C H A P T E R 2 6 Transmission Mechanisms of Monetary Policy: The Evidence 623
monetary policy, which lowers nominal interest rates, also causes an improvement in firmsÕ balance sheets because it raises cash flow. The rise in cash flow causes an improvement in the balance sheet because it increases the liquidity of the firm (or household) and thus makes it easier for lenders to know whether the firm (or household) will be able to pay its bills. The result is that adverse selection and moral hazard problems become less severe, leading to an increase in lending and economic activity. The following schematic describes this additional balance sheet channel:
M↑ i↓ cash flow ↑ adverse selection ↓
,
moral hazard ↓ lending ↑ I ↑ Y↑
(8)
An important feature of this transmission mechanism is that it is nominal interest rates that affect firmsÕ cash flow. Thus this interest-rate mechanism differs from the traditional interest-rate mechanism discussed earlier, in which it is the real rather than the nominal interest rate that affects investment. Furthermore, the short-term interest rate plays a special role in this transmission mechanism, because it is interest payments on short-term rather than long-term debt that typically have the greatest impact on householdsÕ and firmsÕ cash flow.
A related mechanism involving adverse selection through which expansionary monetary policy that lowers interest rates can stimulate aggregate output involves the credit-rationing phenomenon. As we discussed in Chapter 9, credit rationing occurs in cases where borrowers are denied loans even when they are willing to pay a higher interest rate. This is because individuals and firms with the riskiest investment projects are exactly the ones who are willing to pay the highest interest rates, for if the high-risk investment succeeds, they will be the primary beneficiaries. Thus higher interest rates increase the adverse selection problem, and lower interest rates reduce it. When expansionary monetary policy lowers interest rates, less risk-prone borrowers make up a higher fraction of those demanding loans, and so lenders are more willing to lend, raising both investment and output, along the lines of parts of the schematic in Equation 8.
Unanticipated Price Level Channel. A third balance sheet channel operates through monetary policy effects on the general price level. Because in industrialized countries debt payments are contractually fixed in nominal terms, an unanticipated rise in the price level lowers the value of firmsÕ liabilities in real terms (decreases the burden of the debt) but should not lower the real value of the firmsÕ assets. Monetary expansion that leads to an unanticipated rise in the price level (P ↑ ) therefore raises real net worth, which lowers adverse selection and moral hazard problems, thereby leading to a rise in investment spending and aggregate output as in the following schematic:
M↑ unanticipated P↑ adverse selection ↓
,
moral hazard ↓ lending ↑ I↑ Y ↑
(9)
The view that unanticipated movements in the price level have important effects on aggregate demand has a long tradition in economics: It is the key feature in the debt-deflation view of the Great Depression we outlined in Chapter 8.
Household Liquidity Effects. Although most of the literature on the credit channel focuses on spending by businesses, the credit view should apply equally well to consumer spending, particularly on consumer durables and housing. Declines in bank
624 P A R T V I Monetary Theory
Box 4
Consumers’ Balance Sheets and the Great Depression
The years between 1929 and 1933 witnessed the
of real debt consumers owed also increased sharply
worst deterioration in consumersÕ balance sheets ever
(by over 20%). Consequently, the value of financial
seen in the United States. The stock market crash in
assets relative to the amount of debt declined sharply,
1929, which caused a slump that lasted until 1933,
increasing the likelihood of financial distress. Not
reduced the value of consumersÕ wealth by $692 bil-
surprisingly, spending on consumer durables and
lion (in 1996 dollars), and as expected, consumption
housing fell precipitously: From 1929 to 1933, con-
dropped sharply (by over $100 billion). Because of
sumer durable expenditure declined by over 50%,
the decline in the price level in that period, the level
while expenditure on housing declined by 80%.*
*For further discussion of the effect of consumersÕ balance sheets on spending during the Great Depression, see Frederic S. Mishkin, ÒThe Household Balance Sheet and the Great Depression,Ó Journal of Economic History 38 (1978): 918Ð937.
lending induced by a monetary contraction should cause a decline in durables and housing purchases by consumers who do not have access to other sources of credit. Similarly, increases in interest rates cause a deterioration in household balance sheets, because consumersÕ cash flow is adversely affected.
