The Monetary Transmission Mechanism - Bank of England 2012

8/16/2019 The Monetary Transmission Mechanism - Bank of England 2012

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Ole Rummel

CCBS, bank of England

[email protected]

18 July 2012

The monetary transmission mechanism

mailto:[email protected]:[email protected]


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• What is the transmission mechanism?

• Different channels of transmission:

– the ‘old’ view - interest rate, exchange rate and asset price channels;

– the ‘new’ view – credit market frictions and their consequences; and

– new developments in the transmission mechanism for emergingmarket economies

• Dollarisation, banking sector consolidation and government

intervention

• The risk taking channel

• Summary and conclusions


Outline

Monetary transmission channels, liquidity conditions and determinants of inflation


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The Fed’s direct power over the economy is actually more limited

than is widely appreciated. People often say that the Fed

controls interest rates, but what it actually controls is only an

interest rate, the rate in the overnight federal funds market. And

the interest rate is, in itself, of very little economic importance.

Paul Krugman, New York Times, 14 December 2001


How powerful is a central bank really?


http://www.nytimes.com/2001/12/14/opinion/eleven-and-counting.html?ref=paulkrugmanhttp://www.nytimes.com/2001/12/14/opinion/eleven-and-counting.html?ref=paulkrugmanhttp://www.nytimes.com/2001/12/14/opinion/eleven-and-counting.html?ref=paulkrugman


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• How changes in the monetary policy variable affect inflation and

output

• We are interested in:

– the ‘channels’ (economic relationships) of the monetary

transmission mechanism;

– how quickly they work;

– how reliably they work; and

– how large the effects are


Definition of the monetary transmission mechanism



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• The traditional textbook (Keynesian) channel is known as the

interest rate or the intertemporal substitution channel:

(M ) i C (I ) Y d y π

• Expanding ‘money’ (M ) reduces interest rates (i ), reduces the

cost of borrowing for firms (and consumers), leads to increasedconsumption (C ) as well as investment (I ) and therefore higher

demand (Y d ), a bigger output gap (y ) and finally higher prices and

inflation (π )


The ‘old’ view: the interest rate channel



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• But Bernanke and Gertler (1989) pointed out that the

macroeconomic response to policy-induced interest rate changes

was considerably larger than implied by conventional estimates

of interest elasticities of consumption and investment

• This suggests that mechanisms other than the interest rate

channel may also be at work in the transmission of monetary

policy


The interest rate channel and policy responses



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Source: Kuttner and Mosser (2002).




http://www.newyorkfed.org/research/epr/02v08n1/0205kutt.pdfhttp://www.newyorkfed.org/research/epr/02v08n1/0205kutt.pdfhttp://www.newyorkfed.org/research/epr/02v08n1/0205kutt.pdfhttp://www.newyorkfed.org/research/epr/02v08n1/0205kutt.pdfhttp://www.newyorkfed.org/research/epr/02v08n1/0205kutt.pdfhttp://www.newyorkfed.org/research/epr/02v08n1/0205kutt.pdfhttp://www.newyorkfed.org/research/epr/02v08n1/0205kutt.pdf


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• The exchange-rate channel:

i e NX y π

• Lower interest rates (i ) lead to a depreciation of the exchange

rate (e), an increase in competitiveness, an improved trade

balance (due to higher net exports, NX ) and increased demand,a larger output gap and finally higher inflation

• Moreover…


The exchange rate channel: net exports



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i e P m π

• An exchange rate (e) depreciation also raises import prices (P m),

which are important determinants of firms’ costs and the retail

price of many goods and services: this directly affects the pricelevel and (temporarily) inflation

• An appreciation should reduce inflation (with a longer lag if prices

are sticky on the downside)


The exchange rate channel: import prices



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i e NW y π

• An exchange rate depreciation increases the relative value of

foreign-denominated assets and liabilities and therefore net

wealth (NW ), affecting demand• The sign of the effect depends on the make-up of balance sheets


The exchange rate channel: net wealth



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• Changes in interest rates have a direct effect on the valuation of

financial assets and their expected returns

• For example, lower interest rates increase the present value of

future income flows (or the cost of finance for assets) and

therefore asset prices

• This may have no direct impact on inflation if asset prices are

excluded from the CPI basket...

