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C. One Instrument: The Policy Rate
Monetary policy increasingly focused on the use of one instrument, the policy interest rate,
that is, the short-term interest rate that the central bank can directly control through
appropriate open-market operations. Behind this choice were two assumptions. The first was
that the real effects of monetary policy took place through interest rates and asset prices, not
through any direct effect of monetary aggregates (an exception to this rule was the stated
“two-pillar” policy of the European Central Bank (ECB), which paid direct attention to the
quantity of credit in the economy, but was often derided by observers as lacking a good
theoretical foundation). The second assumption was that all interest rates and asset prices
were linked through arbitrage. So that long rates were given by proper weighted averages of
risk-adjusted future short rates, and asset prices by fundamentals, the risk-adjusted present
discounted value of payments on the asset. Under these two assumptions, one needs only to
affect current and future expected short rates: all other rates and prices follow. And one can
do this by using, implicitly or explicitly, a transparent, predictable rule (thus the focus on
transparency and predictability, a main theme of monetary policy in the past two decades),
such as the Taylor rule, giving the policy rate as a function of the current economic
environment. Intervening in more than one market, say in both the short-term and the long-
term bond markets, is either redundant, or inconsistent.
Under these two assumptions also, the details of financial intermediation are largely
irrelevant. An exception was made, however, for banks (more specifically, commercial
banks), which were seen as special in two respects. First—and in the theoretical literature
more than in the actual conduct of monetary policy—bank credit was seen as special, not
easily substituted by other types of credit. This led to an emphasis on the “credit channel,”
where monetary policy also affects the economy through the quantity of reserves and, in turn,
bank credit. Second, the liquidity transformation involved in having demand deposits as
liabilities and loans as assets, and the resulting possibility of runs, justified deposit insurance
and the traditional role of central banks as lenders of last resort. The resulting distortions
were the main justification for bank regulation and supervision. Little attention was paid,
however, to the rest of the financial system from a macro standpoint.
D. A Limited Role for Fiscal Policy
In the aftermath of the Great Depression and following Keynes, fiscal policy had been seen
as a—perhaps the—central macroeconomic policy tool. In the 1960s and 1970s, fiscal and
monetary policy had roughly equal billing, often seen as two instruments to achieve two
targets—internal and external balance, for example. In the past two decades, however, fiscal
policy took a backseat to monetary policy. The reasons were many: first was wide skepticism
about the effects of fiscal policy, itself largely based on Ricardian equivalence arguments.
Second, if monetary policy could maintain a stable output gap, there was little reason to use
another instrument. In that context, the abandonment of fiscal policy as a cyclical tool may
have been the result of financial market developments that increased the effectiveness of
monetary policy. Third, in advanced economies, the priority was to stabilize and possibly
decrease typically high debt levels; in emerging market countries, the lack of depth of the
domestic bond market limited the scope for countercyclical policy anyway. Fourth, lags in
the design and the implementation of fiscal policy, together with the short length of