Collaborative Research: Experimental Evidence on Monetary Policies

Indiana University, Bloomington IN

Investigators

Abstract

The Great Recession of 2008-09 led central banks to experiment with non-traditional monetary policies, for example, quantitative easing in Japan, the U.K. and the U.S. and negative interest rates on excess reserves in Denmark, Sweden and the Eurozone. Nevertheless, the extent of policy experimentation was greatly tempered by the need to avoid, to the extent foreseeable, harmful macroeconomic impacts from these non-traditional policies. In this project we set out an agenda for conducting monetary policy experiments more broadly in the controlled conditions of the experimental laboratory with the aim of understanding the welfare consequences of various monetary policies prior to their possible implementation in the field. Our approach is analogous to wind-tunnel testing of aircraft before the aircraft is allowed to fly. The study of monetary policies in the necessarily small-scale, low-stakes laboratory environment with paid human subjects is much less restrictive or expensive than experimentation in the field, thereby allowing for evaluation of a much richer and even radical set of monetary policies. Indeed, our aim is to provide new evidence on the welfare impacts of various monetary policies that would be difficult, if not impossible to implement in the field at least without some prior evidence on their effectiveness. We seek to begin the process of gathering such evidence. Our larger goal is to demonstrate that laboratory tests of monetary policies can be a complementary tool to theory and empirical analysis of field data in the evaluation of the efficacy of different monetary policies. Our framework for monetary policy analysis is Lagos and Wright's search-theoretic model of money, a work-horse model in monetary economics that we have previously implemented in the laboratory. In this project we propose to use the Lagos-Wright model to explore the celebrated Friedman rule (Friedman 1969) for monetary policy. The Friedman rule is known to be optimal in a very wide variety of different monetary models, including the Lagos-Wright model. In essence, Friedman showed that the welfare-maximizing monetary policy is to set inflation so as to make the nominal interest rate - the private marginal cost of holding money -- equal to zero. Since the social marginal cost of producing more money is essentially zero, if the private marginal cost were positive, there would be an inefficient gap that could be closed by making the nominal interest rate equal to zero. It follows that, if the real rate of return on safe government bonds is ñ>0, and the nominal interest rate, i, as given by the Fisher equation, is i= EI + ñ, where EI denotes the expected inflation rate, then, in order for i=0 the central bank should work to set EI = -ñ <0. While central bankers are undoubtedly aware of the Friedman rule and often express a genuine desire for low inflation, it would be very much against conventional wisdom for central bankers to argue for, let alone attempt to implement, a negative inflation rate (deflation) as the Friedman rule would typically require. In the laboratory we are not bound by such considerations and thus we propose to implement the Friedman rule in two different ways and assess the welfare implications. The first approach is a deflationary monetary policy of the type outlined above. The second approach is to pay a competitive market interest rate on money holdings removing altogether the private marginal cost from holding money. As with the first approach, the practicalities of providing interest on hand-to-hand cash holdings has likely rendered this possibility unworkable. In this project we explore, for the first time both implementations of the Friedman rule in our experimental Lagos-Wright economy. In addition to exploring the welfare consequences of the two different implementations of the Friedman rule, we are also interested in using our framework to study the welfare consequences of inflationary policies. Specifically, we are interested in the welfare costs of low versus high inflation rates, and we propose to address this question by varying the money growth rate. Finally, following up on one of our previous studies, we wish to study whether legal restrictions on the use of fiat money (e.g. to pay taxes) matter for the adoption of fiat money and for welfare.