• ...but it may raise (total) wealth which will affect demand


Other asset price effects



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• The investment channel (Tobin’s q):

i P e q I y π

• Consider two ways of increasing the size of a firm:

– buy another firm (and acquire ‘old’ capital); or

– invest in new capital• The ratio of the market value of a firm to the replacement cost of

its assets is known as Tobin’s q

• Tobin (1969) argued that a firm should invest in new buildings

and equipment if the stock market will value the project at more

than its cost (that is, if the project's q is greater than 1)• Increased equity prices (P e) mean that new investment projects

have become relatively cheaper to finance and therefore more

attractive


Other asset price effects: investment (Tobin’s q )



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• Other asset price effects: consumption

i P e TW C y π

• The permanent income hypothesis postulates that consumers’

spending is related to (total) wealth

• Increased wealth (as a result of higher equity prices, P e, say) – ifit is perceived to be permanent – leads to a (much smaller)

increase in (desired) consumption


Other asset price effects: consumption



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• Other asset price effects: housing wealth

i P h TW ? C y π

• Increased house prices (P h) are often associated with increasedprivate consumption in the UK/US

• Why? – housing wealth represent greater wealth for some (but for the

economy as a whole?);

– housing wealth increases available collateral and therefore reduces

credit constraints; and

– people may be more likely to change house or spend on

improvements/consumer durables (in a process called mortgage

equity withdrawal)


Other asset price effects: housing wealth



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• An increase in short-term interest rates has an ambiguous effect

on longer-term interest rates

• Expectations are all about how monetary policy changes are

interpreted as an indicator of future short rates

• Interest-rate changes affect consumer confidence, cause firms torevise spending plans and affect asset values in financial

markets (risk premia)


How do interest rates affect expectations?



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• Financial markets do not always work perfectly

• We generally assume that the effects of monetary policy work

through interest rates and that firms and individuals can borrow

freely at the quoted interest rate

• In practice, most individuals and many firms can borrow onlyfrom banks…

• …and banks often turn down potential borrowers, despite their

willingness to pay the posted interest rate

• Why does that happen and how does it affect our view of how

monetary policy works?


Credit market frictions



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• Asymmetric information and costly enforcement of financial

contracts create principal-agent problems in financial markets

• Banks play a special role in the financial system because they

are well suited to deal with certain types of borrowers, especially

small firms and private individuals, where the problems of

asymmetric information can be especially pronounced


A ‘new’ view: the role of banks in financial markets



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• The credit channel holds that monetary policy has additional

effects because interest-rate decisions by the central bank affect

the cost and availability of credit by more than would be implied

by the associated movement in risk-free interest rates


The role of banks and the credit channel



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• Two basic channels of monetary transmission arise in the credit

channel as a result of principal-agent problems in credit markets:

– the bank lending channel, also know as the narrow credit channel;

and

– the balance sheet channel, also known as the broad credit

channel


Two forms of the credit channel



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• Asset values play an important role in the broad credit or

balance sheet channel developed by Bernanke and Gertler

(1989)

• In the broad credit channel, asset prices are especially important

in that they determine the value of the collateral that firms and

individuals will have to present when obtaining a loan


The balance sheet or broad credit channel (1)



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• In ‘frictionless’ credit markets, a fall in the value of borrowers’

collateral will not affect investment decisions by the bank (due to

the Modigliani-Miller theorem)…

• …but in the presence of information or agency costs, declining

collateral values will increase the premium borrowers must pay

for external finance, which in turn will reduce consumption and

investment


The balance sheet or broad credit channel (2)



