Limits of Monetary Policy in Theory and Practice

14 Pages Posted: 12 Apr 2013

See all articles by Carmen Reinhart

Carmen Reinhart

Harvard University, Harvard Kennedy School (HKS), Belfer Center for Science and International Affairs (BCSIA) ; Harvard University - Harvard Kennedy School (HKS)

Vincent R. Reinhart

American Enterprise Institute (AEI)

Date Written: October 15, 2011

Abstract

The view that modest alterations to monetary policy have vast consequences for national economies would seem to be inconsistent with theory and evidence. Most modern economic models (represented authoritatively by Woodford 2005) offer limited scope for policy surprises. The basic logic is that spending depends on decisions capitalized over the longer term, and small perturbations in the level of the short-term interest rate do not matter much to those values. More fundamentally, the prominence accorded to authorities controlling nominal magnitudes seems to undervalue the resilience of market economies, which are supposed to be efficient in grinding out appropriate relative prices so as to employ resources efficiently. In other words, if central bankers are crucial to moderating the operations of capitalist economies, then capitalist economies may have serious drawbacks.

We will argue that this fascination with the Fed is also at odds with the evidence by taking a close look at the responses of asset markets to changes in the short-term interest rate since the founding of the Fed in 1914. In fact, there are no apparent effects on either longterm interest rates or housing prices. We will also show that the policy rate more recently had no systematic relationship with long-term interest rates. A global view of capital markets casts doubt on those arguing that a different policy path might have crucially mattered.

Keywords: U.S. Federal Reserve, Central Banking, American Monetary Policy, federal policy, economic policy

JEL Classification: E42, E50, E52

Suggested Citation

Reinhart, Carmen and Reinhart, Vincent R., Limits of Monetary Policy in Theory and Practice (October 15, 2011). Cato Journal, Vol. 31, No. 3, 2011, Available at SSRN: https://ssrn.com/abstract=2248082

Carmen Reinhart (Contact Author)

Harvard University, Harvard Kennedy School (HKS), Belfer Center for Science and International Affairs (BCSIA) ( email )

79 JFK Street
Cambridge, MA 02138
United States
617-496-8643 (Phone)

Harvard University - Harvard Kennedy School (HKS) ( email )

79 John F. Kennedy Street
Cambridge, MA 02138
United States

Vincent R. Reinhart

American Enterprise Institute (AEI) ( email )

1150 17th Street, N.W.
Washington, DC 20036
United States

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