learning objective
- What are monetary policy transmission mechanisms and why are
they important?
Most economists accept the proposition that money matters and
have been searching for structural models that delineate the
specific transmission mechanisms between MS and Y. The most basic
model says the following:
Expansionary monetary policy (EMP), real interest rates
down, investment up, aggregate output up
The importance of interest rates for consumer expenditures
(especially on durables like autos, refrigerators, and homes) and
net exports has also been recognized, leading to the following:
EMP, ir ↓, I ↑, C ↑, NX ↑, Y
↑
Tobin’s q, the market value of
companies divided by the replacement cost of physical capital, is
clearly analogous to i and related to I. When q is
high, firms sell their highly valued stock to raise cash and buy
new physical plant and build inventories. When q is low, by
contrast, firms don’t get much for their stock compared to the cost
of physical capital, so they don’t sell stock to fund increases in
I. By increasing stock prices, the MS may be positively related to
q. Thus, another monetary policy transmission mechanism may be the
following:
EMP, Ps↑, q ↑, I ↑, Y↑
The wealth effect is a transmission
mechanism whereby expansionary monetary policy leads to increases
in the prices of stocks (Ps), homes, collectibles, and
other assets (Pa), in other words, an increase in
individual wealth. That increase, in turn, induces people to
consume more:
EMP, Pa ↑, wealth ↑, C ↑,
Y↑
The credit view posits several
straightforward transmission mechanisms, including bank loans,
asymmetric information, and balance sheets:
EMP, bank deposits ↑, bank loans ↑, I
↑, Y↑
EMP, net worth ↑, asymmetric
information ↓, lending ↑, I ↑, C ↑, Y↑
EMP, i ↓, cash flow ↑,
asymmetric information ↓, lending ↑, I ↑, C ↑, Y↑
EMP, unanticipated P* ↑, real net worth
↑, asymmetric information ↓, lending ↑, I ↑, Y↑
Asymmetric information is a powerful
and important theory, so scholars’ confidence in these transmission
mechanisms is high.
Stop and Think Box
The Fed thought that it would quickly
squelch the recession that began in March 2001, yet the downturn
lasted until November of that year. The terrorist attacks that
September worsened matters, but the Fed had hoped to reverse the
drop in Y* well before then. Why was the Fed’s forecast overly
optimistic? (Hint: Corporate accounting scandals at Enron,
Arthur Andersen, and other firms were part of the mix.)
The Fed might not have counted on some
major monetary policy transmission mechanisms, including reductions
in asymmetric information, being muted by the accounting scandals.
In other words,
EMP, net worth ↑, asymmetric
information ↓, lending ↑, I ↑, C ↑, Y↑
EMP, i ↓, cash flow ↑,
asymmetric information ↓, lending ↑, I ↑, C ↑, Y↑
EMP, unanticipated P ↑, real net worth
↑, asymmetric information ↓, lending ↑, I ↑, Y↑
became something more akin to the
following:
EMP, net worth ↑, asymmetric
information — (flat or no change), lending —, I ↑, C —, Y —
EMP, i ↑, cash flow ↑,
asymmetric information —, lending —, I ↑, C —, Y —
EMP, unanticipated P ↑, real net worth
↑, asymmetric information—, lending —, I —, Y — because asymmetric
information remained high due to the fact that economic agents felt
as though they could no longer count on the truthfulness of
corporate financial statements.
The takeaway of all this for monetary policymakers, and those
interested in their policies (including you), is that monetary
policy needs to take more into account than just short-term
interest rates. Policymakers need to worry about real interest
rates, including long-term rates; unexpected changes in the price
level; the interest rates on risky bonds; the prices of other
assets, including corporate equities, homes, and the like; the
quantity of bank loans; and the bite of adverse selection, moral
hazard, and the principal-agent problem.
Stop and Think Box
Japan’s economy was going gangbusters
until about 1990 or so, when it entered a fifteen-year economic
funk. To try to get the Japanese economy moving again, the Bank of
Japan lowered short-term interest rates all the way to zero for
many years on end, to no avail. Why didn’t the Japanese economy
revive due to the monetary stimulus? What should the Japanese have
done instead?
As it turns out, ir stayed
quite high because the Japanese expected, and received, price
deflation. Through the Fisher Equation, we know that ir
= i − πe, or real interest rates equal nominal
interest rates minus inflation expectations. If πe is
negative, which it is when prices are expected to fall, ir will be
> i. So i can be 0 but ir can be 1, 2, 3…10 percent per
year if prices are expected to decline by that much. So instead of
EMP, ir ↓, I ↓ C ↓ NX ↑, Y↑ the Japanese experienced
ir ↑, I ↓ C ↓ NX ↓, Y↓. Not good. They should have
pumped up the MS much faster, driving πe from negative
whatever to zero or even positive, and thus making real interest
rates low or negative, and hence a stimulant. The Japanese made
other mistakes as well, allowing land and equities prices to
plummet, thereby nixing the Tobin’s q and wealth effect
transmission mechanisms. They also kept some big shaky banks from
failing, which kept levels of asymmetric information high and bank
loan levels low, squelching the credit channels.
key takeaways
- Monetary policy transmission mechanisms are essentially
structural models that predict the precise chains of causation
between expansionary monetary policy (EMP) or tight monetary policy
(TMP) and Y.
- They are important because they provide central bankers and
other monetary policymakers with a detailed view of how changes in
the MS affect Y, allowing them to see why some policies don’t work
as much or as quickly as anticipated.
- That, in turn, allows them to become better policymakers, to
the extent that is possible in a world of rational
expectations.
- Transmission mechanisms include:
- EMP, ir↓, I ↑ C ↑, NX ↑, Y↑, EMP, q ↑, I ↑, Y↑
- EMP, Pa ↑, wealth ↑, C ↑, Y↑
- EMP, bank deposits ↑, bank loans ↑, I ↑, Y↑
- EMP, net worth ↑, asymmetric information ↓, lending ↑, I ↑, C
↑, Y↑
- EMP, i ↓, cash flow ↑, asymmetric information ↓,
lending ↑, I ↑, C ↑, Y↑
- EMP, unanticipated P* ↑, real net worth ↑, asymmetric
information ↓, lending ↑, I ↑, Y↑