Zero Lower Bound

Macroeconomic Performance Since 2008

7% drop GDP in 18 months at start of recession Essentially flat 3 years after In 2013 GDP 14% lower than predicted pre recession Took until 2015 to return to 2008 peak

Forward Guidance

A central bank commitment to a future path of the policy interest rate Feeds into current long-term rates

Zero Lower Bound

A macroeconomic problem that occurs when the short-term nominal interest rate is at or near zero, causing a liquidity trap and limiting the capacity that the central bank has to stimulate economic growth. Negative rates unsustainable.

Stagflation

A period of slow economic growth and high unemployment (stagnation) while prices rise (inflation) e.g. in early years of recession inflation rising due to higher import, energy and food prices, lowering r or sticking to a standard PP would've depended recession Can adapt PP to a measure that excludes stagflation drivers e.g. domestically generated inflation - BUT hard to do

Does QE work?

Boosted narrow money supply but not increased bank lending enough to boost broad money supply Not aggressive enough - bank can still resell. Solution mean to ensure bank cannot resell? - Friedmanite helicopter drop - Purchase then cancel gov. bonds Permanent increase liquidity would increase inflation but risk of hyper inflation

Time Inconsistency in Practice

CB would maybe stick to promised irresponsibility but other agents to consider e.g. periods low rates -> accusations currency manipulation, complaints from pensioners that savings 'taxed away' Early exits from accommodating mon pol prolonged Great Depression in US and 'Lost Decade' in Japan

Quantitative Easing

Creation of electronic money by the central bank used to purchase government or corporate bonds with the aim of increasing liquidity and boosting lending and consumption Can lock CB into future higher inflation - when reach target cant withdraw quickly enough to avoid overshoot without flooding market

Gaspar et al. 2007

For: - Under RE price path stability acts as automatic stabilisers - Alleviates ZLB Against: - If expectations mainly backwards looking/low CB credibility - Have to explain new policy to public and make sure they understand (costly) - Relies on assumption CB can control p.l. - mistakes due to uncertainty generates volatility, have to generate more volatility to correct

Financial Markets Expectations

Forward guidance relies on financial markets having rational expectations Evidence to suggest do

Commit to Irresponsibility

In order to forward guidance to have impact, CB needs to commit to future higher levels of inflation to stimulate inflation now. Not optimal decision in time period Evidence in practice: BoE linked forward guidance to inflation forecasts of 2.5% two years ahead

Monetary Policy since 2008

Large interest rate cuts e.g. Bank of England reduced by 1.5% in Nov 2008 By 2009 UK = 0.5%, US = 0.25%, Euro Area = 1%

Aoki and Nikolov 2005

Price path targeting generating least welfare loss when uncertainty leads to mistakes compared to history-dependent and non-inertial rules

Price Path Targets

Set a targeted price path rather than targeted inflation, any deviations have to be corrected in future 1 - Remedies time inconsistency (Mankiw) 2 - Reduces probability of hitting Zero Lower Bound - automatic stabiliser 3 - Prevents demand deficiency - common criticism that CB quick to react when inflation above 2% but slower when below

Do Price Paths work in practice?

Stimulate economy through 2 channels: 1- Expectation lower future nominal policy rates lower current long rates - requires RE in financial sector, evidence exist 2 - Rise in expected future inflation lowers current real long rates - depends on RE of consumers/corporate - when exp. inflation increases loans today more attractive in real terms so borrow and consumption up - less evidence RE than in financial

Nominal GDP targets

Target nominal GDP growth Pros: - Retains advantages PP - Stable in stagflation shocks - Output fall and prices rise, nominal GDP approx same Cons: Harder to anchor to target - Observed quarterly not monthly - Frequently revised years after due to measurement challenges - Risk responding to false signals - Excludes imports (consumed by UK HHs) but not exports (not consumed) so not a true reflection of living costs