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Chapter 23 – Modern Monetary Policy and the Challenges Facing Central Bankers

Chapter 23

Modern Monetary Policy and the Challenges Facing

Central Bankers

Chapter Overview

The purpose of this chapter is two-fold. First, we will examine all the ways that

monetary policy affects real economic activity—that is, all the channels through which

monetary policy is transmitted. Second, we will look at the challenges that central

bankers face today and examine what the factors are that make modern monetary policy

so difficult.

Learning Objectives: Establish an understanding of:

1. The monetary policy transmission mechanism

2. Policy challenges

a. Asset bubbles

b. The zero bound

c. The evolution of the financial system

Important Points of the Chapter

The aggregate demand/aggregate supply framework described in Chapter 21 helps us to

understand the sources of inflation and fluctuations in the business cycle, as well as how

stabilization policy works. But to understand those occasions when the standard policy

tool of changing the real interest rate does not work, we need to look at all the ways in

which monetary policy actions can affect economic activity.

Application of Core Principles

Principle #3: Information. Information problems make external financing too difficult

and costly for firms to undertake, and so the vast majority of investments are financed by

businesses themselves through their own funds. This makes the interest-rate channel of

monetary policy transmission a weak one.

Principle #3: Information. 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.

Teaching Tips/Student Stumbling Blocks

The final chapter of the text builds on the analysis of Chapters 21 and 22. Using

Core Principles 3 and 5, it extends students’ knowledge of the basics of monetary

policy to some important nuances of the policy process.

The primary focus of this chapter is, again, on how monetary policy affects

economic stability, but with additional detail. Specifically, the monetary policy

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transmission mechanism is discussed and the basic analysis of how policy affects

the economy is extended to various additional “channels” of monetary policy.

In addition to policy affecting spending by altering interest rates directly, interest

rate changes also have indirect effects. Among these are: (1) the exchange rate

channel, by which interest rate changes alter the relative attractiveness of financial

assets denominated in other currencies, which, as was discussed in Chapter 10,

affects the exchange rate and ultimately exports and imports; and (2) the asset

price channel, where interest rate changes affect wealth by altering prices of assets

such as stock prices, real estate prices, and the prices of capital goods.

In addition to direct and indirect interest rate effects, policy affects the economy

in other ways. These “channels” include: (3) the bank lending channel, which

arises due to portfolio effects on the asset side of bank balance sheets, since open

market operations alter the relative proportions of assets held as reserves,

securities, and loans, and banks then adjust their loan portfolios in response; and

(4) balance sheet channels, which are wealth effects that arise as households and

firms experience changing values of assets and liabilities, reflecting at least in part

the interest rate effects of policy on net worth.

Emphasize to students that each of these channels plays a role in determining the

position of the aggregate demand curve and hence in the size of the output gap.

Each channel represents a way by which monetary policy can be used to stabilize

the economy, enhancing economic welfare. That’s Core Principle 5.

Other applications of Core Principle 5 are discussions of two important

“pathologies” that can substantially disrupt the economy: deflation and “bubbles”

in asset prices. Monetary policy can be used not only to combat these problems

when they arise, but can also potentially preempt the problems.

Finally, it is apparent in the chapter that one type of information that allows for

good central bank policy decisions is accurate data on potential GDP. Mistakes in

estimating this key measure of long-run economic activity shows the kinds of

policy errors that can arise and destabilize the economy. This is the final example

of how the Core Principles often interact.

Features in this Chapter

Tools of the Trade: Correlation Does Not Imply Causality

The fact that two events happened together does not indicate that one caused the other.

Establishing a causal relationship is difficult in economics. We do have some evidence

that higher interest rates are associated with lower levels of real growth, but does that

mean that increases in the interest rate cause recessions? Maybe there is some other

factor involved.

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Chapter 23 – Modern Monetary Policy and the Challenges Facing Central Bankers

Your Financial World: Don’t Count on Inflation to Bail You Out

When policymakers lower interest rates, their aim is to encourage people to borrow and

drive output higher. While the increase in debt may help the economy as a whole, for

individuals there is a clear danger that they will borrow too much and end up with more

debt than they can manage.

Applying the Concept: What Happened in Japan?

The collapse of the Japanese stock market, and the associated decline in property prices,

caused collapses in both consumption and investment and also did considerable damage

to both the creditworthiness of borrowers and to banks’ balance sheets. Many banks had

virtually no capital left, but for political reasons, they were not shut down. Given the

large numbers of both bankrupt firms and impaired banks, it was no wonder that the Bank

of Japan’s monetary policy had virtually no impact. The fact that the interest rate was

zero simply didn’t matter, because the channels through which interest rate reductions

would normally have influenced real economic activity were almost completely blocked.

