The Fed’s rate rise may not provide enough of a boost to the financial sector to allow the US recovery to take off.

Last week, the US Federal Reserve announced that it would increase its Fund Rate by 0.25 percent – the first such increase in nine years. Eddie Gerba writes that under normal economic conditions such an interest rate rise would help savers, lead to more balanced investments, and help firm productivity. But, he points out, conditions post-Great Recession are far from normal. Lower levels of corporate productivity and higher interest rates may mean fewer firms survive, and the financial sector may no longer be able to lead economic recovery due to uncertainty about regulation and the sector’s future

Financial (in)stability, low interest rates and (un)conventional monetary policy: potential risks and policy measures

Since the advent of the global financial crisis of 2007–08, major central banks in advanced economies - the US Fed, the Bank of England, the Bank of Japan and the ECB - have undertaken monetary policies with a view to keep interest rates low. They have also significantly expanded the monetary base (and their balance sheets) through the adoption of unconventional monetary policies, although at different times and in different forms. Several years of unconventional monetary policies and exceptionally low interest have improved banks’ health, eased credit conditions and, ultimately, helped supporting the economy. However, these policies may have undesirable side- effects that could put financial stability at risk the longer they are in place. Against this background, this paper discusses the main threats to financial stability potentially triggered by unconventional monetary policies, especially in an environment of low interest rates, analyse the interrelation between financial stability and monetary policy at the current juncture and briefly assess the viability of specific measures that could prove helpful to contain such risks, given the current institutional framework

Macroprudential policy in a Knightian uncertainty model with credit-, risk-, and leverage cycles

We study the impact of uncertainty on financial stability and the business cycle. We extend the work of Boz and Mendoza (2014) by endogenizing credit production, modifying learning mechanism into an adaptive set-up, as well as including financial and monetary policies. In our model households are (intrinsically) rational but take economic decisions under incomplete information. The incompleteness is not caused by their cognitive limitations, as in rational inattention theory (Sims, 2003). Households `learn by doing' and once a sufficient number of realizations of the state variable have materialized, and the incomplete information set is completed. This learning set-up is incorporated into a New Keynesian model with credit market frictions, extended to include uncertainty, where a share of households needs external financing to consume. Because of limited enforceability of financial contracts, households are required to provide collateral for their loans, and so the relationship between the bank and household is tightened for many periods ahead. We find in our framework the build up of risk, leverage, increase in consumption and price of collateral takes longer than in other DSGEs with standard financial friction models. We also find that both the frequency and the amplitude of expansions and contractions are asymmetric - recessions are less frequent and deeper than expansions. Moreover, we find that boom-bust cycles occur as rare events. Using the Cogley and Sargant's (2008) definition of a severe(or systemic) crisis, we find on average two such events per century. We also find that, different from standard boom-bust cycles, a systemic crisis can be followed by a sequence of subsequent contractions, as it makes the economy more unstable. The result is asymmetric distributions of key macroeconomic and financial variables, with high skewness and fat tails. Lastly, we also find that, by reducing the amount of borrowing and leverage in upturns, the LTV-ratio regulation is effective in smoothing the cycles and reducing the effects of a deep contraction on the real-financial variables. We also discuss the role of macroprudential policy in reducing information incompleteness by generating information that helps the agent learn faster the new environment, or provide a smoother transition to the new economic environment

The finance-welfare state nexus. ACES Cases No. 2013.1

At the height of the financial crisis, the Western welfare state prevented a repeat of the Great Depression. But there were also suggestions that social policy had contributed to the crisis, particularly by promoting households’ access to credit in pursuit of welfare goals. Others claim that it was the withdrawal of state welfare that led to the disaster. Against this background that motivated our interest, we propose a systematic way of assessing the relationship between financial market and public welfare provisions. We use structural vector auto-regression to establish the causal link and its direction. Two hypotheses about this relationship can be inferred from the literature. First, the notion that welfare states ‘decommodify’ livelihoods or that there is an equity-efficiency tradeoff would suggest that welfare states substitute to varying degrees for financial market offers of insurance and savings. By contrast, welfare states may support private interests selectively and/or help markets for households to function better; thus the nexus would be one of complementarity. Our empirical strategy is to spell out the causal mechanisms that can account for a substitutive or complementary relationship and then to see whether advanced econometric techniques find evidence for the existence of either of these mechanisms in six OECD countries. We find complementarity between public welfare (spending and tax subsidies) and life insurance markets for four out of our six countries, notably even for the United States. Substitution between welfare and finance is the more plausible interpretation for France and the Netherlands, which is surprising. Data availability constrains us from testing the implications for the welfare state contribution to the crisis directly but our findings suggest that the welfare state cannot generally be blamed for the financial crisis

Spending rises are more effective in expanding the economy by as much as 20 percent compared to tax cuts

