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a blog from young economists at Nova SBE

An outlook of the last 10 years of Monetary Policy in Europe

The primary objective of the European System of Central Banks (ESCB) shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union. The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set.

In 1999, 12 European countries joint in a monetary union, adopting a single currency and taking the same monetary rules. To conduct the common monetary policy, it was created an independent institution, the European Central Bank (ECB). According to the statutes, the European Central Bank must ensure price stability which was defined by the Governing Council as year-on-year increase in the Harmonised Index of Consumer Prices for the euro area of below, but close to 2%. In order achieve it, the main instrument used is interest rate.

Until 2007, there are no big doubts that the ECB was able to fully commit with its objective. However, after this period, the objective was harder to attain. In fact, after 2007 inflation was more volatile and consequently the price level was not so stable as before. In 2007, a set of events happened that made monetary policy harder and create some challenges. Actually, the crisis of 2008 is called the Big Recession that is only compared with the Big Depression of 1929. From 2007 until the most recent days, some actions and speeches affected the course of monetary policy in Europe. In this article, I will focus on that, presenting the economic intuition for them.


Inflation Rate in Eurozone (1999-2017)

2007 – 2009: Lack of confidence and liquidity problems

The first incident was an injection of €94.8 billion by the ECB in the Eurosystem, at that time the biggest one ever, to deal with a liquidity crisis of the banking system. The origin of this injection was a lack of confidence of commercial banks that put the interbank interest rate (EONIA) at maximums. BNP Paribas, one of the largest European banks, made a declaration suspending three funds that were based on Asset Backed Securities whose associated products had started to have ratting problems. After that, EONIA continue to increase because banks no longer trust in each other and the liquidity of the system vanished. To try to solve the liquidity crisis and avoid a big financial crisis, the ECB had to intervened lending to almost 50 commercial banks. As we know today the crisis was not avoid, only postponed, and despite of that, some economic historians consider the 9th of August of 2007 as the start date of the Big Recession.

Nevertheless, only on the 15th October of 2008, the first big commercial bank felt and the consequences of the international financial crisis arrived to Europe. The European monetary policy start changing through altering interest rates. The rate on the main refinancing operations went from 4.25% to 2.50% during 2008. This was the response of the central bank to the problem that surged in the interbank market. Banks did not belief each other any longer, since nobody was sure about the risk it was to lend to another bank. Economically speaking, there were enormous asymmetries of information on the real value of assets of banks’ balance sheet. In response, the interbank interest rate continued to grow, in other words the market breakdown – there was no price that cleaned the market. The action of the central bank of decreasing interest rate made EONIA fall, as expected, and inflation rate went up reaching historical maximums of roughly 4%. Several economists criticize the action of ECB because it failed on assuring price stability, its main responsibility.


EONIA (1999-2017)

2010 – 2013: Spend, Indebt, Rescue. Repeat

But the crisis had already installed giant problems. With the subprime crises, GDP stop growing which led the major developed economies into a recession, including the European countries. European governments, following the recommendations of the European Commission, increased public expenditure which created huge public deficits and a problem related with sovereign debt. Indeed, European countries in 2010 had enormous public debts, most of them above the 60% limit imposed by the Maastricht Treaty. Until these days, markets had always trusted the capability of countries to pay its debts. However, back to that time markets became very suspicious and started doubting on the credibility of some countries to pay. Interest rates of public debt of Greece, Ireland, Portugal, Spain and Italy reached very high values that some countries were not able to deal with. On top of that, and especially in these five economies, the health of the financial system was weak.

