Chapter 23 Modern Monetary Policy and the Challenges Facing Central Bankers Conceptual and Analytical Problems Explain in detail how monetary policy influences banks’ lending behavior. Show how an open market purchase affects the banking system’s balance sheet, and discuss the impact on the supply of bank loans. (You may wish to refer to Chapter 17 in answering this question.) Answer: The traditional tool of monetary policy in the U.S. is the federal funds rate. To achieve the target rate, the Fed buys or sells Treasury securities. When the Fed purchases securities, it increases the amount of reserves in the banking system. If the opportunity cost adjusted for risk (the difference between the interest rate on loans and the interest rate paid by the Fed on reserves) of holding excess reserves is too high for banks, they will increase the volume of loans they make. Explain why you might expect the recovery from the 2007–2009 recession to be weaker than normal. Answer: Recoveries from recessions precipitated from financial crises tend generally to be weaker. Banks tend to tighten credit standards in the wake of financial disruptions which makes it harder for firms—particularly small firms who are more bank dependent—and households to borrow. (Figure 23.2 provides supporting evidence.) Households’ demand for credit may also be weak as anxieties arising from the crisis spur higher rates of savings. The large government deficits in the wake of the crisis also make it likely that fiscal policies will be tight. Explain why the traditional interest-rate channel of monetary policy transmission from monetary policy actions to changes in investment and consumption decisions may be relatively weak. Answer: External financing by firms is made difficult by problems associated with asymmetric information, weakening the impact of changes in the cost of external funds on investment. Interest-sensitive consumption decisions depend on longer-term interest rates and so the impact of policy changes on consumption depends on the extent to which changes in the short-term rate influence longer-term rates through the term structure of interest rates. Explain why monetary policymakers’ actions in cutting the target range for the federal funds rate to 0 to ¼ percent were not sufficient to boost economic activity during the recession of 2007–2009. Answer: The financial system is the key link between monetary policy and economic activity. When the financial system is disrupted, so too is the mechanism that transmits monetary policy actions to the real economy. The financial crisis aggravated problems relating to asymmetric information resulting in a feedback loop between worsening economic prospects and the deterioration of financial conditions that influence spending. Monetary policymakers had to resort to unconventional tools to influence financial conditions in an effort to contain the crisis. When monetary policymakers hit the effective lower bound with their policy rate, they have the option to turn to unconventional tools of monetary policy. How do these unconventional tools work, and why might policymakers be reluctant to use them except in very difficult circumstances? Answer: Forward guidance, quantitative easing and targeted asset purchases are examples of unconventional tools. Forward guidance, where the central bank expresses the intent to keep interest rates low in the future; influencing long-term interest rates if it is credible. A policy of targeted asset purchases involves buying different assets than usual, such as longer-term Treasury bonds and mortgage-backed securities issued by government agencies, thereby altering the composition of the central bank’s balance sheet. Quantitative easing involves open-market purchases and lending that increase bank reserves beyond the level necessary to keep the policy rate at its target (typically near zero), expanding the size of the central bank’s balance sheet. Policymakers usually are reluctant to use these tools as they have limited experience with them, making the impact of their use less predictable. In addition, exiting can be difficult: for example, the central bank may suffer losses on the sale of unconventional assets acquired through targeted purchases. If these losses are substantial, the central bank’s reliance on the Government may be increased, compromising its independence. The government decides to place limits on the interest rates banks can pay their depositors. Seeing that alternative investments pay higher interest rates, depositors withdraw their funds from banks and place them in bonds. Will their action have an impact on the economy? If so, how? Answer: If depositors withdraw their funds, banks will be forced to shrink the size of their balance sheets so the supply of loans will fall, with a special effect on small firms and households that cannot issue debt in the securities markets (the “banking channel”). However, the increase in the demand for bonds would drive their yields down, making it cheaper for larger firms to borrow. U.S. experience suggests that the net result of these two effects would be to limit investment. New developments in information technology have simplified the assessment of individual borrowers’ creditworthiness. What are the likely consequences for the structure of the financial system? For monetary policy? Answer: Individuals can now obtain loans and mortgages from many different sources, not just banks. This means that the link between the amount of reserves in the banking system and the supply of loans is no longer as strong as it once was. Describe the theory of the exchange-rate channel of the monetary transmission mechanism. How, through the exchange rate, does an interest rate increase influence output? Why is this link difficult to find in practice? Answer: A rise in nominal interest rates will lead to a rise in real interest rates in the face of price stickiness. This makes domestic investments more attractive to foreign investors, leading to an increase in demand for domestic currency and an appreciation of the exchange rate. This appreciation makes exports more expensive for foreigners and imports less expensive for domestic consumers and so net exports fall leading to a fall in output. In practice, there are many factors that affect the demand and supply for domestic currency, making it difficult to isolate the impact of monetary policy changes on the exchange rate and net exports. Why might the effective lower bound on nominal interest rates lead