Description
The purpose of the paper is to improve policy, and also to simplify theory and policy.
Design/methodology/approach – Theory is used in a simple and yet powerful way. Stylized facts
are used. This paper reconsiders the prevailing macroeconomic policy regime, and proposes an
alternative policy regime
Journal of Financial Economic Policy
Thinking afresh about central bank’s interest rate policy
Gurbachan Singh
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Gurbachan Singh , (2015),"Thinking afresh about central bank’s interest rate policy", J ournal of
Financial Economic Policy, Vol. 7 Iss 3 pp. 221 - 232
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Thinking afresh about central
bank’s interest rate policy
Gurbachan Singh
Indian Statistical Institute, New Delhi, India
Abstract
Purpose – The purpose of the paper is to improve policy, and also to simplify theory and policy.
Design/methodology/approach – Theory is used in a simple and yet powerful way. Stylized facts
are used. This paper reconsiders the prevailing macroeconomic policy regime, and proposes an
alternative policy regime.
Findings – The low interest rate policy of the central bank in a recession is tantamount to imposition
of tax on lenders’ interest income and a subsidy for borrowers implying an implicit tax-subsidy scheme.
This scheme may be replaced by a different and explicit tax-subsidy scheme. This may also be
supplemented by lower consumption taxes in a recession. From the viewpoint of stabilization of
aggregate demand, the prevailing policy regime and the proposed policy regime can be equivalent.
However, from the viewpoint of general macroeconomic and asset price stability, the proposed policy
regime is superior, though it has (additional) cost of administration.
Social implications – Macroeconomic and fnancial instability has large social cost. This paper can
be useful in this context, as it has suggestions for improved macroeconomic policy. It also has policy
implications for developing countries and highly indebted countries.
Originality/value – This paper’s innovation goes well beyond refnements to prevailing theories and
policies. Also, it paves the way for further research.
Keywords Financial markets and the macroeconomy, Central banks and their policies,
Fiscal policy
Paper type Research paper
1. Introduction
The policy framework used to deal with macroeconomic and fnancial stability
proved to be inadequate in the years around 2007, which witnessed a major fnancial
crisis and the Great Recession in the USA and elsewhere. The failure of the policy
regime may have come as a surprise to many people. However, a Nobel laureate
commented bluntly much earlier in 1988 specifcally about the Federal Reserve
System (FED), “No major institution in the USA has so poor a record of performance
over so long a period, yet so high a public reputation” (Friedman, 1988). There is also
increasing dissatisfaction with macroeconomic theory in recent years. See, for
example, the following observation:
JEL classifcation – E44, E58, E62
The author appreciates the role of his family and ISI in making this possible. The author thanks
Sunil Ashra, Chetan Ghate and Nirvikar Singh for comments on different versions of the paper.
This paper has been presented as part of my seminar at National Council of Applied Economic
Research (NCAER) on 20 August 2014. The author thanks the organizers, the discussant and the
participants. Finally, the author thanks an anonymous referee for a reviewwhich was very useful
for this revised version of the paper. Any errors are my responsibility.
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1757-6385.htm
Central bank’s
interest rate
policy
221
Received23 August 2014
Revised7 February2015
Accepted12 March2015
Journal of Financial Economic
Policy
Vol. 7 No. 3, 2015
pp. 221-232
©Emerald Group Publishing Limited
1757-6385
DOI 10.1108/JFEP-08-2014-0051
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[…] the current core of macroeconomics […] has begun to confuse the precision it has achieved
about its own world with the precision that it has about the real one. This is dangerous […] we
should be in “broad-exploration mode”. (Caballero, 2010).
The title in a recent paper is “Has Macro progressed?” and the author’s answer is by and
large negative (Fair, 2012). A recent empirical paper concluded:
Available research does not support the viewthat the Federal Reserve System[in its nearly 100
years of existence] has […] tended to err on the side of infation […] That deterioration has not
been compensated for, to any substantial degree, by enhanced stability of real output.
Although a genuine improvement did occur during […] the “Great Moderation”, that
improvement, besides having been temporary, appears to have been due mainly to factors
other than improved monetary policy. Finally, the Fed cannot be credited with having reduced
the frequency of banking panics […] The Fed’s record suggests that […] the only real hope for
a better monetary system lies in regime change. (Selgin et al., 2012).
In response to the different criticisms, there have been attempts to defend the FED
policies (see, for example, Bernanke (2013) which views the failures as part of a learning
process in its 100 years of history). There have been updated statements in recent years
on monetary policy regimes and their performance (Benati and Goodhart, 2011); there
are also revised statements on theory related to monetary policy (see, for example,
Woodford, 2011). There have also been attempts to rethink macroeconomic policy (see,
for example, Blanchard et al., 2010). However, all this (otherwise exceptionally very
good) work is essentially on the same track. So, there is still a need for fresh thinking to
deal with macroeconomic policy issues. This paper is an attempt in this direction. More
specifcally, this paper considers afresh the central bank’s interest rate policy over the
business cycle.
This paper will reconsider the prevailing macroeconomic policy regime and propose
an alternative macroeconomic policy regime. The meaning of the prevailing policy
regime and the proposed policy regime will become clear as we proceed. This paper
covers new ground in so far as policy instruments are concerned. There has been an
inadvertent obfuscation of issues in the way the prevailing policy regime has evolved
over time. This paper simplifes the basic theory and makes the policy issues more
transparent than they are at present.
Given the nature of the “large” macroeconomic problem, several aspects are
considered here, albeit briefy and simply. This paper will:
• focus on the main effects of policies;
• consider a closed economy;
• confne the analysis to policy-induced changes in asset prices rather than fnancial
stability more generally;
• abstract from political economy issues in the short run; and
• include a limited review of the large literature.
Though this paper provides an alternative way of thinking, it does not claim to have a
perfect plan but in any case, “[…] the greatest enemy of a good plan is the dream of a
perfect plan” (The Prussian General Clausewitz).
To begin with, it will be shown that from the viewpoint of maintaining aggregate
demand, there can be an equivalence between the prevailing policy regime and the
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proposed policy regime (Section 2). Thereafter, it will be shown that from the viewpoint
of general macroeconomic stability and asset price stability, the equivalence does not
hold; in fact, the proposed policy regime can be superior to the prevailing policy regime
in several ways (Section 3). Though the proposed policy regime is more benefcial than
the prevailing policy regime, it also has (additional) cost. The administrative work can
increase (Section 4). If the cost of the proposed policy regime is small relative to the many
benefts, then there is a rationale for a switch in policy regime. Possible exceptions are
where the public administration does not make much use of information technology (as
is possibly the case in many developing economies) and where there the government has
hardly any credibility to borroweven with adequate safeguards for investors (Section 5).
2. A basic insight and an equivalence result
Take a simplifed viewof a business cycle; this has a recession and a boom. Consider two
groups of economic agents – savers, and investors in projects. For simplicity, let us view
households and frms as savers and investors, respectively. A stylized version of the
interest rate policy of the central bank over the business cycle is as follows. In a recession
when the central bank reduces the interest rate to encourage investment, the interest
incomes of households fall and the interest costs of frms decrease. It is as if a tax is
imposed on interest incomes of households and a subsidy is given on interest costs of
frms. We may say that there is an implicit tax-subsidy scheme at work, which is inbuilt
into the prevailing interest rate policy of the central bank in a recession.
In a boom, the central bank is expected to do the opposite of what it does in a
recession; it is expected to increase interest rates. In this case, there is a rise in interest
incomes of households and a rise in interest costs of frms. Now, it is as if a subsidy is
given to households and a tax is levied on frms in a boom. We may say that there is an
implicit tax-subsidy scheme at work in a boomjust as there is one at work in a recession,
though the benefciaries and losers in a boom are different from those in a recession:
P1a. Under the prevailing policy regime, an implicit tax-subsidy scheme is inbuilt
into the typical central bank’s interest rate policy over the business cycle.
