Two Reasons Why Money and Credit May be Useful in Monetary Policy

We describe two examples which illustrate in different ways how money and credit may be useful in the conduct of monetary policy. Our first example shows how monitoring money and credit can help anchor private sector expectations about inflation. Our second example shows that a monetary policy that focuses too narrowly on inflation may inadvertently contribute to welfare-reducing boom-bust cycles in real and financial variables. The example is of some interest because it is based on a monetary policy rule fit to aggregate data. We show that a policy of monetary tightening when credit growth is strong can mitigate the problems identified in our second example.

The Great Depression and the Friedman-Schwartz hypothesis

We evaluate the Friedman-Schwartz hypothesis that a more accommodative monetary policy could have greatly reduced the severity of the Great Depression. To do this, we first estimate a dynamic, general equilibrium model using data from the 1920s and 1930s. Although the model includes eight shocks, the story it tells about the Great Depression turns out to be a simple and familiar one. The contraction phase was primarily a consequence of a shock that induced a shift away from privately intermediated liabilities, such as demand deposits and liabilities that resemble equity, and towards currency. The slowness of the recovery from the Depression was due to a shock that increased the market power of workers. We identify a monetary base rule which responds only to the money demand shocks in the model. We solve the model with this counterfactual monetary policy rule. We then simulate the dynamic response of this model to all the estimated shocks. Based on the model analysis, we conclude that if the counterfactual policy rule had been in place in the 1930s, the Great Depression would have been relatively mild. JEL Classification: E31, E40, E51, E52, E58, N12deflation, General Equilibrium, lower bound, shocks

Financial factors in economic fluctuations

We augment a standard monetary DSGE model to include a banking sector and financial markets. We fit the model to Euro Area and US data. We find that agency problems in financial contracts, liquidity constraints facing banks and shocks that alter the perception of market risk and hit financial intermediation — ‘financial factors’ in short — are prime determinants of economic fluctuations. They have been critical triggers and propagators in the recent financial crisis. Financial intermediation turns an otherwise diversifiable source of idiosyncratic economic uncertainty, the ‘risk shock’, into a systemic force. JEL Classification: E3, E22, E44, E51, E52, E58, C11, G1, G21, G3Bayesian estimation, DSGE model, Financial Frictions, Financial shocks, Funding channel, Lending channel

Shocks, structures or monetary policies? The euro area and US after 2001

The US Federal Reserve cut interest rates more vigorously in the recent recession than the European Central Bank did. By comparison with the Fed, the ECB followed a more measured course of action. We use an estimated dynamic general equilibrium model with financial frictions to show that comparisons based on such simple metrics as the variance of policy rates are misleading. We find that - because there is greater inertia in the ECB’s policy rule - the ECB’s policy actions actually had a greater stabilizing effect than did those of the Fed. As a consequence, a potentially severe recession turned out to be only a slowdown, and inflation never departed from levels consistent with the ECB’s quantitative definition of price stability. Other factors that account for the different economic outcomes in the Euro Area and US include differences in shocks and differences in the degree of wage and price flexibility. JEL Classification: C51, E52, E58DSGE model, Policy activism, policy inertia, shocks

The Great Depression and the Friedman-Schwartz Hypothesis

We evaluate the Friedman-Schwartz hypothesis that a more accommodative monetary policy could have greatly reduced the severity of the Great Depression. To do this, we first estimate a dynamic, general equilibrium model using data from the 1920s and 1930s. Although the model includes eight shocks, the story it tells about the Great Depression turns out to be a simple and familiar one. The contraction phase was primarily a consequence of a shock that induced a shift away from privately intermediated liabilities, such as demand deposits and liabilities that resemble equity, and towards currency. The slowness of the recovery from the Depression was due to a shock that increased the market power of workers. We identify a monetary base rule which responds only to the money demand shocks in the model. We solve the model with this counterfactual monetary policy rule. We then simulate the dynamic response of this model to all the estimated shocks. Based on the model analysis, we conclude that if the counterfactual policy rule had been in place in the 1930s, the Great Depression would have been relatively mild.