Between 2010 and 2013, five European countries received financial help from troika (ECB, European Commission and IMF). The first was Greece to deal with the high levels of public debt and solve several structural problems, receiving 3 different financial rescues (€110bl+ €130bl+ €80bl). Ireland came after with a help to deal with the financial system problems that were contaminated with the subprime of USA (€80bl). The third country was Portugal that received the money (€78bl) in a time where there were several doubts on how to pay the salaries of public servants in an economy with very high levels of external debt, especially public debt. Spain and Cyprus have also received international financial help, when they felt a sudden stop that closed international financial markets to them. The money was essentially to the financial system, namely the banking system that was full of troubles. During this time, several other European countries received small amounts of money to be able to deal with problems in their financial systems and avoiding self-fulfilling crisis.

Public Debt

Public Debt in Europe (1999-2017)

2013 – 2016: Super Mario fights the Euro Zone monster

In the middle of this time, the ECB president changed and with the new president some policies were implemented. In the very beginning of his mandate, Mr. Mario Draghi created a program of very long-term loans with the aim of increase the security of the banking system. In July of 2012 he delivered one of the most famous speeches during the crisis, where he said that “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” These two sentences changed the way how markets thought about ECB. With this speech, Mr. Draghi said that the central bank will not only commit with price stability, but also with the survival of euro. In the very same day, he launched a program to buy public debt of countries in need, namely the ones that were under financial help programs. Also, since this day the interest rate felt in a consistent way.

Still, these conventional policies were not enough. Between 2013-2015 the Euro-Area lived afraid of another “economic monster”: deflation, i.e. the fall of price level. Thus, the European Central Bank had to create other measures to avoid it, which are called non-conventional measures. One of the first ones was the forward guidance, where the Central Bank gave guarantees of the interest rate for the medium and long term. The idea is to stabilize expectations of monetary policy for a longer-term and protect the Euro zone from other exogenous shocks.

Furthermore, the ECB had also extended the program of buying assets with a big emphasis on public debt, acquiring €60 billion per month. In March of 2016 it increased to €80 billion per month to finally destroy the monster of deflation and, on top of that, in the same day, the official interest rate was set to zero percent. European economy is in a liquidity trap, it reached the zero lower bond. Conventional instruments are not enough and only with extra measures, as the quantitative easing is possible to produce real effects on the European economy.

Balance Sheet

Eurosystem balance sheet in €M (1999-2016)

2017: After a storm comes a calm

More recently, in 2017, the risk of deflation has already gone and inflation rate have been consistently increasing (in September of 2017 it was 1.5%). In March of 2017, Mario Draghi announced a reduction in the asset buying program returning to €60 billion per month. Nonetheless, interest rate is still at the zero lower bond. In the last October, it was announced another decrease of the asset buying program to €30 billion for September of 2018, but fragile economies as Portugal will continue to be supported by the Central Bank that will buy its public debt. Moreover, the interest rate will stay low, further beyond the stimulus program of ECB. Indeed, the prediction of inflation rate for the next periods is still below the target of 2%. The ECB wants to keep the Euro zone together.

Tiago Bernardino

Reference List:



Housing bubble effects in the US economy

In beginnings 2004, the United States faced a great inflation housing bubble, an increase in housing princes powered an increase in demand in the event of limited supply which takes a long time to adjust, the speculators enter the market convinced that they can make short run profits through quick buying and selling. With the purpose of reducing the impact of this event, the Federal Reserve desired to increase mortgage rates. But instead of the increasing the federal funds rate, i.e., an increase in short-term rates, it did not raise the long-term rates, as expected.

The yield on long-term bonds can be explained by three different variables: expected inflation, average short-term rates and a term premium.  The relation between them can lead to different results. According to Ben Bernanke chairman of United States Federal Reserve, the biggest contributor for the lower long-term rates is the decline in the term premium, which is nearly zero and sometimes even negative.

The central bank purchases of government debt are one of the motives that generate a very low term premium. Since the government debt is commonly used in transactions between financial banks as collateral, its demand continues firm regardless the low or below zero real return.

