Economic Cycles and Monetary Policy
Speech by Lucas Papademos, Vice President of the ECB
Speech delivered at the International Symposium of the Banque de France on “Monetary Policy, the Economic Cycle and Financial Dynamics”
Paris, 7 March 2003
“Economic Cycles and Monetary Policy” has been a subject at the centre of theoretical and policy debates among economists for a very long time. This reflects the complexity of the issues raised by the existence of economic cycles for the conduct of monetary policy. No simple policy formulae have been found which have proved valid over time. One reason is our imperfect knowledge of the factors and processes determining the amplitude and duration of economic cycles. Another reason is the uncertainty surrounding the magnitude of, and the time lags in, the effects of monetary policy on economic activity. Complexity and uncertainty, however, do not imply a lack of understanding. Economic theory and empirical evidence lend support to a number of propositions regarding the links between economic cycles and monetary policy. These propositions and the experience of policy-makers offer some general lessons on the role and effectiveness of monetary policy in dealing with economic cycles. My aim is to provide an assessment of the validity of these propositions and policy lessons.
Only a few years ago, the topic we are discussing seemed largely irrelevant or obsolete. Over the past twenty years, aggregate output volatility has declined steadily and recessions have become shorter and milder in industrialised countries, except Japan. Indeed, following the continuous expansion of economic activity in the previous decade, notably in the United States (US), many predicted in the late 1990s the demise of the economic cycle as a consequence of continuous advances in information technology, which foster higher productivity growth, as well as of the stabilising effects of globalisation, financial liberalisation and the ability of macroeconomic policy to minimise output fluctuations. Moreover, over the past twenty years it has progressively become accepted that the overriding objective of monetary policy is to secure price stability, through which it can foster higher, sustainable growth and help to reduce output volatility. Unfortunately, the predictions concerning the demise of the economic cycle have proved to be premature. The US recession in 2001, the significant slowdown in the euro area, the prolonged deflation in Japan, and the very sluggish and uncertain global recovery in 2003 have provided unwelcome evidence that the cycle is still alive. In addition, some of the factors which have contributed to or explain recent economic developments, for instance the collapse of equity prices and the excessive growth of debt, have raised doubts about the ability of monetary policy to minimise output volatility by maintaining price stability. As a result, there is renewed interest in issues such as the changing nature of economic cycles as well as the role and effectiveness of monetary policy in stabilising output fluctuations, particularly in an environment of low inflation.
In my presentation I will address several relevant issues as follows. In Section 2, I will review the main theoretical arguments and the supporting empirical evidence concerning the links between monetary policy and the economic cycle. In this context, the alternative views that have been expressed about the necessity, feasibility and desirability of a counter-cyclical monetary policy will be highlighted. In Section 3, the changes observed in the nature and magnitude of economic cycles in recent years will be examined with a focus on the role of financial markets and monetary factors in generating cycles. Then, in Section 4, the available empirical evidence regarding the monetary policy transmission mechanism will be summarised, drawing in particular on recent research by ECB and Eurosystem economists. Finally, on the basis of the preceding analysis and empirical results, I will consider a number of propositions concerning, first, the role of monetary policy in influencing the economic cycle and, second, the appropriate strategy for the conduct of a stability-oriented monetary policy.
Economic cycles and the role of monetary policy: the alternative views
Economic cycles are a consequence of the influence of various factors and processes. They can be triggered and driven by different types of shocks affecting demand and supply in product and financial markets. Such shocks include changes in policies, whether macroeconomic or structural. Moreover, economic cycles – their magnitude and duration – reflect the dynamics of the economic system, as determined by technological processes, agents’ behaviour and expectations, and institutional features of the economy. Policies influence the cycle not only by directly affecting aggregate demand and supply but also by shaping expectations and institutions.
The role of monetary policy in influencing the economic cycle can be discussed in terms of five questions about whether and how policy can perform a stabilising function. The first question is whether it is necessary for monetary policy to play a stabilising role or whether it can be expected that output deviations from its long-term growth trend will be short-lived as a result of the smooth operation of market mechanisms, especially in an environment of price stability. The second question is whether, or under which conditions, monetary policy can influence aggregate real output in a systematic and effective way in both the short term and the long term. The third is whether monetary policy can stabilise cyclical fluctuations without jeopardising its ability to achieve its primary goal of maintaining price stability. Fourth, given the uncertainty associated with the size and timing of various disturbances and given our imperfect knowledge of the structure and dynamics of the economy, can monetary policy successfully mitigate cyclical fluctuations or could it end up accentuating them as a consequence of inaccurate information and overambitious or mistaken actions? Finally, and provided that the answers to the previous questions lead to the conclusion that monetary policy can indeed play a stabilising role, a number of important practical issues must be addressed as regards how monetary policy can best contribute to reducing cyclical fluctuations: should it be conducted in a discretionary way or on the basis of a well-defined and publicly announced strategy and policy rules?