policymakers to raise their inflation objective? Answer: Nominal interest rates cannot fall significantly below zero. If an economy experiences a deflationary shock when the nominal interest rate is zero, policymakers may have no way to restore their inflation target without using unconventional policy tools. Because of the dangers of a deflationary spiral, policymakers may feel safer with somewhat higher actual and expected inflation rates. Considering the role of the U.S. house price bubble in the financial crisis of 2007–2009, how do you think monetary policymakers should respond to bubbles in asset markets? Answer: Sharp changes in asset prices can be very damaging to the economy, creating large swings in consumption through wealth effects, facilitating booms and busts in investment and damaging the balance sheets of financial institutions. While monetary policymakers may wish to act to avoid or contain such bubbles, there is disagreement as to what they should (and indeed can) do. A major problem is that it is difficult to identify bubbles as they are emerging and so policymakers may not be in a position to act. Even if policymakers could identify an emerging bubble, you might argue that the interest rate is not the appropriate policy tool to use, because the extent to which rates would have to increase could be devastating to the economy. Macroprudential regulatory policy—such as rules linking capital requirements to the business cycle—might be more appropriate to deal with asset price bubbles. For each of the following, explain whether the response is theoretically consistent with a tightening of monetary policy and identify which traditional channel of monetary policy is at work: Firms become more likely to undertake investment projects. Households become less likely to purchase refrigerators and washing machines. Net exports fall. Answer: This is not consistent with a tightening of monetary policy, which would make firms less likely to undertake investment projects through the interest-rate channel. This is consistent with a tightening of monetary policy. In the face of higher interest rates, households become less likely to borrow to purchase consumer durables such as refrigerators and washing machines. This effect works through the interest-rate channel. This is consistent with a tightening of monetary policy. When interest rates rise, there is an increase in investor demand for U.S. assets, leading to an appreciation of the dollar. This would increase demand for imports and reduce demand for exports, causing a fall in net exports through the exchange-rate channel. In Country A suppose that changes in short-term interest rates translate quickly into changes in long-term interest rates, while in Country B long-term interest rates do not respond much to changes in short-term rates. In which country would you expect the interest-rate channel of monetary policy to be stronger? Explain your answer. Answer: Households’ decisions to buy cars and houses and firms’ decisions to engage in long-run investment projects generally depend on longer-term interest rates, so the interest-rate channel is likely to be stronger in Country A. Consider a situation where central bank officials repeatedly express concern that output exceeds potential output, implying that the economy is overheating. Although they haven’t implemented any policy moves as yet, the data show that consumption of luxury goods has begun to slow. Explain how this behavior could reflect the asset-price channel of monetary policy at work. Answer: Policymakers expressing concern about the economy overheating may lead to expectations of future increases in interest rates. Stock prices may fall in anticipation of a rise in interest rates leading to a fall in consumer wealth and demand for luxury goods. Do you think the balance-sheet channel of monetary policy would be stronger or weaker if: Firms’ balance sheets in general are very healthy? Firms have a lot of existing variable-rate debt? Answer: The balance-sheet channel is likely to be weaker if firms generally have high net worth and are not borderline in terms of being considered creditworthy. The balance-sheet channel is likely to be stronger if firms have high levels of existing variable-rate debt, as changes in monetary policy could significantly impact their net worth. In the wake of the financial crisis of 2007–2009, would you anticipate the bank-lending channel becoming more or less important in the United States? Explain your answer. Answer: The financial crisis interrupted the trend toward securities market finance, which could increase the importance of bank lending and strengthen the bank-lending channel. Over time, however, advantages associated with securitization such as greater risk diversification may cause the pre-crisis trend to resume. Regulatory reforms are likely to influence the extent and pace of the recovery of markets for asset-backed securities. Suppose there is an unexpected slowdown in the rate of productivity growth in the economy so that forecasters consistently overestimate the growth rate of GDP. If the central bank bases its policy decisions on the consensus forecast, what would be the likely consequences for inflation assuming it maintains its existing inflation target? Answer: Suppose, for example, the consensus forecast was for positive productivity growth while actual productivity growth was zero, resulting in no change to the position of the LRAS curve. Thinking the LRAS curve was shifting to the right, the central bank’s appropriate policy response to maintain the existing inflation target would be to shift the dynamic aggregate demand curve to the right. But given that the LRAS is not really shifting to the right, the central bank's action would lead to increased inflation in the short run. Suppose the policy interest rate controlled by the central bank and the inflation rate were both zero. Explain in terms of the aggregate demand–aggregate supply framework how the economy could fall into a deflationary spiral if it were hit by a negative aggregate demand shock. Answer: A negative aggregate demand shock shifts the aggregate demand curve to the left, leading in the short run to output falling below potential output. In the absence of a policy response, this will eventually put downward pressure on prices. Starting with a situation where the nominal interest rate and the inflation rate are both zero, there cannot be a conventional monetary policy response to the shock as nominal interest rates cannot