Lesson 30

Monetary Policy Continued..

Nonconventional monetary
policy tools: liquidity
provision
Lecture No. 130
Need for nonconventional tools
In normal times conventional tools can be used to revive
economy
Like, OMO, discount loans, change in reserve requirement,
interest on reserves

In financial crises, such tools are ineffective

Non-interest-rate (nonconventional) tools are required

Reasons of ineffectiveness

Financial system is unable to allocate funds to productive use.

Investment decreases and economy cannot come out of recession

Money market interest rate hits zero lower bound

Negative money market rate cannot function as no bank is willing to

lend; better to hold cash
1. Liquidity Provision

Discount window expansion: lowering gap between target policy

rate and upper bound of money market rate (discount rate); Fed
did this by lowering the gap from 100 basis points to 50 basis
points and then 25 basis points

Limited use in crisis due to indication that the borrowing bank is in

trouble
1. Liquidity Provision

Auctioned loan: banks were lent through competitive

rates rather than penalty rates set by central bank.

The rate was lower than discount rate

Heavily used by banks

1. Liquidity Provision

New lending programs:

Traditionally lending to banks only

Lending to investment banks and to promote purchase of

securities
 Nonconventional monetary
policy tools: large scale asset
purchases
Lecture No. 131
2. Large scale asset purchases

Traditionally, OMOs involve sale and purchase of government

securities, and mostly short term

In crisis, purchase of mortgage backed securities to increase their

prices and lower interest rate on residential mortgages

Purchase of long term government securities to lower long term

rate that didn’t hit zero lower bound as did short term interest rate
Quantitative Easing

Large scale asset purchases result in expansion of balance

sheet of central banks

Expansion in balance sheet is referred to as Quantitative

Easing

Seems to stimulate economic activity as large increase in

monetary base result in expansion of money supply
Quantitative Easing may be ineffective
Large changes in monetary base didn’t result in expansion of
money supply as it was held as excess reserves, which
lowered money multiplier
Short term interest rates were already close to zero. So such
expansions in balance sheet didn’t lower interest rate
further. So economic activity didn’t pick up.
Increase in monetary base led by QE does not necessarily
increase lending. Excess reserves can be held. [QE failed in
Japan]
Credit Easing, not Quantitative Easing

QE; expansion of central bank’s balance sheet

CE; altering the composition of balance sheet

Benefits of CE:

Increases liquidity of a particular troubled segment/market of

the overall credit market, which makes it functioning
Credit Easing, not Quantitative Easing

Purchase of particular securities raises prices

and lowers interest rate on those securities; like
mortgage backed securities for housing
mortgages and long term government securities
for long term interest rate. Stimulates spending
in particular sectors and long term investment
Nonconventional monetary
policy tools: forward
guidance
Lecture No. 132
Limitation on interest rate channel

Also known as management of expectations

One way to lower long term interest rate is to cut

short term interest rate; but not possible due to
zero lower bound
An alternative: Forward Guidance
Alternative: communication of commitment by central bank to keep
short term interest rate near zero for long time period

Will affect future expectations about short term interest rate

Expectations theory of term structure: long term interest rate equals

average of expected future short term interest rates
Fall in expected future short term interest rates lowers current long
term interest rate
Conditional and unconditional commitment

Conditional commitment: lower interest rate will remain till state of

the economy remains weak.

Or high interest rate will remain till high inflation does not come down

Unconditional commitment: lower or higher interest rate will prevail

without mentioning the situation this stance is dependent on.
Relative strength of conditional vs.
unconditional commitment
Unconditional commitment is more effective as
conditional commitment creates doubts on stance
of policy

Conditional commitment is aligned with, while

unconditional commitment contradicts credibility
of central banks’ statements
Relative strength of conditional vs.
unconditional commitment
Unconditional commitment is better strategy for short term
gain in changing expectations
Conditional commitment is better for long term goal of
credibility
Rational expectations hypothesis denies the relative
effectiveness of unconditional commitment

As people know policymaker’s intentions

 Nonconventional monetary
policy tools: negative interest
rate on reserves
Lecture No. 133
Negative interest rates on reserves
Another nonconventional measure taken by some central banks in an
environment of low inflation and economic activity
Negative interest rate on deposits of commercial banks with central
bank

To motivate banks to lend, rather than holding reserves

To increase spending by consumers and businesses

Policy adopted by central banks

The central bank of Sweden in July 2009

the central bank of Denmark in July 2012

the ECB in June 2014

the central bank of Switzerland in December 2014

the Bank of Japan in January 2016.

The policy may not work….

Banks may prefer to convert their reserves into cash instead

of lending; bear cost but may be preferred in a situation
May have contractionary effects: banks earn negative
interest but have to pay positive return to their depositors –
may cut lending due to lower profitability

Evidence is limited on the effectiveness of this tool