The Cost Channel of Monetary Transmission Barth and Ramey

Introduction Notice the stylized facts about the effects of a contractionary monetary policy action: Notice the stylized facts about the effects of a contractionary monetary policy action: a) Output falls after a lag of about four months. b) Short-term interest rates have largely transitory effects. c) The price level is unresponsive for almost two years. Traditional models try to explain these facts by assuming sticky wages or prices. However, it is difficult to explain why a decline in aggregate demand does not lead firms to lower prices. An alternative explanation is to allow monetary shocks to have both supply-side and demand-side effects.

The authors argue that: 1. If after a tightening in monetary policy output and prices decline simultaneously, then it should be the case that there was a demand- side response to the policy. 2. If output declines and prices increase, then the market response comes from the supply-side. 3. If output declines and prices do not change, then there was a simultaneous reaction on the supply and the demand side of the market.

Theoretical Framework Firms Firms Maximize profits given by WhereP it = price of output Q it = production R it = supply side effect of monetary policy C(Q it ) = convex cost function

Firms face an inverse demand function given by: Firms face an inverse demand function given by: Where Q it = production D it = demand effect of monetary policy D it = demand effect of monetary policy

Wages are allowed to be endogenously determined: Wages are allowed to be endogenously determined: The authors solve the model to show the relationship between output and prices.

Equilibrium Results Equilibrium Results A negative demand shock (i.e. a decline in Dit) leads to lower equilibrium output Qit and lower equilibrium prices relative to wages, Pit/Wit. A negative demand shock (i.e. a decline in Dit) leads to lower equilibrium output Qit and lower equilibrium prices relative to wages, Pit/Wit. A negative supply shock (i.e. a rise in Rit) leads to lower equilibrium output Qit but higher equilibrium Pit/Wit. A negative supply shock (i.e. a rise in Rit) leads to lower equilibrium output Qit but higher equilibrium Pit/Wit.

Empirical Framework Empirical Framework Estimate a series of VAR’s considering the system:

Where IP t = industrial production (proxy for output) P t = personal consumption expenditure deflator PCOM t = producer price index NB2TOT t = difference in total reserves FFR t = Federal funds rate Q it = industrial production in industry i PW it = ratio of price to wages in industry i SD t = constants and seasonal dummies HP t = Hoover and Perez dummy

The VAR’s are estimated for total manufacturing, durable manufacturing, and non-durable manufacturing, 18 two- digit industries and two three-digit industries. The VAR’s are estimated for total manufacturing, durable manufacturing, and non-durable manufacturing, 18 two- digit industries and two three-digit industries. The authors consider three sample periods. The authors consider three sample periods. a) From February 1959 to December b) From February 1959 to September 1979 (pre- Volcker period). c) From January 1983 to December 1996 (Modern Era)

Results The results of the estimations for the full sample are illustrated with impulse-response functions. The results of the estimations for the full sample are illustrated with impulse-response functions. They find that in 13 of the 21 industries considered, output falls and prices rise in response to a positive shock to the Federal funds rate (evidence of a supply- side response). They find that in 13 of the 21 industries considered, output falls and prices rise in response to a positive shock to the Federal funds rate (evidence of a supply- side response). Industries such as Lumber Products, Primary Metals, Fabricated Metals, Other Durables, and Food, and Rubber exhibit a strong demand-side effect. Industries such as Lumber Products, Primary Metals, Fabricated Metals, Other Durables, and Food, and Rubber exhibit a strong demand-side effect.

The authors present the impulse-response function results for the sub-sample labeled “Pre-Volcker”. Although they do not present the “Modern Era” results, they discuss their findings. The authors present the impulse-response function results for the sub-sample labeled “Pre-Volcker”. Although they do not present the “Modern Era” results, they discuss their findings. They mention that the “Pre-Volcker” period shows very strong cost channel effects, whereas the “Modern Era” shows little evidence of cost channel effects. They mention that the “Pre-Volcker” period shows very strong cost channel effects, whereas the “Modern Era” shows little evidence of cost channel effects. Why? Institutional changes Why? Institutional changes Financial innovation and deregulation. Financial innovation and deregulation. During the earlier period contractionary monetary policy was accompanied by credit actions. During the earlier period contractionary monetary policy was accompanied by credit actions.

Alternative Explanations of price and output responses. Alternative Explanations of price and output responses. a) The increase in the price/wage ratio may be due to falling wages, rather than to price increases. b) Do not consider the Fed’s forecasts of future inflation. c) Counter-cyclical markups. d) Increasing returns to scale.

Conclusions The document presents empirical evidence of a supply- side effect of monetary policy. The document presents empirical evidence of a supply- side effect of monetary policy. In key manufacturing industries, prices increase and output decreases following an unanticipated monetary contraction. In key manufacturing industries, prices increase and output decreases following an unanticipated monetary contraction. There is evidence of strong demand-side effects of monetary policy in some industries. There is evidence of strong demand-side effects of monetary policy in some industries.