The Simple Analytics of Monetary Policy: A Post-Crisis Approach

Benjamin M. Friedman

The Journal of Economic Education, 2013, vol. 44, issue 4, 311-328

Abstract: The standard workhorse models of monetary policy now commonly in use, both for teaching macro- economics to students and for supporting policymaking within many central banks, are incapable of incorporating the most widely accepted accounts of how the 2007--9 financial crisis occurred and are incapable too of analyzing the actions that monetary policymakers took in response to it. They also offer no point of entry for the frontier research that many economists have subsequently undertaken, especially research revolving around frictions in financial intermediation. The author suggests a simple model that bridges this gap by distinguishing the interest rate that the central bank sets from the interest rate that matters for the spending decisions of households and firms. One version of this model adds to the canonical "new Keynesian" model a fourth equation representing the spread between these two interest rates. An alternate version replaces this reduced-form expression for the spread with explicit supply and demand equations for privately issued credit obligations. The discussion illustrates the use of both versions of the model for analyzing the kind of breakdown in financial intermediation that triggered the 2007--9 crisis as well as "unconventional" central bank actions like large-scale asset purchases and forward guidance on the policy interest rate.

Date: 2013
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DOI: 10.1080/00220485.2013.825109

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