2. Topics in Monetary Policy: The Zero Lower Bound Flashcards
What is the main issue with interest rates set at zero?
Usually during a recession the CB can lower interest rates to encourage people to spend today rather than tomorrow (people want more liquidity when interest rates are lower) and hence stimulate economic growth. This can’t be done if interest rates are zero
What are the 2 main instruments that the CB can use if the interest rate cannot be lowered?
Quantitative Easing
Forward Guidance
How does QE work?
2 points
The CB buys bonds from smaller banks with money that it has created itself.
This encourages banks to loan more money out to people, which hence stimulates the economy
What is the intuition behind forward guidance?
Where the CB promises to keep interest rates low. By the Euler equation, this stimulates current consumption relative to future consumption
Who proposes an alternative to forward guidance?
What is it called?
Correia, Farhi, Nicolini & Teles (2013)
“Unconventional Fiscal Policy at the Zero Bound”
What is the idea behind “Unconventional Fiscal Policy at the Zero Bound”
Promise that taxes will be permanently higher in future to encourage higher consumption today relative to the future
What do many VAR frameworks suggest about MP and the CB?
2 points
That MP has very little effect on the movements of the economy
Hence the role of the central bank is redundant
What are the potential issues with the VAR framework?
3 points
The CBs policy instruments might change over time
Sometimes changes in the interest rate are not related to policy e.g. if inflation is high then people might expect the CB to increase the interest rate and hence change their behaviour
If the markets’ expectations are correct then there may be no effect left to occur by the time the policy change actually happens
What approach is used in Romer & Romer (2004)
A “narrative approach” (use historical accounts of interest rate decisions made by the Fed)
What do Romer & Romer (2004) find?
That MP has a huge influence on economic activity
What are “impulse response functions”?
Where shocks are imposed on output, prices and interest rates and the systems reaction is observed
What paper uses a combination of the VAR approach with R&Rs approach? What does it find?
Coibion (2012)
Find that the magnitude of MP effects is somewhere in between those estimated by VAR models and R&R
Give the 2 equations that you require to explain forward guidance
Fisher eqn: rt = it - πt
Euler eqn: U’(ct) = βEt[(1+r[t+1])U’(ct+1)
Why does lowering the interest rate encourage more consumption today relative to tomorrow?
A decrease in the interest rate increases the demand for money, because it is relatively less profitable to keep the money in the bank
