This document summarizes a presentation by Markus Brunnermeier on monetary policy in light of the "I-Theory" of money. Some key points: 1) Monetary policy must consider its interconnections with financial stability, fiscal policy, and the price level. The traditional focus on just inflation and output gaps is insufficient. 2) Risk in the financial system is endogenous and time-varying, driven by factors like liquidity mismatches between the maturities of assets and liabilities. This can lead to crises. 3) There is a potential trade-off between price stability and financial stability - monetary policy may need to accept more risk-taking to boost the economy and reduce deflation

1. Brunnermeier & Sannikov 2014
http://scholar.princeton.edu/markus
http://scholar.princeton.edu/sites/default/files
/markus/files/2014a_sanfranciscofed_mopo
_new_normal.pdf
Monetary Policy: A New Normal?
& The I Theory of Money
Markus K. Brunnermeier
Princeton University
San Francisco Federal Reserve
San Francisco, Nov. 10th, 2014

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3. Brunnermeier & Sannikov 2014
Stability concepts & interconnections
 OUTPUT (GAP)
E[W( 푦೦− 푦
∗,
PRICE STABILITY
휋೦− 휋∗, )]
 Instruments
short-term interest rate
unconventional MoPo
3

4. Brunnermeier & Sannikov 2014
Stability concepts & interconnections
 OUTPUT (GAP)
E[W( 푦೦− 푦
∗,
PRICE STABILITY FINANCIAL STABILITY FISCAL DEBT
휋೦− 휋∗, risk concentration, sustain.)]
 Instruments
short-term interest rate
unconventional MoPo
micro-prudential
LOLR
fiscal rules
4

5. Brunnermeier & Sannikov 2014
Stability concepts & interconnections
 OUTPUT (GAP)
E[W( 푦೦− 푦
∗,
PRICE STABILITY FINANCIAL STABILITY FISCAL DEBT
휋೦− 휋∗, risk concentration, sustain.)]
 Instruments
short-term interest rate
unconventional MoPo
micro-prudential
LOLR
fiscal rules
The Fiscal Theory
of the Price Level
5

6. Brunnermeier & Sannikov 2014
Stability concepts & interconnections
 OUTPUT (GAP)
E[W( 푦೦− 푦
∗,
PRICE STABILITY FINANCIAL STABILITY FISCAL DEBT
휋೦− 휋∗, risk concentration, sustain.)]
 Instruments
short-term interest rate
unconventional MoPo
macro-prudential
LOLR
fiscal rules
The Fiscal Theory
of the Price Level
Diabolic Loop
Bank-Sovereign Nexus
6

7. Brunnermeier & Sannikov 2014
Stability concepts & interconnections
 OUTPUT (GAP)
E[W( 푦೦− 푦
∗,
PRICE STABILITY FINANCIAL STABILITY FISCAL DEBT
휋೦− 휋∗, risk concentration, sustain.)]
 Instruments
short-term interest rate
unconventional MoPo
macro-prudential
LOLR
For complete description:
Brunnermeier Sannikov (2013) “Redistributive MoPo” (Jackson Hole paper)
fiscal rules
6
The Fiscal Theory
of the Price Level
The I Theory
of Money
Diabolic Loop
Bank-Sovereign nexus

8. Brunnermeier & Sannikov 2014
Financial Stability in the I Theory
Δprice = 푓(Δ೦ future cash flows , Δrisk
premia)
• Term spread:
• Credit spread:
expectations hypothesis fails
default risk +
risk premium predicts future economic activity
Gilchrist & Zakrajsek
 Endogenous risk (dynamics)
• Amplification
• Runs
 Risk premia (time varying)
8

9. Brunnermeier & Sannikov 2014
Financial Stability in the I Theory
Δprice = 푓(Δ೦ future cash flows , Δrisk
premia)
• Term spread:
• Credit spread:
expectations hypothesis fails
default risk +
risk premium predicts future economic activity
Gilchrist & Zakrajsek
 Endogenous risk (dynamics)
• Amplification
• Runs
 Risk premia (time varying)
9

10. Brunnermeier & Sannikov 2014
Financial Stability in the I Theory
Δprice = 푓(Δ೦ future cash flows , Δrisk
premia)
 Endogenous risk (dynamics)
• Amplification
• Runs
 Risk premia (time varying)
• Term spread:
• Credit spread:
expectations hypothesis fails
default risk +
risk premium predicts future economic activity
Gilchrist & Zakrajsek
 Volatility Paradox
• Measured volatility is low when risk builds up (in background)
1
0

11. Brunnermeier & Sannikov 2014
Financial Stability in the I Theory
Δprice = 푓(Δ೦ future cash flows , Δrisk
premia)
 Endogenous risk (dynamics)
• Amplification
• Runs
 Risk premia (time varying)
• Term spread:
• Credit spread:
expectations hypothesis fails
default risk +
risk premium predicts future economic activity
Gilchrist & Zakrajsek
 Volatility Paradox
• Measured volatility is low when risk builds up (in background)
 Measure of Topography (distribution) of
risk concentration pockets
• Distribution of Liquidity Mismatch
10