The Great Depression and the Friedman-Schwartz hypothesis

The authors evaluate the Friedman-Schwartz hypothesis--that a more accommodative monetary policy could have greatly reduced the severity of the Great Depression. To do this, they first estimate a dynamic, general equilibrium model using data from the 1920s and 1930s. Although the model includes eight shocks, the story it tells about the Great Depression turns out to be a simple and familiar one. The contraction phase was primarily a consequence of a shock that induced a shift away from privately intermediated liabilities, such as demand deposits and liabilities that resemble equity, and towards currency. The slowness of the recovery from the Depression was due to a shock that increased the market power of workers. The authors identify a monetary base rule that responds only to the money demand shocks in the model.Depressions ; Financial crises ; Friedman, Milton ; Schwartz, Anna Jacobson ; Monetary policy

Monetary policy and stock market boom-bust cycles

We explore the dynamic effects of news about a future technology improvement which turns out ex post to be overoptimistic. We find that it is difficult to generate a boom-bust cycle (a period in which stock prices, consumption, investment and employment all rise and then crash) in response to such a news shock, in a standard real business cycle model. However, a monetized version of the model which stresses sticky wages and a Taylorrule based monetary policy naturally generates a welfare-reducing boom-bust cycle in response to a news shock. We explore the possibility that integrating credit growth into monetary policy may result in improved performance. We discuss the robustness of our analysis to alternative specifications of the labor market, in which wage-setting frictions do not distort on going firm/worker relations. JEL Classification: C11, C51, E5, E13, E32Asset price boom-busts, DSGE Models, monetary policy

Monetary Policy and Stock Market Booms

Historical data and model simulations support the following conclusion. Inflation is low during stock market booms, so that an interest rate rule that is too narrowly focused on inflation destabilizes asset markets and the broader economy. Adjustments to the interest rate rule can remove this source of welfare-reducing instability. For example, allowing an independent role for credit growth (beyond its role in constructing the inflation forecast) would reduce the volatility of output and asset prices.inflation targeting, sticky prices, sticky wages, stock price boom, DSGE model, New Keynesian model, news, interest rate rule

A monetary policy strategy in good and bad times: lessons from the recent past

We evaluate the ECB’s monetary policy strategy against the underlying economic structure of the euro area economy, in normal times and in times of severe financial dislocations. We show that in the years preceding the financial crisis that started in 2007 the strategy was successful at ensuring macroeconomic stability and steady growth despite shocks to the supply side and to the transmission mechanism which complicated the policy process. Emphasis on monetary indicators in the ECB’s monetary policy strategy – the monetary pillar – was instrumental in avoiding more volatile and less predictable patterns of inflation and growth. After the collapse of financial intermediation in late 2008, the strategy of the ECB was to preserve the integrity of the monetary policy transmission mechanism by adopting a comprehensive package of non-standard policy measures. According to our quantitative evaluation of the impact of the non-standard policy package, which notably did not include entering commitments regarding the future path of the policy rate, the liquidity interventions decided in October 2008 and in May 2009 were critical to preserving price stability and forestalling a more disruptive collapse of the macro-economy. JEL Classification: E31, E44, E51, E58credit, financial crisis, monetary policy, monetary transmission, Non-standard policy measures, Supply factors

Asset purchase programmes and financial markets: lessons from the euro area

We evaluate the effects on asset prices of the ECB asset purchase programme (APP) announced in January 2015 and assess its main transmission channels. We do so by first extending a term structure model with bond supply effects to account for assets with different types of risk premia. We then derive model-based predictions for cross-asset price movements associated with the transmission channels identified in the model. We finally validate empirically these predictions by means of an event- study methodology, reaching the following conclusions: The impact of the APP on asset prices is sizeable albeit the programme was announced at a time of low financial distress. This may appear puzzling in light of existing literature that finds a large impact of asset purchases only in periods of high financial distress. Consistent with the model, we explain this apparent puzzle by showing how the low financial distress, while indeed weakening certain transmission channels, has reinforced other channels because of its interplay with the asset composition of the programme. Targeting assets at long maturity and spanning the investment-grade space have supported the duration and the credit channels. At the same time, the low degree of financial stress prevailing at announcement of the programme, while weakening the local supply channel, has facilitated spill-overs to non-targeted assets