The Very Model of Modern Monetary Policy
Greg Kaplan, BENJAMIN MOLL, GIOVANNI L. VIOLANTE
March 2023
Credit: ISTOCK/ francescoch
New economic models can help policymakers better understand the effects of their inflation-taming measures
Much about today’s inflation is not well understood. Why are some households seriously harmed while others barely feel inflation’s impact, and may even benefit? How is the battle against inflation affected by the glut of savings and government payments brought on by the pandemic? How important were pandemic-related supply shocks and the Russian invasion of Ukraine?
The evolving objectives of monetary policy further complicate our understanding of inflation. Monetary policy has long emphasized controlling inflation by stabilizing aggregate demand. But recently, central banks have broadened their objectives to include financial stability, climate and geopolitical risks, and social inclusion.
Macroeconomic models play a key role in helping to navigate this complicated landscape. Models help policymakers interpret empirical observations about the state of the economy, suggest how different policy settings will affect their objectives, and ultimately guide policy decisions. Quantitative models measure the strengths of different forces at play, helping to assess the trade-offs between competing objectives.
But traditional models ignore income and wealth inequalities and assume that what’s good for the typical consumer, as defined by the models, must be good for the broader economy.
A newly developed class of quantitative models is particularly suited to guiding central bankers across this new monetary policy territory, in which the wealth and income distributions are a central consideration. Known as HANK models, they combine heterogeneous agent models (macroeconomists’ workhorse framework for studying income and wealth distributions) with New Keynesian models (the basic framework for studying monetary policy and movements in aggregate demand).
HANK models impart new lessons about redistribution and the heterogeneous effects of monetary policy and shed new light on traditional central bank objectives of inflation control and output stabilization. Here are four broad lessons, and some preliminary thoughts, on how HANK models may illuminate our current high-inflation environment.
Los nuevos modelos económicos pueden ayudar a los responsables políticos a comprender mejor los efectos de sus medidas de control de la inflación.
Hay muchos aspectos de la inflación actual que no se comprenden bien. ¿Por qué algunos hogares se ven gravemente perjudicados mientras que otros apenas sienten el impacto de la inflación, e incluso pueden beneficiarse? ¿Cómo afecta a la lucha contra la inflación el exceso de ahorro y de pagos públicos provocado por la pandemia? ¿Hasta qué punto fueron importantes los shocks de oferta relacionados con la pandemia y la invasión rusa de Ucrania?
La evolución de los objetivos de la política monetaria complica aún más nuestra comprensión de la inflación. Durante mucho tiempo, la política monetaria ha hecho hincapié en el control de la inflación mediante la estabilización de la demanda agregada. Pero recientemente, los bancos centrales han ampliado sus objetivos para incluir la estabilidad financiera, los riesgos climáticos y geopolíticos y la inclusión social.
Los modelos macroeconómicos desempeñan un papel fundamental en este complicado panorama. Los modelos ayudan a los responsables de las políticas a interpretar las observaciones empíricas sobre el estado de la economía, sugieren cómo afectarán a sus objetivos las diferentes configuraciones de las políticas y, en última instancia, orientan las decisiones políticas. Los modelos cuantitativos miden la fuerza de las distintas fuerzas en juego y ayudan a evaluar las compensaciones entre objetivos contrapuestos.
Pero los modelos tradicionales ignoran las desigualdades de renta y riqueza y asumen que lo que es bueno para el consumidor típico, según lo definen los modelos, debe ser bueno para la economía en general.
Una nueva clase de modelos cuantitativos es especialmente adecuada para guiar a los banqueros centrales en este nuevo territorio de la política monetaria, en el que las distribuciones de la riqueza y la renta son una consideración central. Conocidos como modelos HANK, combinan modelos de agentes heterogéneos (el marco de trabajo de los macroeconomistas para estudiar las distribuciones de la renta y la riqueza) con modelos neokeynesianos (el marco básico para estudiar la política monetaria y los movimientos de la demanda agregada).
Los modelos HANK aportan nuevas lecciones sobre la redistribución y los efectos heterogéneos de la política monetaria y arrojan nueva luz sobre los objetivos tradicionales de los bancos centrales de control de la inflación y estabilización de la producción. He aquí cuatro lecciones generales, y algunas reflexiones preliminares, sobre cómo los modelos HANK pueden iluminar nuestro actual entorno de alta inflación.
Lesson 1: Predicting indirect policy impacts
HANK models have taught us how monetary policy affects household consumption expenditures, both directly and indirectly. Direct channels are those that can be directly ascribed to a change in short-term policy rates, such as consumers’ decisions to postpone purchases when interest rates increase. Indirect channels arise through the impact of the policy rate on other interest rates (such as long-term bond and mortgage rates), on asset prices (such as housing and stocks), and on dividends, wages, and government taxes and transfers.
