Sunday, 11 January 2015

The Problem with Monetary Policy

The prevalent view regarding demand management is that is best achieved through monetary  policy - typically interest rate manipulation - rather than fiscal policy (at least when rates are not at the zero lower bound).  There are a number of aspects to this question, but one of the main objections would have to be the conflict between short term and long term effects.  Monetary policy often works in the short term by raising debt levels and inflating asset prices, but this can store up problems for the future.

Those who have worked with SFC models may be familiar with these dynamics, but they tend to figure less in mainstream constructs.  What I have attempted to do here, therefore, is look at this issue in the context of a simple model with optimising agents and rational expectations.  In addition to illustrating the problems with an over-reliance on monetary policy, it also brings out certain dynamics which seem relevant to recent economic trends.

I have based this on a simple model I have used previously to look at the question of why money has value, which I have extended to include a government sector.  A technical specification of the model is given at the end of this post.

The economy consists of overlapping generations that live for two periods, providing a fixed amount of labour in the first and not working in the second.  Households own land and consume a single consumption good, which is produced by labour alone with constant returns to scale.  Asset transactions take place at the end of the period.  The new generation is born just prior to the end of the period preceding the one in which they work, enabling them to buy land from the households that are due to die.

Newborns acquire land by taking out loans.  These loans are repaid with interest at the end of the first period.  At this point households may also buy or sell amounts of land.  The balance of funds is held on deposit.  Retireds finance their consumption by selling their land (at the end of the period) and using their deposits.

There is a government that spends in acquiring the consumption good and that levies taxes on workers.  The fiscal rule sets the level of spending and the rate of tax, which is applied to labour income only.  The balance is financed by issuing bonds.  Government issued bonds are acquired by banks, which also make the loans to newborns, in each case by issuing deposits.  The same interest rate is applied to loans, bonds and deposits.  This rate is set by the monetary authority.

The balance sheet for this economy is shown below.  Balances are shown as at the start of each period.  Loans, deposits and bonds are shown in nominal terms.  Land is shown as a quantity multiplied by a price.

Aw. Pa
Ar. Pa







The flow of funds in a single period is then shown in the table below.  Repayment of all financial assets is shown gross of interest.  R is equal to the nominal interest rate plus one.

Consumer spending

-Cw . P
-Cr . P

Government spending

-G . P

( G + Cr + Cw ) . P



Land purchases
-Aw . Pa
(Awt-1 - Ar) . Pa
Art-1 . Pa


- L

Loan repayment

- Lt-1 . Rt-1

Lt-1 . Rt-1

Bond issuance

- B
Bond redemption

Bt-1 . Rt-1
- Bt-1 . Rt-1

- D


Deposit repayment

Dt-1 . Rt-1
- Dt-1 . Rt-1


Households choose how much to consume in each period and how much land to hold in each period, subject to their budget constraints. 

Starting form a steady state, the particular experiment here involves a temporary (single period) reduction in government expenditure.  It is assumed that this reduction is unexpected, but that the subsequent reversion to the normal level is expected.

Under perfect price flexibility, with the nominal interest rate held constant, the level of output can be maintained by a one-off drop in the price level.  This raises the real value of deposits holdings causing retireds to increase their spending.  The fall in the price level also increases the real debt burden of workers, who respond by reducing their spending but the effect is less.  There is some knock-on effect due to redistribution between generations, but the economy settles fairly quickly back to the same (real) steady state values.  This is illustrated in the charts below.


What we wish to consider is whether the monetary authority can use the nominal interest rate to avoid this deflation.  This is equivalent to asking whether they can maintain the level of output even when the price of goods is fixed (but the price of land is allowed to vary). 

The charts below illustrate the outcome where the monetary authority adjusts the interest rate for ten periods but then holds it stable (the chart for government spending is as above).  Compensating for the reduced government spending requires cutting the interest rate in the first period.  This boosts private spending through a wealth effect.  Lower interest rates increase the price of land, increasing the spending power of those holding it.

However, even when government spending returns to its baseline value, the interest rate needs to stay low.  In boosting private spending, the reduced interest rate has led to greater private debt and reduced financial savings.  This reduces the spending capacity of both workers and retireds.  In fact, in order to counter this and keep private spending at the original level, the interest rate has to be reduced again.

As soon as the interest rate is held stable, private spending drops and output settles at a permanently lower level (but land prices and debt levels stay at a higher level).  To keep private spending at the level needed to ensure no output gap, the monetary authority would need to keep cutting the interest rate and inflating land values indefinitely.  It is easy to see why this must be.  In a steady state, the values of all balances must be constant.  For the level of bonds to be constant, the government's budget must be balanced, i.e. we need the following equation to hold.

                                                          G . P - T + ( R - 1 ) B = 0

With a given level of output, T is fixed.  A fall in G therefore requires a higher level of ( R - 1 ) B.  Cutting the interest rate reduces R.  But it also reduces B, because B is equal to the net financial position of the private sector.  As R falls, households borrow more and also run down deposits, so B falls.  In order to achieve a steady state, R needs to rise, not fall.  But as soon as the monetary authority increases R, the immediate impact is a fall in output

There is therefore no way (within this model) that the interest rate can be used to achieve price stability in both goods and land and a zero output gap, unless fiscal policy adjusts accordingly.

Technical Specification

The number of household in each generation is constant.  Each household in the ith generation chooses ci,1, ci,2, ai,1 and ai,2 to maximise expected utility, where c is consumption and a is holding of land and the second subscripts indicate whether the value is for the first or second period of life.  Labour is assumed to be supplied in a fixed quantity in the first period of life only.  Utility is given by:

 (1)          Ui = ( ln ci,1 + φ ln ai,1 ) + β-1 ( ln ci,2 + φ ln ai,2 )

The budget constraints can be derived from the flow of funds matrix.

