Macroeconomic effectiveness of non‐standard monetary policy and early exit. A model‐based evaluation

• Author: Alessandro Notarpietro,Lorenzo Burlon,Andrea Gerali,Massimiliano Pisani
• Date: 01 June 2017
• DOI: http://doi.org/10.1111/infi.12112
• Published date: 01 June 2017

DOI: 10.1111/infi.12112

ARTICLE

Macroeconomic effectiveness of non-standard

monetary policy and early exit. A model-based

evaluation

Lorenzo Burlon

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Andrea Gerali

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Alessandro Notarpietro

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Massimiliano Pisani

Bank of Italy, Research Department,

Roma, Rome, Italy

Correspondence

Massimiliano Pisani, Bank of Italy,

Research Department, Via Nazionale 91,

Roma, Rome 00184, Italy.

Email:

massimiliano.pisani@bancaditalia.it

Abstract

This paper evaluates the macroeconomic effects of the

Eurosystem’s expanded asset purchase programme (APP)

under alternative assumptions about (i) unwinding the asset

positions accumulated under the APP and (ii) current and

future paths of the policy rate (forward guidance). To this

purpose, we simulate a New Keynesian model of the euro

area (EA). Our results are as follows. First, if the monetary

authority brings forward the unwinding of its long-term

sovereign bond holdings, the stimulus from the APP on

inflation and economic activity is correspondingly reduced.

Second, if the monetary authority communicates that the

policy rate will be held constant for 1 year instead of 2, the

APP would be less effective and the increase in inflation

would be halved. Third, an early exit from bond holding

subduesthe impact of the APP, delaying thenormalization of

monetary policy conditions after a negative EA-wide

demand shock.

It is extremely difficult to appraise the effectiveness of a program all of whose parameters have

been announced at the beginning of the program. But I regard it as significant with respect to the

effectiveness of QE that the taper tantrum in 2013, apparently caused by a belief that the Fed was

going to wind down its purchases sooner than expected, had a major effect on interest rates.

—Stanley Fischer, Vice Chairman of the U.S. Federal Reserve Board of Governors (2016)

International Finance. 2017;20:155–173. wileyonlinelibrary.com/journal/infi © 2017 John Wiley & Sons Ltd

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INTRODUCTION

The launch of the euro area (EA) expanded asset purchase programme (APP) has spurred a debate on

the elements of its design (amounts of purchases, composition, and duration) that influence its

effectiveness in stimulating the real economy and inflation.

On the one hand, some have emphasized the costs of an over-prolonged programme, which could

fuel inflation and inflation expectations well above the definition of price stability, thus forcing the

monetary authority to subsequently embrace a restrictive stance. On the other hand, others have

stressed the macroeconomic costs of a programme that does not last for a sufficient amount of time (so-

called ‘early exit’) and thus turns out to be insufficient to achieve the price stability objective. The risk

is that this may result in reiterated implementation of too timid successive non-standard measures,

which may end up being counterproductive because the commitment to achieve price stability becomes

less and less credible as time goes by.

In this paper we evaluate the APP’s effectiveness in relation to its announced duration and the

possibility that the programme is exited too early, by simulating a three-region New Keynesian model

of the EA and the world economy. The EA is formalized as a monetary union of two regions, Home and

rest of the EA (REA), where Home is of medium size (its GDP is around 20% of the overall EA GDP).

The model includes a third region outside the EA, which represents the rest of the world (RW). The

presence of the latter region makes it possible to take into account the role of the nominal exchange rate

and extra-EA trade for the transmission of monetary stimulus to the real economy.

Crucially, we relax the so-called ‘Wallace neutrality’, and make short- and long-term sovereign bonds

imperfect substitutes in household portfolios. In this way, central bank purchases of long-term sovereign

bonds affect the consumption-saving decisions of households and firms.

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Specifically, we follow Chen,

Cúrdia, and Ferrero (2012) and introduce a preferred habitat assumption in the otherwise standard New

Keynesian open economy framework. In each EA region, some households (labelled as ‘restricted’)have

access only to long-term sovereign bonds and indirectly invest in physical capital accumulation, as they hold

a constant (parametric) share of domestic ‘capital producers’. The purchase of long-term government bonds

by the monetary authority reduces long-term interest rates and induces restricted households to increase

consumption and investment via the standard intertemporalsubstitution effect. The reductioninthelong-term

nominal interest rate leads to an increase in inflation expectations, which in turn reinforces the expansionary

effect on aggregate demand and contributes to further reductions in the real interest rate.

We simulate the following scenarios.

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First (‘benchmark’case), we simulate the EA APP. The shock is calibrated so that it corresponds to

overall quarterly purchases of €180 billion, which last for seven quarters. It is assumed that long-term

sovereign bonds are held to maturity (on average 8 years) and thereafter the obtained principal

payments are immediately reinvested in long-term sovereign bonds, for a period of 5 years.

Subsequently, the central bank starts to gradually sell the bonds.

Second, we simulate the effects of three alternative scenarios of ‘early exit from sovereign bond

holdings’. In one case, the principal payments are reinvested for 1 year only. In the alternative cases,

there is no reinvestment, as the central bank starts to gradually sell the bonds before they mature, that is,

either immediately or 4 years after the last quarter in which the purchases are made. In all (benchmark

and ‘early exit from sovereign bond holdings’) scenarios, we assume that the monetary authority

commits to keeping the short-term policy rate at its baseline level (0.25) during the first 2 years of the

simulations (we call it ‘Forward Guidance’, FG henceforth).

Third, we explore the consequences of assuming that the same purchases are carried out as in the

benchmark scenario but the short-term rate is kept at the baseline for 1 year instead of 2. This scenario

can be considered a case of ‘early exit from FG’.

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