ZLB - zero lower bound

Question 1

What is the Zero Lower Bound (ZLB)?

Answer 1

The situation where the nominal interest rate is at or near zero, limiting the capacity of central banks to stimulate the economy through conventional monetary policy

= The ZLB occurs when interest rates cannot be lowered further to encourage economic activity

Question 2

What happens to the IS curve during a large negative aggregate demand shock?

Answer 2

The IS curve shifts inwards and output decreases - IS -> IS’ inwards (to the left)

= This reflects a decrease in overall demand within the economy

IS curve = \, y axis r, x axis y

Question 3

What is the Fisher equation?

Answer 3

it = rt + πe

This equation relates nominal interest rates (it), real interest rates (rt), and expected inflation (πe).

Question 4

What is the ‘curse of flexibility’ in the context of the ZLB?

Answer 4

The faster adjustment of prices (larger alpha in PC = steeper) and expectations (larger the fraction of agents with RE) can lead to a quicker deflationary spiral

= It suggests that the economy may worsen if prices and expectations adjust too quickly

PC = / , y axis pi inflation, x axis y output

Question 5

What is Keynes’ Liquidity Trap?

Answer 5

A situation where monetary policy becomes ineffective in promoting economic recovery during deep recessions, necessitating fiscal policy instead

• MP not effective in promoting economic recovery because making liquidity cheaper/more accessible, i.e. raising supply, would be ineffective at stimulating demand

= This occurs when lowering interest rates does not stimulate demand

Question 6

What is Pigou’s stabilizing effect (escape from liquidity trap)?

Answer 6

Falling prices increase the value of assets with fixed nominal value (eg cash), stimulating expenditure and shifting the IS curve to the right

• If this wealth effect is sufficiently large, the economy loop back to the equilibrium level of output
• This effect relies on the economy having a substantial stock of private assets - otherwise falling prices could raise real value of debts and cause IS to shift left

Question 7

What is hysteresis in economic terms?

Answer 7

A phenomenon where a negative output shock leads to a permanent leftward shift in the VPC, affecting future output levels
= even when expenditure and IS curve recovers, the economy will only return to VPC that has permanently shifted left

= It implies that the economy may not fully recover from a recession

Question 8

What are some solutions to the Zero Lower Bound?

Answer 8

Possible solutions include:
* Forward guidance: announcing a positive inflation target, or announcing a price-level target
* Expanding the monetary base / expansionary fiscal policy
* Reducing long interest rates
* Currency depreciation
* Introducing a tax on money

= These solutions aim to stimulate the economy when traditional monetary policy is ineffective

Question 9

What is forward guidance?

Answer 9

CB signalling it will keep rates at ZLB for greater length of time than hitherto expected

• loosening MP while nominal and real rate reductions cannot be achieved at ZLB

Question 10

What is the commitment to irresponsibility in monetary policy?

Answer 10

CB must pledge to keep policy rates at ZLB not only until the economy equilibrates but until inflation exceeds the official target

Question 11

What is the effect of low long-term interest rates on the economy?

Answer 11

Benefits:
Lower debt service costs for the government and cheaper financing for banks, firms, and households

Latter bc banks often source funding for mortgages and corporate loans from money markets in which opp cost of money = long-term bond yield

= This can lead to increased investment and consumption

Question 12

What are the potential problems with forward guidance?

Answer 12

Lack of credibility, doubts about the central bank’s ability to achieve inflation targets, and potential for the central bank to renege on its promises

= These issues can undermine the effectiveness of forward guidance

Question 13

What is the role of currency depreciation in escaping the ZLB?

Answer 13

It stimulates the economy by boosting exports and creating expectations of higher future price levels

= A depreciated currency can enhance competitiveness in international markets

Question 14

What is Svensson’s (2003) foolproof way to escape a liquidity trap?

Answer 14

A three-part plan involving:
- Commitment to a higher future price level
- Concrete action to demonstrate this commitment
- An exit strategy for returning to normal monetary policy

= This approach aims to establish credibility and stimulate economic recovery

Question 15

What is a potential criticism of Svensson’s foolproof way?

Answer 15

Simultaneous liquidity traps in multiple regions could prevent all from depreciating their currencies effectively

• This highlights the challenge of coordinated monetary policy across regions

Question 16

What does the term ‘time inconsistency’ refer to in monetary policy?