The insight in P1a paves the way for an alternative policy regime. Consider the case
where the central bank does not vary its interest rate for the purpose of stabilizing
investment demand in a business cycle. So there is no implicit tax-subsidy scheme of the
kind encountered above. Instead, the treasury adopts a different scheme. This will,
hereafter, be referred to as the explicit tax-subsidy scheme.
The proposed policy regime is that the treasury should have the constitutional
mandate to give an explicit subsidy on interest costs of frms in a recession. Such a
constitutional mandate can reduce, if not avoid, delays. With a subsidy on interest costs,
there is an effective reduction in interest rate for frms during the recession. So,
investment can increase after the treasury intervenes in a recession. In a boom, there can
be an opposite policy; the treasury can have the constitutional mandate and obligation to
impose a tax on interest costs of frms[1]. This is an effective increase in the interest rate
for frms in a boom, which can discourage excess investment. All this helps to stabilize
output over the business cycle. Note that the proposed policy involves only frms; there
is no tax or subsidy for households:
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P1b. Under the proposed policy regime, an explicit tax-subsidy scheme by the
treasury can be used for stabilization of investment (and output more
generally) over the business cycle.
The proposed explicit subsidy on interest cost on investment is, in practice, qualitatively
similar to investment tax credit, which is a tax beneft that the government often gives to
encourage investment. Some other related precedents to the proposed scheme in the
literature include a subsidy to frms to boost employment in a recession (Phelps, 1994),
and a Pigouvian tax to deal with externalities in Macroeconomics (Jeanne and Korinek,
2010).
The explicit tax-subsidy scheme is obviously a fscal policy. However, this is
different fromthe standard Keynesian fscal policy, which is by and large about generally
increasing government expenditure and reducing taxes in a recession. The explicit
tax-subsidy scheme is relatively more specifc; it is for varying the effective interest rate
for investing frms.
The central bank’s prevailing interest rate policy is not a substitute for Keynesian
fscal policy. As the explicit tax-subsidy scheme proposed in this paper is a
substitute for the prevailing interest rate policy of the central bank, it follows that
the proposed explicit tax-subsidy scheme is also not a substitute for Keynesian fscal
policy.
Tax-subsidy schemes usually attract a lot of attention. However, this is not true of the
implicit tax-subsidy scheme that is built into the central bank’s interest rate policy
at present. Why? There are various reasons. The implicit tax-subsidy scheme is, as the
name suggests, not explicit. It is usually not recognized that tax and subsidy are
involved in the prevailing policy. Also, there is a natural tendency to associate
tax-subsidy schemes with the treasury and not with the central bank. As the implicit
tax-subsidy scheme is implemented by the central bank and not the treasury, it is not
clearly understood. Finally, the implicit tax on savers is equal to the implicit subsidy for
investing entities in a recession. So, there is a balanced implicit budget related to the
implicit tax-subsidy scheme. Now, a balanced budget is not worrisome and so it hardly
draws attention. In the process, the implicit tax-subsidy scheme itself does not draw
attention.
The central bank has a balance in its implicit budget in each period in a recession as
well as in a boom. Obviously, then it has an implicit balanced inter-temporal budget.
Next, consider the explicit tax-subsidy scheme; the treasury runs a defcit in a recession
and a surplus in a boom. However, there is no inter-temporal imbalance in the
government’s budget related to the scheme:
P1c. The central bank has a balanced (implicit) budget related to its interest rate
policy in each period. The treasury can have an inter-temporal balance in its
budget related to the explicit tax-subsidy scheme.
It may be of academic interest only but note that the provision of a constitutional
mandate alongside an obligation to use the explicit tax-subsidy scheme in a boomavoids
the possible problem of dynamic inconsistency in a boom. Also, a recession may be
characterized by low animal spirits. A subsidy in a recession can be a lot more valuable
than the perceived cost of a tax in a boom. It follows that Ricardian Equivalence does not
hold; the beneft of a subsidy in a recession does not cancel out the burden of a tax in a
boom.
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So far, the effect of the central bank’s interest rate policy on investment was
considered. Let us now consider its possible effect on consumption. This can happen
through the effect of a change in interest rate on asset prices, which can in turn affect
consumption through wealth effect. Some of the material in the rest of this section is
familiar in the literature. However, there is a need to integrate this with the rest of the
unfamiliar material in the paper.
Achange in interest rate by the central bank can affect asset prices in two ways. First,
central bank intervention can stabilize output over a business cycle and possibly also
stabilize corporate profts. Accordingly, the fundamental value of assets can rise
somewhat. Assume, for simplicity, that this effect is zero. Second, the low interest rate
policy in a recession is typically followed by a high interest rate policy in a boom. So the
“overall net change” in interest rate in a business cycle as a whole can have limited effect
on fundamental values of assets. So, asset prices will not be much affected in an effcient
market. However, if the market is not effcient, there can be a rise in asset prices due to
an induced and “temporary” fall in interest rates (for related issues, see Baker and
Wurgler, 2013). This can, in turn, have a (positive) wealth effect on consumption. At a
later stage, when the central bank increases the interest rate, asset prices can fall[2]. Now
consumption demand can fall through a (negative) wealth effect:
P2a. If fnancial markets are ineffcient, then central bank’s interest rate policy can
stabilize consumption demand over the business cycle through wealth effect of
changed asset prices.
The question nowis whether there is an alternative way to affect consumption demand.
Suppose that the policymakers do not change the interest rate over the business cycle
and thereby avoid the effect on consumption demand through a change in asset prices.
Instead, it is proposed that the treasury temporarily reduces consumption taxes (or even
gives subsidies) in a recession. Subsequently, when the economy is in a boom, the
policymakers can temporarily increase consumption taxes. This set of policy changes
can induce an increase in consumption demand in a recession and a contraction in
consumption demand during a boom:
P2b. Variable consumption taxes can stabilize consumption demand over the
business cycle.
For reasons similar to those behind P1c, we have:
P2c. Due to the central bank’s interest rate policy over the business cycle, there is a
balance in the central bank’s (implicit) budget in each period. Related to the
treasury’s policy of varying consumption taxes over the business cycle, there
can be a balance in the treasury’s (explicit) inter-temporal budget.
This section has considered two separate fscal policies, one can affect investment and
other can affect consumption. The effects of the central bank’s interest rate policy on
investment and on consumption over the business cycle were considered separately for
reasons of pedagogy. However, it is a case of two effects of one and the same policy. It is
time to put the pieces together, and introduce some qualifcations. Assume for now that
the zero lower bound (ZLB) on the interest rate is not hit, so that the central bank can
indeed use its interest rate policy. Further, assume for nowthat there are no (additional)
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administrative costs related to the new proposed policy. These will be discussed
separately later. The overall conclusion in this section is as follows:
P3. From the viewpoint of maintaining aggregate demand in the economy over a
business cycle, there is an equivalence between: (a) the central bank’s interest
rate policy (given that the ZLB on interest rate is not hit and that fnancial
markets are ineffcient), and (b) the treasury’s explicit tax-subsidy scheme, and
the scheme of variable consumption taxes (given that there are no (additional)
administrative costs).
Observe that in case (b), there is no need to assume that fnancial markets are ineffcient.
It is possibly true that fnancial markets are ineffcient at present, making this a
harmless assumption in case (a). However, if fnancial markets were to somehowbecome
effcient in future, then the proposed policy regime will be more robust than the
prevailing policy regime.
P3 is a useful benchmark result. The next section will show the conditions under
which the equivalence does not hold.
