Monetary policy effectiveness: Regimes and instruments
By Scott Sumner
The Mercatus Center has a new working paper by Hylton Hollander and Lars Christensen. Here’s the abstract:
The monetary authority’s choice of operating procedure has significant implications for the role of monetary aggregates and interest rate policy on the business cycle. Using a dynamic general equilibrium model, we show that the type of endogenous monetary regime, together with the interaction between money supply and demand, captures well the actual behavior of a monetary economy—the United States. The results suggest that the evolution toward a stricter interest rate–targeting regime renders central bank balance-sheet expansions ineffective. In the context of the 2007–2009 Great Recession, a more flexible interest rate–targeting regime would have led to a significant monetary expansion and more rapid economic recovery in the United States.
The following statement on page 45 caught my eye:
A strict interest rate–targeting regime becomes problematic, however, if the operational instrument—the policy rate—cannot lower the real interest rate enough. It is the monetary regime, not the zero lower bound, that renders monetary policy ineffective.
This is something that needs to be shouted from the rooftops. Many people think about the question of monetary policy effectiveness without first considering the nature of the policy regime. A central bank that is unable to lower their interest rate target any further, can still make policy more expansionary by targeting the foreign exchange rate at a lower level. Alternatively, they can target a higher level of the broad money supply, or a higher level of NGDP futures prices. Thus fiscal stimulus is not needed.
Hollander and Christensen argue that a flexible policy that used both interest rates and monetary aggregates would have been more effective in reducing the severity of the Great Recession:
Figure 11 provides the counterfactual paths of the output gap, inflation, and money growth for the Great Moderation monetary regime under the scenario that the Federal Reserve maintained interest rates at the zero lower bound. The results highlight the far greater responsiveness of the variables when the growth rate of the money stock is not constrained by a floor regime associated with a satiated market for bank reserves. Turning to figure 12, we observe that both the actual data and the unconstrained forecast show the Federal Reserve achieving its 2 percent inflation target after 7 quarters (2011Q2). In contrast, a one-off permanent increase in the stock of (broad) money reduces the 2009Q3 output gap from −6 percent to −2 percent, maintains the central bank’s 2 percent inflation target after 1 quarter, and sees the normalization of interest rates from the zero lower bound. One explanation for this observed stagnant recovery is that the Federal Reserve was unable to make a credible commitment to permanently expand the monetary base (Beckworth 2017). In the context of 49 the 2007–2009 Great Recession, the results confirm that a strict interest rate–targeting regime renders the monetary expansion ineffective. A more flexible interest rate regime would have, in contrast, led to a significant monetary expansion and to more rapid economic recovery in the United States.