The Channels of Monetary Transmission: Lessons for Monetary Policy

1. The Channels of Monetary Transmission: Lessons for Monetary Policy Frederic S. Mishkin

2. Transmission mechanisms can be classified as: • Asset Price Channels a) Interest rate channel b) Exchange rate channel c) Equity prices channel • Credit Channels a) Bank lending channel b) Balance sheet channel

3. Interest Rate Channels Follow the traditional ISLM model Where M= money supply ir= real interest rate Pe= expected price level pe= expected inflation I= investment Y= real output M ↑, ir ↓, I ↑, Y ↑ M ↑, Pe↑, pe↑, ir ↓, I ↑, Y ↑

4. Exchange Rate Channel • Derived from macroeconomic models built under a Keynesian framework M ↑, ir ↓, E ↓, NX ↑, Y↑ Where M = money supply ir= real interest rate E = nominal exchange rate NX = net exports Y = real output

5. Equity Price Channels a) Tobin’s q Theory: monetary policy affects the real sector through its effect on the valuation of equities. M ↑, Pe ↑, q ↑, I ↑, Y ↑ Where M=money supply Pe= equity prices q = market value of firms/replacement cost of capital I = investment Y = real output

6. b) Wealth effects on consumption: assumes that consumption is a function of lifetime resources, which include stocks. M ↑, Pe ↑, W ↑, C ↑, Y ↑ Where M= money supply Pe= stock prices W = wealth C = consumption Y = real output

7. Notice that the concept of equity and wealth can be applied to housing and land prices. An increase in house prices leads to an increase in Tobin’s q for housing. An increase in house prices leads to an increase in wealth.

8. Credit Channels • Bank Lending Channel M ↑, bank deposits ↑, bank loans ↑, I ↑, Y ↑ Notice that the effect of monetary policy of firms is asymmetric. The greater the dependence on bank loans, the greater the effect of monetary policy on investment.

9. Balance-Sheet Channels a) Via the net worth of firms M ↑, Pe ↑, adverse selection ↓, moral hazard ↓, net worth ↑, lending↑,I ↑, Y ↑ b) Via nominal interest rates and cash flow M ↑, i ↓, cash flow ↑, adverse selection ↓, moral hazard ↓, lending ↑, I ↑, Y ↑

10. c) Via the general price level M ↑, unanticipated P ↑, adverse selection ↓ ,moral hazard ↓ lending ↑, I ↑, Y ↑ d) Household Balance-Sheet Effect: M ↑, Pe ↑, value of financial assets ↑, likelihood of financial distress ↓, consumerdurable and housing expenditure ↑, Y ↑

11. Lesson 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.