3. The superiority of the proposed policy regime
When the treasury uses the explicit tax-subsidy scheme, the change is in the effective
interest rate for frms only. There is no general change in the interest rates in the
economy. In particular, there are no (direct or signifcant) changes in interest rates in the
fnancial markets. So asset prices are somewhat immune to the targeted change in
the effective interest rate for investing entities in the real sector under the proposed
policy regime. In contrast, under the prevailing interest rate policy of the central bank,
asset prices can, as seen already, fuctuate in response to changes in interest rates.
Accordingly, asset prices can be more stable under the proposed policy regime than
under the prevailing policy regime.
It is true that if asset prices are not pushed up through a reduction in central bank’s
interest rate, there will be no wealth effect which can push up consumption demand.
However, recall that the proposed policy regime includes a variation of consumption
taxes over the business cycle, so that the consumption demand can be pushed up in a
recession through this other route. This obviates the need for using central bank’s
interest rate policy to affect asset prices which can in turn affect consumption through
wealth effect:
P4a. Asset prices can be more stable if (variable) consumption taxes are used to
stabilize consumption demand than if the central bank uses its interest rate
policy.
Under the prevailing policy regime, once a recession ends or is seen to be approaching an
end, there is a rationale for the central bank to end low interest rates. However, an
increase in interest rates can lead to a fall in asset prices, and to possible fnancial
instability more generally in the economy. There can then be a dilemma for
policymakers under the prevailing policy regime. In the process, there can be a costly
delay in ending the low interest rate policy (for related issues, see Giavazzi and
Giovannini, 2010). Consider nowthe proposed policy. Under this policy, asset prices are
not (signifcantly or directly) affected due to the explicit tax-subsidy scheme or due to
the change in consumption taxes. Hence:
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P4b. An exit from the proposed policy is easier than an exit from the prevailing
policy.
As is well known and mentioned above, the central bank’s prevailing interest rate policy
works so long as the ZLB on interest rate is not hit. It is interesting, however, that the
proposed policy can be used even if the ZLBis hit. The reason is simple: the central bank
does not need to lower the interest rate. Instead, the treasury needs to give out an explicit
subsidy on the interest cost incurred by frms, so that they are encouraged to increase
investment. Such a subsidy can be given to frms regardless of where the interest rate
stands; the fact that it is zero or that it cannot be lower than zero does not matter:
P4c. The interest rate policy for stabilization of investment demand can be used by
the central bank so long as the ZLB on interest rate is not hit. This is not a
constraint in case of the explicit tax-subsidy scheme.
Under the prevailing policy regime, if there is a big recession, then the central bank can
infuence the long-term interest rate after the short-term interest has hit the ZLB. This
may be done through a programme of large-scale asset purchase, more familiar as
quantitative easing (QE) (Bernanke, 2013). It is interesting that under the proposed
policy regime, there is no need for QE. The reason is simple. The use of an explicit
tax-subsidy scheme, which can be implemented even if the short-term interest rate hits
the ZLB, obviates the need for a QE programme:
P4d. To overcome a big recession, the central bank’s low interest rate policy to
stabilize demand needs to be supplemented by QE. This is not required if the
explicit subsidy scheme is used.
It will help to get some idea about the size of the proposed explicit subsidy that may be
needed in a big recession. Consider an economy wherein investment is only 7 per cent of
gross domestic product (GDP) but it needs to be increased by another 8 percentage
points; for this, suppose that the interest rate needs to be lowered by 5 percentage points.
This scenario is close to that considered by Buiter (2009). In this scenario, if the treasury
needs to provide an explicit subsidy for the entire investment in the economy, the cost of
subsidy for the treasury is 0.75 per cent of GDP[0.75 ?(0.07 ?0.08) ?5] in a given year.
Alternatively, if the treasury needs to provide a subsidy for the additional investment
only, the cost of the subsidy is 0.40 per cent of GDP [0.40 ?0.08 ?5].
The proposed explicit tax-subsidy scheme is a pragmatic and workable policy. The
reason is that the proposed policy is only a replacement of the prevailing policy under
which in any case an implicit subsidy of a similar size is given to frms on their interest
costs. Furthermore, the proposed policy includes not only a subsidy in recession but also
a tax in a boom. This avoids an inter-temporal defcit. Finally, the size of the proposed
subsidy is actually small, relative to the size of the huge fscal stimulus in the USAafter
2007-2008.
The focus so far has been on stabilizing output in the economy. However, it is
important to consider other objectives of the policymakers. Under the prevailing policy,
the typical central bank may be thought of as having to take care of two objectives (low
and stable infation, and full employment) with one instrument (interest rate). The
proposed policy is as follows. The central bank can use its single instrument to take care
of only one objective, viz., maintaining lowand stable infation. The treasury can use its
explicit tax-subsidy scheme to achieve the other objective, viz., maintaining full
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employment. This paves the way for the central bank to adopt and to stick to infation
targeting:
P4e. The central bank is less constrained in adopting or sticking to infation
targeting under the proposed policy regime, than it is under the prevailing
policy regime.
Let us take P4d and P4e together. The QEprogramme in recent years has, it appears, not
been in confict with maintaining low and stable infation. However, a policy regime
needs to have the wherewithal to deal with the general case. Accordingly, the proposed
policy regime helps.
Though the terms prevailing policy regime and proposed policy regime have been
used repeatedly, we can now be more precise about the meanings.
The prevailing policy regime includes:
• the central bank’s standard interest rate policy, and occasional use of QE; and
• the treasury’s standard Keynesian fscal policy.
The proposed policy regime includes:
• the central bank’s interest rate policy to maintain low and stable infation; and
• the treasury’s explicit tax-subsidy scheme, variable consumption taxes and
reformed Keynesian fscal policy to maintain full employment.
A few comments are in order. First, the reformed Keynesian fscal policy refers to the
Keynesian fscal policy with the constitutional obligation that a “negative stimulus”
must be used in booms just as the usual (positive) stimulus is used in recessions; this
avoids any signifcant imbalance in the government’s inter-temporal budget related to
the policy. Second, there can be some ambiguity in nomenclature in the literature. Some
may classify the use of variable consumption taxes within the category of the Keynesian
fscal policy; this paper has put it as a separate category. Third, the proposed policy
regime includes an altogether new policy instrument, viz., the treasury’s explicit
tax-subsidy scheme.
This section suggests that the proposed policy regime is superior to the prevailing
policy regime. However, there is a fip side to the former regime.
4. The fip side of the proposed policy regime
Under the explicit tax-subsidy scheme, in a recession, the treasury is liable to pay a
subsidy to each investing entity separately (or adjust its collection of usual taxes after
subtracting the specifc subsidy under consideration here). Similarly, in a boom, it needs
to collect a tax from each investing entity. So there is an administrative cost involved.
This kind of an administrative cost is absent in case of central bank’s implicit
tax-subsidy scheme, though there can be some other small costs[3]:
P5. The administrative cost of the prevailing policy regime is far less than that in the
case of the proposed policy regime.
Though the proposed policy involves additional administrative work, note that the
investing entities need to fle tax returns in any case. The only change required under the
proposed policy regime is that the tax returns can include specifc implications of
the proposed explicit tax-subsidy scheme. So the administrative cost of the proposed
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scheme, though positive, need not be large, given the fxed cost of preparing and fling
tax returns. Accounting practices and preparation of tax statements can rely heavily on
information technology these days. With costs of information technology falling
dramatically over time, the additional administrative burden need not be large though
the initial unfamiliarity may be bothersome.
