## _spn1003 ## Source details **Canonical URL:** [_spn1003](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/spn/2010/_spn1003.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/spn/2010/_spn1003.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/spn/2010/_spn1003.pdf.json) --- ### I. Introduction - Paper structure: - Review of precrisis views on macro policy. - Identification of where those views were wrong. - Tentative contours of a new macroeconomic policy framework. - Scope caveat: - Focus on general principles; translation to advanced, emerging, and developing economies left for later. - Largely avoids broader issues (international monetary system, overall financial regulation) except where directly relevant. ### II. What We Thought We Knew - Core precrisis consensus: - Monetary policy: one target (inflation) and one instrument (the policy rate). - Fiscal policy: secondary role, constrained by politics and implementation lags. - Financial regulation: largely outside macroeconomic policy considerations. - One Target: Stable Inflation - Central banks presented stable, low inflation as primary mandate, supported by New Keynesian models where constant inflation yields a zero output gap. - In practice: "flexible inflation targeting," attention to asset prices and external sustainability, but often public denial of broader concerns. - Low Inflation - Majority of central banks targeted around 2 percent. - Concerns about liquidity trap due to lower average nominal rates; belief that commitment to future money growth could manage expectations and mitigate zero bound risks. - Historical/liquidation episodes (Great Depression, Japan in the 1990s) were seen as avoidable or caused by lack of commitment. - One Instrument: The Policy Rate - Policy focused on controlling the short-term policy interest rate; assumed arbitrage links all interest rates and asset prices. - Exceptions: ECB "two-pillar" attention to credit quantity; recognition of special role of banks (credit channel, lender of last resort). - Little macro attention to the broader financial system or to interventions across different asset markets. - A Limited Role for Fiscal Policy - Shift from fiscal activism to monetary centrality due to doubts about fiscal effectiveness (Ricardian equivalence), improved monetary stabilization, financing constraints, implementation lags, and political distortion. - Emphasis on debt sustainability, fiscal rules, and strengthening automatic stabilizers; little innovation in designing better stabilizers. - Financial Regulation: Not a Macroeconomic Tool - Regulation targeted individual institutions and market failures; systemic and macro implications were largely ignored in advanced economies. - Limited use of prudential ratios (capital, loan-to-value) as cyclical tools, with some exceptions (Spain, Colombia). - The Great Moderation - Observed steady decline in variability of output and inflation beginning arguably in early 1980s (with ambiguity). - Causes debated: luck, structural changes, improved policy; better anchoring of inflation expectations likely important. - Successful responses to shocks (1987 crash, LTCM, tech bubble) reinforced confidence in policy frameworks. ### III. What We Have Learned from the Crisis - Stable Inflation May Be Necessary, but Is Not Sufficient - Core inflation stability did not prevent undesirable developments in asset prices, credit aggregates, or output composition. - No single index suffices; relationship between activity and inflation is complex, especially at low inflation rates. - Low Inflation Limits the Scope of Monetary Policy in Deflationary Recessions - When demand collapsed in 2008, central banks cut policy rates to near zero; estimates using a simple Taylor rule suggest another 3 to 5 percent of headroom for the United States. - Zero nominal interest rate bound forced greater reliance on fiscal policy and larger deficits. - Higher average inflation (and higher nominal rates) would have allowed deeper cuts and likely reduced output and fiscal deterioration. - Financial Intermediation Matters - Market segmentation and specialized investors can lead to large price effects when investors withdraw; wholesale funding resembles demand deposits in liquidity demand. - Policy rate alone is insufficient when arbitrage links break; central bank interventions (accepting collateral, asset purchases—credit easing) can affect different asset class rates. - Evidence reinforces the existence and risks of bubbles (e.g., housing). - Countercyclical Fiscal Policy Is an Important Tool - Fiscal policy regained centrality because monetary policy reached limits and because the recession was expected to be long lasting. - Importance of "fiscal space": high-debt advanced economies and procyclical emerging markets faced constrained fiscal responses, whereas some emerging markets with lower debt could act more aggressively. - Drawbacks of discretionary fiscal policy remain: formulation and implementation lags (U.S. stimulus enacted in February 2009, with only half of authorized spending projected to have been spent by the end of 2009). - Crisis highlighted gaps in knowledge about fiscal policy effectiveness, optimal package composition, and