The main idea behind monetary policy–either discretionary or rules based–depends on interest rates being able to impact output. As the Economist recently noted, it appears that interest rates have not affected investment–and therefore output. The author of the paper cited in the article is quoted as saying
Companies tend to dwell too much on recent experience when deciding how much to invest and too little on how changing circumstances may affect future returns. This is particularly true in difficult times. Appealing opportunities may exist, and they may be all the more attractive because of low interest rates. That should matter—but the data suggest it does not.
This implies that there is a behavioral foundation at the heart of investment that varies from rational expectations theory. Now, if the theories that predict investment should rise made correct predictions, then it might not matter what the model looks like. However, when the models are not making good predictions, you may want to consider looking at your assumptions.
Since we have been at (or close) to the zero-lower bound across the world in the last several years, inflation has not accelerated as most central banks might have hoped. Should another shock occur, could central banks do much to offset this shock? Or would we be forced to rely on fiscal policy to give economies the boost they need. Not to mention that economists have been wrong time and again when looking at interest rates, and doomsday predictions of inflation have also been far off the mark.
There are other problems that have surfaced in Switzerland and the Euro zone which led the Swiss National Bank to fix their exchange rate to the Euro at a rate of 1.20 in order to protect their economy. they have been maintaining this peg for some time. However, there is a movement for the SNB to hold 1/5 of their assets in gold, which might limit their ability to maintain their peg. In the U.S., there is another movement to fight the Fed’s power and the narrative that they have done a good job since their founding. The desire to return to the gold standard has risen in recent years, but as mentioned in the Economist, the gold standard has its own serious flaws.
Questions you might consider
- What might alternative behavioral foundations suggest about monetary policy? The rules and heuristics that firms and central bankers use might be flawed, and therefore in order to have effective monetary policy you would need to understand these behavioral foundations. Look for more research or writing on the behavioral interpretation of interest rates and economic activity.
- Do you believe there is a danger of the world facing a large negative shock (like the breakup of the Euro) which could lead to global deflation and depression? If so, what could central banks do in the event of one of these shocks? What would happen in a global financial crisis if we were on the gold standard? You could look at the case of Switzerland and the arguments made about why the central bank might not want to have its assets held as gold.
- What are other explanations of why monetary policy might not have been having the intended effects of raising output? Could there be an effect of having central banks deny that they want higher inflation when they actually probably want higher inflation rates than they currently have? Is there a deflationary bias among central bankers? Could this be part of the problem faced by central banks?