It can be a somewhat different story in developing economies. The tax administration
can be under-developed. This is particularly true where the use of information
technology is concerned. In some of these economies, the administrative diffculties can
be much more than a mere qualifcation to the argument that the proposed policy regime
can be far more benefcial than the prevailing policy regime. There is a policy lesson
here. Many developing economies need to develop not just economically and fnancially
but also administratively. This aspect is often ignored in the literature on economic
development (see, for instance, Ray, 2008). There is need for a change.
5. A perspective
The prevailing policy regime and the proposed policy regime were compared in P3. This
was about an equivalence between the two policy regimes from the viewpoint of
maintaining aggregate demand. Now:
P6a. From the viewpoint of general macroeconomic stability and asset price
stability, the proposed policy regime is superior to the prevailing policy regime
if the benefts of the proposed regime vis-a`-vis the prevailing regime (in the fve
parts of P4) are more than the additional cost (in P5).
If the proposed policy is adopted in a boom, then the treasury gets a surplus. It can
always store this surplus till the time of a recession which is when the funds are
needed. So there is, in practice, no diffculty in implementation of the proposed
policy, if it is adopted in a boom by any country for which it is desirable to make a
switch.
Next, consider the case where the proposed policy is adopted initially in a recession.
In this case, there can be a defcit to begin with. This needs to be fnanced by investors
in the debt market. It is true that the proposed policy regime includes constitutional
provisions as safeguards for investors. Recall that the constitutional provisions in the
proposed policy regime include the obligation to use (additional) taxes in booms, which
can be used to repay the investors. Even though the treasury will have no inter-temporal
budget constraint related to the proposed new policies, investors may still be reluctant;
perceptions based on past experience may matter even if that is in the context of a
different policy regime. Under such conditions, fnancing a defcit due to the proposed
policy may be diffcult:
P6b. If the proposed policy regime is superior to the prevailing policy regime,
“normal” countries can actually make a switch but this may not be possible for
countries that are “abnormal” and in a recession; they may be able to adopt the
new policy regime in future.
Abnormal countries here refer to those that have large public debt and little fscal space.
Which countries are “normal” and which are “abnormal” in practice? Table I shows the
debt-GDP ratios for four different groups of countries.
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In Table I, it is in one group of countries, viz., the advanced economies that the
average debt-GDP ratio is high. However, even in this group it is not the case that all
advanced economies have fscal diffculties. The proposal is therefore more useful
than it appears at frst glance even if we consider advanced economies only.
Table I depicts the recent situation. However, the proposed policy regime is not just
for the present day economies but also for the future. Even if some economies are unable
to adopt the proposed policy regime now, this does not rule out their usefulness in future.
Ball et al. (2014) are not pessimistic about the government’s budget constraint in the
context of overcoming the Great Recession in the USA. Their conclusion can hold a
fortiori in case of the proposed policy regime, as it also includes a constitutional
safeguard for investors.
As is clear fromTable I, the fscal situation in the last three groups of countries on an
average appears to be comfortable. It may be said that many of these countries should
have no diffculty in adopting the proposed policy regime in so far as the debt-GDP ratio
is concerned. However, many of these may have an administration that does not
extensively use information technology; this can be a binding constraint in such
countries at present.
6. Conclusion
The basic insight in this paper is that the central bank’s interest rate policy has an
inbuilt implicit tax-subsidy scheme. This insight paved the way for a new policy
regime that is proposed here. This regime has an additional fscal policy instrument.
It was shown that the proposed policy regime has several benefts over the
prevailing policy regime. First, it enables the asset markets to have more stable
prices. Second, an exit from the proposed policy is relatively easy. Third, it can be
used even when the ZLB on the interest rate is hit. Fourth, it obviates the need for QE
programme. Fifth, it paves the way to adopt and to stick to infation, targeting
without sacrifcing the other objective of full employment. Last but not the least, it
is more transparent.
Though the proposed policy can accomplish more than the prevailing policy, it has a
cost of administration. If this cost is small (as it may well be with considerable use of
information technology in many advanced countries and in some emerging economies),
it is desirable to make a switch fromthe prevailing policy regime to the proposed policy
regime. Many developing economies and some highly indebted economies may,
however, have to carry out other reforms before the proposed policy regime can be
adopted there. Such reforms would be benefcial for themin any case. This paper shows
that there is an additional reason for such reforms.
Table I.
Debt as per cent of
GDP in 2013
Group of countries Gross debt Net debt
Advanced economies 106.2 72.5
Emerging market and middle income economies 39.7 17.0
Low income countries 31.0 23.2
Oil producers 22.2 Not available
Source: Data extracted from Table 1.2, p. 4, International Monetary Fund (2014)
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Apolicy regime needs to be thought over in advance with a vision for the future and not
just with a view of the current realities in some countries. In this context, the proposed
policy regime can be a part of the preparation to reduce macroeconomic and fnancial
instability in future.
Notes
1. This provision is in line with the legislation that attempts to ensure that the treasury has fscal
responsibility to maintain reasonable debt-GDP ratio.
2. Gali (2013) shows that a fall in interest rate can lead to a fall in the size of a bubble in asset
prices. However, the analysis is theoretical and in the context of a rational bubble.
3. There can also be some increase in administrative costs due to changes that need to be made
to consumption taxes. This paper ignores these as they are likely to be small.
References
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Constantinides, G.M., Harris, M. and Stulz, R.M. (Ed.), Handbook of the Economics of
Finance, Chapter 5, Volume 2B, Elsevier B.V, Amsterdam.
Ball, L., DeLong, B. and Summers, L. (2014), “Fiscal policy and full employment”, Working Paper,
Centre on Budget and Policy Priorities, Washington, 2 April, available at: www.
pathtofullemployment.org/wp-content/uploads/2014/04/delong_summers_ball.pdf
Benati, L. and Goodhart, C. (2011), “Monetary policy regimes and economic performance: the
historical record, 1979-2008”, in Friedman, B.M. and Woodford, M. (Eds), Handbook of
Monetary Economics, Chapter 21, Volume 3B, Elsevier, North Holland, San Diego.
Bernanke, B.S. (2013), “A century of US central banking: goals, frameworks, accountability”, The
Journal of Economic Perspectives, Vol. 7 No. 4, pp. 3-16.
Blanchard, O., Delláriccia, G. and Mauro, P. (2010), “Rethinking macroeconomic policy”, Journal of
Money, Credit and Banking, Vol. 42 No. S1, pp. 119-215.
Buiter, W.H. (2009), “Negative nominal interest rates: three ways to overcome the zero lower
bound”, The North American Journal of Economics and Finance, Vol. 20 No. 3, pp. 213-238.
Caballero, R.J. (2010), “Macroeconomics after the crisis: time to deal with the pretense-
of-knowledge syndrome”, Journal of Economic Perspectives, Vol. 24 No. 4, pp. 85-102.
Fair, R.C. (2012), “Has macro progressed?”, Journal of Macroeconomics, Vol. 34 No. 1, pp. 2-10.
Friedman, M. (1988), “The FED has no clothes”, The Wall Street Journal, 15 April.
Gali, J. (2013), “Monetary policy and rational asset price bubbles”, NBER Working Paper 18806,
February, Massachusetts, Cambridge.
Giavazzi, F. and Giovannini, A. (2010), “Central banks and fnancial system”, NBER Working
Paper No. 16228, National Bureau of Economic Research, July, available at: www.nber.org/
papers/w16228
Jeanne, O. and Korinek, A. (2010), “Excessive volatility in capital fows: a Pigouvian taxation
approach”, American Economic Review: Papers & Proceedings, Vol. 100 No. 2, pp. 403-407.
Phelps, E.S. (1994), “Low-wage employment subsidies versus the welfare state”, American
Economic Review, Vol. 84 No. 2, pp. 54-58.
