Conventional and Unconventional Monetary Policy
Vasco Cúrdia and Michael Woodford
November 2, 2009
We extend a standard New Keynesian model to incorporate heterogeneity in spending opportunities and two sources of (potentially time-varying) credit spreads, and to allow a role for the central bank’s balance sheet in equilibrium determination. We use the model to investigate the implications of imperfect ﬁnancial intermediation for familiar monetary policy prescriptions, and to consider additional dimensions of central-bank policy — variations in the size and composition of the central bank’s balance sheet, and payment of interest on reserves — alongside the traditional question of the proper choice of an operating target for an overnight policy rate. We also give particular attention to the special problems that arise when the zero lower bound for the policy rate is reached. We show that it is possible to provide criteria for the choice of policy along each of these possible dimensions, within a single uniﬁed framework, and to provide policy prescriptions that apply equally when ﬁnancial markets work eﬃciently and when they are sub ject to substantial disruptions, and equally when the zero bound is reached and when it is not a concern.
The recent global ﬁnancial crisis has confronted central banks with a number of questions beyond the scope of many conventional accounts of the theory of monetary policy. For example, do pro jections of the paths of inﬂation and of aggregate real activity under some contemplated path for policy provide a suﬃcient basis for monetary policy decisions, or must ﬁnancial conditions be given independent weight in such deliberations? (The fact that the Fed began aggressively cutting its target for the federal funds rate, in late 2007 and early 2008, while inﬂation was arguably increasing and real GDP was not yet known to be contracting — and has nonetheless often been criticized as responding too slowly in this period — suggests that familiar prescriptions that focus on inﬂation and real GDP alone, such as the Taylor (1993) rule or common accounts of “ﬂexible inﬂation targeting” (Svensson, 1997), may be inadequate to circumstances of the kind recently faced.1 As a further, more speciﬁc question, how should a central bank’s interest rate policy be aﬀected by the observation that other key interest rates no longer co-move with the policy rate (the federal funds rate, in the case of the US) in the way that they typically have in the past? (The dramatically diﬀerent behavior of the LIBOR-OIS spread, shown in Figure 1, since August 2007, has drawn particular comment. Indeed, John Taylor himself (Taylor, 2008) has suggested that movements in this spread should be taken into account in an extension of his famous rule.)
In addition to such new questions about traditional interest-rate policy, the very focus on interest-rate policy as the central question about monetary policy has been called into question. The explosive growth of base money in the US since September 2008 (shown in Figure 2) has led many commentators to suggest that the main instrument of US monetary policy has changed, from an interest-rate policy to one often described as “quantitative easing.” Does it make sense to regard the supply of bank reserves (or perhaps the monetary base) as an alternative or superior operating target for monetary policy? Does this (as some would argue) become the only important monetary policy decision once the overnight rate (the federal funds rate) has reached the zero lower bound, as it eﬀectively has in the US since December 2008 (Figure 3)? And now that the Federal Reserve has legal authorization to pay interest on reserves (under the Emergency Economic Stabilization Act of 2008), how should this additional potential dimension of policy be used?
The past two years have also seen dramatic developments with regard to the composition of the asset side of the Fed’s balance sheet (Figure 4). Whereas the Fed had largely held Treasury securities on its balance sheet prior to the fall of 2007, other kinds of assets — including both a variety of new “liquidity facilities” and new programs under which the Fed has essentially become a direct lender to certain sectors of the economy — have rapidly grown in importance, and decisions about the management of these programs have occupied much of the attention of policymakers during the recent period. How should one think about the aims of these programs, and the relation of this new component of Fed policy to traditional interest-rate policy? Is Federal Reserve credit policy a substitute for interest-rate policy, or should it be directed to diﬀerent goals than those toward which interest- rate policy is directed?
These are clearly questions that a theory of monetary policy adequate to our present circumstances must address. Yet not only have they been the focus of relatively little attention until recently, but the very models commonly used to evaluate the eﬀects of alternative prescriptions for monetary policy have little to say about them. Many New Keynesian models abstract entirely from the role of ﬁnancial intermediation in the economy (by assuming a representative household), or assume perfect risk-sharing (to facilitate aggregation), so that the consequences of ﬁnancial disruptions cannot be addressed. Many models include only a single interest rate (or at any rate, only a single interest rate of a given maturity, with long rates tied to short rates through a no-arbitrage condition), and hence cannot say anything about the proper response to changes in spreads. And many models abstract entirely from the balance sheet of the central bank, so that questions about the additional dimensions of policy resulting from the possibility of varying the size and composition of the balance sheet cannot be addressed.