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• The narrow credit or bank lending channel also relies on credit

market frictions, but banks play a more central role (Bernanke

and Blinder (1988))

• 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 assets – bank loans – with few

close substitutes


The bank lending or narrow credit channel (1)



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• Because banks rely on reservable demand deposits as an

important source of funds, contractionary monetary policy which

reduces the aggregate volume of bank reserves will reduce the

availability of bank loans…

• …in consequence, because a significant number of firms and

households rely heavily (or exclusively) on bank financing, a

reduction in loan supply will depress aggregate spending





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• Theory suggests that two key conditions must be satisfied for the

bank lending channel to operate:

– the first essential element is that banks should not be able to fully

shield their loan portfolios from changes in monetary policy;

– the presumption is that banks cannot offset completely the decline

in liquid funds due to restrictive monetary policy by resorting toalternative sources of funding without incurring additional costs; and

– as a result, banks reduce their loan supply





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• Theory suggests that two key conditions must be satisfied for the

bank lending channel to operate:

– the second crucial element is that there is a substantial group of

borrowers, firms or consumers that cannot insulate their spending

from the reduction in bank credit; and

– this, in turn, can depress real investment and consumption





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• The traditional intertemporal substitution channel in emerging

markets may have been modified due to recent changes in the

balance-sheet position of the private sector (Mohanty and Turner

(2008)):

– changes in household balance sheets implied by the growth in

household credit;

– changes in the response of investment to monetary policy changes

as a result of corporate financial disintermediation; and

– the impact due to structural changes in (banks’) balance sheets


New developments in emerging-market economies


http://www.bis.org/publ/bppdf/bispap35a.pdfhttp://www.bis.org/publ/bppdf/bispap35a.pdfhttp://www.bis.org/publ/bppdf/bispap35a.pdfhttp://www.bis.org/publ/bppdf/bispap35a.pdfhttp://www.bis.org/publ/bppdf/bispap35a.pdfhttp://www.bis.org/publ/bppdf/bispap35a.pdf


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• The implications of the greatly increased proportion of bank

lending to households include:

– a magnification of the intertemporal substitution effects of monetarypolicy;

– potential wealth effects from monetary policy, particularly through the

housing market; and – cash-flow effects of monetary policy on consumption and residential

investment, in the sense that high interest rates impose a cash-flowconstraint on prospective borrowers


Intertemporal substitution: new developments (1)



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• Corporate balance sheets and the monetary transmission

mechanism:

– the impact of monetary policy on non-residential investmentdepends in part on the balance sheet position of corporates (throughthe ‘financial accelerator’ described in Bernanke et al. (1999))

• Potential indicators of trends in corporate balance sheetvulnerabilities include net worth (the ratio of net assets toincome), the ratio of debts to assets (‘leverage’) and the ratio ofnet interest payments to income





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• Implications of changes in bank balance sheets:

– the relaxation of resource constraints on banks reduces non-price

related distortions on credit supply and may reduce the importance

of the bank lending channel…

– …but changes in banks’ balance sheets may affect their exposure to

market risks and changes in monetary policy could thus aggravatesuch exposures

– another major source of exposure to monetary policy shocks could

arise from the investment portfolio of banks (which could well have

financial accelerator effects again)





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• Monetary policy needs to take into consideration banks’

exposures to currency mismatches and the risk of a run on dollar

deposits in the banking system

• Even with macro-prudential measures to control some of these

risks, exchange rate intervention to smooth currency fluctuations

may have unwanted effects


The transmission mechanism and ‘dollarisation’ (1)