debt sustainability determinants. - Regulation Is Not Macroeconomically Neutral - Limited regulatory perimeter and regulatory arbitrage amplified the crisis (off-balance-sheet entities, leverage, AIG). - Rules intended to preserve individual institution soundness (mark-to-market combined with fixed regulatory capital ratios) exacerbated fire sales and deleveraging once the crisis began. - Reinterpreting the Great Moderation - Good performance against familiar demand and supply shocks masked vulnerability to financial shocks. - Success in moderating standard shocks may have led to understated macro risk, neglect of tail risks, higher leverage, and riskier foreign currency exposures. ### IV. Implications for the Design of Policy - Main lesson: macroeconomic policy must have many targets; many instruments exist (monetary innovations, fiscal tools, regulatory instruments). - Key challenges: - Allocating instruments across targets among monetary, fiscal, and financial policies. - Preserving useful elements of precrisis consensus while correcting conceptual flaws identified by the crisis. - Next steps: substantial research required to determine optimal use and assignment of instruments to address macro-financial stability, cyclical stabilization, and long-term sustainability. ### A. Should the Inflation Target Be Raised? - Policy question: aim for a higher target inflation rate in normal times to increase room for monetary policy to react to shocks? - Key comparisons and considerations: - Are net costs of inflation much higher at 4 percent than at 2 percent, the current target range? - Is it more difficult to anchor expectations at 4 percent than at 2 percent? - Benefits and costs of inflation revisited: - Inflation tax is distortionary, but alternative taxes are also distortionary. - Distortions from inflation often come from a tax system that is not inflation neutral (examples: nominal tax brackets, deductibility of nominal interest payments); correcting these could allow for a higher optimal inflation rate. - Indexed bonds can protect investors from inflation risk if higher inflation is associated with higher inflation volatility. - Other distortions (lower holdings of real money balances, greater dispersion of relative prices) are more difficult to correct; empirical evidence suggests their effects on output are difficult to discern so long as inflation remains in the single digits. - Risk that higher inflation induces structural changes (e.g., widespread wage indexation) that magnify inflation shocks and reduce the effectiveness of policy action. - Related question: when inflation becomes very low, should policymakers err on the side of more lax monetary policy to minimize likelihood of deflation, even at the risk of higher inflation if demand unexpectedly picks up (issue noted as on the mind of the Fed in the early 2000s). ### B. Combining Monetary and Regulatory Policy - Core position: the policy rate is a poor tool to deal with excess leverage, excessive risk taking, or deviations of asset prices from fundamentals. - Suggested approach: use cyclical regulatory tools for targeted interventions: - If leverage appears excessive → increase regulatory capital ratios. - If liquidity appears too low → introduce/increase regulatory liquidity ratios. - To dampen housing prices → decrease loan-to-value ratios. - To limit stock price increases → increase margin requirements. - Limitations: - None of these tools is a magic bullet and all can be partially circumvented, but they are likely more targeted than using the policy rate. - On low interest rates and risk taking: - If low rates induce excessive leverage/risk taking, use regulatory instruments that directly affect leverage/risk taking rather than keeping policy rate higher than standard rules imply. - Macroprudential framework implications: - Traditional regulatory and prudential frameworks need a macroeconomic dimension. - Measures reflecting systemwide cyclical conditions should complement institution-level rules and supervision. - Macroprudential measures should be updated on a regular and predictable (or even semi-automatic) basis to maximize effectiveness through a credible and understood policy stance. - Challenge: trade-off between a sophisticated, fine-tuned system and an approach based on simple-to-communicate triggers and easy-to-implement rules. - Institutional coordination: - Issue of coordination between monetary and regulatory authorities, or central bank control of both. - Arguments for central banks as macroprudential regulators: positioned to monitor macroeconomic developments; in several countries they already regulate banks; coordination problems observed during crisis (example: Northern Rock bailout). - Past arguments against central bank regulatory power: - Central bank may take a “softer” stance against inflation because interest rate hikes can hurt bank balance sheets. - Central bank would have a more complex mandate and be less easily accountable. - Conclusion: both arguments have merit and imply need for further transparency if central bank is given responsibility for regulation; alternative (separate authorities) seems worse. ### C. Inflation Targeting and Foreign Exchange