Bernanke, also stated that the inflows from the Global savings glut countries, that is when the desired savings by these countries exceed the desired investment, are an important explanation for a small long-term interest rates In the United States last years. Bernanke expressed concern about the significant rise in global supply of savings, whose implications in monetary policy can be adverse.  This occurrence also has an effect in rising global imbalances with respect to international current account balances.

Foreign governments and central banks with positive current accounts hold approximately half of the total amount of the treasury debt outstanding as international reserves. The recently financial crisis has increased the demand of treasury securities lowering treasury yields, which consequently implies a low or negative term premium.

The problem behind foreign governments wanting to purchase American government debt is related to the fact that it decreases the competitiveness of America by diminishing its exports due to the increase in relative price of the dollar.

United States Federal Reserve could through its available tools implement different fiscal policy in order to stop the reckless lending. For example, moderate inflation may be a useful device to increase long-term rates.

The American monetary policy may boost the exposure of foreign countries if they continue to accumulate reserves which become a weakening force to the American economy. A greater accumulation of reserves by the foreign governments will lead to higher dependency on domestic demand to the US economy. If the American government creates more treasuries that is highly demanded by the rest of the world, it would be able to borrow massively and consequently be able to invest in several areas such as infrastructure, education, research and development, health, defense, etc… If the Federal Reserve boosts interest rates by a small percentage it would make investments in treasuries more appealing besides that investors also consider the fact that dollars could appreciate in a few years.

If we consider the hypothesis of an increase in the interest rate the United States would sell more treasuries at the same time investing on debt from other countries. It would increase the number of Treasuries available on the market therefore it would demand the markets to deal with these new supply and would increase the long term rates which would help the economy to recover. Buying foreign debts would be good for these foreign economies which would decrease the value of the dollar and boost American exports helping to stabilize the financial system at a global level.




Is Serbia on the Right Track towards EMU Convergence?

The shadows of the Yugoslav Wars gradually evaporating from memory, the Republic of Serbia is now looking to join the European Union, and with it, the European Monetary System. However, given the current state of economic stagnation, applying for EU membership is no longer considered as an unanimously beneficial decision. This post presents the challenges that Serbia will face if/when it becomes a part of the EMU, namely regarding capital inflows and expected changes in competitiveness.

In order to join the European Union, Serbia must comply with the Maastricht criteria, which include a series of conditions, namely low inflation rates, controlled government deficit and debt, low long-term interest rates and having been within the bands defined by the Exchange Rate Mechanism (ERM) for at least two years. As of yet, Serbia hasn’t attained any of these convergence criteria; nonetheless, the Serb Central bank has recently reaffirmed its commitment to targeting inflation via interest rates.

Serbia, like several other Eastern European countries, has lower wages and lower price of non-tradable goods than the more developed EU economies. Joining the EU would, in principle, translate into higher productivity. The issue, however, is that productivity generally rises faster in the tradable goods sector. According to the Balassa Samuelson effect, this imbalance will exert pressure on wages of both sectors to adjust; in order for firms of the non-tradable sector to stay profitable, they will have to increase their prices. This would be reflected in an increase of the Consumer Price Index, which could threaten to push Serbia away from the inflation goal. The upsurge in prices can be avoided by letting the currency appreciate; still, this could imply that the Serbian dinar veers off the limits imposed by the ERM. It is clear, though, that none of the policy choices can avoid the appreciation of the real exchange rate.

These concerns state the implicit direction towards “catching-up” process the Serbian economy is slowly pursuing. Looking closer at the fundamentals, inflation does not seem to be a problem since the NBS is credibly committing to holding it within the targeted band of 2-6%. Furthermore, the NBS forecasts are about 1% growth, which comes after the past five-year recession the country experienced. Facing the decrease in FDI due to the crisis, Serbia depreciated the Dinar increasing its competitiveness towards the EU countries with a fixed exchange rate; however, this cannot continue if the country is to achieve convergence with the rest of the more developed countries, as per the Balassa Samuelson effect explained above. This means that Serbia might need to change policies in the future.

