Thus, additional and large deficits provide only transitory gains in economic activity, which are quickly followed by weaker business conditions. With slower economic growth and inflation, long-term rates inevitably fall. That means the government—because it is the most creditworthy borrower—sucks up capital and leaves less available to private borrowers.
They must then pay more for it via higher interest rates or a weakened currency. Yet clearly it has not been the case for larger developed economies. That is not how most macroeconomic theories say debt-funded fiscal stimulus should work. Additional cash flowing through the economy is supposed to spur growth and in turn raise inflation and interest rates. This has not happened.
In much of the developed world, the existing debt load is so heavy that additional dollars have a smaller effect. The higher taxes that politicians often think will reduce the deficit serve mainly to depress business activity. The result is slower economic growth, plus lower interest rates and inflation. This is because net interest income is usually the largest single component of bank profits and because the effect of lower rates on net interest income is long-lasting while that on the other components is only temporary, [12] or at least wanes over time.
This helps to explain, for instance, the very negative response of bank stocks in January to markets' perceptions that interest rates would stay lower for longer BIS A negative effect of low rates on bank profitability can reduce the effectiveness of monetary policy.
It may inhibit loan supply, which depends positively on bank capitalisation and hence on profits — retained earnings being the main source of capital accumulation.
In their model, this level could even be positive, depending on structural features of the economy and the financial system. Conventional consumption theory suggests that low real interest rates depress saving and boost consumption through intertemporal substitution. When the real interest rate is low, the returns from postponing consumption are also low.
This means that current consumption should increase substitution effect. This reasoning is the cornerstone of the standard Euler consumption equation — the consumption demand-block of modern DSGE models. In more general settings, interest rates may also affect consumption by influencing income or cash flows and through wealth effects. Lower interest rates mean lower interest payments by borrowers to the extent that loans are at adjustable rates or can be refinanced. But they also mean lower interest receipts for lenders and depositors.
While these channels are in essence redistributive, they can give rise to first-order effects in the aggregate whenever borrowers have higher marginal propensities to consume than lenders and depositors, as is typically assumed Tobin ; Auclert Clearly, the strength of the redistribution channel will also depend on the structural features of credit markets.
If interest rates are persistently low, additional expected income effects may come into play. If agents become concerned that the low returns on savings will persist and render their envisaged lifetime savings insufficient to ensure an adequate standard of living after retirement, they may step up saving and reduce consumption to compensate for the shortfall White ; Hannoun To be sure, in principle this effect should operate regardless of the level of interest rates. But it may become much more visible and prominent when interest rates are unusually and persistently low.
For instance, concerns about the viability of pension funds or much less remunerative life insurance saving products can highlight the need for higher saving for retirement see below.
As a result, the effect of low rates on consumption may diminish and even reverse as rates drop to very low levels. That said, while this argument is often brought up in public debate, we are not aware of a formalisation of this point in a theoretical model of consumption and saving. A possible countervailing force relates to wealth effects, linked to the boost that lower interest rates give to asset prices.
Of course, such a countervailing force would tend to be weaker during recoveries from a balance sheet recession, given heightened risk aversion and initial overvaluation. Finally, just as in the case of bank lending, nominal interest rates may matter quite independently of real rates. While monetary expansions usually appear to attenuate uncertainty and risk perceptions Bekaert, Hoerova and Lo Duca ; Hattori, Schrimpf and Sushko , persistently very low rates could have adverse effects on expectations and confidence.
If central banks push rates to levels that are unusually low by historical standards, agents might interpret this as signalling dark economic prospects, potentially offsetting the usual stimulus. Here, too, nominal interest rates may play a special role. Insurance companies' contracts, and their guaranteed returns, are typically set in nominal terms. The discounting method of pension fund liabilities varies across countries and institutions but stickiness in long-term assumptions about inflation and wage growth would generally tend to heighten the effect of changes in nominal rates.
