Macpherson
4/25/2001
Chapter David 25: Transmission Mechanisms of Monetary Policy: The Evidence
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1. Framework for Evaluating Empirical Evidence
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Types of Models
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Structural models
Keynesian models examine channels which money supply effects output. x Diagram
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Reduced form models
Monetarist models examine directly the relationship between the money supply and output. x Diagram
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Chapter 25 1
David Macpherson
4/25/2001
Advantages of Structural Models
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Provides more pieces of evidence about money's effect on economic activity. May help us more accurately predict the effect that money has on economic activity. May allow economists to more accurately predict the impact of institutional changes on the link between money and income.
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Monetarist Criticisms of Structural Models
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May not know correct structure of the model. The channels of influence in Keynesian models are too narrowly defined understating the effect of the money supply.
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Evaluation of Reduced Form Models
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Advantage
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Best model if the channels through which the money supply affects output are diverse and continually changing.
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Keynesian criticisms
Reverse causation - "correlation does not necessarily imply causation." x Third factor could be driving money supply and output.
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Chapter 25 2
David Macpherson
4/25/2001
2. Early Keynesian Evidence on the Importance of Money
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Evidence for No Effect of Money Supply on Output
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Interest rates 3-month t-bills fell to very low levels in the Great Depression. Early studies found no link between interest rates and investment spending. Surveys found decisions to purchase physical capital were not affected by interest rates.
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Objections to Early Keynesian Evidence
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Interest rates on higher risk securities rose to unprecedented high levels in great depression. Prices fell in the Great Depression, causing real interest rates to unprecedented high real levels. Weak link between nominal interest rates and investment spending does not imply monetary policy ineffectiveness since it may affect output through many channels.
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Chapter 25 3
David Macpherson
4/25/2001
3. Early Monetarist Evidence on the Importance of Money
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Timing Evidence
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Friedman and Schwartz found that the rate of money growth fell prior to every business downturn they studied.
Only evidence valid that money supply change is exogenous x Money supply could be lagging output not leading output.
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Statistical Evidence
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Friedman and Meiselman found that the money supply was more high correlated with output than government and investment spending
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They used only 1 equation and did not construction spending variable carefully.
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Chapter 25 4
David Macpherson
4/25/2001
Historical Evidence
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Exogenous increase in reserve requirements in 1936-37 caused lower money supply and output. This is the best evidence supporting monetarist argument on the importance of money.
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5. Transmission Mechanisms of Monetary Policy
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Traditional Interest Rate Channels
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Traditional Keynesian view
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M ir I Y
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Interest rates also affect consumer durable spending and also residental housing spending. Real interest rate affects spending and not the nominal rate
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Chapter 25 5
David Macpherson
4/25/2001
Other Asset Price Channels
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Exchange rate effects
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M ir E NX Y
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Tobins q theory
q = market value of firms replacement cost of capital x If q is high, then firms can issue stock and issue proceeds to buy capital at a low cost x M Stock prices q I Y
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Wealth effects
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M Stock prices Wealth Consumption Y
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Credit View
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Bank lending channel
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M bank deposits bank loans I Y M stock prices adverse selection and moral ha...