Thus policymakers had little ability to shift the dynamic aggregate demand curve, or even

to influence its slope. It is the state of Japan’s banking system that explains the contrast

between Japan’s situation and that of the United States; a healthy banking system makes

all the difference.

Your Financial World: Know the Level of Inflation

The first step in dealing with inflation is to become informed. The Bureau of Labor

Statistics web site provides important information. Consumers should focus on the

12-month changes that exclude food and energy; these core measures are more

representative of the long-term trend.

In the News: Should the Fed Pap Bubbles by Raising Interest Rates?

Federal Reserve Governor Jeremy Stein discussed ways that monetary policy can

encourage bubbles in financial markets and argued that central banks should be ready to

use their control over interest rates to address them. This is contrary to central banking

orthodoxy in which central bankers have been reluctant to use interest rates to stabilize

financial markets, fearing it is too big a response to a relatively targeted problem.

Lessons of the Article: Central bankers typically use regulatory tools to address fi-

nancial instability, while assigning interest rate and balance‐sheet tools to the task of

securing price and economic stability. They remain very reluctant to adjust interest

rates for other reasons. Following the financial crisis of 2007–2009, however, policy-

makers no longer rule out hiking interest rates to counter an asset bubble that infects

the balance sheets of leveraged intermediaries and, as a result, threatens a systemic

disruption.

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Additional Teaching Tools

In this video from the Wall Street Journal, Federal Reserve Bank of Chicago President

Charles Evans talks about how long easy money policies should remain.

http://live.wsj.com/video/seib-wessel-risks-of-easy-money-low-interest-rates/58C4BEC2-

A76D-4325-A2F3-27E33A6CF705.html?KEYWORDS=unconventional+money+tools#!

58C4BEC2-A76D-4325-A2F3-27E33A6CF705

In this blog post from the Wall Street Journal, Jon Hilsenrath discusses the idea recently

floated that central bankers should promote longer-run growth and employment.

http://blogs.wsj.com/economics/2013/12/10/central-station-another-job-for-central-banke

rs/?KEYWORDS=unconventional+money+tools

Virtual Tools

The Bureau of Labor Statistics web site provides information on inflation (and other

economic data) on a state and regional basis as well as for the country as a whole. Scroll

down until you see the map and click on your state to find out more about the inflation

rate in your area.

http://www.bls.gov/

Here’s another view on inflation targets and interest rates being too low; Paul Krugman

talks about the “liquidity trap” (the term used by Keynes) referring to the situation in

which interest rates cannot move lower. He concludes that there is “no middle ground.”

http://web.mit.edu/krugman/www/nomiddle.html

For More Discussion

How important are interest rates to consumers’ decisions about purchases like a car or

home? Take an informal poll in your class to see if anyone had made such purchases and

how (or if!) they shopped around for financing.

Chapter Outline

I. The Monetary Policy Transmission Mechanism

A. The Traditional Channels: Interest Rates and Exchange Rates

1. Central banks target a very short-term interest rate, and changes in that rate

have a direct effect on total spending.

2. As the interest rate falls, financing becomes less expensive, so investment and

consumption increase.

3. The exchange rate is also affected; as investors demand less of U.S. assets the

value of the dollar drops, which in turn means higher net exports.

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4. The interest-rate channel appears to be a weak one; information problems

make external financing too difficult and costly for firms to undertake, so the

vast majority of investments are financed by firms through their own funds.

5. While a change in the interest rate does change the cost of external financing,

it doesn’t have much of an effect on investment decisions because not many

companies obtain their funds that way.

6. The impact on households is also rather modest because people’s decisions to

purchase cars or houses depend on longer-term interest rates; so consumption

will change only to the extent that changing the target rate affects long-term

interest rates, and the overall effect is not that large.

7. As for the effect on the exchange rate, in the real world the interest rate

controlled by policymakers is just one of many factors that shift the demand

and supply for the dollar; the influence of these other factors renders the

impact of monetary policy on the exchange rate (and net exports)

unpredictable.

8. Thus, after careful analysis, we can conclude that the traditional channels of

monetary policy transmission aren’t very powerful.

9. Yet evidence shows that monetary policy is effective; something else must be

amplifying the impact of monetary policy changes on real economic activity.

