CHAPTER 25 FYI Transmission Mechanisms of Monetary Policy 651 Real Business Cycle Theory and the Debate on Money and Economic Activity New entrants to the debate on money and economic activity are advocates of real business cycle theory, which states that real shocks to tastes and technology (rather than monetary shocks) are the driving forces behind business cycles Proponents of this theory are critical of the monetarist view that money matters to business cycles because they believe that the correlation of output with money reflects reverse causation; that is, the business cycle drives money, rather than the other way around An important piece of evidence they offer to support the reverse causation argument is that almost none of the correlation between money and output comes from the monetary base, which is controlled by the monetary authorities.* Instead, the money output correlation stems from other sources of money supply movements that, as we saw in Chapter 16, are affected by the actions of banks, depositors, and borrowers from banks and are more likely to be influenced by the business cycle * Robert King and Charles Plosser, Money, Credit and Prices in a Real Business Cycle, American Economic Review 74 (1984): 363 380; Charles Plosser, Understanding Real Business Cycles, Journal of Economic Perspectives (Summer 1989): 51 78 develop a better understanding of channels (other than interest-rate effects on investment) through which monetary policy affects aggregate demand In this section we examine some of these channels, or transmission mechanisms, beginning with interest-rate channels because they are the key monetary transmission mechanism in the ISLM and AD /AS models you have seen in Chapters 22, 23, and 24 Traditional Interest-Rate Channels The traditional components view of the monetary transmission mechanism can be characterized by the following schematic, which shows the effect of expansionary monetary policy: Expansionary monetary policy ir* I c Y c (1) where an expansionary monetary policy leads to a fall in real interest rates (ir*), which in turn lowers the cost of capital, causing a rise in investment spending (I c), thereby leading to an increase in aggregate demand and a rise in output (Y c) Although Keynes originally emphasized this channel as operating through businesses decisions about investment spending, the search for new monetary transmission mechanisms recognized that consumers decisions about housing and consumer durable expenditure (spending by consumers on durable items such as automobiles and refrigerators) also are investment decisions Thus the interestrate channel of monetary transmission outlined in Equation applies equally to consumer spending, in which I also represents residential housing and consumer durable expenditure An important feature of the interest-rate transmission mechanism is its emphasis on the real rather than the nominal interest rate as the rate that affects consumer and business decisions In addition, it is often the real long-term interest rate and not the real short-term interest rate that is viewed as having the major impact on spending How is it that changes in the short-term nominal interest rate induced