Over the past decade, monetary policy has played a disproportional role in pursuing growth and inflation across the world, while structural reforms and fiscal policies have taken a back seat, arguably due to political gridlock that has plagued much of the world.
In this piece, I would like to take a theoretical approach in understanding the channel of transmission mechanisms of quantitative easing, and explore why it appears ineffective in pursuing the growth that continues to elude much of the world today.
Federal Reserve Building, Washington DC, USA
In short, the economics of monetary policy lies within four main channels:
1. Deceptive Economics (Robert Lucas Jr., 1972)
In a hypothetical example, an unannounced decision to increase money supply will cause price levels to rise in the absence of price rigidity, since there is more money in circulation for the same amount of goods and services. Citizens will then observe an increase in price levels, but unable to discern whether it is a result of increased aggregate demand or the deceptive acts of central bank money-creation. As such, they assign a probability that there is indeed an increase in aggregate demand, which encourages them to work longer hours and consequently produce more goods.
However, when the central bank erodes its credibility (when citizens realise there is no increased demand in the next period) by brazenly printing money in an attempt to reduce unemployment, the above-mentioned probability reduces and the correlation of the Philips Curve breaks down. This is what was observed during the 1970s when the term ‘stagflation’ was coined – economists around the world could not understand why the relationship between inflation and unemployment (or growth) deviated from a historically negative correlation to a positive one.
An extreme example of this is the case of the Volcker Recession, when then Fed governor Paul Volcker had to artificially raise interest rate in order to rein in inflation expectations, which ultimately led the US economy to a painful recession, in order to regain the Fed’s credibility. Today, the Fed has become one of the most credible central bank in the world, and the credibility and trust that it has painstakingly built are no longer put at risk to deceive the citizens in order to achieve its mandate.
2. Portfolio Rebalancing (James Tobin, 1961)
This effect has been most emphasised by central bankers, particularly Mario Draghi who chants it like a mantra during his press conferences. The idea here is that low interest rates encourages risk-taking behaviour by pushing yield-seeking investors into risky assets, such as undertaking a business project or taking out loans to small businesses.
Naturally, the collective portfolio rebalancing will lead to asset price inflation. This allows the ‘wealth effect’ to take place, when investment returns provide households with higher purchasing power to increase their consumption. Put together, both effects boost investment and consumption, which lead to an increase in aggregate demand.
3. Begger-thy-neighbour
Quite the opposite, this channel has traditionally been a taboo to speak about by any central banker, in fear of incurring the wrath of their trade partners. In fact, countries often accuse each other of artificially devaluing their currencies to gain an unfair advantage in trade. In this channel, central bank lowers their interest rates, which makes their country relatively less attractive for international investors to store their assets. Investors then withdraw their money, which causes the currency to depreciate. When this happens, the country’s exports become cheaper while imports become more expensive. Net exports rise, leading to an increase in aggregate demand. This is also known as the ‘begger-thy-neighbour’ policy.
4. Price Sluggishness
Under price sluggishness, two channels of mechanisms co-exist.
Firstly, the central bank partakes in open market operations to buy government bonds with newly printed money. When this happens, money is injected into the system, allowing credit constrained citizens, who were previously denied access to credit, to consume goods and services since their price has not adjusted to new money supply.*
Secondly, in the process of buying government bonds, their yields (or nominal interest rates) get depressed. Given inflation expectations, real interest rates is pushed down accordingly. All else constant, this increases consumption and investment by consumers and businesses, which stimulate the economy. This process is similar to an interest rate cut in countries that do not use open market operations to control their interest rates.
So, there you have it – the four (non-exhaustive) channels of transmission mechanisms of monetary policy. However, many questions in the realms of macroeconomics remain today. Some economists have questioned the variables of loan demand and called out at the lack of responsiveness of interest rates on aggregate demand, and prove using various statistical models that investment and consumption have a lot more to do with sentiment and business outlook than access to credit. Others, like Lawrence Summers, have urged the government to take advantage of the low interest rates to replace the role of the private sector to stimulate demand by investing into infrastructure projects and other forms of public spending.
It’s an age-old debate that economics is more of an art than science. Today, we are looking at a significant number of developed countries adopting negative interest rates, even though the consequences are not well understood. Developing countries that have in the past relied on debt and binged on seemingly cheap dollar funding are also facing problems trying to deleverage. In this world where we are facing an aging population, low productivity growth and a whole lot of uncertainties, a global recovery we have long been waiting for may still be some time away.
*In theory, increasing the money supply will increase the cash in circulation (M1 Money Supply) through the money multiplier. Central bank may also change the required reserves ratio or increase its lending to financial institutions to increase the M1 Money Supply.
Regards from Amsterdam,
P
Edit: Previously, I only considered the effects within a closed-economy. However, because of the prevalent role the exchange rate channel plays in any monetary policy, I have added it in my article.
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