I will now focus on the first four questions, which relate to the necessity, feasibility and desirability of a counter-cyclical monetary policy. The answers to these questions on the output-stabilising role of monetary policy depend on our views about certain key features of the structure and functioning of the economy, particularly of the labour and financial markets. Views still seem to differ, as evidenced by recent theoretical and empirical work. For this reason, it is useful to review and assess the alternative theoretical views and the supporting empirical evidence before reaching any conclusions. Such a review will also highlight how the theoretical and policy debate on these issues has evolved over time partly in a cyclical fashion, influenced, not surprisingly, by the economic cycle itself.
Following the Great Depression, Keynes (1936) made the case for stabilisation policies in general and particularly for the role of monetary policy in stabilising the cycle under certain circumstances. Keynes and his followers argued in favour of stabilisation policies on the basis of two premises: the first being the downward rigidity of wages (and prices); the second the concept of liquidity preference, that is the proposition that the demand for money also depends on the interest rate, the opportunity cost of holding money. The first premise, downward wage rigidity, implies that full employment cannot automatically be restored following a shortfall in aggregate demand. It thus establishes the need for stabilisation policy. The two premises together imply that, if aggregate demand is insufficient, an expansion of the nominal money supply can restore output to its full employment equilibrium, as long as there is no “liquidity trap” associated with very low interest rates. Thus, the feasibility of a stabilising monetary policy is established, though its effectiveness depends on the conditions prevailing in financial markets. The Keynesian paradigm may seem highly relevant in the light of the recent economic slowdown, particularly with respect to its causes, features and potential cures: subdued animal spirits of entrepreneurs, rising nominal wages despite the sluggish economic activity, and an environment of historically low interest rates in the United States and the euro area, and indeed zero interest rates in Japan. This paradigm, however, does not fully explain the causes and nature of the recent economic slowdown. Hence, no direct conclusions should be drawn concerning the appropriate stance or potential effectiveness of monetary policy.
A central theoretical issue, with crucial implications for the dynamics of the cycle and the role of monetary policy in stabilising it, is the nature and stability of the relationship between inflation and output fluctuations in both the short term and the long term. This issue has been at the core of the theoretical debate and associated econometric work for more than forty years, since Phillips (1958) observed an apparent empirical relationship between the growth of wages and the rate of unemployment. The nature of this relationship, particularly its short-term dynamics, is more complex than initially considered, for it reflects the effects of various factors influencing behaviour in labour and product markets, such as agents’ expectations, incomplete information, contractual arrangements and market adjustment mechanisms. Certain aspects of this relationship are still considered open, since the relevant evidence is not judged to be final. It is noteworthy that some of the open issues relate to current concerns.
The empirical results of Phillips appeared to expand the realm of stabilisation policy to include choosing the unemployment rate and output level which could be permanently secured as a function of long-term inflation. The long-term output-inflation trade-off formed the basis of aggregate demand management and anti-inflation policy in the late 1950s and in the 1960s, although the theoretical underpinnings to this relationship were relatively few (see Samuelson and Solow, 1960). A theory for the existence of a non-vertical long-term Phillips curve was put forward by Tobin (1972), who argued that the observed downward rigidity of nominal wages requires a certain amount of inflation in order to enable real wages to adjust to changing economic conditions. This argument, which has recently been further elaborated and empirically refined, does not rest on money illusion but on the idea that workers will resist relative wage cuts and that, consequently, inflation provides a means of synchronising real wage reductions across the economy.
The rising inflation in the late 1960s and early 1970s coincided with, and contributed to, a resurgence of classical-monetarist views on the relationship between output and inflation and on the role of monetary policy. Milton Friedman (1968) and Edmund Phelps (1968) independently advanced theories based on the notion of the natural rate of unemployment (or level of output) to explain deviations of output from its potential level or growth trend not as a consequence of changes in aggregate demand, but as a result of mistaken price expectations and misperceptions regarding the real wage. As misperceptions can only be temporary, deviations of output from its long-term potential level would also be temporary. Two major conclusions emerged from this analysis: first, no inflation-output trade-off exists in the long run and, second, expectations and their nature are of crucial importance in generating output fluctuations in the short run and in determining the effectiveness of monetary policy in stabilising output.
