The Cost Channel of Monetary Transmission

1. The Cost Channel of Monetary Transmission Barth and Ramey

2. Introduction • Notice the stylized facts about the effects of a contractionary monetary policy action: • Output falls after a lag of about four months. • Short-term interest rates have largely transitory effects. • The price level is unresponsive for almost two years. Traditional models try to explain these facts by assuming sticky wages or prices. However, it is difficult to explain why a decline in aggregate demand does not lead firms to lower prices. An alternative explanation is to allow monetary shocks to have both supply-side and demand-side effects.

3. The authors argue that: • If after a tightening in monetary policy output and prices decline simultaneously, then it should be the case that there was a demand-side response to the policy. • If output declines and prices increase, then the market response comes from the supply-side. • If output declines and prices do not change, then there was a simultaneous reaction on the supply and the demand side of the market.

4. Theoretical Framework • Firms Maximize profits given by Where Pit = price of output Qit = production Rit = supply side effect of monetary policy C(Qit) = convex cost function

5. Firms face an inverse demand function given by: Where Qit = production Dit = demand effect of monetary policy

6. Wages are allowed to be endogenously determined: The authors solve the model to show the relationship between output and prices.

7. Equilibrium Results • A negative demand shock (i.e. a decline in Dit) leads to lower equilibrium output Qit and lower equilibrium prices relative to wages, Pit/Wit. • A negative supply shock (i.e. a rise in Rit) leads to lower equilibrium output Qit but higher equilibrium Pit/Wit.

8. Empirical Framework Estimate a series of VAR’s considering the system:

9. Where IPt= industrial production (proxy for output) Pt = personal consumption expenditure deflator PCOMt= producer price index NB2TOTt= difference in total reserves FFRt= Federal funds rate Qit= industrial production in industry i PWit= ratio of price to wages in industry i SDt= constants and seasonal dummies HPt= Hoover and Perez dummy

10. The VAR’s are estimated for total manufacturing, durable manufacturing, and non-durable manufacturing, 18 two-digit industries and two three-digit industries. • The authors consider three sample periods. a) From February 1959 to December 1996. b) From February 1959 to September 1979 (pre- Volcker period). c) From January 1983 to December 1996 (Modern Era)

11. Results • The results of the estimations for the full sample are illustrated with impulse-response functions. • They find that in 13 of the 21 industries considered, output falls and prices rise in response to a positive shock to the Federal funds rate (evidence of a supply-side response). • Industries such as Lumber Products, Primary Metals, Fabricated Metals, Other Durables, and Food, and Rubber exhibit a strong demand-side effect.

15. The authors present the impulse-response function results for the sub-sample labeled “Pre-Volcker”. Although they do not present the “Modern Era” results, they discuss their findings. • They mention that the “Pre-Volcker” period shows very strong cost channel effects, whereas the “Modern Era” shows little evidence of cost channel effects. • Why? Institutional changes • Financial innovation and deregulation. • During the earlier period contractionary monetary policy was accompanied by credit actions.

19. Alternative Explanations of price and output responses. • The increase in the price/wage ratio may be due to falling wages, rather than to price increases. • Do not consider the Fed’s forecasts of future inflation. • Counter-cyclical markups. • Increasing returns to scale.

20. Conclusions • The document presents empirical evidence of a supply-side effect of monetary policy. • In key manufacturing industries, prices increase and output decreases following an unanticipated monetary contraction. • There is evidence of strong demand-side effects of monetary policy in some industries.