In response to the 2008-09 crisis, central banks aggressively cut monetary policy rates and implemented a broad set of unconventional monetary policy measures. We propose a simple framework to analyse the optimal sequencing of standard policy and unconventional measures.
In our model, central banks implement unconventional measures to provide credit to the economy when bank lending is impaired. We seek answers to the following questions. If unconventional measures are used effectively to address financial market impairments, do they also reduce the likelihood that interest rates will reach the effective lower bound? Should central banks use interest rate policy at all, once they have deployed unconventional measures? How long should they optimally keep those measures in place?
Our main result is that, when credit spreads rise due to an increase in costs associated with asset liquidation, unconventional measures may be a more efficient tool than standard interest rate policy. Under these specific circumstances, interest rate cuts should be considered only when the scope for unconventional measures is exhausted. Hence, deploying unconventional measures may prevent interest rates from reaching their effective lower bound.
We study the optimal combination of interest rate policy and unconventional monetary policy in a model where agency costs generate a spread between deposit and lending rates. We show that credit policy can be a powerful substitute for interest rate policy. In the face of shocks that negatively affect banks' monitoring efficiency, unconventional measures insulate the real economy from further deterioration in financial conditions and it may be optimal for the central bank not to cut rates to zero. Thus, credit policy lowers the likelihood of hitting the zero bound constraint. Reductions in the policy rates without non-standard measures are suboptimal as they inefficiently force savers to change their intertemporal consumption patterns.
JEL codes: E44, E52, E61
Keywords: optimal monetary policy, unconventional policies, zero-lower bound, asymmetric information
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