The Channels of Monetary Transmission: Lessons for Monetary Policy Frederic S. Mishkin

Transmission mechanisms can be classified as: Asset Price Channels a) Interest rate channel b) Exchange rate channel c) Equity prices channel Credit Channels a) Bank lending channel b) Balance sheet channel

Interest Rate Channels Follow the traditional ISLM model Where M= money supply ir= real interest rate Pe= expected price level pe= expected inflation I= investment Y= real output M ↑, ir ↓, I ↑, Y ↑ M ↑, Pe↑, pe↑, ir ↓, I ↑, Y ↑

Exchange Rate Channel M ↑, ir ↓, E ↓, NX ↑, Y↑ Derived from macroeconomic models built under a Keynesian framework M ↑, ir ↓, E ↓, NX ↑, Y↑ Where M = money supply ir= real interest rate E = nominal exchange rate NX = net exports Y = real output

Equity Price Channels M ↑, Pe ↑, q ↑, I ↑, Y ↑ a) Tobin’s q Theory: monetary policy affects the real sector through its effect on the valuation of equities. M ↑, Pe ↑, q ↑, I ↑, Y ↑ Where M=money supply Pe= equity prices q = market value of firms/replacement cost of capital I = investment Y = real output

b) Wealth effects on consumption: assumes that consumption is a function of lifetime resources, which include stocks. M ↑, Pe ↑, W ↑, C ↑, Y ↑ Where M= money supply Pe= stock prices W = wealth C = consumption Y = real output

Notice that the concept of equity and wealth can be applied to housing and land prices. An increase in house prices leads to an increase in Tobin’s q for housing. An increase in house prices leads to an increase in wealth.

Credit Channels Bank Lending Channel M ↑, bank deposits ↑, bank loans ↑, I ↑, Y ↑ Notice that the effect of monetary policy of firms is asymmetric. The greater the dependence on bank loans, the greater the effect of monetary policy on investment.

Balance-Sheet Channels a) Via the net worth of firms M ↑, Pe ↑, adverse selection ↓, moral hazard ↓, net worth ↑, lending ↑,I ↑, Y ↑ b) Via nominal interest rates and cash flow M ↑, i ↓, cash flow ↑, adverse selection ↓, moral hazard ↓, lending ↑, I ↑, Y ↑

c) Via the general price level M ↑, unanticipated P ↑, adverse selection ↓ ,moral hazard ↓ lending ↑, I ↑, Y ↑ d) Household Balance-Sheet Effect: M ↑, Pe ↑, value of financial assets ↑, likelihood of financial distress ↓, consumer durable and housing expenditure ↑, Y ↑

Lesson 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.