Another way of looking at how the balance sheet channel may operate through consumers is to consider liquidity effects on consumer durable and housing expendituresÑfound to have been important factors during the Great Depression (see Box 4). In the liquidity effects view, balance sheet effects work through their impact on consumersÕ desire to spend rather than on lendersÕ desire to lend. Because of asymmetric information about their quality, consumer durables and housing are very illiquid assets. 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. (This is just a manifestation of the lemons problem described in Chapter 8.) 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. Hence if consumers expect a higher likelihood of finding themselves in financial distress, they would rather be holding fewer illiquid consumer durable or housing assets and more liquid financial assets.
A consumerÕs balance sheet should be an important influence on his or her estimate of the likelihood of suffering financial distress. Specifically, when consumers have a large amount of financial assets relative to their debts, their estimate of the probability of financial distress is low, and they will be more willing to purchase consumer durables or housing. When stock prices rise, the value of financial assets rises as well; consumer durable expenditure will also rise because consumers have a more secure financial position and a lower estimate of the likelihood of suffering financial distress. This leads to another transmission mechanism for monetary policy, operating through the link between money and stock prices:19
M↑
Ps↑ financial assets ↑ likelihood of financial distress ↓
consumer durable and housing expenditure ↑ Y ↑
(10)
19See Frederic S. Mishkin, ÒWhat Depressed the Consumer? The Household Balance Sheet and the 1973Ð1975 Recession,Ó Brookings Papers on Economic Activity 1 (1977): 123Ð164.
C H A P T E R 2 6 Transmission Mechanisms of Monetary Policy: The Evidence 625
Why Are Credit
Channels Likely to
Be Important?
The illiquidity of consumer durable and housing assets provides another reason why a monetary expansion, which lowers interest rates and thereby raises cash flow to consumers, leads to a rise in spending on consumer durables and housing. A rise in consumer cash flow decreases the likelihood of financial distress, which increases the desire of consumers to hold durable goods or housing, thus increasing spending on them and hence aggregate output. The only difference between this view of cash flow effects and that outlined in Equation 8 is that it is not the willingness of lenders to lend to consumers that causes expenditure to rise but the willingness of consumers to spend.
There are three reasons to believe that credit channels are important monetary transmission mechanisms. First, a large body of evidence on the behavior of individual firms supports the view that credit market imperfections of the type crucial to the operation of credit channels do affect firmsÕ employment and spending decisions.20 Second, 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-con- strained.21 Third, and maybe most compelling, 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 (all topics discussed in Chapter 8). The best support for a theory is its demonstrated usefulness in a wide range of applications. By this standard, the asymmetric information theory supporting the existence of credit channels as an important monetary transmission mechanism has much to recommend it.
Application
Corporate Scandals and the Slow Recovery from the March 2001 Recession
The collapse of the tech boom and the stock market slump led to a decline
in investment spending that triggered a recession starting in March 2001. Just
as the recession got under way, the Fed rapidly lowered the federal funds
rate. At first it appeared that the FedÕs actions would keep the recession mild
and stimulate a recovery. However, the economy did not bounce back as
quickly as the Fed had hoped. Why was the recovery from the recession so
sluggish?
One explanation is that the corporate scandals at Enron, Arthur
Andersen, and several other large firms caused investors to doubt the quality
of the information about corporations. Doubts about the quality of corporate
information meant that asymmetric information problems worsened, so that
it became harder for an investor to screen out good firms from bad firms
when making investment decisions. Because of the potential for increased
adverse selection, as described in the credit view, individuals and financial
20For a survey of this evidence, see Hubbard, ÒIs There a ÔCredit ChannelÕ for Monetary Policy?Ó (note 17).
21See Mark Gertler and Simon Gilchrist, ÒMonetary Policy, Business Cycles, and the Behavior of Small Manufacturing Firms,Ó Quarterly Journal of Economics 109 (May 1994): 309Ð 340.
626 P A R T V I Monetary Theory
institutions were less willing to lend. This reluctance to lend in turn led to a decline in investment and aggregate output.
