Credit markets, including the market for bank loans, are characterized by imperfect and asymmetric information. These informational frictions can interact with other economic forces to produce periods of credit-market stress, in which intermediation is unusually costly and households and businesses have difficulty obtaining credit. A high level of credit-market stress, as in a severe financial crisis, may in turn produce a deep and prolonged recession. I present evidence that financial distress and disrupted credit markets were important sources of the Great Depression of the 1930s and the Great Recession of 2007–2009. Changes in the state of credit markets also play a role in “ garden-variety” business cycles and in the transmission of monetary policy to the economy.

To overcome the limits on traditional monetary policy imposed by the effective lower bound on short-term interest rates, in recent years the Federal Reserve and other advanced-economy central banks have deployed new policy tools. This lecture reviews what we know about the new monetary tools, focusing on quantitative easing (QE) and forward guidance, the principal new tools used by the Fed. I argue that the new tools have proven effective at easing financial conditions when policy rates are constrained by the lower bound, even when financial markets are functioning normally, and that they can be made even more effective in the future. Accordingly, the new tools should become part of the standard central bank toolkit. Simulations of the Fed’s FRB/US model suggest that, if the nominal neutral interest rate is in the range of 2–3 percent, consistent with most estimates for the United States, then a combination of QE and forward guidance can provide the equivalent of roughly 3 percentage points of policy space, largely offsetting the effects of the lower bound. If the neutral rate is much lower, however, then overcoming the effects of the lower bound may require additional measures, such as a moderate increase in the inflation target or greater reliance on fiscal policy for economic stabilization.

General Nature of the Editorial Process

In recent decades, asset booms and busts have been important factors in macroeconomic fluctuations in both industrial and developing countries. In light of this experience, how, if at all, should central bankers respond to asset price volatility? We have addressed this issue in previous work (Bernanke and Gertler, 1999). The context of our earlier study was the relatively new, but increasingly popular, monetary-policy framework known as inflation-targeting (see e.g., Bernanke and Frederic Mishkin, 1997). In an inflation-targeting framework, publicly announced medium-term inflation targets provide a nominal anchor for monetary policy, while allowing the central bank some flexibility to help stabilize the real economy in the short run. The inflation-targeting approach gives a specific answer to the question of how central bankers should respond to asset prices: Changes in asset prices should affect monetary policy only to the extent that they affect the central bank’s forecast of inflation. To a first approximation, once the predictive content of asset prices for inflation has been accounted for, there should be no additional response of monetary policy to assetprice fluctuations. In use now for about a decade, inflationtargeting has generally performed well in practice. However, so far this approach has not often been stress-tested by large swings in asset prices. Our earlier research employed simulations of a small, calibrated macroeconomic model to examine how an inflation-targeting policy (defined as one in which the central bank’s instrument interest rate responds primarily to changes in expected inflation) might fare in the face of a boom-and-bust cycle in asset prices. We found that an aggressive inflationtargeting policy rule (in our simulations, one in which the coefficient relating the instrument interest rate to expected inflation is 2.0) substantially stabilizes both output and inflation in scenarios in which a bubble in stock prices develops and then collapses, as well as in scenarios in which technology shocks drive stock prices. Intuitively, inflation-targeting central banks automatically accommodate productivity gains that lift stock prices, while offsetting purely speculative increases or decreases in stock values whose primary effects are through aggregate demand. Conditional on a strong policy response to expected inflation, we found little if any additional gains from allowing an independent response of central-bank policy to the level of asset prices. In our view, there are good reasons, outside of our formal model, to worry about attempts by central banks to influence asset prices, including the fact that (as history has shown) the effects of such attempts on market psychology are dangerously unpredictable. Hence, we concluded that inflationtargeting central banks need not respond to asset prices, except insofar as they affect the inflation forecast. In the spirit of recent work on robust control, the exercises in our earlier paper analyzed the performance of policy rules in worst-case † Discussants: Robert Shiller, Yale University; Glenn Rudebusch, Federal Reserve Bank of San Francisco; Kenneth Rogoff, Harvard University.