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The authors embed human capital-based endogenous growth into a New-Keynesian model with search and matching frictions in the labor market and skill obsolescence from long-term unemployment. The model can account for key features of the Great Recession: a decline in productivity growth, the relative stability of inflation despite a pronounced fall in output (the "missing disinflation puzzle"), and a permanent gap between output and the pre-crisis trend output.
In the model, lower aggregate demand raises unemployment and the training costs associated with skill obsolescence. Lower employment hinders learning-by-doing, which slows down human capital accumulation, feeding back into even fewer vacancies than justified by the demand shock alone. These feedback channels mitigate the disinflationary effect of the demand shock while amplifying its contractionary effect on output. The temporary growth slowdown translates into output hysteresis (permanently lower output and labor productivity).
Macroeconomic stabilisation and monetary policy effectiveness in a low-interest-rate environment
(2021)
The secular decline in the equilibrium real interest rate observed over the past decades has materially limited the room for policy-rate reductions in recessions, and has led to a marked increase in the incidence of episodes where policy rates are likely to be at, or near, the effective lower bound on nominal interest rates. Using the ECB's New Area-Wide Model, we show that, if unaddressed, the effective lower bound can cause substantial costs in terms of worsened macroeconomic performance, as rejected in negative biases in inflation and economic activity, as well as heightened macroeconomic volatility. These costs can be mitigated by the use of nonstandard instruments, notably the joint use of interest-rate forward guidance and large-scale asset purchases. When considering alternatives to inflation targeting, we find that make-up strategies such as price-level targeting and average-inflation targeting can, if they are well-understood by the private sector, largely undo the negative biases and heightened volatility induced by the effective lower bound.
Central banks normally accept debt of their own governments as collateral in liquidity operations without reservations. This gives rise to a valuable liquidity premium that reduces the cost of government finance. The ECB is an interesting exception in this respect. It relies on external assessments of the creditworthiness of its member states, such as credit ratings, to determine eligibility and the haircut it imposes on such debt. The authors show how such features in a central bank’s collateral framework can give rise to cliff effects and multiple equilibria in bond yields and increase the vulnerability of governments to external shocks. This can potentially induce sovereign debt crises and defaults that would not otherwise arise.
We study the incidence and severity of lower-bound episodes and the efficacy of three types of state-dependent policies—forward guidance about the future path of interest rates, large-scale asset purchases and spending-based fiscal stimulus—in ameliorating the adverse consequences stemming from the effective lower bound on nominal interest rates. In particular, we focus on the euro area economy and examine, using the ECB’s New Area- Wide Model, the consequences of the lower bound both for the near-term economic outlook, characterised by persistently low nominal interest rates and inflation, and in a lasting low-real-interest-rate world. Our findings suggest that, if unaddressed, the lower bound can have very substantial costs in terms of worsened macroeconomic performance. Forward guidance, if fully credible, is most powerful and can largely undo the distortionary effects due to the lower bound. A combination of imperfectly credible forward guidance, asset purchases and fiscal stimulus is almost equally effective, in particular when asset purchases enhance the credibility of the forward guidance policy via a signalling effect.
This Policy White Paper assesses several main elements of ECB’s upcoming review of its monetary policy strategy, announced in January 2020. Four aspects of the review are discussed in detail: i) ECB’s definition of price stability and the arguments for and against inflation targeting; ii) the scope of ECB’s objectives, considering financial stability, employment and the sustainability of the environment; iii) an update of ECB’s economic and monetary analyses to assess the risks to price stability; iv) the ECB’s communication practice. Furthermore, an overview of the ECB’s monetary policy strategy and its last evaluation in 2003 is given.
The term structure of interest rates is crucial for the transmission of monetary policy to financial markets and the macroeconomy. Disentangling the impact of monetary policy on the components of interest rates, expected short rates and term premia, is essential to understanding this channel. To accomplish this, we provide a quantitative structural model with endogenous, time-varying term premia that are consistent with empirical findings. News about future policy, in contrast to unexpected policy shocks, has quantitatively significant effects on term premia along the entire term structure. This provides a plausible explanation for partly contradictory estimates in the empirical literature.
Monetary policy and prudential supervision – from functional separation to a holistic approach?
(2018)
When prudential supervision was put in the hands of the European Central Bank (ECB), it was the political understanding that the ECB should follow a policy of meticulous separation between monetary policy and financial supervision. However, the financial crisis showed that monetary policy and prudential supervision deeply affect each other and that an overly strict separation might generate systemic risk. As a consequence, the prevalent model of “functional separation” – central banking and financial supervision in separate entities – has been questioned and calls for a more holistic approach increased.
This policy letter states that from a legal perspective, such a holistic approach would be in conformity with the current legal framework of the Economic and Monetary Union. Although the realization of a holistic approach might intensify the doubts of democratic legitimation under the framework of the ESCB, the independence of the ECB should not be given up. As viable alternatives to protect monetary policy against the time inconsistency problem that would render central bank independence moot do not seem to be available and given the great importance of the independence of the European institutions for the European integration, the democratic control over the ECB should be strengthened instead of stripping the ECB of its independence.
We establish a benchmark result for the relationship between the loanable funds and the money-creation approach to banking. In particular, we show that both processes yield the same allocations when there is no uncertainty and thus no bank default. In such cases, using the much simpler loanable funds approach as a shortcut does not imply any loss of generality.
Financial market interactions can lead to large and persistent booms and recessions. Instability is an inherent threat to economies with speculative financial markets. A central bank’s interest rate setting can amplify the expectation feedback in the financial market and this can lead to unstable dynamics and excess volatility. The paper suggests that policy institutions may be well-advised to handle tools like asset price targeting with care since such instruments might add a structural link between asset prices and macroeconomic aggregates. Neither stock prices nor indices are a good indicator to base decisions on.
The global financial crisis and the ensuing criticism of macroeconomics have inspired researchers to explore new modeling approaches. There are many new models that deliver improved estimates of the transmission of macroeconomic policies and aim to better integrate the financial sector in business cycle analysis. Policy making institutions need to compare available models of policy transmission and evaluate the impact and interaction of policy instruments in order to design effective policy strategies. This paper reviews the literature on model comparison and presents a new approach for comparative analysis. Its computational implementation enables individual researchers to conduct systematic model comparisons and policy evaluations easily and at low cost. This approach also contributes to improving reproducibility of computational research in macroeconomic modeling. Several applications serve to illustrate the usefulness of model comparison and the new tools in the area of monetary and fiscal policy. They include an analysis of the impact of parameter shifts on the effects of fiscal policy, a comparison of monetary policy transmission across model generations and a cross-country comparison of the impact of changes in central bank rates in the United States and the euro area. Furthermore, the paper includes a large-scale comparison of the dynamics and policy implications of different macro-financial models. The models considered account for financial accelerator effects in investment financing, credit and house price booms and a role for bank capital. A final exercise illustrates how these models can be used to assess the benefits of leaning against credit growth in monetary policy.