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MONPMOD Report Summary

Project ID: 614879
Funded under: FP7-IDEAS-ERC
Country: Italy

Periodic Report Summary 2 - MONPMOD (New Directions for Monetary Policy Analysis)

The project has delivered new theoretical models to understand and analyze the role of monetary policy in the aftermath of the financial crisis. There are two main outcomes: i) a model of coexistence between safe and pseudo-safe assets analyzing a liquidity crunch and related policy interventions; ii) a post-crisis New-Keynesian model studying the optimal monetary policy reaction to a process of debt deleveraging.

In “Safe Assets, Liquidity and Monetary Policy” published in the American Economic Journal Macroeconomics, in Volume 9, Issue 2, p.182-227 authored by P. Benigno and S. Nistico’ a model of coexistence between safe and pseudo-safe assets is analyzed showing that the worsening in the quality of pseudo-safe assets can generate a liquidity crunch and a contraction in aggregate demand and real activity. Monetary policy can counteract the crisis by issuing more safe assets, using reserves or money, and thereby avoiding the shortage of liquidity and the contraction in aggregate demand. Moreover, the reduction in the interest rate on reserves can bring about a fall of the interest rate in other markets, like the lending rate, and minimize the distributional impact of the liquidity shock on savers and borrowers. The framework rationalizes as optimal policies the main monetary policy actions adopted during the recent crisis such as balance-sheet and zero-lower-bound policies focusing on different forces than those underlined by the literature.

The paper “Dynamic Debt Deleveraging and Optimal Monetary Policy” published as CEPR Discussion Paper No. 11180 and authored by P. Benigno, G. Eggertsson and F. Romei, proposes a tractable post-crisis New-Keynesian model to understand the propagation mechanism of debt deleveraging to macroeconomic variables. The first main conclusion of the paper is that the duration of a negative natural rate of interest –the source of a liquidity trap-- is now endogenous depending on the speed of deleveraging and therefore on macroeconomic policy. The second key result of the paper is to some extent a corollary of the first. Endogenous deleveraging in general amplifies the effect of policy at the zero bound. The third result is the possibility to derive a social welfare function inside a heterogenous agent model. While the standard New Keynesian model involves only output and inflation objectives, the social welfare function of this analysis involves an additional term because of the heterogenous-agent model and the assumption of incomplete insurance between the borrowers and savers. The additional term gives the government even further reason to engage in aggressive countercyclical policy. A fourth result that emerges is that optimal monetary policy in a liquidity trap under dynamic deleveraging prescribes excess inflation, and possibly output above potential, well above the inflation target, even during the period in which the zero bound is binding and the natural rate of interest is negative.

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