Intervention - Inflation-targeting central banks typically cared about exchange rate only to extent it affected inflation; in large advanced economies this held, but many smaller countries paid close attention and intervened to smooth volatility and influence level. - Rationale for intervention in small open economies: - Large exchange rate fluctuations from sharp shifts in capital flows can create large disruptions in activity. - Large appreciation may squeeze tradable sector and hinder its recovery. - Widespread contract denomination in foreign currency can create severe balance-sheet effects on depreciation with negative consequences for financial stability and output. - Policy implications: - Central banks in small open economies should openly recognize that exchange rate stability is part of their objective function without abandoning inflation targeting. - Imperfect capital mobility can endow central banks with a second instrument: reserve accumulation and sterilized intervention, to help control external target while leaving domestic objectives to the policy rate. - Limits to sterilized intervention can be reached if capital account pressures are large and prolonged; limits are country-specific and depend on openness and financial integration. When limits are reached and burden falls solely on the policy rate, strict inflation targeting is not optimal and consequences of adverse exchange rate movements must be considered. - Interaction with prudential policy: - Prudential rules that prevent or contain contract dollarization allow greater policy freedom on exchange rate movements; perception of an “excessively stable” exchange rate can increase incentives for contract dollarization. ### D. Providing Liquidity More Broadly - Crisis forced central banks to extend lender-of-last-resort role to non-deposit-taking institutions and to intervene directly (purchases) or indirectly (acceptance of assets as collateral) in a broad range of asset markets. - Question: should expanded liquidity provision be kept in tranquil times? - Arguments for extending liquidity provision in normal times: - If liquidity problems stem from disappearance of deep-pocket private investors or coordination problems of small investors (bank runs), government is uniquely positioned to intervene (long horizon and deep pockets) and should be ready to replace private investors if needed. - Traditional arguments against public liquidity provision: - Departure of private investors may reflect solvency concerns → government liquidity provision carries balance sheet risk and bailout probability, with consequences for risk taking. - Liquidity provision may induce more maturity transformation and less-liquid portfolios (moral hazard), which is not necessarily bad if public liquidity can be provided at no cost; cost may be positive reflecting need for higher taxation or foreign borrowing. - Mitigation measures: - Use of insurance fees and haircuts; in normal times prefer indirect support with appropriate haircuts rather than direct purchases to reduce credit risk. - Regulation: draw up list of assets eligible as collateral (ECB had a longer list than the Fed) and link access to liquidity to being under regulatory and supervision umbrella. ### E. Creating More Fiscal Space in Good Times - Key lesson: desirability of fiscal space to run larger fiscal deficits when needed. - Analogy: need for more fiscal space mirrors need for more nominal interest rate room; with more room to cut interest rates and adopt expansionary fiscal stance, governments would be better able to fight crises. - Postcrisis fiscal challenge: - Required degree of fiscal adjustment (after recovery is securely under way) will be formidable given need to reduce debt and aging-related pension and health care challenges. - Lesson: target debt levels should be lower than precrisis levels. - Policy implications for next decade or two: - When cyclical conditions permit, major fiscal adjustment is necessary. - If economic growth recovers rapidly, use it to reduce debt-to-GDP ratios substantially rather than to finance expenditure increases or tax cuts. - Recipe to create additional fiscal space and ensure booms improve fiscal positions: - Medium-term fiscal frameworks. - Credible commitments to reducing debt-to-GDP ratios. - Fiscal rules with escape clauses for recessions. - Expenditure frameworks based on long-term revenue assessments to limit spending increases during booms. - Eliminate explicit revenue earmarking for prespecified budget purposes to avoid automatic expenditure cuts when revenues fall. - Ensure all public sector operations are transparently reflected in fiscal data and that well-designed budget processes reduce incentives to postpone needed adjustment. ### F. Designing Better Automatic Fiscal Stabilizers - Discretionary fiscal measures come too late to fight a standard recession; strong case for improving automatic stabilizers. - Distinction between: - Truly automatic stabilizers (rigid government expenditures + revenue elasticity ≈ one; social insurance programs; progressive income taxes). - Ways to increase macroeconomic effect: increase size of government, make taxes more progressive, make social insurance