5.9 financial markets and central bank online test
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Week23.pptxModern Monetary Policy and the Challenges Facing Central Bankers
Chapter 23
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Learning Objectives
Analyze the monetary policy transmission mechanism.
Discuss the key challenges facing monetary policymakers.
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Financial Crisis and the Transmission of Monetary Policy
The crisis of 2007-2009 intensified the fundamental problems of asymmetric information that affect the provision of credit in a modern economy.
The widespread losses at intermediaries and the heightened uncertainty about the damage suffered by specific intermediaries reduced confidence.
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Financial Crisis and the Transmission of Monetary Policy
Funding liquidity dried up.
Households’ and nonfinancial firms’ net worth fell substantially, reducing their ability to borrow so they cut spending.
The result of all this was a destabilizing feedback loop between worsening economic prospects and the deterioration of financial conditions that influence spending.
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Financial Crisis and the Transmission of Monetary Policy
When the policy transmission mechanism is obstructed, central banks cannot assume that a cut in their target policy rate will ease the financial conditions that influence the economy.
Central banks must always take into account the workings of the monetary policy transmission mechanism in order to achieve their goals of economic and price stability.
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The Challenges Modern Monetary Policymakers Face
Stock prices and property values have a tendency to go through boom and bust cycles.
Policymakers’ options are limited
The nominal interest rate cannot fall below the effective lower bound.
The structures of the economy and the financial system are constantly evolving.
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Booms and Busts in Property and Equity Prices
Bubbles are damaging because the wealth effects they create cause consumption to surge and then contract just as rapidly.
Bubbles are identified after the fact by a sharp rise then a sharp decline in prices.
The collapse of the Internet bubble in the 1990s had a relatively minor impact because intermediaries faced limited credit exposure and remained well capitalized.
The loss of capital in the financial system in 2007-2009 could have led to catastrophe without extraordinary government actions.
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Booms and Busts in Property and Equity Prices
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Booms and Busts in Property and Equity Prices
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Booms and Busts in Property and Equity Prices
Proponents of a policy of “leaning against bubbles” say that stabilizing inflation and real growth means raising interest rates to discourage bubbles from developing.
Opponents of this interventionist view claim that bubbles are too difficult to identify when they are developing.
Central banks should wait until the bubble bursts and only then react aggressively to limit the fallout on the economy by cleaning up the mess.
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Booms and Busts in Property and Equity Prices
Today, the proper policy toolkit for addressing bubbles is not interest rates but the macroprudential regulatory approach
According to this view, bubbles are a major threat.
The best result would be to adjust regulatory rules to inhibit intermediaries from extending such risky credit in economic booms.
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Booms and Busts in Property and Equity Prices
This approach still depends on the foresight and judgment of regulators to limit the buildup of an asset price bubble.
Using interest rates to combat asset price bubbles now is more likely to be viewed as a backup approach for extreme circumstances.
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Deflation and the Effective Lower Interest Rate Bound
Nominal interest rates cannot be deeply negative.
There is an effective lower bound (ELB) that is below zero due to transactions costs
Investors can always hold cash, so bonds must have yields above the ELB to attract bondholders.
The risk of becoming caught in precisely such a predicament, where policymakers have no scope to lower rates further, has concerned central banks since Japan’s experience in the 1990s.
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Deflation and the Effective Lower Interest Rate Bound
Think about the consequences of a shock that depresses aggregate expenditure.
The dynamic aggregate demand curve shifts to the left.
Real output falls below potential - a recessionary output gap putting downward pressure on inflation.
Monetary policymakers would normally react by cutting interest rates.
This would increase spending, raise real output, and eliminate the output gap.
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Deflation and the Effective Lower Interest Rate Bound
What if, when the shock occurs, inflation is zero and the policy interest rate that central bankers control is at the ELB?
The decline in aggregate demand still drives real output below potential output.
There is downward pressure on inflation.
But when inflation falls, it drops below zero so that, on average, prices are falling.
This result is deflation.
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Deflation and the Effective Lower Interest-Rate Bound
Deflation isn’t necessarily a problem unless the shock that moves the economy away from its long-run equilibrium is big enough to drive output down to such a low level that policymakers can’t bring it back up.
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Deflation and the Effective Lower Interest Rate Bound
When there is a recessionary output gap, current inflation is below expected inflation and expected inflation falls, which drives deflation down even more.
Because the nominal interest rate is at the ELB, policymakers cannot counter the worsening deflation by lowering it.
The real interest rate rises, reducing spending, shifting the AD curve to the left.
This expands the recessionary output gap.
The result is deflationary spiral in which deflation grows worse and worse.
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Deflation and the Effective Lower Interest Rate Bound
Deflation makes it more difficult for businesses to obtain financing for new projects.
Without investment there is no growth.
Deflation, therefore, increases the real value of a firm’s liabilities without affecting the real value of its assets.
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Deflation and the Effective Lower Interest Rate Bound
Policymakers can minimize the chances of this sort of catastrophe:
They can set their inflation objective with the perils of deflation in mind
They can act boldly when there is even a hint of deflation
They can utilize unconventional policy tools
23-19
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Deflation and the Effective Lower Interest Rate Bound
The difficulties posed by the effective lower bound arise only when central bankers have achieved their objective of low, stable, inflation.
Should central bankers set their inflation level target to minimize the possibility of a deflationary spiral?
23-20
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Deflation and the Effective Lower Interest Rate Bound
Reducing the interest rate significantly and rapidly when faced with the possibility of hitting the ELB is “acting preemptively.”
Central bankers can use unconventional policy tools that include:
Forward guidance
Quantitative easing
Targeted asset purchases
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Deflation and the Effective Lower Interest Rate Bound
Central bankers are very reluctant to use unconventional policy tools
Continued uncertainty about how and why they work and how to apply them effectively
Policy exit may be difficult
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The Evolving Structure of the Financial System
Changes in financial structure will change the impact of monetary policy.
The shift away from bank financing toward direct financing in the capital markets means that the bank-lending channel of monetary policy became less important in the decades before the financial crisis.
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The Evolving Structure of the Financial System
The decline of banks as a source of finance was accompanied by a corresponding rise in the importance of securities markets and shadow banks.
The financial crisis that ended in 2009 has interrupted the trend toward capital market finance:
Securitization has declined or slowed since 2006.
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The Evolving Structure of the Financial System
Effective securitization can lead to a better diversification of risk.
Macroprudential regulation will tend to restrain the future pace of securitization.
The changing effectiveness of conventional monetary policy likely will require central bankers to update their unconventional policy tools.
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The Evolving Structure of the Financial System
As the characteristics of money, banks, and loans evolve, we will all adjust:
How we pay for our purchases
How we hold our wealth
How we obtain credit
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