Nonetheless, Serbia represents one of the biggest capital recipient country of the Balkan region in the last years. The inflows financed mostly the manufacturing tradable sector, having an industrializing effect on the composition of the GDP’s country – an example of Serbia “pulling in” capital flows. On the other side, during the crisis the inflows decreased, probably also due to the Ukrainian situation in more recent periods. This can mean that the original nature of capital flowing into Serbia was due to ‘push’ factors, that is, factors that affect the international willingness to place capital abroad, such as the conflict in Crimea.

If we look at risk-premium, we see that it increased to a level of 8% during the last years. Also, real estate prices fell, diminishing the value of collaterals; this has a negative impact on national firms’ borrowing capacity, which could decrease output and thus real convergence. However, under the Serbian managed float exchange rate regime and with real interest rates constant around 10%, the capital inflows will not increase inflationary pressure since they would reflect an upward shift of the money-demand curve, and not a temporary capital inflow (which would be dependent on lower international interest rates). As inflation remains under control, the capital inflows seem to be of sustained nature, and may have to do with an increase preference of the population for money, which in turn can be due to an increase in GDP growth (more transactions take place). The fact that most of Serbia’s growth is consumption-based supports this assertion, although solving the uncertainty problem seems to be fundamental to stabilize the path of the run-up, as the country may be vulnerable to unfavorable developments in the Ukrainian conflict.

In summary, it seems like Serbia is on the right track to achieving convergence with the EU. The capital inflows appear to be sustainable since there is productivity growth in the tradable sector, and the NBS has committed to keeping the inflation within the specified limits without needing to devalue the currency, implying that the real exchange rate should move along a smooth path. Nevertheless, Serbia should be wary of the ‘weighing-in’ syndrome, where countries lose control of inflation after joining the EU. Also, the country still needs structural reforms to ensure stability and the rule-of-law, which doesn’t seem to be in the immediate priorities of the populist Vučić government. Therefore, challenges remain ahead for the former Yugoslav nation.


Rui Mascarenhas  – 694 –

Francesco Cestari – 731 –

Aid: A new strain of the “Dutch”

With the recent discussion of Dutch Disease and how it is affecting (or not) the Canadian economy, we thought this was an opportune time to review the effects of this “curse” on developing countries. In this post we will relate the consequences of Dutch Disease to large aid flows, present some solutions and, in the process also shed some light on a, personally, important and intriguing Development Economics issue.

The term Dutch Disease was first mentioned in a 1977 edition of The Economist and it was used to describe the problems afflicting the Dutch manufacturing sector. Generally, it is related to the effects of shifts in production patterns – namely between tradable and non-tradable goods – that arise due to large changes in wealth. The latter can be caused by the discovery of natural resources, a drastic change in its world price or when large aid inflows take place.

To illustrate this concept, imagine a country that neither has natural resources nor receives aid. The only way for its citizens to buy imports is through exports, hence exporters generate foreign exchange and importers buy the foreign exchange off them. Thus, for the export producing country, exports’ value results from the need of paying for imports. Now, let natural resource exports – aid in our case – come into place. As resources are sources of foreign exchange, exports lose their value domestically. Id est, non-tradables become more expensive and so resources get rechanneled into producing them. As you can infer the problem lies with the inflow of foreign exchange; and aid, in its most basic form, is nothing more than an inflow of foreign currency. Therefore, the large shift in domestic demand caused by foreign aid leads to a consumption boom, expanding the non-tradable sector and squeezing the tradable one, damaging precisely the economic sector most in need for development[1]. Empirically, this topic is being studied by Raghuram Rajan (2005)[2], in which he shows that aid tends to retard the growth of labour-intensive exports activities needed for diversification.

