Chapter 25: Transmission Mechanisms of Monetary Policy: The Evidence

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Chapter 25 Transmission Mechanisms of Monetary
Policy The Evidence
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• 1. Framework for Evaluating Empirical Evidence

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Types of Models

• Structural models
• Keynesian models examine channels which money
  supply affects output.
• Diagram
• Reduced form models
• Monetarist models examine directly the
  relationship between the money supply and
  output.
• Diagram

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Advantages of Structural Models

• Provides more pieces of evidence about
  money's effect on economic activity.
• May help us more accurately predict the
  effect that money has on economic
  activity.
• May allow economists to more accurately predict
  the impact of institutional changes on the link
  between money and income.

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Monetarist Criticisms of Structural Models

• May not know correct structure of the
  model.
• The channels of influence in Keynesian
  models are too narrowly defined
  understating the effect of the money
  supply.

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Evaluation of Reduced Form Models

• Advantage
• Best model if the channels through which the
  money supply affects output are diverse and
  continually changing.
• Keynesian criticisms
• Reverse causation - "correlation does not
  necessarily imply causation."
• Third factor could be driving money supply and
  output.

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• 2. Early Keynesian Evidence on the Importance
  of Money

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Evidence for No Effect of Money Supply on Output

• Interest rates 3-month t-bills fell to
  very low levels in the Great Depression.
• Early studies found no link between
  interest rates and investment spending.
  
• Surveys found decisions to purchase
  physical capital were not affected by
  interest rates.

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Objections to Early Keynesian Evidence

• Interest rates on higher risk securities
  rose to unprecedented high levels in
  great depression.
• Prices fell in the Great Depression,
  causing real interest rates to
  unprecedented high real levels.
• Weak link between nominal interest rates
  and investment spending does not imply
  monetary policy ineffectiveness since it
  may affect output through many
  channels.

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• 3. Early Monetarist Evidence on the Importance
  of Money

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Timing Evidence

• Friedman and Schwartz found that the rate of
  money growth fell prior to every
  business downturn they studied.
• Only valid evidence that money supply change is
  exogenous
• Money supply could be lagging output not leading
  output.

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Statistical Evidence

• Friedman and Meiselman found that the money
  supply was more highly
  correlated with output than government and
  investment spending
• They used only 1 equation and did not
  create construction spending variable
  carefully.

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Historical Evidence

• Exogenous increase in reserve
  requirements in 1936-37 caused lower money
  supply and output.
• This is the best evidence supporting monetarist
  argument on the importance of money.

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• 5. Transmission Mechanisms of Monetary Policy

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Traditional Interest Rate Channels

• Traditional Keynesian view
• ?M ? ?ir ? ?I ? ?Y
• Interest rates also affect consumer durable
  spending and also residential housing spending.
• Real interest rate affects spending and not the
  nominal rate

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Other Asset Price Channels

• Exchange rate effects
• ?M ? ?ir ? ? E ? ?NX ? ?Y
• Tobins q theory
• q market value of firms
  replacement cost of capital
• If q is high, then firms can issue stock and
  issue proceeds to buy capital at a low cost
• ?M ? ? Stock prices? ?q ? ? I ? ?Y
• Wealth effects
• ?M ? ? Stock prices? ?Wealth? ?Consumption ? ?Y

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Credit View

• Bank lending channel
• ?M ? ? bank deposits ? ? bank loans ?I ? ?Y
• Balance sheet channel
• ?M ? ?stock prices ? ?adverse selection and
  moral hazard ? ? lending ? ?I ? ?Y
• Cash flow channel
• ?M ? ? nominal i ? ?adverse selection and moral
  hazard ? ? lending ? ?I ? ?Y

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Credit View

• Unanticipated price level channel
• ?M ? ?unanticipated P ? ?adverse selection and
  moral hazard ? ? lending ? ?I ? ?Y
• Household liquidity channel
• ?M ? ? stock price ? ?financial assets ?
  ?financial distress ? ? consumer durable and
  housing spending ? ?Y

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• 6. Lessons for Monetary Policy

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Lessons for Monetary Policy

• Changes in short-term nominal rates dont
  necessarily mean easing or tightening of monetary
  policy.
• Real interest rate matters.
• Asset prices contain important information about
  monetary policy.
• Monetary policy can be effective even when
  short-term rates are near zero.
• Other mechanisms matter.
• Avoiding unanticipated changes in the price level
  is an important goal.

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EndChapter 25