The global financial crisis had a profound impact on how monetary policy is conducted, and the tools that were used for the financial crisis are needed again because of the effects of the pandemic. The global financial crisis was extreme- the fed couldn’t manage the financial system effectively by setting the federal funds rate. The federal funds rate is constrained by an effective lower bound (the point at which lowering the interest rate isn’t effective enough in increasing output and to lower it further would be harmful). The in-class IS-LM model is useful for illustrating this problem, viewing the global financial crisis as a left shift in the IS curve. If a shift is far enough left that the output suffers from the flattening bottom of the IS curve (which yields diminishing returns in output with respect to lowering interest rates), the output can still fall short of the objective output at the federal fund rate’s lower bound (Blanchard, 93). This situation is shown in the figure (Blanchard, 122), and is the setup for using other tools for monetary policy.
One of the main tools the fed has at its disposal when the federal funds rate hits its effective lower bound are balance sheet policies. There are quite a few balance sheet policies, although in the framework of the IS-LM model they have one goal, to shift the IS curve back to the right, where the ELB doesn’t limit output (and all its associated benefits). One example of balance sheet policies is quantitative easing, which is quite simple, the fed buys assets en masse injecting cash into the economy and expanding its balance sheet. Outside of balance sheet policies, the fed will engage in forward guidance, which is the fed communicating the state of the economy and likely future actions the fed will take. The goal of forward guidance is to better inform the populace so that they won’t be surprised by monetary policy and will make better decisions. The onset of the global financial crisis caused the fed to use these tools- to varying effects depending on who’s asked. However, “The majority view is that balance sheet policies and forward guidance made up for some but not all of the shortfall [from the effective lower bound] (Caldara, 433). Regardless, the effective lower bound remains a barrier to effective monetary policy, as balance sheet policies and forward guidance don’t make up for the lost output. In fact, in a simulation of a financial shock between a relaxed effective lower bound and a realistic one, there’s a significant difference between the two in terms of GDP, this can be seen in the U.S. real GDP graph (Caldara, 444).
If the effective lower bound restricts effective monetary policy, and the alternative tools to combat that only partially made up for that restriction in 2008, then it’s reasonable to be concerned about monetary policy in a world facing a pandemic and even in the post-pandemic economy. In fact, some projections show that the effective lower bound will restrict monetary policy up to 40% of the time (Kiley, 8). With a number as daunting as that- the development of unconventional monetary tools makes sense. The secretary of the treasury thinks that “the FOMC could consider a number of approaches. Some involve the deployment of unconventional tools, such as longer-term asset purchases” (Yellen). These unconventional tools will likely become more effective than the policies used in 2008, especially if there’s an impetus from the effective lower bound becoming a barrier more.
Bibliography
Blanchard, Olivier. Macroeconomics Seventh Edition. Pearson, 2017.
Caldara, Dario, et al. “Monetary Policy and Economic Performance since the Financial Crisis.” Federal Reserve Bank of St. Louis Review, vol. 103, no. 4, 4th Quarter 2021, pp. 425–60. EBSCOhost, https://search-ebscohost-com.ezproxy.plu.edu/login.aspx?direct=true&db=ecn&AN=1933158&site=ehost-live&scope=site.
Kiley, Michael T and John M. Roberts, “Monetary Policy in a Low Interest Rate World,” Brookings Papers on Economic Activity, Spring 2017.
Yellen, Janet L. “Comments on Monetary Policy at the Effective Lower Bound.” Brookings, Brookings, 14 Sept. 2018, https://www.brookings.edu/blog/up-front/2018/09/14/comments-on-monetary-policy-at-the-effective-lower-bound/.
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