The New Palgrave Dictionary of Economics Online
monetary transmission mechanism
Peter N. Ireland
From The New Palgrave Dictionary of Economics, Second Edition, 2008
Edited by Steven N. Durlauf and Lawrence E. Blume
Abstract
The monetary transmission mechanism describes 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. Specific channels of monetary transmission operate through the effects that monetary policy has on interest rates, exchange rates, equity and real estate prices, bank lending, and firm balance sheets. Recent rearch on the transmission mechanism eks to understand how the channels work in the context of dynamic, stochastic, general equilibrium models.
Keywords
ast price channels of monetary transmission; balance sheet channel of monetary transmission; balance sheet credit channel; bank lending credit channel; bank rerves; bonds; central banks; currency; exchange rate channel of monetary transmission; inflation targeting; interest rate channel of monetary transmission; interest rates; IS–LM model; Keynesianism; life-cycle theory of consumption; liquidity trap; loanable funds theory; monetarism; monetary ba; monetary policy; monetary transmission mechanism; New Keynesian economics; New Keynesian Phillips curve; open market operations; Phillips curve; rational expectations models; real business cycles; Taylor rule
Article
The monetary transmission mechanism describes 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.
Key assumptions
Central bank liabilities include both components of the monetary ba: currency and bank rerves. Hence, the central bank controls the monetary ba. Indeed, monetary policy actions typically begin when the central bank changes the monetary ba through an open market operation, purchasing ot
her curities – most frequently, government bonds – to increa the monetary ba or lling curities to decrea the monetary ba.
If the policy-induced movements in the monetary ba are to have any impact beyond their immediate effects on the central bank's balance sheet, other agents must lack the ability to offt them exactly by changing the quantity or composition of their own liabilities. Thus, any theory or model of the monetary transmission mechanism must assume that there exist no privately issued curities that substitute perfectly for the components of the monetary ba. This assumption holds if, for instance, legal restrictions prevent private agents from issuing liabilities having one or more characteristics of currency and bank rerves.
Both currency and bank rerves are nominally denominated, their quantities measured in terms of the economy's unit of account. Hence, if policy-induced movements in the nominal monetary ba are to have real effects, nominal prices must not be able to respond immediately to tho movements in a way that leaves the real value of
the monetary ba unchanged. Thus, any theory or model of the monetary transmission mechanism must also assume that some friction in the economy works to prevent nominal prices from adjusting immediately and proportionally to at least some changes in the monetary ba.
The monetary ba and the short-term nominal interest rate
If, as in the US economy today, neither component of the monetary ba pays interest or if, more generally, the components of the monetary ba pay interest at a rate that is below the market rate on other highly liquid asts such as short-term government bonds, then private agents’ demand for real ba money M/P can be described as a decreasing function of the short-term nominal interest rate i: M/P=L(i). This function L summarizes how, as the nominal interest rate ris, other highly liquid asts become more attractive as short-term stores of value, providing stronger incentives for houholds and firms to economize on their holdings of currency and banks to economize on their holdings of rerves. Thus, when the price level P cannot adjust fully in the short run, the central bank's monopolistic control over the nominal quantity of ba money M also allows it to influence the short-term nominal interest rate i, with a policy-induced increa in M leading to whatever decline in i is necessary to make private agents willing to hold the additional volume of real ba money and, converly, a policy-induced decrea in M leading to a ri in i. In the simplest model where changes in M reprent the only source of uncertainty, the deterministic relationship that links M and i implies that monetary policy actions can be described equivalently in terms of their effects on either the monetary ba or the short-term nominal interest rate.
Poole's (1970)
analysis shows, however, that the economy's respon to random shocks of other kinds can depend importantly on whether the central bank operates by tting the nominal quantity of ba money and then allowing the market to determine the short-term nominal interest rate or by tting the short-term nominal interest rate and then supplying whatever quantity of nominal ba money is demanded at that interest rate. More specifically, Poole's analysis reveals that central bank policy insulates output and prices from the effects of large and unpredictable disturbances to the money demand relationship by tting a target for i rather than M. Perhaps reflecting the widespread belief that money demand shocks are large and unpredictable, most central banks around the world today – including the Federal Rerve in the United States – choo to conduct monetary policy with reference to a target for the short-term nominal interest rate as oppod to any measure of the money supply. Hence, in practice, monetary policy actions are almost always described in terms of their impact on a short-term nominal interest rate – such as the federal funds rate in the United States – even though, strictly speaking, tho actions still begin with open market operations that change the monetary ba.
