Must-Read: Òscar Jordà, Moritz Schularick, and Alan M. Taylor: Monetary Policy Medicine: Large Effects from Small Doses?

Must-Read: Òscar Jordà, Moritz Schularick, and Alan M. Taylor: Monetary Policy Medicine: Large Effects from Small Doses?: “How do we know that higher interest rates will bring prices under control?… http://www.frbsf.org/economic-research/publications/economic-letter/2017/april/monetary-policy-medicine-using-quasi-random-experiments/

…And how do we know how much of the monetary “medicine” to administer?… The long history of international finance turns out to be an excellent laboratory to conduct monetary experiments…. Interest rates have sizable effects….

Economies that fix their exchange rate but allow capital to move freely across borders effectively relinquish control of domestic monetary policy. In such situations, monetary policy may not respond to domestic conditions and hence may produce quasi-random variation in interest rates that is less sensitive to unobserved factors. We take advantage of this…. Figure 1 shows the response of inflation-adjusted GDP per capita in response to a 1 percentage point increase in short-term interest rates in year 0 calculated two different ways… controlled variation… peg variation…. In the first case, interest rates barely cause a ripple, whereas in the second, real GDP per capita is about 2% lower in year 4 than it was at the start…. The measured response of prices using controlled variation in interest rates is muted—prices are about 0.5% lower by year 4 relative to year 0. The same response calculated with peg variation is estimated to be nearly 2%. In other words, assuming a constant rate of price decline, inflation is about 0.4 percentage point per year lower…