research has shown that the effect of fiscal contraction can be largely compensated by the expansionary policies of an unconstrained central bank. Due to the above reasons, monetary policy is often considered a better stimulus tool than fiscal policy.

Moreover, if Ricardian equivalence is true, then fiscal policy is completely ineffective. Ricardian equivalence is a controversial concept proposed by some Chicago school economists. It holds that people anticipate future tax increases when the government increases spending or reduces taxes. Due to this expectation, consumers will save an additional dollar for every dollar spent by the state to stimulate the economy. As a result, fiscal expansion is completely offset by the decrease in private consumption, with no impact on the economy. 

References 

Abel, A. B., Bernanke, B. S., & Croushore, D. (2007). Macroeconomics (6th ed.). Boston, MA: Pearson/Addison Wesley. 

Case, K. E., Fair, R. C., & Oster, S. C. (2009). Principles of economics (9th ed.). Upper Saddle River, NJ: Prentice Hall.

Mishkin, F. S. (2010). The economics of money, banking and financial markets (9th ed.). Boston, MA: Pearson Education.

(Entry 2 of 4 in the An Introduction to Monetary Policy series) 
 

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The Traditional Tools of Monetary Policy

Since monetary policy is controlled by the central bank of a country, let's begin our discussion with central banking. This entry will also discuss the tools used by central banks to manage the economy.

The Central Bank and the Money Supply 

A central bank has two main goals. The first one is to maintain low and stable inflation. The second one is to achieve high and stable growth and a low unemployment rate. To meet these policy goals, a central bank changes the money supply to raise or lower the interest rate. A changing interest rate in turn affects consumption and investment decisions, which are two of the important components in a country’s economic activities. The control of money supply gives a central bank the means to stimulate a weak economy and cool down an overheating economy when necessary.

Money supply, defined as the product of the monetary base and the money multiplier, reflects the liquidity supplied to the economy by the financial system. The monetary base includes both the currency in circulation and the reserves in commercial banks, whereas the money multiplier reflects the demand for loans and the willingness of banks to lend. For example, if either the demand for or the supply of loans increases, the money multiplier increases. More credit is created holding the monetary base constant.

Monetary Tools: Minimum Reserve Requirement and the Discount Window

Traditionally, there are three ways to indirectly control the money supply, namely the required minimum reserve ratio, the discount window and the open market operations. In countries where the bond markets lack depth and liquidity (such as China), central banks usually adjusts the reserve requirement in order to restrict or loosen credit. This gives the central bank control over the money multiplier.

The discount window allows banks to borrow from the central bank at the discount rate. But this rarely happens in practice because banks can often borrow at a lower cost elsewhere. Only when a bank is in trouble will it borrow from the central bank, which acts as the lender of last resort.

The Most Important Monetary Tool: Open Market Operations

In many countries, central banks carry out monetary policy in the form of open market operations, because they can be implemented quickly and reversed easily. In many countries, central banks carry out monetary policy in the form of open market operations, because they can be implemented quickly and reversed easily.

Open market operations refer to the purchase and sale of government bonds by the central bank. To inject liquidity into the economy, the central bank buys bonds from the market (and pay money to the market participants). The increase in the demand for bonds will push up bond prices.

Since bonds make fixed payments at specified time, a higher price means that the interest rate (or bond yield, to be more exact) decreases. To tighten liquidity, the central bank sells bonds to market participants (and collect money from them). The increase in the supply of bonds will push down bond prices and raises the interest rate. What we’ve applied here is the inverse relationship between bond prices and interest rates/yields, which is an important concept in economics and finance.

Monetary Policy Rule

Though there are still disputes among economists, most research studies have shown that central bank transparency and credibility can make monetary policy more effective by reducing private sector uncertainty and keeping market expectations in line with its own. Ben Bernanke, Chairman of the Federal Reserve, is precisely trying to communicate with the public on Fed policies and increase the transparency and credibility of U.S. monetary policy.

A predetermined monetary rule can increase transparency and credibility, and is widely believed to work better than discretionary policy. In particular, many central banks set the interest rate target according to the Taylor rule. It states that the central bank should raise the nominal interest rate when output is above the equilibrium level and/or when inflation is above the equilibrium rate. 

References 

Abel, A. B., Bernanke, B. S., & Croushore, D. (2007). Macroeconomics (6th ed.). Boston, MA: Pearson/Addison Wesley.

Case, K. E., Fair, R. C., & Oster, S. C. (2009). Principles of economics (9th ed.). Upper Saddle River, NJ: Prentice Hall.

Mishkin, F. S. (2010). The economics of money, banking and financial markets (9th ed.). Boston, MA: Pearson Education.

(Entry 1 of 4 in the An Introduction to Monetary Policy series) 

 

How Monetary Policy Works and Differs from Fiscal Policy   Next >

  

An Introduction to Monetary Policy

Four years have passed and the world economy still hasn’t fully recovered from the 2008 financial crisis. Monetary policy has become a frequent and important topic in news reports, as economists and commentators often debate on what central banks should and shouldn’t do to save the economy. It seems a basic knowledge of monetary policy is now essential for anybody who wants to understand economic and financial news.

This 4-part series serves as a comprehensive introduction to monetary policy. In addition to explaining the tools and transmission mechanisms of monetary policy, I’ll argue that monetary policy alone is insufficient in a severe financial crisis. Since a financial crisis is different from a typical recession, fiscal stimulus is needed to complement monetary policy.

To learn what monetary policy is really about, click on the links below:

Part 1  The Traditional Tools of Monetary Policy

Part 2  How Monetary Policy Works and Differs from Fiscal Policy

Part 3  Liquidity Trap and Unconventional Monetary Tools

Part 4  The Insufficiencies of Monetary Policy in a Severe Financial Crisis 

Most of the theories in Part 1 and Part 2 can be found in undergraduate economics textbooks. To avoid the trouble of citations for all these basic concepts, I’ll simply put down a list of the relevant textbooks that I’ve read in class at the end of these entries.

I hope you'll find these articles helpful and informative. Please feel free to leave a comment.
  
P.S. A sincere thank you to Banbi for inspiring me to start this blog.