Chapter 26
Transmission Mechanisms
of Monetary Policy:
The Evidence
Two Types of Empirical Evidence
Structural Model Evidence
M i I Y Reduced Form Evidence
M ? Y
Structural Model Evidence Advantages:
1. Understand causation because more information on link between M and Y
2. Knowing how M affects Y helps prediction
3. Can predict effects of institutional changes that change link from M to Y
Disadvantages:
1. Structural model may be wrong, negating all advantages
Reduced Form Evidence
Advantages:
1. No restrictions on how M affects Y: better able to find link from M to Y
Disadvantages:
1. Reverse causation possible
2. Third factor may produce correlation of M and Y
Early Keynesian Evidence
Evidence:
1. Great Depression: i on T-bonds to low levels monetary policy was “easy”
2. No statistical link from i to I 3. Surveys: no link from i to I
Objections to Keynesian evidence Problems with structural model
1. i on T-bonds not representative during Depression: i very high on low-grade bonds: Figure 1 in Ch. 6
2. ir more relevant than i: ir high during Depression: Figure 1 3. Ms during Depression (Friedman and Schwartz): money
“tight”
4. Wrong structural model to look at link of i and I, should look at i and I: evidence in 1 and 2 suspect
Real and Nominal Interest Rates
Early Monetarist Evidence
Monetarist evidence is reduced form Timing Evidence
(Friedman and Schwartz)
1. Peak in Ms growth 16 months before peak in Y on average 2. Lag is variable
Criticisms:
1. Uses principle: Post hoc, ergo propter hoc
2. Principle only valid if first event is exogenous: i.e., if have controlled experiment
3. Hypothetical example (Fig 2): Reverse causation from Y to M and yet Ms growth leads Y
Hypothetical Example in Which M/M leads Y
Statistical Evidence
Horse race: correlation of A vs M with Y;
Friedman and Meiselman, M wins Criticisms:
1. Reverse causation from Y to M, or third factor driving
M and Y are possible
2. Keynesian model too simple, unfair handicap 3. A measure poorly constructed
Postmortem with different measures of A: no clear- cut victory
Historical Evidence
Friedman and Schwartz: Monetary History of the U.S.
1. Important as criticism of Keynesian evidence on Great Depression
2. Documents timing evidence
More convincing than other monetarist evidence:
Episodes are almost like “controlled experiments”
1. Post hoc, ergo propter hoc applies
2. History allows ruling out of reverse causation and third factor: e.g., 1936–37 rise in reserve
requirements and 1937-38 recession
Monetary Transmission Mechanisms
Traditional Interest-Rate Channels:
M , ir , I , Y
The interest rate channel of monetary transmission applies equally to C. Also, it places emphasis on ir rather than i. Moreover, it is the long-term ir and not the short-term ir that is viewed as having the major impact on C and I spending.
With sticky P, an in M leads to a in short term i and also short term ir. According to the expectations hypothesis of the term structure of interest rates, this also long-term ir. The in short- and long-term ir leads to an in C and I spending.
Note: The interest rate transmission mechanism is effective even when i has already been driven to zero by the MA during a deflationary period. With i = 0,
M , Pe , e , i , C and I , Y
Monetary Transmission Mechanisms
Other Asset Channels
Exchange Rate Channel:
M , ir , E , NX , Y
When ir the domestic currency depreciates (see Chapter 7), that is E . This makes domestic goods relatively less expensive and
NX .
Recent work indicates that the exchange rate transmission
$ E euro
Monetary Transmission Mechanisms
Other Asset Channels
Tobin’s q Channel:
where MVF = market value of firms and RCC = replacement cost of
capital. If q is high, MFV is high relative to RCC, and new plant and equipment capital is cheap relative to the market value of firms. 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 M , Pe , q , I , Y
where P is the price of equity (not the expected price level)
RCC q MVF
Monetary Transmission Mechanisms
Other Asset Channels
Wealth Channel:
Was introduced by Franco Modigliani in his famous “life cycle hypothesis of consumption.” He argued that the most important
transmission mechanism of monetary policy involves consumption.
Considering that an expansionary monetary policy stock prices, the wealth transmission mechanism works as follows:
M , Pe , W , C , Y
Note: Tobin’s q and wealth mechanisms allow for a general
definition of equity that includes housing and land. For example, an
in house prices, which their value relative to replacement cost,
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 A. Bank lending, and
B. Firms’ and households’ balance sheets Note:
Adverse selection is an asymmetric information problem that occurs before the transaction occurs: potential bad credit risks are the ones who most actively seek out loans.
Moral hazard arises after the transaction occurs: the lender runs the risk that the borrower will engage in activities that are
undesirable form the lender’s point of view.
Credit View
Bank Lending Channel:
Because of asymmetric information problems in credit markets, many borrowers do not have access to the stock and bond markets and depend on bank loans to finance their activities. Because of banks’ ability to solve such problems (see Chapter 8), an
expansionary monetary policy which bank reserves and deposits,
the quantity of bank loans available to small credit-constrained borrowers. The in loans causes C and I to . The monetary
policy transmission is:
M , bank deposits , bank loans , C and I , Y
Credit View
Balance Sheet Channel:
As we saw in Chapter 8, the lower the net worth (NW) of
business firms (and therefore the lower the collateral that they have for their loans), the more severe the adverse selection and moral hazard problems in lending to these firms. In fact, a in NW, the adverse selection and moral hazard problems and leads to a in lending and hence in I.
Monetary policy can affect firms’ balance sheets in several
ways. For example, expansionary monetary policy, Pe (along lines discussed earlier) and the NW of firms and so leads to an in I and Y. The monetary policy transmission is:
M , Pe , adverse selection , moral hazard , lending , I , Y
Credit View
Balance Sheet Channel
Cash Flow Channel:
This is another balance sheet channel. It operates through its effects on cash flow, the difference between cash receipts and cash expenditures.
Expansionary monetary policy, i and raises cash flow. The in cash flow causes an improvement in firms’ balance sheets, because it liquidity and makes it easier for lenders to know if the firm will be able to pay its bills. This adverse selection and moral hazard problems, leading to an in lending. Hence,
M , i , cash flow adverse selection , moral hazard , lending , I , Y
Note: In this transmission mechanism it is the short-term i (not
Credit View
Balance Sheet Channel
Unanticipated Price Level Channel:
This is another balance sheet channel, operating through its effects on P.
Expansionary monetary policy, produces a surprise in P,
lowering the real value of firms’ liabilities, leaving unchanged the real value of firms’ assets. This real NW, adverse
selection and moral hazard problems, leading to an in I and Y.
M , unanticipated P , adverse selection , moral hazard , lending , I
, Y
Credit View
Balance Sheet Channel
Household Liquidity Effects Channel:
The credit view applies equally well to consumer spending, particularly on consumer durables and housing.
An in M, i and causes an in durables and housing purchases by consumers who do not have access to other sources of credit. Similarly, i cause an improvement in household balance sheets because they cash flow to consumers. An in consumer cash flow, likelihood of financial distress, which the desire of consumers to hold durable goods or housing, thus spending on them. Hence,
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 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.