In addition, as we saw in Chapter 7, the corporate scandals caused investors to be less optimistic about earnings growth and to think that stocks were riskier, an effect leading to a further drop in the stock market. The decline in the stock market also weakened the economy, because it lowered household wealth. In turn, the decrease in household wealth led not only to restrained consumer spending, but also to weaker investment, because of the resulting drop in TobinÕs q. In addition, the stock market decline weakened corporate balance sheets. This weakening increased asymmetric information problems and decreased lending and investment spending.
Corporate scandals have not only decreased our confidence in business leaders, but have also created a drag on the economy that has hindered the recovery from recession.
Lessons for Monetary Policy
What useful implications for central banksÕ conduct of monetary policy can we draw from the analysis in this chapter? There are four basic lessons to be learned.
1.It is dangerous always to associate the easing or tightening of monetary policy with a fall or a rise in short-term nominal interest rates. Because most central banks use short-term nominal interest ratesÑtypically, the interbank rateÑas the key operating instrument for monetary policy, there is a danger that central banks and the public will focus too much on short-term nominal interest rates as an indicator of the stance of monetary policy. Indeed, it is quite common to see statements that always associate monetary tightenings with a rise in the interbank rate and monetary easings with a decline in the rate. This view is highly problematic, becauseÑas we have seen in our discussion of the Great Depression periodÑmovements in nominal interest rates do not always correspond to movements in real interest rates, and yet it is typically the real and not the nominal interest rate that is an element in the channel of monetary policy transmission. For example, we have seen that during the contraction phase of the Great Depression in the United States, short-term interest rates fell to near zero and yet real interest rates were extremely high. Short-term interest rates that are near zero therefore do not indicate that monetary policy is easy if the economy is undergoing deflation, as was true during the contraction phase of the Great Depression. As Milton Friedman and Anna Schwartz have emphasized, the period of near-zeroshort-term interest rates during the contraction phase of the Great Depression was one of highly contractionary monetary policy rather than the reverse.
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. As we have seen in this chapter, economists have come a long way in understanding that other asset prices besides interest rates have major effects on aggregate demand. The view in Figure 3 that other asset prices, such as stock prices, foreign exchange rates, and housing and land prices, play an important role in monetary transmission mechanisms is held by both monetarists and Keynesians. Furthermore, the discussion of such additional channels as those operating through the exchange rate, TobinÕs q, and
C H A P T E R 2 6 Transmission Mechanisms of Monetary Policy: The Evidence 627
wealth effects provides additional reasons why other asset prices play such an important role in the monetary transmission mechanisms. Although there are strong disagreements among economists about which channels of monetary transmission are the most importantÑnot surprising, given that economists, particularly those in academia, always like to disagreeÑthey do agree that other asset prices play an important role in the way monetary policy affects the economy.
The view that other asset prices besides short-term interest rates matter has important implications for monetary policy. When we try to assess the stance of policy, it is critical that we look at other asset prices besides short-term interest rates. For example, if short-term interest rates are low or even zero and yet stock prices are low, land prices are low, and the value of the domestic currency is high, monetary policy is clearly tight, not easy.
3.Monetary policy can be highly effective in reviving a weak economy even if short-term interest rates are already near zero. We have recently entered a world where inflation is not always the norm. Japan, for example, recently experienced a period of deflation, when the price level was actually falling. One common view is that when a central bank has driven down short-term nominal interest rates to near zero, there is nothing more that monetary policy can do to stimulate the economy. The transmission mechanisms of monetary policy described here indicate that this view is false. As our discussion of the factors that affect the monetary base in Chapter 15 indicated, expansionary monetary policy to increase liquidity in the economy can be conducted with open market purchases, which do not have to be solely in shortterm government securities. For example, purchases of foreign currencies, like purchases of government bonds, lead to an increase in the monetary base and in the money supply. This increased liquidity helps revive the economy by raising general price-level expectations and by reflating other asset prices, which then stimulate aggregate demand through the channels outlined here. Therefore, monetary policy can be a potent force for reviving economies that are undergoing deflation and have short-term interest rates near zero. Indeed, because of the lags inherent in fiscal policy and the political constraints on its use, expansionary monetary policy is the key policy action required to revive an economy experiencing deflation.