Answer 16

The tendency for policymakers to change their plans once the public’s expectations have been set, undermining credibility

= This can lead to suboptimal economic outcomes

Question 17

What is a liquidity trap?

Answer 17

A situation where interest rates are low and savings rates are high, rendering monetary policy ineffective in stimulating the economy

= In a liquidity trap, even with low nominal interest rates, people hoard cash instead of spending or investing

Question 18

What does Fischer (2001) suggest about yen depreciation?

Answer 18

It cannot be pushed too far due to beggar-thy-neighbour/competitive devaluation concerns

Question 19

What is the implication of successful expansionary monetary policy?

Answer 19

It implies a currency depreciation by increasing expectations of future price levels and lowering real interest rates

Question 20

What is time inconsistency of monetary policy at the ZLB?

Answer 20

The tendency of Central Banks to deviate from announced inflation targets due to changing conditions and pressures

Question 21

What happens when a Central Bank announces a future inflation target of 5%?

Answer 21

Consumers with fixed-rate mortgages may increase consumption due to lower real costs, potentially returning output to equilibrium

Question 22

What is the ‘bliss point’ for a Central Bank?

Answer 22

The point where output returns to equilibrium and inflation meets the target, reducing the incentive to pursue irresponsible policies

Question 23

What is a price path target?

Answer 23

1. During a deep recession, inflation dips below target to point A
2. Restoring the price path means raising inflation to point B, before it can stabilise to the long-run target
3. CB mandate requiring a price path target to be achieved would be a strong commitment to policy irresponsibility
   - No CB currently implements explicit price-level targeting, although Sweden did so during part of the 1930s (Berg and Jonung, 1999)

= A commitment by a CB to restore inflation to a specific path after a recession before stabilizing at a long-run target

Acts as an automatic stabiliser that lower real IR as soon as inflation starts to fall reduces likelihood of hitting ZLB

Question 24

What is a major criticism of Central Banks regarding monetary stimulus?

Answer 24

Delays in providing monetary stimulus allow adverse demand multipliers to set in, increasing the risk of hitting the ZLB

Question 25

What are adverse demand multipliers?

Answer 25

Consequences of delayed MP that lead to bankruptcies and reduced consumption, exacerbating economic downturns

Question 26

What is a secular demand deficit?

Answer 26

A prolonged shortage of demand resulting from lower inflation transferring income from borrowers to savers

Question 27

What are the limitations of a price path target?

Answer 27

It relies on rational expectations in the financial sector (there is strong evidence for RE in financial markets) and consumer / corporate sectors (less clear cut) Can face challenges from non-linearities eg convex Phillips Curves - occur when there are obstacles to deflation eg union resist nominal wage costs Inflation isn’t perfectly controlled by CBs = policy-makers prefer the simplest possible adjustment path for inflation - risk of possible overshoot = undermines CB credibility - risk of whilst correcting previous inflation overshoot, a shock drives inflation negative

Question 28

What is the impact of stagflation (inflation, and -ve output gap) on a price path target?

Answer 28

It could require future inflation below target, leading to higher real long-term rates and exacerbating recession eg UK inflation did not dip below 2% during the last recession, instead rising import, energy and food prices pushed inflation to 5% - A PP for the Consumer Price Index (CPI) would have required future inflation below 2% thus a rise in real long-term rates today – exacerbating the output recession To avoid this, can specific price-path in terms of a refined price measure that excludes stagflation drivers but coming up with refined price measure that works well in all circumstances

Question 29

What does nominal GDP equal?

Answer 29

Nominal GDP = Price level x output = PY

Question 30

What is a limitation of nominal GDP targets?

Answer 30

Nominal GDP data is less timely and frequently revised, raising the risk of responding to inaccurate signals (nominal GDP observed quarterly whereas CPI observed monthly) & (nominal GDP is frequently revised several years after the event due to challenges in measuring quantities, whereas revision to the CPI are rare = raises the risk of responding to false signals in nominal GDP) Also, under nominal GDP targets, the P that is stabilised (where PY = nominal GDP) is known as the GDP deflator price concept; it excludes imports (consumed by UK households), includes exports (not consumed by UK households) and as such is a less good measure of cost of living (and hence consumer welfare) than CPI

Question 31

What is the role of risk premium in commercial rates?