Robert Lucas (1972, 1976) and his associates developed the Friedman-Phelps theory further, reaching striking neoclassical conclusions about the nature of economic dynamics and the role of monetary policy. On the basis of the propositions that (i) expectations are “rational” and (ii) wages and prices are sufficiently flexible, they showed that output fluctuations around long-term equilibrium levels due to demand shocks are transient, randomly distributed and likely to be small. They also demonstrated that there are no short-term Phillips curve trade-offs that can be exploited by monetary policy to stabilise the economy. They therefore concluded that it is neither necessary nor feasible for monetary policy to stabilise the economy. Furthermore, they warned against the risks of mistakes inherent in excessively pro-active monetary and fiscal policies. This analysis has been used to advocate the advantages of adopting some strict form of monetary targeting.
Nevertheless, the magnitude and duration of macroeconomic fluctuations in the 1970s and 1980s demonstrated that various forms of nominal rigidities do exist and cannot be assumed away. Furthermore, although agents’ expectations should, in principle, be formed “rationally”, in practice they are based on more limited information about the structure of the economy than is normally assumed in theoretical models. These facts led to the development of theories which, although accepting neoclassical postulates and the “rationality” of expectations, imply that there exist short-term inflation-output trade-offs that can be exploited by central banks. Moreover, specific monetary policy rules have been proposed and estimated, notably by John Taylor (1996, 1999), which aim to minimise output and price fluctuations around policy targets.
In the low-inflation environment of the 1990s, theoretical arguments were presented, together with some empirical results, to support the view that when inflation is low there exists a stable long-term relationship between inflation and unemployment. Moreover, it had previously been argued that economic cycles generated by demand shocks could have permanent effects on aggregate supply. Akerlof, Dickens and Perry (1996, 2000), building on the ideas of Tobin, contended that at very low inflation a permanently higher rate of unemployment can emerge and that, consequently, a moderate inflation rate may be necessary to “grease the wheels” of the labour market. In particular, they calculated that in the face of downward wage rigidity an attempt to reduce inflation from 3% to zero would raise the equilibrium rate of unemployment in the United States by 2.6 percentage points. Wyplosz (2001), employing a different approach, presented some indications that a “grease effect” is present at low inflation rates in Europe. The relevance of these results for the choice of an appropriate price stability objective is obvious. The evidence, however, of the existence of nominal rigidities is mixed
In a similar vein, Blanchard and Summers (1986, 1987) emphasised that economic cycles can have permanent supply-side effects based on the notion of hysteresis in unemployment. There are a number of possible reasons why this may be the case. For instance, following a downturn and a consequent rise in unemployment, the newly unemployed experience a process of gradually diminishing human capital and search effort as their unemployment spell lengthens and they become less attractive to potential employers. Alternatively, “insider-outsider” models of the type developed by Lindbeck and Snower (1986), in which unions set wages by taking into account only the interests of those currently employed, imply that wages will be set too high to allow the unemployed to return to work. These theories suggest that monetary policy should aim to prevent marked and persistent increases in unemployment in order to speed up its return to the “natural” equilibrium rate and also in order to avoid possible permanent effects of cyclical fluctuations on potential output and the “natural” unemployment rate.
What are the implications of the alternative theories and the associated supporting empirical evidence for the role monetary policy can play in stabilising the economic cycle? Academic economists still seem to be divided on this issue, though views have converged significantly over the last twenty years. There is a long list of articles presenting the pros and cons of a counter-cyclical monetary policy. I would like to point out two contributions which have made the cases for and against monetary stabilisation policies in a comprehensive and forceful way: the presidential addresses delivered at the annual meetings of the American Economic Association by Franco Modigliani (1977) and Robert Lucas (2003). It is interesting to note that although these two leading economists differ in their approaches to and conclusions on the necessity and desirability of counter-cyclical monetary policy, at the same time they do accept the validity of a number of key propositions regarding (i) certain basic features of the economy’s functioning and (ii) the effects of monetary policy on macroeconomic aggregates.
In arguing the case for stabilisation policies, Modigliani (1977) recognises that the economy is not inherently unstable and that ambitious attempts to fine-tune it could be destabilising. He emphasises that money is neutral in the long run, though he questions the notion of “long run” from a policy viewpoint. Nevertheless, he argues that the economy is far from shockproof and that stabilisation policies can play an important role in maintaining it on a stable full employment path. In particular, he suggests that the deterioration in economic stability in the mid-1970s should be attributed to the failure to use stabilisation policies effectively to deal with the major supply shocks of the period.
Lucas (2003) directly addresses the magnitude of the benefits of stabilisation policies. He acknowledges that macroeconomic policies have succeeded in protecting the economy from deflationary risks using both monetary and fiscal instruments. He argues, however, that the welfare gain from more active stabilisation policies is negligible: just a tiny fraction of one percent of aggregate consumption in the United States. This negligible gain has to be weighed against the risk of wrong policies which actually aggravate the economic cycle. Conversely, Lucas emphasises the role of public policies (monetary and fiscal, as well as structural policies in the real and financial sectors) in enhancing economic growth and welfare from the supply side. With regard to monetary policy, he argues that emphasis should be placed on providing a stable nominal framework for the formation of agents’ expectations. This requires, first and foremost, that monetary policy ensures price stability.
