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24.3 Transmission Mechanisms

Learning Objective

  1. What are monetary policy transmission mechanisms and why are they important?

Most economists accept the proposition that money matters and have been searching for structural models that delineate the specific transmission mechanisms between MS and Y. The most basic model says the following:

Expansionary monetary policy (EMP), real interest rates down, investment up, aggregate output up

The importance of interest rates for consumer expenditures (especially on durables like autos, refrigerators, and homes) and net exports has also been recognized, leading to the following:

EMP, ir ↓, I ↑, C ↑, NX ↑, Y ↑

Tobin’s q, the market value of companies divided by the replacement cost of physical capital, is clearly analogous to i and related to I. When q is high, firms sell their highly valued stock to raise cash and buy new physical plant and build inventories. When q is low, by contrast, firms don’t get much for their stock compared to the cost of physical capital, so they don’t sell stock to fund increases in I. By increasing stock prices, the MS may be positively related to q. Thus, another monetary policy transmission mechanism may be the following:

EMP, Ps↑, q ↑, I ↑, Y↑

The wealth effect is a transmission mechanism whereby expansionary monetary policy leads to increases in the prices of stocks (Ps), homes, collectibles, and other assets (Pa), in other words, an increase in individual wealth. That increase, in turn, induces people to consume more:

EMP, Pa ↑, wealth ↑, C ↑, Y↑

The credit view posits several straightforward transmission mechanisms, including bank loans, asymmetric information, and balance sheets:

EMP, bank deposits ↑, bank loans ↑, I ↑, Y↑

EMP, net worth ↑, asymmetric information ↓, lending ↑, I ↑, C ↑, Y↑

EMP, i ↓, cash flow ↑, asymmetric information ↓, lending ↑, I ↑, C ↑, Y↑

EMP, unanticipated P* ↑, real net worth ↑, asymmetric information ↓, lending ↑, I ↑, Y↑

Asymmetric information is a powerful and important theory, so scholars’ confidence in these transmission mechanisms is high.

Stop and Think Box

The Fed thought that it would quickly squelch the recession that began in March 2001, yet the downturn lasted until November of that year. The terrorist attacks that September worsened matters, but the Fed had hoped to reverse the drop in Y* well before then. Why was the Fed’s forecast overly optimistic? (Hint: Corporate accounting scandals at Enron, Arthur Andersen, and other firms were part of the mix.)

The Fed might not have counted on some major monetary policy transmission mechanisms, including reductions in asymmetric information, being muted by the accounting scandals. In other words,

EMP, net worth ↑, asymmetric information ↓, lending ↑, I ↑, C ↑, Y↑

EMP, i ↓, cash flow ↑, asymmetric information ↓, lending ↑, I ↑, C ↑, Y↑

EMP, unanticipated P ↑, real net worth ↑, asymmetric information ↓, lending ↑, I ↑, Y↑

became something more akin to the following:

EMP, net worth ↑, asymmetric information — (flat or no change), lending —, I ↑, C —, Y —

EMP, i ↑, cash flow ↑, asymmetric information —, lending —, I ↑, C —, Y —

EMP, unanticipated P ↑, real net worth ↑, asymmetric information—, lending —, I —, Y — because asymmetric information remained high due to the fact that economic agents felt as though they could no longer count on the truthfulness of corporate financial statements.

The takeaway of all this for monetary policymakers, and those interested in their policies (including you), is that monetary policy needs to take more into account than just short-term interest rates. Policymakers need to worry about real interest rates, including long-term rates; unexpected changes in the price level; the interest rates on risky bonds; the prices of other assets, including corporate equities, homes, and the like; the quantity of bank loans; and the bite of adverse selection, moral hazard, and the principal-agent problem.

Stop and Think Box

Japan’s economy was going gangbusters until about 1990 or so, when it entered a fifteen-year economic funk. To try to get the Japanese economy moving again, the Bank of Japan lowered short-term interest rates all the way to zero for many years on end, to no avail. Why didn’t the Japanese economy revive due to the monetary stimulus? What should the Japanese have done instead?

As it turns out, ir stayed quite high because the Japanese expected, and received, price deflation. Through the Fisher Equation, we know that ir = i − πe, or real interest rates equal nominal interest rates minus inflation expectations. If πe is negative, which it is when prices are expected to fall, ir will be > i. So i can be 0 but ir can be 1, 2, 3…10 percent per year if prices are expected to decline by that much. So instead of EMP, ir ↓, I ↓ C ↓ NX ↑, Y↑ the Japanese experienced ir ↑, I ↓ C ↓ NX ↓, Y↓. Not good. They should have pumped up the MS much faster, driving πe from negative whatever to zero or even positive, and thus making real interest rates low or negative, and hence a stimulant. The Japanese made other mistakes as well, allowing land and equities prices to plummet, thereby nixing the Tobin’s q and wealth effect transmission mechanisms. They also kept some big shaky banks from failing, which kept levels of asymmetric information high and bank loan levels low, squelching the credit channels.

Key Takeaways

  • Monetary policy transmission mechanisms are essentially structural models that predict the precise chains of causation between expansionary monetary policy (EMP) or tight monetary policy (TMP) and Y.
  • They are important because they provide central bankers and other monetary policymakers with a detailed view of how changes in the MS affect Y, allowing them to see why some policies don’t work as much or as quickly as anticipated.
  • That, in turn, allows them to become better policymakers, to the extent that is possible in a world of rational expectations.
  • Transmission mechanisms include:
  • EMP, ir↓, I ↑ C ↑, NX ↑, Y↑, EMP, q ↑, I ↑, Y↑
  • EMP, Pa ↑, wealth ↑, C ↑, Y↑
  • EMP, bank deposits ↑, bank loans ↑, I ↑, Y↑
  • EMP, net worth ↑, asymmetric information ↓, lending ↑, I ↑, C ↑, Y↑
  • EMP, i ↓, cash flow ↑, asymmetric information ↓, lending ↑, I ↑, C ↑, Y↑
  • EMP, unanticipated P* ↑, real net worth ↑, asymmetric information ↓, lending ↑, I ↑, Y↑