Transcript Chapter 23 Transmission Mechanisms of Monetary Policy

Chapter 23
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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Reduced-Form
• 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
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Structural Model Advantages
and Disadvantages
• Advantages
– Opportunity to gather more evidence gives more
confidence on the direction of causation
– More accurate predictions
– Understand how institutional changes affect the
links
• Disadvantage
– Only as good as the model it is based on
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Reduced-Form Advantages
and Disadvantages
• Advantage
– No restrictions imposed on the way monetary
policy affects the economy
• Disadvantage
– Correlation does not necessarily imply causation
• Reverse causation
• Outside driving factor
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Early Keynesian Evidence
• 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
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Objections to Early
Keynesian Evidence
• Friedman and Schwartz publish 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
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FIGURE 1 Real and Nominal Interest Rates
on Three-Month Treasury Bills, 1931–2008
Sources: Nominal rates from www.federalreserve.gov/releases/h15/update/. The real rate is constructed
using the procedure outlined in Frederic S. Mishkin, “The Real Interest Rate: An Empirical Investigation,”
Carnegie-Rochester Conference Series on Public Policy 15 (1981): 151–200. This involves estimating
expected inflation as a function of past interest rates, inflation, and time trends and then subtracting the
expected inflation measure from the nominal interest rate.
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Timing Evidence of Early
Monetarists
• 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
– Timing evidence is hard to interpret
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FIGURE 2 Hypothetical Example in
Which Money Growth Leads Output
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Statistical Evidence
• Autonomous expenditure variable (A) equal
to investment spending plus government
spending
– For Keynesian model A should be highly
correlated with aggregate spending but money
supply should not
– For Monetarist money supply should be highly
correlated with aggregate spending but A should
not
• Neither model has turned out be more
accurate than the other
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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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FIGURE 3 The Link Between Monetary Policy
and GDP: Monetary Transmission Mechanisms
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Asset Price Effects
• Traditional interest rate effects
Expansionary monetary policy
 ir  I  Y 
Emphasis on real interest rate: Expansionary monetary
policy
 P e   e  ir  I  Y 
• Exchange rate effects on net
exports
 ir  E  NX  Y 
Expansionary monetary policy
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Asset Price Effects (cont’d)
• Tobin’s q theory
Expansionary monetary policy
 Ps  q  I  Y 
• Wealth effects
Expansionary monetary policy
 Ps  wealth 
 consumption  Y 
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Credit View
• Bank lending channel
Expansionary monetary policy → bank deposits ↑ → bank loans ↑ →
→I↑→Y↑
• Balance sheet channel
Expansionary monetary policy → Ps ↑ → net worth ↑ →
→ adverse selection ↓, moral hazard ↓→ lending ↑ →
→I↑→Y↑
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Credit View (cont’d)
• Cash flow channel
Expansionary monetary policy → i ↓→ cash flow ↑ → adverse selection ↓,
moral hazard ↓→ lending ↑ → I ↑ → Y ↑
• Unanticipated price level channel
Expansionary monetary policy → unanticipated P ↑ → real net worth ↑ →
→ adverse selection ↓, moral hazard ↓→ lending ↑ → I ↑ → Y ↑
• Household liquidity effects
Expansionary monetary policy → Ps ↑ → value of financial assets ↑ →
likelihood of financial distress ↓→ consumer durable and housing
expenditure↑ → Y ↑
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Lessons for Monetary Policy
• It is dangerous always to associate the
easing or the tightening of monetary policy
with a fall or a rise in short-term nominal
interest rates
• Other asset prices besides those on shortterm debt instruments contain important
information about the stance of monetary
policy because they are important
elements in various monetary policy
transmission mechanisms
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Lessons for Monetary Policy
(cont’d)
• Monetary policy can be highly effective in reviving a
weak economy even if short-term interest rates are
already near zero
• Avoiding unanticipated fluctuations in the price level
is an important objective of monetary policy, thus
providing a rationale for price stability as the
primary long-run goal for monetary policy
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