Monetary policy plays a key role in macroeconomics. For most of recent decades, the focus of monetary policy has been the central bank’s target for short-term interest rates. Lower interest rates can encourage borrowing and spending, which stimulates an economy with under-utilized resources as discussed on our Keynesian Basics pages. Higher interest rates choke off spending, a policy typically used to fight fears of accelerating inflation, although at the risk of raising unemployment.
In the years following the Great Recession, attempts by the U.S. Federal Reserve and most other central banks in mature economies around the world to stimulate demand led them to push short-term interest rates almost to zero. Interest rates cannot fall below zero by more than a negligible amount as long as people and institutions have the option to hold their liquid assets as currency with a constant nominal value. (Why hold assets that decline in nominal value when there is a perfectly liquid alternative that has constant nominal purchasing power?) As this “zero bound” constraint for interest rates has become binding, monetary policy has turned to less conventional means in an attempt to stimulate the economy. In particular, central banks have created money to purchase a variety of assets that they did not typically purchase prior to hitting the zero bound. These include mortgage-backed securities and long-term bonds. The hope is that this so-called “quantitative easing” would raise the prices of various assets, reduce the cost of long-term borrowing, and stimulate further spending.
There are many fascinating debates about what monetary policy can and cannot accomplish in the modern economy. These pages will address the relevant issues in more detail in months to come.