(2)          q0 ai,1    li

(3)          ci,1 + q1 ( ai,2 - ai,1 ) + di    wi - ti - R1 li p0 / p1

(4)          ci,2    q2 ai,2 + R2 di p1 / p2

where w, t, l and d are wages, taxes, loans and deposits respectively, all expressed in terms of the consumer good.  R is one plus the nominal interest rate, p is the price of the consumer good and q is the price of land expressed in terms of the consumer good.  The subscript for R indicates the period in which the interest is paid.

Production is by labour only and at constant returns to scale, so competition ensures that the total wages of each generation are equal to total spending.

(5)          wi  =  ci,1 + ci-1,2 + gi

where gi is government spending in the period in which the ith generation is working, expressed in terms of the consumer good.  Taxes are a proportion (τi) of wages.

(6)          ti  =  τi wi

The total amount of available land is fixed.

(7)          ai,1 + ai-1,2  =  a*

Parameters for the simulations were: β = 1.50, φ = 0.10.  Baseline values were: g = 100, τ = 0.25, R = 1.30, a* = 125.  The shock was a one-period reduction in g to 95.  

Initial simulations were constructed over a long period using steady state solutions as proxy for expected future values.  Expected values were then adjusted and the process repeated until the expectation error was negligible.

[EDIT: After originally posting this, I noticed an error in the model used to generate the graphs. I have corrected this and replaced the graphs.  The narrative remains the same.]


  1. To recap for dummies like myself:

    According to your model, if a temporary reduction in government spending is countered by monetary policy (reducing interest rates), the spending gap is offset through an expansion of private balance sheets. This increased leverage then becomes a drag on output when interest rates are raised again.

    Now, the usual argument against fiscal policy is based on ricardian equivalence, if I'm not mistaken. Output does not increase because consumers expect taxes to rise in the next period and thus they save more this period.

    The interest rate case seems analogous in that private entities, fearing furure interest rate rises, would refrain from borrowing more, thus nullyfying monetary policy.

    Considering people and businesses are probably more careful when calculating their own financial risk, vs. that of their country, it would seem that this effect should, if anything, be stronger than the ricardian effect.

    Has any such effect been postulated? Or am I missing something obvious?

    1. I'd agree with your recap.

      Ricardian equivalence does not hold in this model because of the overlapping generation assumption. Households only care about utility over their life. The only people who care about future taxes are the future taxes and their decisions have no impact on current spending.

      I think there is something in what you say about the balance between current rates and expected future rates, but I don't think that is really captured in this model. Also, there is no uncertainty here - this is a model where agents have perfect foresight. That's not to say, of course, that I think uncertainty doesn't matter - it's just that I wanted to show how it is not necessary for the conclusion that interest rate management alone can be problematic.

  2. I think your model nicely shows the phenomenon Michal Kalecki talked about in his 1943 essay:

    "It may be shown, however, that the stimulation of private investment does not provide an adequate method for preventing mass unemployment. There are two alternatives to be considered here. (i) The rate of interest or income tax (or both) is reduced sharply in the slump and increased in the boom. In this case, both the period and the amplitude of the business cycle will be reduced, but employment not only in the slump but even in the boom may be far from full, i.e. the average unemployment may be considerable, although its fluctuations will be less marked. (ii) The rate of interest or income tax is reduced in a slump but not increased in the subsequent boom. In this case the boom will last longer, but it must end in a new slump: one reduction in the rate of interest or income tax does not, of course, eliminate the forces which cause cyclical fluctuations in a capitalist economy. In the new slump it will be necessary to reduce the rate of interest or income tax again and so on. Thus in the not too remote future, the rate of interest would have to be negative and income tax would have to be replaced by an income subsidy. The same would arise if it were attempted to maintain full employment by stimulating private investment: the rate of interest and income tax would have to be reduced continuously."

    Steve Waldman also wrote about that Michal Kalecki essay:

    My impression was that reducing interest rates boosted credit expansion and so was inflationary but it is very much the rate of change of the interest rate that does that NOT the low absolute level of the interest rate. Expanded debt is deflationary even though expanding debt is inflationary. So monetary policy is painting itself into a corner. I guess you're just nicely showing that in a model.

    1. Thanks. I wasn't aware of that.

      Generally, the point I'm making here shouldn't be a suprise to many people - certainly those of a post-Keynesian orientation. I just wanted to see if I could demonstrate it within a micro-founded framework. Although I have used specific assumptions (particularly the overlapping generations structure) I would expect the result to appear in most models of sufficient richness.

    2. I just saw something by the Bank of England where they are I think effectively going along with the idea that increased indebtedness is deflationary,

      "The potential for household indebtedness to lead to large
      adverse impacts on aggregate demand was an important
      reason why the Financial Policy Committee took policy
      action at its June 2014 meeting to insure against the risks
      from a further significant increase in the number of highly
      indebted households."

      It makes it all the more contrary that the only remedy from monetary policy is to try and get the banks lending again.

      Sorry if all of this is old hat.

    3. Yes, I saw that when it came out and it's very interesting. One thing it illustrates is the importance of recognising heterogeneity when it comes to looking at household spending. Households in the marginal position can have a big impact in variations in the aggregate.

    4. The OBR are relying {up to 2020} upon a large? increase in household gross debt relative to income to increase aggregate demand? P76: