Topic 7 unconventional monetary policy Flashcards
What is unconventional monetary policy?
A set of monetary policy tools used when traditional methods are ineffective.
List three types of unconventional monetary policy tools.
- Quantitative easing
- Forward guidance
- Negative interest rates
What is quantitative easing?
A monetary policy where a central bank purchases government securities to increase money supply.
True or False: Forward guidance is a method to influence expectations about future interest rates.
True
Fill in the blank: _______ involves lowering interest rates below zero to encourage borrowing and spending.
[Negative interest rates]
What is the primary goal of unconventional monetary policy?
To stimulate economic growth during periods of low inflation or recession.
True or False: Unconventional monetary policy is used only during times of economic stability.
False
What can be a potential risk of quantitative easing?
Asset bubbles and increased inflation.
What does forward guidance typically communicate?
The central bank’s future plans regarding interest rates.
Fill in the blank: Unconventional monetary policy became more prevalent after the _______ financial crisis.
[2008]
What is the effect of negative interest rates on bank reserves?
Banks are charged for holding excess reserves, incentivizing lending.
List two potential benefits of unconventional monetary policy.
- Increased liquidity in the economy
- Lower borrowing costs for consumers and businesses
What is a primary concern regarding the long-term use of unconventional monetary policy?
The potential for financial instability.
What is the IR lower bound and the issues with it
Nominal IR are subject to a lower bound as physical cash guarantees a zero nominal return.
so experiment with ‘forward guidance’ and QE
FG: shifts expectations of future short term IR
QE: buy risky assets
Consequences of IR lower bound for MP
- Cannot satisfy Taylor principle if economy faces severe deflation
- Cannot offset negative demand shocks if r * is too low to move i down
Draw the IR lower bound and the impact of a large shock to the economy
WHy use FG
Expectations theory ( I = (i + i’e)/2)
change i’e through FG
Challenges of FG
Has to be credible, but:
- CB may have to convince people it will keep MP too loose given future conditions (time inconsistency)
- May also damage confidence if interpreted as saying economy is in worse condition than previously
what are assumptons of the portfolio choice model
Safe asset with risk-free real return r1. Prob of t1
Risky asset with uncertain real return r2. Prob of t1
r2 > r1
Fraction x of funds to allocate t safe asset and 1-x to risky asset
wealth = 1
WHat are the investment proceeds consumed in c1 and c2 given the assumptions
C1 = 1 + rfx + r1(1-x)
c2 = 1 + rfx + r2(1-x)
Draw the indifference curve of risk averse investors
What are the investors budget constraint
If choose axes, you get intercepts of:
x=1 –> (c1,c2) = (1 + rf, 1 + rf), on the no risk line (c2=c1)
x=0 –> (c1, c2) = (1 + r1, 1 + r2), lies above no risk line as r1>r2
choosing values of 0 < x < 1 get any (c1,c2) on straight line joining intercepts - (1 + r1, 1 + r2) and (1 + r1, 1 + r2)
Draw the optimal portfolio choice
optimal point at tangency point of budget constraint and indifference curve
what determines if risky asset held
Impact of QE purchases on risky assets
In equilibrium:
purchases of risky assets –> private investors hold a smaller fraction of risky assets and a larger fraction of risk free
results in lower bond risk premium would reduce long term IR
Higher asset prices boost collateral values, so easier to borrow
What is the impact of the prices of risky assets going up
Future returns r1 and r2 fall –> gradient of budget constraint declines in portfolio choice diagram
Investors substitute away from risky towards safe assets (SE dominating IE)
Smaller reward for bearing risk –> safe asset share rises
Draw the impact of lower expected risky assets
Draw the portfolio balance effect
CB purchase of risky assets –> reduced supply of risky assets –> higher risky asset price –> declined risk premium –> QE transfers risk from private investors’ portfolio to CB
payment with reserves –> more risk free assets
Critique of portfolio balance effect
Risk of CB ultimately borne by taxpayers –> Ricardian Equivalence
Benefit of a higher inflation target?
Lower bound on nominal IR reduces power of MP
Higher π * implies higher nominal i on average as
π ‘ e = π * : i = r * + π *
more room to lower i, real interest rate can be reduced to -π *
Benefits of average inflation targetting instead of standard
Target based on rates averaged over a number of years
- expected average of π and π’ to be stable
- if π falls because of a negative demand shock, expect higher π’ value in future
- higher π’e reduces real IR and boosts demand now
Alternatve targets instead of inflation
- Price level targeting –> if credible lower inflation now causes expectation of future inflation to rise
- Target for level of nominal GDP –> if credible, low inflation and recession now means an increase in expectations of future inflation or future real GDP
