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Symposium 2015

Virtual Library File - Monetary policy in a downturn: Are financial crises special?

The Challenge

With the onset of the Financial Crisis 2008 many central banks worldwide considerably eased their monetary policies. Some central banks, like the Federal Reserve, the European Central Bank, and the Ba ...

With the onset of the Financial Crisis 2008 many central banks worldwide considerably eased their monetary policies. Some central banks, like the Federal Reserve, the European Central Bank, and the Bank of England, quickly reached the zero-lower-bound on nominal interest rates; these central banks then started conducting extraordinary measures like quantitative easing and forward guidance. There is some consensus that this massive monetary stimulus in the first, ‘acute’, phase of the crisis was largely appropriate, preventing a second Great Depression. However, since then, discussion has turned toward how long monetary policy should remain highly expansionary, because of doubts about the effectiveness of expansionary monetary policy in the aftermath of banking crises. Moreover, expansionary monetary policy over a long period of time might be associated with adverse side effects such as financial instability, asset price bubbles, slower structural adjustment, distorted investment decisions, and inflation.

This paper analyzes empirically the effectiveness of monetary policy during downturns that are associated with financial crises. It finds that (accommodative) monetary policy is less effective during a downturn if the downturn was associated with a financial crisis. Moreover, this paper shows that private sector deleveraging during a downturn helps to induce a stronger recovery.