Although there are still differences in the theoretical approaches to the analysis of economic cycles and alternative, opposing views are still being expressed about the role of monetary policy in stabilising output fluctuations, a significant convergence of approaches and views has occurred. Today, conceptual differences are much less stark. Most elements of the neoclassical critique have become accepted. For instance, the notion of a long-term vertical Phillips curve and the central importance of expectations are largely undisputed. At the same time, New Keynesian features such as nominal rigidities have retained a central role in explaining data. The literature on optimal monetary policy (see, for example, Woodford (2003) for a survey of that literature) emphasises output stabilisation as a central element. The so-called New Neoclassical Synthesis, as presented by Goodfriend and King (1997), expresses a consensus that combines long-term neoclassical and real business cycle features with New Keynesian short to medium-term adjustments. Models used by central banks, including the ECB, embody these features, emphasising the optimal behaviour of agents over time and rational expectations, but they also take into account the existence of nominal rigidities, imperfect competition and incomplete information.
Today central bankers can count on stronger and clearer guidance from the theoretical and empirical work of academics than was the case in the 1960s and 1970s. Two general propositions are widely accepted: the benefits of price stability and the importance of maintaining a stable policy framework for guiding the public’s expectations. It is also generally accepted that there are no permanent trade-offs between inflation and output growth or unemployment. Nevertheless, the debate regarding the role of a counter-cyclical stabilisation policy remains active: in particular, whether such stabilisation is necessary, whether it can yield significant benefits, and whether it is realistically feasible. Ultimately, the answers to these questions depend on the empirical evidence. To shed some further light on these questions, I will next examine the nature of the economic cycle and the state of our knowledge of the monetary policy transmission mechanism, particularly in the euro area.
The changing nature of the economic cycle
The potential for stabilisation policies depends on both the size and the nature of economic cycles. Recent analyses of the United States have pointed to a long-term decline in output volatility. While some studies identify a structural break in US output volatility at the beginning of the 1980s, Blanchard and Simon (2001) argue that this decline, although it was temporarily halted during the 1970s, is a phenomenon which can be traced back at least to the 1950s. Moreover, they report that, with the notable exception of Japan, other industrialised countries including Germany, France and Italy have also experienced a downward trend in output volatility. There are several reasons for this significant phenomenon: among them are the increasing relative importance of services in aggregate output, improvements in inventory management, and the stabilising effects of monetary policy.
The increasing share of output generated by services is a well-documented feature of industrialised countries. The production of services requires less physical capital and commodities than manufactured goods. Hence, services are less susceptible than industrial production to large swings in commodity prices, which have frequently contributed to past economic cycles. In addition, lower capital requirements also imply a lower sensitivity of output to the investment cycle, which is another defining feature of macroeconomic fluctuations.
Moreover, changes have taken place in inventory management techniques. The classic inventory cycle when, following a fall in demand, firms are left holding large inventories, therefore exacerbating the need to cut production, appears to have become less severe. Blanchard and Simon find that, over the last fifteen years, inventories have become counter-cyclical in the United States. McConnel and Perez-Quiros (2000) show that a sharp decline in the volatility of US output since 1984 has coincided with a significant drop in the proportion of durables output accounted for by inventories. Possible reasons for this change include a more accurate forecasting of demand, the favourable impact of information technology and more flexible production methods allowing for “just-in-time” stock management. The consequence of these developments is that firms need not reduce output drastically when confronted with a fall in demand.
Another important factor underlying the decline in output volatility is the change in the orientation and conduct of monetary policy. Following the experience of high and variable inflation in the 1970s and early 1980s, monetary policy in many countries has put greater emphasis on attaining and maintaining price stability over the medium and longer term rather than on stabilising short-term output fluctuations. This change, which in many countries has also been possible as a result of the increased independence of central banks, has helped to deliver not only lower and less variable inflation, but also more stable output growth. It is a fact that, in the 1980s, the volatility of both inflation and output dropped sharply, together with the decline in the level of inflation in industrialised countries; moreover, output growth and inflation remained stable in the 1990s, while the level of inflation remained low.
In sum, economic cycle volatility has declined in the last few decades in many industrialised economies. However, there are also reasons to believe that other structural changes in these economies may have created new sources of potential instability that policy-makers ought to monitor very closely. In particular, I would like to discuss the role of asset prices in the economic cycle, a topic which has recently received a lot of attention.