Some solutions have been proposed by the academia and no consensus has been reached. For instance Paul Collier[3], the author of The Bottom Billion[4], suggests that countries should use their aid in creating import demand – aid automatically creates import supply – through technical assistance, this is, importing skills, which decreases the likelihood of Dutch Disease. Moreover, Collier argues that aid spent in developing the export sector may avoid infection, because, after an infrastructure improvement at ports, aid is scaled back and there is no further Dutch Disease, just a better port, for example. Nonetheless, William Easterly[5], the author of The Elusive Quest for Growth[6], puts forward the idea of “conditional adjustment lending”, where aid should be conditioned on policies with very specific stringent targets concerning indicators such as inflation, exchange rates and average black market premium, reforms on the public sector, budget deficit as a percentage of GDP, real interest rates and corruption levels.

In summary, Dutch Disease on developing countries appears to have a harmful effect, undermining growth. Basic forms of aid do not relief the problem and, instead, can be considered as a Dutch Disease catalyst. As Easterly put it “The operation [aid] was a success for everyone except the patient […] much lending, little adjustment, little growth (…).” On the other hand, Canada, a developed country, states that it is healed due to its diversified economy (and, personally, good institutions). Thus, developing countries must aim to diversify their economies and improve the foundation of their institutions (if they want to be cured).

Mariana Tavares no 64

Miguel Vian no 634

[1] This reasoning is in par with the concepts behind the TNT model as non-tradables have to be produced internally and tradables can be imported to satisfy changes in domestic demand.

[2] Rajan , Raghuram G. and Arvind Subramanian, 2005, What Undermines Aid’s Impact on Growth?, IMF Working Paper No. 05/126

[3] Professor Collier is the Director for the Centre for the Study of African Economies at The University of Oxford

[4] Collier, Paul, 2007, The Bottom Billion, Oxford

[5] Professor of Economics at New York University specialized in economic growth and foreign aid.

[6] Easterly, William, 2001, The Elusive Quest for Growth, MIT Press

Stunning Similarities

While Germany won’t ever forget about the hyperinflation disaster of the early 20’s – something The Economist recently referred to as Germany’s hyperinflation phobia[1] – the German debt crisis right before the Nazis seized power surprisingly seems to have widely faded away from collective memory. Specifically when observing the German debate on to which degree the ECB shall be allowed to financially support the crisis-stricken, indebted south European countries, it seems odd that this part of German history remains almost unmentioned.  In contrast, though, German opinion makers seem to never tire of emphasizing the bitter experience made by hyperinflation when debating on potential instruments of the ECB’s crisis management.

After World War I and the accompanying hyperinflation Germany borrowed heavily from the US in order to finance the war reparation payments but also used debt to boost economic growth. Thus, it was basically a credit bubble that financed Germany’s Golden 20’s, a situation very similar to the economic boost experienced by South European countries before the arise of the financial crisis in 2008. Then, in 1929 the Great Depression erupted in the US causing the German bubble to burst. At once there was a sudden stop as US banks started withdrawing funds from Germany and suspended new lending. In the course of the increasing pressure of debt repayment Germany’s US $ reserves were shrinking which forced Germany to build up a trade account surplus in order to earn the US dollars needed to settle its debt. But as Germany’s currency was tied to the gold standard the possibility of devaluation was not given, while the defense of the exchange rate was further accumulating the decline of US $ reserves. Furthermore, due to the Great Depression the US demand for imports was plummeting, and so did German exports. Thus, the only way to pay back debt and regain trust from international investors was strict fiscal tightening. However, this was resulting in a banking crisis including bank panics, bank socialization and a credit crunch paralyzing the economy and consequently leading to rising unemployment up followed by mass demonstrations and violent clashes of political opponents. When foreign reserves were finally exhausted, so that the exchange rate was not anymore defendable, Germany was forced to abandon the gold standard and to devaluate its currency. But the effect did not sufficiently boost exports in order to earn the dollars needed to keep up with the debt payments. Between 1929 and 1932 the German GNP declined by 25 %, culminating in an unemployment rate of 30 % in 1932. The disastrous economic situation represented fertile ground for the radical political fringes and accompanied by the debt default in 1933 the Nazis seized power[2].

