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)
Chapter 25 Transmission Mechanisms of Monetary Policy: The Evidence 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) 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 Structural Model Advantages and Disadvantages • Possible to gather more evidence ⇒ more confidence on the direction of causation • More accurate predictions • Understand how institutional changes affect the links • Only as good as the model it is based on Advantages and Disadvantages of Reduced Form Evidence • No restrictions imposed on the way monetary policy affects the economy • Correlation does not necessarily imply causation – Reverse causation – Outside driving factor 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 – 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 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 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 Real and Nominal Interest Rates (T-bills) 1931-2009 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 Hypothetical Example in Which Money Growth Leads Output Statistical Evidence • Autonomous expenditure variable equal to investment spending plus government spending – For Keynesian model AE should be highly correlated with aggregate spending but money supply should not – For Monetarist money supply should be highly correlated with aggregate spending but AE should not • Neither model has turned out be more accurate than the other 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 Transmission Mechanisms of Monetary Policy Traditional Interest-Rate Channels: expansionary monetary policy 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 shortterm ir that is viewed as having the major impact on C and I spending expansionary monetary policy Pe ↑, πe ↑, ir ↓, C and I ↑, Y ↑ 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 Tobin’s q Tobin’s q Channel: q= MVF 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) 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 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 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 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 ↑ 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 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 ↑ Household Liquidity Effects Channel Reductions in i causes a rise in durables and housing purchases by consumers who 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 ↑ Why Are Credit Channels Likely to be Important? Evidence supports that credit channels affect firms’ employment and spending decisions Evidence that small firms are hurt more by tight monetary policy than are large firms 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 Monetary Transmission Mechanisms Lessons for Monetary Policy Dangerous to associate easing or tightening with fall or rise in nominal interest rates Other asset prices besides short-term debt have information about stance of monetary policy Monetary policy is effective in reviving economy even if short-term interest rates near zero Avoiding unanticipated fluctuations in price level important: rationale for price stability objective ... exogenous event and the change in the business cycle soon followed Transmission Mechanisms of Monetary Policy Traditional Interest-Rate Channels: expansionary monetary policy ir ↓, I ↑, Y↑ The interest... 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. .. 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