B. Bank Lending and Balance Sheet Channels

1. Policymakers at the Fed conduct surveys on bank lending so that they can tell

if a change in the quantity of new loans resulted from a change in demand or a

change in supply.

2. Banks are essential to a modern industrial economy; they direct resources

from savers to investors, solve problems caused by information asymmetries,

monitor loan recipients, and are the conduit through which monetary policy is

transmitted to the economy.

3. Banks and Bank Lending

a. The vast majority of individuals and firms obtain financing through banks;

thus bank lending is an important channel through which monetary policy

affects the economy.

b. This policy mechanism is referred to as the bank lending channel of

monetary policy transmission.

c. When the Fed engages in an open market purchase, bank reserves increase

and they have fewer interest-bearing securities.

d. Unless the bank does something, its income will fall; the natural reaction

is to lend the new funds.

e. Financial regulators can also affect bank lending. Changes in financial

regulation, such as an increase or decrease in the amount of capital a bank

is required to hold, will have an impact on the amount of bank lending.

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4. Firms’ Balance Sheets and Household Net Worth

a. Monetary policy has an important effect on the creditworthiness of

borrowers, or at least their perceived creditworthiness.

b. This balance sheet channel of monetary policy transmission works

because monetary policy has a direct influence on the net worth of

potential borrowers.

c. An easing of monetary policy improves firms’ and households’ balance

sheets, increasing their net worth, which in turn reduces the problems of

moral hazard and adverse selection, lowering the information costs of

lending and allowing borrowers to obtain financing more easily.

d. The higher the net worth of a borrower, the more likely that the lender will

be repaid, and a monetary policy expansion can improve borrowers’ net

worth because it drives up asset prices and reduces the burden of

repayment.

e. At lower interest rates, the percentage of a person’s income devoted to

loan payments drops, and individuals can qualify for higher loans.

f. As interest rates fall, the supply of loans increases.

g. Information is the driving force in the bank-lending and balance-sheet

channels of monetary policy transmission.

h. Financial instability, which is characterized by large and unpredictable

moves in asset prices, accompanied by widespread bankruptcy, will reduce

lenders’ willingness to supply financing.

i. Inferior information leads to an increase in adverse selection, reducing

bank lending, lowering investment, and ultimately depressing the quantity

of aggregate output demanded.

j. With the growth of loan brokers and asset-backed securities, the

bank-lending channel became less important than it once was until the

financial crisis of 2007-2009.

C. Asset Price Channels: Investment and Wealth

1. When the interest rate moves, so do stock prices. A fall in the interest rate

tends to push stock prices up, a relationship that is called the asset price

channel of monetary policy transmission.

2. The interest rate influences stock prices because the value of a stock is the

present value of a stream of future dividends, and a change in the interest rate

changes the rate at which that stream is discounted.

3. Added to this relationship is the fact that an easing of monetary policy might

well improve consumer and business confidence in the prospects for future

growth, which would mean more revenue and higher profits, as well as higher

stock prices.

4. In fact, stock prices will rise in anticipation of a cut in the interest rate.

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5. Monetary policy affects real estate markets in the same way that it influences

stock markets; a decrease in the target interest rate drives mortgage rates

down, increasing the demand for housing and raising the prices of existing

homes.

6. In short, when the central bank reduces its target interest rate, the stock and

real estate markets are likely to boom. The higher asset prices affect both

individual consumption and business investment.

7. For individuals, the increase in asset prices increases their wealth and thus

their consumption.

8. As stock prices rise, firms find it easier to raise funds by issuing new shares,

and so investment increases.

D. Financial Crisis Obstructs Monetary Policy Transmission

1. Monetary policy is transmitted to the economy through financial

intermediaries and through asset prices, yet financial conditions deteriorated

through much of the crisis of 2007-2009 because of information asymmetries.

2. A reduction in the quality of information about a borrower makes it more

difficult for them to borrow.

II. The Challenges Modern Monetary Policymakers Face

A. Booms and Busts in Property and Equity Prices

1. Abrupt changes in asset prices are particularly damaging because the wealth

effects they create cause consumption to surge and then collapse.

2. Equity bubbles allow firms to finance projects more easily, but the subsequent

collapse in prices impairs the balance sheets of financial intermediaries that

made the loans.

3. Proponents of “leaning against bubbles” say that discouraging bubbles would

temper the busts that follow.

4. Opponents of intervention point out the identifying a bubble is difficult and

that central banks should wait until the bubbles burst and then react

aggressively.

