Transcript Chapter 25 PPP

Chapter 25
Transmission Mechanisms of
Monetary Policy: The Evidence
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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
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)
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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: “Liquidity Trap”
– “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 but on
investors’ ‘wild’ expectations (of the future income). “Animal
Spirits”
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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
• Distinction between Nominal and Real Interest
Rates: A Weak link between nominal interest rates
and investment spending does not rule out a strong
link between real interest rates and investment
spending; real interest was very high.
• Interest-rate effects are only one of many channels
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Real and Nominal Interest Rates (T-bills)
1931-2009
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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
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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
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Transmission Mechanisms of Monetary
Policy
Traditional Interest-Rate Channels:
expansionary monetary policy
expansionary monetary policy
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ir , I , Y
Pe , e , ir , C and I , Y 
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These are only temporary if ever working, and
does not work in the long-run (refer to my
note on the “Liquidity Effect and Expectations
Effect of MS on Interest rates”
There is no empirical support.
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Exchange Rate Channel
expansionary monetary policy
ir , E , NX , Y 
When ir  the domestic currency depreciates,
that is E . This makes domestic goods
relatively less expensive and NX .
Recent work indicates that the exchange rate
transmission mechanism plays an important
role in how monetary policy affects the
economy.
<- Valid only in the short-run
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Tobin’s q
Tobin’s q Channel:
MVF
q
RCC
In this case, companies can issue stock and get a high price
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 Pe , q , I , Y 
where Pe is the price of equity (not the expected price level)
<- Adjustment Costs not taken into account; not always
working
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Wealth Channel
Expansionary monetary policy  stock prices, the wealth
transmission mechanism works as follows:
expansionary monetary policy
Pe , 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.
Also, an  in housing and land prices  W, thereby  C & Y.
<- It works opposite for those with Bonds
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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
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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
firms, which can access the credit markets.
<- Eventually Banking Crisis and Collapse may come; 10
years of cycles?
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Balance Sheet Channel
Monetary policy can affect firms’ balance sheets
in several ways. For example, expansionary
monetary policy,  Pe and  the NW of firms
and so leads to an  in I and Y.
The monetary policy transmission is:
Expansionary monetary policy
Pe, adverse selection , moral hazard ,
lending , I , Y 
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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 ir)
that affects cash flow. Hence, this interest rate mechanism is
different from the traditional interest rate mechanism.
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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 
<- Unanticipated MP leads to Fluctuations of Y: Instability
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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
Pe , value of financial assets , likelihood of financial distress ,
consumer durable and housing expenditure ,Y 
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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
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Monetary Transmission Mechanisms
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Lessons for Monetary Policy
1. Dangerous to associate easing or tightening with fall or
rise in nominal interest rates (o)
2. Other asset prices besides short-term debt have
information about stance of monetary policy(o): Banks,
Financial Market Boom and Bust, Periodic Banking
Crisis, etc. have to be monitored; MP may create
financial shocks.
* Mishkin argues that monetary policy may be effective
in reviving economy even if short-term interest rates
near zero(X: Han disagrees).
3. Avoiding unanticipated fluctuations in price level
important: rationale for price stability objective.
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• Impact of MS on Y is dubious, and only
effective in the short-run if ever.
• Arbitrary MP can create Monetary Shocks and
Income Instability
• A good MP should be “Stable Monetary
Policy” (not Activist Monetary Policy).
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