The Transmission Mechanism of Monetary Policy

Summary

This chapter examines the various channels whereby monetary policy may influence expenditure decisions. We begin with the standard Keynesian IS/LM paradigm in which shifts in the money stock cause changes in interest rates in a widening circle of financial markets starting with short-term money markets and extending to long-term bond and foreign-exchange markets. In turn, such changes in financial conditions then affect expenditures. Most large-scale (Keynesian) macro-economic models retain this basic transmission mechanism.

Having briefly recapitulated the IS/LM framework in Section 1(i), we then examine (in Section 1 (ii)) how it can be related to the wider and more general portfolio adjustment models of the form used as an analytical aid in earlier chapters. Not only is the IS/LM model highly simplified, with an extreme degree of aggregation over both sectors and assets, but also the model constrains and limits the range of relationships that are treated. The paths along which substitution between assets is allowed to occur are thus unduly limited, being restricted to a single route from money to bonds and from bonds to real assets. Second, wealth effects are ignored; yet, the positions of the IS/LM curves depend on the level of wealth and changes in the variables in the model will alter wealth.

Within the framework of the IS/LM model, the potency of monetary policy depends on the relative magnitude of the interest elasticity of the demand for money, already reviewed in Chapters 3 and 4, as compared with the interest elasticity of the demand for goods. Estimates of the latter are examined in Section 1(iii) using two recent surveys emanating from the Bank of England and the Federal Reserve Bank of New York for the UK and USA respectively. Apart from the transmission route via the exchange rate, the calculated interest elasticities appear to be quite low, especially in the short run.

Such findings of low interest elasticities of expenditures (i.e., a steep IS curve) formed the centrepiece of Keynesian scepticism of the power of monetary policy. So, we next turn to examine the monetarist counter-offensive in Section 2. Although monetarists did confront Keynesians (initially successfully) over the subject of the stability of the demand for money function, they did not directly challenge the findings of low interest elasticities in expenditure functions. Instead, they argued — I believe correctly — that Keynesians had artificially and wrongly limited the width of the channels whereby monetary shocks might work through to the economy as a whole. A monetary disturbance, monetarists claim, would not just initially affect prices and yields in money markets but would have a much more generalised effect on assets and expenditures. This more general relationship was evidenced and supported by the (econometric) relationship between monetary stimuli and changes in nominal incomes. Such reduced-form studies led to a lengthy discussion and literature on the nature of statistical causality, reverse causation, etc. which has more recently died down, partly with the worsening instability of demand for money functions, partly with the shift in theoretical interest to the rational expectations — perfect clearing market neo-classical paradigm.

A problem with the monetarist approach is that the finding of long lags in the demand for money function, which should cause the arguments in that function to overshoot initially in response to a money supply shock, appeared to conflict with the empirical finding of lengthy lags between monetary stimuli and changes in prices and output. Neo-classicists provided one possible resolution with their distinction between anticipated monetary shocks (implying immediate price adjustment) and unanticipated shocks (slower output and price responses). This explanation, however, presupposes perfectly flexible markets. In the absence of such perfect markets, an alternative explanation of the findings about the dynamic adjustment of the system is that, in the short-run, agents allow their money holdings to respond passively, within some limits, to monetary shocks, a ‘buffer stock’ mechanism. This is discussed in Section 3. We indicate how such buffer-stock adjustment mechanisms can be modelled. A problem with this approach is that some large well-known agents — e.g., the public sector and large companies — can always borrow additional funds on very fine terms. In their case, money balances will not necessarily serve as a buffer and some other set of assets (e.g., net liquid assets) may be more appropriate. This leads on to the conclusion that it is market imperfections that give ‘money’ its strategic importance within the economic system.

We take this insight, that it is the existence of market imperfections that gives certain assets, which form a part of total wealth, their particular importance over into Section 4, where we consider wealth effects. A change in the real value of the National Debt (e.g., caused by a fall in the price level) thus does not really represent a change in wealth since we owe the debt to ourselves, and will have to repay it in future taxation, the Ricardian Equivalence Theorem. On the other hand, the change may allow for a relaxation of certain constraints on agents’ choice and behaviour (e.g., non-negativity of bequests and capital market imperfections). The issue of whether an increase in the real value of outside money balances represents an enhancement of wealth is more difficult since there are no interest payments to make. Even so, in a perfect information — perfect market context, any shock to real balances would become immediately exhausted in price adjustments, so once again any real changes deriving from nominal monetary shocks find their origins in some kind of market imperfection.