Monetary Transmission Mechanism Chapter 23

Two Types of Economic Models 1. Reduced Form 2. Structural

Reduced Form An empirical relationship between two variables is established. For example, the relationship between the growth of a monetary aggregate and the rate of inflation. Milton Friedman’s approach.

Limitations of Reduced Form Correlation does not imply causation. Difficult to figure out the timing of changes in economic variables.

Structural Model A structural model attempts to spell out the causal chain that lies between the two variables in the reduced form. A change in the monetary aggregate leads to a change in the interest rate which leads to a change in investment. If aggregate demand exceeds potential output inflation will ensue.

Limitation of the Structural Approach It’s difficult to identify the right model. If the model is incorrect, it will be misleading when applied to policy debates. Early Keynesians concluded that monetary policy is ineffective, on the basis of an incorrect model.

Transmission Mechanism Structural models that attempt to explain how money affects output and inflation.

Effect of Money on Interest Rates Changes in the money supply can have only a short-run effect on the nominal interest rate. Suppose the money supply increases, the nominal rate will initially fall but if inflation ensues the nominal rate will adjust to compensate. Result: no long-run effect on the real interest rate.

Other Transmission Channels Consumer spending. Stock prices affecting ability of firms to raise capital. Exchange rates affecting exports.