Answer 31

Risk premium compensates for potential loan defaults and varies based on perceived risk and lender appetite

Question 32

How can Central Banks lower commercial rates?

Answer 32

By purchasing corporate and mortgage bonds, acting as a lender with greater risk tolerance than the market

Question 33

What is Quantitative Easing (QE)?

Answer 33

1. CB can enter the market as a lender w greater risk tolerance than the market average and hence provide credit at a lower rate = thus lowering the commercial rate - this can happen even when risk-free rates are at the ZLB, commercial rates need not be at the ZLB - can be done through purchasing corporate bonds (loans to companies) and mortgage bonds (fund mortgages at process implying lower IR than than could be achieved in the market - ie CBs took role of commercial banks through plugging gap in the market which developed as a result of limited risk appetite - direct interventions of this kind tend to deliver results but some CBs can be reluctant, e.g. the BofE didn’t want to take responsibility for private credit allocation or risk its reputation should private lending go bad 2. The creation of new electronic money to purchase assets (eg gov. and corp. bonds), boosting the money supply and stimulating the economy - If assets are purchased at a fair price then the net worth of the financial sector is unchanged, but bank and investor balance sheets are more liquid such that they can boost lending and trigger increased expenditure to raise inflation - QE is reversible (CB can sell assets and drain away liquid cash) slowly - QE on a sufficient scale could lock the CB into higher future inflation since on the inflation target is restored the QE money cannot be withdrawn quickly enough to avoid an inflation overshoot

Question 34

What are the channels through which QE operates (Joyce et al. 2011) ?

Answer 34

1. Policy signalling effects through asset prices = signals MPC’s determination to meet inflation target 2. Portfolio balancing effects through asset prices = reduces the spreads of longer-term IRs over expected policy rates (term premia) and the required return on risky assets relative to risk-free assets (risk premia) more generally 3. Liquidity premia effects through asset prices = asset prices may increase through lower premia for illiquidity, effects only persist when monetary authority is conducting asset purchases 4. Confidence effects = may directly boost consumer confidence & people’s willingness to spend 5. Bank lending effects = higher level of liquid assets could encourage banks to extend more new loans - didn’t work in GFC due to strains on financial system - resultant pressures on banks to reduce size of their balance sheets

Question 35

What is the initial ‘impact’ phase of QE's impact?

Answer 35

Asset purchases change portfolio composition, increasing broad money while decreasing medium and long-term gilts - gilts & money are imperfect substitutes = initial imbalance - as asset portfolios rebalanced, asset prices are bid up until equilibrium in money and asset markets is restored

Question 36

What does the ‘adjustment’ phase of QE entail?

Answer 36

Stimulus from asset purchases works through the economy, leading to rising consumer and asset prices, raising the demand for money balances and supply of long-term assets - initial imbalance in money and asset markets shrinks and real asset prices begin to fall back - boost to demand diminishes over time - price level continues to increase by smaller amounts - whole process continues until price level has risen sufficiently to restore real money balances, real asset prices and real y to equ. levels

Question 37

What evidence exists regarding the effectiveness of QE?

Answer 37

It is believed to have boosted narrow money supply but not significantly increased bank lending needed to convert this to broad money supply, demand and inflation Monetarists: argue QE hasn’t been practised aggressively enough - bc ultimately CBs can retrieve money created through selling assets - in order to credibly commit to irresponsibility the CBs must permanently increase liquidity, e.g.: Friedmanite helicopter drop (everyone gets a cheque from the CB) or use QE money to buy up gov. bonds and then cancel them – this is what European gov.’s did to trigger hyperinflation in the early C20th

Question 38

What is the Friedmanite helicopter drop?

Answer 38

A monetary policy where the CB distributes money directly to the public to stimulate demand - credible commitment to irresponsibility

Question 39

What did Joyce et al. (2011) conclude about QE in the UK post-2008?

Answer 39

QE asset purchases had economically significant effects - March 2009 - Jan 2010 £200 bn of assets were purchased (made up mostly of government. securities, representing abt 14% of annual GDP) - Including a reduction in gilt yields by around 100 basis points - equivalent to a 150-300 basis point cut in Bank rate - but considerable uncertainty around precise magnitude of the impact

Question 40

Problem with negative interest rates

Answer 40

• Most CB policy rates are rates at which the CB lend short-term to commercial banks • -ve lending rates would expose CBs to losses which they could tolerate for a while but would ultimately force them to seek taxpayer support (which would weaken CB legitimacy) • CBs also set deposit rates at which commercials can invest funds • instead of this, commercial banks can hold cash in vaults which offers only a slightly negative return (given insurance/storage costs) thus CB deposit rates have a lower bound of zero

Question 41

When might hysteresis happen?

