Macroeconomics – The Monetary Transmission mechanism

The methods through which various monetary policy approaches bring about real economic effects has been a subject widely explored in economics. Monetary transmission mechanism in this  respect has been used to describe “how policy-induced changes in the nominal money stock or the short-term nominal interest rate impact on real variables such as aggregate output and employment” (Ireland, 2005, p. 1). Accordingly channels such as those influenced by alteration of interest rate, exchange rate mediated channel, and the credit channel have been proposed to be ways through which the monetary policy adopted acts (Mishkin, 1995).

The interest rate channel of monetary transmission has been recognized in economic literature for many decades. The Keynesian economics portrayal of how a contractionary monetary policy affects real economic outcomes for instance had the interest rate channel’s aspects at its centre (Mishkin, 1995). Through a contractionary policy, real interest rates increase hence raising the cost of capital and consequently leading to a declined spending on investment (Mishkin, 1995). Such decline in investment spending further influences aggregate demand adversely thus resulting into a fall in output (Mishkin, 1995). Though this early model was mainly advanced on business entity’s investment spending; research later included consumer spending decisions on aspects such as housing and consumer durables to be part of the applicable investment spending that could be influenced through the interest rate channel (Mishkin, 1995). The interest rate channel thus applies to investment spending decisions for both businesses and consumers.

As international trade has gained impetus in recent years, a second way through which monetary policy is thought to affect real economic variables was formulated. The exchange rate channel contends that monetary policy approaches could influence the net exports of the country involved (Mishkin, 1995). Such an effect is also partly a consequence of the interest rate effects that make domestic currency deposits more attractive than foreign currency deposits (Mishkin, 1995). Such increased demand for the domestic currency would raise its value relative to other currencies thus making domestic products more expensive than the foreign ones and thus adversely affecting the country’s exports (Mishkin, 1995).

Apart from interest rates and exchange rates effects, it has been contended that the monetary policy could also have real economic impacts by affecting the prices of other assets and real wealth (Mishkin, 1995). Among the many theories advocating for this channel, the theory advanced by Tobin – q theory – of impacts on valuation of equities is popular. Q in the theory is used to represent the result of dividing “the market value firms… by the replacement cost of capital” (Mishkin, 1995, p.6). A high q would promote new investment because with only a small issue of equity the entity can raise adequate funds for substantial investment (Mishkin, 1995). Conversely a low q – indicative of relative high costs of capital to market value – would deter investment (Mishkin, 1995). With the theory’s association to investment spending; it is contended that equity purchases could be vulnerable to reduced public spending in the event of decreased money supply thus reducing their demand and eventually their prices (Mishkin, 1995). Similarly interest rate increment as a result of a contractionary monetary policy could lead to a relative preference for bonds to equities thus adversely affecting the prices of the latter (Mishkin, 1995). In such a case then the monetary policy would have affected the equity prices resulting into a decline in q hence reducing investment expenditure (Mishkin, 1995).

Similarly, equity prices could act as a transmission channel through a model proposed by Modigliani. In this life-cycle model consumption spending is determined by the consumers’ lifetime resources comprised of real capital, human capital and financial wealth (Mishkin, 1995). Common stocks are advanced to constitute a major part of financial wealth hence their price declines affected by a contractionary monetary policy would reduce the lifetime resources of the consumers and consequently reduce their consumption levels (Mishkin, 1995). Other asset prices that can be affected by the monetary policy thus act as its means of transmission include land and property ones.

A different view on monetary transmission mechanism devoid of interest rates’ changes effects on borrowing, expenditure and investment decisions has been provided by the credit channel models. These contend that monetary policy-influenced real economic effects may be attributed to its exacerbation of agency difficulties in the credit markets (Mishkin, 1995). Accordingly two mechanisms – the bank lending and the balance sheet channels have been proposed (Bernanke, 2007).

The bank lending channel is advanced on the critical role of the banks in the financial system, which results from their suitability in dealing with borrowers, particularly small enterprises, where pronounced problems of asymmetric information may exist (Mishkin, 1995; Bernanke, 2007). By its effect of decreasing bank reserves and deposits, a contractionary monetary policy, would lead to decline in bank loans thus affecting the availability of credit to these small firms (Mishkin, 1995). This then would adversely affect investment hence decreasing the output in the economy. This channel would only be critical when banks are shown to actually play the said role in financial systems but not where their role in credit granting is far much subdued (Mishkin, 1995).

The second credit channel, the balance sheet model, emphasizes the importance of net worth in providing collateral for loans granted (Mishkin, 1995; Bernanke, 2007). Low net worth would have the effect of decreasing the collateral the lenders hold for advanced loans hence increasing losses from adverse selection (Mishkin, 1995). A decline in net worth is associated with declined lending for investment spending due to heightened adverse selection problem (Mishkin, 1995).  Similarly a lower net worth could be viewed as a promoter of imprudent practices due to the owners’ lower equity stake in the entity (Mishkin, 1995). In such a way investment lending could be shunned upon out of the fear that funds lent could be used in imprudent investment thus affecting repayment; a result of which would be curtailing investment spending (Mishkin, 1995). The role of a contractionary monetary policy in all this would be to promote the decline in the net worth of the business through such ways as reducing equity prices – as earlier discussed – hence ultimately resulting to decreased investment spending due to reduced lending (Mishkin, 1995). Similarly, such a monetary policy, by raising interest rates would adversely affect the firms’ balance sheet by reducing the cash flow (Mishkin, 1995). The credit channel application to consumer spending is thought to be: (a) through bank lending channel by causing a reduction in housing and durables purchases from consumers without access to alternative sources of credit, and (b) through balance sheet channel by affecting cash flow as a result of increased interest rates (Mishkin, 1995).

  • Interest rate channel = M↑→ i↓ → I↓→ Y↑
  • Exchange rate Channel = M↓→ i↑ → E↑→ NX↑→Y↓
  • Asset prices channel = M↓ → Pe ↓→q↓→ I↓→Y↓
  • Asset prices channel = M↓ →  Pe ↓→Wealth↓ → Consumption↓ → Y↓
  • Credit channel – bank lending = M↓ → Bank deposits↓ → bank loans↓ →I↓ → Y↓

o Balance sheet = M↓ → Pe ↓→adverse selection↑→ moral hazard↑ → lending↓ →Y↓

 

Key

M = monetary policy

i = interest rate

I = investment

Y = output/aggregate demand

NX = net export

E = exchange rate

Source (Mishkin, 1995).

 References

Bernanke, B. S. (2007, June, 15). The Financial accelerator and the credit channel. Speech at the Credit Channel of Monetary Policy in the Twenty-first Century Conference. Retrieved January 26, 2010, from http://www.federalreserve.gov/newsevents/speech/Bernanke20070615a.htm

Colander, D. (2008). Macroeconomics. (7th ed.). New York: McGraw-Hill/Irwin.

Ireland, P. N. (2005, October). The monetary transmission mechanism. Retrieved January 26, 2010, from http://fmwww.bc.edu/ec-p/wp628.pdf

Mankiw, N. G. (2002). Macroeconomics (5th ed.). New York: Worth Publishers.

Mishkin, F. S. (1995). Symposium on the monetary transmission mechanism. Journal of Economic Perspectives, 9(4), 3-10. Retrieved June 18, 2010, from http://www.econ.puc-rio.br/Goldfajn/Macro%20III/Symposium%20on%20the%20Monetary%20Transmission%20Mechanism.pdf

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