MONETARY POLICY IN A MULTIPOLAR WORLDJ. E. StiglitzWashington, DCOctober 8, 2013

Motivation Monetary policy by one large country can

have affects on other countries Other countries are likely to respond Key questions:

How to think about the resulting global equilibrium?

How could global coordination improve matters? In the absence of (perfect) coordination, how

can global financial architecture (the rules of the game) improve matters?

Example: QE2 Probably had only minimal effects on US

Effects on LT government rates small Effects on private sector lending rates even smaller Has not led to much more lending to only sector which is constrained, SME

But many other countries believe it had adverse effects on them, as liquidity stimulated their economies Money is going where it’s not needed, and not going where it’s needed Especially with credit channel in US still clogged

These other countries offset the actions Imposing capital controls Buying dollars to keep their exchange rates from appreciation

Fed “sold” dollars, other CB “bought” dollars Does such a move have much effect on US, other countries, global economy?

Monetary policy in a world of globalization, and several “large” players may be markedly different in the closed economy

Second Motivation To move away from “perfect markets” models

which have dominated monetary policy debate

Towards models in which Credit availability is important Distributive consequences are important The difference between T-bill rates and lending

rates (to businesses) is endogenous and important

The market equilibrium, on its own, is not in general Pareto efficient

Outline Monetary policy in a limiting case—

money issued by two monetary authorities are perfect substitutes

Variable exchange rates “perfect” capital markets credit constraints

Why monetary policy has any effects

Monetary policy in a limiting case Single country with two CB, E and W Economies in two regions imperfectly

correlated Two forms of money, ME and Mw , are

perfect substitutes Utility functions Vi (M, T)Where M = ME + MW total money supplyT is transfer paid by one region to other

Nash equilibrium (no cooperation) T = 0 VE ‘(ME + MW , 0) = 0, VW’(ME + MW , 0) =

0Note effects of policy in East (in recession)

on West (in boom) Spill-overs from trade (exports, imports),

from financial flows, from commodity prices

Pareto Optimum Max VE(M, T) + VW(M,-T)Generating f.o.c.(3A) VE

M + VWM = 0

(3B) VET = VW

T

Nash equilibrium is not, in general, Pareto Optimal

Note: “Independence” of central banks makes it difficult to achieve PO, because of the absence of compensatory fiscal instruments

Additional instruments can reduce externalities

Vi = V(M, T, αi )Where αi is a vector of other variablesNash equilibriumVi

αi = 0A coordinated solution would be

preferable: VE

αi + VWαi = 0

Even if compensatory payments are not allowed, cooperative agreements can be reached, i.e. denoting the Nash equilibrium by {Mi*, αi*} , there exists an alternative policy vector {Mi**, αi**} which is Pareto Superior, where each party shifts more of its policy agenda towards variables that have smaller spillovers

Variable exchange rateAdditional channel through monetary

policy exerts its affects—with strong externalities on other country (countries)

Slight generalization of earlier model:Vi(Mi, Mj, αi, αj, βi, βj)Where βi are variables that affect

spillovers (in or out), like capital control

Note: unlike trade liberalization, there is neither theory or evidence that capital and financial market liberalization is necessarily welfare enhancing to both countries And even if it were, there could be strong

distributive consequences that are not easily offset Hence, there are strong distributive consequences

across countries resulting from these liberalization measures Explaining why many countries have to be “forced” to

open up markets

Nash EquilibriumVi

Mi =

Vi αi = Vi β i= 0

Not Pareto OptimalRestricting externality reducing actions

(like capital controls) makes things worse

Credit availabilityIn the real world, what matters as much or

more than interest rate is the availability of credit.

High r can lead to an influx of capital, increasing credit availability, L(r), L’ > 0

Assume potential output is Y*. Actual output is

Y(L(r))Optimal r solves Y(L(r*)) = Y*

Demand side shock Yd = Yd(L(r), ε )Raising r increases capital inflow,

exacerbates inflationary pressureShould use additional instruments. AssumeV (Yd(L(r, α)) , α, r)Optimal policy entails  VY YL Lr + Vr = 0 VY YL L α + V α = 0

Optimal policy1) Takes account of the effect of r directly

on welfare (e.g. through distributive effects)

2) Can be improved upon by adjusting regulations (reserve requirements, capital adequacy regulations, lending standards)