Financial markets have increased markedly in importance since the 1970s. For instance, between 1990 and 2000, stock market capitalisation in the United States and the euro area increased fivefold. One implication of the increasing size of stock markets is that changes in stock prices are likely to have a more pronounced impact on the economy than in the past. However, while the development of financial markets improves the allocation of resources between savers and investors, economists have long been aware that financial markets can be characterised by periods in which asset prices tend to deviate substantially from their equilibrium values.
A common feature of an asset price boom, in either stock or real estate markets, is that it tends to coincide with a parallel significant expansion of credit aggregates. These parallel developments can be mutually reinforcing during periods of expansion or contraction. For example, in the case of mortgage lending, where it is possible to borrow against the value of the real estate, credit and real estate price increases have been mutually reinforcing. Since the famous article of Irving Fisher (1933) in the first issue of Econometrica, it has been recognised that these processes can lead to debt overhang and deflation spirals once the bubble bursts. These known potential consequences are usually forgotten or underestimated during periods of expansion. Nevertheless, the risk that financial instability may spread to the real economy does, of course, exist. Indeed, many of the more pronounced cyclical fluctuations and, for that matter, the deepest recessions experienced in OECD countries in the last two decades have been associated with asset price cycles.
The monetary policy transmission mechanism: general features and euro area evidence
In order to assess the impact that monetary policy may have on the economic cycle, a good understanding of the features and dynamics of its transmission mechanism is necessary. Our knowledge of this mechanism is inevitably imperfect owing to its complexity, including its potentially time-varying nature. Following the launch of the euro, the ECB, in particular, was faced with an additional formidable factor of uncertainty, stemming from the potential impact of the introduction of the new common currency and the conduct of the single monetary policy on the expectations and behaviour of economic agents in the euro area. Hence, the study of the transmission mechanism has been the top priority on our research agenda. Empirical studies of the monetary policy transmission mechanism are numerous for the United States and other industrialised countries, but corresponding research for the euro area is relatively limited. In this part of my presentation, I will focus on the evidence available concerning the transmission mechanism in the euro area, emphasising its general features and certain empirical results relevant to the conduct of monetary policy and its potential response to the economic cycle.
A group of Eurosystem researchers worked on this topic over a two-year horizon, assembling a large body of empirical evidence. Their findings, which have been published in the ECB Working Paper Series (numbers 91-114) and subsequently in Angeloni, Kashyap and Mojon (2003), focus on the effects of changes in policy-driven interest rates on aggregate demand and its components, money, credit and prices. A wide range of macroeconomic and microeconomic data and models were used, partly in order to ensure that the empirical results would not be overly sensitive to arbitrary choices of models or data sets. Both the euro area and the individual Member States were analysed. The outcome of this research leads to a number of interesting conclusions.
A first conclusion is that there are important similarities in the cyclical behaviour of the euro area and the US economies as well as in their responses to monetary policy. The time sequence of lead and lagged reactions to monetary policy characterising prices, output, and the main components of aggregate demand appear to be remarkably similar between the two economies. This should perhaps not be surprising, given that the size, degree of openness and output structure of these two economies are not very dissimilar. It suggests that the inner workings of the two largest world market economies may not be all that different. This is reassuring because the vast theoretical and empirical literature on the monetary transmission mechanism in the United States could be a benchmark for evaluating the transmission mechanism in the euro area. Although there are still lively discussions among central bankers and academics on the relative importance of the various channels of monetary policy in the United States, a broad consensus exists on the stylised facts regarding the effects of changes in interest rates on output and prices as well as on the different channels through which these changes are likely to be transmitted.
The stylised facts on the effects of monetary policy on aggregate output and the price level have mainly been established using vector auto-regression models. According to a wide variety of such models, a change in the monetary policy stance, say an easing of monetary policy, is followed by a temporary increase in output, which peaks within four to eight quarters but diminishes eventually to zero, while the price level adjusts more gradually, albeit permanently. In addition to the results obtained from vector auto-regressions, this pattern of responses is also borne out by more traditional econometric models such as the Federal Reserve model of the US economy. This evidence is consistent with the view that there is no output-inflation trade-off in the long run.
From a theoretical perspective, these patterns of output and price responses are also consistent with the two-stage consensus paradigm of the transmission mechanism. First, due to nominal rigidities, changes in nominal interest rates affect real interest rates and aggregate demand (along the IS curve). Second, the change in demand conditions influences prices and wages as the aggregate supply responds only partially to demand. This reading of the empirical evidence on the transmission mechanism is also supported by simulations based on highly stylised dynamic general equilibrium models. Several theoretical contributions have shown that, provided that they include some form of nominal rigidities, these models would deliver this type of output and price responses to a change in the monetary policy stance.
