Interest Rates, Prices and Liquidity Many of the assumptions that underpin mainstream macroeconomic models have been challenged as a result of the traumatic events of the recent financial crisis. Until recently, it was widely agreed that short-term interest rates were a sufficient instrument of monetary policy. However, early on in the financial crisis interest rates effectively hit zero per cent and so central banks had to resort to a set of largely untested instruments, the purchase of financial assets under quantitative easing (QE). This book brings together contributions from economists working in aca- demia, financial markets and central banks to assess the effectiveness of these policy instruments and to explore what lessons have so far been learned. jagjit s. chadha is Professor of Economics at the University of Kent, Canterbury. sean holly is Professional Fellow at Fitzwilliam College and Director of Research at the Faculty of Economics, University of Cambridge. Macroeconomic Policy Making Series editors Professor JAGJIT S. CHADHA University of Kent, Canterbury Professor SEAN HOLLY University of Cambridge The 2007–2010 financial crisis has asked some very hard questions of modern macroeconomics. The consensus that grew up during ‘the Great Moderation’ has proved to be an incomplete explanation for how to conduct monetary policy in the face of financial shocks. This series brings together leading macroeconomic researchers and central bank economists to analyse the tools and methods neces- sary to meet the challenges of the post- financial crisis world. Interest Rates, Prices and Liquidity Lessons from the Financial Crisis Edited by Jagjit S. Chadha and Sean Holly cambridge university press Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, São Paulo, Delhi, Tokyo, Mexico City Cambridge University Press The Edinburgh Building, Cambridge CB2 8RU, UK Published in the United States of America by Cambridge University Press, New York www.cambridge.org Information on this title: www.cambridge.org/9781107014732 © Cambridge University Press 2012 This publication is in copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press. First published 2012 Printed in the United Kingdom at the University Press, Cambridge A catalogue record for this publication is available from the British Library Library of Congress Cataloguing in Publication data Interest rates, prices and liquidity : lessons from the financial crisis / edited by Jagjit S. Chadha, Sean Holly. p. cm. – (Macroeconomic policy making) Papers presented at a conference held in Cambridge, England in Mar. 2010. ISBN 978-1-107-01473-2 (hardback) 1. Interest rates. 2. Monetary policy. 3. Global Financial Crisis, 2008–2009. I. Chadha, Jagjit. II. Holly, Sean. III. Title. HG1621.I588 2012 339.5 0 –dc23 2011030680 ISBN 978-1-107-01473-2 Hardback Cambridge University Press has no responsibility for the persistence or accuracy of URLs for external or third-party Internet websites referred to in this publication, and does not guarantee that any content on such websites is, or will remain, accurate or appropriate. Contents List of figures page vii List of tables ix List of contributors x 1 New instruments of monetary policy jagjit s. chadha and sea n holly 1 2 Liquidity and monetary policy douglas gale 32 3 Interest rate policies and stability of banking systems hans gersbach and jan wenzelburger 71 4 Handling liquidity shocks: QE and To bin ’sq john driffil l an d m arc us m i lle r 108 5 Asset purchase policies and portfolio balance effects: a DSGE analysis richard harrison 117 6 Financial intermediaries in an estimated DSGE model for the UK stefania villa and jing yang 144 7 Central bank balance sheets and long-term forward rates sharon kozic ki, eri c san tor an d l en a s uc han ek 172 8 Non-standard monetary policy measures and monetary developments domenico giannone, michele lenza, huw pill and lucrezia reichlin 195 9QE– one year on spen ce r d al e 222 v 10 What saved the banks: unconventional monetary or fiscal policy? michael wickens 233 11 Non-conventional monetary policies: QE and the DSGE literature evren caglar, jagjit s. chadha, jack meaning, jam es warren and alex waters 240 Index 274 vi Contents Figures 1.1 QE in a CC/LM framework page 9 1.2 UK policy rate and nominal GDP growth 12 1.3 Policy rates 13 1.4 Money multiplier 14 1.5 CPI and core inflation in Japan 15 1.6 Bank of England and Federal Reserve purchases of assets 17 1.7 Bank of England’s balance sheet – assets 18 1.8 Bank of England’s balance sheet – liabilities 19 2.1 Uncertainty about asset returns and risk preferences 57 3.1 Sectors of the economy 77 3.2 Repayments of entrepreneurs 88 3.3 Collapse of the banking system 91 3.4 Convergence to the consumption trap 94 3.5 Resolving a banking crisis 97 3.6 Preventing a banking crisis 99 4.1 Capital accumulation and real equity prices before and after the 1929 stock market crash 109 4.2 Central bank total liabilities in the crisis (August 2007=100) 110 4.3 Portfolio balance and zero net investment 111 4.4 Liquidity shock shifts equilibrium from E to E´: stock market falls in the short run 112 4.5 Effect of a liquidity shock that is expected to last for eight quarters 114 4.6 Bursting of asset bubble leading to liquidity contraction 115 5.1 UK government bond portfolio and yield curve slope 1991–2010 119 5.2 Responses to conventional monetary policy shock 134 5.3 Responses to purchases of long-term bonds 136 5.4 Responses to asset purchase shock 137 5.5 Responses to contractionary demand shock 139 vii 5.6 Responses to contractionary demand shock with asset purchase policies 140 6.1 Fit of the model 155 6.2 The estimated IRFs to a technology shock and to an interest rate shock 159 6.3 The estimated IRFs to a shock to the quality of capital and to a shock to bank capital 160 6.4 Historical decomposition 165 6.5 The estimated IRFs with and without credit policy 167 7.1 UK ten-year government bond yields 173 7.2 US ten-year Treasury yields 173 7.3 US central bank assets and claims to potential GDP 183 7.4 Federal Reserve bal ance sheet assets 184 8.1 Behaviour of US money stocks during the Great Depression, 1929–39 198 8.2 Behaviour of euro area money stocks during the financial crisis, 2000– 10 199 8.3 Spread between three-month EURIBOR and three-month general collateral (GC) repo rate 202 8.4 Eurosystem balance sheet 205 8.5 Substitution of central