Generalization: Composition of output also matters Some sectors (1) more associated with instability (real

estate) Some (2) have greater technological spillovers/learning

benefits Some more dependent on capital inflows (real estate),

affected by restrictions on cross border flows (β) Some more affected by restrictions on domestic

legislation Increase in r increases flow of funds to real estate,

reduces flow of funds from domestic banks to other sector Capital inflows limit effectiveness of monetary policy through

traditional channels

Welfare maximizationV(Yd1(βL1 (r, α), r) , Yd2 (L2 (r, α),r) α, β,r)F.O.C. VY1 Yd1

L L1 + Vβ = 0 VY1 Yd1

L β L1α + VY2 Yd2

L L2α + V α = 0

 VY1 [Yd1

L β L1r + Yd1

r ] + VY2 [Yd2L L2

r + Yd2r ]

+ V r = 0.

Implications If an increase in r leads to an expansion of

unproductive sector and contraction of productive sector, we set r lower than we otherwise would (tolerate more inflation)

If we can restrict capital inflows, we should If inflationary pressures related to sum of

outputs, Yd1 + Yd2 = Y*,Any inflation target an be achieved by large

number of policies {α , β, r}. Choose the one which optimizes sectoral composition

Optimal to use multiple instruments Increasing reserve requirements and

lowering interest rates (or raising them less than they otherwise would be) may be preferable to just raising interest rates

But imposing controls (taxes) on the inflow of capital may be still preferable

General point: Pervasiveness of macro-externalities With credit rationing, collateral, incentive

compatibility, self-selection constraints (and/or imperfect risk markets), economy is essentially never constrained Pareto efficient (Greenwald-Stiglitz) Those with access to international capital markets

borrow excessively Public policy should be directed at “correcting”

these market failures No presumption that markets, on their own, are efficient No presumption that market based interventions (“r”)

are the best set of interventions

Some general observations about monetary policy Generalized MM theorem predicts that

monetary policy shouldn’t have much effect Especially with CMA accounts allowing using, in

effect, T bills for transactions purposes But monetary policy has some effects: Why?

Market imperfections (capital constraints) Institutional features Distributive consequences Market “irrationality” (not seeing through public

veil)

Modern monetary theory lives in a half-way house of incompletely articulated assumptions of imprecisely defined market imperfections and distributive effects, leading to speculative observations about possible channels through which monetary policy might yield effects, with ambiguous quantitative significance .

Examples Banks are central—mediate flow of credit to

SME’s Focus should be understanding bank behavior “Liquidity trap”—circumstances in which

monetary policy does not lead to more lending Distinctively different from Keynesian liquidity trap Note that in Great Depression, real interest rate

was greater than 10%, now it is -2%. No evidence that zero lower bound is critical

constraint—would lowering real interest rate to -3% make any real difference?

Temporary interventions With infinitely lived rational individuals,

without capital constraints why should they have any effect?

With life cycle model, elderly with stock will consume more

But elderly depending on interest payments will consume less

Distributive consequences are crucial

Market imperfections help explain ineffectiveness of QE

Domestic lending channel blocked (especially to SME’s) Community and regional banks still weak—

disproportionately responsible for SME lending SME lending collateral based; collateral real

estate; real estate prices still markedly down Refinancing limited

Banking sector concentrated—incentive not to increase lending (take lower government rate as profit)

Large fraction of homeowners who are not underwater have already refinanced

Insolvency vs. Illiquidity A central distinction in Central Bank doctrine But is it totally persuasive?

In a world with perfect information, a firm that was solvent would presumably have access to funds

Of course, every bank will believe the market has “misjudged” its future prospects

But why should a Central Banker believe that his judgments are better than that of market, when no one is willing to supply funds to the bank?

Conclusions In a world of truly free capital mobility, the effects of

monetary policy are different (typically weaker) than in a closed economy

Restrictions on capital flows may enhance the ability of the government to maintain the economy near full employment Macro-benefits more than offset micro-distortions But in more properly formulated model, no presumption

that markets on their own are efficient Cooperation may lead to Pareto improvements

More likely to be true—more likely to be able to obtain cooperation—if there are more instruments

Restrictions on cross-border capital flows and other instruments can reduce cross-border externalities, improve efficiency, and mitigate distributive consequences Strong presumption that markets are not Pareto efficient Strong presumption that optimality requires using a panoply of

instruments Single-minded focus on interest rate has been foolish

Governments/monetary authorities should be concerned about the structure of the economy and the distribution of income If so, they should use a multitude of instruments, not just

interest rates And engage in unorthodox policies

To respond to a potential influx of distorting capital from abroad