Dario Bonciani and Joonseok Oh
In the wake of the global financial crisis in 2008, nominal interest rates in the US and other advanced economies have approached the effective lower bound (ELB). This fact has motivated new research to understand, both theoretically and empirically, the impact of monetary policies when the nominal policy rate is at the ELB. In a new paper, we show that accounting for balance sheet policies (QE) can ease the constraints imposed by the ELB on monetary policy and resolve several paradoxical results arising in canonical New Keynesian models at the ELB. The ‘paradox of flexibility’, the ‘paradox of toil’ and the puzzle of excessively large fiscal multipliers are all resolved when QE is added to the model as policy tool.
Policy paradoxes at the effective lower bound of short-term rates
Conventional theoretical models used for monetary policy analysis may deliver puzzling results when the policy rate is at its ELB:
- Negative demand shocks have bigger output falls the more flexible prices are: ‘the paradox of flexibility‘.
- Labour tax cuts are contractionary: ‘the paradox of toil‘.
- The multiplier of government spending is unreasonably large (see Christiano et al (2011) and Hills and Nakata (2018)). Whereas there is empirical evidence that government spending multipliers may be larger at the ELB, the puzzling aspect of the theoretical result is that it holds even under the assumption that government spending is purely wasteful.
The reason for these paradoxical results, is that in a liquidity trap, interest rates are constrained, and monetary policy cannot provide stimulus in the usual way: a fall in prices leads to a decline in inflation expectations, a rise in the real rate (because nominal rates are constrained), and hence a fall in output. In such a context, greater price flexibility exacerbates the fall in inflation expectations and amplifies the drop in output in response to an adverse demand shock. Similarly, distortionary labour tax cuts, reducing inflation and inflation expectations, cause an increase in the real rate and a fall in output. Government spending multipliers, by increasing inflation and inflation expectations, reduce the real rate and, therefore, tend to have larger positive effects on output than away from the ELB.
Accounting for QE in a DSGE model
We revisit these paradoxes through the lenses of a stylised Dynamic Stochastic General Equilibrium (DSGE) model that also accounts for quantitative easing (QE) policies, the four-equation New Keynesian model (Sims et al (2021)). In particular, the model includes a frictional commercial banking sector that provides long-term financing to households. Long-term asset purchases by the central bank (ie QE) put upward pressure on the price of these assets, thereby increasing the real value of the assets held by commercial banks. As a result, QE eases credit to the private sector. Conventional monetary policy, ie reduction/increase in the short-term interest rate in response to macroeconomic changes, is assumed to bypass the banking sector and directly stimulates/curbs households’ consumption.
Because of these modelling assumptions, QE turns out to be only an imperfect substitute for conventional monetary policy and its ability to stabilise inflation is more muted. Specifically, unlike conventional monetary policy, which only stimulates the demand-side of the economy, QE positively affects both aggregate demand and aggregate supply.
The policy paradoxes in New Keynesian models are mostly a theoretical result
The paradoxes discussed come from the assumption that monetary policy at the ELB is completely powerless. Allowing the central bank to carry out long-term bonds purchases as a tool to stabilise inflation can effectively solve the paradoxes. Quantitatively, our analysis suggests that only relatively modest adjustments in the central bank’s balance sheet are required to resolve the paradoxes. More specifically, following an annualised one percentage point fall in inflation, a five per cent increase in long-term bond holdings and a 27 annualised basis point decrease in their yield is sufficient to resolve the paradox of flexibility. Intuitively, with greater price flexibility, inflation initially drops more, causing a more decisive monetary policy response via an increase in QE, which significantly mitigates the fall in output.
Given a one percentage point decrease in inflation, a 13% increase in real long-term bond holdings and a 50 basis point reduction in their yield is sufficient to make labour tax cuts expansionary. The reason is that, in this case, the monetary policy response to the fall in inflation caused by the tax cut is strong enough to offset the fall in inflation expectations and the rise in the real rate, thereby boosting output.
Under a similar monetary policy response, the multiplier of government spending becomes smaller than one. In this case, in fact, the reduction in the central bank’s balance sheet (quantitative tightening), in response to the rise in inflation caused by the government spending shock, counteracts the fall in the real rate and significantly mitigates the rise in output.
Policy implications
The fact that the three puzzles disappear when QE is allowed, suggests that these puzzles are purely theoretical results, which we would not expect to see in the ‘real world’ where central banks have a variety of unconventional tools at their disposal – so long as these tools are deployed appropriately. They emerge not merely because policy rates are constrained, but rather because it is assumed there are no other tools to overcome this constraint.
Dario Bonciani works in the Bank’s Monetary Policy Outlook Division and Joonseok Oh works at Freie Universität Berlin.
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