Vicious Circle: Expectation Of Failure And Real Failure22 September, 2011, 23:33. Posted by Zarathustra
Tags: Economy, Monetary Policy
When everyone is convinced that a certain monetary policy will not work, it will probably end up not working.
That’s a bit of a collective self-fulfilling prophecy kind of things. As I wrote that everyone thought that Operation Twist does not help the economy much. Well, it may end up really not working.
A paper by Andrew Caplin and John Leahy (1996) examined this problem in their paper “Monetary Policy as a process of search”. Here’s the abstract of the paper:
Monetary policy makers are uncertain about the state of the economy and learn from the economy’s reaction to policy. Private agents, however, anticipate any systematic attempt to incorporate this information into future policy. We analyze this feedback in the context of a monetary authority’s attempt to stimulate an economy in recession. We show that modest stimuli may prove ineffectual. If small reductions in interest rates are unlikely to promote a response, then they may be followed by further cuts. A vicious circle develops in which the expectation that the policy could fail leads investors to delay investment thereby promoting failure.
So, perhaps actually doing the twist is really rather pointless because no one expects it to work, and that will further feed into a vicious circle. In some way, it feels like Japan. No one ever expects actions from Bank of Japan work.