THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 671

CHAPTER 25 Transmission Mechanisms of Monetary Policy 639 economy We then go on to examine the transmission mechanisms of monetary policy and evaluate the empirical evidence on them to better understand the role that monetary policy plays in the economy We will see that these monetary transmission mechanisms emphasize the link between the financial system (which we studied in the first three parts of this book) and monetary theory, the subject of this part FRAM EWORK FO R E VALUAT I NG EM P IRI CAL E VI DE N CE To develop a framework for understanding how to evaluate empirical evidence, we need to recognize that there are two basic types of empirical evidence in economics and other scientific disciplines Structural model evidence examines whether one variable affects another by using data to build a model that explains the channels through which this variable affects the other; reducedform evidence examines whether one variable has an effect on another simply by looking directly at the relationship between the two variables Suppose that you were interested in whether drinking coffee leads to heart disease Structural model evidence would involve developing a model that analyzed data on how coffee is metabolized by the human body, how it affects the operation of the heart, and how its effects on the heart lead to heart attacks Reducedform evidence would involve looking directly at whether coffee drinkers tend to experience heart attacks more frequently than non coffee drinkers How you look at evidence whether you focus on structural model evidence or reduced-form evidence can lead to different conclusions This is particularly true for the debate on the importance of monetary policy to economic fluctuations Structural Model Evidence The components analysis of aggregate demand discussed in Chapter 24 is specific about the channels through which the money supply affects economic activity (called the transmission mechanisms of monetary policy) This approach typically examines the effect of changes in the money supply on economic activity by building a structural model, a description of how the economy operates using a collection of equations that describe the behaviour of firms and consumers in many sectors of the economy These equations then show the channels through which monetary and fiscal policy affect aggregate output and spending A structural model might have behavioural equations that describe the workings of monetary policy with the following schematic diagram: M i I Y The model describes the transmission mechanism of monetary policy as follows: the change in the money supply M affects interest rates i, which in turn affect investment spending I, which in turn affects aggregate output or aggregate spending Y Structural model evidence on the relationship between M and Y looks at empirical evidence on the specific channels of monetary influence, such as the link between interest rates and investment spending Reduced-Form Evidence The quantity theory approach to aggregate demand does not describe specific ways in which the money supply affects aggregate spending Instead, it suggests that the effect of money on economic activity should be examined by looking at