Both fiscal and monetary authorities have engaged in ‘unconventional’ policies over the past few years in order to bring the Great Recession under control. But, have these actions been intentionally coordinated, and what has been their economic impact? More fundamentally, has there ever been a systematic or regular coordination between fiscal and monetary policy in the US? Eddie Gerba and Klemens Hauzenberger find sufficient evidence for an implicit coordination of policies, and demonstrate how it has changed over the past three decades. They find that spending and tax stimuli have notably been more efficient in expanding the economy during the Volcker chairmanship (1979-84) and the Great Recession (2008-12). Taking into account that the current interest rate is constrained by the zero lower bound, fiscal authorities have an unprecedented window of opportunity to pursue activist policies aimed at expanding output, if and only if they carefully manage the expectations of private agents

Monetary transmission under competing corporate finance regimes = Transmisión monetaria bajo regímenes alternativos de finanzas corporativas

The behavioural agent-based framework of De Grauwe and Gerba (2015) is extended to allow for a counterfactual exercise on the role of banks for monetary transmissions. A bank-based corporate financing friction is introduced and the relative contribution of that friction to the effectiveness of monetary policy is evaluated. We find convincing evidence that the monetary transmission channel is stronger in the bank-based system compared to the market-based. Impulse responses to a monetary expansion are around the double of those in the market-based framework. The (asymmetric) effectiveness of monetary policy in counteracting busts is, on the other hand, relatively higher in the market-based model. The statistical fit of the bank-based behavioural model is also improved compared to the benchmark model. Lastly, we find that a market-based (bankbased) financing friction in a general equilibrium produces highly asymmetric (symmetric) distributions and more (less) pronounced business cycles

What is the fiscal stress in Euro Area? Evidence from a joint monetary-fiscal structural model

I examine the importance of fiscal policy in stabilizing the Euro Area economy and the degree of interaction with monetary policy. The results provide solid evidence of a common fiscal reaction in the monetary union despite the lack of a formal fiscal union. I identify area-wide shocks and find statistically significant (endogenous) responses of fiscal policies to shocks. I also find strong evidence for interactions between fiscal-and monetary policy. Said that, the nature of interactions depends very much on the shocks that hit the economy. At the same time, the way the two fiscal policies interact with monetary policy is also different and independent of each other. Furthermore, the spending multiplier is higher than the tax multiplier. Nonetheless, their relative efficacy has changed over time, with the spending (tax) multiplier falling (rising) since the onset of the Great Recession. To conclude, there are considerable differences in the nature of Euro Area monetary-fiscal interactions compared to the US. Not only are the impulse responses to different shocks significantly different, but also the fiscal multipliers vary a lot. Keynesian (or spending-oriented) fiscal policy is more effective in expanding output in the Euro Area while tax reductions are more effective in the US

The role of cognitive limitations and heterogeneous expectations for aggregate production and credit cycle

The behavioural model of De Grauwe and Macchiarelli (2015) is extended to include financial frictions on the (aggregate) supply side. The result is a tight and sustained feedback loop between animal spirits on one hand, and supply of credit, capital purchase and production on the other. During phases of optimism, credit is abundant, access to production capital is easy, the cash-in-advance constraint is lax, risks are undervalued, and production is booming. Upon reversal in market sentiment, the contraction is quick and deep. Moreover, the model is capable of replicating the stylized fact of a long and sustained simultaneous growth in credit, production and asset prices observed in the US since mid1990’s. Lastly, the behavioural model does a decent job in matching US data including multiple supply-side relations including capital-firm credit and inflation-interest rate

Stock market cycles and supply side dynamics : two worlds, one vision?

En este trabajo se comparan dos metodologías macroeconómicas punteras pero a la vez muy distintas: el modelo DSGE con expectativas racionales y el modelo de comportamiento con racionalidad limitada. Procedemos a ampliar los dos para incluir fricciones financieras por el lado de la oferta agregada. En ambos casos, los resultados apuntan a que la producción, la oferta de crédito y el pago anticipado a los productores de capital dependen en gran medida de los ciclos bursátiles. Durante las fases de optimismo, el crédito es abundante, hay facilidad de acceso al capital, existen pocas restricciones al pago por adelanto, los riesgos se infravaloran y se produce un boom en la producción. Sin embargo, cuando el clima de los mercados cambia, la contracción de todas estas variables se vuelve más profunda y asimétrica. Esto es aún más evidente en el modelo de comportamiento, en el que las limitaciones cognitivas de los agentes económicos generan una contracción aún mayor. Aunque ambos modelos captan correctamente las regularidades empíricas, los ejercicios de validación son incluso más favorables para el modelo de comportamientoThis paper compares two state-of-the-art but very distinct methods used in macroeconomics: rational-expectations DSGE and bounded rationality behavioural models. Both models are extended to include financial frictions on the supply side. The result in both frameworks is that production, supply of credit and the front payment to capital producers depend heavily on stock market cycles. During phases of optimism, credit is abundant, access to production capital is easy, the cash-in-advance constraint is lax, risks are undervalued, and production booms. But with a reversal in market sentiment, the contraction in all these parameters is deep and sometimes asymmetric. This is all the more evident in the behavioural model, where economic agents’ cognitive limitations exacerbate the contraction. While both models capture the empirical regularities very well, the validation exercise is even more favourable to the behavioural mode