5. Today, there is an argument that macroprudential regulatory tools should be

used on bubbles. This relies on the foresight and judgment of regulators,

which may be difficult.

B. Deflation and the Zero Nominal Interest Rate Bound

1. There is a zero nominal interest rate bound; since investors can hold cash,

bonds must have positive yields.

2. This places a significant restriction on what monetary policymakers can do. At

some point there is no room for further easing.

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3. If inflation is zero and the target nominal interest rate that central bankers

control is close to zero, then a decline in the quantity of aggregate output

demanded can result in deflation.

4. Deflation isn’t necessarily a problem unless the shock that moves the

economy away from its long-run equilibrium is big enough to reduce output

down to such a level that policymakers can’t bring it back up.

5. Deflation aggravates information problems in ways that inflation does not,

making it more difficult for businesses to obtain financing for new projects,

thus decreasing investment and growth.

6. The reason for this is that deflation makes dollars more valuable and so

increases the value of a firm’s liabilities without affecting the value of its

assets; companies are suddenly less creditworthy.

7. Policymakers can avoid this pitfall by setting their inflation objective with the

perils of deflation in mind, by acting boldly when there is even a hint of

deflation, and by adopting unconventional policies.

8. Central bankers should set their inflation objective high enough to minimize

the possibility of a deflationary spiral.

9. Reducing the interest rate significantly and rapidly when faced with the

possibility of hitting the zero nominal interest rate bound is another approach

to avoiding deflation (central bankers call this “acting preemptively”).

10. Central bankers can use unconventional policy tools such as forward

guidance, quantitative easing, and targeted assets purchases when interest rate

changes are not feasible. However, these methods have results that are

difficult to predict and are difficult to exit from.

11. Monetary policymakers are reluctant to use such unconventional options

because they have little experience with them; they don’t know what the

quantitative impact of an unconventional policy would be.

C. The Evolving Structure of the Financial System

1. Monetary policy works through its effects on the financial system; thus

differences in financial structure across countries may help to explain

differences in the effectiveness of monetary policy.

2. Changes in financial structure will change the impact of monetary policy.

3. Banks are crucial to this mechanism; as the nature of banking changes, the

importance of this channel of monetary policy transmission will change along

with it.

4. The shift away from bank financing and toward direct financing in the capital

markets means that the bank-lending channel of monetary policy transmission

is likely to become less and less important.

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5. As financial instruments, markets, and institutions evolve, the central bank’s

balance sheet will change with them, along with the monetary transmission

mechanism.

6. The changing nature of the financial system is important for individuals as

well as policymakers.

Terms Introduced in Chapter 23

asset-price channel

balance-sheet channel

bank-lending channel

deflation

exchange-rate channel

interest-rate channel

monetary policy transmission mechanism

zero nominal-interest-rate bound

Using FRED: Codes for Data in This Chapter

Data Series FRED Data Code

Real GDP – United States GDPC1

U.S. 3‐month Treasury bill rate TB3MS

U.S. 10‐year Treasury bond yield GS10

One‐year inflation expectations (University of Michigan) MICH

Real trade weighted U.S. dollar broad index TWEXBPA

Trade weighted U.S. dollar broad index TWEXBMTH

Household net worth TNWBSHNO

Disposable personal income DPI

Personal saving rate PSAVERT

S&P 500 stock price index SP500

S&P Case‐Shiller 20‐city home price index SPCS20RSA

Consumer price index CPIAUCSL

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Lessons of Chapter 23

1. Monetary policy influences the economy through several channels.

a. The traditional channels of monetary policy transmission are interest rates and

exchange rates.

i. Interest rates influence consumption and investment.

ii. Exchange rates affect net exports.

b. Monetary policy affects the supply of bank loans, changing the availability of

bank financing to firms and individuals.

c. Monetary policy can change firms’ and households’ net worth, affecting their

creditworthiness as borrowers.

d. The asset price channel of monetary policy transmission works through stock and

real estate prices.

i. Stock and property prices influence household wealth and consumption.

ii. Stock prices also affect businesses’ ability to raise funds and make

investments.

2. Monetary policymakers face significant challenges. To be successful, they require

a. Accurate estimates of potential GDP, even when its growth trend is shifting.

b. An understanding of how to cope with the problems created by the zero

nominal-interest-rate bound and the possibility of deflation.

c. A knowledge of how and when to react to the possibility of a stock or real estate

boom (and bust).

d. An awareness of the changing structure of the financial system and a knowledge

of how to react to it.

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