Monetary transmission mechanism through the Expectation-Augmented channel Soumya Bhadury 1, Taniya Ghosh 2 *1 University of Kansas, *2 IGIDR, July 23, 2015

Introduction Motivation Model Setup Empirical Result Conclusion

Introduction Central Banks of the major industrialized economies have followed a path of Quantitative Easing, post-crisis Interest rates are at a historic low in a zero lower bound environment Naturally in such a setting, channels of monetary policy transmission (that works through affecting the aggregate demand) in the economy is questionable Clearly there is a situation of policy paralysis!! Neither the CB can raise the rate for fear of choking the growth in aggregate demand nor can they lower it any further to boost the aggregate demand

Introduction (cont.) More importantly rational economic agents (households and firms) are expected to behave and optimize differently in a post-crisis environment i.e. in a prolonged recovery phase It is generally believed that the monetary policy has limited direct effect on the economic activity working through the supply side The purpose of this paper is to understand and explore the monetary policy transmission that may work through the supply side Monetary policy in a near-zero setting can possibly augment the supply side, when we appreciate the change in expectation of the market participants following policy actions and announcements

Introduction Motivation Model Setup Empirical Result Conclusion

Motivation  There are possibly three effects of an asset purchase by the Bank of England (a) total wealth increase (b) decrease in the cost of borrowing (c) increase in bank lending  Together (a), (b) and (c) are expected to increase spending, employment and income.  While asset purchase led to sharp rise in monetary base but not the rise in broader monetary aggregate  Banks voluntarily held the increased monetary base as bank reserves  An increase in monetary base does not guarantee an increased bank lending and calls into question the efficacy of QE measure

Motivation (cont.)  Official interest rates, affect expectation, which not just affect asset prices but also influence wages and price settings  But the diagram fails to acknowledge, the changes in wage and price setting that might have an impact on the supply of labor and aggregate supply in the economy  It is accepted in literature that monetary policy has limited effect on aggregate supply or productive capacity  However, the ability of household to expand their supply of labor and firms to execute their business plans are impacted by policy changes when we appreciate the presence of expectation

Motivation (cont.) There are several IMF working papers that have explored the monetary policy transmission mechanism in the Low-income and the Emerging market economies (a) IMF working paper by Kevin. C. Cheng (b) IMF working paper by Prachi Mishra and Peter Montiel (c) IMF working paper by Sonali-Jain Chandra and D.Filiz Unsal On the one hand, the researchers reason out a slew of structural weaknesses in the financial sector which impede the transmission mechanism of monetary policy On the other hand, the researchers explain that countries with strong and well –integrated financial market, which thereby draws large foreign capital, can impede the monetary policy transmission. So is it a weak functioning or a growing and well-integrated financial market that impede the monetary policy transmission?

Is expectation that big?!!!

Wage adjusted asset prices and Labor market participation  In the left scatter plot, we have wages adjusted of asset prices on the y-axis and the number of job-claimants on the x-axis  The graph is mostly positive with backward-bending nature after some critical value  Households will increase their labor market participation when wages increase (and wage is below the critical level)  In the right panel, we plot the wage adjusted asset price in the last 15 years.  Notice that the value has dropped below the critical level by 2010 and continues to drop further

Introduction Motivation Model Setup Empirical Result Conclusion

Model Setup A representative CB following a path of monetary easing in a prolonged post-recession period In this setting, we evaluate the real effect of MP shock through the Expectation-augmented channel (E-A) We intend to capture the role of expectation, once a MP shock kicks in, through the changes in wage and asset prices Finally we explore how employment, prices and GDP respond to MP shock in the presence of the E-A channel

Model Setup (cont.)

Introduction Motivation Model Setup Empirical Result Conclusion

Is the supply side augmented at all? We compared the response of output to domestic monetary policy shocks keeping wage adjusted asset prices exogenous and endogenous alternately in simple VAR setup Setup 1: Endogenous and Exogenous setup with wage adjusted asset prices of lag length 1, 2, 3 and 4 respectively. No labor in this setup Setup 2: Endogenous and Exogenous setup with wage adjusted asset price of lag length 1 across different labor combination L1, L2, L3, and L4. Setup 3: Endogenous set contains wage adjusted asset price lag length 1 and exogenous setup contains wage adjusted asset price of higher lag i.e. 5 and we compare across L1, L2, L3 and L4. Setup 4: Endogenous set contains wage adjusted asset price lag length 1 and exogenous setup contains wage adjusted asset price of higher lag i.e. 6 and we compare across L1, L2, L3 and L4.

