Download Monetary Transmission Mechanism Through an Expectation

Monetary transmission mechanism through
the Expectation-Augmented channel
Soumya Bhadury 1, Taniya Ghosh
2
*1 [email protected]; University of Kansas, USA
*2 [email protected]; IGIDR, India
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?!!!
Official Rate Rise,
following a prolonged
post-crisis recovery
Households
Firms
Interest
Rate Driven
Change
Pure
Expectation
Interest
Rate Driven
Change
Asset prices
drop
Anticipate a better
looking economy
Cash
Rich
Firms roll
out stalled
project
Increased
Deposit
Earning
Pure
Expectation
Anticipate a
better looking
economy
Cash
Deprived
Increased
cost of
Borrowing
Anticipate drop
in Asset income
Anticipate chances of
getting a job by
participating in labor
market increases
Compensate by
increase wage
income
Labor intensive
technology
Increased labor
employment
Wage
drops
Labor
participation
increases
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.)
• Essentially there are two approaches, needed to assess the role of the E-A
channel
• The first approach determines whether MP shock has
significant effect on the wages adjusted of the asset prices
a
statically
• An affirmative answer suggests a statistically well-defined role of the E-A
channel
• The second approach is to determine the quantitative strength of the
channel
• To assess it, Ramey (1993) suggested a simulation approach, based on
comparison of the IRFs of Employment, GDP and Prices to MP shocks
• When 𝑤/𝑝 𝐴 is permitted to respond endogenously to the shock and
alternately treated as exogenous variable.
Model Setup (cont.)
• Therefore we proceed in 3 steps, to examine if an E-A channel exists
• First the response of 𝑤/𝑝 𝐴 to a monetary policy tightening
• Second, we examine the effects of the
computerized-registered U.K. job claimants, 𝐿𝑡
MP
tightening
on
the
• Third, given the impact of the MP tightening on 𝑤/𝑝 𝐴 , we examine the
impact of policy on the output, 𝑌𝑡 , in the presence of E-A channel
• The third step, tells us about not only presence of the channel, but also
its importance in propagation of MP shock
Model Setup (cont.)
• Benchmark VAR
𝑋𝑡′ = 𝑖𝑡𝑈𝑆
𝑌𝑡′ = [ 𝐿𝑡 𝐶𝑃𝐼𝑡 𝑌𝑡 𝑖𝑡 ]
• Augmented-Endogenous VAR
𝑋𝑡′ = [𝑖𝑡𝑈𝑆 ]
𝐴
𝑌𝑡′ = [𝑤/𝑝𝑡−1
𝐿𝑡 𝐶𝑃𝐼𝑡 𝑌𝑡 𝑖𝑡 ]
• Exogenized VAR
𝐴
𝐴
𝑋𝑡′ = 𝑖𝑡𝑈𝑆 𝑤/𝑝𝑡−2
… . 𝑤/𝑝𝑡−𝑝
𝑌𝑡′ = [ 𝐿𝑡 𝐶𝑃𝐼𝑡 𝑌𝑡 𝑖𝑡 ]
• 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 :2000:01-2014:12 and Sub
Sample :2008:01-2014:12 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 :2000:01-2014:12 and
Sub sample :2008:01-2014:14
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 :2000:01-2014:12 and Sub
Sample :2008:01-2014:12 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 :2000:01-2014:12
and Sub sample :2008:01-2014:14
Impulse Response Function
A

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)
Impulse Response Function
B

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)
Impulse Response Function
C

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)
Impulse Response Function
D

