Effects of Quasi-Random Monetary Experiments

Abstract

The trilemma of international finance explains why interest rates in countries that fix their exchange rates and allow unfettered cross-border capital flows are largely outside the monetary authority’s control. Using historical panel-data since 1870 and using the trilemma mechanism to construct an external instrument for exogenous monetary policy fluctuations, we show that monetary interventions have very different causal impacts, and hence implied inflation-output trade-offs, according to whether: (1) the economy is operating above or below potential; (2) inflation is low, thereby bringing nominal rates closer to the zero lower bound; and (3) there is a credit boom in mortgage markets. We use several adjustments to account for potential spillover effects including a novel control function approach. The results have important implications for monetary policy.

The costs of macroprudential policy

“…Table 9 displays estimates of the response of real output to a 100 basis point increase in policy rates found in several studies. In particular, we present estimates based on a narrative identification approach (Romer and Romer (2004)), estimates based on high-frequency identification (Gertler and Karadi (2015)) and estimates that are obtained by exploiting the open-economy trilemma for identification (Jordà et al (2017)). Furthermore, we report the state-dependent effects analysed in Tenreyro and Thwaites (2016).…”

“…The effect is more pronounced in emerging market economies (EMEs), while the path of output is almost unaffected by LTV limit changes in the set of advanced economies (AEs). In a back-of-the-envelope calculation, we compare the magnitude of this effect to estimates of GDP responses to monetary policy in Jordà et al (2017), which are also based on a broad sample of countries. We find that the two-year response of GDP to a 10 percentage point reduction in the maximum LTV ratio can be compared to that of a 26 basis points increase in interest rates.…”

The Long-Run Effects of Monetary Policy

“…Detailed descriptions of the sources of the variables contained therein, their properties, and other ancillary information are discussed in Jordà, Schularick, and Taylor (2017) and Jordà, Schularick, and Taylor (2019), as well as references therein. Importantly, we will rely on the trilemma instrument discussed in Jordà, Schularick, and Taylor (2016), and more recently, Jordà, Schularick, and Taylor (2019) as the source of exogenous variation in interest rates. We refer the reader to the last reference for a detailed analysis and proceed from hereon without further discussion on the instrument construction.…”

“…where y i,t+h is the outcome variable for country i observed h periods from today; α i are country fixed effects, ∆r i,t refers to the change in the short-term government bond (3-months in duration), our stand-in for the policy rate which we will instrument with z i,t , the trilemma instrument borrowed from Jordà, Schularick, and Taylor (2019)…”

“…In monetary economics, most theories embrace the assumption that an exogenous shock to interest rates has only transitory effects on prices and economic activity (see, e.g., Christiano, Eichenbaum, and Evans, 1999;Ramey, 2016;Coibion, Gorodnichenko, and Ulate, 2017). However, recent research by Jordà, Schularick, and Taylor (2019) suggests that previous measures of monetary shocks might have been endogenous responses to the outlook. They introduce a new instrumental variable based on the trilemma of international finance (see, e.g., Taylor, 2004, 2005;Shambaugh, 2004) to document that monetary shocks have larger and more persistent effects than previously measured, and closer in magnitude to measures obtained with narrative shocks (Romer and Romer, 2004) and market-based, high-frequency identified shocks (Gertler and Karadi, 2015).…”