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. As we saw in Chapter 18, central banks in recent years have been putting greater emphasis on price stability as the primary long-run goal for monetary policy. Several rationales have been proposed for this goal, including the undesirable effects of uncertainty about the future price level on business decisions and hence on productivity, distortions associated with the interaction of nominal contracts and the tax system with inflation, and increased social conflict stemming from inflation. The discussion here of monetary transmission mechanisms provides an additional reason why price stability is so important. As we have seen, unanticipated movements in the price level can cause unanticipated fluctuations in output, an undesirable outcome. Particularly important in this regard is the knowledge that, as we saw in Chapter 8, price deflation can be an important factor leading to a prolonged financial crisis, as occurred during the Great Depression. An understanding of the monetary transmission mechanisms thus makes it clear that the goal of price stability is desirable, because it reduces uncertainty about the future price level. Thus the price stability goal implies that a negative inflation rate is at least as undesirable as too high an inflation rate. Indeed, because of the threat of financial crises, central banks must work very hard to prevent price deflation.
628 P A R T V I Monetary Theory
Application
Applying the Monetary Policy Lessons to Japan
Until 1990, it looked as if Japan might overtake the United States in per capita income. Since then, the Japanese economy has been stagnating, with deflation and low growth. As a result, Japanese living standards have been falling farther and farther behind those in the United States. Many economists take the view that Japanese monetary policy is in part to blame for the poor performance of the Japanese economy. Could applying the four lessons outlined in the previous section have helped Japanese monetary policy perform better?
The first lesson suggests that it is dangerous to think that declines in interest rates always mean that monetary policy has been easing. In the mid1990s, when short-term interest rates began to decline, falling to near zero in the late 1990s and early 2000s, the monetary authorities in Japan took the view that monetary policy was sufficiently expansionary. Now it is widely recognized that this view was incorrect, because the falling and eventually negative inflation rates in Japan meant that real interest rates were actually quite high and that monetary policy was tight, not easy. If the monetary authorities in Japan had followed the advice of the first lesson, they might have pursued a more expansionary monetary policy, which would have helped boost the economy.
The second lesson suggests that monetary policymakers should pay attention to other asset prices in assessing the stance of monetary policy. At the same time interest rates were falling in Japan, stock and real estate prices were collapsing, thus providing another indication that Japanese monetary policy was not easy. Recognizing the second lesson might have led Japanese monetary policymakers to recognize sooner that they needed a more expansionary monetary policy.
The third lesson indicates that monetary policy can still be effective even if short-term interest rates are near zero. Officials at the Bank of Japan have frequently claimed that they have been helpless in stimulating the economy, because short-term interest rates had fallen to near zero. Recognizing that monetary policy can still be effective even when interest rates are near zero, as the third lesson suggests, would have helped them to take monetary policy actions that would have stimulated aggregate demand by raising other asset prices and inflationary expectations.
The fourth lesson indicates that unanticipated fluctuations in the price level should be avoided. If the Japanese monetary authorities had adhered to this lesson, they might have recognized that allowing deflation to occur could be very damaging to the economy and would be inconsistent with the goal of price stability. Indeed, critics of the Bank of Japan have suggested that the bank should announce an inflation target in order to promote the price stability objective, but the bank has resisted this suggestion.
Heeding the advice from the four lessons in the previous section might have led to a far more successful conduct of monetary policy in Japan in recent years.
C H A P T E R 2 6 Transmission Mechanisms of Monetary Policy: The Evidence 629
Summary
1.There are two basic types of empirical evidence: reducedform evidence and structural model evidence. Both have advantages and disadvantages. The main advantage of structural model evidence is that it provides us with an understanding of how the economy works and gives us more confidence in the direction of causation between money and output. However, if the structure is not correctly specified, because it ignores important monetary transmission mechanisms, it could seriously underestimate the effectiveness of monetary policy. Reduced-form evidence has the advantage of not restricting the way monetary policy affects economic activity and so may be more likely to capture the full effects of monetary policy. However, reduced-form evidence cannot rule out the possibility of reverse causation or an outside driving factor, which could lead to misleading conclusions about the importance of money.
