Analysis of Monetary and Fiscal Policies

Jean Monnet Lecture: Effective Demand Failures and the Limits of Monetary Stabilization Policy in a Pandemic

Presented at the Annual Research Conference of the ECB, September 4, 2020.

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The background paper for this lecture is available immediately below.

Effective Demand Failures and the Limits of Monetary Stabilization Policy

August 2020 draft
Note:  An earlier version was presented at the 2020 NBER Summer Institute under the title “Pandemic Shocks, Effective Demand, and Stabilization Policy”

Revised September 2021

Abstract:  The COVID-19 pandemic presents a challenge for stabilization policy that is different from those resulting from either “supply” or “demand” shocks that similarly affect all sectors of the economy, owing to the degree to which the necessity of temporarily suspending some (but not all) economic activities disrupts the circular flow of payments, resulting in a failure of what Keynes (1936) calls “effective demand.” In such a situation, economic activity in many sectors of the economy can be much lower than would maximize welfare (even taking into account the public health constraint), and interest-rate policy cannot eliminate the distortions — not because of a limit on the extent to which interest rates can be reduced, but because monetary stimulus fails to stimulate demand of the right sorts. Fiscal transfers are instead well-suited to addressing the fundamental problem, and can under certain circumstances achieve a first-best allocation of resources without any need for a monetary policy response.

Post-Pandemic Monetary Policy and the Effective Lower Bound

August 2020
Presented at the Federal Reserve Bank of Kansas City Annual Research [“Jackson Hole”] Symposium,  Navigating the Decade Ahead: Implications for Monetary Policy, August 28, 2020.

A brief and non-technical exposition of an argument that is presented in more detail in “Effective Demand Failures and the Limits of Monetary Stabilization Policy.”

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Quantitative Easing and Financial Stability

May 2016
Published in E. Albagli, D. Saravia, and M. Woodford, eds., Monetary Policy Through Asset Markets: Lessons from Unconventional Measures and Implications for an Integrated World, Santiago, Central Bank of Chile, 2016
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Abstract: The massive expansion of central-bank balance sheets in response to recent crises raises important questions about the effects of such “quantitative easing” policies, both their effects on financial conditions and on aggregate demand (the intended effects of the policies), and their possible collateral effects on financial stability. The present paper compares three alternative dimensions of centralbank policy — conventional interest-rate policy, increases in the central bank’s supply of safe (monetary) liabilities, and macroprudential policy (possibly implemented through discretionary changes in reserve requirements) — showing in the context of a simple intertemporal general-equilibrium model why they are logically independent dimensions of variation in policy, and how they jointly determine financial conditions, aggregate demand, and the severity of the risks associated with a funding crisis in the banking sector. In the proposed model, each of the three dimensions of policy can be used independently to influence aggregate demand, and in each case a more stimulative policy also increases financial stability risk. However, the policies are not equivalent, and in particular the relative magnitudes of the two kinds of effects are not the same. Quantitative easing policies increase financial stability risk (in the absence of an offsetting tightening of macroprudential policy), but they actually increase such risk less than either of the other two policies, relative to the magnitude of aggregate demand stimulus; and a combination of expansion of the cental bank’s balance sheet with a suitable tightening of macroprudential policy can have a net expansionary effect on aggregate demand with no increased risk to financial stability. This suggests that quantitative easing policies may be useful as an approach to aggregate demand management not only when the zero lower bound precludes further use of conventional interest-rate policy, but also when it is not desirable to further reduce interest rates because of financial stability concerns.

Conventional and Unconventional Monetary Policy with Endogenous Collateral Constraints

Revised December 2013
(With Aloisio Araujo and Susan Schommer)
Published in American Economic Journal: Macroeconomics
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Abstract: We consider the effects of central-bank purchases of a risky asset, financed by issuing riskless nominal liabilities (reserves), as an additional dimension of policy alongside “conventional” monetary policy (central-bank control of the riskless nominal interest rate), in a general-equilibrium model of asset pricing and risk sharing with endogenous collateral constraints of the kind proposed by Geanakoplos (1997). When sufficient collateral exists for collateral constraints not to bind for any agents, we show that central-bank asset purchases have no effects on either real or nominal variables, despite the differing risk characteristics of the assets purchased and the ones issued to finance these purchases. At the same time, the existence of collateral constraints allows our model to capture the common view that large enough central-bank purchases would eventually have to effect asset prices. But even when central-bank purchases raise the price of the asset, owing to binding collateral constraints, the effects need not be the ones commonly assumed. We show that under some circumstances, central-bank purchases relax financial constraints, increase aggregate demand, and may even achieve a Pareto improvement; but in other cases, they may tighten financial constraints, reduce aggregate demand, and lower welfare. The latter case is almost certainly the one that arises if central-bank purchases are sufficiently large.

Optimal Monetary Stabilization Policy

February 2010
Published in: B.M. Friedman and M. Woodford, eds., Handbook of Monetary Economics, vol. 3B, 2011
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