Chapter 23

Modern Monetary Policy and the Challenges

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The Monetary Policy Transmission
Mechanism
• We need to examine the various ways in which
changes in the policy-controlled interest rate
influence the quantity of aggregate output
demanded in the economy as a whole.
– These are collectively referred to as the channels of
the monetary policy transmission mechanism.
• We will begin with the traditional interest-rate
and exchange-rate channels.
• We will then study the role of banks and finally
the importance of stock price movements.

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The Traditional Channels: Interest Rates
and Exchange Rates
• Easing of monetary policy - a decrease in
the target nominal interest rate, which
lowers the real interest rate - leads to a
depreciation of the dollar.
• The less valuable dollar:
– Drives up the cost of imported goods and
services, reducing imports from abroad, and
– Makes U.S. goods and services cheaper to
foreigners, so they will buy more of them.
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 The Traditional Channels: Interest Rates
and Exchange Rates
• However, the interest-rate channel is not very
powerful.
• Data suggest that the investment component of
total spending isn’t very sensitive to interest
rates.
• While a small change in the interest rate does
change the cost of external financing, it doesn’t
have much effect on investment decisions.

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The Traditional Channels: Interest Rates
and Exchange Rates
• The impact of short-term interest rates on
household decisions is also rather modest.
• The problems is that people’s decisions to
purchase cars or houses depend on longer-
term interest rates rather than the
policymakers’ short-run target rate.
• Household consumption decisions will only
change to the extent that the target interest
rate affects long-term interest rates.

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 The Traditional Channels: Interest Rates
and Exchange Rates
• As for the effect of monetary policy on the
exchange rate, once again, theory and practice
differ.
• The policy-controlled interest rate is just one
of many factors that shift the demand and
supply for the dollar on foreign exchange
markets.

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 The Traditional Channels: Interest Rates
and Exchange Rates
• We must conclude that the traditional
channels of monetary policy transmission
aren't very powerful.
• Yet evidence shows that monetary policy is
effective.
• Something else must be amplifying the impact
of monetary policy changes on real economic
activity.

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• Correlation does not imply causality.
• In economics, establishing a causal
relationship is much more difficult.
• We need to look for clear evidence that
particular monetary policy actions are
unrelated to some third factor that drives up
the interest rate, forcing growth down at the
same time.

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 Bank-Lending and Balance-Sheet
Channels
• Four times a year the Fed conducts an opinion
survey on bank-lending practices.
– This survey provides important information to
monetary policymakers.
– Without it they would not be able to tell whether
a change in the quantity of new loans granted
resulted from a shift in supply or a shift in
demand.

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Bank-Lending and Balance-Sheet
Channels
• The fact is that banks are essential to the
operation of a modern industrial economy.
– They direct resources from savers to investors and
solve problems caused by information asymmetries.
• Banks are also the conduit through which
monetary policy is transmitted to the economy.
• To understand monetary policy change
completely, we need to look carefully at how
they affect the banking system.
– We need to examine the impact of policy changes on
banks and bank lending.
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Banks and Bank Lending
• Borrowers do not have access to direct
capital market financing.
– They must go to banks.
• When banks stop lending, a large class of
borrowers simply can’t obtain financing.
– Bank lending is an important channel through
which monetary policy affects the economy.
• By altering the supply of funds to the
banking system, policymakers can affect
banks’ ability and willingness to lend.
– The bank-lending channel of monetary policy
transmission. 23-13
Banks and Bank Lending
• We see that an open market purchase has
a direct impact on the supply of loans.
• But, financial regulators can also influence
bank-lending practices.
• Changes in financial regulations, such as
an increase or decrease in the amount of
capital banks are required to hold when
they make certain types of loans.
– This will have an impact on the amount of
bank lending.
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Banks and Bank Lending
• Figure 23.2 plots two surveys of how
credit conditions for large and small
nonfarm businesses vary over time.
– One line shows the net share of banks
tightening standards for loans to large firms.
– The other shows the share of small firms that
view credit as harder to obtain minus the
share that view credit as easier to obtain.
• In both cases, credit conditions typically
tighten in recessions and ease in booms.
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Banks and Bank Lending
• Note, however, that small firms sometimes
face tight credit conditions even in
economic recoveries.
• A cutback in lending to creditworthy small
firms or households limits the pace of
national economic growth during recovery.
• Policymakers worry that the recovery from
a recession caused by a financial crisis may
be weaker than the recovery from a
recession caused by other factors.
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Banks and Bank Lending

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• The problem with people buying more during
lower interest rates is that some might take on
more debt than they can manage.
• Don’t borrow on the assumption that your
income is going to increase rapidly.
• This is similar to depending on inflation to bail
you out, so don’t depend on that either.

