Transcript The Role of the Interest Rate Channel of

The Role of the Interest Rate Channel of
Monetary Policy Transmission in the Recovery of
the US Economy after the Recession of 2001.
by
Caesar R. Cabral Jr.
ECO6226
(Professor O. Mikhail)
U.S. Federal Reserve System
•A key function of the central bank is the
formulation of monetary policy.
•Federal Open Market Committee (FOMC), which
is one of the six structural components that make up
the Federal Reserve System, is solely responsible
for setting the reserve requirements for banking
institutions and shares the responsibility with the
Reserve Banks for discount rate policy.
Open Market Operations
•Open market operations constitute the buying and
selling of government securities with the underlying
intention to either increase the money supply or
decrease the money supply, respectively.
•The previous two functions plus the ability to carry
out open market operations constitute the monetary
policy tools of the Federal Reserve System.
Monetary Transmission Mechanism
•“The monetary transmission mechanism describes
how policy-induced changes in the nominal money
stock or the short-term nominal interest rate impact
on real variables such as aggregate output and
employment” (Peter Ireland 2005).
Channels of Monetary Transmission
•Interest Rate Channel – Traditional Keynesian
•Exchange Rate Channel – Traditional Keynesian
•Balance-sheet channel
•Bank Lending Channel
•Asset Price Channel
•Credit Channel
Contractionary vs. Expansionary
According to the Interest Rate Channel Story:
Contractionary Monetary Policy (tightening):
•FOMC wishes to decrease money supply,
•Sells securities on the open market,
•This leads to a rise in interest rates,
•High interest rates increase the cost of financing
capital projects,
•This leads to decline in investment spending,
•This leads to decline in aggregate demand and a
fall in output
Contractionary vs. Expansionary
According to the Interest Rate Channel Story:
Expansionary Monetary Policy (easing):
•FOMC wishes to increase money supply,
•Buys securities on the open market,
•This leads to a fall in interest rates,
•Low interest rates decrease the cost of financing
capital projects,
•This leads to an increase in investment spending,
•This leads to a rise in aggregate demand and a fall
in output
Schematic Diagrams of Channels
Interest Rate Channel (expansionary)
M↑→i↓→I↑→Y↑
where, M = monetary base (currency and bank
reserves)
i = real interest rates
I = investment spending
Y = income (GDP) or output)
Schematic Diagrams of Channels
Exchange Rate Channel (contractionary)
M ↓ → i ↑ → E ↑ → NX ↓ → Y ↓
where, E = exports
NX = net exports (exports – imports)
Tobin’s q Channel (contractionary)
M ↓ → Pe ↓ → q ↓ → I ↓ → Y ↓
where, q = the ratio of market value to
replacement cost
Schematic Diagrams of Channels
Wealth and Consumption Channel
(contractionary)
M ↓ → Pe ↓ → wealth ↓ → consumption ↓ → Y ↓
where, Pe = stock prices
Bank Lending Channel (contractionary)
M ↓ → bank deposits ↓ → bank loans ↓ → I ↓ →
Y↓
Balance-sheet Channel (contractionary)
M ↓ → Pe ↓ → adverse selection ↑ & moral
hazard ↑ → lending ↓ → I ↓ → Y ↓
The Recession of 2001
Non-quantitative Approach: Trend Analysis
(Expansionary Policy-Increase Money Supply)
(Monetary Base – Upward Trend)
The Recession of 2001
Non-quantitative Approach: Trend Analysis
(Expansionary Policy-Increase Money Supply)
(Bank Prime Loan Rate – Downward Trend)
The Recession of 2001
Non-quantitative Approach: Trend Analysis
(Expansionary Policy-Increase Money Supply)
(Total Investments – Upward Trend)
The Recession of 2001
Non-quantitative Approach: Trend Analysis
(Expansionary Policy-Increase Money Supply)
(Real Gross Domestic Product – Upward Trend)
Interest Rate Channel: Weak Connection
Interest Rate: Counter Argument
1. Empirical studies find spending fairly
insensitive to interest rates and monetary
policy.
2. Should have its strongest influence on shortterm interest rates like the federal funds rate
and its weakest effect on the long-term rates.
(Ben S. Bernanke and Mark Gertler)
Interest Rate Channel: Strong Connection
Interest Rate: In-Favor
John Taylor’s model of economic effect of
contractionary monetary policy found an
increase in short-term interest rates which, given
the assumption that price and wages are rigid,
then led to an increase in real long-term interest
rates.
Alternate Channel
M↑→i↓→E↓
Domestic real interest rates drop, domestic currency
deposits become less attractive, depreciation of the
dollar, denoted by E ↓
Conclusion
Despite some criticism regarding the connection
between spending and fluctuations in real
interest rates, the interest rate channel of
monetary transmission proves to be viable in
analyzing the trends of it’s key components in
the recent recession of 2001. It is also evident
from observation, that it served as one of
multiple mechanisms through which monetary
policy was executed.
QUESTIONS??