Transmission mechanisms of monetary policy the evidence

Examines whether one variable affects another by using data to build a model that explains the channels through which the variable affects the other Transmission mechanism The change in the money supply affects interest rates Interest rates affect investment spending Investment spending is a component of aggregate spending (output)

Chapter 25

Transmission Mechanisms of

Monetary Policy: The Evidence

Structural Model

• Examines whether one variable affects another by

using data to build a model that explains the

channels through which the variable affects the

• Examines whether one variable has an effect

on another by looking directly at the

relationship between the two

• Analyzes the effect of changes in money

supply on aggregate output (spending) to see

if there is a high correlation

• Does not describe the specific path

Structural Model Advantages and Disadvantages

• Possible to gather more evidence  more

confidence on the direction of causation

• More accurate predictions

• Understand how institutional changes affect

the links

• Only as good as the model it is based on

Advantages and Disadvantages of

Reduced Form Evidence

• No restrictions imposed on the way monetary policy affects the economy

• Correlation does not necessarily

imply causation

– Reverse causation

– Outside driving factor

Early Keynesian Evidence on the

Importance of Money

• Monetary policy does not matter at all

• Three pieces of structural model evidence

– Low interest rates during the Great Depression indicated

expansionary monetary policy but had no effect on the economy

– Empirical studies found no linkage between movement in

nominal interest rates and investment spending – Surveys of business people confirmed that investment in

physical capital was not based on market interest rates

Objections to Early Keynesian Evidence

• Friedman and Schwartz published a monetary history

of the U.S showing that monetary policy was

actually contractionary during the Great Depression

• Many different interest rates

• During deflation, low nominal interest rates do not

necessarily indicate expansionary policy

• Weak link between nominal interest rates and

investment spending does not rule out a strong link between real interest rates and investment spending

• Interest-rate effects are only one of many channels

Real and Nominal Interest Rates (T-bills)

1931-2009

Early Monetarist Evidence on the

Importance of Money

• Money growth causes business cycle fluctuations but its effect on the business cycle operates with “long

and variable lags”

• Post hoc, ergo propter hoc

– Exogenous event

– Reduced form nature leads to possibility of

reverse causation – Lag may be a lead

Hypothetical Example in Which Money

Growth Leads Output

Statistical Evidence

• Autonomous expenditure variable equal

to investment spending plus government spending

– For Keynesian model AE should be highly correlated with aggregate spending but money supply should not

– For Monetarist money supply should be highly correlated with aggregate spending but AE

should not

• Neither model has turned out be more accurate

than the other

Historical Evidence

• If the decline in the growth rate of the money supply

is soon followed by a decline in output in these

episodes, much stronger evidence is presented that money growth is the driving force behind the

business cycle

• A Monetary History documents several instances in

which the change in the money supply is an

exogenous event and the change in the business

cycle soon followed

Transmission Mechanisms of Monetary

Policy

Traditional Interest-Rate Channels:

expansionary monetary policy i r , I , Y

The interest rate channel of monetary transmission

applies equally to C Also, it places emphasis on i r rather

than i Moreover, it is the long-term i r and not the

short-term i r that is viewed as having the major impact on C and I spending

Exchange Rate Channel

expansionary monetary policy ir , E , NX , Y 

Recent work indicates that the exchange rate transmission mechanism plays an important

role in how monetary policy affects the

Tobin’s q

Tobin’s q Channel:

for it relative to the cost of the facilities and equipment they

are buying I  because firms can buy a lot of new investment

goods with only a small issue of stock.

The transmission mechanism for monetary policy is

expansionary monetary policy P e , q , I , Y 

RCC MVF

q 

Wealth Channel

Expansionary monetary policy  stock prices, the wealth

transmission mechanism works as follows:

expansionary monetary policy

P e , W , C , Y 

Tobin’s q and wealth mechanisms allow for a general definition of

equity that includes housing and land

An  in house prices, which  their value relative to replacement

cost,  Tobin’s q for housing, thereby stimulating production

Credit View

This view proposes that two types of monetary

transmission channels arise as a result of information problems (such as adverse selection and moral hazard problems) in credit markets

These channels operate through their effects on

1) Bank lending

2) Firms’ and households’ balance sheets

Bank Lending Channel

expansionary monetary policy:

bank deposits , bank loans , C and I , Y 

Note: Monetary policy will have a greater effect

on spending by smaller firms, which are more dependent on bank loans, than it will on large

Balance Sheet Channel

Monetary policy can affect firms’ balance sheets

in several ways For example, expansionary

monetary policy,  P e and  the NW of firms and

so leads to an  in I and Y.

The monetary policy transmission is:

Expansionary monetary policy

P e, adverse selection , moral hazard , lending

, I , Y 

Cash Flow Channel

Declining interest rates raises cash flow The increased cash flow

causes an improvement in firms’ balance sheets, because it increases liquidity and makes it easier for lenders to know if the firm will be

able to pay its bills This reduces adverse selection and moral

hazard problems, leading to an increase in lending

Expansionary monetary policy

i , cash flow  adverse selection , moral hazard , lending , I , Y



Note: In this transmission mechanism it is the short-term i (not i r)

that affects cash flow Hence, this interest rate mechanism is

Unanticipated Price Level Channel

Expansionary monetary policy produces a surprise

increase in P, lowering the real value of firms’

liabilities, leaving unchanged the real value of firms’ assets

This increases real NW, reduces adverse selection and moral

hazard problems, leading to an increases in I and Y

Expansionary monetary policy

unanticipated P , adverse selection , moral hazard , lending , I ,

Y 

Household Liquidity Effects Channel

Reductions in i causes a rise in durables and housing purchases by

consumers who do not have access to other sources of credit The

reduction ini causes an improvement in household balance

sheets because they increase cash flow to consumers

The rise in consumer cash flow reduceslikelihood of financial

distress, which raises the desire of consumers to hold durable

goods or housing, thus  spending on them

Expansionary monetary policy

P e , value of financial assets , likelihood of financial distress ,

Why Are Credit Channels Likely to be Important?

1 Evidence supports that credit channels do affect

firms’ employment and spending decisions

2 Evidence that small firms are hurt more by tight

monetary policy than are large firms

3 The asymmetric view of credit market

imperfections has proved useful in explaining the existence and structure of financial institutions and why crises are so damaging to the economy

Monetary Transmission Mechanisms

Lessons for Monetary Policy

1 Dangerous to associate easing or tightening with fall or rise in nominal interest rates

2 Other asset prices besides short-term debt have

information about stance of monetary policy

3 Monetary policy is effective in reviving economy even if short-term interest rates near zero

4 Avoiding unanticipated fluctuations in price level

important: rationale for price stability objective