Chapter 25

Transmission
Mechanisms of
Monetary Policy
 Transmission Mechanisms of
Monetary Policy

• 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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 Traditional Interest-Rate
Channels
• An important feature of the interest-rate
transmission mechanism is its emphasis on the real
(rather than the nominal) interest rate as the rate
that affects consumer and business decisions

• In addition, it is often the real long-term interest

rate (not the real short-term interest rate) that is
viewed as having the major impact on spending

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 Other Asset Price Channels

• In addition to bond prices, two other asset

prices receive substantial attention as
channels for monetary policy effects:
-foreign exchange rates
-the prices of equities (stocks)

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 Figure 1 The Link Between Monetary Policy
and Aggregate Demand: Monetary
Transmission Mechanisms

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 Tobin’s q Theory

• Theory that explains how monetary policy can

affect the economy through its effects on the
valuation of equities (stock)
• Defines q as the market value of firms divided by
the replacement cost of capital
• If q is high, the market price of firms is high
relative to the replacement cost of capital, and new
plant and equipment capital is cheap relative to the
market value of firms
• When q is low, firms will not purchase new
investment goods because the market value of
firms is low relative to the cost of capital

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 Wealth Effects

• Franco Modigliani looked at how consumers’

balance sheets might affect their spending decisions
• Consumption is spending by consumers on
nondurable goods and services
• An important component of consumers’ lifetime
resources is their financial wealth, a major
component of which is common stocks
• When stock prices rise, the value of financial wealth
increases, thereby increasing the lifetime resources
of consumers, and consumption should rise

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 Credit View

• Dissatisfaction with the conventional stories that

interest-rate effects explain the impact of monetary
policy on expenditures on durable assets has led to
a new explanation based on the problem of
asymmetric information in financial markets that
leads to financial frictions
• This explanation, referred to as the credit view,
proposes that two types of monetary transmission
channels arise as a result of financial frictions in
credit markets: those that operate through effects
on bank lending and those that operate through
effects on firms’ and households’ balance sheets

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 Credit View (cont’d)

• Bank Lending Channel: based on the analysis that

demonstrates that banks play a special role in the
financial system because they are especially well
suited to solve asymmetric information problems in
credit markets

• Balance Sheet Channel: Like the bank lending

channel, the balance sheet channel arises from the
presence of financial frictions in credit markets

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 Credit View (cont’d)

• Cash Flow Channel: another balance sheet channel

operates by affecting cash flow, the difference
between cash receipts and cash expenditures

• Unanticipated Price Level Channel: another balance

sheet channel operates through monetary policy
effects on the general price level

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 FYI Consumers’ Balance Sheets
and the Great Depression
• The years between 1929 and 1933 witnessed the
worst deterioration in consumers’ balance sheets
ever seen in the United States

• Because of the decline in the price level in that

period, the level of real debt consumers owed also
increased sharply (by over 20%)

• Consequently, the value of financial assets relative

to the amount of debt declined sharply, increasing
the likelihood of financial distress

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 Household Liquidity Effects

• Another way of looking at how the balance sheet

channel may operate through consumers is to
consider liquidity effects on consumer durable and
housing expenditures
• If, as a result of a bad income shock, consumers
needed to sell their consumer durables or housing
to raise money, they would expect a big loss
because they could not get the full value of these
assets in a distress sale
• In contrast, if consumers held financial assets (such
as money in the bank, stocks, or bonds), they could
easily sell them quickly for their full market value
and raise the cash

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 Why Are Credit Channels Likely
to Be Important?

• There are three reasons to believe that

credit channels are important monetary
transmission mechanisms

– 1. a large body of evidence on the behavior of

individual firms supports the view that financial
frictions of the type crucial to the operation of
credit channels do affect firms’ employment and
spending decisions

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 Why Are Credit Channels Likely
to Be Important? (cont’d)
– 2. there is evidence that small firms (which are
more likely to be credit-constrained) are hurt
more by tight monetary policy than large firms,
which are unlikely to be credit-constrained

– 3. the asymmetric information view of credit

market imperfections at the core of the credit
channel analysis is a theoretical construct that
has proved useful in explaining many other
important phenomena, such as why many of our
financial institutions exist, why our financial
system has the structure that it has, and why
financial crises are so damaging to the economy

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 Application: The Great Recession

• With the advent of the financial crisis in the

summer of 2007, the Fed began a very aggressive
easing of monetary policy
• At first, it appeared that the Fed’s actions would
keep the growth slowdown mild and prevent a
recession. However, the economy proved to be
weaker than the Fed or private forecasters
expected, with the most severe recession in the
post-war period beginning in December of 2007
• Why did the economy become so weak despite this
unusually rapid reduction in the Fed’s policy
instrument?

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 Application: The Great Recession
(cont’d)

• The subprime meltdown led to negative

effects on the economy from many of the
channels we have outlined

– The rising level of subprime mortgage defaults,

which led to a decline in the value of mortgage-
backed securities and CDOs, led to large losses
on the balance sheets of financial institutions

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 Application: The Great Recession
(cont’d)
– With weaker balance sheets, these financial
institutions began to deleverage and cut back on
their lending
– With no one else to collect information and make
loans, adverse selection and moral hazard
problems increased in credit markets, leading to
a slowdown of the economy.
– Credit spreads also went through the roof with
the increase in uncertainty from failures of so
many financial markets. The decline in the stock
market and housing prices also weakened the
economy, because it lowered household wealth

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 Lessons for Monetary Policy

• Four basic lessons:

– 1.  It is dangerous always to associate the easing
or the tightening of monetary policy with a fall or
a rise in short-term nominal interest rates
– 2. Other asset prices besides those on short-term
debt instruments contain important information
about the stance of monetary policy because
they are important elements in various monetary
policy transmission mechanisms

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 Lessons for Monetary Policy
(cont’d)
– 3. Monetary policy can be effective in reviving a
weak economy even if short-term interest rates
are already near zero
– 4. Avoiding unanticipated fluctuations in the price
level is an important objective of monetary
policy, thus providing a rationale for price
stability as the primary long-run goal for
monetary policy

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 APPLICATION Applying the
Monetary Policy Lessons to Japan

• First lesson suggests that it is dangerous to think that

declines in interest rates always mean that monetary
policy has been easing

• Second lesson suggests that monetary policymakers

should pay attention to other asset prices in assessing
the stance of monetary policy

• Third lesson indicates that monetary policy can still be

effective even if short-term interest rates are near zero

• Fourth lesson indicates that unanticipated fluctuations in

the price level should be avoided

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