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Firms’ Balance Sheets and Household Net
Worth
• The balance-sheet channel of monetary
policy transmission works because
monetary policy has the direct influence on
the net worth of potential borrowers.
– An easing of monetary policy improves firms’
and households’ balance sheets, increasing
their net worth.
– Increases in net worth reduce the problems of
moral hazard and adverse selection.
• This lowers information costs of lending and allows
borrowers to obtain financing more easily.
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Firms’ Balance Sheets and Household Net
Worth
• How does monetary policy expansion
improve borrowers’ net worth?
1. Expansionary policy drives up asset prices,
increasing the value of firms and the wealth
of households.
2. Lower interest rates reduce the burden of
repayment of current loans of borrowers.

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Firms’ Balance Sheets and Household Net
Worth
• At lower interest rates, a person with a
variable rate loan enjoys lower interest
payments.
– The percentage of this person’s income that is
devoted to loan payments will be lower.
– As interest rates fall, the supply of loans increases.
• Information services are central to banks’ role
in the financial system.
– They help to address the problems of adverse
selection and moral hazard.

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Firms’ Balance Sheets and Household Net
Worth
• Inferior information leads to an increase in
adverse selection. This:
– Reduces bank lending,
– Lowers investment, and ultimately
– Depresses the quality of aggregate output
demanded.

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Firms’ Balance Sheets and Household Net
Worth
• The channels of monetary policy transmission
depend on the structure of the financial system.
• To the extent that banks are unimportant
sources of funds for firms and individuals, the
bank-lending channel is not tremendously
important.
• While technology has made the processing of
increasing amount of information easier and
cheaper, it seems unlikely to solve the problems
of adverse selection and moral hazard.

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Asset-Price Channels: Wealth and
Investment
• When the interest rate moves, so do stock
prices.
• This relationship is referred to as the asset-
price channel of monetary policy transmission.
• Recall that the fundamental value of a stock is
the present value of the stream of its future
dividends.
• The lower the interest rate, the higher the
present value is and the higher the stock price.

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Asset-Price Channels: Wealth and
Investment
• When policymakers reduce their interest-rate
target, it drives the mortgage rate down.
– This means higher demand for residential housing,
driving up the prices of existing homes.
• Stock and property prices affect both
individual consumption and business
investment.
– Higher stock and real estate prices means an
increase in wealth.
– An increase in wealth means higher consumption.

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 Asset-Price Channels: Wealth and
Investment
• As stock prices rise, firms find it easier to raise
funds by issuing new shares.
• As financing become less expensive, more
investments become profitable.

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The Monetary Policy Transmission
Mechanism

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Financial Crisis Obstructs Monetary
Policy Transmission
• What prevented policy easing from being
transmitted as usual to the real economy?
• The crisis intensified the fundamental
problems of asymmetric information that
affect the provision of credit in a modern
economy.
• The widespread losses at intermediaries in
general and the heightened uncertainty about
the damage suffered by specific intermediaries
reduced confidence.
– This virtually cut off the availability of credit to
many of them.
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 Financial Crisis Obstructs Monetary
Policy Transmission
• 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 Obstructs Monetary
Policy Transmission
• The bottom-line is that 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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• Why did Japan’s economy fail to respond to
interest rates near zero?
• One possibility is that the stock market
collapse lowered borrower net worth.
• In addition, with borrowers unable to repay,
banks had virtually no capital and could not
make additional loans.

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23-32
The Challenges Modern Monetary
Policymakers Face
• To do their jobs well, central bankers need
a detailed understanding of how both the
financial system and the real economy will
react to their policy changes.
• Modern policymakers face a series of
daunting challenges.
• We will look at three challenges that grew
more prominent thanks to the financial
crisis of 2007-2009.
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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, as we have
seen by the fact that the nominal interest rate
cannot fall below zero.
• The structures of the economy and the
financial system are constantly evolving.

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 Booms and Busts in Property and Equity
Prices
• Nearly everyone agrees that we would all be
better off without skyrocketing increases in
property and stock prices followed by sudden
collapses.
• Abrupt changes in asset prices, like the U.S
house price bubble, affect virtually every
aspect of economic activity.

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 Booms and Busts in Property and Equity
Prices
• Bubbles are particularly 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.

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Booms and Busts in Property and Equity
Prices
• In contrast, the loss of capital in the
financial system in 2007-2009 could have
led to catastrophe without extraordinary
government actions.
• The devastating worldwide effects of the
reversal in U.S. house prices beginning in
2006 has focused renewed attention on
how monetary policymakers should react
to asset price bubbles.

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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 in the
first place.
• Opponents of this interventionist view claim
that bubbles are too difficult to identify when
they are developing.

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 Booms and Busts in Property and Equity
Prices
• Opponents of leaning against bubbles used to
argue that central banks should simply wait
until the bubble bursts and only then react
aggressively to limit the fallout on the
economy by cleaning up the mess.
• The crisis of 2007-2009 undermined the rosy
view that policymakers can sit back and clean
up after a bubble bursts.

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 Booms and Busts in Property and Equity
Prices
• Central bankers still worry that interest rates
are only a blunt tool and that pricking an asset
price bubble could require rate hikes so severe
that they would hurt the economy and reduce
the likelihood of hitting a central bank's
objective for inflation.

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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 tools that
we discussed in Chapter 14.
• 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 a menacing 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, if
the first-best methods of macroprudential
regulation fail to limit a systemic threat.

