Monetary and Fiscal Policy on Business Cycles

Monetary Policy

To smooth out extreme inflation or deflation, central banks act as mediators. It is generally accepted that expansionary policies are less effective than those that are restrictive. In other words, it’s easier for governmental authorities to cool down a hot economy than to spark the growth of a cold economy. The Taylor rule models the relationships between GDP, inflation, and interest rates.

The Taylor Rule

$$ {i}^\ast =r_{\text{neutral}} + {\pi}_{e}+ {0.5}\left[{y}_{e}-{y}_{\text{trend}}\right]+{0.5}\left[{\pi}_{e}-{\pi}_{\text{target}}\right] $$

Where:

\(i^\ast\) = Target nominal short-term interest rate.

\(r_\text{neutral}\) = Neutral real short term interest rate.

\(y_e\) = Expected GDP growth rate.

\(y_\text{trend}\) = Long-term trend in the GDP growth rate.

\(\pi_e\) = Expected inflation rate.

\(\pi_\text{target}\) = Target inflation rate.

The Taylor rule serves as a guide to many central banks in setting appropriate policy rates. The target rate–or rate the bank should set–equals the neutral rate, scaled by the differences in expected versus trend inflation and GDP. For example, if GDP is expected to be higher than its trend rate, this would call for higher interest rates. This is intuitive as higher-than-normal GDP indicates an over-heating economy, and rising interest rates are a lever the central bank can use to cool the economy down. The same logic goes for inflation.

Zero or Negative Interest Rates

Before 2008, it was believed that negative interest rates would not work to stimulate the economy. The logic was that upon discovering that bank deposits were earning a negative interest rate, depositors would withdraw all their funds and move into cash, which could not be ‘taxed’ by a negative interest rate.

It turns out that several European banks could sustain negative interest rates over reasonably long periods. The reason that this worked is that a modern economy cannot be entirely operated in cash. Bank deposits facilitate millions of daily transactions, which would be slow, if not impossible, to achieve with pure cash. As long as there is a need for these transactions, depositors are not entirely free to switch to cash-only.

Negative Interest Rate Implications

Negative policy rates are expected to produce asset class returns like those in the contraction and early recovery phases of a “more normal” business/policy cycle. Although such historical periods may provide a reasonable starting point in formulating appropriate scenarios, it is essential to note that negative rate periods may indicate severe economic distress and thus involve more significant uncertainty regarding the timing and strength of the recovery. Key considerations to keep in mind when forecasting in a negative or zero interest rate environment include:

• Historical data may not be reliable.
  • Limited valuable data may be available.
  • Since this data was generated, significant structural changes in markets and the economy may have occurred.
  • Quantitative models may have discrepancies in cases that differ from those on which they were estimated/calibrated.
  • Forecasting must explain the differences between the current environment and historical averages.
• The effects of other monetary policy measures occurring simultaneously, e.g., quantitative easing).
  • These may interfere with market relationships, including, e.g., the shape of the yield curve.

Fiscal Policy

Fiscal policy is a tool the government uses to manage the economy. A government can implement a loose fiscal policy to stimulate the economy. This is done by decreasing taxes or increasing spending, which increases the budget deficit. A tight fiscal policy can be implemented to slow down the economy.

Question

An analyst is following a country on the Asian continent that was recently affected by a devastating typhoon. The economy has become rocky, so the expected GDP is much lower than the trend GDP. According to the Taylor rule, this drop in GDP would most likely lead to:

1. An increase in expected inflation.
2. A decrease in the target interest rate.
3. A decrease in trend inflation.

Solution

The correct answer is B.

The Asian country is headed towards an economic slowdown as it focuses on rebuilding. Logically, this would not be a time for the government to increase interest rates, which is a brake on economic progress. Instead, lowering the target rate would encourage investment and help stimulate economic activity. As borrowing becomes more affordable, asset prices would also increase.

A is incorrect. The Taylor rule does not suggest that a decrease in GDP would lead to an increase in expected inflation. Instead, the Taylor rule computes the optimal federal funds rate based on the gap between the desired (targeted) inflation rate and the actual inflation rate and the output gap between the actual and natural output levels.

C is incorrect. The Taylor rule does not suggest that a decrease in GDP would lead to a decrease in trend inflation. The Taylor rule prescribes a relatively high-interest rate when actual inflation is higher than the inflation target1. In this case, since there is a decrease in GDP, it would most likely lead to a decrease in the target interest rate, not a decrease in trend inflation.

Reading 1: Capital Market Expectations – Part 1 (Framework and Macro Considerations)

Los 1 (h) Discuss the effects of monetary and fiscal policy on business cycles