Monetary Policy and Interest Rates

• Transmission mechanisms of monetary policy affect aggregate demand and the larger economy.

Traditional Interest-Rate Channels

• The effect of easing monetary policy lowers the real interest rate: r↓ → I↑ → Yad ↑
• Real interest rate (not nominal) affects consumer and business decisions.
• Real long-term interest rates (not short-term) have major impact on spending.
• Expectations hypothesis suggests a lower real short-term interest rate leads to a fall in the real long-term interest rate, as long as it is expected to persist.
• Lower real interest rates increases business fixed investment, residential housing investment, inventory investment, and consumer durable expenditure, leading to rise in aggregate demand.
• Monetary policy can still be effective even when nominal interest rates are at zero.
  • During financial crises, central banks keep overnight interest rates at or near zero for extended periods.
  • The intention is to prevent inflation expectations from falling, ensuring real interest rates stay low.

Other Asset Price Channels

• Exchange Rate Effects on Net Exports:
  • Exchange rates are affected by interest rates.
    • Domestic real rates fall, domestic dollar assets become less attractive, dollar depreciates.
  • Lower value of domestic currency makes domestic goods cheaper than foreign goods.
  • Net exports rise, aggregate demand rises as well.
• Tobin's q Theory:
  • Monetary policy effects on the economy are mediated by the valuation of equities (stock).
    • q is the market value of firms divided by the replacement cost of capital.
    • If q is high, new capital is cheap relative to the market value of firms.
    • If q is low, firms will not purchase new investment goods because the market value of firms is low relative to the cost of capital
• Link: r↓ → Ps↑ → q↑ → I↑ → Yad ↑
• Wealth Effects:
  • Consumption is spending by consumers on nondurable goods and services
  • Consumers' lifetime resources include financial wealth, largely common stocks.
  • Rising stock prices boosts value of financial wealth, increasing lifetime resources of consumers, leading to a rise in aggregate demand.

Credit View

• The Credit View is based on asymmetric information which leads to financial frictions in financial markets.
• Monetary transmission channels arise as a result of financial frictions in credit markets.
  • This operates through effects on bank lending
  • This operates through effects on firms' and households' balance sheets
• Bank Lending Channel:
  • Banks solve asymmetric information issues.
  • Expansionary monetary policy increases bank reserves and deposits, raising available bank loans.
    • The increase in loans causes investment and consumer spending to rise.
• Balance Sheet Channel:
  • Easing monetary policy raises stock prices, therefore raising net worth of firms.
  • Higher investment spending and higher AD are caused by a decrease in adverse selection and moral hazard.
• Cash Flow Channel:
  • Easing monetary policy lowers nominal interest rates, improving firms' balance sheets because it raises cash flow.
    • Increased cash flow increases liquidity of firm or household, making it easier for lenders to assess ability to pay bills.
  • Reduced adverse selection/moral hazard increases lending and economic activity.
• Unanticipated Price Level Channel:
  • Unanticipated rise in price level raises real net worth, lowering adverse selection and moral hazard.
• Household Liquidity Effects:
  • Consumer durable and housing assets lead to monetary easing, lowering interest rates and leads to rise in spending on consumer durables and housing.
  • Increase in consumer cash flow decreases likelihood of financial distress, increasing desire to accumulate durable goods/housing, increasing spending/aggregate demand.

Why Credit Channels Are Likely To Be Important

• Financial frictions crucial to the operation of credit channels affect firms' employment/spending decisions.
• Small firms (credit-constrained) are hurt more by tight monetary policy than large firms.
• Asymmetric information assists in explaining many important phenomena.

FYI: Consumers' Balance Sheets and the Great Depression

• The US saw worst deterioration in consumers' balance sheets between 1929 and 1933
• The level of real debt consumers owed also increased sharply (by over 20%) due to the decline in the price level.
• The value of financial assets relative to the amount of debt declined sharply, increasing the likelihood of financial distress.
• Spending on consumer durables and housing fell precipitously.

Application: The Great Recession

• The Fed began easing monetary policy in the summer of 2007 when financial crises arose.
• At first, it appeared that the Fed's actions would keep the growth slowdown mild and prevent a recession
• Beginning in December of 2007, the US faced the most severe recession in the post-war period
• The subprime meltdown led to negative effects on the economy from various channels
• The rising level of subprime mortgage defaults led to a decline in the value of mortgage-backed securities and CDOs, leading to large losses on the balance sheets of financial institutions
• Financial institutions began to deleverage and cut back on their lending
• Adverse selection and moral hazard problems led to a slowdown of the economy

Lessons for Monetary Policy

• Four Basic Lessons:
  • It is dangerous always to associate the easing or the tightening of monetary policy with a fall or a rise in short-term nominal interest rates
  • Other asset prices besides those on short-term debt instruments contain important information about the stance of monetary policy because they are important elements in various monetary policy transmission mechanisms
  • Monetary policy can be effective in reviving a weak economy even if short-term interest rates are already near zero
  • Avoiding unanticipated fluctuations in the price level is an important objective of monetary policy, thus providing a rationale for price stability as the primary long-run goal of monetary policy

Application: Applying the Monetary Policy Lessons to Japan

• Think of declines in interest rates as being dangerous because monetary policy has been easing
• Monetary policymakers should pay attention to other asset prices in assessing the stance of monetary policy
• Monetary policy can still be effective even if short-term interest rates are near zero
• Avoiding unanticipated fluctuations in the price level is an important objective