programs more generous—but such reforms should be based on broader equity and efficiency objectives, not solely stabilization motives. - Rules with prespecified triggers tied to the state of the economic cycle (automatic fiscal stimulus triggered by macro variables). - This second type is more promising; does not carry the costs of the first type and can be applied to tax or expenditure items with large multipliers. - Examples of contingent policies: - Tax side: temporary tax policies targeted at low-income households (flat, refundable tax rebate; percentage reduction in taxpayer liability), cyclical investment tax credits for firms. - Expenditure side: temporary transfers targeted at low-income or liquidity-constrained households. - Triggers would be crossing of thresholds by macro variables. GDP is natural but available only with a delay; labor market variables (employment or unemployment) are promising alternatives. - Open issues: how to define relevant thresholds and which taxes or transfers to make contingent. ### V. Conclusions - The crisis was not triggered primarily by macroeconomic policy but exposed flaws in the precrisis policy framework, forced policy experimentation during the crisis, and requires rethinking of postcrisis macroeconomic policy architecture. - Core policy framework largely remains: ultimate goals are stable output gap and stable inflation. - Crisis showed policymakers must monitor many targets including composition of output, asset prices, and leverage, and that more instruments are available than before the crisis. - Two promising routes for policy design: - Combination of traditional monetary policy and regulation tools (macroprudential approach). - Design of better automatic stabilizers for fiscal policy. - Reinforced lessons: - Low public debt in good times creates room to act forcefully when needed. - Good plumbing (prudential regulation) and transparent data in monetary, financial, and fiscal areas are critical. - Forward agenda: develop creative policy innovations and build public support for difficult but necessary adjustments and reforms stemming from crisis lessons. *Source: _spn1003 - conclusions from macroeconomic theory,still hold. Among them, the ultimate targets remain* ### References................................................................................................17 ### _spn1003 - References................................................................................................17 ### I. Introduction - Paper structure: - Review of precrisis views on macro policy. - Identification of where those views were wrong. - Tentative contours of a new macroeconomic policy framework. - Scope caveat: - Focus on general principles; translation to advanced, emerging, and developing economies left for later. - Largely avoids broader issues (international monetary system, overall financial regulation) except where directly relevant. ### II. What We Thought We Knew - Core precrisis consensus: - Monetary policy: one target (inflation) and one instrument (the policy rate). - Fiscal policy: secondary role, constrained by politics and implementation lags. - Financial regulation: largely outside macroeconomic policy considerations. - A. One Target: Stable Inflation - Central banks presented stable, low inflation as primary mandate, supported by New Keynesian models where constant inflation yields a zero output gap. - In practice: "flexible inflation targeting," attention to asset prices and external sustainability, but often public denial of broader concerns. - B. Low Inflation - Majority of central banks targeted around 2 percent. - Concerns about liquidity trap due to lower average nominal rates; belief that commitment to future money growth could manage expectations and mitigate zero bound risks. - Historical/liquidation episodes (Great Depression, Japan in the 1990s) were seen as avoidable or caused by lack of commitment. - C. One Instrument: The Policy Rate - Policy focused on controlling the short-term policy interest rate; assumed arbitrage links all interest rates and asset prices. - Exceptions: ECB "two-pillar" attention to credit quantity; recognition of special role of banks (credit channel, lender of last resort). - Little macro attention to the broader financial system or to interventions across different asset markets. - D. A Limited Role for Fiscal Policy - Shift from fiscal activism to monetary centrality due to doubts about fiscal effectiveness (Ricardian equivalence), improved monetary stabilization, financing constraints, implementation lags, and political distortion. - Emphasis on debt sustainability, fiscal rules, and strengthening automatic stabilizers; little innovation in designing better stabilizers. - E. Financial Regulation: Not a Macroeconomic Tool - Regulation targeted individual institutions and market failures; systemic and macro implications were largely ignored in advanced economies. - Limited use of prudential ratios (capital, loan-to-value) as cyclical tools, with some exceptions (Spain, Colombia). - F. The Great Moderation - Observed steady decline in variability of output and inflation beginning arguably in early 1980s (with ambiguity). - Causes debated: luck, structural