Monday, November 10, 2008

Monetary sado-masochism

Since 1999 the FED moved the policy rate 45 times, the ECB 25 times. And yet, given the fact that the European labor market is much more rigid, it would make sense for the ECB to be more activist than the FED (I, sort of, show it in this paper). Moreover, in these tough times prudence can be counterproductive. A 1996 AER paper byCaplin and Leahy makes the point very well: Modest stimuli may prove ineffectual. If small reductions in interest rates are unlikely to promote a response, then they may be followed by further cuts. A vicious circle develops in which the expectation that the policy could fail leads investors to delay investment, thereby promoting failure.
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