1. Copyright © 2010 Pearson Education. All rights reserved. Chapter 23 Transmission Mechanisms of Monetary Policy: The Evidence

2. Copyright © 2010 Pearson Education. All rights reserved. 23-2 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 © 2010 Pearson Education. All rights reserved. 23-3 Reduced-Form Examines whether one variable has an effect on another by looking directly at the relationship between the two Analyzes the effect of changes in money supply on aggregate output (spending) to see if there is a high correlation Does not describe the specific path

4. Copyright © 2010 Pearson Education. All rights reserved. 23-4 Structural Model Advantages and Disadvantages Advantages –Opportunity to gather more evidence gives more confidence on the direction of causation –More accurate predictions –Understand how institutional changes affect the links Disadvantage –Only as good as the model it is based on

5. Copyright © 2010 Pearson Education. All rights reserved. 23-5 Reduced-Form Advantages and Disadvantages Advantage –No restrictions imposed on the way monetary policy affects the economy Disadvantage –Correlation does not necessarily imply causation Reverse causation Outside driving factor

6. Copyright © 2010 Pearson Education. All rights reserved. 23-6 Early Keynesian Evidence 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 –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

7. Copyright © 2010 Pearson Education. All rights reserved. 23-7 Objections to Early Keynesian Evidence Friedman and Schwartz publish 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 Weak link between nominal interest rates and investment spending does not rule out a strong link between real interest rates and investment spending Interest-rate effects are only one of many channels

8. Copyright © 2010 Pearson Education. All rights reserved. 23-8 FIGURE 1 Real and Nominal Interest Rates on Three-Month Treasury Bills, 1931–2008 Sources: Nominal rates from www.federalreserve.gov/releases/h15/update/. The real rate is constructed using the procedure outlined in Frederic S. Mishkin, “The Real Interest Rate: An Empirical Investigation,” Carnegie-Rochester Conference Series on Public Policy 15 (1981): 151–200. This involves estimating expected inflation as a function of past interest rates, inflation, and time trends and then subtracting the expected inflation measure from the nominal interest rate.

9. Copyright © 2010 Pearson Education. All rights reserved. 23-9 Timing Evidence of Early Monetarists 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 –Timing evidence is hard to interpret

10. Copyright © 2010 Pearson Education. All rights reserved. 23-10 FIGURE 2 Hypothetical Example in Which Money Growth Leads Output

11. Copyright © 2010 Pearson Education. All rights reserved. 23-11 Statistical Evidence Autonomous expenditure variable (A) equal to investment spending plus government spending –For Keynesian model A should be highly correlated with aggregate spending but money supply should not –For Monetarist money supply should be highly correlated with aggregate spending but A should not Neither model has turned out be more accurate than the other

12. Copyright © 2010 Pearson Education. All rights reserved. 23-12 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

13. Copyright © 2010 Pearson Education. All rights reserved. 23-13 FIGURE 3 The Link Between Monetary Policy and GDP: Monetary Transmission Mechanisms

14. Copyright © 2010 Pearson Education. All rights reserved. 23-14 Asset Price Effects Traditional interest rate effects Expansionary monetary policy Emphasis on real interest rate: Expansionary monetary policy Exchange rate effects on net exports Expansionary monetary policy

15. Copyright © 2010 Pearson Education. All rights reserved. 23-15 Asset Price Effects (cont’d) Tobin’s q theory Expansionary monetary policy Wealth effects Expansionary monetary policy

16. Copyright © 2010 Pearson Education. All rights reserved. 23-16 Credit View Bank lending channel Expansionary monetary policy → bank deposits ↑ → bank loans ↑ → → I ↑ → Y ↑ Balance sheet channel Expansionary monetary policy → P s ↑ → net worth ↑ → → adverse selection ↓, moral hazard ↓→ lending ↑ → → I ↑ → Y ↑

17. Copyright © 2010 Pearson Education. All rights reserved. 23-17 Credit View (cont’d) Cash flow channel Expansionary monetary policy → i ↓→ cash flow ↑ → adverse selection ↓, moral hazard ↓→ lending ↑ → I ↑ → Y ↑ Unanticipated price level channel Expansionary monetary policy → unanticipated P ↑ → real net worth ↑ → → adverse selection ↓, moral hazard ↓→ lending ↑ → I ↑ → Y ↑ Household liquidity effects Expansionary monetary policy → P s ↑ → value of financial assets ↑ → likelihood of financial distress ↓→ consumer durable and housing expenditure↑ → Y ↑

18. Copyright © 2010 Pearson Education. All rights reserved. 23-18 Lessons for Monetary Policy It is dangerous always to associate the easing or the tightening of monetary policy with a fall or a rise in short-term nominal interest rates Other asset prices besides those on short- term debt instruments contain important information about the stance of monetary policy because they are important elements in various monetary policy transmission mechanisms

19. Copyright © 2010 Pearson Education. All rights reserved. 23-19 Lessons for Monetary Policy (cont’d) Monetary policy can be highly effective in reviving a weak economy even if short-term interest rates are already near zero Avoiding unanticipated fluctuations in the price level is an important objective of monetary policy, thus providing a rationale for price stability as the primary long-run goal for monetary policy