If one imagine, how the course of history may have gone if debt would have been restructured in a way to better avoid such a deflationary economic development it gives cause for thought. Something the US – being the major creditor – had learned from, which gave rise to the Marshall Plan after the disaster of WW2. Of course, in the awakening of the cold war, complemented by the importance of European export markets for the US economy, there was much political calculation involved, however, it gave Germany the possibility to rebuild the economy by creating an efficient institutional framework, that led to the impressive economic growth during the 60ies and finally to the full repayment of the loans granted by the Marshall Plan.

Today’s political circumstances are different; still, the similarities of economic pattern are stunning. Since the awake of the crisis Greek GDP was constantly shrinking and in 2013 unemployment reached a new record high of 27 %[3]; and with economic change inevitably comes political change. Today’s disastrous economic situation again is leading to the empowerment of radical political fringes – from both the left and the right extremes. A recent survey showed a 15 % public support for the Greek neo-Nazi party “Golden Dawn” and violent clashes between political opponents are increasingly reported.[4]

This time Germany plays a main part as being a main creditor and the long-term level of reimbursement depends on an economic comeback of the high indebted economies. Furthermore, Germany’s industries strongly depend on its export potential, which in turn is positively affected by the Euro that makes exports cheap, something that would not be the case without the Euro zone (an own German currency would highly appreciate). The allowance of the Target2 transfers, which remain relatively unnoticed by the public, show that German officials are aware of these facts, however, their political leeway is constrained by the voter’s opinion and still; the key aspect of how the German public widely perceives the financial aid is to pay for mistakes made by others rather than the economic and historical based moral rationales behind the support.  To extent the debate by German’s own history of deflation could help to shift the inner German discussion from the question of if to support to the question of how to best support to enable struggling countries to build the right institutional and economic frameworks to get back on track. But this of course would require further investments, which obviously is not feasible without sufficient financial support in the form of debt reliefs.

Hans Kaufmann and Svenja Telle
Macroeconomic Analysis – Fall semester 2013

[1] Cf.: The Economist (2013, November 15): “Germany’s hyperinflation-phobia” retrieved from

[2] Cf.: Ritschl, Albrecht and Sarferaz, Samad (2006): “Currency vs. Banking in the German debt crisis of 1931”; Humboldt University of Berlin

[3] Statista (2013): “Greece: Unemployment rate from 2003 to 2013”; retrieved from

“De Gato p’ra Lebre”

It was in 13th October of 1987 that Portuguese people listened from their Prime Minister, Aníbal Cavaco Silva, that investors would be buying “gato por lebre” (“Pig in a poke”).

Emerging from a revolution, Portugal was a new player in the European team and had recently received foreign aid throughout two adjustment programs to solve the problem of external imbalance.

The crisis passed, the stock reacted and Portuguese economic situation steadied during a decade of growth.  Being able to recognize the mistakes made since then we find ourselves today in a situation that is no less serious, hovering over the whole economy a question: will we be “gato ou lebre”?

Between Portugal’s entry in EU and the euro membership it was witnessed a period of economic growth, with a strong inflow of EU capital, launching major public investments in infrastructures and a national effort to catch up with other member states. With the euro started a period of stagnation that came to result in the crisis recently faced.

Without its own currency and no autonomy in monetary or exchange rate policy, since 2000 Portugal went through a period called “the lost decade” marked by an artificial enrichment resulting from a large inflow of foreign capital with desirable interest rates.

Excess liquidity and easy credit access resulted in a strong expansion of aggregate demand and also in a progressive external debt due to a permanent trade balance deficit. At the same time, the real exchange rate appreciated, resulting in a huge loss of competitiveness of Portuguese exports and an allocation of resources in favour of the non-tradable sector.

