1. Copyright  2011 Pearson Canada Inc. 25 - 1 Chapter 25 Transmission Mechanisms of Monetary Policy: The Evidence

2. Copyright  2011 Pearson Canada Inc. 25 - 2 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)

3. Copyright  2011 Pearson Canada Inc. 25 - 3 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: “Liquidity Trap” –“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 but on investors’ ‘wild’ expectations (of the future income). “Animal Spirits”

4. Copyright  2011 Pearson Canada Inc. 25 - 4 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 do not necessarily indicate expansionary policy Distinction between Nominal and Real Interest Rates: A Weak link between nominal interest rates and investment spending does not rule out a strong link between real interest rates and investment spending; real interest was very high. Interest-rate effects are only one of many channels

5. Copyright  2011 Pearson Canada Inc. 25 - 5 Real and Nominal Interest Rates (T-bills) 1931-2009

6. Copyright  2011 Pearson Canada Inc. 25 - 6 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

7. Copyright  2011 Pearson Canada Inc. 25 - 7 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

8. Copyright  2011 Pearson Canada Inc. 25 - 8 Transmission Mechanisms of Monetary Policy Traditional Interest-Rate Channels: expansionary monetary policy i r , I , Y  expansionary monetary policy P e ,  e , i r , C and I , Y 

9. These are only temporary if ever working, and does not work in the long-run (refer to my note on the “Liquidity Effect and Expectations Effect of MS on Interest rates” note on the “Liquidity Effect and Expectations Effect of MS on Interest rates” There is no empirical support. Copyright  2011 Pearson Canada Inc. 25 - 9

10. Copyright  2011 Pearson Canada Inc. 25 - 10 Exchange Rate Channel expansionary monetary policy i r , E , NX , Y  When i r  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. <- Valid only in the short-run

11. Copyright  2011 Pearson Canada Inc. 25 - 11 Tobin’s q Tobin’s q Channel: 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 P e , q , I , Y  where P e is the price of equity (not the expected price level) <- Adjustment Costs not taken into account; not always working

12. Copyright  2011 Pearson Canada Inc. 25 - 12 Wealth Channel Expansionary monetary policy  stock prices, the wealth transmission mechanism works as follows: expansionary monetary policy P e , 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. <- It works opposite for those with Bonds

13. Copyright  2011 Pearson Canada Inc. 25 - 13 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

14. Copyright  2011 Pearson Canada Inc. 25 - 14 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. <- Eventually Banking Crisis and Collapse may come; 10 years of cycles?

15. Copyright  2011 Pearson Canada Inc. 25 - 15 Balance Sheet Channel Monetary policy can affect firms’ balance sheets in several ways. For example, expansionary monetary policy,  P e and  the NW of firms and so leads to an  in I and Y. The monetary policy transmission is: Expansionary monetary policy P e , adverse selection , moral hazard , lending , I , Y 

16. Copyright  2011 Pearson Canada Inc. 25 - 16 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 i r ) that affects cash flow. Hence, this interest rate mechanism is different from the traditional interest rate mechanism.

17. Copyright  2011 Pearson Canada Inc. 25 - 17 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  <- Unanticipated MP leads to Fluctuations of Y: Instability

18. Copyright  2011 Pearson Canada Inc. 25 - 18 Household Liquidity Effects Channel Reductions in i causes a rise in durables and housing purchases by consumers who do 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 P e , value of financial assets , likelihood of financial distress , consumer durable and housing expenditure ,Y 

19. Copyright  2011 Pearson Canada Inc. 25 - 19 Why Are Credit Channels Likely to be Important? 1.Evidence supports that credit channels do affect firms’ employment and spending decisions 2.Evidence that small firms are hurt more by tight monetary policy than are large firms 3.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

20. Copyright  2011 Pearson Canada Inc. 25 - 20 Monetary Transmission Mechanisms

21. Copyright  2011 Pearson Canada Inc. 25 - 21 Lessons for Monetary Policy 1.Dangerous to associate easing or tightening with fall or rise in nominal interest rates (o) 2.Other asset prices besides short-term debt have information about stance of monetary policy(o): Banks, Financial Market Boom and Bust, Periodic Banking Crisis, etc. have to be monitored; MP may create financial shocks. * Mishkin argues that monetary policy may be effective in reviving economy even if short-term interest rates near zero(X: Han disagrees). 3.Avoiding unanticipated fluctuations in price level important: rationale for price stability objective.

22. Impact of MS on Y is dubious, and only effective in the short-run if ever. Arbitrary MP can create Monetary Shocks and Income Instability A good MP should be “Stable Monetary Policy” (not Activist Monetary Policy). Copyright  2011 Pearson Canada Inc. 25 - 22