Is the supply side augmented at all? (cont.) Model setup 1, with endogenous setup on left and exogenous setup on the right. Wage adjusted asset price lag length 2; No labor

Is the supply side augmented at all? (cont.) Model setup 2, with endogenous setup on left and exogenous setup on right. Wage adjusted asset price lag length 1; Labor L2

Is the supply side augmented at all? (cont.) General Observation: The demand effect is consistently more pronounced in exogenous setup compared to the endogenous setup (a) Initial drop in output due to monetary policy more sharp in exogenous setup (b) The rise following the initial drop in exogenous setup lower (c) The IRFs for the endogenous setup stay closer to zero axis (d) IRF response relatively more significant in endogenous setup Punchline: It is possible that by endogenizing the wage adjusted asset price, we augment the supply side of the economy which negate the effect of the demand side and thereby the drop in output is less pronounced in the endogenous setup.

Variance decomposition of Wage adjusted Asset price  The left and right tables in the top panel represent the endogenous setup with wage adjusted asset price, one-period lag and L3 at two different sample periods; Full Sample :2000: :12 and Sub Sample :2008: :12 respectively  The left and right tables in the bottom panel represent the endogenous setup with wage adjusted asset price, one-period lag and L2 at two different sample periods; Full Sample :2000: :12 and Sub sample :2008: :14

Variance decomposition of the Labor employment  The left and right tables in the top panel represent the endogenous setup with wage adjusted asset price, one-period lag and L3 at two different sample periods; Full Sample :2000: :12 and Sub Sample :2008: :12 respectively  The left and right tables in the bottom panel represent the endogenous setup with wage adjusted asset price, one-period lag and L2 at two different sample periods; Full Sample :2000: :12 and Sub sample :2008: :14

Impulse Response Function  In the left panel of the figure we have the exogenous setup, including the wage adjusted asset prices, lag 6 period, labor L3 and subsample:2008(1) to 2014(12)  In the right panel of the figure we have the endogenous setup, including the wage adjusted asset prices, lag 1 period, labor L3 and subsample:2008(1) to 2014(12) A

Impulse Response Function  In the left panel of the figure we have the exogenous setup, including the wage adjusted asset prices, lag 6 period, labor L2 and subsample:2008(1) to 2014(12)  In the right panel of the figure we have the endogenous setup, including the wage adjusted asset prices, lag 1 period, labor L2 and subsample:2008(1) to 2014(12) B

Impulse Response Function  In the left panel of the figure we have the exogenous setup, including the wage adjusted asset prices, lag 5 period, labor L3 and subsample:2008(1) to 2014(12)  In the right panel of the figure we have the endogenous setup, including the wage adjusted asset prices, lag 1 period, labor L3 and subsample:2008(1) to 2014(12) C

Impulse Response Function  In the left panel of the figure we have the exogenous setup, including the wage adjusted asset prices, lag 5 period, labor L2 and subsample:2008(1) to 2014(12)  In the right panel of the figure we have the endogenous setup, including the wage adjusted asset prices, lag 1 period, labor L2 and subsample:2008(1) to 2014(12) D

Historical Decomposition Historical decomposition provides further information about the contribution of wage shocks and labor shocks to output and price fluctuations. The historical values of output and prices are decomposed in to a base projection and accumulated effect of current and past structural innovations like wage innovations and labor innovations. One can thus see to what extent movement in output and prices are due to wage and labor shocks. The black line shows the actual path of output and prices. The blue line shows the base projection made using shocks in all variables The green line shows the sum of the base projection and the effect of wage innovation (or the employment innovation) in the model.

Historical Decomposition

Introduction Motivation Model Setup Empirical Result Conclusion

General Observation on U.K. and Conclusion The labor participation rate- the share of the population either working/ looking for work has been stable or mostly rising since This occurrence isn’t however because of superior demographics; in fact Britain’s population is aging, just like in the U.S. Mark Carney, the BOE’s governor, says, “One reason might be that in Britain, many people who might have retired saw their wealth shrivel up during the crisis and had to keep working” In the U.S. economy post September 11, As equity prices dropped then, share/owning households felt less-wealthier and this forced the workers to exert greater work effort Also post-2008 in U.K., wages adjusted of inflation gone down encouraging employers to substitute equipment for labor.

Conclusion (cont.) It is generally accepted in the literature that monetary policy has limited effects on aggregate supply or productive capacity In a near-zero post-crisis setting, even a small and definite MP shock can signal possible changes in the health of the economy It will also signal about the possible changes in the valuation of the assets of the households A Firm might anticipate a possible changes in their cost-revenue composition due to a rate rise Finally, if we appreciate the role of expectation, following an MP shock, it is fairly reasonable that household might increase their labor supply Firms might also switch to more labor-intensive technologies of production in the medium to long term, affecting the aggregate supply in the economy