Monetary policy: When will they learn?

Posted: October 14, 2014 in economy
Tags: , ,

THE monetary economics of a world in which interest rates are close to zero are not especially mysterious. Stimulating the economy at that point requires central banks to raise expected inflation. Disinflation, by contrast, results in passive tightening, since the central bank can’t lower its policy rate and since the real interest rate is the policy rate less expected inflation. In this world, the downside risks are much larger than those to the upside. There is infinite room to raise interest rates if inflation runs uncomfortably high (one might even welcome that opportunity to push rates up as that would reduce the probability that rates would fall to zero again in future). But there is no room to reduce interest rates if inflation is running to low. That, in turn, forces central banks to use unconventional policy or run psychological operations to try to boost expectations. Central banks are not very good at those sorts of things.You need to overshoot, in other words, because undershooting feeds on itself. The zero lower bound is a heavy drag on an economy that must be thrown off by rapid growth. If a central bank is too cautious it will not simply fail to escape the ZLB; the effort of trying to provide stimulus through unconventional routes may lead to stimulus fatigue. The central bank may simply become less willing to take the necessary expansionary steps, creating …

via Economic Crisis


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