Economic Brief March 2017, EB17-03 Are the Effects of Monetary Policy Asymmetric? By Regis Barnichon, Christian Matthes, and Tim Sablik The Federal Reserve uses monetary policy to stimulate the economy when unemployment is high and to rein in inflationary pressures when the econ- omy is overheating. However, evidence suggests that these policy stances have unequal effects. Contractionary monetary shocks raise unemployment more strongly than expansionary shocks lower it. The Federal Reserve has a “dual mandate” to policies during the Great Recession after reduc- maintain stable prices and maximum sustain- ing its target rate to nearly zero seemed to have able employment. It does so primarily by con- little effect on unemployment. trolling its target interest rate (the federal funds rate), which influences short-term market rates. Monetary policy asymmetry is best described When unemployment is elevated, the Fed loos- using a metaphor. Imagine a string with mon- ens monetary policy (lowers its target rate) to etary policy at one end and the economy at the stimulate economic activity and boost output. other. Employing tight monetary policy when When inflation is rising, the Fed tightens policy inflation is rising is like pulling on the string to (raises its target rate) to slow economic activity keep the economy in check — it works fairly and counteract inflationary pressure. well. But attempting to stimulate the economy with loose policy during a downturn is like try- But are both types of policy responses equally ing to push on the string to move the economy effective? Since the Great Depression, econo- — not very effective. mists have suspected that tight policy may have a stronger effect on output than loose In addition to monetary changes having asym- policy because the Fed’s response to the market metric effects based on their direction, the crash of 1929 failed to avert the Great Depres- strength of monetary policy may also vary with sion. Milton Friedman and Anna Schwartz later the state of the economy. Previous tests for mon- argued in their 1963 book, A Monetary History of etary policy asymmetries have had somewhat the United States, that this was because the Fed’s mixed results, but this Economic Brief presents policy stance during the early 1930s actually new evidence to confirm the asymmetric effects was contractionary rather than expansionary, of monetary policy. but other examples have reinforced the view that expansionary monetary policy may be more Why Might Monetary Policy Be Asymmetric? limited than contractionary policy. Most recently, There are several theoretical reasons why mon- the Fed was forced to turn to unconventional etary policy could have asymmetric effects on EB17-03 - Federal Reserve Bank of Richmond Page 1 economic output.1 The first relates to the behavior Testing for Asymmetry of lenders and borrowers under different monetary If monetary policy does have asymmetric effects on conditions. When the Fed raises its policy rates, mar- output, that finding would have important implica- ket rates tend to rise accordingly. One might expect tions for how the Fed conducts policy. Conclusive that banks would simply pass these higher rates on to evidence one way or the other has proven some- their borrowers. While this is true to an extent, raising what elusive, however. A number of studies do find loan rates too high could increase the likelihood that evidence that contractionary policy has a stronger risky borrowers default. As a result, banks may choose effect on output than expansionary policy, as the to ration credit during a period of high interest rates, theory predicts.2 But other studies find that what constraining credit for some consumers and leading matters is not the direction of the monetary change to a bigger decline in output, thus amplifying the but rather its size.3 And still other studies find evi- impact of contractionary monetary policy. On the dence that the impact of monetary policy depends other hand, expansionary policy will not necessarily chiefly on the state of the economy.4 increase borrowing and spending if economic condi- tions have reduced demand. Unlike tight monetary One problem facing economists trying to find evi- policy, it is not a binding constraint on consumers (as dence of asymmetry is that the standard models expressed in the old adage, you can lead a horse to used for measuring the effects of shocks, such as water but you can’t make it drink). changes in monetary policy, have difficulty identify- ing asymmetric effects. Economists have attempted Another reason why expansionary monetary policy to get around this problem in two ways. The first might be less effective than contractionary policy involves looking at unanticipated increases and is because prices seem less likely to adjust down- decreases in the money supply and testing whether ward — that is, they are “sticky.” Firms also may be these changes have asymmetric effects. One chal- reluctant to lower wages for fear of damaging worker lenge with this approach is correctly identifying morale. Because of such downward price and wage unanticipated monetary shocks. Additionally, while rigidity, firms will tend to respond to contraction- these models may be able to detect asymmetry ary monetary policy by reducing output rather than based on the direction of a monetary change, prices. Prices and wages are less upwardly sticky, they struggle to measure other potential causes of however. Firms are accustomed to raising prices and asymmetry. Another approach makes use of regime- wages gradually due to inflation, for example. As a switching models that allow for the impact of one result, expansionary monetary policy is more likely variable (monetary policy) to depend upon changes to prompt a change in prices rather than output. in another variable (the state of the economy). But while these models can identify whether the effects Finally, monetary policy may have asymmetric effects of monetary policy change with the business cycle, during different points in the business cycle due to they are not able to determine if the effects of con- changes in consumer outlook. Similar to the credit- tractionary policy are inherently different from constraint argument, if consumers are pessimistic those of expansionary policy. about economic conditions, then lowering rates may not do much to stimulate borrowing and spending. Two of the authors of this brief, Barnichon and Mat- This explanation is not entirely compelling, however, thes, have developed an alternative approach for since consumer optimism during a boom period addressing these issues.5 They start with a model should also weaken the effect of tight monetary of the economy in which the behavior of a system policy. For contractionary policy to have a stronger of macroeconomic variables is determined by its effect than expansionary policy, consumers and firms (possibly asymmetric) response to past and present would have to be more pessimistic during economic shocks. They then use Gaussian functions to para- downturns than they are optimistic during booms. meterize the dynamic effects of structural shocks This is certainly possible but perhaps not realistic. on the economy. The advantage of this approach Page 2 — dubbed Gaussian Mixture Approximation — is hand, a 0.7 percentage point decrease in the federal that it uses only a small set of free parameters, which funds rate produces only a 0.04 percentage point de- then allows for a much more efficient estimation of crease in unemployment — an effect that is not models with asymmetric responses. In simulations, statistically different from zero. This implies that Barnichon and Matthes’ approach not only performs contractionary monetary policy has a significantly as well as benchmark models in estimating linear or stronger effect on unemployment than expansion- symmetric responses, it can also detect asymmetric ary policy. responses in nonlinear models. Barnichon and Mat- thes use their new methodology to estimate wheth- Barnichon and Matthes also find some, albeit incon- er monetary shocks generate asymmetric responses clusive, evidence that prices respond asymmetrically depending on the direction of the shock as well as to monetary changes. Prices appear stickier follow- the state of the economy. ing monetary contractions than following monetary expansions. This provides some supporting evidence Results and Implications for the theory that monetary policy has asymmetric Barnichon and Matthes first test whether the direc- effects because firms are more reluctant to lower tion of a monetary shock alone results in different prices and wages than to raise them. economic responses. Applying data from 1959 through 2007 to their model, they find strong evi- Next, Barnichon and Matthes expand their model dence of an asymmetric response in unemployment to allow the effects of monetary policy to depend depending on the direction of the monetary change. on both the direction of the change and the state They estimate that an increase in the federal funds of the economy. Again, they find that expansionary rate of 0.7 percentage points results in an increase in monetary policy has a weaker effect on unemploy- unemployment of 0.15 percentage points, a larger ment than contractionary policy. Additionally, they effect than the 0.10 percentage points estimated by find that the effect of expansionary policy depends a standard linear model.6 (See Figure 1.) On the other on the state of the economy. When unemployment Figure 1: Asymmetric