changes, improved policy; better anchoring of inflation expectations likely important. - Successful responses to shocks (1987 crash, LTCM, tech bubble) reinforced confidence in policy frameworks. ### III. What We Have Learned from the Crisis - A. Stable Inflation May Be Necessary, but Is Not Sufficient - Core inflation stability did not prevent undesirable developments in asset prices, credit aggregates, or output composition. - No single index suffices; relationship between activity and inflation is complex, especially at low inflation rates. - B. Low Inflation Limits the Scope of Monetary Policy in Deflationary Recessions - When demand collapsed in 2008, central banks cut policy rates to near zero; estimates using a simple Taylor rule suggest another 3 to 5 percent of headroom for the United States. - Zero nominal interest rate bound forced greater reliance on fiscal policy and larger deficits. - Higher average inflation (and higher nominal rates) would have allowed deeper cuts and likely reduced output and fiscal deterioration. - C. Financial Intermediation Matters - Market segmentation and specialized investors can lead to large price effects when investors withdraw; wholesale funding resembles demand deposits in liquidity demand. - Policy rate alone is insufficient when arbitrage links break; central bank interventions (accepting collateral, asset purchases—credit easing) can affect different asset class rates. - Evidence reinforces the existence and risks of bubbles (e.g., housing). - D. Countercyclical Fiscal Policy Is an Important Tool - Fiscal policy regained centrality because monetary policy reached limits and because the recession was expected to be long lasting. - Importance of "fiscal space": high-debt advanced economies and procyclical emerging markets faced constrained fiscal responses, whereas some emerging markets with lower debt could act more aggressively. - Drawbacks of discretionary fiscal policy remain: formulation and implementation lags (U.S. stimulus enacted in February 2009, with only half of authorized spending projected to have been spent by the end of 2009). - Crisis highlighted gaps in knowledge about fiscal policy effectiveness, optimal package composition, and debt sustainability determinants. - E. Regulation Is Not Macroeconomically Neutral - Limited regulatory perimeter and regulatory arbitrage amplified the crisis (off-balance-sheet entities, leverage, AIG). - Rules intended to preserve individual institution soundness (mark-to-market combined with fixed regulatory capital ratios) exacerbated fire sales and deleveraging once the crisis began. - F. Reinterpreting the Great Moderation - Good performance against familiar demand and supply shocks masked vulnerability to financial shocks. - Success in moderating standard shocks may have led to understated macro risk, neglect of tail risks, higher leverage, and riskier foreign currency exposures. ### IV. Implications for the Design of Policy - Main lesson: macroeconomic policy must have many targets; many instruments exist (monetary innovations, fiscal tools, regulatory instruments). - Key challenges: - Allocating instruments across targets among monetary, fiscal, and financial policies. - Preserving useful elements of precrisis consensus while correcting conceptual flaws identified by the crisis. - Next steps: substantial research required to determine optimal use and assignment of instruments to address macro-financial stability, cyclical stabilization, and long-term sustainability. *Source: _spn1003 - References................................................................................................17* ### conclusions from macroeconomic theory,still hold. Among them, the ultimate targets remain ### _spn1003 - conclusions from macroeconomic theory,still hold. Among them, the ultimate targets remain ### A. Should the Inflation Target Be Raised? - Crisis experience shows large adverse shocks can and do happen (examples: financial sector shocks, pandemic effects on tourism and trade, major terrorist attack on a large economic center). - Policy question: aim for a higher target inflation rate in normal times to increase room for monetarypolicyto react to shocks? - Key comparisons and considerations: - Are net costs of inflation much higher at 4 percent than at 2 percent, the current target range? - Is it more difficult to anchor expectations at 4 percent than at 2 percent? - Benefits and costs of inflation revisited: - Inflation tax is distortionary, but alternative taxes are also distortionary. - Distortions from inflation often come from a tax system that is not inflation neutral (examples: nominal tax brackets, deductibility of nominal interest payments); correcting these could allow for a higher optimal inflation rate. - Indexed bonds can protect investors from inflationrisk if higher inflation is associated with higher inflation volatility. - Other distortions (lower holdings of real moneybalances, greater dispersion of relative prices) are more difficult to correct; empirical evidence suggests their effects on output are difficult to discern so long as inflation remains in the single digits. - Risk that higher inflation induces structural changes (e.g., widespread wage indexation) that magnifyinflation shocks and reduce the effectiveness of policyaction. - Related question: when inflation becomes very low, should policymakers err on the side of more lax monetarypolicy to minimize likelihood of deflation, even at the risk of higher inflation if demand unexpectedly picks up (issue noted as on the mind of the Fed in the early 2000s). ### B. Combining Monetary and Regulatory Policy - Debate precrisis: whether interest rate rule should be extended to deal with asset prices; crisis added candidates (leverage, current account positions, measures of systemic risk). - Core position: the policyrate is a poor tool to deal with excess leverage, excessive risk taking, or deviations of asset prices from fundamentals. - Suggested approach: use cyclical regulatorytools for targeted interventions: - If leverage appears excessive → increase regulatory capital ratios. - If liquidity appears too low → introduce/increase regulatoryliquidityratios. - To dampen housing prices → decrease loan-to-value ratios. - To limit stock price increases → increase margin requirements. - Limitations: none of these tools is a magic bullet and all can be partially circumvented, but they are likely more targeted than using the policyrate. - On low interest rates and risk taking: if low rates induce excessive leverage/risk taking, use regulatory instruments that directly affect leverage/risk taking rather than keeping policy rate higher than standard rules imply. - Macroprudential framework implications: - Traditional regulatory and prudential frameworks need a macroeconomic dimension. - Measures reflecting systemwide cyclical conditions should complement institution-level rules and supervision. - Macroprudential measures should be updated on a regular and predictable (or even semi-automatic) basis to maximize effectiveness through a credible and understood policy stance. - Challenge: trade-off between a sophisticated, fine-tuned system and an approach based on simple-to-communicate triggers and easy-to-implement rules. - Institutional coordination: - Issue of coordination between monetary and regulatory authorities, or central bank control of both. - Arguments for central banks as macroprudential regulators: positioned to monitor macroeconomic developments; in several countries theyalreadyregulate banks; coordination problems observed during crisis (example: Northern Rock bailout). - Past arguments against central bank regulatory power: - Central bank may take a “softer” stance against inflation because interest rate hikes can hurt bank balance sheets. - Central bank would have a more complex mandate and be less easily accountable. - Conclusion: both arguments have merit and imply need for further transparency if central bank is given responsibilityfor regulation; alternative (separate authorities) seems worse. ### C. Inflation Targeting and Foreign Exchange Intervention - Inflation-targeting central banks typically cared about exchange rate only to extent it affected inflation; in large advanced economies this held, but many smaller countries paid close attention and intervened to smooth volatility and influence level. - Rationale for intervention in small open economies: - Large exchange rate fluctuations from sharp shifts in capital flows can create large disruptions in activity. - Large appreciation may squeeze tradable sector and hinder its recovery. - Widespread contract denomination in foreign currency can create severe balancesheet effects on depreciation with negative consequences for financial stability and output. - Policy implications: - Central banks in small open economies should openly recognize that exchange rate stability is part of their objective function without abandoning inflation targeting. - Imperfect capital mobility can endow central banks with a second instrument: reserve accumulation and sterilized intervention, to help control external target while leaving domestic objectives to the policyrate. - Limits to sterilized intervention can be reached if capital account pressures are large and prolonged; limits are country-specific and depend on openness and financial integration. When limits are reached and burden falls solely on the policy rate, strict inflation targeting is not optimal and consequences of adverse exchange rate movements must be considered. - Interaction with prudential policy: prudential rules that prevent or contain contract dollarization allow greater policy freedom on exchange rate movements; perception of an “excessively stable” exchange rate can increase incentives for contract dollarization. ### D. Providing Liquidity More Broadly - Crisis forced central banks to extend lender-of-last-resort role to non-deposit-taking institutions and to intervene directly (purchases) or indirectly (acceptance of assets as collateral) in a broad range of asset markets. - Question: should expanded liquidity provision be kept in tranquil times? - Arguments for extending liquidity provision in normal times: - If liquidity problems stem from disappearance of deep-pocket private investors or coordination problems of small investors (bank runs), government is uniquely positioned to intervene (long horizon