The country, itself not athletic, then settled down in its basket as a big fat cat, sedentary, domesticated and oblivious of the difficulties that would follow.

As Guillermo Calvo and coauthors document for the Latin American economies in the 1990s, large capital inflows typically come with increases in the real exchange rate, that is, increases in the domestic prices relatively to prices abroad. Therefore, this Portuguese crisis can be analyzed through the Salter & Swan approach, observing the tradable and non-tradable sector dynamics.

According to Ricardo Reis, an explanation for the Portuguese slump is the large capital inflows that were misallocated across sectors, causing a strong fall in the domestic productivity growth. This misallocation caused a strong increase in the non-tradable prices and the country ran successive current account deficits until we reached this situation. Additionally, the government amounted to an excessive annual deficit which caused an unsustainable level of public debt, i.e. becoming more and more dependent from abroad.

After the sudden stop, the Portuguese government was forced to sign the Memorandum of Understanding which established, beyond other goals, the commitment of supporting “the reallocation of resources towards the tradable sector.” Figuratively speaking, the country committed on ceasing to be “the gato” and start being “the lebre”, capable of becoming positive the animal spirit in order to achieve economic stability, growth and development.

Have we been successful?

preços copy

emprego copy2

Despite the difficulties associated with nominal rigidities in prices and wages and a huge lack of ability to attract international investment, prices of non-tradables have decreased in contrast to the perceived inflation in tradables.

Although, the pricing system is not promoting an efficient allocation in the labor market, and consequently we can see that until the first quarter of 2013 the employment reduction felt more in the non-tradable sector (more subject to international competition). This is not a good indicator of success.

aula copyEven though, Portugal has managed to generate trade balance surpluses because of a massive contraction in domestic demand. Considering the graph, Portugal was producing at A and it’s now at C, which is clearly ineficient.

However, according to Eurostat, it is estimated that in the 2nd and 3rd quarters of the year Portugal was the EU country where employment grew most, a factor which is due to the recovery of markets and investors confidence and a clear support in the export sector.

Fortunatelly, the signs of this adjustment process are starting to be noticed and soon our production level will be able to return to the Production Possibilities Frontier (at B) with a strong, competitive and sustainable economy.

The effort has been tremendous but the optimists say that if, even after the end of the adjustment program, these reforms continue to be undertaken with the same determination, the “gato” will become “lebre”.


Dino Alves #607

Sara Simões #643

Macroeconomic Analysis

[Graphs on Tradables and Non-Tradables – Prices and Employment – from Equilibria nº 1 and 2]

Unconventional Monetary Policies: Do the Benefits outweigh the Risks?

Over the past decades, most of the world’s Central Banks have widely used open market operations to influence the short-term interest rates to achieve their main objectives of controlling inflation and promoting economic growth. Recently, however, the short-term interest rates, in major developed economies, have reached the so-called “zero lower bound” (i.e. they cannot be lowered anymore because with interest rate equal to zero people would simply prefer to keep their money as cash).

In the aftermath of 2008 crisis, the slack of major developed economies pushed Central Banks to implement the so-called unconventional monetary policies, which include the clearer communication by Central Banks of their expectations regarding the future path of short-term interest rates (the so-called Forward Policy Guidance) and the Large Scale Asset Purchases (LSAPs), more popularly known as Quantitative Easing (QE).

Economists have extensively debated these unconventional monetary policies and although currently there is more or less a consensus about the importance of the Forward Policy Guidance, the LSAPs still divide many opinions. The ongoing debate about the LSAPs can be summarized in three questions: Are the LSAPs really effective in lowering interest rates and fostering economic growth? What are the risks and possible unintended consequences of the LSAPs? Do the benefits outweigh the risks?