2.The early Keynesians believed that money does not matter, because they found weak links between interest rates and investment and because low interest rates on Treasury securities convinced them that monetary policy was easy during the worst economic contraction in U.S. history, the Great Depression. Monetarists objected to this interpretation of the evidence on the grounds that
(a) the focus on nominal rather than real interest rates may have obscured any link between interest rates and investment, (b) interest-rate effects on investment might be only one of many channels through which monetary policy affects aggregate demand, and (c) by the standards of real interest rates and interest rates on lower-grade bonds, monetary policy was extremely contractionary during the Great Depression.
3.Early monetarist evidence falls into three categories: timing, statistical, and historical. Because of reverse
causation and outside-factor possibilities, some serious doubts exist regarding conclusions that can be drawn from timing and statistical evidence alone. However, some of the historical evidence in which exogenous declines in money growth are followed by recessions provides stronger support for the monetarist position that money matters. As a result of empirical research, Keynesian and monetarist opinion has converged to the view that money does matter to aggregate economic activity and the price level. However, Keynesians do not agree with the monetarist position that money is all that matters.
4.The transmission mechanisms of monetary policy include traditional interest-rate channels that operate through the cost of capital and affect investment; other asset price channels such as exchange rate effects, TobinÕs q theory, and wealth effects; and the credit view channelsÑthe bank lending channel, the balance sheet channel, the cash flow channel, the unanticipated price level channel, and household liquidity effects.
5.Four lessons for monetary policy can be drawn from this chapter: (a) It is dangerous always to associate monetary policy easing or tightening with a fall or a rise in shortterm nominal interest rates; (b) 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 the monetary policy transmission mechanisms; (c) monetary policy can be highly effective in reviving a weak economy even if short-term interest rates are already near zero; and (d) 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.
Key Terms
consumer durable expenditure, p. 617
reduced-form evidence, p. 604
structural model evidence, p. 603
consumption, p. 620
reverse causation, p. 606
transmission mechanisms of
credit view, p. 618
structural model, p. 604
monetary policy, p. 604
630 P A R T V I Monetary Theory
QUIZ Questions and Problems
Questions marked with an asterisk are answered at the end of the book in an appendix, ÒAnswers to Selected Questions and Problems.Ó
1.Suppose that a researcher is trying to determine whether jogging is good for a personÕs health. She examines this question in two ways. In method A, she looks to see whether joggers live longer than nonjoggers. In method B, she looks to see whether jogging reduces cholesterol in the bloodstream and lowers blood pressure; then she asks whether lower cholesterol and blood pressure prolong life. Which of these two methods will produce reduced-form evidence and which will produce structural model evidence?
2.If research indicates that joggers do not have lower cholesterol and blood pressure than nonjoggers, is it still possible that jogging is good for your health? Give a concrete example.
3.If research indicates that joggers live longer than nonjoggers, is it possible that jogging is not good for your health? Give a concrete example.
*4. Suppose that you plan to buy a car and want to know whether a General Motors car is more reliable than a Ford. One way to find out is to ask owners of both cars how often their cars go into the shop for repairs. Another way is to visit the factory producing the cars and see which one is built better. Which procedure will provide reduced-form evidence and which structural model evidence?
*5. If the GM car you plan to buy has a better repair record than a Ford, does this mean that the GM car is necessarily more reliable? (GM car owners might, for example, change their oil more frequently than Ford owners.)
*6. Suppose that when you visit the Ford and GM car factories to examine how the cars are built, you have time only to see how well the engine is put together. If Ford engines are better built than GM engines, does that mean that the Ford will be more reliable than the GM car?
7.How might bank behavior (described in Chapter 16) lead to causation running from output to the money supply? What does this say about evidence that finds a strong correlation between money and output?
*8. What operating procedures of the Fed (described in Chapter 18) might explain how movements in output might cause movements in the money supply?