Answer 41

Weak output away from VPC, meaning VPC permanently shifts left Equilibrium output follows short-term output patterns Occurs if the recession shifts either the PS (\) or WS (/) curve left (as VPC determined by intersection of PS and WS) - could occur due to: 1. capital scrapping (unprofitable firms suspend investment and allow depreciation to take effect - shifts PS left) 2. long term unemployed stop seeking work (shifts WS left)

Question 42

Why do CB’s need to commit to irresponsibility?

Answer 42

Just announcing an inflation target and a future monetary expansion doesn’t need to be credible with the private sector and therefore doesn’t need to affect inflation expectations, in the absence of any commitment mechanism or any action supporting the announcement (Svensson, 2003) = if a CB in a liquidity trap promises high inflation in the future, the private sector may doubt either the ability or the will of the CB to achieve that future inflation - the CB may be tempted to cheat, that is, to promise high future inflation to get out of the liquidity trap, but once out renege on the promise and keep inflation low It is possible that signalling low policy rates into the future imparts stimulus to the economy and lowers long-term rates, but fails to eradicate the demand deficit (e.g. Japan) – in these circumstances, monetary policy must commit to irresponsibility = CB must pledge to keep policy rates at the ZLB not only until the economy equilibrates but until inflation exceeds the official target - Long-term real IRs will fall because the expected inflation rises, providing incentives for higher expenditure and economic recovery - This policy reduces real IR via expected inflation rather than via nominal interest rates and so is not affected by the lower bound problem - rt = it + pie

Question 43

Commitment to irresponsibility in practice

Answer 43

• In 2012, the US Federal Reserve offered time-dependent interest rate guidance that the policy rate would remain at ZLB until 2014 • The BoE issued state-dependent guidance that the policy rate would remain at ZLB until specific unemployment objectives were achieved (assuming inflation remained below 2.5%, beyond the official 2% target) • In November 2016, the Bank of Japan explicitly committed to inflation above 2% target

Question 44

What is the case for a Price Path Target for ZLB?

Answer 44

Price Path target acts as an automatic stabiliser that lower real interest rate as soon as inflation starts to fall reduces the likelihood of hitting the ZLB - A common criticism of CBs is that when adverse developments take place there is a delay in monetary stimulus provided which allows adverse demand multipliers to set in so further rate cuts are needed and ZLB looms - Internal tensions over how to respond to Eurozone crisis caused delays in ECB action - Adverse demand multipliers: Firms that would have stayed in business had rates and debt service costs been lowered end up bankrupt and lay off workers who in turn cut consumption and reduce income elsewhere - Any delay or ambiguity over action may reduce confidence in the CB and create pessimism regarding the future economic output Price Path target wards off the threat of a secular demand deficit through forcing Central Banks to behave symmetrically - A common criticism of CBs under inflation targets is that they view their targets asymmetrically: their quick to snuff out inflation above target but relaxed about inflation below target - This asymmetric attitude towards inflation can lead to secular demand deficits, where real income is transferred from borrowers to savers (because inflation is lower than that assumed in the debt contracts) and savers have a lower consumption propensity so the overall level of demand drops - In theory, extra saving generated should fund investment and correct the problem, but credit market failures often mean that this doesn’t happen - Secular demand deficit creates an underlying demand shortage that leaves the economy vulnerable to hitting the ZLB should an adverse shock occur

Question 45

Case for nominal GDP targets?

Answer 45

• Targeting a path for nominal GDP has been suggested as an alternative to the Price Path target - In times of pure demand shocks both price level and output fall, inducing low nominal GDP growth that must be offset by future rapid nominal GDP growth (and hence loose monetary policy) so retains this advantage of price-path targeting - Following stagflation shocks output falls but price levels rise, so nominal GDP is roughly stable – thus wouldn’t induce unnecessary tightening of policy unlike price-path targeting

Question 46

What is commercial rate?

Answer 46

Commercial rate = government bond yield + risk premium The real commercial rate defines expenditure in IS and is a markup of the risk free rate to compensate for possible loan default