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Investment
The Behavior of Monetary Transmission Mechanism Channels
INTRO
This presentation is based on the article "How Has Monetary Transmission Mechanism Evolved Over Time?" by Jean Boivin, Michael T. Kelly, Frederic S. Mishkin
Monetary Policy: Expansionary & Contractionary
Money supply(OMO):
Interest Rate:
Monetary policy
Monetary transmission Mechanism & its channels
Financial markets are perfect.
Neoclassical Channels
Investment-Based, Consumption-Based & International trade-Based Channels
Involve Financial markets imperfections.
Non-neoclassical Channels
Credit supply from government interventions in credit markets, The Bank-Based & Balance-Sheet Channels
Changes in the channels
Why the Monetary Transmission Mechanism may have changed?
~Institutional changes in the Credit Markets.
~Changes in the ways expectations are formed.
Neoclassical
Neoclassical Channels
Perfect Financial Markets (perfect competition)
"Much of the traditional channels of monetary policy consumption we use today have been developed during the mid-20th century."
- key channels:
~Investment: direct interest rate channel operating through the user cost of capital & Tobin's q channel.
~Consumption: Wealth effects & intertemporal substitution effects.
~ International Trade: Exchange rate.
Investment Based Channels
The impact of interest rates on the user cost of capital is crucial to the fundamental understanding of monetary transmission.
These types of channels demonstrate that the user cost of capital is a key determinant of the demand for capital, whether it be investment goods, residential housing or consumer durables.
Direct Interest Rate Channels
Fed manipulates the economy by lowering interest rate.
Direct Interest Rate Channels
Rffr --- RLT--- Uc---- [ DI ---- AE ---- AD---- Y ---]
Tobin's q Theory
Tobin's q theory
James Tobin conceived the framework for Tobin's q. A theory that emphasizes a direct link between stock prices and investment spending. Essentially, q is defined as market value divided by replacement cost of capital. As q increases, so does the market price of companies in relation to the replacement cost of capital.
Consumption Based Channels
Life-Cycle Hypothesis of saving and consumption, the consumption spending of an individual is closely related to the lifetime resources of consumers(includes wealth such as stock, real-estate, and other assets).
Wealth Effects (Psychological effect)
The fed lowers the interest rate, future income from assets such as equity must be discounted at a lower rate than before as a result the owner feels richer and spend more.
Wealth Effects
Inter-temporal Substitution Effects
Inter-temporal Substitution Effect
This channel is central to the DSGE models as it influences the slope of the consumption profile. If the fed increases the interest rate, then today's consumption will decrease and consumers will save more, and vice versa.
Interest Rate:
C (today):
C(Future):
Inter-Trade
International-Trade Based Channels
-Exchange Rate Channel allow for monetary policy to be transmitted to the larger economy through its impact on the value of domestic currency
-Directly affect the aggregate expenditures and aggregate demand of countries by manipulating interest rates
-Expenditure Switching - attempts to switch the expenditure of domestic consumers away from imports toward domestic produced goods and services
What happens when the central bank lowers interest rate?
Interest Rate
Return on Domestic
Assets(relative to foreign assets)
Domestic Currency
Aggregated Demand
&
Net Export
Impact through the exchange rate channel
Inter-Trade
Two Factors:
1) Sensitivity of the exchange rate to interest rate movements
- Uncovered interest rate parity (UIP)- difference in interest rates between two countries is equal the expected change in exchange rates between those countries’ currencies
2) Openness of an economy
Non-Neoclassical Channels
Market imperfections
Nonneoclassical
~Effects on Credit Supply from Government Interventions in Credit Markets.
~Bank-based Channels.
~Balance Sheet Channel.
Government Intervention in Credit Markets
Credit Market
Why? The achievement of certain policy objectives
Ex. Encourage particular types of investment
US government intervention has been important in housing finance
The Supply of Credit to the Mortgage Market
Deregulation in the 1980s
Elimination of the deposit rate ceiings
Government intervention in the mortgage credit markets is no longer an important channel of monetary transmission
Mortgage Market
Pre-1980s
Regulations
-Thrift Institutions made long-term fixed rate mortgage loans
- Ceiling on the interest rates on deposits
If the Fed raised interest rates:
1. Contraction in net interest income for thrifts
- Higher short-term interest rates increased costs of funds
-Income from fixed rate mortages is slow to change
-Leads to weakening of thrifts balance sheets
2. Disintermediation
-Could lead to rates > deposit rate ceilings
-Depositors withdraw funds and opt for higher-yield securities
-Leads to restricted fund amounts
Result: Contraction in mortgage credit and in residential construction activity
Bank Lending Channel
What happens when credit issues arise?
Expansionary Monetary Policy
Bank based channels
Increase in Investment
Increase in Consumer Spending
Bank Capital Channel
Bank Capital Channel
What is the bank capital channel?
What happens when asset prices fall?
"Deleveraging" Process
Expansionary Monetary Policy
Balance Sheet Channel
Balance Sheet Channel
Bernanke and Gertler Model (1989)
- Monetary Contractions and Net Worth of Borrowers
Lending, Spending, AD
Company Asset Prices (Equity prices)
Higher R Higher R Pmt Fall in CF
Households
Higher house prices! + Other Assets
Efficiency in spending
Increase in house prices = sensitive consumer spending in "better-developed" mortgage markets
Factor-Augmented Vector Auto Regression
(FAVAR)
(1) Observable macroeconomic indicators
(2) Evolution of the co-movements among macroeconomic indicators
Change in Monetary Transmission
Xt - a potentially long vector of observed indicators of interest,
Ft - a vector of potentially unobserved variables governing the co-movements
et - a specific observational error and finally
ut - are innovations that are linear combinations of the structural macroeconomic shocks
Factor-Augmented Vector Auto Regression
(FAVAR)
(1) Observable macroeconomic indicators
(2) Evolution of the co-movements among macroeconomic indicators
Credit Market
Xt - a potentially long vector of observed indicators of interest,
Ft - a vector of potentially unobserved variables governing the co-movements
et - a specific observational error
ut - are innovations that are linear combinations of the structural macroeconomic shocks
- A change in the transmission of monetary policy means that some of the parameters of system (1) – (2)
How it works
- Those observed variables are relevant fundamental macroeconomic concepts, such as real activity, inflation and interest rate.
- Many studies find that over the last decade, real activity has become more responsive to monetary policy shocks on impact.
These include mainly real activity, price and interest rate measures, but also exchange rates, stock prices, and money and credit aggregates.
Results
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