The world is experiencing an unprecedented demographic shift. The population is aging, especially in advanced economies. The consequences of a graying population for government spending and tax (that is, fiscal) policy have been widely explored, and there is general agreement that a combination of higher taxes, reduced pension benefits, and longer working lives is essential to deal with the fiscal burden an aging population imposes—although the political challenges of doing so are enormous.
But there has been little exploration of the impact of an aging population on monetary policy—the process by which central banks influence interest rates and the supply of money to promote stable inflation, employment, and growth.
The life-cycle hypothesis—which posits that households borrow mainly when they are young, accumulate assets and pay down their loans until they retire, then live off their assets in retirement—suggests a clear link between the effectiveness of monetary policy and demographics. Part of the reason economists have barely explored that link is because monetary policy is typically designed to react to short-term shocks over a short horizon of one to two years, not to slow-moving factors, such as demographic change, that materialize over decades.
Silent and sluggish though demographic change may be, my research points to significant implications for monetary policy in advanced economies—including for current unconventional approaches, such as quantitative easing, those economies have deployed in recent years. Theoretically, the impact of an aging population is ambiguous: older populations are affected in different ways than the young by the various channels through which monetary policy moves. On balance, though, I found that a graying society blunts the effectiveness of monetary policy.
Monetary policy was accorded much of the credit for containing and stabilizing inflation, thereby fostering the steady growth and major reduction in business cycle volatility that lasted in advanced economies from the mid-1980s until the global financial crisis that began in 2008. By keeping inflation expectations in check, the analysis has it, central banks reduced the uncertainty that can cloud investment decisions and hold back consumption, and were able to respond flexibly to shocks. Both the Gulf War in 1991 and the collapse of the Internet bubble in 2000 were followed by a swift loosening of monetary policy to restart economic activity. That quick response was possible because inflation expectations were low.
But belief in the effectiveness of monetary policy was upended by the 2008 global financial crisis. Since the beginning of the crisis, central banks have found it difficult to prop up growth and prices—whether in Japan, the United States, or Europe. And now evidence is mounting that even during the roughly 25 years of the so-called Great Moderation that preceded the crisis, monetary policy was less omnipotent than it appeared.
That new evidence shows that monetary policy has had a diminished and diminishing impact on variables such as unemployment and inflation since the mid-1980s. The declining effectiveness—measured by the impact of interest rate changes on unemployment and inflation—is usually attributed to better-anchored inflation and output expectations, which are then less affected by interest rate changes (Boivin, Kiley, and Mishkin, 2010). Inflation is generally less responsive to changes in the cyclical unemployment-output gap (the difference between what an economy can produce at full employment and what it actually is producing) when inflation expectations remain well anchored on the central bank’s target, including during deep recessions, such as the recent global financial crisis (IMF, 2013). Many economists say these factors explain why the unprecedented...