Low-inflation-targeting monetary policy and differential unemployment rate: Is monetary policy to be blamed for the financial crisis? — Evidence from major OECD countries

Rosmy Jean Louis and Faruk Balli

Economic Modelling, 2013, vol. 30, issue C, 546-564

Abstract: Since the mid-1990s, monetary policy discussion has been centered around whether targeting inflation rate too low was responsible for the differential unemployment rate observed between major OECD countries and the US. In late 2000s with the financial crisis, critiques have argued that these economies had fallen into liquidity trap sooner because of the policy mistake of adhering to the 2% inflation target when the policy rate was already too close to zero. As the argument goes, since there was not enough room left to maneuver, central bankers were powerless in their attempt to revive the economy when aggregate demand collapsed. Using SVAR methodology, this paper formally investigates whether unanticipated deviation of OECD short-term rates from the fund rate can indeed explain differential unemployment rate with the US. It also discusses whether low-inflation targeting monetary policy is to be blamed for the financial crisis. The results show that interest rate differential shocks have no effects on unemployment in the very short-run. However, in the long-run, the cost for deviating drastically from US monetary policy is indeed higher and persistent unemployment at home, on average 30, 102, and 186 basis-points after 10, 15, and 20 quarters, respectively for the period 1989q1–2009q4. This cost is on average higher for inflation- than non-inflation targeting countries. These findings suggest that the fear of unemployment was partly the reason central bankers kept interest rate low since commodity prices were falling as a result of globalization while the economies were returning to normal partly due to positive supply shocks. Since Canada had its interest rate well aligned with the fund rate prior to the crisis while the inflation target was 2%, but did not suffer as much because sound mortgage rules and financial regulation were in place, the view that higher inflation target might have produced a different outcome does not seem to rest on firm grounds. Therefore, this paper lends support to the view that lax mortgage rules and financial deregulations in the US were the main factors responsible for the crisis.

Keywords: Differential interest rate; Differential unemployment rate; OECD vs.USA; SVAR; Cointegration analysis; Inflation targeting; Monetary policy effectiveness (search for similar items in EconPapers)
JEL-codes: C32 E52 F02 (search for similar items in EconPapers)
Date: 2013
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (9)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecmode:v:30:y:2013:i:c:p:546-564

DOI: 10.1016/j.econmod.2012.09.042

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