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Low-inflation-targeting monetary policy and differential unemployment rate: Is monetary policy to be blamed for the financial crisis? — Evidence from major OECD countries


  • Jean Louis, Rosmy
  • Balli, Faruk


Since the mid-1990s, monetary policy discussion has been centered around whether targeting inflation rate too low was responsible for the differential unemployment rate observed between major OECD countries and the US. In late 2000s with the financial crisis, critiques have argued that these economies had fallen into liquidity trap sooner because of the policy mistake of adhering to the 2% inflation target when the policy rate was already too close to zero. As the argument goes, since there was not enough room left to maneuver, central bankers were powerless in their attempt to revive the economy when aggregate demand collapsed. Using SVAR methodology, this paper formally investigates whether unanticipated deviation of OECD short-term rates from the fund rate can indeed explain differential unemployment rate with the US. It also discusses whether low-inflation targeting monetary policy is to be blamed for the financial crisis. The results show that interest rate differential shocks have no effects on unemployment in the very short-run. However, in the long-run, the cost for deviating drastically from US monetary policy is indeed higher and persistent unemployment at home, on average 30, 102, and 186 basis-points after 10, 15, and 20 quarters, respectively for the period 1989q1–2009q4. This cost is on average higher for inflation- than non-inflation targeting countries. These findings suggest that the fear of unemployment was partly the reason central bankers kept interest rate low since commodity prices were falling as a result of globalization while the economies were returning to normal partly due to positive supply shocks. Since Canada had its interest rate well aligned with the fund rate prior to the crisis while the inflation target was 2%, but did not suffer as much because sound mortgage rules and financial regulation were in place, the view that higher inflation target might have produced a different outcome does not seem to rest on firm grounds. Therefore, this paper lends support to the view that lax mortgage rules and financial deregulations in the US were the main factors responsible for the crisis.

Suggested Citation

  • Jean Louis, Rosmy & Balli, Faruk, 2013. "Low-inflation-targeting monetary policy and differential unemployment rate: Is monetary policy to be blamed for the financial crisis? — Evidence from major OECD countries," Economic Modelling, Elsevier, vol. 30(C), pages 546-564.
  • Handle: RePEc:eee:ecmode:v:30:y:2013:i:c:p:546-564 DOI: 10.1016/j.econmod.2012.09.042

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    References listed on IDEAS

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    Cited by:

    1. José De Gregorio, 2009. "Implementation of Inflation Targets in Emerging Markets," Chapters,in: Monetary Policy Frameworks for Emerging Markets, chapter 3 Edward Elgar Publishing.
    2. Pierre-Richard Agénor & Luiz A. Pereira da Silva, 2013. "Inflation Targeting and Financial Stability: A Perspective from the Developing World," Working Papers Series 324, Central Bank of Brazil, Research Department.
    3. Armand Fouejieu,, 2017. "Inflation targeting and financial stability in emerging markets," Economic Modelling, Elsevier, vol. 60(C), pages 51-70.
    4. Renée A. Fry-McKibbin & Chen Wang, 2014. "Does Inflation Targeting Outperform Alternative Policies during Global Downturns?," CAMA Working Papers 2014-64, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.

    More about this item


    Differential interest rate; Differential unemployment rate; OECD vs.USA; SVAR; Cointegration analysis; Inflation targeting; Monetary policy effectiveness;

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F02 - International Economics - - General - - - International Economic Order and Integration


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