By Lasitha R.C. Pathberiya
In this study, I examine the robustness of an unconventional monetary policy in a cost channel economy. The unconventional monetary policy proposed by Schmitt-Grohé and Uribe (2017, American Economic Journal: Macroeconomics, SGU henceforth), recommends a tight monetary policy during a liquidity-trapped recession to stimulate the economy and to avoid jobless recovery. The results of my study show that the existence of the cost channel implies that the SGU policy induces sharp initial contractions in the employment rate and the growth rate, and a sharp increase in inflation following a negative confidence shock. Welfare is lower in cost channel economies compared to no-cost channel economies due to the SGU policy recommendation. Two alternative interest rate-based exit policies are also examined. The Overshoot interest rate policy, irrespective of the presence of the cost channel, is superior to the SGU policy with regard to welfare. The Staggered policy has lower immediate pain in the cost channel economy compared to the SGU policy or the Overshoot policy. However, welfare-wise, the Staggered policy is inferior to the other two policies examined in both economies considered.
In other words, one should not be afraid to use shock therapy. Easier said than done for a policymaker.