1. Monetary Transmission Mechanisms (MTM)
MONETARY ECONOMICS
Monetary Transmission Mechanisms (MTM)

2. M  interest rate  I, C  AD  GDP, P
GRAPH: IS-LM-AD
M  interest rate  I, C  AD  GDP, P
Monetary policy affects the short term interest rate.
However, what matters for investment is REAL long term interest rate
Assumptions: price is sticky in the short run and the term structure of interest rate work.

3. EQUATION: IS-LM IS: LM:
Within the IS-LM framework, Y and r are endogenous while other variables are exogenous (i.e. M, P, G).
Since we are interested in the effect of change in M, the changes in other exogenous factors (i.e. dM and dG) are set to 0.
Rearrange the equations by placing the endogenous variables on the left-hand-side and others on the right-hand-side.

4. EQUATION: IS-LM
Divide by dM

5. EQUATION: IS-LM
Income increases and interest rate decreases as money supply increase.
If interest rate elasticity of investment is zero, dY/dM = 0
(Investment Trap)
If interest rate elasticity of money demand is perfectly elastic, dY/dM = 0 (Liquidity Trap).
In the case of liquidity trap, monetary policy will be effecrive only if monetary policy has wealth effect.

6. EQUATION: IS-LM-AS
The incorporation of the IS function is straightforward.
In IS-LM-AS, Y, r, and P are endogenous variables. As such, there will be three equations to work with in comparative statics.
The third equation.

7. CHANNELS OF MTM
What we have discussed so far is the interest rate channel.
Other channels:
- Exchange rate channel
- Tobin’s Q Channel
- Wealth Channel
- Credit View

8. EXCHANGE RATE CHANNEL M , ir , E , NX , Y 
When ir  the domestic currency depreciates, that is E . This makes domestic goods relatively less expensive and NX .

9. TOBIN’S Q CHANNEL 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 Pe is the price of equity (not the expected price level)

10. 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 

11. 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.

12. 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 
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.

13. CREDIT VIEW Balance Sheet Channel:
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 

14. CREDIT VIEW Cash Flow Channel:
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 ir) that affects cash flow. Hence, this interest rate mechanism is different from the traditional interest rate mechanism.

15. CREDIT VIEW Household Liquidity Effects Channel:
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,
M , Pe , value of financial assets , likelihood of financial distress , consumer durable and housing expenditure , Y 