Lessons for Monetary Policy from the
Financial Crisis
• 1. Developments in the financial sector have a far greater impact on economic activity than was earlier realized
Importance of financial markets
• 2. The zero-lower-bound on interest rates can be a serious problem
Nonconventional tools to stimulate economy are less predictable
• 3. The cost of cleaning up after a financial crisis is very high
Economic growth is expected to be low for a decade after the crisis
• 4. Price and output stability do not ensure financial stability
Recent policy by the CBT
How should Central banks respond to
asset price bubbles?
Asset-price bubble: pronounced increase in asset prices that
depart from fundamental values, which eventually burst.
Alan Greeenspan (former chairman of the Fed): Central
Banks should not prick bubbles because:
• Bubbles are very difficult to identify. If CB knows, why wouldn’t market
participants know that prices are increasing beyond fundamentals
• Raising interest rates may or may not be effective in stopping such type
of buying behavior
• Monetary policy affects all markets broadly, not a specific market where
there is a bubble
• MP is a very powerful tool with strong consequences (unemployment,
decline in overall price level) that it may do more damage to the
economy while trying to prick the bubble
• It makes more sense to address the problem after the bubble bursts
• Types of asset-price bubbles
Credit-driven bubbles
• Most dangerous one for the economy
• Easy creditRise in asset valuesappreciation
of collateralmore lending for those assets
more demand for the assetsPrices go up
even more..
• Subprime financial crisis
Bubbles driven solely by irrational
exuberance
• Driven by expectations (e.g. Tech. Bubble of late
1990s
• Leaning against the bubble vs. cleaning the
bubble afterwards:
Recent crisis suggests that CBs should lean against credit-
driven bubbles rather than cleaning up afterwards
• Macropudential policy: regulatory policy to affect
what is happening in credit markets in the aggregate.
The idea is to curb excessive risk taking
Financial regulation and supervision to prevent excessive risk
taking
• Monetary policy: Central banks and other regulators
should not have a laissez-faire attitude and let credit-
driven bubbles proceed without any reaction.
Tactics: Choosing the Policy
Instrument
• Tools
Open market operation
Reserve requirements
Discount rate
• Policy instrument (operating instrument)
Reserve aggregates
Interest rates
May be linked to an intermediate target
• An intermediate target is a bridge between the policy instrument and the
ultimate goals of monetary policy
• An intermediate target is easier to measure relative to final goals
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• By using intermediate and operating targets, CB can more quickly judge whether its policies are on the right track
• Ex:
Suppose the CB thinks 5% is the GDP growth rate at full-emp. (GOAL)
To achieve 5% GDP growth, long-term interest rates should be 7%, short-term interest rates should be 4% (INTERMEDIATE TARGET)
These interest rate targets are achievable with FFRT=3.5% (OPERATING TARGET)
OMO will be conducted to achieve the target (TOOL)
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OMOFederal funds rate target (3.5%)
Short-term interest rate (4%)
Long term interest rate (7%)
Investment (10%)
Output (5%)
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• Periodically, CB will check the growth
rates/levels of its intermediate targets and re-
adjust its operating target to achieve the
desirable level in its intermediate target
• Difficulty: In real life, it is hard to measure the
exact impact of your operating target on your
intermediate target or the precise link between
the intermediate target and the policy goals.
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Criteria for
Choosing the Policy Instrument
• Observability and Measurability
The policy instrument must be easily
measured to be informative about where
MP stands
Nominal interest rates are measured faster
than monetary aggregates, however, real
interest rates are more difficult to measure
It is hard to choose between interest rates
vs. monetary aggregates based on this
criteria
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• Controllability
The CB should have effective control over
the instrument.
CB has direct control on overnight nominal
interest rates and imperfect control over
money (which is determined by public
behavior)
CB’s control over longer term interest rates
is harder due to inflation expectations
It is hard to choose between interest rates
vs. monetary aggregates based on this
criteria
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• Predictable effect on Goals
The control over intermediate target should imply indirect control over policy goals.
• Question: The Fed has switched from a monetary aggregates targeting to interest rate targeting. Why?
• Answer: The link between monetary aggregates and macroeconomic variables (output growth) weakened (Chapter 19)
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