Chapter 26

Transmission
Mechanisms
of Monetary Policy:
The Evidence

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Two Types of Empirical Evidence
Structural Model Evidence
M i I Y
Reduced Form Evidence
M ? Y
Structural Model Evidence
Advantages:
1. Understand causation because more information on link
between M and Y
2. Knowing how M affects Y helps prediction
3. Can predict effects of institutional changes that change
link from M to Y
Disadvantages:
1. Structural model may be wrong, negating all advantages
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 Reduced Form Evidence

Advantages:
1. No restrictions on how M affects Y: better able to
find link from M to Y
Disadvantages:
1. Reverse causation possible
2. Third factor may produce correlation of M and Y

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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
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 Real and Nominal Interest Rates

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 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

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Hypothetical
Example in
Which M/M
leads Y

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 Statistical Evidence

Horse race: correlation of A vs M with Y;

Friedman and Meiselman, M wins
Criticisms:
1. Reverse causation from Y to M, or third factor
driving
M and Y are possible
2. Keynesian model too simple, unfair handicap
3. A measure poorly constructed
Postmortem with different measures of A: no clear-
cut victory
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 Historical Evidence
Friedman and Schwartz: Monetary History of the U.S.
1. Important as criticism of Keynesian evidence on
Great Depression
2. Documents timing evidence
More convincing than other monetarist evidence:
Episodes are almost like “controlled experiments”
1. Post hoc, ergo propter hoc applies
2. History allows ruling out of reverse causation and
third factor: e.g., 1936–37 rise in reserve
requirements and 1937-38 recession

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 Monetary Transmission Mechanisms
Traditional Interest-Rate Channels:
M , ir , I , Y 
The interest rate channel of monetary transmission applies equally
to C. Also, it places emphasis on ir rather than i. Moreover, it is
the long-term ir and not the short-term ir that is viewed as having
the major impact on C and I spending.
With sticky P, an  in M leads to a  in short term i and also 
short term ir. According to the expectations hypothesis of the
term structure of interest rates, this also  long-term ir. The  in
short- and long-term ir leads to an  in C and I spending.
Note: The interest rate transmission mechanism is effective even
when i has already been driven to zero by the MA during a
deflationary period. With i = 0,
e e
M , P ,  , ir , C and I , Y 
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 Monetary Transmission Mechanisms
Other Asset Channels
Exchange Rate Channel: E 
euro
$

M , ir , E , NX , Y 

When ir  the domestic currency depreciates (see Chapter 7), that

is E . This makes domestic goods relatively less expensive and
NX .

Recent work indicates that the exchange rate transmission

mechanism plays an important role in how monetary policy
affects the economy.
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 Monetary Transmission Mechanisms
Other Asset Channels
Tobin’s q Channel:
MVF
q 
RCC
where MVF = market value of firms and RCC = replacement cost of
capital. If q is high, MFV is high relative to RCC, and new plant and
equipment capital is cheap relative to the market value of firms. In
this case, companies can issue stock and get a high price for it
relative to the cost of the facilities and equipment they are buying. I
 because firms can buy a lot of new investment goods with only a
small issue of stock.
The transmission mechanism for monetary policy is
M , Pe , q , I , Y 
where Pe is the price of equity (not the expected price level)
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 Monetary Transmission Mechanisms
Other Asset Channels

Wealth Channel:
Was introduced by Franco Modigliani in his famous “life cycle
hypothesis of consumption.” He argued that the most important
transmission mechanism of monetary policy involves consumption.
Considering that an expansionary monetary policy  stock prices,
the wealth transmission mechanism works as follows:
M , Pe , W , C , Y 
Note: Tobin’s q and wealth mechanisms allow for a general
definition of equity that includes housing and land. For example, an
 in house prices, which  their value relative to replacement cost,
 Tobin’s q for housing, thereby stimulating its production. Also, an
 in housing and land prices  W, thereby  C and Y.
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 Credit View

This view proposes that two types of monetary transmission

channels arise as a result of information problems (such as
adverse selection and moral hazard problems) in credit markets.
These channels operate through their effects on
A. Bank lending, and
B. Firms’ and households’ balance sheets
Note:
Adverse selection is an asymmetric information problem that
occurs before the transaction occurs: potential bad credit risks
are the ones who most actively seek out loans.
Moral hazard arises after the transaction occurs: the lender runs
the risk that the borrower will engage in activities that are
undesirable form the lender’s point of view.
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 Credit View
Bank Lending Channel:
Because of asymmetric information problems in credit markets,
many borrowers do not have access to the stock and bond markets
and depend on bank loans to finance their activities. Because of
banks’ ability to solve such problems (see Chapter 8), an
expansionary monetary policy which  bank reserves and deposits,
 the quantity of bank loans available to small credit-constrained
borrowers. The  in loans causes C and I to . The monetary
policy transmission is:

M , bank deposits , bank loans , C and I , Y 

Note: Monetary policy will have a greater effect on spending by

smaller firms, which are more dependent on bank loans, than it
will on large firms, which can access the credit markets.
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 Credit View
Balance Sheet Channel:
As we saw in Chapter 8, the lower the net worth (NW) of
business firms (and therefore the lower the collateral that they
have for their loans), the more severe the adverse selection and
moral hazard problems in lending to these firms. In fact, a  in
NW,  the adverse selection and moral hazard problems and
leads to a  in lending and hence in I.
Monetary policy can affect firms’ balance sheets in several
ways. For example, expansionary monetary policy,  Pe (along
lines discussed earlier) and  the NW of firms and so leads to
an  in I and Y. The monetary policy transmission is:

M , Pe , adverse selection , moral hazard , lending , I , Y 

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Credit View
Balance Sheet Channel
Cash Flow Channel:
This is another balance sheet channel. It operates through its
effects on cash flow, the difference between cash receipts and
cash expenditures.
Expansionary monetary policy,  i and raises cash flow. The 
in cash flow causes an improvement in firms’ balance sheets,
because it  liquidity and makes it easier for lenders to know if
the firm will be able to pay its bills. This  adverse selection
and moral hazard problems, leading to an  in lending. Hence,
M , i , cash flow  adverse selection , moral hazard , lending ,
I , Y 
Note: In this transmission mechanism it is the short-term i (not
ir) that affects cash flow. Hence, this interest rate mechanism is
different from the traditional interest rate mechanism.
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 Credit View
Balance Sheet Channel
Unanticipated Price Level Channel:
This is another balance sheet channel, operating through its
effects on P.
Expansionary monetary policy, produces a surprise  in P,
lowering the real value of firms’ liabilities, leaving unchanged
the real value of firms’ assets. This  real NW,  adverse
selection and moral hazard problems, leading to an  in I and Y.

M , unanticipated P , adverse selection , moral hazard , lending , I

, Y 

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 Credit View
Balance Sheet Channel
Household Liquidity Effects Channel:
The credit view applies equally well to consumer spending,
particularly on consumer durables and housing.

An  in M,  i and causes an  in durables and housing

purchases by consumers who do not have access to other
sources of credit. Similarly,  i cause an improvement in
household balance sheets because they  cash flow to
consumers. An  in consumer cash flow,  likelihood of financial
distress, which  the desire of consumers to hold durable goods
or housing, thus  spending on them. Hence,

M , Pe , value of financial assets , likelihood of financial distress

, consumer durable and housing expenditure , Y 
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 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.

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