And here, in contrast to the effect on asset prices, the effect on the value of the liabilities would actually increase at lower rates. The best known channel here works through the banking sector. Low rates reduce the perceived need for banks to clean up their balance sheets. They tend to encourage banks to roll over rather than charge-off non-performing loans in a number of ways.
Lower rates increase the expected recovery from non-performing loans by reducing the discount factor. All this saps banks' intermediation capacity because rolled-over bad loans crowd out new lending for more productive borrowers. In turn, this can complicate the prudential authorities' task of identifying and resolving weak institutions, in concert with other policymakers.
Here, too, nominal rates may have a prominent role to play. This is because they influence banks' funding costs and are commonly used in the discounting of non-performing loan recovery values.
It is also because some loan covenants become less effective when interest rates, and hence contractual repayments, are very low. In general, distinguishing viable from less viable businesses becomes harder. Testing the hypothesis of reduced monetary policy effectiveness at persistently low rates faces a number of challenges. To start with, assessing the effectiveness of monetary policy requires disentangling its effects from those of other factors driving the macroeconomy.
The coexistence of persistently low interest rates and economic weakness is in itself no proof of policy ineffectiveness. Monetary policy may be as effective as ever but its power may be masked by the depressed economic conditions.
Put differently, the apparent reduced effectiveness may just be spurious if the countervailing forces are not controlled for. This, of course, is a familiar identification issue in econometrics.
But it may be especially hard to resolve when economic conditions are particularly depressed or unusual, as they are during a balance sheet recession, and when the central bank resorts to multiple policy instruments in addition to the policy rate, such as large-scale asset purchases, which can confound the signal.
In a similar vein, and for similar reasons, even if policy is indeed less effective, it is difficult to disentangle the factors at work. In particular, is it because of headwinds that coincide with low rates or because of inherent nonlinearities linked to the level of rates? True, one might be able to shed further light on this issue by focusing on specific channels and using more granular data e.
Even so, this would still leave open the question of relevance of the detected effect at the aggregate level. In what follows, we provide a selective review of the extant evidence. Two main strands of empirical literature can be distinguished: i studies that assess the role of headwinds in monetary transmission but which could also capture effects coming from inherent nonlinearities; and ii studies that focus on specific nonlinearities, such as the effect of low rates on bank profitability and through this on credit supply , on consumption and on resource misallocation.
In the wake of the GFC, a growing literature has sought to assess whether financial crisis-related headwinds influence the effectiveness of monetary policy. Since periods of financial stress are usually also periods of low interest rates, this literature also speaks to the question of whether transmission is different when rates are low, albeit only indirectly. As already mentioned, one has to differentiate between the different phases of a financial crisis and a balance sheet recession.
Monetary policy is probably more effective than usual in the acute phase of a crisis but less effective in the recovery phase. This conjecture seems to be borne out by the empirical evidence, for both conventional policy i. A number of recent studies have found that conventional monetary policy has stronger effects in periods of financial stress. More generally, Dahlhaus finds that the effect of a monetary policy shock in the United States is larger in periods of financial stress than otherwise.
This result is confirmed by Jannsen, Potjagailo and Wolters for a sample of 20 advanced economies based on panel vector autoregression VAR analysis. They find that the effect of monetary policy in the acute phases of a financial crisis is larger than in normal phases. These results are consistent with the notion that monetary policy might be more effective in the acute phase of a financial crisis as it can reduce uncertainty and tail risks.
That said, the mechanisms through which higher policy effectiveness during crises work remain untested. At the same time, there is evidence that monetary policy is less effective in the recovery from a balance sheet recession, presumably reflecting the effects of persistent headwinds and possibly low rates themselves.
Jannsen et al allow for three different phases in the analysis of monetary policy effectiveness: a normal phase, a crisis phase and a recovery phase. While, as noted, they find stronger transmission during crises than during normal phases, their analysis also suggests that monetary policy has essentially no macroeconomic effect during the recovery from a financial crisis. This finding is consistent with previous BIS research.