Ray, D. (2008), “Development economics”, in Durlauf, S.N. and Blume, L.E. (Eds), The New
Palgrave Dictionary of Economics, 2nd ed., Palgrave Macmillan, New York, Vol. 2,
pp. 468-483.
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Selgin, G., Lastrapes, W.D. and White, L.H. (2012), “Has the FED been a failure?”, Journal of
Macroeconomics, Vol. 34 No. 3, pp. 569-596.
Woodford, M. (2011), “Optimal monetary stabilization policy”, in Friedman, B.M. and
Woodford, M. (Eds), Handbook of Monetary Economics, Chapter 14, Volume 3B, Elsevier,
North Holland, San Diego.
Further reading
International Monetary Fund (2014), “Fiscal monitor – back to work: how fscal policy can help”,
World Economic and Financial Surveys, October.
About the author
Gurbachan Singh is an independent Economist, and a visiting faculty member at the ISI, Delhi
Centre since January, 2010. He teaches an optional course on “Theory of Finance II: Finance and
Volatility” in the last semester of Master of Science in Quantitative Economics (MSQE)
programme. He takes some lectures in the MBA programme at Management Development
Institute, Gurgaon. His area of research is macro-fnancial stability. He has published papers in
academic journals. He have authored a book on banking crises. Much of the work is policy-
motivated and is geared towards fnding possible ways to have a more stable macro-fnancial
system. He has a PhDfromISI and MAfromDelhi School of Economics. Gurbachan Singh can be
contacted at: [email protected]
For instructions on how to order reprints of this article, please visit our website:
www.emeraldgrouppublishing.com/licensing/reprints.htm
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doc_325861557.pdf
The purpose of the paper is to improve policy, and also to simplify theory and policy.
Design/methodology/approach – Theory is used in a simple and yet powerful way. Stylized facts
are used. This paper reconsiders the prevailing macroeconomic policy regime, and proposes an
alternative policy regime
Journal of Financial Economic Policy
Thinking afresh about central bank’s interest rate policy
Gurbachan Singh
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Thinking afresh about central
bank’s interest rate policy
Gurbachan Singh
Indian Statistical Institute, New Delhi, India
Abstract
Purpose – The purpose of the paper is to improve policy, and also to simplify theory and policy.
Design/methodology/approach – Theory is used in a simple and yet powerful way. Stylized facts
are used. This paper reconsiders the prevailing macroeconomic policy regime, and proposes an
alternative policy regime.
Findings – The low interest rate policy of the central bank in a recession is tantamount to imposition
of tax on lenders’ interest income and a subsidy for borrowers implying an implicit tax-subsidy scheme.
This scheme may be replaced by a different and explicit tax-subsidy scheme. This may also be
supplemented by lower consumption taxes in a recession. From the viewpoint of stabilization of
aggregate demand, the prevailing policy regime and the proposed policy regime can be equivalent.
However, from the viewpoint of general macroeconomic and asset price stability, the proposed policy
regime is superior, though it has (additional) cost of administration.
Social implications – Macroeconomic and fnancial instability has large social cost. This paper can
be useful in this context, as it has suggestions for improved macroeconomic policy. It also has policy
implications for developing countries and highly indebted countries.
Originality/value – This paper’s innovation goes well beyond refnements to prevailing theories and
policies. Also, it paves the way for further research.
Keywords Financial markets and the macroeconomy, Central banks and their policies,
Fiscal policy
Paper type Research paper
1. Introduction
The policy framework used to deal with macroeconomic and fnancial stability
proved to be inadequate in the years around 2007, which witnessed a major fnancial
crisis and the Great Recession in the USA and elsewhere. The failure of the policy
regime may have come as a surprise to many people. However, a Nobel laureate
commented bluntly much earlier in 1988 specifcally about the Federal Reserve
System (FED), “No major institution in the USA has so poor a record of performance
over so long a period, yet so high a public reputation” (Friedman, 1988). There is also
increasing dissatisfaction with macroeconomic theory in recent years. See, for
example, the following observation:
JEL classifcation – E44, E58, E62
The author appreciates the role of his family and ISI in making this possible. The author thanks
Sunil Ashra, Chetan Ghate and Nirvikar Singh for comments on different versions of the paper.
This paper has been presented as part of my seminar at National Council of Applied Economic
Research (NCAER) on 20 August 2014. The author thanks the organizers, the discussant and the
participants. Finally, the author thanks an anonymous referee for a reviewwhich was very useful
for this revised version of the paper. Any errors are my responsibility.
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1757-6385.htm
Central bank’s
interest rate
policy
221
Received23 August 2014
Revised7 February2015
Accepted12 March2015
Journal of Financial Economic
Policy
Vol. 7 No. 3, 2015
pp. 221-232
©Emerald Group Publishing Limited
1757-6385
DOI 10.1108/JFEP-08-2014-0051
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[…] the current core of macroeconomics […] has begun to confuse the precision it has achieved
about its own world with the precision that it has about the real one. This is dangerous […] we
should be in “broad-exploration mode”. (Caballero, 2010).
The title in a recent paper is “Has Macro progressed?” and the author’s answer is by and
large negative (Fair, 2012). A recent empirical paper concluded:
Available research does not support the viewthat the Federal Reserve System[in its nearly 100
years of existence] has […] tended to err on the side of infation […] That deterioration has not
been compensated for, to any substantial degree, by enhanced stability of real output.
Although a genuine improvement did occur during […] the “Great Moderation”, that
improvement, besides having been temporary, appears to have been due mainly to factors
other than improved monetary policy. Finally, the Fed cannot be credited with having reduced
the frequency of banking panics […] The Fed’s record suggests that […] the only real hope for
a better monetary system lies in regime change. (Selgin et al., 2012).
In response to the different criticisms, there have been attempts to defend the FED
policies (see, for example, Bernanke (2013) which views the failures as part of a learning
process in its 100 years of history). There have been updated statements in recent years
on monetary policy regimes and their performance (Benati and Goodhart, 2011); there
are also revised statements on theory related to monetary policy (see, for example,
Woodford, 2011). There have also been attempts to rethink macroeconomic policy (see,
for example, Blanchard et al., 2010). However, all this (otherwise exceptionally very
good) work is essentially on the same track. So, there is still a need for fresh thinking to
deal with macroeconomic policy issues. This paper is an attempt in this direction. More
specifcally, this paper considers afresh the central bank’s interest rate policy over the
business cycle.
This paper will reconsider the prevailing macroeconomic policy regime and propose
an alternative macroeconomic policy regime. The meaning of the prevailing policy
regime and the proposed policy regime will become clear as we proceed. This paper
covers new ground in so far as policy instruments are concerned. There has been an
inadvertent obfuscation of issues in the way the prevailing policy regime has evolved
over time. This paper simplifes the basic theory and makes the policy issues more
transparent than they are at present.
Given the nature of the “large” macroeconomic problem, several aspects are
considered here, albeit briefy and simply. This paper will:
• focus on the main effects of policies;
• consider a closed economy;
• confne the analysis to policy-induced changes in asset prices rather than fnancial
stability more generally;
• abstract from political economy issues in the short run; and
• include a limited review of the large literature.
Though this paper provides an alternative way of thinking, it does not claim to have a
perfect plan but in any case, “[…] the greatest enemy of a good plan is the dream of a
perfect plan” (The Prussian General Clausewitz).
