Narayana Kocherlakota: On the limits to monetary policy
Executive summary by Mr Narayana Kocherlakota, President of the Federal Reserve Bank of
Minneapolis, of the 2nd Annual Hyman P Minsky Lecture, Washington University, St Louis,
Missouri, 20 March 2012.
* * *
Slides to the original speech can be found on the Federal Reserve Bank of Minneapolis's website
(http://www.minneapolisfed.org/news_events/pres/kocherlakota_minsky_speech_032012.pdf).
Since the start of the Great Recession, employment has fallen considerably, while average
inflation has been near the Federal Reserve's target of 2 percent. Given the Federal
Reserve's dual mandate to promote price stability and maximum employment, an obvious
question is "Why does the Federal Reserve appear to be doing so much better on one
mandate than the other?"
In this speech, I present a simple model that suggests an answer to this question. A key
labor demand
feature of the model is that there are two distinct types of demand shocks:
shocks and product demand shocks. The labor demand shocks reflect factors such as
adverse credit conditions and increased uncertainty that lead firms to demand fewer workers
at a given real wage. The product demand shocks reflect factors such as a loss of wealth
and a higher risk of job loss that lead households to demand fewer goods at a given real
interest rate. Each of these shocks leads to a fall in employment, with the decline in
employment magnified by slow adjustments in the real wage.
When considering these shocks, it is important to distinguish how monetary and
non-monetary policies influence the level of output and employment. In the model I employ,
the Federal Reserve controls the real interest rate; lowering the real interest rate increases
the demand for goods and services, and thereby influences national output and employment.
can
The first implication of the model is that monetary policy offset the impact of the product
demand shocks on employment, but it cannot offset the employment loss due to the fall in
labor demand and any associated slow real wage adjustment. As a result, the level of
"maximum employment" achievable through monetary policy is less than the "full
employment" of labor resources.
A second implication is that non-monetary policies specifically designed to stimulate the
demand for workers (such as government subsidies for hiring) can offset some of the
employment loss due to the labor demand shocks, but only if accompanied by monetary
easing. That is, monetary and non-monetary policy must work in concert to reduce the
impact of a decline in labor demand; neither can do it alone.
Returning to the question posed at the beginning, this model suggests that the Federal
Reserve is performing about as well as it can on both mandates. The Federal Reserve's
accommodative policy has offset much of the impact of product demand shocks and so has
kept inflation near target. However, this policy has been unable to offset the large adverse
shocks to labor demand. The model implies that, in terms of employment, there are limits to
what monetary policy can achieve on its own.