Regarding other aspects of the monetary transmission mechanism, there is no consensus view about the relative importance of the interest rate channel and the credit channels in the first stage of the transmission mechanism described above. Some economists argue that the response of the real interest rate to money supply changes is too small and short-lived to explain the size of the response of investment and, more generally, of aggregate demand. Hence, in their view, it is likely that changes in the interest rate may actually affect spending by shifting the liquidity constraint of either banks or firms and households. Others consider that although the credit channel may amplify the policy effects via the interest rate channel, the quantitative significance of such amplifications remains to be demonstrated convincingly.
A second general conclusion about the monetary transmission mechanism in the euro area is that a change in the policy interest rate seems to lead to an adjustment in output that reaches a peak after a period of between one and two years. The response of the price level is typically estimated to be much more gradual, but long lasting. This broad qualitative pattern emerges consistently across a variety of empirical models. However, the exact time profile of these dynamic effects cannot be estimated precisely, particularly for the euro area. The old monetarist creed, summarised by the famous characterisation by Milton Friedman of the transmission lags as “long and variable”, is confirmed by the evidence available for the euro area.
A third set of conclusions concerns the channels of influence of monetary policy through financial markets. Looking at all the evidence, it appears that a set of simple links across the structure of interest rates, together with the estimated responses of private expenditure to those rates, is sufficient to account for the main patterns of the euro area response to policy changes. Thus, the interest rate channel seems to work reliably. This does not mean, however, that other influences reflecting the structure of financial markets are not relevant. As we know, financial and banking structures can be important, particularly in the euro area. The ECB has recently published a special report focusing on a comparison of euro area financial structures, and is actively engaged, together with competent national and European authorities, in initiatives aimed at fostering the integration and efficiency of the European financial system.
A fourth result relates to the potential presence of significant asymmetries across countries in the functioning of the transmission mechanism and the impact of monetary policy. However, the likely presence of ongoing structural change makes it particularly difficult to draw firm conclusions on cross-country differences. The effects of monetary policy may depend to a considerable extent on the monetary policy regime itself and its effects on expectations. During the typical sample period for which models were estimated, euro area countries adopted a variety of monetary policy strategies. Hence, the change in the policy regime resulting from the introduction of the euro could have affected the transmission channels in some countries more than in others. At present, there is neither consistent nor reliable evidence that the output and price responses to a change in monetary policy in individual countries differ markedly from the euro area average.
A fifth important issue that needs to be considered is whether the effects of monetary policy on output and the price level are linear and symmetric, i.e. whether the effects of monetary policy are the same regardless of the cyclical conditions of the economy, the level of interest rates and the direction of change in the policy stance. The existence of such nonlinearities or asymmetries obviously has implications for the impact of monetary policy over the economic cycle.
Theoretical analyses of the functioning of credit markets under imperfect information suggest that a change in the policy interest rate may trigger a more than proportional change in the cost of raising external finance for some class of borrowers than for some others. In particular, proponents of the credit channel of monetary policy consider that a more restrictive policy stance can reduce loanable funds by worsening the quality of the borrowers’ balance sheets and collateral. This mechanism is likely to be more pronounced during an economic slowdown, as the cash flow of firms and the income of households are deteriorating. Our results on this topic are tentative, mainly due to the limitations of our statistics. However, the evidence available shows that in euro area countries and the United States the response of output to changes in the interest rate is stronger during recessions than during booms.
Another important source of asymmetry or nonlinearity in the effects of monetary policy, on which much emphasis has been placed in recent years, relates to the functioning of the transmission mechanism at very low levels of inflation and interest rates
A pertinent question is whether monetary policy retains its effectiveness at very low rates of interest. This issue has been contentious since Keynes (1936) suggested the possibility of a liquidity trap. It has also become topical again with the recent Japanese experience of virtually zero interest rates. As we know there are two views. The first or liquidity trap view is based on the proposition that when interest rates are zero there is an infinitely elastic demand for money balances and any increase in the money supply is simply absorbed in higher balances. Monetary policy therefore becomes unable to affect output or prices. The alternative view states that households and firms will eventually become satiated with money balances and an increase in the money supply beyond some level will lead to portfolio shifts and changes in spending. Thus, in this case, an expansionary monetary policy can be effective even when the short-term nominal interest rate is zero and when it can be implemented by open market operations in which the monetary authority purchases assets of many forms such as bonds, real estate, equities and foreign exchange.
The debate concerning the validity of these two views essentially boils down to answering an empirical question regarding the nature of the money demand function at very low interest rates. Not surprisingly, work in this area is hampered by the lack of observations of such interest rates. However, Meltzer (2001) found that on two occasions, when short-term interest rates were close to zero in the United States, the money base growth had a significant impact on consumption even after interest rate and lagged consumption effects had been taken into consideration. This suggests that households can become satiated in money balances. Nevertheless, as King (1999) pointed out, it is not clear what mechanism causes changes in base money to have an impact on output and prices at low interest rates. It may be related to changes in risk premia on other assets, as suggested by King, or it may also involve other channels. This is an issue which merits further research.
