Is monetary policy alone enough to stimulate economic recovery?

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Diana Correia's picture

With economies stuck in a liquidity trap with low levels of real growth, high unemployment and increasing costs of sovereign debt, central banks have been pressured to take on alternative actions to resolve the crisis. In this essay I argue that reducing real interest rates via inflation expectation is unattainable, as the quantitative easing has been unsuccessful in this sense, and adopting a nominal income target is inefficient. Furthermore, I suggest that supply-side polices are a complementary solution to help in economic recovery.

Almost all major economies are at the zero lower bound, or very close to it, in terms of nominal interest rates set by the monetary authorities. Canada has kept its target at 1% since it raised it from 0,75% in September 2010, United Kingdom cut to 0,5% in March 2009, Japan lowered to 0% in October 2010, United States is expected to hold at 0,25% until at least 2014, Switzerland remains at 0% since August 2011, and the Eurozone returned to 1% last December. When the nominal interest rate approaches zero, the conventional monetary policies lose their ability to expand output in the short-run (Krugman, 1998). This entails a Liquidity Trap, in which bonds and money become perfect substitutes. Under these circumstances, additional money injected in the economy is saved rather than used to purchase goods and services.

One might argue that interest rates on loans are usually higher than those on savings (i.e., bonds), hence, even in a liquidity trap, there is margin for central banks to expand credit, by increasing reserves and decreasing interest rates on loans.

This is suggested by Bernanke and Blinder (1988), in a model where bonds and loans are not perfect substitutes because their respective interest rates differ. An increase in reserves expands output more than in the traditional IS-LM model, since reserves are incorporated both in the LM curve (money and bonds market) and in the CC curve, which represents the credit and commodities market and replaces the traditional IS curve. Moreover, an increase in credit supply accompanied, say, by a decline in the perceived risk of loans, decreases the interest on loans, thereby increasing output and interest rates on bonds.

Nevertheless, the recent increase in banks reserves is not coming from the credit and deposit multiplier effect, but from banks’ portfolio allocation between bonds and excess reserves. The former allow the banks higher returns, while the latter protect them against the risk of deposits outflow. Such an increase in reserves does not lead to the effect predicted by Bernanke and Blinder (1988), as it does not derive from credit expansion.

The increase in credit supply is also unlikely to happen, since the perceived risk on loans has been increasing, and the interbank lending pattern was disrupted, not only due to the financial instability but also because of the decreased opportunity cost of holding excess reserves, given the interest associated with them.

Furthermore, we cannot rely on fiscal policy to restore the economy by pulling demand, since most countries are constrained by contractionary fiscal consolidations and a growing level of sovereign debt. Consequently, households, facing decreasing income, are reducing consumption and firms do not have the incentives to invest. Exports are not likely to help economies revitalizing. Given the global nature of the crisis, it would require exchange rate policies that may trigger currency wars. These would be huge devaluations or temporarily peg to a depreciated currency, only possible for an economy with its own currency and unlikely feasible for a large open economy, as the countries whose currencies were supposed to appreciate against would probably not allow this to happen.

As a result, the challenge to restore the economy, and rescue it from the liquidity trap, has been put in non-conventional monetary policies, like creating inflation expectations through the quantitative easing and adopting a nominal income target (NGDP target), or in supply-side policies, namely increasing productivity.

It has been claimed that the creation of inflation expectations may be powerful, in the sense that it drives down real interest rates, thus making agents fear the erosion of their cash holdings and leading them to stop hoarding. From this view arises the NGDP target rule, which allows central banks to pursue higher rates of inflation when economies are in recession. However, the ability of central banks to create inflation expectation in a credible way is debatable. We have argued that using the monetary base to flood banks with liquidity, through open market operations, or buying private assets directly (like the Fed’s Credit Easing Program) has been useful in terms of liquidity provision and in stabilizing the banking system, but has not gone into loans, as CBs have no control over banks’ actions. Consequently, central banks have no means to stimulate demand, hence they cannot create a shortage of goods and therefore inflation expectations.

Regarding the NGDP target, Laurence Ball (1997) shows that this policy is highly inefficient, since an inflation target achieves a lower volatility of output and inflation. Although the NGDP target has some advantages over an inflation one, mainly in responding to supply-side shocks, it leads both output and inflation to fluctuate far from its long-run levels. The idea is as follows: when output falls, so does inflation in the next period, thus CB expands to keep NGDP on target. But once output is on its target, inflation will remain lower in the next period, which pressures the CB to expand output above the target in order to bring inflation down. This leads us to conclude that the NGDP target could be a solution to the liquidity trap once weights on output and inflation of central banks’ mandate are taken into account.

The limited role of monetary policy may be enhanced if appropriately complemented with supply side policies. If there is an effective supply-side improvement, firms and consumers may have more confidence in the future of the economy, thus encouraging consumption and investment today and allowing the CBs to create inflation expectations.

A nice illustration of this is put forward by Fernández-Villaverde et al.(2011), who use a two-period model to show that supply-side policies may play a role in expanding demand when economies are in a liquidity trap. The mechanism rests on the fact that, if policies that raise productivity in the future are undertaken today (or, alternatively, firms’ mark-ups are lowered), consumption in the future will rise. This is consistent with intertemporal consumption maximization only if current consumption increases, since Interest rates cannot increase to clear the market at the zero lower bound. Eggertson (2009) argues that supply side improvements or cuts in the marginal labour income tax lower inflation expectation, thus increasing real interest rates and leading to the opposite effect of the central banks’ aim. Nevertheless, we may expect that the increase in confidence in the future may more than offsets the rise in the cost of the current consumption.

Supply-side policies entail a cost, not only because they imply sacrificing today’s welfare to get more in the future but also due the length of results. But, since we are in a liquidity trap, supply-side policies should been seen as desirable as they might have a higher-than-normal rate of return.

This is not an argument to leave other policy tools inactive but instead to use them in a coordinated way. One could, for instance, make use of fiscal policies directed towards expenditure, like investment in infrastructures or R&D which, beyond pulling demand today, may raise productivity tomorrow.

In this essay I stressed the weaknesses of monetary policy tools in a liquidity trap and highlighted some alternatives. The effectiveness of such alternative policies is constrained by some factors. Firstly, it is a mistake to rely on supply-side policies alone. Secondly, since the reforms that yield higher productivity may decrease the rents of some groups and the outcomes take time, there may be political pressure against the implementation of the reforms.

References: 
  1. Ball, L., 1997a. Efficient Rules for Monetary Policy. NBER working paper no. 5952.
  2. Bernanke, B.S. and A. S. Blinder. 1988. "Credit, Money and Aggregate Demand." American Economic Review 78: 2: 435-439.
  3. Buiter, Willem H., and Nikolas Panigirtzoglou (1999), “Liquidity Traps: How to Avoid Them and How to Escape Them,” Working Paper.
  4. Eggertson, Gauti B., 2009. “What Fiscal Policy is Effective at Zero Interest Rates?” Federal Reserve Bank of New York, Staff Report 402.
  5. Fernández-Villaverde, J, P Guerrón-Quintana, and JF Rubio-Ramírez (2011). "Supply-Side Policies and the Zero Lower Bound", CEPR Discussion Paper 8642, November.
  6. Krugman, P (1998): “It’s back! Japan’s slump and the return of the liquidity trap”, Brookings Papers on Economic Activity, 2.