When central banks pump money into the banking system during a financial crisis, such a policy is initially very effective, but the impact declines over the course of the crisis. That is the conclusion drawn by researchers at the Institute for the World Economy (IfW), who have empirically analyzed the transmission of monetary policy during financial crises.
The research suggests that during the acute phase of a crisis, expansionary monetary policy has a positive effect on gross domestic product (GDP) and a stabilizing effect on inflation. Both parameters reacted faster and more strongly than when the economy is not in crisis. "During the acute phase of the current financial crisis, i.e., essentially in 2008 and 2009, central bank policy action probably made a major contribution toward stabilizing the economy," says Nils Jannsen, economic researcher at the IfW. This is explained by the fact that the high level of uncertainty among market participants and lack of confidence in the economic outlook during the acute phase of a crisis put a damper on both output and inflation. In such a scenario, an expansionary monetary policy boosts confidence.
In contrast, pursuing an expansionary monetary policy in the recovery phase of a financial crisis is largely ineffective, according to the researchers. Output and inflation no longer respond significantly to any further increase of the money supply or reduction in interest rates. In the recovery phase, a raft of new expansionary measures can be interpreted by the markets as a sign that the economy is in a worse state than previously thought. As such, the measures may even prove harmful to the economy. With reference to the current crisis, the additional steps taken by the central banks from around 2010 onward, which also include the QE-Program from the ECB, have probably not been very effective, according to Jannsen. The low impact of monetary policy could even be the reason why the recovery has been unexpectedly weak in many places. "The research shows that monetary policy is not a silver bullet with the ability to control GDP growth and inflation at will," Jannsen states. "Central banks should exercise caution around additional expansionary measures during an emerging post-crisis recovery, especially given that highly expansionary monetary policy is also associated with considerable risks, such as asset price bubbles."
In their empirical study, the IfW researchers analyzed data from the past 30 years for 20 advanced economies, including the US and the larger eurozone countries. The full study, entitled "Monetary Policy during Financial Crises: Is the Transmission Mechanism Impaired?," by Nils Jannsen, Galina Potjagailo, and Maik Wolters, is available here.