The channels of monetary transmission
Mishkin (1995)
ufully describes the various channels through which monetary policy actions, as summarized by changes in either the nominal money stock or the short-term nominal interest rate, impact on real variables such as aggregate output and employment.
According to the traditional Keynesian interest rate channel, a policy-induced increa in the short-term nominal interest rate leads first to an increa in longer-term nominal interest rates, as investors act to arbitrage away differences in risk-adjusted expected returns on debt instruments of various maturities as described by the expectations hypothesis of the term structure. When nominal prices are slow to adjust, the movements in nominal interest rates translate into movements in real interest rates as well. Firms, finding that their real cost of borrowing over all horizons has incread, cut back on their investment expenditures. Likewi, houholds facing higher real borrowing costs scale back on their purchas of homes, automobiles and other durable goods. Aggregate output and employment fall. This interest rate channel lies at the heart of the traditional Keynesian textbook IS–LM model, due originally to Hicks (1937), and also appears in the more recent New Keynesian models described below.
In open economies, additional real effects of a policy-induced increa in the short-term interest rate come about through the exchange rate channel. When the domestic nominal interest rate ris above its foreign counterpart, equilibrium in the foreign exchange market requires that the domestic currency gradually depreciate at a rate that, again, rves to equate the risk-adjusted returns on various debt instruments, in this ca debt instruments
denominated in each of the two currencies – this is the condition of uncovered interest parity. Both in traditional Keynesian models that build on Fleming (1962), Mundell (1963), and Dornbusch (1976) and in the New Keynesian models described below, this expected future depreciation requires an initial appreciation of the domestic currency that, when prices are slow to adjust, makes domestically produced goods more expensive than foreign-produced goods. Net exports fall; domestic output and employment fall as well.
Additional ast price channels are highlighted by Tobin's (1969) q-theory of investment and Ando and Modigliani's (1963) life-cycle theory of consumption. Tobin's q measures the ratio of the stock market value of a firm to the replacement cost of the physical capital that is owned by that firm. All el equal, a policy-induced increa in the short-term nominal interest rate makes debt instruments more attractive than equities in the eyes of investors; hence, following a monetary tightening, equilibr
ium across curities markets must be re-established in part through a fall in equity prices. Facing a lower value of q, each firm must issue more new shares of stock in order to finance any new investment project; in this n, investment becomes more costly for the firm. In the aggregate across all firms, therefore, investment projects that were only marginally profitable before the monetary tightening go unfunded after the fall in q, leading output and employment to decline as well. Meanwhile, Ando and Modigliani's life-cycle theory of consumption assigns a role to wealth as well as income as key determinants of consumer spending. Hence, this theory also identifies a channel of monetary transmission: if stock prices fall after a monetary tightening, houhold financial wealth declines, leading to a fall in consumption, output and employment.
According to Meltzer (1995), ast price movements beyond tho reflected in interest rates alone also play a central role in monetarist
descriptions of the transmission mechanism. Indeed, monetarist critiques of the traditional Keynesian model often start by questioning the view that the full thrust of monetary policy actions is completely summarized by movements in the short-term nominal interest rate. Monetarists argue instead that monetary policy actions impact on prices simultaneously across a wide variety of markets for financial asts and durable goods, but especially in the markets for equities and real est
ate, and that tho ast price movements are all capable of generating important wealth effects that impact, through spending, on output and employment.
Two distinct credit channels, the bank lending channel and the balance sheet channel, also allow the effects of monetary policy actions to propagate through the real economy. Kashyap and Stein (1994) trace the origins of thought on the bank lending channel back to Roosa (1951) and also highlight Blinder and Stiglitz's (1983) resurrection of the loanable funds theory and Bernanke and Blinder's (1988) extension of the IS–LM model as two approaches that account for this additional source of monetary non-neutrality. According to this lending view, banks play a special role in the economy not just by issuing liabilities – bank deposits – that contribute to the broad monetary aggregates but also by holding asts – bank loans – for which few clo substitutes exist. More specifically, theories and models of the bank lending channel emphasize that for many banks, particularly small banks, deposits reprent the principal source of funds for lending and that for many firms, particularly small firms, bank loans reprent the principal source of funds for investment. Hence, an open market operation that leads first to a contraction in the supply of bank rerves and then to a contraction in bank deposits requires banks that are especially dependent on deposits to cut back on their lending, and firms that are especially dependent on bank loans to cut back on their investment spending. Fin
ancial market imperfections confronting individual banks and firms thereby contribute, in the aggregate, to the decline in output and employment that follows a monetary tightening.