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• Tighter monetary policy on its own will tend to accelerate the

short-run impact on inflation and could generate additional

adverse output effects through the exchange rate channel

• But when combined with exchange market intervention, the

inflation and output effects of monetary tightening are longer-

lasting and more effective





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• Yet, excessive foreign exchange intervention runs the risk that

people do not internalise the risks of denominating their debts in

foreign currencies

• This is because resisting exchange-rate appreciation does not

discourage – and may even encourage, by preventing the

emergence of two-way risks and leading to one-way bets in local

currency markets – an upsurge in speculative net portfolio flows





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• The balance of factors of the effect of banking sector

consolidation (mergers and acquisitions or foreign ownership) on

monetary policy transmission is uncertain:

– a few large banks may dominate the banking market, which could

reduce and lower the pass-through to the policy rate to bank deposit

and lending rates; or – bank consolidation could increase the effectiveness of the interest

rate channel if it increases efficiency, reduces transaction costs and

speed up information processing


Banking sector consolidation



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• In the past, government intervention in the financial system

affected the monetary transmission process in at least three

ways:

– by imposing interest rate controls or other limits on financial market

prices;

– by imposing direct limits on bank lending; or

– by providing government-financed credit to selected areas


Government intervention



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• The most recent channel to be identified is the risk taking

channel (Bernanke and Kuttner (2005), Borio and Zhu (2008),

Adrian and Shin (2009) and Gambacorta (2009)):

– an easy monetary policy (i.e., low interest rates) may give rise to

‘expected excess return’ by reducing the riskiness of stocks (for

instance, by improving the balance sheet position of firms) as well asincreasing investors’ willingness to bear risk (for instance, by

increasing expected future income)


The risk taking channel (1)


http://www.bis.org/publ/work268.pdfhttp://www.newyorkfed.org/research/staff_reports/sr398.pdfhttp://www.bis.org/publ/qtrpdf/r_qt0912f.pdfhttp://www.bis.org/publ/qtrpdf/r_qt0912f.pdfhttp://www.bis.org/publ/qtrpdf/r_qt0912f.pdfhttp://www.bis.org/publ/qtrpdf/r_qt0912f.pdfhttp://www.newyorkfed.org/research/staff_reports/sr398.pdfhttp://www.bis.org/publ/work268.pdfhttp://www.bis.org/publ/work268.pdfhttp://www.bis.org/publ/work268.pdf


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• In a nutshell, monetary policy may influence banks’ perceptions

of, and attitudes towards, risk in at least two ways:

– through a search for yield process, especially in the case of nominal

return targets; and

– by means of the impact of interest rates on valuations, incomes and

cash flows, which in turn can modify how banks measure risk


The risk taking channel (2)



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• Developments in financial markets can affect both banks’ ability

and willingness to lend and companies’ ability to raise funds in

the capital markets…

• …which, in turn, will affect the consumption and investment

decisions of households and businesses

• Endogenous changes in creditworthiness may increase the

persistence and amplitude of business cycles (the financial

accelerator ) and strengthen the influence of monetary policy (the

credit channel)


Summary (1)



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• These channels complement the traditional interest rate channel

• The different channels of the monetary transmission mechanism

are not mutually exclusive…

• …and the economy’s overall response to monetary policy will

incorporate the impact of a variety of channels

• But monetary policy appears to have less of an impact on real

activity than it once had – although the causes of that change

remain an open issue


Summary (2)



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• The transmission mechanism is important

• We need to know the structure of the economy – i.e., what is the

relevant transmission mechanism (in different countries)?

• The channels of transmission continue to change as the

economy evolves – central banks therefore need to be alert to

the implications of such changes and calibrate their policy

responses to macroeconomic developments

• The uncertainty of the impact of any policy change increases the

importance of having a credible and transparent monetary policy

regime


Conclusions



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Adrian, T and Shin, H S (2009), ‘Financial intermediaries and

monetary economics’, Federal Reserve Bank of New York Staff

Reports No. 398 .

http://www.newyorkfed.org/research/staff_reports/sr398.pdf .

Bernanke, B S and Blinder, A S (1988), ‘Credit, money and

aggregate demand’, American Economic Review , Vol. 78, No. 2,pages 435-9.