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)
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
Historical Decomposition of Prices
4.875
Monetary Policy Shock
Wages-Adjusted-of-Asset-Prices Shock
4.875
LCPI
PROJECTION
MP
LCPI
PROJECTION
WAGES
4.875
4.850
4.850
4.850
4.825
4.825
4.825
4.800
4.800
4.800
4.775
4.775
4.775
4.750
4.750
4.750
4.725
4.725
4.725
4.700
4.700
4.700
4.675
4.675
4.675
4.650
4.650
2008
2010
2012
2014
Historical Decomposition of Output
Job Claimants Shock
4.725
LCPI
PROJECTION
JOBS
4.650
2008
2010
2012
2014
Monetary Policy Shock
Wages-Adjusted-of-Asset-Prices Shock
4.725
LGDP
PROJECTION
MP
2010
2012
2014
4.725
4.700
4.700
4.700
4.675
4.675
4.675
4.650
4.650
4.650
4.625
4.625
4.625
4.600
4.600
4.600
4.575
4.575
4.575
4.550
2008
LGDP
PROJECTION
WAGES
4.550
2008
2010
2012
'Exogenous' setup with wage adjusted asset price of 6 lag as the exogenous variable and Labor L3
2014
Job Claimants Shock
LGDP
PROJECTION
JOBS
4.550
2008
2010
2012
2014
2008
2010
2012
2014
Historical Decomposition
L
PSHOCK
0.015
0.020
0.02
0.02
0.01
0.01
0.00
0.00
-0.01
-0.01
-0.02
-0.02
-0.03
-0.03
-0.04
-0.04
-0.010
-0.05
-0.05
-0.015
-0.06
-0.005
-0.005
-0.010
2008
2009
2010
2011
2012
2013
2014
Output Shocks
Price Shocks
Structural Shocks
0.000
-0.06
2008
2009
2010
'Exogenous' setup with wage adjusted asset price of 6 lag as the exogenous variable and Labor L3
2011
2012
2013
2014
Structural Shocks
0.03
0.005
0.000
W
R
Y
0.03
0.010
0.005
P
0.025
0.015
0.010
L
YSHOCK
W
R
Y
P
0.020
Historical Decomposition
Historical Decomposition of Output
Historical Decomposition of Prices
4.875
Monetary Policy Shock
Wages-Adjusted-of-Asset-Prices Shock
4.875
LCPI
PROJECTION
MP
LCPI
PROJECTION
WAGES
4.875
4.850
4.850
4.850
4.825
4.825
4.825
4.800
4.800
4.800
4.775
4.775
4.775
4.750
4.750
4.750
4.725
4.725
4.725
4.700
4.700
4.700
4.675
4.675
4.675
4.650
4.650
2008
2010
2012
2014
Job Claimants Shock
4.725
LCPI
PROJECTION
JOBS
2010
2012
2014
Wages-Adjusted-of-Asset-Prices Shock
4.725
LGDP
PROJECTION
MP
2008
2010
2012
2014
LGDP
PROJECTION
WAGES
4.725
4.700
4.700
4.700
4.675
4.675
4.675
4.650
4.650
4.650
4.625
4.625
4.625
4.600
4.600
4.600
4.575
4.575
4.575
4.550
4.650
2008
Monetary Policy Shock
4.550
2008
2010
2012
2014
'Endogenous' setup with wage adjusted asset price of 1 lag and Labor L3 as the endogenous variable
Job Claimants Shock
LGDP
PROJECTION
JOBS
4.550
2008
2010
2012
2014
2008
2010
2012
2014
Historical Decomposition
L
P
Y
R
W
YSHOCK
L
P
Y
R
W
0.025
0.02
0.04
0.020
0.020
0.01
0.03
0.015
0.015
0.005
0.005
0.000
0.000
-0.005
-0.010
2008
2009
2010
2011
2012
2013
2014
Output Shocks
0.010
0.01
-0.01
0.00
-0.02
-0.01
-0.03
-0.02
-0.04
-0.005
-0.05
-0.010
-0.06
-0.03
-0.04
-0.05
2008
2009
'Endogenous' setup with wage adjusted asset price of 1 lag and Labor L3 as the endogenous variable
2010
2011
2012
2013
2014
Structural Shocks
0.010
0.02
0.00
Structural Shocks
Price Shocks
PSHOCK
0.025
• 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 2008.
• 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, 2001. 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