The Role of the Interest Rate Channel of Monetary Policy Transmission in the Recovery of the US Economy after the Recession of by Caesar R. Cabral Jr. ECO6226 (Professor O. Mikhail)

A key function of the central bank is the formulation of monetary policy. U.S. Federal Reserve System Federal Open Market Committee (FOMC), which is one of the six structural components that make up the Federal Reserve System, is solely responsible for setting the reserve requirements for banking institutions and shares the responsibility with the Reserve Banks for discount rate policy.

Open Market Operations Open market operations constitute the buying and selling of government securities with the underlying intention to either increase the money supply or decrease the money supply, respectively. The previous two functions plus the ability to carry out open market operations constitute the monetary policy tools of the Federal Reserve System.

Monetary Transmission Mechanism “The monetary transmission mechanism describes how policy-induced changes in the nominal money stock or the short-term nominal interest rate impact on real variables such as aggregate output and employment” (Peter Ireland 2005).

Channels of Monetary Transmission Interest Rate Channel – Traditional Keynesian Exchange Rate Channel – Traditional Keynesian Balance-sheet channel Bank Lending Channel Asset Price Channel Credit Channel

Contractionary vs. Expansionary Contractionary Monetary Policy (tightening): FOMC wishes to decrease money supply, Sells securities on the open market, This leads to a rise in interest rates, High interest rates increase the cost of financing capital projects, This leads to decline in investment spending, This leads to decline in aggregate demand and a fall in output According to the Interest Rate Channel Story:

Contractionary vs. Expansionary Expansionary Monetary Policy (easing): FOMC wishes to increase money supply, Buys securities on the open market, This leads to a fall in interest rates, Low interest rates decrease the cost of financing capital projects, This leads to an increase in investment spending, This leads to a rise in aggregate demand and a fall in output According to the Interest Rate Channel Story:

Schematic Diagrams of Channels Interest Rate Channel (expansionary) M ↑ → i ↓ → I ↑ → Y ↑ where, M = monetary base (currency and bank reserves) i = real interest rates I = investment spending Y = income (GDP) or output)

Schematic Diagrams of Channels Exchange Rate Channel (contractionary) M ↓ → i ↑ → E ↑ → NX ↓ → Y ↓ where, E = exports NX = net exports (exports – imports) Tobin’s q Channel (contractionary) M ↓ → Pe ↓ → q ↓ → I ↓ → Y ↓ where, q = the ratio of market value to replacement cost

Schematic Diagrams of Channels Wealth and Consumption Channel (contractionary) M ↓ → Pe ↓ → wealth ↓ → consumption ↓ → Y ↓ where, Pe = stock prices Bank Lending Channel (contractionary) M ↓ → bank deposits ↓ → bank loans ↓ → I ↓ → Y ↓ Balance-sheet Channel (contractionary) M ↓ → Pe ↓ → adverse selection ↑ & moral hazard ↑ → lending ↓ → I ↓ → Y ↓

The Recession of 2001 (Expansionary Policy-Increase Money Supply) Non-quantitative Approach: Trend Analysis (Monetary Base – Upward Trend)

The Recession of 2001 (Expansionary Policy-Increase Money Supply) Non-quantitative Approach: Trend Analysis (Bank Prime Loan Rate – Downward Trend)

The Recession of 2001 (Expansionary Policy-Increase Money Supply) Non-quantitative Approach: Trend Analysis (Total Investments – Upward Trend)

The Recession of 2001 (Expansionary Policy-Increase Money Supply) Non-quantitative Approach: Trend Analysis (Real Gross Domestic Product – Upward Trend)

Interest Rate Channel: Weak Connection 1.Empirical studies find spending fairly insensitive to interest rates and monetary policy. 2.Should have its strongest influence on short- term interest rates like the federal funds rate and its weakest effect on the long-term rates. (Ben S. Bernanke and Mark Gertler) Interest Rate: Counter Argument

Interest Rate Channel: Strong Connection John Taylor’s model of economic effect of contractionary monetary policy found an increase in short-term interest rates which, given the assumption that price and wages are rigid, then led to an increase in real long-term interest rates. Interest Rate: In-Favor

Alternate Channel M ↑ → i ↓ → E ↓ Domestic real interest rates drop, domestic currency deposits become less attractive, depreciation of the dollar, denoted by E ↓

Conclusion Despite some criticism regarding the connection between spending and fluctuations in real interest rates, the interest rate channel of monetary transmission proves to be viable in analyzing the trends of it’s key components in the recent recession of It is also evident from observation, that it served as one of multiple mechanisms through which monetary policy was executed.

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