fall below zero. The subsequent fall in prices leads to deflation when we start from a position of zero inflation. Through the Fisher equation (i = r + пe), we can see that a fall in inflation expectations with the nominal interest rate at zero leads to a rise in the real interest rate. This reduces investment and consumption, pushing output further below its potential level. This can lead to a deflationary spiral, in which falling output aggravates deflation and raises real interest rates, depressing output further. In these circumstances, a central bank focused on stabilizing inflation may wish to use unconventional monetary policy tools to counter the initial demand shock. Use the aggregate demand–aggregate supply framework to show how a boom in equity prices might affect inflation and output in the short run. Describe the long-run impact on inflation and output: (a) if the central bank implicitly allows its inflation target to rise and (b) if it retains its original inflation target. Answer: The boom in equity prices would increase consumer wealth, boosting consumption. It would make financing cheaper for firms, boosting investment. The dynamic aggregate demand curve would shift to the right. In the short run (point B), inflation and output would both rise. If the central bank does not take offsetting action to counter the demand curve shift, it is implicitly raising its inflation target. In this case, the SRAS curve would shift to the left until long-run equilibrium is restored (point C) at the original Y* but at a higher level of inflation. If the central bank maintained its original inflation target, monetary policy would tighten sufficiently to offset the initial shift in aggregate demand to AD’, returning the aggregate demand curve to its initial position. Output and inflation would both return to their initial values. Compare the impact of a given change in monetary policy in two economies that are similar in every way except that in Economy A the financial system has a large shadow banking system providing many alternatives to bank financing, while in Economy B bank loans account for almost all of the financing in the economy. Answer: Given the reliance on bank loans in Economy B, the bank-lending channel would be stronger than in Economy A, leading to a larger shift in the dynamic aggregate demand curve in Economy B for a given change in monetary policy. Suppose that the anemic growth in the U.S. economy following the financial crisis of 2007–2009 was a result of “secular stagnation.” Use the Fisher equation to explain why raising the central bank’s inflation target could help boost economic growth in circumstances where nominal interest rates are close to the effective lower bound. Answer: The Fisher equation links the nominal interest rate, the real interest rate and expected inflation according to the equation i = r + πe According to the secular stagnation hypothesis, post-crisis economic weakness reflected a persistent shortfall in aggregate demand, with the equilibrium long-run real interest rate having dropped well below zero. With the nominal interest rate at the effective lower bound, inflation expectations limit how far the real interest rate can fall. For example, if the effective lower bound on nominal interest rates is zero, then with a 2 percent inflation target, the real interest rate is bounded below at -2 percent. If raising the inflation target from 2 percent to 3 percent is perceived as credible, the resulting higher inflationary expectations would lower the real interest rate by an additional one percent, providing further stimulus to growth. If the anemic growth experienced in the U.S. economy since the financial crisis primarily reflects slower growth of the labor force and slowing technological innovation, can monetary policy be used to address the problem? Answer: No. For the most part, these factors (which influence aggregate supply) are not driven by aggregate demand. In the context of the AD/AS model, monetary policy can shift the dynamic aggregate demand curve, but not long-run aggregate supply, which reflects changes in potential output. In which of the following economies do you think the bank lending channel would play a more important role, everything else being equal:
a) an economy dominated by large, financially sophisticated firms
b) an economy consisting of a large number of small firms.
Explain your choice. Answer: The bank lending channel is likely to play a more important role in b). The reason is that small firms are more bank dependent than larger firms, which also have the option to obtain funds in capital markets. Data Exploration In conducting monetary policy, the European Central Bank (ECB) must balance the needs of euro-area countries with differing economic conditions. Plot since 1990 the yield spread between government bonds in Italy (FRED code: INTGSBITM193N) and Germany (FRED code: INTGSBDEM193N), along with the yield spread between government bonds in Spain (FRED code: INTGSBESM193N) and Germany. Discuss the yield spreads after 2008 and explain how they reflect policy challenges for the ECB. Answer: The data are plotted below. Prior to the euro-area financial crisis, the yields on government bonds were nearly identical across the countries of the euro area. During the crisis, however, concerns emerged about the risks of default on the part of some governments (including Greece, Ireland, Italy, Portugal, and Spain) and about the solvency of their banking systems as their economies declined. In these countries, even as the ECB policy rate declined, bank lending rates to private borrowers remained relatively high (despite much lower central bank lending rates), reflecting both the banks’ incapacity to lend and the deteriorating creditworthiness of the borrowers. As the crisis intensified, fears also arose that some countries might depart from the euro area and re-introduce their own currencies to repay their euro-denominated debt in a currency of lesser value (“redenomination risk”). In contrast, investors and depositors viewed Germany as a safe haven; the resulting inflow of capital and bank deposits to Germany (and out of the sagging economies on the euro area’s geographic periphery) lowered its cost of funding, helping to widen the economic divergence across the euro area. While they have narrowed sharply since the peak of the crisis, the yield spreads for Italy and Spain remain elevated compared with the pre-crisis era, continuing to reflect many of the concerns noted above.
