Monetary Policy in a Multipolar World

1. Monetary Policy in a Multipolar World J. E. Stiglitz Washington, DC October 8, 2013

2. 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?

3. 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

4. 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

5. 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

6. 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 supply T is transfer paid by one region to other

7. Nash equilibrium (no cooperation) • T = 0 • VE ‘(ME + MW , 0) = 0, VW’(ME + MW , 0) = 0 Note effects of policy in East (in recession) on West (in boom) • Spill-overs from trade (exports, imports), from financial flows, from commodity prices

8. Pareto Optimum • Max VE(M, T) + VW(M,-T) Generating f.o.c. (3A) VEM+ VWM = 0 (3B) VET = VWT 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

9. Additional instruments can reduce externalities Vi = V(M, T, αi ) Where αiis a vector of other variables Nash equilibrium Viαi= 0 Acoordinated solution would be preferable: VEαi + VWαi = 0

10. 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

11. Variable exchange rate Additional 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

12. 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

13. Nash Equilibrium ViMi = ­Viαi = Viβi= 0 Not Pareto Optimal Restricting externality reducing actions (like capital controls) makes things worse

14. Credit availability In 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*

15. Demand side shock • Yd = Yd(L(r), ε ) Raising r increases capital inflow, exacerbates inflationary pressure Should use additional instruments. Assume V (Yd(L(r, α)) , α, r) Optimal policy entails VY YLLr + Vr = 0 VYYL L α + V α = 0

16. Optimal policy • Takes account of the effect of r directly on welfare (e.g. through distributive effects) • Can be improved upon by adjusting regulations (reserve requirements, capital adequacy regulations, lending standards)

17. 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

18. Welfare maximization V(Yd1(βL1 (r, α), r) , Yd2 (L2 (r, α),r) α, β,r) F.O.C. VY1 Yd1L L1 + Vβ = 0 VY1 Yd1L β L1α + VY2 Yd2L L2α + V α = 0 VY1 [Yd1L β L1r + Yd1r ] + VY2 [Yd2L L2r + Yd2r]+ V r = 0.

19. 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

20. 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

21. 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

22. 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)

23. 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 .

24. 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?

25. 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

26. 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

27. 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?

28. 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

29. 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