The Transmission Mechanism

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The Transmission Mechanism
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Schematic view of the short- and medium-run model
Source Carlin Soskice, p12
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Monetary transmission mechanism

• Describes channels through which a change in
  monetary policy influences economic activity
• Various channels, eg
• market interest rates other asset prices
  exchange rate, share prices, house
  prices expectations/confidence balance sheets

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Transmission mechanism of monetary policy
Market rates
Domestic demand
Domestic inflationary pressure
Total demand
Asset prices
Official rate
Net external demand
Inflation
Expectations/confidence
Import prices
Exchange rate
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Interest rate channel

• Primary mechanism at work in traditional
  Keynesian models and contemporary macroeconomic
  models
• Requires some degree of price stickiness so that
  decrease in nominal interest rates (i) translates
  into lower real interest rates (r) across the
  yield curvei? ? r? ? investment? , consumer
  durables ? ? y?
• Macroeconomic response to policy-induced interest
  rate changes typically larger than implied by
  conventional estimates of interest elasticities
  of consumption and investment. Suggests other
  channels at work

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Exchange rate channel

• Lower domestic interest rate requires domestic
  currency to appreciate over time to rule out
  arbitrage opportunities
• Expected future appreciation requires an initial
  depreciation of the currency (e rises, where e is
  defined as domestic currency units per foreign
  currency unit)
• With sticky prices, domestically produced goods
  become cheaper than foreign-produced goods,
  resulting in a rise in net exportsi? ? e? ? net
  exports? ? y?

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Equity price channel (1)

• Tobins q theory of investment q
  market value of firm replacement
  cost of capital
• If q is high, firms can buy a lot of new
  investment goods with only a small issue of
  equity. Hence investment rises
• Lower interest rates raise value of equities
  because any given expected income stream is
  discounted at a lower rate which raises its
  value. This raises q and investment. i? ?
  Pequities? ? q? ? investment ? ? y?

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Equity price channel (2)

• Higher share prices increase the financial wealth
  of households, so their lifetime resources are
  higher
• The life-cycle hypothesis or permanent income
  hypothesis would predict that households will
  spend more
• i? ? Pequities? ? wealth? ? consumption ? ? y?

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Balance sheet credit channels

• Lower interest rates reduce payments to service
  debt. They also increase the capitalised value of
  a firms long-lived assets. Both cause balance
  sheets to improve
• In presence of financial market imperfections,
  the cost of credit to firms and households falls
  when the strength of their balance sheets
  improve
• Lower interest rates also reduce risk that
  borrowers will be unable to pay back their loans.
  Banks may increase lending
• i? ? cashflow ? balance sheets? ? investment?
  and consumption ? ? y?

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Expectations and confidence channels

• Monetary policy changes can influence
  expectations about future course of real activity
  and inflation
• A central bank with a high degree of credibility
  firmly anchors expectations of low and stable
  inflation. May lead to change in wage and price
  setting behaviour
• Direction in which such expectations work may
  sometimes be hard to predict. Eg bond yields may
  not rise in response to a rise in short rates if
  investors perceive that future inflation will be
  lower

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Higher interest rates do not always tighten
financial conditions (1)
Source Goldman Sachs
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Higher interest rates do not always tighten
financial conditions (2)
Source Goldman Sachs
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Households

• Households affected by monetary policy changes in
  several ways
• First, change in interest rates affects
  disposable income as well as incentive to
  save/consume now
• Second, financial wealth changes
• Third, any exchange rate adjustment changes the
  relative prices of goods and services priced in
  domestic and foreign currency
• Higher interest rates generally imply lower
  consumption

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Firms

• Firms also affected by monetary policy changes
• First, higher interest rates worsen financial
  position of firms dependent on short-term
  borrowing
• Second, by altering required rates of return,
  higher interest rates encourage postponement of
  investment
• Third, policy changes may change firms
  expectations about future course of economy, and
  confidence with which those expectations are
  held
• Higher interest rates generally imply lower
  investment and employment

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Second round effects

• Even if some households and firms are not
  affected directly by a change in official
  interest rates, the resulting change in aggregate
  spending may have a knock-on effect to their
  spending decisions . . . the multiplier
• To the extent that these indirect effects can be
  anticipated by others means that there could be a
  large impact on expectations and confidence
• Also possible that effects will be dampened if
  economic agents expect a monetary policy
  response. Policy actions will differ in their
  qualitative effects depending on whether these
  actions are anticipated or unanticipated

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Time lags
Current monetary policy affects the output gap
after one year the output gap, in turn, affects
inflation after one year
Source Carlin Soskice, p154
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Euro area responses to a 1 increase in ECB repo
rate for two years
Real GDP
Consumer prices
Year 1
Year 2
Year 3
Year 1
Year 2
Year 3
ECB -0.34 -0.71
-0.71 -0.15
-0.30 -0.38
NCB -0.22 -0.38
-0.31 -0.09
-0.21 -0.31
NIGEM -0.34 -0.47
-0.37 -0.06
-0.10 -0.19
Note The table shows responses of real GDP and
consumer prices to a two-year increase of 100
basis points in the policy-controlled interest
rates of the euro area. Figures are expressed in
per cent from baseline. Simulations are performed
using the ECBs area-wide model, the national
central banks macroeconometric models and the
multi-country model of the NIESR
Source ECB Monthly Bulletin, October 2002, p45
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UK responses to a 1 increase in BoE repo rate
for one year
Private sector output
CPI annual inflation
Source The Bank of England Quarterly Model, p130
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Aggregate demand the IS curve

• IS curve shows combinations of real interest rate
  and output at which there is equilibrium in goods
  market
• For goods market equilibrium, aggregate demand
  (yD) for goods and services must equal supply
  (y). In short run, assume wages and prices fixed
  supply of output adjusts to any change in
  aggregate demand
• Aggregate demand refers to planned real
  expenditure on goods and services in economy as a
  whole. Equilibrium requires that yD y
  goods market
  equilibrium yD C I G (X-M)
  aggregate demand

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IS curve
In absence of shocks, central bank targetsr
a/ß, consistent with zero output gap
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Features of IS curve

• IS curve is downwards sloping to right. A low
  real rate raises planned expenditure a high real
  rate reduces it
• Slope of IS curve depends on interest sensitivity
  of demand. IS curve becomes flatter as interest
  sensitivity of demand increases
• IS curve shifts when autonomous (non-interest
  rate sensitive) spending changes
• When goods market is in equilibrium, output gap
  is zero ? r a/ß
  natural rate of interest

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Extensions to IS curve

• Open economy y a ßr ?q eD
  q real exchange rate
• Time lags yt a ßrt-1 eD
• New-Keynesian expectational IS curve yt
  Etyt1 s(it Etpt1)
• NK IS curve links output to its expected future
  value and to the ex ante real interest rate.
  Derived from explicit microfoundations

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Further reading

• Carlin and Soskice, Macroeconomics, pp279-282,
  pp28-33
• Ireland, P (2006), The Monetary Transmission
  Mechanism, Federal Reserve Bank of Boston Working
  Papers 06-01http//www.bos.frb.org/economic/wp/wp
  2006/wp0601.pdf
• ECB(2002), Recent Findings on monetary policy
  transmission in the euro area, ECB Monthly
  Bulletin, October 2002http//www.ecb.int/pub/pdf/
  mobu/mb200210en.pdf
• Bank of England (1999). The transmission
  mechanism of monetary policy, Paper by the
  Monetary Policy Committee, April
• http//www.bankofengland.co.uk/publications/other
  /monetary/montrans.pdf