Instead, deleveraging seems to be the key factor determining the speed of recovery Figure 4, right-hand panel. Overall, these results support the relevance of balance sheet-related headwinds in reducing monetary policy effectiveness once the acute crisis phase is over. Other studies test directly for the effect of specific types of headwind, in particular, debt overhang and heightened uncertainty.
Bloom et al show for the United Kingdom that higher uncertainty, measured by stock market volatility proxying financial headwinds more generally , [24] significantly reduces the responsiveness of investment to demand conditions, which in turn depend on the monetary policy stance. Similarly, Aastveit et al find that in the United States the monetary transmission to real output is weaker when uncertainty also measured by stock market volatility is high. They interpret this result as reflecting the effect of uncertainty on investment but acknowledge that other mechanisms might also be at work since the response of consumption drops significantly too.
This suggests that the relationship between uncertainty and monetary transmission may itself be state dependent: while monetary policy may be more effective in the acute crisis phase where it can work to lower the elevated level of uncertainty and tail-risk perceptions, heightened uncertainty in general seems to sap monetary policy effectiveness.
The literature on the effectiveness of unconventional monetary policies implemented in the wake of the GFC should also give us some clues about monetary policy effectiveness in environments of persistent headwinds and low interest rates.
Indeed, the lacklustre recovery from the GFC has raised doubts about the effectiveness of extraordinary measures, as discussed in BIS There is by now a large literature assessing the effectiveness of the measures on financial market prices and a somewhat smaller one investigating the ultimate effect on the macroeconomy see Borio and Zabai for an overview.
The overall picture is that the measures have been effective in easing monetary conditions by lowering interbank rates, bond yields and credit risk spreads, and, less conclusively, that these effects have also boosted the macroeconomy.
For our purposes, however, the extant studies are less informative than would be desirable. The reason is that they do not specifically test the hypothesis of reduced effectiveness at low rates. More generally, they tend to assume that previous relationships continue to hold — whether these concern the link between central bank balance sheets and activity and hence indirectly interest rates , or that between interest rates and economic activity.
One obvious reason is the limited sample size. Indeed, for any time series analysis of the extraordinary measures' effect on macroeconomic variables the sample period is typically rather short. That said, with now eight years of available data, it is becoming easier to assess whether the effects have changed over time, although the results should be taken with a pinch of salt.
Similar evidence is reported in Haldane et al They find that QE shocks have a significant effect when financial market stress is high but not when it is low, with the two regimes roughly coinciding with the sample split of Hesse et al Panizza and Wyplosz explore the decreasing effectiveness hypothesis for the core advanced economies that implemented large-scale asset purchases United States, euro area, Japan and United Kingdom , also based on sub-sample analysis, and come to inconclusive results.
For some empirical exercises they find decreasing effectiveness, but not for others. In fact, there has been explicit recognition of the persistent problem posed by CRE price bubbles as part of new bank capital requirements, and regulators have already moved to address this concern.
Since this regulation has not been in place very long, it is difficult to measure its effectiveness. But if the regulation is not doing the job, the correct response is to fix it, not to slow the economy down. Could the risk weight and the minimum investor equity position be increased? Would this not be preferable to putting people out of work and lowering incomes? Substituting contractionary monetary policy for appropriate financial regulations is not a short-term policy choice, it is a long-run decision to accept a trade-off of slower GDP growth and insufficient regulation.
Moreover, the invocation of financial instability as a justification for interest rate increases ignores the fact that higher rates themselves are a key trigger of financial instability, contributing measurably to run risk in the financial system. Thus, even if raising rates is an effective policy response to one risk to financial stability, any stability gains may be offset by increased risks elsewhere. Recent research has shown that increases in short-term rates causes cash to migrate from the banking sector to the shadow banking sector.