Lessons for central banks
The role of monetary policy
The preceding review of the theory and evidence of the links between macroeconomic fluctuations and monetary policy leads to a number of conclusions about the role and conduct of monetary policy. The first relates to monetary policy objectives. Both theory and evidence support the proposition that monetary policy should primarily aim at maintaining price stability, as it can effectively control the price level in the medium and longer run, while its effects on real output are only transitory. Moreover, the evidence available strongly suggests that, by securing price stability, monetary policy fosters sustainable growth in various ways and can also help to reduce output volatility. The long lags in the effects of monetary policy on the price level and the importance of expectations in the transmission process imply that monetary policy should be implemented in a forward-looking way and in a manner which helps anchor expectations to the price stability objective.
Monetary policy can influence aggregate economic activity in the short and the medium term. Consequently, in principle, it can play a stabilising role. However, this does not imply that, in general and in practice, such a role is necessary or desirable in the sense that it can be performed effectively. The decline in the magnitude of cyclical output fluctuations over the last twenty years in many countries would suggest that the need for such a counter-cyclical role has, on average, diminished. Moreover, there is evidence that a large, if not the largest part of cyclical output variability cannot be attributed to nominal demand shocks but is a consequence of real (e.g. technology-related) shocks which cannot be effectively offset by monetary policy. In addition, under “normal circumstances”, i.e. when the central bank is faced with cyclical fluctuations of average magnitude, the systematic pursuit of activist counter-cyclical policy can be ineffective and run the risk of accentuating rather than mitigating output volatility. This risk is a consequence of the uncertainty and variability of the lags in the effects of monetary policy on output as well as of the uncertainties associated with identifying the types of shocks and the precise cyclical position of the economy. For all these reasons, which are supported by the balance of evidence, the conduct of an activist, fine-tuning counter-cyclical monetary policy involves more risks than potential benefits and should be avoided under normal circumstances.
However, there may exist “particular circumstances” which can be triggered by severe shocks and/or characterised by unusually large fluctuations due to the cumulative impact of various factors. In such situations, monetary policy can play an output-stabilising role which is consistent with its commitment to its primary objective of securing price stability. Such a policy must be implemented carefully and communicated effectively so that public expectations and the central bank's credibility are not adversely affected. The appropriate policy response will partly depend on the type of shock which is primarily responsible for the observed cyclicality of output. In the case of a sizeable demand shock that also causes inflation expectations to diverge from the norm of price stability, the boundaries between price stability and cyclical stabilisation become blurred. Monetary policy should endeavour to counteract inflationary and deflationary risks alike in a symmetric, proactive and forward-looking manner. The experience of the early 1980s, when the US Federal Reserve acted to stabilise the economy and to counteract expected inflation, is a characteristic success story. Risks of deflation support the need for additional caution in this respect because of the possibility that monetary policy may encounter problems associated with the zero bound on nominal interest rates. In such circumstances, timely and forward-looking action may be required to ensure that expectations remain firmly anchored on price stability and risks to growth are minimised.
This links up to the issue of the role of asset prices in the monetary policy process. History has shown that asset price movements can be the forerunners of large inflationary and deflationary risks – for instance, the experience of the United States in the 1920s and 1930s and of Japan in the 1980s and 1990s. In my view this is a major reason why these prices deserve attention. Identifying asset price misalignments, particularly in individual markets, is exceedingly difficult. But financial imbalances are normally indicated by several concurring signals. In this respect, our analysis confirms that asset price movements that are not in line with fundamentals tend to be accompanied by unusual changes in monetary and credit aggregates. By taking these movements into account, a central bank can assess and indirectly address a potential source of instability. However, in view of the implied risks signalled by rapid money or credit growth, using the interest rate instrument to help stabilise asset prices is not likely to be easy in practice and may not be particularly effective, given the dominant role of expectations in fuelling asset bubbles. Thus, warnings by the authorities about the potential risks and/or the implementation of appropriate supervisory policies may be a more effective means to address this problem, as stressed by Yamaguchi (1999).
In the case of a major supply shock, a central bank is likely to face a dilemma. For instance, a marked and persistent rise in the price of oil can create conditions in which a central bank’s actions to maintain price stability may conflict with the aim of smoothing the direct contractionary impact of the shock. A monetary policy geared towards medium-term price stability should normally aim at containing the second-round effects on prices coming from wage earners and from firms seeking to maintain real wages and profits unchanged, despite the loss in the terms of trade. The more established credibility the monetary authority has in terms of preserving price stability, the easier this task should be. In this respect, it is important to acknowledge that supply-side shocks always entail a change in the non-inflationary potential level of output. Price stability and economic cycle stability may be reconciled if the loss of potential output stemming from supply shocks is properly recognised.
