Quantitative Easing and the Bounded Rationality Model
MACROECONOMIC RESEARCH CALLS INTO QUESTION THE NEW CLASSICAL PARADIGM ON THE EFFECTIVENESS OF UNCONVENTIONAL MONETARY POLICY, WHICH SIDESTEPS WALLACE NEUTRALITYby Luigi Iovino, Dept. of Economics, Bocconi
Translated by Alex Foti
Most central banks in countries affected by the 2008 financial crisis reacted at first with a conventional monetary policy, reducing the interest rate and making it easier and cheaper to borrow in the hope of stimulating consumption and investment and staving off deep recession. However, there is a limit on conventional monetary policy, given by the fact that nominal interest rates can’t go below zero. The exceptional severity of the global recession in recent years nevertheless forced many central banks to cut interest rates down to zero. Hence the ensuing decision to adopt unconventional monetary policies such as “forward guidance” and Quantitative Easing (QE). While the former consists of the promise to keep interest rates low for an extended period of time, the second proposes to increase the normal purchase of securities by central banks by adding slightly riskier financial assets to their balance sheets.
Since the start of the Great Recession, a substantial part of the research community has worked to fill the gaps in the economic literature on the effects of unconventional macro policies. For example, empirical research has estimated that such policies reduce the risk premium asked by investors and, as a result, stimulate consumption and investment. Economic theory, on the other hand, has focused on models aimed at identifying and quantifying the mechanisms at work with the new monetary policy instruments. Of particular interest is the theoretical analysis of QE, since in classical macroeconomic models, such as those employed by many central banks, QE operations are completely irrelevant. The intuition behind this result (formally known as the "Wallace Irrelevance Proposition") is very simple: when buying securities from households and companies, the central bank takes on the risk associated with future returns of the securities, but then transfers it again to them via the tax system. In fact, the central bank's balance sheet is closely linked to the Treasury’s, since, by statute, the former transfers to the latter the profits or losses deriving from monetary policy operations. The Treasury, in turn, balances the budget by reducing taxes in the event of profits and increases them in the event of losses. The risk of the securities purchased by the central bank is therefore "returned to the sender" in the form of higher or lower taxes.
Under the hypothesis of rational expectations, therefore, households and businesses understand that the risk of securities sold to the central bank has not been eliminated, but simply transformed from financial into fiscal risk, and consequently leave their consumption and investment plans unchanged. This assumption, however, requires such a degree of understanding of the functioning of the economic system (and a level of computing capabilities) on the part of economic agents to seem unrealistic. In fact, even in much simpler contexts, the behavior of individuals is far from the one predicted by rational expectations theory (see, for example, the countless experiments conducted in the context of the ultimatum game).
A strand of macroeconomic literature has therefore challenged the mainstream paradigm by introducing agents with limited rationality. The results are, so far, positive: these new models are able to overcome some of the most extreme and paradoxical conclusions coming from the previous literature and produce more realistic predictions. In my research, for example, I have shown that in the presence of agents with bounded rationality, Wallace neutrality no longer holds and that, consequently, QE is an effective tool to stimulate the economy. Although it might be still premature to take limited rationality as the new theoretical paradigm, empirical evidence does seem to suggest its validity.