The reason for this shift is that the rate of interest on privately issued liabilities is closer to the Fed funds rate than the rate of interest offered on bank deposits. But because these privately created liabilities are not insured like deposits, they are the source of run risk in the financial system. During the financial crisis, there were widespread runs on privately created short-term liabilities—including asset-backed commercial paper, money market funds, and repurchase agreements.
These runs threatened to produce a massive fire sale of assets and forced the federal government to replace the lost funding through the creation of huge lending facilities to stem the runs. The Fed has acknowledged that the risks created by so-called runnable private liabilities are significant and remain unresolved. Raising rates to prevent one bubble does not increase overall financial stability if it increases run risks elsewhere in the system.
Considering the wider financial system, it is not at all clear why monetary policy should be a first option when policymakers are confronted by potential stability issues. Even a casual look at the provisions of the Dodd-Frank Act demonstrates that Congress gave the FSOC a very large set of tools precisely so that it could get into all of the cracks by changing the incentives of financial market participants and the structure of financial markets when necessary to prevent significant financial instability.
List of Partners vendors. When it comes to influencing macroeconomic outcomes, governments have typically relied on one of two primary courses of action: monetary policy or fiscal policy.
Monetary policy involves the management of the money supply and interest rates by central banks. To stimulate a faltering economy, the central bank will cut interest rates, making it less expensive to borrow while increasing the money supply. If the economy is growing too rapidly, the central bank can implement a tight monetary policy by raising interest rates and removing money from circulation. Fiscal policy , on the other hand, determines the way in which the central government earns money through taxation and how it spends money.
To stimulate the economy, a government will cut tax rates while increasing its own spending; while to cool down an overheating economy, it will raise taxes and cut back on spending.
There is much debate as to whether monetary policy or fiscal policy is the better economic tool, and each policy has pros and cons to consider. Monetary policy refers to the actions taken by a country's central bank to achieve its macroeconomic policy objectives.
Some central banks are tasked with targeting a particular level of inflation. In the United States, the Federal Reserve Bank the Fed has been established with a mandate to achieve maximum employment and price stability.
This is sometimes referred to as the Fed's "dual mandate. As a result, many central banks, including the Federal Reserve , are operated as independent agencies. When a country's economy is growing at such a fast pace that inflation increases to worrisome levels, the central bank will enact restrictive monetary policy to tighten the money supply, effectively reducing the amount of money in circulation and lowering the rate at which new money enters the system.
Raising the prevailing risk-free interest rate will make money more expensive and increase borrowing costs, reducing the demand for cash and loans. The Fed can also increase the level of reserves commercial and retail banks must keep on hand, limiting their ability to generate new loans. Selling government bonds from its balance sheet to the public in the open market also reduces the money in circulation. Economists of the Monetarist school adhere to the virtues of monetary policy. When a nation's economy slides into a recession , these same policy tools can be operated in reverse, constituting a loose or expansionary monetary policy.
In this case, interest rates are lowered, reserve limits loosened, and bonds are purchased in exchange for newly created money. If these traditional measures fall short, central banks can undertake unconventional monetary policies such as quantitative easing QE. A small amount of inflation is healthy for a growing economy as it encourages investment in the future and allows workers to expect higher wages. Inflation occurs when the general price levels of all goods and services in an economy increases.
By raising the target interest rate, investment becomes more expensive and works to slow economic growth a bit. Central banks can act quickly to use monetary policy tools. Often, just signaling their intentions to the market can yield results. Even if monetary policy action is unpopular, it can be undertaken before or during elections without the fear of political repercussions. Increasing the money supply or lowering interest rates tends to devalue the local currency.
A weaker currency on world markets can serve to boost exports as these products are effectively less expensive for foreigners to purchase. The opposite effect would happen for companies that are mainly importers, hurting their bottom line.
Even if implemented quickly, the macro effects of monetary policy generally occur after some time has passed.
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