Thursday, October 1, 2009

Capital markets policy

Standard theories on macroeconomic policy making have focussed on monetary policy, with its objective of controlling short-term interest rates, and fiscal policy, with its risk of impact on long-term rates. However, the present crisis, in which Central Banks and governments have resorted to widespread use of unconventional monetary policy responses (or quantitative easing) - liquidity injections and bank recapitalizations, loan guarantees, nationalizations, bank rescues, asset purchases, lowering of collateral standards etc - highlights the need to revisit academic research on macroeconomic policymaking.

For a start, Brad DeLong makes the distinction by lumping such unconventional responses under the rubric of "capital markets" policy. Broadly, all these actions are aimed at sending signals that alter the expected rate of future inflation and keep interest rates anchored between the short-term rates of monetary policy and the longer term rate expectations unleashed by fiscal policy. Prof DeLong makes the differentiates between monetary and capital markets policy,

"Normal monetary policy works by shifting the private sector's asset holdings toward assets that people spend more readily and rapidly, thus boosting spending. Quantitative easing at the zero bound does not do that: it simply exchanges one zero-yield government asset for another. What it does do is to change bond prices, rather by raising the safe short-term nominal interest rate and thus giving people an incentive to spend the money they already have more quickly."

And managing the exit from such expansionary policies would help anchor longer term expectations and keep the bond markets from tightening too much from a fear of inflation and large dficits.

Also, Paul Krugman's recent posts about the "crowding in" effect and lower real cost of the deficits of expansionary policies is relevant. The real costs of deficits in a recession or a zero-bound liquidity trap, are smaller than the nominal deficit incurred for two reasons.

First, as the spending finds its way into the economy, it has the effect of boosting aggregate demand and repaying itself partially through taxes and other government revenues (and lowering of expenditures on say, welfare measures, that government would otherwise have had to incur). It is for this reason that economists advocate that any such expansionary spending is done to get money in the hands of people who are likely to spend (andnot save or merely repay debts) it immediately. Krugman feels that the revenues cause something like a 40 percent offset, leaving the actual csots of fiscal stimulus to be only 60 percent of what it nominal cost.

Second, the expansionary policies boost aggregate demand and economic growth by hastening the return to normalcy and therefore lowers the real cost of both the debt and its servicing burden.

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