What’s at stake: It was a heavy week of conferences last week (The 6th ECB research conference and the IMF “Jacques Polak” research conference). Both came up with a range of insightful and challenging thoughts which seem to converge on the importance and challenges facing monetary policy. The recent research unsurprisingly focuses on the importance of the financial sector which was broadly absent from macroeconomic models and on the relevance of macro-prudential policy going forward.
Monetary policy framework: the role of the financial sector in generating nonlinearities
Frederic Mishkin argued in a paper presented at the ECB conference that macro/monetary economists and central bankers do not have to go back to the drawing board and throw out all that they have learned over the last forty years. Much of the science of monetary policy remains intact. The recent financial crisis, however, does require some major rethinking about the details of the flexible inflation targeting framework for monetary policy strategy, the role of the financial sector and the highly nonlinear nature of the economy. There is now a strong case for a risk management framework that factors in tail risks that can produce very adverse outcomes for the economy. Another lesson is that there is a stronger case for monetary policy to lean against credit bubbles (but not asset-price bubbles per se), rather than just cleaning up after the bubble has burst. Finally, the financial crisis has made it clear that the interactions between the financial sector and the aggregate economy imply that monetary policy and financial stability policy are closely intertwined.
Gauti Eggertsson and Paul Krugman posted a draft paper on debt, deleveraging and the liquidity trap that has generated a lot of interest in the blogosphere. In a way, the paper builds on the limitations of the current New Keynesian framework identified by Mishkin and formalises the notion of a deleveraging crisis, in which there is an abrupt downward revision of views about how much debt it is safe for individual agents to have, and in which this revision of views forces highly indebted agents to reduce their spending sharply. One thing that is especially clear from the analysis is the likelihood that policy discussion in the aftermath of a deleveraging shock will be even more confused than usual, at least viewed through the lens of the model. Because the shock pushes us into a world of topsy-turvy, in which saving is a vice, increased productivity can reduce output and flexible wages increase unemployment. For more on this paper, see the reactions from MacroMania, ModeledBehavior, WorthwhileCanadianIniatiative, NewMonetaristEconomist.
Olivier Blanchard summarizes in a blog post the papers on monetary policy presented at the Jacques Polack conference. Monetary policy can lessen the adverse effects of financial disruptions on the real economy. One paper showed, using a quantitative macroeconomic model, how the negative feedback between the financial sector and real economy resulted in such a deep economic contraction with the 2007-09 crisis.
Monetary policy framework: bounded rationality
Jean Claude Trichet has stressed, in his opening address of the ECB Central Banking Conference, the lessons for macroeconomics and finance theory. In particular, and this is something that is very much shared by the Fed Chairman, the importance of economic history. Also, he explained the importance of modelling to assist monetary policy makers and the extent to which they had failed during the crisis. He argues that this highlighted the danger to rely on a single tool, methodology or paradigm and urged to explore the contribution of behavioural macroeconomics; agent- based computational finance as well as rational inattention and learning.
Paul de Grauwe – who is currently writing a textbook on behavioural macroeconomics – has a paper that provides a good introduction to that field of research and shows how it modifies monetary policy. The model produces endogenous waves of optimism and pessimism (“animal spirits”) that are generated by the correlation of biased beliefs. The author contrasts the dynamics of this model with a stylized DSGE-version of the model and studies the implications for monetary policies. De Grauwe finds that strict inflation targeting is suboptimal because it gives more scope for waves of optimism and pessimism to emerge, thereby destabilizing output and inflation.
The financial sector and macro prudential policy
The IMF conference concluded with an economic forum which discussed macro prudential regulation in some details. Viral Acharya, Jose Vinals, Vincent Reinhart and Donald Kohn and Markus Brunnermeier were the main participants. Acharya explained the work done by NYU Stern on the measure of systemic risk which is being used by the Federal Reserve Board of Governors. Brunnermeier insists that because of the volatility paradox, systemic risks are by nature invisible. Kohn explains how monetary policy needs to be clearly distinct from macro-prudential policy and highlights the question of accountability for financial stability.
The Mundell Flemming keynote address at the IMF conference was delivered by Anil Kashyap, who added an important theoretical contribution to our understanding of financial stress by modelling “fire sale” as a source of financial instability, which is conceptually different from both liquidity shocks and defaults. Charles Goodhart, Anil Kashyap and Richard Berner have proposed a macro-prudential toolkit that suggests the existence of three pillars to manage systemic risk: capital rules and liquidity requirements (on the asset and liability side), but also constraints to non-bank financial institutions in the form of higher margins to control the “shadow” banking system.
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