Monetary policy models: lessons from the Eurozone crisis

The global financial crisis (GFC) prompted a reassessment of monetary economy models, particularly for the Eurozone. The Eurozone experienced a prolonged period characterized by expansionary monetary policies alongside deflation, reduced credit flows, and declining real activity. This contradicts standard monetary theory principles. Existing models, such as the quantitative theory of money, Keynesian and new-Keynesian models, and fully backed central bank money models, struggle to reconcile these observations. For example, the quantitative theory of money fails to explain the lack of inflationary pressure despite expansionary policies and relatively constant money velocity. Keynesian and new-Keynesian models do not account for the unexpected positive relationship between interest rates and loan volumes, or the lack of output growth following expansionary policies. Fully backed central bank money models are also inapplicable since the Eurozone operates on a fiat money system and the ECB's response involved unconventional tools beyond open market operations. Inside money models, while better explaining deflationary pressures, conflict with the empirical evidence showing no real effects from expansionary monetary policies. Therefore, a reevaluation of existing monetary models and a consideration of missing elements are necessary to accurately model the Eurozone's unique experience.

The literature extensively examines the ECB's crisis response and the Eurozone's monetary transmission mechanisms. Studies highlight continuous inflation targeting by the ECB, unresponsive credit growth despite increased money supply and lowered interest rates, and the significant role of changes in monetary transmission mechanisms. Several authors emphasize debt-deflation mechanisms as a crucial explanation for the coexistence of deflation, GDP contraction, and expansionary policies. Empirical studies using VAR models have focused on the ECB's response to the crisis. However, these studies omit the importance of long-run steady relationships, a critical element addressed in this paper using a VECM model. This approach builds upon Holtemöller (2004), which already showed evidence of such long-run relationships in the Eurozone but is extended by including the GFC. The current study's theoretical model addresses the need to explain empirically identified long-run relationships, reconcile the distinct short-run and long-run effects of monetary policy, and account for debt-deflation channels and the financial sector's crucial role.

This research employs a two-pronged approach: theoretical modeling and empirical analysis. A dynamic stochastic general equilibrium (DSGE) model, drawing on limited participation models (Christiano and Eichenbaum, 1992; Fuerst, 1992; Gutiérrez, 2006), is developed. This model emphasizes the role of the loan-to-deposit ratio (leverage ratio) in the financial sector as a key variable in the monetary transmission mechanism. The model incorporates microeconomic foundations for the financial decisions of households and firms, detailing the role of banks as intermediaries and the impact of ECB instruments. A key theoretical result is the derivation of long-run relationships between inflation and variables controlled by the ECB. The model demonstrates how expansionary monetary policies can coexist with deflation and reduced aggregate demand due to endogenous declines in loan volumes. This is done by considering the total loans-to-total deposits ratio as a key variable to model the interactions between debt-deflation channels, monetary policy tools, and financial leverage. The model also explicitly models the ECB's three main monetary policy instruments: open market operations, standing facilities, and minimum reserve requirements, and their interactions with the debt-deflation channels. The empirical analysis uses a vector error correction model (VECM) to test the model's predictions. The VECM analyzes the dynamic links between real, monetary, and financial variables in the Eurozone, using data from November 2007 to December 2019. Variables included are the core Harmonized Index of Consumer Prices (HICP) (for price level), the real interest rate (adjusted for expected inflation using ECB Survey of Professional Forecasters), and the loan-to-deposit ratio. The Johansen test is employed to assess cointegration, and impulse response functions (IRFs) are used to analyze short-run dynamics using Cholesky decomposition with specific recursive assumptions on the causal ordering. To improve robustness, dummy variables representing the European sovereign debt crisis and the zero lower bound (ZLB) episode are included. The analysis is further extended to a broader period (January 1999-December 2020) to assess the generality of the findings.

The theoretical model generates two long-run relationships linking inflation, the real interest rate, and the loan-to-deposit ratio. The VECM confirms the existence of these relationships in the Eurozone data, supporting the presence of debt-deflation mechanisms during the crisis. Specifically, the VECM reveals a positive long-run relationship between the loan-to-deposit ratio and inflation, and a negative relationship between the leverage ratio and real interest rates. The estimated coefficients for the error correction terms (ECTs) indicate significant long-run adjustments toward equilibrium, particularly for the price level and loan-to-deposit ratio. The IRFs confirm the presence of debt-deflationary dynamics. A real interest rate shock leads to a persistent decline in the leverage ratio, followed by a positive price level response. Leverage shocks have a self-reinforcing effect, consistent with a deleveraging process. Inflation shocks have a significant positive effect on itself and the leverage ratio. The short-run dynamics also reveal the impact of expansionary fiscal policies (crowding-out effects on interest rates and prices) and macroprudential tightening policies (contractionary effects on loan volumes). The extended analysis using data from 1999 to 2020 revealed one cointegration vector instead of two. However, imposing two cointegration vectors, similar relationships were found but with modified short-term dynamics. Pre-crisis data shows a stronger positive response of the real interest rate to leverage shocks and different relationships between leverage and price or interest rate shocks. This reflects the different economic environments (overheated economy before the crisis versus a crisis environment). The analysis highlights the crucial role of the loan-to-deposit ratio in understanding the monetary transmission mechanism during the crisis. A significant contraction in this ratio is noted, attributed to the decrease in loans to the production sector due to both macroprudential tightening and banks' increased liquidity concerns and default risk.

The findings address the research question by showing how a combination of expansionary monetary and fiscal policies, along with financial deleveraging, contributed to the unusual economic situation in the Eurozone during the crisis. The model's key variable, the loan-to-deposit ratio, is instrumental in understanding this interaction. The model demonstrates how long-run relationships between key macroeconomic variables were at play, providing a cohesive theoretical framework for interpreting the empirical observations. The results show that debt-deflationary dynamics, coupled with the effects of fiscal and macroprudential policies, influenced the Eurozone's economic trajectory. The significant long-run adjustments towards equilibrium, especially in the price level and leverage ratio, highlight the influence of ECB monetary policy in shaping the economic landscape. The findings are relevant to the field by providing a new and comprehensive model that captures the complex interplay between monetary policy, financial leverage, and real economic activity during a period of significant economic turmoil.

This study offers a novel theoretical model and empirical analysis that effectively explains the complex economic dynamics in the Eurozone following the GFC. The key contribution lies in the identification of the loan-to-deposit ratio as a pivotal variable in the monetary transmission mechanism. This allows for a more complete understanding of the debt-deflation processes and the interaction of monetary and fiscal policies. The model provides insights for future research into the role of financial variables in monetary transmission, and the interaction between monetary, fiscal, and macroprudential policies in crisis situations. Further research could explore the non-linearities in monetary transmission mechanisms, especially in the context of changing financial interdependence and structural economic shifts.

The model is a stylized representation of a complex economy. The assumptions made about the financial sector and the monetary policy instruments may not fully capture the nuances of the Eurozone economy. The analysis focuses on aggregate data, potentially obscuring heterogeneity across countries and sectors. The causal interpretations derived from IRFs are based on specific ordering assumptions which could influence the results. The analysis largely focuses on the Eurozone's experience, and the generalizability to other economies should be explored.