Bernanke and Gertler (1995)
describe a broader credit channel, the balance sheet channel, where financial market imperfections also play a key role. Bernanke and Gertler emphasize that, in the prence of financial market imperfections, a firm's cost of credit, whether from banks or any other external source, ris when the strength of its balance sheet deteriorates.
A direct effect of monetary policy on the firm's balance sheet comes about when an increa in interest rates works to increa the payments that the firm must make to rvice its floating rate debt. An indirect effect aris, too, when the same increa in interest rates works to reduce the capitalized value of the firm's long-lived asts. Hence, a policy-induced increa in the short-term interest rate not only acts immediately to depress spending through the traditional interest rate channel, it also acts, possibly with a lag, to rai each firm's cost of capital through the balance sheet channel, deepening and extending the initial decline in output and employment. Recent developments
Recent theoretical work on the monetary transmission mechanism eks to understand how the traditional Keynesian interest rate channel operates within the context of dynamic, stochastic, general equilibrium models. This recent work builds on early attempts by Fischer (1977) and Phelps and Taylor (1977) to combine the key assumption of nominal price or wage rigidity with the assumption that all agents have rational expectations so as to overturn the policy ineffectiveness result that McCallum (1979) associates with Lucas (1972) and Sargent and Wallace (1975). This recent work builds on tho earlier studies by deriving the key behavioural equations of the New Keynesian model from more detailed descriptions of the objectives and constraints faced by optimizing houholds and firms.
More specifically, the basic New Keynesian model consists of three equations involving three variables: output y t, inflation πt, and the short-term nominal interest rate i t. The first equation, which Kerr and King (1996) and McCallum and Nelson (1999)
dub the expectational IS curve, links output today to its expected future value and to the ex ante real interest rate, computed in the usual way by subtracting the expected rate of inflation from the nominal interest rate:
y t=E t y t+1−σ(i t−E tπt+1),
where σ, like all of the other parameters to be introduced below, is strictly positive. This equation corresponds to a log-linearized version of the Euler equation linking an optimizing houhold's intertemporal marginal rate of substitution to the inflation-adjusted return on bonds, that is, to the real interest rate. The cond equation, the New Keynesian Phillips curve, takes the form
πt=βE tπt+1+γy t
and corresponds to a log-linearized version of the first-order condition describing the optimal behavior of monopolistically competitive firms that either face explicit costs of nominal price adjustment, as suggested by Rotemberg (1982), or t their nominal prices in randomly staggered fashion, as suggested by Calvo (1983). The third and final equation is an interest rate rule for monetary policy of the type propod by Taylor (1993),
i t=απt+ψy t,
according to which the central bank systematically adjusts the short-term nominal interest in respon to movements in inflation and output. This description of monetary policy in terms of interest rates reflects the obrvation, noted above, that most central banks today conduct monetary policy using targets for the interest rate as oppod to any of the monetary aggregates. A money de
mand equation could be appended to this
three-equation model, but that additional equation would rve only to determine the amount of money that the central bank and the banking system would need to supply to clear markets, given the tting for the central bank's interest rate target (e Ireland, 2004, for a detailed discussion of this last point).
In this benchmark New Keynesian model, monetary policy operates through the traditional Keynesian interest rate channel. A monetary tightening in the form of a shock to the Taylor rule that increas the short-term nominal interest rate translates into an increa in the real interest rate as well when nominal prices move sluggishly due to costly or staggered price tting. This ri in the real interest rate then caus houholds to cut back on their spending, as summarized by the IS curve. Finally, through the Phillips curve, the decline in output puts downward pressure on inflation, which adjusts only gradually after the shock.
Importantly, however, the expectational terms that enter into the IS and Phillips curves displayed above imply that policy actions will differ in their quantitative effects depending on whether the actions are anticipated or unanticipated; hence, this New Keynesian model follows the earlier rationa
l expectations models of Lucas and Sargent and Wallace by stressing the role of expectations in the monetary transmission mechanism. And, as emphasized by Kimball (1995), by deriving the expectational forms for the IS and Phillips curves from completely spelled-out descriptions of the optimizing behaviour of houholds and firms, the New Keynesian model takes advantage of the powerful microeconomic foundations introduced into macroeconomics through Kydland and Prescott's (1982)
real business cycle model while also drawing on insights from earlier work in New Keynesian economics as exemplified, for instance, by the articles collected in Mankiw and Romer's (1991) two-volume t.
Clarida, Gali and Gertler (1999) and Woodford (2003) trace out the New Keynesian model's policy implications in much greater detail. Obstfeld and Rogoff (1995)
develop an open-economy extension in which the exchange rate channel operates together with the interest rate