The ECB’s policy framework and macroeconomic stability
I would now like to focus on the role the ECB can play so as to contribute to macroeconomic stability. The Treaty and the ESCB/ECB Statute clearly state that the primary objective of the single monetary policy is to maintain price stability. They also state that, provided that the attainment of its primary objective is not jeopardised, the ECB will support the general economic policies of the European Union so as to contribute to the achievement of the EU’s objectives. These include “sustainable and non-inflationary growth”. Thus, the ECB’s mandate and the conclusions previously reached regarding the role of monetary policy are consistent. This mandate, which is enshrined in the Treaty, lays the foundations for the ECB’s commitment to price stability and, together with the Treaty provisions concerning central bank independence and accountability, it supports the ECB’s credibility.
To implement its mandate and complement the Treaty provisions, the ECB has formally adopted a monetary policy strategy, which provides the framework for internal policy decisions and external communication. A key element of this strategy is the commitment to maintain price stability in the medium term according to an explicit quantitative definition. The announcement of a quantitative definition of price stability aims to anchor the public’s inflation expectations. The evidence available confirms that this goal has been achieved, since inflation expectations in the euro area – as measured from surveys – have consistently remained below but close to 2%. Another important feature of the ECB’s strategy is that it is forward looking, with a medium-term orientation. This reflects the long time lags in the effects of monetary policy on the price level, which have been confirmed by the empirical evidence on the monetary transmission mechanism in the euro area. As such, the strategy does not justify short-term activism and policies aimed at fine-tuning the economy. At the same time, the medium-term orientation of the strategy allows for a gradualist policy response to shocks to the price level and provides a degree of flexibility which may be needed to deal with various types of severe shocks.
The combination of commitment and flexibility which characterises the ECB’s strategy allows for some “constrained discretion” in dealing with cyclical output fluctuations, consistent with maintaining price stability. The forward-looking, medium-term orientation of the strategy also makes it possible to be proactive in monetary policy-making. As I have mentioned, this is essential if monetary policy is to react promptly and effectively when significant risks of inflation or deflation emerge. Furthermore, in the case of cycles caused by supply shocks, the medium-term orientation helps to maintain expectations of price stability, thereby helping to minimise undesirable second-round price effects and at the same time speeding up the return to a path of long-term growth.
In conclusion, I would like to emphasise that economic theory and evidence support the proposition that the primary objective of monetary policy should be to maintain price stability in the medium and longer term. By attaining this objective, monetary policy fosters sustainable growth and helps to reduce the volatility of aggregate output. Thus, an activist counter-cyclical monetary policy aimed at fine-tuning the economy should be avoided under normal circumstances. The risks such a policy entails outweigh potential benefits. This, however, does not mean that we should not retain some flexibility to act when faced with severe shocks that imply major risks to growth. The monetary policy strategy of the ECB provides flexibility to react appropriately to such situations and in a manner which is consistent with its commitment to price stability.
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 : The author would like to thank Benoît Mojon and Julian Morgan for their assistance in preparing this contribution. This revised version may slightly differ from the oral presentation.
 This proposition, which reflects the role of money as a financial asset and not only as a medium of exchange, has implications for the effectiveness of monetary policy in stabilising output.
 See, for example, Sargent and Wallace (1975).
 This evidence is briefly surveyed in Issing (2001).
 See Fischer (1994, 1996), Feldstein (1999) and Issing (2001)
 See, for example, Bernanke and Gertler (1999).
 See Borio and Lowe (2002).
 See, for instance, the surveys by Bean, Larsen and Nikolov (2003) and Mishkin (1995).
 These models mainly differ in terms of the information that is available to the central bank when it determines the monetary policy stance. See Christiano, Eichenbaum and Evans (1999).
 See, for instance, Benassy (2002) and Smets and Wouters (2002).
 Bernanke and Gertler (1995) review the debate on the credit channel and show that interest rate channel effects cannot explain the monetary policy transmission completely thus leaving room for other channels. Angeloni et al. (2003) find that the interest rate channel cannot explain the overall transmission patterns in several euro area countries (Germany, France, Italy, Belgium, Greece and Austria), thus allowing a role for a credit channel.
 See Peersman and Smets (2001).
 For a discussion of the relevant issues, see, for example, Viñals (2001)
 The term “constrained discretion” has previously been employed by King (1997) and Bernanke and Mishkin (1997) to describe the inflation targeting approach to monetary policy. I use this term in a broader and different sense, similar to that used by Bernanke (2003).