A quick note on monetary policy

In yesterday’s post on why I am seriously starting to worry about the US economy and our plans for fixing it I said that monetary policy had with some exceptions run out of power. I want to elaborate a little bit on what I meant by this after stumbling upon two succinct paragraphs that give an overview of the problem in this post by Edward Hugh. First,  the problem:

Keynes argued that monetary policy ran the risk of becoming impotent in stimulating demand and raising spending since interest rates were already at their lowest possible level. Essentially he argued that increasing the monetary base by buying short-term government bonds is irrelevant at zero interest rates since money and short-term government bonds become effectively perfect substitutes.

As I said in my last post, however, there are still some things that can be done and while the Fed cannot lower short term interest rates any further it can still influence long term interest rates:

This (monetary policy impotence) argument has been challenged to some extent of late, most notably by Ben Bernanke, who argues that while the central bank may lose policy leverage over short term interest rates, by buying longer term instruments (10 or 30 year bonds) the bank may influence rates further up the yield curve.

This basically means that while short term interest rates have effectively reached zero the Federal Reserve can buy longer term bonds and thereby lower the interest rates on those, and incentivizing banks to shift their money to loan on which they can earn higher yields. This is extremely similar to what is generally known as Quantitive Easing (and unneccessarily complicated sounding term for a relatively simple concept).

Unfortunately even this won’t help too much in the situation that we are currently faced with since it does not address the underlying problem but it is something that other central banks such as the ECB should keep in mind. Some other possible actions a central bank could take are explained in this paper by Gauti Eggertson of the IMF that I have just started reading.