The recent crisis one more time revealed the importance and complexity of the financial sector of the economy and the problem of its proper regulation. The crash of Lehman brothers marked the failure of the financial system in its existing form. Nowadays there are heated debates about the future of the world financial system in the political and academic circles. In this context the topic of my essay is seen to be very important and pressing. The monetary authorities all over the world got a chance to test their latest developments in monetary policy in practice.
Although the idea that the money supply affects the real economy came to people`s mind in the middle of XVIII century it was the subject of ideological controversy among economic schools for a long time. The “classics” proposed the principles of neutrality of money that is changes in monetary variables affect only nominal variables (price level, nominal wages, etc.) but don`t change the real variables (output, employment, etc.). Partly as a result of such underestimation the monetary policy was not popular with politicians until 1960s since it was treated as ineffective in comparison with the fiscal policy. The turning point was 1968 year when M. Friedman wrote his famous “The role of monetary policy” article where he described advantages and applications of monetary policy and how it should be conducted.
Since then the monetary policy have been in wide practice worldwide and through the last 10 or more years it is seen as preferable by many economists and politicians as opposed to fiscal policy. A lot of water has flowed under the bridge since then, financial instruments, markets and the whole economic environment has changed dramatically and so did the monetary policy tools. My primary goal today is to describe in depth the latest developments in monetary policy tools which came into practice over the last 10 to 15 years. To do so, I will start by explaining what the conventional monetary policy is and how it works. I will outline then when and why conventional monetary policy tools may become ineffective. Subsequently I will proceed to highlighting the unconventional monetary policy measures and analyzing their use and effectiveness in real world applying the case-study.
The monetary policy is the government stabilization policy that is aimed at reaching macroeconomic goals (most common are economic growth, high employment and stable price level) by controlling the money supply. The monetary policy acts through the financial markets and depends heavily on them in its efficiency. The monetary policy is conducted by the Central Bank (CB) of the country which is the public authority but nominally independent from the government in its decisions. The CB is also responsible for overseeing the commercial banks, printing money and controlling the exchange rate.
In conducting monetary policy the CB should heavily rely on and take account of the general interconnections and mechanisms through which the monetary variables (money supply, interest rates, etc.) affect real economy that are known as monetary transmission mechanism. The effectiveness of monetary policy depends heavily on the matching of the features of particular country`s transmission mechanism and the tools used by the central Bank. Therefore it is important to conduct a thorough investigation into the distinctive features and characteristics of the transmission mechanism of the country. The generally accepted classification of monetary transmission channels belongs to famous American economist F. Mishkin and it comprises the following basic channels (I will highlight them in brief):
1) interest rate channel
It works through the following chain of events: when the CB reduces the interest rate the cost of borrowing falls, firms are willing to invest more, and households are willing to consume more. The economic activity is reviving.
2) asset price channel
When the CB reduces interest rate the investment and consumption, and thus, the aggregate demand, are increasing, the prices of all the assets in the economy rise, people begin to feel more wealthy, that enables them to increase their consumption and investment further, the economic activity is reviving.
3) credit channel
When the money supply increases, banks have more excess funds and thus they may and are willing to expand their lending contributing thus to economic reviving.
Depending on dominant channel(s) the CB should choose proper tools to better impact the economic activity in the direction needed.
In order to set the initial monetary impulse the Central Banks use three principal tools (that are called conventional monetary policy measures, for have been known and used since early stages of monetary policy):
* reserve requirements – that is the proportion of deposits that the commercial bank must hold in physical reserves rather than lend out. The higher the reserve requirements ratio, the less funds commercial banks may lend out, and the less money may be created in the economy.
* discount rate – that is the interest rate at which the CBs lend money to commercial banks. The higher the discount rate, the less attractive are borrowings from the CB to the commercial banks, the less funds they have in excess reserves, and the less money may be created in the economy.
* open market operations – the purchase/sale of government bonds by the CB from/to the general public.When CB buys/sells bonds, the money supply decreases/increases and the economic activity declines/revives.
These three instruments have been and still are in the wide practice of CBs all over the world. But, as we have already shown, any CB chooses the best fitting tool to impact the economy of its country: the US`s CB (the Fed) and other developed countries prefer open market operations, Chinese CB also relies on reserve requirements, developing countries generally rely on discount rate.
However, there are situations when traditional monetary policy tools simply do not work or cannot be used at all. Consider, for example, the situation when the CB conducting expansionary monetary policy increases money supply but it doesn`t convert into the rise in investment or consumption because of lack of confidence for instance. This situation is known as investment trap. Or when the CB in attempt to stimulate the economy reduces interest rate but even the significant fall in it doesn`t provoke the rise in public spending. This is known as liquidity trap. Or at last imagine the situation when the interest rate has already reached the zero level and the CB would be willing to reduce it further but the nominal interest rate cannot be negative. It is so-called zero-bound problem. Applying Fisher equation we may infer further that if there is a deflation in the economy then the real interest rate is negative so that CB cannot affect it furthermore, and who would be so fool to be willing to lend at negative interest?
Such situations are not rare and not unique. Through the last 15 years such problems arose several times in different countries of the globe. In the course of my essay I will address to two (most impressive in my opinion) examples: the one of Japan, and of the US.
In the late 1990s Japanese economy encountered the recession: output declined, unemployment rose and prices fell. Expansionary conventional monetary policy measures were applied but soon they ran against the zero-bound of interest rate. As nothing could more help Japanese CB had to invent something completely new to stimulate the economy.
Another striking experience saw the light in the American economy during the recent crisis. After the one of the most heavy calamities in its history the economic agents in the US lost confidence and were not willing to spend money preferring to save it to better times. Even the massive Fed`s stimulating policy didn`t work, and recovery hadn`t shown up.
In order to overcome such problems smart people have recently invented brand new monetary policy techniques, which were called unconventional monetary policy measures and which are in great use nowadays in ailing economies all over the world. In the course of my essay I will cover the most popular and most widely used of them:
* quantitative easing – that is massive expansion of money supply in the economy. This policy is aimed at inducing the public who lost confidence to spend money (either consume or invest) rather than save it. In practice this usually involves printing money in unlimited quantities so that to satisfy and even excess people`s needs for liquidity in order to stimulate them spend money to revive economic activity.
* credit easing – this policy involves levying credit restrictions and regulations and easing collateral requirements to borrowers so that more firms and households were able to borrow that will result in economic recovery.
* signaling – is the policy of managing public expectations (which are of utmost importance in developed countries) concerning future conduct of monetary policy in order to convince them in keeping the favorable credit conditions for a specified period of time.
These are the most common and widespread of the unconventional monetary policy measures although there can be named some more. What I`d like to emphasize is that these are not simply theoretical tools but in contrast they were firstly applied in practice and only then penetrated into theory. On the other hand since they have already been used in some countries we may draw some conclusions and assess their effectiveness. As it was above we will study the cases of Japan and the US.
Japanese example is notable mainly because it has first in the history used the unconventional monetary policy techniques in practice. After all other measures failed to achieve a positive result the Japanese CB invoked the quantitative easing program in the late 1990s. Looking at it in retrospect I may say that in Japan the effectiveness of QE was rather low: the real economy crept along for a number of years after the implementation of the program, and still lacks the confidence, real effects are almost invisible.
As to the US experience I may also infer that the effect of the QE, CE programs and signaling was rather small: the best that they managed to achieve is to head off the downturn, but real improvements and recovery hadn`t still shown up. So the effectiveness of the unconventional monetary policy measures still remains an open question. Probably that is not because of the shortcomings of unconventional monetary policy measures itself but because of the severity and the unprecedented global nature of the recent crisis.