There are many ways for monetary policy to remain potent under ZLB

There are several important points that I have learnt in the past few days. Most importantly, monetary policy has many ways to remain potent even under zero lower bound (ZLB). Before pursuing further, let's take a step back and understand what a central bank is supposed to do and legally obligated to do.

Firstly, a central bank has two different tools to influence the direction of an economy. Those are money supply and interest rate. Let's assume that if an economy is on a downward trend, a central bank can either increase its money supply and/or push down the interest rate. Same goes for the other way, where if an economy is overheating, a central bank can slow down its money supply into the economy and/or increase the interest rate. This is a straightforward framework.

Secondly, we need to understand what a central bank is supposed to do. A central bank is responsible for keeping prices on check and implementing necessary tools to achieve its goals. To my knowledge, only the Federal Reserve is responsible for managing price stability and achieving maximum employment.

Thirdly, let's talk about what a central bank is legally obligated to do. Let's take the Bank of Thailand (BoT) and the Bank of Korea (BoK) as examples. I choose them because these are the central banks that are most likely to encounter the ZLB problem in the future. If we look at the BoT's website here and the BoK's website here, many jurisdictions fall under these central banks, including currency issuance, financial stability, and foreign exchange stability. 

Now that I have clarified several crucial points regarding the central bank and its functions, we can now look at the ZLB problem.

In late December 1999, former Fed Chair Ben Bernanke (during this period, he was a professor at Princeton) pointed out several ways for a monetary policy to remain potent under ZLB. This was in response to the officials at the Bank of Japan on how they responded to the asset price collapsed, which eventually put Japan in a continuous battle with deflation for two decades.

In summary, these are the proposed measures:

Announce the central bank intention (a.k.a forward guidance) with a higher inflation target.

• The first part of the description is pretty similar to what we're seeing now, where the central bank announces its intention on how long the short-term interest rate to stay low. However, announcing a plan without any numerical goal is pointless. Therefore, announcing at what rate a central bank wants its inflation rate to be is plausible. This was mentioned by Krugman (1998). Bear in mind that the Reserve Bank of New Zealand was the first central bank to implement an inflation-target in its monetary policy operations.

Let the FX to depreciate.

• I would call this as a "short-cut" to get inflation rate faster to its goal. Even though this works in theory, it is hard to implement in real-world, especially if politics are involved. 

Money-financed transfers (a.k.a. helicopter drop).

• It sounds exactly as it is, where a central bank prints money (because they are legally able to do so), take the whole money into a helicopter, and fly it into a certain place, and drop the money to the public. That's probably a cartoonish way to illustrate. 

Now that I have shown how monetary policy can operate under ZLB, we need to think about whether these can be implemented in countries like Thailand and South Korea.

My next post should be about how these central banks ideally implement these policies.

Sources:

Bernanke, B. (1999). Japanese Monetary Policy: A Case of Self-Induced Paralysis?

Krugman, P. (1998). It’s baaack: Japan’s Slump and the Return of the Liquidity Trap. Brookings Papers on Economic Activity, 1998(2), 137–205.