To begin with, it will be shown that from the viewpoint of maintaining aggregate
demand, there can be an equivalence between the prevailing policy regime and the
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proposed policy regime (Section 2). Thereafter, it will be shown that from the viewpoint
of general macroeconomic stability and asset price stability, the equivalence does not
hold; in fact, the proposed policy regime can be superior to the prevailing policy regime
in several ways (Section 3). Though the proposed policy regime is more benefcial than
the prevailing policy regime, it also has (additional) cost. The administrative work can
increase (Section 4). If the cost of the proposed policy regime is small relative to the many
benefts, then there is a rationale for a switch in policy regime. Possible exceptions are
where the public administration does not make much use of information technology (as
is possibly the case in many developing economies) and where there the government has
hardly any credibility to borroweven with adequate safeguards for investors (Section 5).
2. A basic insight and an equivalence result
Take a simplifed viewof a business cycle; this has a recession and a boom. Consider two
groups of economic agents – savers, and investors in projects. For simplicity, let us view
households and frms as savers and investors, respectively. A stylized version of the
interest rate policy of the central bank over the business cycle is as follows. In a recession
when the central bank reduces the interest rate to encourage investment, the interest
incomes of households fall and the interest costs of frms decrease. It is as if a tax is
imposed on interest incomes of households and a subsidy is given on interest costs of
frms. We may say that there is an implicit tax-subsidy scheme at work, which is inbuilt
into the prevailing interest rate policy of the central bank in a recession.
In a boom, the central bank is expected to do the opposite of what it does in a
recession; it is expected to increase interest rates. In this case, there is a rise in interest
incomes of households and a rise in interest costs of frms. Now, it is as if a subsidy is
given to households and a tax is levied on frms in a boom. We may say that there is an
implicit tax-subsidy scheme at work in a boomjust as there is one at work in a recession,
though the benefciaries and losers in a boom are different from those in a recession:
P1a. Under the prevailing policy regime, an implicit tax-subsidy scheme is inbuilt
into the typical central bank’s interest rate policy over the business cycle.
The insight in P1a paves the way for an alternative policy regime. Consider the case
where the central bank does not vary its interest rate for the purpose of stabilizing
investment demand in a business cycle. So there is no implicit tax-subsidy scheme of the
kind encountered above. Instead, the treasury adopts a different scheme. This will,
hereafter, be referred to as the explicit tax-subsidy scheme.
The proposed policy regime is that the treasury should have the constitutional
mandate to give an explicit subsidy on interest costs of frms in a recession. Such a
constitutional mandate can reduce, if not avoid, delays. With a subsidy on interest costs,
there is an effective reduction in interest rate for frms during the recession. So,
investment can increase after the treasury intervenes in a recession. In a boom, there can
be an opposite policy; the treasury can have the constitutional mandate and obligation to
impose a tax on interest costs of frms[1]. This is an effective increase in the interest rate
for frms in a boom, which can discourage excess investment. All this helps to stabilize
output over the business cycle. Note that the proposed policy involves only frms; there
is no tax or subsidy for households:
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P1b. Under the proposed policy regime, an explicit tax-subsidy scheme by the
treasury can be used for stabilization of investment (and output more
generally) over the business cycle.
The proposed explicit subsidy on interest cost on investment is, in practice, qualitatively
similar to investment tax credit, which is a tax beneft that the government often gives to
encourage investment. Some other related precedents to the proposed scheme in the
literature include a subsidy to frms to boost employment in a recession (Phelps, 1994),
and a Pigouvian tax to deal with externalities in Macroeconomics (Jeanne and Korinek,
2010).
The explicit tax-subsidy scheme is obviously a fscal policy. However, this is
different fromthe standard Keynesian fscal policy, which is by and large about generally
increasing government expenditure and reducing taxes in a recession. The explicit
tax-subsidy scheme is relatively more specifc; it is for varying the effective interest rate
for investing frms.
The central bank’s prevailing interest rate policy is not a substitute for Keynesian
fscal policy. As the explicit tax-subsidy scheme proposed in this paper is a
substitute for the prevailing interest rate policy of the central bank, it follows that
the proposed explicit tax-subsidy scheme is also not a substitute for Keynesian fscal
policy.
Tax-subsidy schemes usually attract a lot of attention. However, this is not true of the
implicit tax-subsidy scheme that is built into the central bank’s interest rate policy
at present. Why? There are various reasons. The implicit tax-subsidy scheme is, as the
name suggests, not explicit. It is usually not recognized that tax and subsidy are
involved in the prevailing policy. Also, there is a natural tendency to associate
tax-subsidy schemes with the treasury and not with the central bank. As the implicit
tax-subsidy scheme is implemented by the central bank and not the treasury, it is not
clearly understood. Finally, the implicit tax on savers is equal to the implicit subsidy for
investing entities in a recession. So, there is a balanced implicit budget related to the
implicit tax-subsidy scheme. Now, a balanced budget is not worrisome and so it hardly
draws attention. In the process, the implicit tax-subsidy scheme itself does not draw
attention.
The central bank has a balance in its implicit budget in each period in a recession as
well as in a boom. Obviously, then it has an implicit balanced inter-temporal budget.
Next, consider the explicit tax-subsidy scheme; the treasury runs a defcit in a recession
and a surplus in a boom. However, there is no inter-temporal imbalance in the
government’s budget related to the scheme:
P1c. The central bank has a balanced (implicit) budget related to its interest rate
policy in each period. The treasury can have an inter-temporal balance in its
budget related to the explicit tax-subsidy scheme.
It may be of academic interest only but note that the provision of a constitutional
mandate alongside an obligation to use the explicit tax-subsidy scheme in a boomavoids
the possible problem of dynamic inconsistency in a boom. Also, a recession may be
characterized by low animal spirits. A subsidy in a recession can be a lot more valuable
than the perceived cost of a tax in a boom. It follows that Ricardian Equivalence does not
hold; the beneft of a subsidy in a recession does not cancel out the burden of a tax in a
boom.
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So far, the effect of the central bank’s interest rate policy on investment was
considered. Let us now consider its possible effect on consumption. This can happen
through the effect of a change in interest rate on asset prices, which can in turn affect
consumption through wealth effect. Some of the material in the rest of this section is
familiar in the literature. However, there is a need to integrate this with the rest of the
unfamiliar material in the paper.
Achange in interest rate by the central bank can affect asset prices in two ways. First,
central bank intervention can stabilize output over a business cycle and possibly also
stabilize corporate profts. Accordingly, the fundamental value of assets can rise
somewhat. Assume, for simplicity, that this effect is zero. Second, the low interest rate
policy in a recession is typically followed by a high interest rate policy in a boom. So the
“overall net change” in interest rate in a business cycle as a whole can have limited effect
on fundamental values of assets. So, asset prices will not be much affected in an effcient
market. However, if the market is not effcient, there can be a rise in asset prices due to
an induced and “temporary” fall in interest rates (for related issues, see Baker and
Wurgler, 2013). This can, in turn, have a (positive) wealth effect on consumption. At a
later stage, when the central bank increases the interest rate, asset prices can fall[2]. Now
consumption demand can fall through a (negative) wealth effect:
P2a. If fnancial markets are ineffcient, then central bank’s interest rate policy can
stabilize consumption demand over the business cycle through wealth effect of
changed asset prices.
The question nowis whether there is an alternative way to affect consumption demand.
Suppose that the policymakers do not change the interest rate over the business cycle
and thereby avoid the effect on consumption demand through a change in asset prices.
Instead, it is proposed that the treasury temporarily reduces consumption taxes (or even
gives subsidies) in a recession. Subsequently, when the economy is in a boom, the
policymakers can temporarily increase consumption taxes. This set of policy changes
can induce an increase in consumption demand in a recession and a contraction in
consumption demand during a boom:
P2b. Variable consumption taxes can stabilize consumption demand over the
business cycle.
For reasons similar to those behind P1c, we have:
P2c. Due to the central bank’s interest rate policy over the business cycle, there is a
balance in the central bank’s (implicit) budget in each period. Related to the
treasury’s policy of varying consumption taxes over the business cycle, there
can be a balance in the treasury’s (explicit) inter-temporal budget.