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• Making informed economic and financial
decisions requires that you know the inflation
rate.
• Focus on 12-month changes, especially
measures that exclude food and energy.
• Stay informed about inflation so that you can
adjust for it.
• Know the real interest rate you receive or pay
and how much your real wage is changing.

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Deflation and the Zero Nominal-Interest-
Rate Bound
• We noted before that nominal interest rates
cannot be negative.
– There is a zero nominal-interest-rate bound.
– Investors can always hold cash, so bonds must
have positive yields 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 Zero Nominal-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
gap.
– 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 Zero Nominal-Interest-
Rate Bound
• What if, when the shock occurs, inflation is
zero and the target nominal interest rate
that central bankers control is close to zero?
– 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 Zero Nominal-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.
• This is one of the central banker’s worst
nightmares:
– A nominal interest rate of zero accompanied by
deflation and real output that is below potential.

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Deflation and the Zero Nominal-Interest-
Rate Bound
• The recessionary gap places further
downward pressure on prices, driving
deflation down even more.
• Because the nominal interest rate is already
zero, 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 Zero Nominal-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 Zero Nominal-Interest-
Rate Bound
• There are ways to minimize the chances
of this sort of catastrophe.
• Policymakers can choose from three
strategies:
1. They can set their inflation objective with
the perils of deflation in mind;
2. They can act boldly when there is even a
hint of deflation; or
3. They can utilize the unconventional policy
tools that we discussed in Chapter 18.
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 Deflation and the Zero Nominal-Interest-
Rate Bound
• The difficulties posed by the zero nominal-
interest-rate bound arise only when central
bankers have achieved their objective of low,
stable, inflation.
• This suggests that central bankers should set
their inflation objective high enough to
minimize the possibility of a deflationary
spiral.

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 Deflation and the Zero Nominal-Interest-
Rate Bound
• The consensus is that an inflation objective of
2 to 3 percent gives policymakers enough
latitude to avoid the problems caused by
deflation.
• Reducing the interest rate significantly and
rapidly when faced with the possibility of
hitting the zero nominal-interest-rate bound is
“acting preemptively.”

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 Deflation and the Zero Nominal-Interest-
Rate Bound
• Dramatic actions of that sort are meant to
ensure that the economy will recover before
deflation can take hold.
• Finally, central bankers have at their disposal a
range of unconventional policy tools that
include:
– Policy duration commitments,
– Quantitative easing, and
– Credit easing.
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 Deflation and the Zero Nominal-Interest-
Rate Bound
• Central bankers are very reluctant to use such
tools and, when used, are eager to exit as
soon as improvements in the economy make it
safe for them to do so.
– One reason is lack of experience in using them.
– Another is that policy exit may be difficult.

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 Deflation and the Zero Nominal-Interest-
Rate Bound
• Central banks prefer assets that are liquid and
that do not tilt the playing field in favor of
specific private borrowers.
• If a central bank faced sufficient losses, it
might need to ask the government to
replenish its capital.
– This could add to inflation expectations.

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The Evolving Structure of the Financial
System
• Changes in financial structure will
change the impact of monetary policy.
• As the nature of banking changes, we
would expect the importance of this
channel of monetary policy transmission
to change along with it.

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The Evolving Structure of the Financial
System
• The shift away from bank financing and
toward direct financing in the capital markets
means that the bank-lending channel of
monetary policy because less important in
the decades before the financial crisis.
• The decline of banks as a source of finance
was accompanied by a corresponding rise in
the importance of securities markets and
shadow banks.

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 The Evolving Structure of the Financial
System
• The financial crisis that ended in 2009 has
interrupted the trend toward direct finance:
– Securitization has declined or slowed since 2006.
• The future of GSEs is highly uncertain, with
many observers calling for them to be
dismantled.

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The Evolving Structure of the Financial
System
• How the post-crisis financial system will
change will depend on how regulatory policy
evolves in coming years as regulators seek to
prevent another crisis or minimize its
potential impact.
• Effective securitization must avoid leaving
concentrations of securitized assets on the
balance sheets of intermediaries that make
them vulnerable to collapsing asset price
bubbles.
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 The Evolving Structure of the Financial
System
• Macroprudential regulation will tend to slow
the future pace of securitization, especially
compared to the boom years preceding the
financial crisis.
• The changing effectiveness of conventional
monetary policy likely will require central
bankers to update their unconventional policy
tools, too.

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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, and
– How we obtain credit.

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• By early 2010, the Fed had presented the
public with considerable detail about the
tools that it would use to tighten monetary
policy and exit from the unconventional
policies that it had implemented during the
financial crisis of 2007-2009.
• The large size and unusual composition of the
Fed’s post-crisis balance sheet meant that the
procedures for tightening would be different
than in normal periods.
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• By raising the interest rate that it pays on
reserves, the Fed is able to tighten policy
without shifting its balance sheet.
• When the Fed tightens, see if you can detect
the shift by examining its assets and liabilities.
– These are reported each week in Federal Reserve
Statistical Release H.4.1.

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