The relative size of indirect versus direct channels depends mainly on the aggregate marginal propensity to consume (MPC), which measures how much of a household’s increase in income gets spent and how much is saved. In traditional models, which try to predict the impact of monetary policy on the typical consumer, the MPC is tiny, and consequently the indirect channels are insignificant. HANK models, instead, are built to be consistent with empirical evidence on consumption and saving behavior. Their aggregate MPC is roughly 10 times larger, and thus the various indirect effects dominate the transmission mechanism.
What does this mean for monetary policy? Through the lens of older models, all a central banker needs to know to predict the aggregate consumption response is an estimate of one parameter, consumer willingness to postpone purchases when interest rates rise (the “intertemporal elasticity of substitution”). But with HANK models, central banks need much more exacting information about the household side of the economy. They need a full picture of the distribution of MPCs, income sources, and the components of household balance sheets. In addition, the importance of indirect channels means that the transmission of monetary policy is mediated by all those mechanisms that contribute to price formation in goods, inputs, credit, housing, and financial markets. Therefore, central banks need a deep comprehension of market structures and frictions, as well as of institutions that play major roles in these settings, such as local governments, unions, and regulatory bodies.
Lesson 2: Some ships are lifted higher, others are sunk
In the traditional view of monetary policy, “a rising tide raises all ships.” HANK models show this is a fiction.
Many channels of monetary policy have divergent, and sometimes opposing, effects on different households. For example, the direct effects of interest rate changes depend on households’ balance sheets: rate cuts benefit debtors, whose interest payments decrease (such as households with adjustable-rate mortgages) and hurt savers, whose interest income falls. Monetary policy also has heterogeneous effects through its impact on inflation. First, inflation benefits households with lots of nominal debt that is revalued downward. Second, prices rise more for some goods than for others, and different households consume these goods in unequal proportions. Finally, the indirect effects of monetary policy on household disposable income are uneven because some households are more exposed to fluctuations in aggregate economic activity than others.
In HANK models, these redistributive channels are not only crucial for understanding who wins and who loses in monetary policy but are also at the core of how monetary policy operates, in the sense that redistribution determines its quantitative effect on macroeconomic aggregates. To the extent that the channels outlined above redistribute from households with low MPCs to those with high MPCs (from savers to spenders), the macroeconomic impact of monetary policy is amplified. These redistributive effects will also differ across countries. For example, they would likely be stronger in countries with a high poverty rate or high inequality, thereby also resulting in different monetary transmission between advanced economies and low- and middle-income countries. HANK models force us to let go of the fiction that we can cleanly separate stabilization from redistribution.
Lesson 3: Fiscal footprints matter
Another widespread misconception is the view that monetary policy can be divorced from fiscal policy.
By introducing income and wealth inequality, HANK models reestablish a strong link between the two, showing how monetary policy leaves consequential “fiscal footprints.” When the central bank raises interest rates, the treasury’s borrowing costs increase, and the increase must be funded by raising taxes or lowering expenditures, now or in the future, or through future inflation. In HANK models, the details of how and when the government makes up this fiscal shortfall, and which households bear the burden, have a tremendous influence on the overall effects of interest rate hikes.
The fiscal footprint of monetary policy thus generates additional redistribution, which, in turn, amplifies or dampens the shock depending on whether it shifts resources from savers to spenders, or vice versa. This force keeps central banks and treasuries inseparably intertwined. The more debt the government owes and the shorter-term it is, the bigger the fiscal footprint.
More generally, HANK models are also a natural environment to study the effects of fiscal policy on aggregate productive efficiency, the degree of social insurance, and the extent of redistribution between households.
Lesson 4: The right tool for redistribution
Where does this leave monetary policy in practice?
Studies of optimal monetary and fiscal policy in HANK models agree that the benefits of aggregate stabilization are dwarfed by the gains from directly alleviating hardship. Optimal policies in HANK models almost always favor redistributing toward hand-to-mouth households in downturns.
One may be tempted to read this as endorsement of using monetary policy to share prosperity and mitigate adversities. But monetary policy is a blunt tool for redistribution or insurance. HANK models tell us that fiscal policy is likely better suited for this task because it can be targeted more precisely to those in need of support.
The current bout of inflation
The current inflation episode is a good example to explore where HANK models can be useful for macroeconomic analysis and policy advice.