Several recent empirical studies tried to access the impact of the LSAPs over the interest rates and the economy as a whole. The core evidence presented so far suggests that the LSAPs have had the intended effects. For instance, regarding the impact over the interest rates, D’Amico et al. (2012) estimated that the first LSAP program undertaken by the Fed in 2009 reduced longer term treasury yields by about 35 bp (tantamount to a cut in federal funds rate of about 140 bp), whereas the second LSAP program reduced the longer term Treasury yields by about 45 bp (equivalent to a cut of approximately 180 bp in the federal funds rate)[1].

In what concerns the effects of previous quantitative easing programs (QE) on the overall economy, Williams (2012) pointed out that QE2 program lowered the interest rate by roughly 0.3% compared with what it would have been without the program and raised GDP and inflation by about 0.5% and 0.2%, respectively. Moreover, the author points out that together QE1 and QE2 reduced the unemployment rate by 1.5% and probably prevented US economy from falling into deflation.

Despite the positive evidence over the impacts of the LSAPs, there are serious risks that these policies will materialize in higher inflation rates in the future. The doubts about the incapacity of central banks to implement effective anti-inflationary policies in the future stem from the fact that current grim economic outlook is refraining banks from pumping LSAP’s money into the system, instead they are “parking” those resources as excess reserves in the central banks[2].

The threat is that, as soon as the economy starts to improve the banks can start to withdraw the reserves from central bank to lend to the public, which would lead to a sudden increase in the money multiplier and, thus, in the monetary aggregates. In such situations the central banks have some options to avoid the inflationary credit expansion, such as, increase the short term interest rates, increase the interest paid on the excess reserves, increase the minimum reserve requirements or even sell part of the assets previously bought[3].

However, the lack of previous experience with these policies creates a lot of uncertainty. Whether these policies will be sufficient to curb monetary expansion or not is a question mark creating uncertainty and the major risk underlying the LSAPs.

The question of whether the benefits of the LSAPs outweigh their risks is fundamental and will dominate the debates among policymakers and central bankers over the next decades. It is certain that unconventional monetary policies have inflationary risks that perhaps in “normal times” would not justify their implementation. Nevertheless, the combination of impossibility to add fiscal stimulus (either in the politically gridlocked United States or in the highly indebted Euro countries) and the negative economic perspectives that major developed economies now face, in my opinion, justify to bear the risks of these unconventional monetary policies, but this does not mean that those policies can be implemented without the proper caution.

As recently pointed out by the president of the Fed San Francisco, John Williams, “the presence of uncertainty does not mean that we shouldn’t be using these tools. […] However, it should be employed more cautiously than policy tools that have more certain effects”.

Miguel Bandeira da Silva (#59)


Bauer, Michael D. 2012. “Fed Asset Buying and Private Borrowing Rates.” FRBSF Economic Letter 2012 – 16 (May 21).

D’Amico, English, Lopez-Salido and Edward Nelson. “The Federal Reserves’s Large Scale Asset Purchase Programmes: Rationale and Effects.” The Economic Journal, 122 (November 2012), F415–F446.

Williams, John C. (2012, November). The Federal Reserve’s Unconventional Policies. Presentation to the Center for Economics and Public Policy
(UC Irvine).
Irvine, California.

Yamaoka, Hiromi and Murtaza Syed (2010). “Managing the Exit: Lessons from Japan’s Reversal of Unconventional Monetary Policy”. IMF Working Paper 10/114.

“QE, or not QE?”. The Economist, July 14th, 2012.

[1] Furthermore, Bauer (2012) by pointed that the past rounds of LSAPs the Fed have lowered not only the yield of the targeted securities (10-year Treasuries and 30-year Mortgage Backed Securities), but also various private borrowing rates such as the conforming mortgage rate, the jumbo mortgage rate and the average yield on investment-grade securities with 7 to 10 years to maturity.

[2] According to figures from the Fed St.Louis, the amount of excess reserves was $ 1.8 billion in August 2008 is now $1,418 billion.

[3] For a more detailed discussion on the exit strategies of unconventional monetary policies see, for instance, Yamaoka and Syed (2010) and references therein.