This section has considered two separate fscal policies, one can affect investment and
other can affect consumption. The effects of the central bank’s interest rate policy on
investment and on consumption over the business cycle were considered separately for
reasons of pedagogy. However, it is a case of two effects of one and the same policy. It is
time to put the pieces together, and introduce some qualifcations. Assume for now that
the zero lower bound (ZLB) on the interest rate is not hit, so that the central bank can
indeed use its interest rate policy. Further, assume for nowthat there are no (additional)
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administrative costs related to the new proposed policy. These will be discussed
separately later. The overall conclusion in this section is as follows:
P3. From the viewpoint of maintaining aggregate demand in the economy over a
business cycle, there is an equivalence between: (a) the central bank’s interest
rate policy (given that the ZLB on interest rate is not hit and that fnancial
markets are ineffcient), and (b) the treasury’s explicit tax-subsidy scheme, and
the scheme of variable consumption taxes (given that there are no (additional)
administrative costs).
Observe that in case (b), there is no need to assume that fnancial markets are ineffcient.
It is possibly true that fnancial markets are ineffcient at present, making this a
harmless assumption in case (a). However, if fnancial markets were to somehowbecome
effcient in future, then the proposed policy regime will be more robust than the
prevailing policy regime.
P3 is a useful benchmark result. The next section will show the conditions under
which the equivalence does not hold.
3. The superiority of the proposed policy regime
When the treasury uses the explicit tax-subsidy scheme, the change is in the effective
interest rate for frms only. There is no general change in the interest rates in the
economy. In particular, there are no (direct or signifcant) changes in interest rates in the
fnancial markets. So asset prices are somewhat immune to the targeted change in
the effective interest rate for investing entities in the real sector under the proposed
policy regime. In contrast, under the prevailing interest rate policy of the central bank,
asset prices can, as seen already, fuctuate in response to changes in interest rates.
Accordingly, asset prices can be more stable under the proposed policy regime than
under the prevailing policy regime.
It is true that if asset prices are not pushed up through a reduction in central bank’s
interest rate, there will be no wealth effect which can push up consumption demand.
However, recall that the proposed policy regime includes a variation of consumption
taxes over the business cycle, so that the consumption demand can be pushed up in a
recession through this other route. This obviates the need for using central bank’s
interest rate policy to affect asset prices which can in turn affect consumption through
wealth effect:
P4a. Asset prices can be more stable if (variable) consumption taxes are used to
stabilize consumption demand than if the central bank uses its interest rate
policy.
Under the prevailing policy regime, once a recession ends or is seen to be approaching an
end, there is a rationale for the central bank to end low interest rates. However, an
increase in interest rates can lead to a fall in asset prices, and to possible fnancial
instability more generally in the economy. There can then be a dilemma for
policymakers under the prevailing policy regime. In the process, there can be a costly
delay in ending the low interest rate policy (for related issues, see Giavazzi and
Giovannini, 2010). Consider nowthe proposed policy. Under this policy, asset prices are
not (signifcantly or directly) affected due to the explicit tax-subsidy scheme or due to
the change in consumption taxes. Hence:
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P4b. An exit from the proposed policy is easier than an exit from the prevailing
policy.
As is well known and mentioned above, the central bank’s prevailing interest rate policy
works so long as the ZLB on interest rate is not hit. It is interesting, however, that the
proposed policy can be used even if the ZLBis hit. The reason is simple: the central bank
does not need to lower the interest rate. Instead, the treasury needs to give out an explicit
subsidy on the interest cost incurred by frms, so that they are encouraged to increase
investment. Such a subsidy can be given to frms regardless of where the interest rate
stands; the fact that it is zero or that it cannot be lower than zero does not matter:
P4c. The interest rate policy for stabilization of investment demand can be used by
the central bank so long as the ZLB on interest rate is not hit. This is not a
constraint in case of the explicit tax-subsidy scheme.
Under the prevailing policy regime, if there is a big recession, then the central bank can
infuence the long-term interest rate after the short-term interest has hit the ZLB. This
may be done through a programme of large-scale asset purchase, more familiar as
quantitative easing (QE) (Bernanke, 2013). It is interesting that under the proposed
policy regime, there is no need for QE. The reason is simple. The use of an explicit
tax-subsidy scheme, which can be implemented even if the short-term interest rate hits
the ZLB, obviates the need for a QE programme:
P4d. To overcome a big recession, the central bank’s low interest rate policy to
stabilize demand needs to be supplemented by QE. This is not required if the
explicit subsidy scheme is used.
It will help to get some idea about the size of the proposed explicit subsidy that may be
needed in a big recession. Consider an economy wherein investment is only 7 per cent of
gross domestic product (GDP) but it needs to be increased by another 8 percentage
points; for this, suppose that the interest rate needs to be lowered by 5 percentage points.
This scenario is close to that considered by Buiter (2009). In this scenario, if the treasury
needs to provide an explicit subsidy for the entire investment in the economy, the cost of
subsidy for the treasury is 0.75 per cent of GDP[0.75 ?(0.07 ?0.08) ?5] in a given year.
Alternatively, if the treasury needs to provide a subsidy for the additional investment
only, the cost of the subsidy is 0.40 per cent of GDP [0.40 ?0.08 ?5].
The proposed explicit tax-subsidy scheme is a pragmatic and workable policy. The
reason is that the proposed policy is only a replacement of the prevailing policy under
which in any case an implicit subsidy of a similar size is given to frms on their interest
costs. Furthermore, the proposed policy includes not only a subsidy in recession but also
a tax in a boom. This avoids an inter-temporal defcit. Finally, the size of the proposed
subsidy is actually small, relative to the size of the huge fscal stimulus in the USAafter
2007-2008.
The focus so far has been on stabilizing output in the economy. However, it is
important to consider other objectives of the policymakers. Under the prevailing policy,
the typical central bank may be thought of as having to take care of two objectives (low
and stable infation, and full employment) with one instrument (interest rate). The
proposed policy is as follows. The central bank can use its single instrument to take care
of only one objective, viz., maintaining lowand stable infation. The treasury can use its
explicit tax-subsidy scheme to achieve the other objective, viz., maintaining full
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employment. This paves the way for the central bank to adopt and to stick to infation
targeting:
P4e. The central bank is less constrained in adopting or sticking to infation
targeting under the proposed policy regime, than it is under the prevailing
policy regime.
Let us take P4d and P4e together. The QEprogramme in recent years has, it appears, not
been in confict with maintaining low and stable infation. However, a policy regime
needs to have the wherewithal to deal with the general case. Accordingly, the proposed
policy regime helps.
Though the terms prevailing policy regime and proposed policy regime have been
used repeatedly, we can now be more precise about the meanings.
The prevailing policy regime includes:
• the central bank’s standard interest rate policy, and occasional use of QE; and
• the treasury’s standard Keynesian fscal policy.
The proposed policy regime includes:
• the central bank’s interest rate policy to maintain low and stable infation; and
• the treasury’s explicit tax-subsidy scheme, variable consumption taxes and
reformed Keynesian fscal policy to maintain full employment.
A few comments are in order. First, the reformed Keynesian fscal policy refers to the
Keynesian fscal policy with the constitutional obligation that a “negative stimulus”
must be used in booms just as the usual (positive) stimulus is used in recessions; this
avoids any signifcant imbalance in the government’s inter-temporal budget related to
the policy. Second, there can be some ambiguity in nomenclature in the literature. Some
may classify the use of variable consumption taxes within the category of the Keynesian
fscal policy; this paper has put it as a separate category. Third, the proposed policy
regime includes an altogether new policy instrument, viz., the treasury’s explicit
tax-subsidy scheme.