and deep pockets) and should be ready to replace private investors if needed. - Traditional arguments against public liquidity provision: - Departure of private investors may reflect solvency concerns → government liquidity provision carries balance sheet risk and bailout probability, with consequences for risk taking. - Liquidity provision may induce more maturitytransformation and less-liquid portfolios (moral hazard), which is not necessarily bad if public liquidity can be provided at no cost; cost may be positive reflecting need for higher taxation or foreign borrowing. - Mitigation measures: - Use of insurance fees and haircuts; in normal times prefer indirect support with appropriate haircuts rather than direct purchases to reduce credit risk. - Regulation: draw up list of assets eligible as collateral (ECB had a longer list than the Fed) and link access to liquidity to being under regulatory and supervision umbrella. ### E. Creating More Fiscal Space in Good Times - Key lesson: desirability of fiscal spaceto run larger fiscal deficits when needed. - Analogy: need for more fiscal space mirrors need for more nominal interest rateroom; with more room to cut interest rates and adopt expansionary fiscal stance, governments would be better able to fight crises. - Postcrisis fiscal challenge: required degree of fiscal adjustment (after recovery is securely under way) will be formidable given need to reduce debt and aging-related pension and health care challenges. - Lesson: target debt levels should be lower than precrisis levels. - Policy implications for next decade or two: - When cyclical conditions permit, major fiscal adjustment is necessary. - If economic growth recovers rapidly, use it to reduce debt-to-GDP ratios substantially rather than to finance expenditure increases or tax cuts. - Recipe to create additional fiscal space and ensure booms improve fiscal positions: - Medium-term fiscal frameworks. - Credible commitments to reducing debt-to-GDP ratios. - Fiscal rules with escape clauses for recessions. - Expenditure frameworks based on long-term revenue assessments to limit spending increases during booms. - Eliminate explicit revenue earmarking for prespecified budget purposes to avoid automatic expenditure cuts when revenues fall. - Ensure all public sector operations are transparently reflected in fiscal data and that well-designed budget processes reduce incentives to postpone needed adjustment. ### F. Designing Better Automatic Fiscal Stabilizers - Discretionary fiscal measures come too late to fight a standard recession; strong case for improving automatic stabilizers. - Distinction between: - Truly automatic stabilizers (rigid government expenditures + revenue elasticity ≈ one; social insurance programs; progressive income taxes). - Ways to increase macroeconomic effect: increase size of government, make taxes more progressive, make social insurance programs more generous—but such reforms should be based on broader equity and efficiency objectives, not solely stabilization motives. - Rules with prespecified triggers tied to the state of the economic cycle (automatic fiscal stimulus triggered by macro variables). - This second type is more promising; does not carry the costs of the first type and can be applied to tax or expenditure items with large multipliers. - Examples of contingent policies: - Tax side: temporary tax policies targeted at low-income households (flat, refundable tax rebate; percentage reduction in taxpayer liability), cyclical investment tax credits for firms. - Expenditure side: temporary transfers targeted at low-income or liquidity-constrained households. - Triggers would be crossing of thresholds by macro variables. GDP is natural but available only with a delay; labor market variables (employment or unemployment) are promising alternatives. - Open issues: how to define relevant thresholds and which taxes or transfers to make contingent. ### V. Conclusions - The crisis was not triggered primarily by macroeconomic policy but exposed flaws in the precrisis policyframework, forced policy experimentation during the crisis, and requires rethinking of postcrisis macroeconomic policy architecture. - Core policy framework largely remains: ultimate goals are stable output gap and stable inflation. - Crisis showed policymakers must monitor many targets including composition of output, asset prices, and leverage, and that more instruments are available than before the crisis. - Two promising routes for policy design: - Combination of traditional monetarypolicy and regulation tools (macroprudential approach). - Design of better automatic stabilizers for fiscal policy. - Reinforced lessons: - Low public debt in good times creates room to act forcefully when needed. - Good plumbing (prudential regulation) and transparent data in monetary, financial, and fiscal areas are critical. - Forward agenda: develop creative policy innovations and build public support for difficult but necessary adjustments and reforms stemming from crisis lessons. *Source: _spn1003 - conclusions from macroeconomic theory,still hold. Among them, the ultimate targets remain* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/spn/2010/_spn1003.pdf_