HANK models show that the impact of a macroeconomic shock on aggregate spending is larger when individual MPCs and individual exposures to the shock are more strongly correlated. In the current economic environment, this means that understanding the redistributive implications of inflation across households is crucial to gauge its aggregate implications. Households consume different bundles of goods and services, making some more sensitive to inflation than others. For example, poor families who spend a larger share of their income on basic goods like energy are especially harmed in this episode. Borrowers gain as the real value of their debt falls, while households with large amounts of cash or liquid savings lose. Workers whose compensation is relatively flexible (for example, because of bonuses and commissions) can limit their loss of purchasing power, whereas workers whose nominal wages are negotiated infrequently, or those paid the minimum wage, will see their real earnings shrink.
The level of household savings, which influences how a change in interest rates affects consumption, is critical. So is the distribution of savings across the population and the correlation with household willingness to spend. For example, excess savings that arose from consumption restrictions due to the pandemic (think of less spending on travel and restaurant meals) are largely held by the well-off and are therefore being spent at a very low rate. Excess savings accumulated from the large government transfer programs in 2020 and 2021 are largely held by low-income households and are being spent much faster. A rapid spending rate sustains aggregate demand and gets in the way of a central bank’s efforts to tame inflation.
Finally, a full evaluation of the welfare effects of the current bout of inflation cannot ignore its causes. The jury is still out on the relative importance of supply shocks (due to the COVID-19 pandemic and war in Ukraine), the large fiscal stimulus in 2020 and 2021, and the loose monetary policy in the decade since the most recent recession. Each of these factors had redistributive components and heterogeneous effects that cannot be understood within the shackles of traditional models. Putting HANK models to work will help us understand the full effects of this episode of monetary history.
El actual episodio de inflación es un buen ejemplo para explorar dónde pueden ser útiles los modelos HANK para el análisis macroeconómico y el asesoramiento político.
Los modelos HANK muestran que el impacto de una perturbación macroeconómica sobre el gasto agregado es mayor cuando los PSM individuales y las exposiciones individuales a la perturbación están más fuertemente correlacionados. En el entorno económico actual, esto significa que comprender las implicaciones redistributivas de la inflación entre los hogares es crucial para calibrar sus implicaciones agregadas. Los hogares consumen diferentes paquetes de bienes y servicios, por lo que algunos son más sensibles a la inflación que otros. Por ejemplo, las familias pobres que gastan una mayor parte de sus ingresos en bienes básicos como la energía se ven especialmente perjudicadas en este episodio. Los prestatarios ganan al caer el valor real de su deuda, mientras que los hogares con grandes cantidades de efectivo o ahorros líquidos pierden. Los trabajadores cuya remuneración es relativamente flexible (por ejemplo, debido a primas y comisiones) pueden limitar su pérdida de poder adquisitivo, mientras que los trabajadores cuyos salarios nominales se negocian con poca frecuencia, o los que cobran el salario mínimo, verán reducirse sus ingresos reales.
El nivel de ahorro de los hogares, que influye en la forma en que una variación de los tipos de interés afecta al consumo, es fundamental. También lo es la distribución del ahorro entre la población y su correlación con la disposición de los hogares a gastar. Por ejemplo, el exceso de ahorro derivado de las restricciones de consumo debidas a la pandemia (pensemos en menos gastos en viajes y comidas en restaurantes) está en gran parte en manos de los más acomodados y, por tanto, se está gastando a un ritmo muy bajo. El exceso de ahorro acumulado por los grandes programas de transferencia del gobierno en 2020 y 2021 está en gran parte en manos de los hogares de bajos ingresos y se está gastando mucho más rápido. Un ritmo de gasto rápido sostiene la demanda agregada y obstaculiza los esfuerzos de un banco central por controlar la inflación.
Por último, una evaluación completa de los efectos sobre el bienestar del actual brote de inflación no puede ignorar sus causas. Todavía no se sabe a ciencia cierta la importancia relativa de las perturbaciones de la oferta (debidas a la pandemia del COVID-19 y a la guerra en Ucrania), el gran estímulo fiscal en 2020 y 2021 y la política monetaria laxa en la década transcurrida desde la recesión más reciente. Cada uno de estos factores tenía componentes redistributivos y efectos heterogéneos que no pueden entenderse dentro de los grilletes de los modelos tradicionales. Poner a trabajar los modelos HANK nos ayudará a comprender todos los efectos de este episodio de la historia monetaria.
GREG KAPLAN is a professor in the Kenneth C. Griffin Department of Economics at the University of Chicago.
BENJAMIN MOLL is a professor of economics at the London School of Economics and Political Science
GIOVANNI L. VIOLANTE is Theodore A. Wells ’29 Professor of Economics at Princeton University.
https://www.imf.org/en/Publications/fandd/issues/2023/03/modern-monetary-policy-kaplan-moll-violante
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