The monetary policy’s efficiency during a recession: A description, evaluation and empirical analysis

Jakob Hans Michael Weinberger

Student thesis: Master thesis

Abstract

The objective of this thesis is to describe, analyze and discuss the traditional monetary policy and its instruments during a recession. There are some discussions amongst different schools of economists, the Keynesian and the Monetarist, on whether the monetary policy will have an effect on the real economy. Where fiscal policy affects the economy directly through the multiplier effect the monetary policy will only indirectly affect the real economy through the transmission channels. Its efficiency has especially been questioned when the economy is caught in a liquidity trap where the monetary interest rates are close to the zero-limit bound. Four alternative strategies that could help the economy to escape the liquidity trap are therefore presented in section 6. Most central banks agree on price-stability as the most important medium to long term target that a central bank can pursue. Denmark has for a long time had a fixed exchange rate first to the deutschmark and later to the euro. Since the Danish krone is fixed to the euro the degree of freedom in terms of monetary policy is rather limited as the spread between the two monetary interest rates can not be too significant. This is to make sure that the exchange rate is held within a certain bound. Other regimes, i.e. inflation targeting, have been used by other central banks in order to reach the goal of price-stability. Research has shown that both fixed exchange rate policy and inflation targeting are almost equally efficient in terms of reaching price stability. After years of global economic boom and high inflation the economic situation changed with the start of the financial crisis. Negative growth rates in real GDP in 2008 and 2009 had severe consequences for the economy in general. The start of the financial crisis challenged the stability of the financial sector and the distrust amongst the financial institutions in the Danish economy meant that the money market froze. The spread seemed to be the result of a money market where the counterparties were extremely risk-averse and were very careful as to take on more risk. This is supported by the empirical data analyzed by an econometric model that measures credit- and liquidity risk influences on the money market interest rate. The interest rate in the traditional monetary policy can in such a situation, as we saw under the financial crisis, be ineffective as it can not reduce the risk premium on the money market by itself. The analysis shows that Danmarks Nationalbank and other central banks have used alternative monetary strategies besides its traditional monetary strategy in order to stabilize the financial sectors. The economy has still not fully recovered and looking at the Danish monetary policy isolated it has not been found sufficient but have been necessary supplement to other economic alternatives, i.e. fiscal policy and banking packages.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2012
Number of pages97