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Chapter 25: Transmission Mechanisms of Monetary Policy: The Evidence

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Title: Chapter 25: Transmission Mechanisms of Monetary Policy: The Evidence


1
Chapter 25 Transmission Mechanisms of Monetary
Policy The Evidence
2
  • 1. Framework for Evaluating Empirical Evidence

3
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

4
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.

5
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.

6
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.

7
  • 2. Early Keynesian Evidence on the Importance
    of Money

8
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.

9
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.

10
  • 3. Early Monetarist Evidence on the Importance
    of Money

11
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.

12
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.

13
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.

14
  • 5. Transmission Mechanisms of Monetary Policy

15
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

16
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

17
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

18
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

19
  • 6. Lessons for Monetary Policy

20
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.

21
EndChapter 25
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