9.ÒIn every business cycle in the past 100 years, the rate at which the money supply is growing always decreases before output does. Therefore, the money supply causes business cycle movements.Ó Do you agree? What objections can you raise against this argument?
*10. How did the research strategies of Keynesian and monetarist economists differ after they were exposed to the earliest monetarist evidence?
11.In the 1973Ð1975 recession, the value of common stocks in real terms fell by nearly 50%. How might this decline in the stock market have affected aggregate demand and thus contributed to the severity of this recession? Be specific about the mechanisms through which the stock market decline affected the economy.
*12. ÒThe cost of financing investment is related only to interest rates; therefore, the only way that monetary policy can affect investment spending is through its effects on interest rates.Ó Is this statement true, false, or uncertain? Explain your answer.
13.Predict what will happen to stock prices if the money supply rises. Explain why you are making this prediction.
*14. Franco Modigliani found that the most important transmission mechanisms of monetary policy involve consumer expenditure. Describe how at least two of these mechanisms work.
15.ÒThe monetarists have demonstrated that the early Keynesians were wrong in saying that money doesnÕt matter at all to economic activity. Therefore, we should accept the monetarist position that money is all that matters.Ó Do you agree? Why or why not?
C H A P T E R 2 6 Transmission Mechanisms of Monetary Policy: The Evidence 631
Web Exercises
1. Figure 1 shows the relationship between estimated real
failure of economic policy. Go to www.econlib.org
interest rates and nominal interest rates. Go to
/library/Enc/Recessions.html and review the material
www.martincapital.com/ and click on Òcharts and
reported on recessions.
dataÓ then on Ònominal versus real market ratesÓ to
a. What is the formal definition of a recession?
find data showing the spread between real interest and
b. What are the problems with the definition?
nominal interest rates. Discuss how the current spread
c. What are the three Ds used by the National
differs from that shown most recently in Figure 1.
Bureau of Economic Research (NBER) to define
What are the implications of this change?
a recession?
2. Figure 2 discusses business cycles. While peaks and
d. Review Chart 1. What trend is apparent about the
length of recessions?
troughs of economic activity are a normal part of the
business cycle, recessions are not. They represent a
C h a p t e r
27 Money and Inflation
PREVIEW
Since the early 1960s, when the inflation rate hovered between 1 and 2%, the economy has suffered from higher and more variable rates of inflation. By the late 1960s, the inflation rate had climbed beyond 5%, and by 1974, it reached the double-digit level. After moderating somewhat during the 1975Ð1978 period, it shot above 10% in 1979 and 1980, slowed to around 5% from 1982 to 1990, and declined further to around 2% in the late 1990s and early 2000s. Inflation, the condition of a continually rising price level, has become a major concern of politicians and the public, and how to control it frequently dominates the discussion of economic policy.
How do we prevent the inflationary fire from igniting and end the roller-coaster ride in the inflation rate of the past 40 years? Milton Friedman provides an answer in his famous proposition that Òinflation is always and everywhere a monetary phenomenon.Ó He postulates that the source of all inflation episodes is a high growth rate of the money supply: Simply by reducing the growth rate of the money supply to low levels, inflation can be prevented.
In this chapter, we use aggregate demand and supply analysis from Chapter 25 to reveal the role of monetary policy in creating inflation. You will find that as long as inflation is defined as the condition of a continually and rapidly rising price level, monetarists and Keynesians both agree with FriedmanÕs proposition that inflation is a monetary phenomenon.
But what causes inflation? How does inflationary monetary policy come about? You will see that inflationary monetary policy is an offshoot of other government policies: the attempt to hit high employment targets or the running of large budget deficits. Examining how these policies lead to inflation will point us toward ways of preventing it at minimum cost in terms of unemployment and output loss.
Money and Inflation: Evidence
The evidence for FriedmanÕs statement is straightforward. Whenever a countryÕs inflation rate is extremely high for a sustained period of time, its rate of money supply growth is also extremely high. Indeed, this is exactly what we saw in Figure 6 in Chapter 1, which shows that the countries with the highest inflation rates have also had the highest rates of money growth.
