Transmission Mechanisms of Monetary Policy: The Evidence

1. Transmission Mechanisms of Monetary Policy: The Evidence

2. Two Types of Empirical Evidence Structural Model Evidence M -> i -> I -> Y Reduced Form Evidence M -> ? -> Y Examples Drinking and GPA

3. 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)

4. 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

5. 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

6. 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

7. 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

8. Real and Nominal Interest Rates

9. 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

10. 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

12. 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

13. 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

14. Hypothetical Example in Which M/M leads Y

15. 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

16. 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

17. 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 Tobin’s q M, Pe, q, I, Y Wealth Effects M, Pe, W, C, Y

18. 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

20. 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.