The challenge for the ECB is to maintain price stability while designing a policy that addresses the diverging economic and financial conditions in both weak and strong economies and limits the threat to the euro as a viable currency. It is unclear that any central bank can achieve such multiple, conflicting goals without a high level of cooperation from fiscal authorities. International Monetary Fund, Interest Rates, Government Securities, Government Bonds for Germany© [INTGSBDEM193N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/INTGSBDEM193N. International Monetary Fund, Interest Rates, Government Securities, Government Bonds for Italy© [INTGSBITM193N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/INTGSBITM193N. International Monetary Fund, Interest Rates, Government Securities, Government Bonds for Spain© [INTGSBESM193N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/INTGSBESM193N. How important is the balance sheet channel of monetary policy? Plot since 1996 the net tightening of credit standards for consumer and credit card loans (FRED code: DRTSCLCC) and (on the right scale) household net worth (FRED code: TNWBSHNO). Do banks adjust lending conditions when household balance sheets improve or deteriorate? Answer: Prior to the onset of the financial crisis of 2007-2009, rising net worth generally was associated with a loosening of lending standards. From the lender’s perspective, higher net worth means that a borrower is more creditworthy and that borrowing to increase spending is less risky. However, much of the increase in household net worth in the 2000s was due to the housing price surge. When housing prices began to decline, banks dramatically tightened their lending standards on consumer loans and credit cards. Once wealth began rising again after the crisis, loan standards began to ease from a very restrictive level. Among the challenges facing central banks around the world is the elevated level of public debt. Plot U.S. federal debt held by the public as a percent of gross domestic product (FRED code: FYPUGDA188S) and discuss the problems that government debt could pose for the Federal Reserve in the future. Answer: The data are plotted below. The key issue is whether the Federal Reserve will come under political pressure to monetize the debt. As an independent central bank, the Fed can resist this pressure up to a point, but Congress and the President together can modify the Fed’s charter. Bowing to political pressure would harm the Fed’s credibility and undermine its ability to keep inflation and inflation expectations low and stable. As of mid-2016, inflation is below the Fed’s target of 2% and inflation expectations appear well-anchored. However, the Fed is still in process of exiting from its unconventional policies to secure price stability. Doing so without disrupting financial markets and the economy will require considerable policy skill.
Separately, the long-term real interest rate, which is determined by economic fundamentals rather than by the Federal Reserve, is unusually low both in the United States and around the world. A sustained rise in the public debt ratio eventually would be expected to put upward pressure on the long-term real interest rate.
Some critics argue that the Federal Reserve stoked the housing price bubble after 2000 by keeping monetary policy too stimulative. To investigate, first plot from 2000 to 2007 on a quarterly basis the Taylor rule gap – the difference between the Taylor rule as described in Chapter 18, Data Exploration Problem 1, and the federal funds rate. Add to this plot on the right scale an index of U.S. housing prices (FRED code: SPCS20RSA). Does the evidence support the critics’ claim? What other evidence might be sought? Answer: The data, plotted below, shows that U.S. urban housing prices more than doubled in this period. It also shows that the FOMC set the federal funds rate well below the Taylor Rule after 2002 for several years. This accommodative monetary policy lowered mortgage interest rates – through the term structure of interest rates – contributing to housing demand. However, note that housing prices had begun to rise earlier in the decade even when the federal funds rate was reasonably close to the Taylor rule prescription. In short, this evidence is consistent with the view that Fed policy contributed to the housing price bubble, but does not show that monetary policy is solely or primarily responsible for the bubble.
S&P Dow Jones Indices LLC, S&P/Case-Shiller 20-City Composite Home Price Index© [SPCS20RSA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/SPCS20RSA. Indicates more difficult problems. Solution Manual for Money, Banking and Financial Markets Stephen G. Cecchetti, Kermit L. Schoenholtz 9781259746741, 9780078021749, 9780077473075
