Monetary Policy - transmission mechanisms

What does monetary transmission mechanism?

Describes channels through which a change in monetary policy influences economic activity.

What kind of channels can we name?

market interest rates; expectations/confidence; balance sheets; other asset prices –exchange rate, share prices, house prices

What is interest rate channel?

Primary mechanism at work in traditional Keynesian models and contemporary macroeconomic models

What interest rate channel requires?

Requires some degree of price stickiness so that decrease in nominal interest rates translates into lower real interest rates across the yield curve

What is exchange rate channel?

Lower domestic interest rate requires domestic currency to appreciate over time to rule out arbitrage opportunities

What is the main rule in exchange rate channel?

Expected future appreciation requires an initial depreciation of the currency (e rises, where e is defined as domestic currency units per foreign currency unit).

What is changing with export in exchange rate channel?

With sticky prices, domestically produced goods become cheaper than foreign-produced goods, resulting in a rise in net exports.

What is q in Tobin's q theory of investment?

q = market value of firm / replacement cost of capita

How do we interpret q?

If q is high, firms can buy a lot of new investment goods with only a small issue of equity. Hence investment rises.

In equity price channel what happens with interest rates?

Lower interest rates raise value of equities because any given expected income stream is discounted at a lower rate which raises its value. This raises q and investment.

What increases higher share prices?

Higher share prices increase the financial wealth of households, so their lifetime resources are higher

What would predict life-cycle hypothesis?

The life-cycle hypothesis or permanent income hypothesis would predict that households will spend more.

What improves balance sheet?

Lower interest rates reduce payments to service debt. They also increase the capitalisedvalue of a firm’s long-lived assets. Both cause balance sheets to improve

When cost of credits fall?

In presence of financial market imperfections, the cost of credit to firms and households falls when the strength of their balance sheets improve

What does lower interest rates do?

Lower interest rates also reduce risk that borrowers will be unable to pay back their loans. Banks may increase lending.

How household changes affected by monetary policy?

change in interest rates affects disposable income as well as incentive to save/consume now; Second, financial wealth changes; Third, any exchange rate adjustment changes the relative prices of goods and services priced in domestic and foreign currency; Higher interest rates generally imply lower consumption

How firms changes affected by monetary policy?

First, higher interest rates worsen financial position of firms dependent on short-term borrowing; Second, by altering required rates of return, higher interest rates encourage postponement of investment; Third, policy changes may change firms’ expectations about future course of economy, and confidence with which those expectations are held; Higher interest rates generally imply lower investment and employment

Anticipation vs monetary policy?

Also possible that effects will be dampened if economic agents expect a monetary policy response. Policy actions will differ in their qualitative effects depending on whether these actions are anticipated or unanticipated