bank intermediation for interbank transactions 207 8.6 Eurosystem interest rate corridor and EONIA 208 8.7 Comparison of outturns with conditional forecasts in Giannone et al. (2010) model 212 8.8 Impact of spread effects of non-standard measures in Lenza et al. (2010) 217 11.1 Announcement effects 250 11.2 M4x 252 11.3 Year-on-year growth of M4x 253 11.4 Net non-deposit liabilities 254 11.5 Sectoral M4 money holdings 255 11.6 Year-on-year growth of money holdings 256 11.7 Reserves 257 11.8 Sectoral year-on-year growth of M4Lx 258 11.9 Impulse respon ses of the Harrison model 259 11.10 Impulse responses of the Gertler–Karadi model 261 11.11 Impulse responses of the Chadha–Corrado model 262 viii List of figures Tables 5.1 Parameter values page 132 6.1 Some statistical properties of the data (1979–2009) 150 6.2 Calibrated parameters 152 6.3 Prior and posterior distributions of structural parameters 153 6.4 Simulated moments 156 6.5 Subsample estimates 157 6.6 The importance of the different frictions 162 7.1 Baseline results for US regressions 185 7.2 Alternative specifications for US regressions (1) 187 7.3 Alternative specifications for US regressions (2) 189 7.4 Panel regressions 191 11.1 MPC announcements regarding the asset purchase programme 243 11.2 Types of asset bought with the creation of new reserves (on a settled basis) 243 11.3 Announcement dates included in event study 245 11.4 Total impact of QE over event study on key variables 246 11.5 Balance sheet changes 255 11.A1 Descriptions and parameter values 264 11.A2 Parameter desc riptions and values 265 11.A3a Parameter descriptions and values 265 11.A3b Steady-state parameter descriptions and values 266 ix [...]... fail The general understanding of these 4 Compare the work of Hawtrey (1934) and Clarida et al (2002) 4 Interest Rates, Prices and Liquidity principles has been associated with the avoidance of banking panics in England since the Overend and Gurney crisis of 1866, which was the previous example of a bank run in the UK until Northern Rock in 2007 The relevance of Bagehot’s principles for the current crisis. .. increase and the money multiplier shrank Although the financial crisis was regarded as a once-in-a-century experience for many western countries, from the Japanese point of view it was actually the second crisis in twenty years One difference for Japan, and which marks it out from what happened in the 1990s, is that this time the cause lay with an exogenous shock from the rest of the world, rather than... fund the budget deficit the Bank of England bought Treasury bills or commercial bills from the market This led to complications in the longer run as the Bank of England accumulated a vast and growing mountain of bills which in practice made the day-to-day conduct of monetary policy increasingly difficult It slightly tilted the yield curve lowering short-term interest rates and raising long-term interest. .. government bonds from the non-bank financial sector; and to stand ready, on the instructions of the Monetary Policy Committee (MPC), to sell those bonds back to the same sector in some more stable state of the world In response, the rest of the financial system has taken the following steps: the Bank of England has financed its loans to the APF by issuing reserves to the banking sector, the non-bank financial... not seen since the end of the Second World War or the aftermath of the Napoleonic wars These purchases amount to some 14 per cent of GDP or well over 20 per cent of outstanding UK public net debt The APF has operated with full indemnity from the Treasury, which receives all profits and will bear any losses Figures 1.7 and 1.8 show the impact of these measures and others on the size of the central bank... to shocks in the real part of the economy, the natural assignment is then broadly to use interest rates rather than the stock of money as the main policy instrument But Poole also showed that, in general, neither instrument would necessarily stabilise the economy better than the other as it depended on the relative magnitude of shocks in these sectors and the sensitivity of output to these respective... new and well-regulated type of limited-purpose financial company, what he calls a narrow bank, to replace the miscellany of vehicles that blossomed in the boom years before the crisis of 2007–8 The key insight from Gale is that we need to understand the reasons why liquidity dried up in order to avoid a repeat of the sub-prime crisis, and to design a more stable and efficient financial system for the. .. and there seems to be little direct impact over time, but any relationship is likely to be highly complex The way in which the ECB responded to the financial crisis differed in many ways from how other central banks responded These differences, it is argued, reflected the different economic and financial structures in the euro area compared with, in particular, the US With the onset of the interbank crisis. .. future Second, there must be an expansion in the size of the central bank’s balance sheet Finally, there must be direct use of the composition of the central bank’s balance sheet to change relative yields These three principles essentially encapsulate how central banks around the world responded in different ways to the crisis 1.1 Macroeconomics and the crisis The financial crisis has pushed the perennial... aggregate demand If the former dominates the latter, interest rates will fall If, however, spending effects dominate 10 Interest Rates, Prices and Liquidity then the latter would dominate The early empirical results on the announcement effects of QE suggest that there has been more of a downward interest rate effect It might very well be therefore that financial market participants have not transmitted the possible . meet the challenges of the post- financial crisis world. Interest Rates, Prices and Liquidity Lessons from the Financial Crisis Edited by Jagjit S. Chadha and Sean Holly cambridge university press Cambridge,. somewhere between panic and pre-panic prices; and (iii) institutions with poor col- lateral should be allowed to fail. The general understanding of these 4 Compare the work of Hawtrey (193 4) and Clarida. together economists from academia, financial markets and central banks to discu ss some of the challenges that arose from both the financial crisis itself and the response to that crisis. Many of the