The aim of the research summarized here is to show how issues of these kinds can be addressed in a DSGE framework. We extend a basic New Keynesian model in directions that are crucial for analysis of the questions just posed: we introduce non-trivial heterogeneity in spending opportunities, so that ﬁnancial intermediation matters for the allocation of resources; we introduce imperfections in private ﬁnancial intermediation, and the possibility of disruptions to the eﬃciency of intermediation for reasons taken here as exogenous; and we introduce additional dimensions of central bank policy by explicitly considering the role of the central bank’s balance sheet in equilibrium determination, and by allowing central-bank liabilities to supply transactions services. Unlike some other recent approaches to the introduction of ﬁnancial intermediation into New Keynesian DSGE models3 — which arguably include some features that allow for greater quantitative realism — our aim has been to develop a model that departs from a standard (representative-household) model in only the most minimal ways necessary to address the issues raised above. In this way, we can nest the standard (and extensively studied) model as a special case of our model, facilitating understanding of the sources of our results and the precise signiﬁcance of the various new model elements that are introduced.
We have shown that a canonical New Keynesian model of the monetary transmission mechanism can be extended in a fairly simple way to allow analysis of additional dimensions of central bank policy that have been at center stage during the recent global ﬁnancial crisis: variations in the size and composition of the central-bank balance sheet, and in the interest rate paid on reserves, alongside the traditional monetary policy issue of the choice of an operating target for the federal funds rate (or some similar overnight inter-bank rate elsewhere). We have also considered the consequences for monetary policy analysis both of non-zero credit spreads all of the time and of ﬁnancial disruptions that greatly increase the size of those spreads for a period of time, and we have also considered the consequences of the fact the zero lower bound for short-term nominal interest rates is sometimes a binding constraint on interest-rate policy.
One of our most important conclusions is that these issues can be ad- dressed in a framework that represents a straightforward extension of the kind of model often used for monetary policy analysis in the past. This allows both the considerations emphasized in the traditional literature and the more novel considerations brought to the fore by recent events to be taken into account, within a single coherent framework. This integration is particularly important, in our view, for clear thinking about the way in which the transition from the current emergency policy regime to a more normal policy framework should be handled, as ﬁnancial conditions normalize. Because of the importance of expectations regarding future policy in determining market outcomes now, we believe that clarity about “exit strategy” is important for the success of policy even during periods of severe disruption of ﬁnancial markets.
Another important implication of our model is that interest-rate policy should continue to be a central focus of monetary policy deliberations, despite the existence of the other dimensions of policy discussed here, and despite the existence of time-varying credit frictions that complicate the relationship between the central bank’s policy rate and ﬁnancial conditions more broadly. While welfare can also be aﬀected by reserve-supply policy, we have argued that this dimension of policy should be determined by a simple principle that does not require any discretionary adjustments in light of changing economic conditions: intermediaries should be satiated in reserves at all times, by maintaining an interest rate on reserves at or close to the current target for the policy rate.
And while welfare can similarly be aﬀected by central-bank credit policy, to the extent that non-trivial credit frictions exist, we nonetheless believe that under normal circumstances, a corner solution (“Treasuries only”) is likely to represent the optimal composition of the central-bank balance sheet, so that decisions about active credit policy will be necessary only under relatively unusual circumstances, and it will be desirable to phase out special credit programs relatively rapidly after the disturbances that have justiﬁed their introduction. We thus do not anticipate that it should be necessary to make state-contingent adjustments of central-bank policy along multiple dimensions as an ongoing aﬀair, even if recent events suggest that it is desirable for central banks to have the power to act along additional dimensions under suﬃciently exigent circumstances.
Finally, our results suggest that the traditional emphasis in interest-rate policy deliberations on the consequences of monetary policy for the pro jected evolution of inﬂation and aggregate real activity is not mistaken, even taking into account the consequences for the monetary transmission mechanism of time-varying credit frictions. At least in the context of the simple model of credit frictions proposed here, optimal interest-rate policy can be characterized to a reasonable degree of approximation by a target criterion that involves the paths of inﬂation and of an appropriately deﬁned output gap, but no other endogenous target variables. This does not mean that central banks should remain indiﬀerent toward changes in ﬁnancial conditions; to the contrary, credit spreads (and perhaps other measures of ﬁnancial market distortions as well) should be closely monitored, and taken into account in judging the forward path of interest-rate policy necessary for conformity with the target criterion; but ﬁnancial variables need not be taken themselves as targets of monetary policy.
The main respect in which the appropriate target criterion for interest-rate policy should be modiﬁed to take account of the possibility of ﬁnancial disruptions is by aiming at a target path for the price level (ideally, for an output-gap-adjusted price level), rather than for a target rate of inﬂation looking forward, as a forward-looking inﬂation target accommodates a permanent decline in the price level after a period of one-sided target misses due to a binding zero lower bound on interest rates. Our analysis implies that a credible commitment to the right kind of “exit strategy” should substantially improve the ability of monetary policy to deal with the unusual challenges posed by a binding zero lower bound during a deep ﬁnancial crisis, and to the extent that this is true, the development of an integrated framework for policy deliberations, suitable both for crisis periods and for more normal times, is a matter of considerable urgency for the world’s central banks.
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