This section suggests that the proposed policy regime is superior to the prevailing
policy regime. However, there is a fip side to the former regime.
4. The fip side of the proposed policy regime
Under the explicit tax-subsidy scheme, in a recession, the treasury is liable to pay a
subsidy to each investing entity separately (or adjust its collection of usual taxes after
subtracting the specifc subsidy under consideration here). Similarly, in a boom, it needs
to collect a tax from each investing entity. So there is an administrative cost involved.
This kind of an administrative cost is absent in case of central bank’s implicit
tax-subsidy scheme, though there can be some other small costs[3]:
P5. The administrative cost of the prevailing policy regime is far less than that in the
case of the proposed policy regime.
Though the proposed policy involves additional administrative work, note that the
investing entities need to fle tax returns in any case. The only change required under the
proposed policy regime is that the tax returns can include specifc implications of
the proposed explicit tax-subsidy scheme. So the administrative cost of the proposed
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scheme, though positive, need not be large, given the fxed cost of preparing and fling
tax returns. Accounting practices and preparation of tax statements can rely heavily on
information technology these days. With costs of information technology falling
dramatically over time, the additional administrative burden need not be large though
the initial unfamiliarity may be bothersome.
It can be a somewhat different story in developing economies. The tax administration
can be under-developed. This is particularly true where the use of information
technology is concerned. In some of these economies, the administrative diffculties can
be much more than a mere qualifcation to the argument that the proposed policy regime
can be far more benefcial than the prevailing policy regime. There is a policy lesson
here. Many developing economies need to develop not just economically and fnancially
but also administratively. This aspect is often ignored in the literature on economic
development (see, for instance, Ray, 2008). There is need for a change.
5. A perspective
The prevailing policy regime and the proposed policy regime were compared in P3. This
was about an equivalence between the two policy regimes from the viewpoint of
maintaining aggregate demand. Now:
P6a. From the viewpoint of general macroeconomic stability and asset price
stability, the proposed policy regime is superior to the prevailing policy regime
if the benefts of the proposed regime vis-a`-vis the prevailing regime (in the fve
parts of P4) are more than the additional cost (in P5).
If the proposed policy is adopted in a boom, then the treasury gets a surplus. It can
always store this surplus till the time of a recession which is when the funds are
needed. So there is, in practice, no diffculty in implementation of the proposed
policy, if it is adopted in a boom by any country for which it is desirable to make a
switch.
Next, consider the case where the proposed policy is adopted initially in a recession.
In this case, there can be a defcit to begin with. This needs to be fnanced by investors
in the debt market. It is true that the proposed policy regime includes constitutional
provisions as safeguards for investors. Recall that the constitutional provisions in the
proposed policy regime include the obligation to use (additional) taxes in booms, which
can be used to repay the investors. Even though the treasury will have no inter-temporal
budget constraint related to the proposed new policies, investors may still be reluctant;
perceptions based on past experience may matter even if that is in the context of a
different policy regime. Under such conditions, fnancing a defcit due to the proposed
policy may be diffcult:
P6b. If the proposed policy regime is superior to the prevailing policy regime,
“normal” countries can actually make a switch but this may not be possible for
countries that are “abnormal” and in a recession; they may be able to adopt the
new policy regime in future.
Abnormal countries here refer to those that have large public debt and little fscal space.
Which countries are “normal” and which are “abnormal” in practice? Table I shows the
debt-GDP ratios for four different groups of countries.
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In Table I, it is in one group of countries, viz., the advanced economies that the
average debt-GDP ratio is high. However, even in this group it is not the case that all
advanced economies have fscal diffculties. The proposal is therefore more useful
than it appears at frst glance even if we consider advanced economies only.
Table I depicts the recent situation. However, the proposed policy regime is not just
for the present day economies but also for the future. Even if some economies are unable
to adopt the proposed policy regime now, this does not rule out their usefulness in future.
Ball et al. (2014) are not pessimistic about the government’s budget constraint in the
context of overcoming the Great Recession in the USA. Their conclusion can hold a
fortiori in case of the proposed policy regime, as it also includes a constitutional
safeguard for investors.
As is clear fromTable I, the fscal situation in the last three groups of countries on an
average appears to be comfortable. It may be said that many of these countries should
have no diffculty in adopting the proposed policy regime in so far as the debt-GDP ratio
is concerned. However, many of these may have an administration that does not
extensively use information technology; this can be a binding constraint in such
countries at present.
6. Conclusion
The basic insight in this paper is that the central bank’s interest rate policy has an
inbuilt implicit tax-subsidy scheme. This insight paved the way for a new policy
regime that is proposed here. This regime has an additional fscal policy instrument.
It was shown that the proposed policy regime has several benefts over the
prevailing policy regime. First, it enables the asset markets to have more stable
prices. Second, an exit from the proposed policy is relatively easy. Third, it can be
used even when the ZLB on the interest rate is hit. Fourth, it obviates the need for QE
programme. Fifth, it paves the way to adopt and to stick to infation, targeting
without sacrifcing the other objective of full employment. Last but not the least, it
is more transparent.
Though the proposed policy can accomplish more than the prevailing policy, it has a
cost of administration. If this cost is small (as it may well be with considerable use of
information technology in many advanced countries and in some emerging economies),
it is desirable to make a switch fromthe prevailing policy regime to the proposed policy
regime. Many developing economies and some highly indebted economies may,
however, have to carry out other reforms before the proposed policy regime can be
adopted there. Such reforms would be benefcial for themin any case. This paper shows
that there is an additional reason for such reforms.
Table I.
Debt as per cent of
GDP in 2013
Group of countries Gross debt Net debt
Advanced economies 106.2 72.5
Emerging market and middle income economies 39.7 17.0
Low income countries 31.0 23.2
Oil producers 22.2 Not available
Source: Data extracted from Table 1.2, p. 4, International Monetary Fund (2014)
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Apolicy regime needs to be thought over in advance with a vision for the future and not
just with a view of the current realities in some countries. In this context, the proposed
policy regime can be a part of the preparation to reduce macroeconomic and fnancial
instability in future.
Notes
1. This provision is in line with the legislation that attempts to ensure that the treasury has fscal
responsibility to maintain reasonable debt-GDP ratio.
2. Gali (2013) shows that a fall in interest rate can lead to a fall in the size of a bubble in asset
prices. However, the analysis is theoretical and in the context of a rational bubble.
3. There can also be some increase in administrative costs due to changes that need to be made
to consumption taxes. This paper ignores these as they are likely to be small.
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Palgrave Dictionary of Economics, 2nd ed., Palgrave Macmillan, New York, Vol. 2,
pp. 468-483.
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Woodford, M. (2011), “Optimal monetary stabilization policy”, in Friedman, B.M. and
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Further reading
International Monetary Fund (2014), “Fiscal monitor – back to work: how fscal policy can help”,
World Economic and Financial Surveys, October.
About the author
Gurbachan Singh is an independent Economist, and a visiting faculty member at the ISI, Delhi
Centre since January, 2010. He teaches an optional course on “Theory of Finance II: Finance and
Volatility” in the last semester of Master of Science in Quantitative Economics (MSQE)
programme. He takes some lectures in the MBA programme at Management Development
Institute, Gurgaon. His area of research is macro-fnancial stability. He has published papers in
academic journals. He have authored a book on banking crises. Much of the work is policy-
motivated and is geared towards fnding possible ways to have a more stable macro-fnancial
system. He has a PhDfromISI and MAfromDelhi School of Economics. Gurbachan Singh can be
contacted at: [email protected]
For instructions on how to order reprints of this article, please visit our website:
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