Transmission Mechanisms of Monetary Policy: The Evidence

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Transmission Mechanisms of Monetary Policy The
Evidence
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Two Types of Empirical Evidence

• Structural Model Evidence
• M -gt i -gt I -gt
  Y
• Reduced Form Evidence
• M -gt ? -gt Y
• Examples
• Drinking and GPA

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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)

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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

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Structural ModelAdvantages and Disadvantages

• Possible to gather more evidence? more confidence
  on the direction of causation
• More accurate predictions
• Understand how institutional changes affect the
  links
• Only as good as the model it is based on

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Reduced-FormAdvantages and Disadvantages

• No restrictions imposed on the way monetary
  policy affects the economy
• Correlation does not necessarily imply causation
• Reverse causation
• Outside driving factor

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Early Keynesian Evidence

• Evidence
• 1. Great Depression i ? on T-bonds to low levels
  ? monetary policy was easy
• 2. No statistical link from i to I
• 3. Surveys no link from i to I
• Objections to Keynesian evidence
• Problems with structural model
• 1. i on T-bonds not representative during
  Depression i very high on low-grade bonds
  Figure 1 in Ch. 6
• 2. ir more relevant than i ir high during
  Depression Figure 1
• 3. Ms ? during Depression (Friedman and
  Schwartz) money tight
• 4. Wrong structural model to look at link of i
  and I, should look at ir and I evidence in 1 and
  2 suspect

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Real and Nominal Interest Rates
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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

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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

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Early Monetarist Evidence

• Monetarist evidence is reduced form
• Timing Evidence
• (Friedman and Schwartz)
• 1. Peak in Ms growth 16 months before peak in Y
  on average
• 2. Lag is variable
• Criticisms
• 1. Uses principle Post hoc, ergo propter hoc
• 2. Principle only valid if first event is
  exogenous i.e., if have controlled experiment
• 3. Hypothetical example (Fig 2) Reverse
  causation from Y to M and yet Ms growth leads Y

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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
• Lag may be a lead

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Hypothetical Example in Which ?M/M leads Y
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Statistical Evidence

• Autonomous expenditure variable equal to
  investment spending plus government spending
• For Keynesian model AE should be highly
  correlated with aggregate spending but money
  supply should not
• For Monetarist money supply should be highly
  correlated with aggregate spending but AE should
  not
• Neither model has turned out be more accurate
  than the other

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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

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Monetary Transmission Mechanisms

• Traditional Interest-Rate Channels
• M ?, i ?, I ?, Y ?
• M ?, Pe ?, ?e ?, ir ?, I ?, Y ?
• Other Asset Price Channels
• International Trade
• M ?, i ?, E ?, NX ?, Y ?
• Tobins q
• M ?, Pe ?, q ?, I ?, Y ?
• Wealth Effects
• M ?, Pe ?, W ?, C ?, Y ?

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Credit View

• Bank Lending
• M ?, deposits ?, bank loans ?, I ?, Y ?
• Balance-Sheet
• M ?, Pe ?, adverse selection ?, moral hazard ?,
  lending ?, I ?, Y ?
• Cash Flow
• M ?, i ?, cash flow ?? adverse selection ?,
  moral hazard ?, lending ?, I ?, Y ?
• Unanticipated Price Level
• M ?, unanticipated P ?, adverse selection ?,
  moral hazard ?, lending ?, I ?, Y ?
• Liquidity Effects
• M ?, Pe ?, value of financial assets ?,
  likelihood of financial distress ?, consumer
  durable and housing expenditure ?, Y ?

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Lessons for Monetary Policy

• 1. Dangerous to associate easing or tightening
  with fall or rise in nominal interest rates.
• 2. Other asset prices besides short-term debt
  have information about stance of monetary policy.
• 3. Monetary policy effective in reviving economy
  even if short-term interest rates near zero.
• 4. Avoiding unanticipated fluctuations in price
  level important rationale for price stability
  objective.