Dario Bonciani and Joonseok Oh
The Global Financial Crisis in 2008 caused a significant and persistent increase in unemployment rates across major advanced economies. The worsening in labour market conditions increased uncertainty about job prospects, which potentially gave rise to precautionary savings, putting further downward pressure on real economic activity and prices. Moreover, in response to the severe drop in demand, central banks worldwide cut short-term nominal interest rates, which rapidly approached the zero lower bound (ZLB), where they remained for a prolonged time. In a recent paper, we show that committing to keep the interest rate at zero longer than implied by current macroeconomic conditions is particularly effective at easing contractions in demand in the presence of countercyclical unemployment risk and low interest rates.
A model with uninsurable unemployment risk
We study optimal monetary policy conduct through the lens of a Heterogeneous Agents New Keynesian (HANK) model with frictions in the labour market, imperfect unemployment insurance, and an occasionally binding ZLB constraint (ie the interest rate may hit the ZLB during a downturn). The model features two types of households: workers and firm owners, though we abstract from the distributional effects of monetary policy in the paper. Workers face the risk of unemployment and a lower income. The presence of idiosyncratic unemployment risk (the possibility of becoming unemployed, which rises in a downturn) leads to a precautionary savings motive for employed workers. Firm owners, instead, do not face any unemployment risk.
We study the impact of monetary policy in response to a negative demand shock that leads the economy into a liquidity trap. We first analyse the economic outcomes when the central bank only responds to current inflation (strict-inflation targeting), comparing the cases with perfect and imperfect unemployment insurance. Given this benchmark, we then study how the economy responds when the central bank follows the optimal monetary policy and can credibly commit to keeping the interest rate ‘lower for longer’ (often referred to as Odyssean forward guidance).
Finally, we study whether simple policy rules can provide results in line with those under optimal monetary policy. In particular, we consider: (i) a Taylor rule augmented with the lagged value of the shadow policy rate (inertial policy rule); (ii) a Price-Level-Targeting (PLT) rule; (iii) an Average-Inflation-Targeting (AIT) rule.
What we find
Under strict-inflation-targeting, the adverse demand shock has significantly stronger effects under imperfect unemployment insurance (ie when unemployed workers are only partially compensated for their income loss). This is because the fall in demand reduces job creation and raises unemployment risk, which induces households to increase their savings for precautionary reasons. The precautionary-savings effect leads to a stronger fall in inflation and inflation expectations. Since the nominal interest rate is stuck at zero (and there are no other monetary tools in our model), the real interest rate rises, putting further downward pressure on consumption and output.
Under the optimal policy, instead, the central bank responds to the contraction in demand by committing to hold the policy rate at zero longer than implied by current economic conditions. This policy has the effect of increasing inflation expectations and reducing the real interest rate. With the interest rate being kept ‘lower for longer’, agents expect improvements in labour market conditions, which reduces their precautionary saving behaviour in the presence of imperfect unemployment insurance. As a result, market incompleteness (ie imperfect insurance) amplifies the rise in inflation expectations and the reduction in the real interest rate, thereby mitigating the decline in real activity. Specifically, when the central bank sets an optimal path for the policy rate, an adverse demand shock causes smaller contractions in real economic activity under incomplete markets than under perfect unemployment insurance.
Under the three simple rules, there is history dependence in the nominal policy rate: a fall in inflation today leads the policy rate to stay at zero for longer than current conditions alone would imply. As a result, all three rules are particularly effective under imperfect insurance. However, unlike the optimal-policy case, these rules do not fully neutralise the fall in inflation expectations caused by the rise in unemployment risk and precautionary savings.
Policy implications
The paper shows that, if the central bank can commit to holding interest rates lower for longer, then such a policy can be particularly effective in the presence of precautionary savings due to higher uninsurable unemployment risk. Within our model, optimal monetary policy can completely offset the deflationary spirals arising from an increase in precautionary savings. Under simpler and more realistic policy rules, the central bank is still able to significantly mitigate the fall in demand. We conclude that, in practice, monetary policy and unemployment insurance policies are necessary tools to stabilise output in response to demand contractions at the ZLB. By reducing the fall in income associated with unemployment, such insurance policies reduce the precautionary savings motive, which in turn reduces the amplification of negative shocks and risk of being stuck in a liquidity trap.
Dario Bonciani works in the Bank’s Monetary Policy Outlook Division and Joonseok Oh works at Freie Universität Berlin.
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