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Chapter 24 Transmission Mechanisms of Monetary Policy: The Evidence Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 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) Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-2 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 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-3 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 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-4 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 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-5 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 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-6 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 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-7 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. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-8 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 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-9 FIGURE 2 Hypothetical Example in Which Money Growth Leads Output Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-10 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 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-11 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 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-12 FIGURE 3 The Link Between Monetary Policy and GDP: Monetary Transmission Mechanisms Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-13 Asset Price Effects • Traditional interest rate effects Expansionary monetary policy i I Y r Emphasis on real interest rate: Expansionary monetary policy P e e ir I Y • Exchange rate effects on net exports ir E NX Y Expansionary monetary policy Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-14 Asset Price Effects (cont’d) • Tobin’s q theory Expansionary monetary policy Ps q I Y • Wealth effects Expansionary monetary policy Ps wealth consumption Y Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-15 Credit View • Bank lending channel Expansionary monetary policy → bank deposits ↑ → bank loans ↑ → →I↑→Y↑ • Balance sheet channel Expansionary monetary policy → Ps ↑ → net worth ↑ → → adverse selection ↓, moral hazard ↓→ lending ↑ → →I↑→Y↑ Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-16 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 → Ps ↑ → value of financial assets ↑ → likelihood of financial distress ↓→ consumer durable and housing expenditure↑ → Y ↑ Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-17 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 shortterm debt instruments contain important information about the stance of monetary policy because they are important elements in various monetary policy transmission mechanisms Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-18 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 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-19