Academic journal article Federal Reserve Bank of St. Louis Review

A Model of U.S. Monetary Policy before and after the Great Recession

Academic journal article Federal Reserve Bank of St. Louis Review

A Model of U.S. Monetary Policy before and after the Great Recession

Article excerpt

The Great Recession of 2007-09 and its aftermath ushered in a new era for U.S. monetary policy. Prior to 2008, the Federal Reserve's policy rate stood in excess of 500 basis points. In 2008, the policy rate declined rapidly to 25 basis points, where it has remained ever since. Prior to 2008, the Fed's balance sheet stood at less than $1 trillion dollars--about 7 percent of gross domestic product (GDP). Fed security holdings and liabilities are presently near $4.5 trillion dollars--about 25 percent of GDP. Most of these liabilities exist as excess reserves in the banking system. Prior to 2008, excess reserves were essentially zero. The situation is so unusual that commentators frequently describe the Fed as sailing in uncharted waters.

The U.S. economy has recovered steadily, if somewhat slowly, since the end of the Great Recession. After peaking at over 10 percent in 2009, the civilian unemployment rate at the time this article was written was close to 5.5 percent. Despite the more than fourfold increase in the supply of base money, personal consumption expenditures (PCE) inflation undershot the Fed's 2 percent target throughout much of the recovery. With inflation varying between 50 and 100 basis points below target and the labor market continuing to improve, the Fed has recently announced its willingness--some might say eagerness--to raise its policy rate as economic conditions dictate. Speculation over the date at which liftoff will occur is rampant in the financial pages of newspapers, as is concern over the wisdom of raising rates prematurely or leaving rates too low for too long.

People have many questions concerning the economic developments and issues just described. Why did interest rates plummet so dramatically in 2008? Why did the massive increase in base money appear to have no noticeable effect on the price level or inflation? Does the fact that most of this new money sits as excess reserves in the banking system portend an impending inflationary episode--an event that the Fed might have trouble controlling? Or will inflation continue to drift lower as interest rates remain low, replicating the experience of Japan over the past two decades? What, if anything, can or should the Fed do in present circumstances?

I answer these (and other) questions through the lens of a simple dynamic general equilibrium model that features three assets: money, bonds, and capital. In the model, money is dominated in rate of return but is nevertheless held to satisfy an exogenous demand for liquidity, modeled here as a legal reserve requirement. This reserve requirement binds when the nominal interest rate on bonds exceeds the interest paid on money. Excess reserves are held willingly when the nominal interest rates on bonds and money are the same. When this latter condition holds, the economy is in a liquidity trap. Open market purchases of bonds have no real or nominal effects, apart from increasing reserves in excess of the statutory minimum.

I demonstrate how the model can be used to interpret the effect of open market operations in normal times--defined as episodes in which money is dominated in rate of return and excess reserves are zero. An open market purchase of securities in this case has the effect of expanding the supply of liquidity in the economy, making it easier for banks and other entities to fulfill their reserve requirements. The policy rate (the interest rate on bonds) declines and the price level rises. As desired capital spending expands, banks increase their loan activity. There is no effect on long-run inflation when the inflation rate is anchored by fiscal policy.

I then consider a negative aggregate demand shock--technically, a news shock (Beaudry and Portier, 2014)--that leads agents to revise downward their forecasts over the future productivity of (or after-tax return on) contemporaneous capital spending. Ceteris paribus, the effect of such a shock is to induce a portfolio substitution away from capital and into government securities (money and bonds), placing downward pressure on bond yields and the price level. …

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