Policies and Interest Rates During the Crisis: A Dynamic Approach

Fiscal policy is another powerful instrument of monetary policy at the disposal of central banks, and the last one we will analyze for the purpose of this study. The focus of this paragraph is based on the theory elaborated by John Maynard Keynes (1936), which has been developed as a revision of the Classical Theory of economics during the Great Depression. The stimulus for a correction occurred, indeed, when economists decided to rely on the Classical Theory’s assumption, according to which markets would self–correct and recover from recession. However, the situation deepened into the most severe crisis, questioning the hypothesis contained in the theory, and making some corrections necessary. Reportedly, Keynes’ intuition is based on the importance of an accurate fiscal policy, especially during periods of recession, undertaken in the short run by governments, because “in the long run, we are all dead” (Keynes, 1924). Fiscal policies base their functioning on two transmission channels essentially; remarkably, a recessive trend should be opposed, firstly, with an increase of public spending to boost the economy, and, secondly, with a reduction of taxes that would grant households more resources, encouraging them to spend more. These two channels ensure important results in term of macroeconomic variables. They, indeed, lead to a higher aggregate demand, which stimulates businesses to increase their output, raising employment rates and, ultimately, improving households’ incomes. Conversely, Keynes suggests a reduction of public spending and an increase in taxes, in periods of rapid–growing inflation. By doing so, economy will slow down and inflationary pressure reduces. Nevertheless, Keynes points at the public spending as the most effective channel between the two; this is due to the fact that government spending directly affects aggregate demand. The whole theory is considered being a strong tool for creating a solid economic structure and stable growth.
An article by Clark Johnson (2012) agrees with the importance of government’s actions to contain recessions. Precisely, he confirms economic literature by Keynes, Taylor and Krugman, whereby stabilisation of agents’ expectation is crucial, so they can trust in an on–going boost that will not be withdrawn soon. Monetary policies work, as broadly explained, through the mechanism of interest rates. However, interest rates are subject to a margin of manoeuvre, which means that adjustments of expansionary policies are limited when rates are already very low. This is well explained in Keynes’ General Theory (1936). According to the English economist, there is a point where motetary policies are no longer effective, and they need to be supported by fiscal policies. This circumstance is known as the Liquidity Trap. The thinking behind this theory is quite straightforward: monetary expansions lower interest rates with the aim of stimulating investment and output gap. However, when nominal rates are close to zero, the possibility for central banks to operate further cuts disappears. These traps have already occurred in 1929 in the United States during the Great Depression and in Japan in the nineties during the Great Deflation. Liquidity traps then trigger a particular situation where open market operations (and, in general, increases of money supply) lose all traction and even purchases of governments debt are uninfluential and no longer affecting the interest rate (Krugman, 2008). Moreover, in this state, the economy expresses a production capacity that is a far cry from the actual potential, in spite of the fact that the cost of borrowing is so low that it would stimulate investment and consumption during regular periods. Therefore, the current situation of markets is quite severe, due to interest rates bordering on zero. For example, back in July Libor hit 0.53%, Eonia 0.18% and Federal Funds 0.16%. Such values reduce the margin of intervention that central banks can operate through monetary measures, making the need for governments’ fiscal policies fundamental. According to Keynes, thus, an increase of public expenditure and tax reliefs would help markets to recover and GDP to restore; this would bring employment rates back to regular values (Spilimbergo, S. Symansky, Blanchard, Cottarelli, 2008). As stated in Keynes’ Treatise on Money (1930), indeed, monetary expansions are not consistently effective, and the aid of public investment and taxes is required. [...]