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Scarcity of safe assets, inflation, and the policy trap

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Listed author(s):
  • Andolfatto, David
  • Williamson, Stephen

Abstract

A goal of this paper is to make sense of the seemingly puzzling behavior of interest rates and inflation – and the role of central banks in that behavior – during and after the Great Recession, particularly in the United States. To this end, we construct a model in which government debt plays a key role in exchange, and can bear a liquidity premium. If asset market constraints bind, then there need not be deflation under an indefinite zero interest rate policy (ZIRP). Further, ZIRP may not be optimal under these circumstances. A Taylor-rule central banker could be subject to a ZIRP trap and persistently undershoot target inflation. As well, a liquidity premium on government debt creates additional Taylor rule perils, because of a persistently low real interest rate. We make a case that this is the key policy predicament currently faced by many central banks in the world.

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File URL: http://www.sciencedirect.com/science/article/pii/S0304393215000495
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Article provided by Elsevier in its journal Journal of Monetary Economics.

Volume (Year): 73 (2015)
Issue (Month): C ()
Pages: 70-92

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Handle: RePEc:eee:moneco:v:73:y:2015:i:c:p:70-92
DOI: 10.1016/j.jmoneco.2015.03.008
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505566

Keywords: Safe assets; Collateral; Policy trap; Monetary policy;

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Find related papers by JEL classification:
  • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
  • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit

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  1. Benhabib, Jess & Schmitt-Grohe, Stephanie & Uribe, Martin, 2001. "The Perils of Taylor Rules," Journal of Economic Theory, Elsevier, vol. 96(1-2), pages 40-69, January.
  2. Ricardo Lagos & Randall Wright, 2005. "A Unified Framework for Monetary Theory and Policy Analysis," Journal of Political Economy, University of Chicago Press, vol. 113(3), pages 463-484, June.
  3. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 129-147, February.
  4. Sanches, Daniel & Williamson, Stephen, 2010. "Money and credit with limited commitment and theft," Journal of Economic Theory, Elsevier, vol. 145(4), pages 1525-1549, July.
  5. Bansal, Ravi & Coleman, Wilbur John, II, 1996. "A Monetary Explanation of the Equity Premium, Term Premium, and Risk-Free Rate Puzzles," Journal of Political Economy, University of Chicago Press, vol. 104(6), pages 1135-1171, December.
  6. Woodford, Michael, 1995. "Price-level determinacy without control of a monetary aggregate," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 43(1), pages 1-46, December.
  7. Gorton, Gary B., 2010. "Slapped by the Invisible Hand: The Panic of 2007," OUP Catalogue, Oxford University Press, number 9780199734153, April.
  8. Lawrence J. Christiano & Martin S. Eichenbaum & Mathias Trabandt, 2015. "Understanding the Great Recession," American Economic Journal: Macroeconomics, American Economic Association, vol. 7(1), pages 110-167, January.
  9. Williamson, Stephen D., 2014. "Low Real Interest Rates, Collateral Misrepresentation, and Monetary Policy," Working Papers 2014-26, Federal Reserve Bank of St. Louis, revised 29 Aug 2014.
  10. Lawrence Christiano, 2014. "Understanding the Great Recession," Annual Meeting Plenary 2014-1, Society for Economic Dynamics.
  11. Timothy J. Kehoe & David K. Levine, 1993. "Debt-Constrained Asset Markets," Review of Economic Studies, Oxford University Press, vol. 60(4), pages 865-888.
  12. Huberto Ennis, 2014. "A simple general equilibrium model of large excess reserves," 2014 Meeting Papers 1357, Society for Economic Dynamics.
  13. Gauti B. Eggertsson & Paul Krugman, 2012. "Debt, Deleveraging, and the Liquidity Trap: A Fisher-Minsky-Koo Approach," The Quarterly Journal of Economics, Oxford University Press, vol. 127(3), pages 1469-1513.
  14. Shouyong Shi, 1997. "A Divisible Search Model of Fiat Money," Econometrica, Econometric Society, vol. 65(1), pages 75-102, January.
  15. Lucas, Robert E, Jr & Stokey, Nancy L, 1987. "Money and Interest in a Cash-in-Advance Economy," Econometrica, Econometric Society, vol. 55(3), pages 491-513, May.
  16. Stephen D. Williamson, 2012. "Liquidity, Monetary Policy, and the Financial Crisis: A New Monetarist Approach," American Economic Review, American Economic Association, vol. 102(6), pages 2570-2605, October.
  17. Ivan Werning, 2011. "Managing a Liquidity Trap: Monetary and Fiscal Policy," 2011 Meeting Papers 1435, Society for Economic Dynamics.
  18. Williamson, Stephen D., 2016. "Scarce collateral, the term premium, and quantitative easing," Journal of Economic Theory, Elsevier, vol. 164(C), pages 136-165.
  19. Michael Woodford, 2012. "Methods of policy accommodation at the interest-rate lower bound," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 185-288.
  20. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, vol. 50(2), pages 237-264, April.
  21. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
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Blog mentions

As found by EconAcademics.org, the blog aggregator for Economics research:
  1. The End of Central Banking
    by Stephen Williamson in Stephen Williamson: New Monetarist Economics on 2016-02-14 16:52:00
  2. Attitude Adjustment
    by Stephen Williamson in Stephen Williamson: New Monetarist Economics on 2016-06-21 22:42:00
  3. Low Real Interest Rates and Monetary Policy
    by Stephen Williamson in Stephen Williamson: New Monetarist Economics on 2017-03-29 21:41:00
Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
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Cited by:

  1. Piazza, Roberto, 2016. "Self-fulfilling deflations," Journal of Economic Dynamics and Control, Elsevier, vol. 73(C), pages 18-40.
  2. Duarte, Fernando M., 2016. "How to escape a liquidity trap with interest rate rules," Staff Reports 776, Federal Reserve Bank of New York, revised 01 Dec 2016.
  3. Williamson, Stephen D., 2015. "Interest on Reserves, Interbank Lending, and Monetary Policy," Working Papers 2015-24, Federal Reserve Bank of St. Louis.
  4. Stephen D. Williamson, 2016. "Current Federal Reserve Policy under the Lens of Economic History: A Review Essay," Journal of Economic Literature, American Economic Association, vol. 54(3), pages 922-934, September.
  5. Herrenbrueck, Lucas & Geromichalos, Athanasios, 2017. "A tractable model of indirect asset liquidity," Journal of Economic Theory, Elsevier, vol. 168(C), pages 252-260.
  6. Mathieu Boullot, 2016. "Secular Stagnation, Liquidity Trap and Rational Asset Price Bubbles," Working Papers halshs-01295012, HAL.

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