Aurora Borealis
1 October 2015 CFA Institute Journal Review

Shock from Graying: Is the Demographic Shift Weakening Monetary Policy Effectiveness (Digest Summary)

  1. Mark K. Bhasin, CFA

In advanced economies, changes in monetary policy are less effective for the economy than in the past because of the demographic shift to a graying society. In five advanced economies, including the United States, the weakening of monetary policy effectiveness with regard to unemployment and inflation is attributed to demographic changes.

What’s Inside?

The author summarizes the transmission channels that could explain why monetary policy is less effective in developed societies. He studies whether the weakening of monetary policy effectiveness in five advanced economies is attributable to changes in demographics.

How Is This Research Useful to Practitioners?

Demographic changes in five advanced economies have contributed to the observed decrease in monetary policy effectiveness in those countries. Monetary policy in a graying/older society will have to operate differently to achieve the same impact as in a younger society.

In societies undergoing a demographic shift, central banks will need to manage new trade-offs related to interest rates, inflation, and output. Because monetary policy has a smaller impact in an older society, central bankers will need to make larger changes in policy rates (i.e., short-term rates) to bring about the desired effect on the economy. Policymakers may also need to focus more on other strategies, such as fiscal and macroprudential policy, as a means to stabilize the economy.

The author focuses on advanced economies, but many African, Asian, and Middle Eastern countries have young populations in which wealth is not as skewed toward older generations. The transmission channels affecting monetary policy effectiveness are different in older and younger societies. In younger societies, such as in many emerging markets and low-income countries, monetary policy effectiveness may not weaken as much as it does in the advanced economies that the author studies.

How Did the Author Conduct This Research?

The author provides an overview of how different channels (interest rate, credit, wealth, risk taking, and expectation) underlying the monetary transmission mechanism affect young and old societies.

The author uses Bayesian estimation techniques for five advanced economies (the United States, Canada, Japan, the United Kingdom, and Germany) to demonstrate that monetary policy has been less effective over time with regard to unemployment and inflation. After demonstrating a relationship between aging and a weakening of monetary policy, the author uses different regressions for the five countries to attribute this weakening to demographic changes. The dependent variable relates to the impact of monetary policy on a country, and the independent variables include the aging of society (i.e., the old-age dependence ratio—the ratio of the number of people older than 65 years relative to those between 15 and 64 years), the intensity of manufacturing output, the degree of economic openness, the share of small companies, and the level of private sector credit in the economy.

The results indicate that an older society, as proxied by the old-age dependence ratio, provides a negative, statistically significant impact on monetary policy effectiveness.

Abstractor’s Viewpoint

The author demonstrates that aging populations in five advanced economies with independent central banks have been a critical factor in explaining the decrease in monetary policy effectiveness. Additional research should be done to observe monetary policy effectiveness in younger societies, such as in many Asian, African, and Middle Eastern countries. Given the prevalence of quantitative easing in many advanced economies since the Great Recession, it would be interesting to analyze whether the effectiveness of this form of monetary policy is also affected by demographics and, if so, to what extent.

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