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How Central Banks Can Fix the Economy

By Matthew Yglesias on December 4, 2009 at 3:58 pm

"How Central Banks Can Fix the Economy"

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“Joe Gagnon for Fed Chair,” writes Brad DeLong. What’s he talking about? An ambitious plan by Peterson Institute economist and former Federal Reserve staffer Joe Gagnon to use monetary policy to restore developed GDP and employment levels to something decent.

The Economist has an able summary:

[B]uy an additional $2 trillion in government bonds, with an average maturity of 7 years. That would be in addition to the $1.75 trillion of Treasury and mortgage-related debt it has already almost finished buying.

Mr Gagnon, extrapolating from the reaction to the current purchase programme, estimates the additional $2 trillion would lower Treasury yields about 0.75 percentage points. That, he reckons, would lower private borrowing rates, boost stock prices 13%, and lower the dollar by 5%. The combined stimulative impact would equal a 1.75 percentage point cut in the federal funds rate, and lift GDP by 3% after two years.

There would be no effect on the dollar if other central banks also ease monetary policy further, as Mr Gagnon advises. Specifically, he calls on the European Central Bank to lower its refinancing rate to 0.5% from 1%, purchase 1 trillion of long term securities, and continue offering unlimited 12-month funding to banks. The Bank of Japan should set an inflation target of 1% (inflation is currently -2.2%), purchase an additional 100 trillion of securities, and commit to buying a similar amount if core inflation over the next 12 months remains negative. The Bank of England should buy an additional £200 billion worth of long-term bonds or the equivalent of foreign currency bonds, hedged with currency swaps.

These are big, scary numbers. But the economic indicators from the developed world are also big and scary, especially when you look at the situation facing the majority of the population that doesn’t have a bachelor’s degree. The fact that the kind of people likely to be personal friends with policymakers and pundits have been in okay shape since the stock market stopped tanking seems to be obscuring from a lot of people the basic reality that a dramatic situation calls for dramatic action.

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