Bernanke, B S and Gertler, M (1989), ‘Agency costs, net worth and

business fluctuations’, American Economic Review , Vol. 79, No.

1, pages 14-31.


References and further reading (1)


http://www.newyorkfed.org/research/staff_reports/sr398.pdfhttp://www.newyorkfed.org/research/staff_reports/sr398.pdfhttp://www.newyorkfed.org/research/staff_reports/sr398.pdf


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Bernanke, B S, Gertler, M and Gilchrist, S (1999), ‘The financial

accelerator in a quantitative business cycle framework’, in Taylor,

J B and Woodford, M (eds), Handbook of Macroeconomics, Vol.

1, No. 3, pages 1341-93.

Bernanke, B S and Kuttner, K N (2005), ‘ What explains the stock

market’s reaction to Federal Reserve policy?’, Journal ofFinance, Vol. 60, No. 3, pages 1221-57.

Borio, C and Zhu, H (2008), Capital regulation, risk-taking and

monetary policy: a missing link in the transmission mechanism?’,

BIS Working Paper No. 268 . http://www.bis.org/publ/work268.pdf .

Gambacorta, L (2009), ‘Monetary policy and the risk taking

channel’, BIS Quarterly Review , December, pages 43-53.

http://www.bis.org/publ/qtrpdf/r_qt0912f.pdf .




http://www.bis.org/publ/work268.pdfhttp://www.bis.org/publ/qtrpdf/r_qt0912f.pdfhttp://www.bis.org/publ/qtrpdf/r_qt0912f.pdfhttp://www.bis.org/publ/work268.pdf


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Goldman Sachs (2010), ‘A global look at the credit channel’, Global

Economics Weekly 10/44, 8 December.

Ireland, P N (2008), ‘The monetary transmission mechanism’ in

Blume, L E and Durlauf, S N (eds), The new Palgrave dictionary

of economics, second edition, London, Palgrave Macmillan.

Kuttner, K N and Mosser, P C (2002), ‘The monetary transmission

mechanism: some answers and further questions’, Federal

Reserve Bank of New York Economic Policy Review , Vol. 8, No.

1, pages 15-26.

http://www.newyorkfed.org/research/epr/02v08n1/0205kutt.pdf .

Mishkin, F S (1995), ‘Symposium on the monetary transmission

mechanism’, Journal of Economic Perspectives, Vol. 9, No. 4,

pages 3-10.




http://www.newyorkfed.org/research/epr/02v08n1/0205kutt.pdfhttp://www.newyorkfed.org/research/epr/02v08n1/0205kutt.pdf


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Mohanty, M S and Turner, P (2008), ‘Monetary policy transmissions

in emerging market economies: what is new?’, in Transmission

mechanisms for monetary policy in emerging market economies,

BIS Papers No. 35, pages 1-59.

http://www.bis.org/publ/bppdf/bispap35a.pdf .

The Monetary Policy Committee (1999), ‘The transmissionmechanism of monetary policy’.

http://www.bankofengland.co.uk/publications/Documents/other/m

onetary/montrans.pdf .

Tobin, J (1969), ‘A general equilibrium approach to monetary

theory’, Journal of Money, Credit, and Banking , Vol. 1, No. 1,pages 15-29.



http://www.bis.org/publ/bppdf/bispap35a.pdfhttp://www.bankofengland.co.uk/publications/Documents/other/monetary/montrans.pdfhttp://www.bankofengland.co.uk/publications/Documents/other/monetary/montrans.pdfhttp://www.bankofengland.co.uk/publications/Documents/other/monetary/montrans.pdfhttp://www.bankofengland.co.uk/publications/Documents/other/monetary/montrans.pdfhttp://www.bis.org/publ/bppdf/bispap35a.pdf

The Monetary Transmission Mechanism - Bank of England 2012

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