12. Brunnermeier & Sannikov 2014
Liquidity Mismatch
A L
Funding liquidity
 Maturity structure of debt
 Can’t roll over short term
debt
 Sensitivity of margins
 Margin-funding is recalled
Technological liquidity
 Reversibility of investment
Market liquidity
 Specificity of capital
Price impact of capital sale
Maturity mismatch
 Distribution of Liquidity Mismatch (with Gorton & Krishnamurthy)
• Across sector
• Substitutability of sector
• Wealth shifts/undercapitalization likely, also shift risk premia

13. Brunnermeier & Sannikov 2014
Risk Build-up Phase – “Volatility Paradox”
 Liquidity mismatch increases during tranquil times
A
Duration of projects Debt maturity
 Long-term irreversible projects
 Austrian element (Hayekian triangle)
Specialization (specificity)
 Low market liquidity
⇒ larger fire-sale discount
 Intermediation chain often hide overall liquidity mismatch
 Distribution matters: “Topography of Liquidity Mismatch”
13
L

14. Brunnermeier & Sannikov 2014
Sectorial analysis
Government
Outside
money
Banks
Inside
money
Equity Savers
Reserves
Credit
Riskier direct lending/credit
Households
Risky
Credit
Real
Estate
Equity
Corporation
Risky
Factory Credit
14
Equity

15. Brunnermeier & Sannikov 2014
“Bare bone” NKModel I Theory
Friction Price/Wage stickiness Financial friction
Manage Price dispersion Potential wealth shifts
- Amplification/runs
- Risk premia
Balance sheet constraintsi
Linear around Steady State Non-linearities
Transmission
mechanism
Euler equation (STABLE)
Substitution effect
Time-varying & depends on
-{LM}sectors
- Financial/mortgage contracts
- Borrowers’ bank dependency
Income/wealth effects
- ex-post: redistributive
- ex-ante: insurance
⇒ affects risk premia
(Hanson-Stein on 10 year Tips)

16. Brunnermeier & Sannikov 2014
“Bare bone” NKModel I Theory
Friction Price/Wage stickiness Financial friction
Money/Interest Interest rate prime focus
(moneyless economy)
푖೦= 휋೦+ ೦೦
+
Endogenous inside money
creation (by financial sector)
Instruments Interest rate & QE Interaction with MacroPru
- Complements
- Substitutes
Rule ∗
휆 푦೦ − 푦∗ + 훼(휋೦ − 휋∗)
coefficients of Taylor rule
are constant/stable
∗
푖೦
푦೦ − 푦
೦푎೦푖೦푎푙 휋೦ − 휋∗
೦ = ೦ 푉푎푅 [푦 ]
푙푖೦೦푖೦푖೦푦೦ ೦ ೦+휏
… ೦೦ ೦푒푐೦표೦
…
Possibly unstable coefficients
and nonlinearities to capture
substitutability/complementarity
Long-term
interest rate
Expectations hypothesis Term risk premia (time varying)

17. Brunnermeier & Sannikov 2014
Trade-off: Price vs. Financial Stability
 Induce “financial risk taking” during crisis in order to
reduce endogenous risk, contraction & disinflation
• Precautionary delevering leads to
 Fire-sale prices
 Disinflation
Liquidity spiral
Disinflation spiral
Inefficient due to pecuniary externalities
• Take on “financial risk” to
 boost economy,
 reduce endogenous risk (& risk premia)
1. “Stealth” recapitalization of
impaired sector (bottleneck)
 Banking vs. insurance, SMEs,
 Corporate sector, household,…
2. Make risk-taking attractive
Banks’ capitalization 16
Total risk/volatility Physical capital

18. Brunnermeier & Sannikov 2014
Interest rate cuts vs. QE/Forward Guidance
Mainstream: QE = interest rate cut below 0
Interest rate cut
휏
Economically
relevant duration
18

19. Brunnermeier & Sannikov 2014
Interest rate cuts vs. QE/Forward Guidance
Mainstream: QE = interest rate cut below 0
Interest rate cut
QE
휏
Economically
relevant duration
19

20. Brunnermeier & Sannikov 2014
Interest rate cuts vs. QE/Forward Guidance
Mainstream: QE = interest rate cut below 0
Interest rate cut
QE
휏
Economically
relevant duration
 I Theory view: different distributional implications
across and within financial sector
- banks borrow short and lend long
- insurance/pension funds companies
- households – depends on mortgage market
Bottleneck MoPo: Whose balance sheets are impaired?
20

21. Brunnermeier & Sannikov 2014
20
Inflation Index: Core vs. Headline
 Empirical view: “core” is better predictor of future 휋೦+휏
- exclude energy since it is mean reverting
 NK view: Core excludes less sticky prices
- exclude energy since prices are flexibel
 I Theory view: price changes cause wealth effect
desirable or not?
- exclude energy (in Europe) since it causes
wealth transfer to middle east/Russia
(Is oil price drop and lowflation bad for Eurozone?)

22. Brunnermeier & Sannikov 2014
21
Conclusions – the “Forgotten Normal”
 Price stability and financial stability are linked
• Money is created by financial sector
Monetary policy and Macro-prudential policy interact
 Taylor rule has to be expanded
• Instruments (LHS of Taylor rule) are multi-dimensional
 I Theory: Wealth/income effects vs. substitution effects
 Financial stability – price stability trade-off:
More financial risk taking (in crisis), less disinflation
 QE/Forward guidance ≠ interest rate cut (below zero)
 Reinterpretation of Optimal Inflation Index
• Optimal inflation index depends on which sector is impaired

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