The Monetary Transmission Mechanism

The monetary transmission mechanism
Ole Rummel
CCBS, bank of England
ole.rummel@bankofengland.co.uk
18 July 2012
Outline
What is the transmission mechanism?
Different channels of transmission:
the old view - interest rate, exchange rate and asset price channels;
the new view credit market frictions and their consequences; and
new developments in the transmission mechanism for emerging
market economies
Dollarisation, banking sector consolidation and government

intervention
The risk taking channel
Summary and conclusions
Monetary transmission channels, liquidity conditions and determinants of inflation
How powerful is a central bank really?

The Feds direct power over the economy is actually more limited
than is widely appreciated. People often say that the Fed
controls interest rates, but what it actually controls is only an
interest rate, the rate in the overnight federal funds market. And
the interest rate is, in itself, of very little economic importance.
Paul Krugman, New York Times, 14 December 2001
Definition of the monetary transmission mechanism

How changes in the monetary policy variable affect inflation and
output
We are interested in:
the channels (economic relationships) of the monetary
transmission mechanism;
how quickly they work;
how reliably they work; and
how large the effects are
The old view: the interest rate channel

The traditional textbook (Keynesian) channel is known as the
interest rate or the intertemporal substitution channel:
(M ) i
C (I)
Yd
y
Expanding money (M) reduces interest rates (i), reduces the

cost of borrowing for firms (and consumers), leads to increased
consumption (C) as well as investment (I) and therefore higher
demand (Yd), a bigger output gap (y) and finally higher prices and
inflation ()
The interest rate channel and policy responses

But Bernanke and Gertler (1989) pointed out that the
macroeconomic response to policy-induced interest rate changes
was considerably larger than implied by conventional estimates
of interest elasticities of consumption and investment
This suggests that mechanisms other than the interest rate
channel may also be at work in the transmission of monetary
policy
Source: Kuttner and Mosser (2002).

The exchange rate channel: net exports

The exchange-rate channel:
i
e
NX
y
Lower interest rates (i) lead to a depreciation of the exchange

rate (e), an increase in competitiveness, an improved trade
balance (due to higher net exports, NX) and increased demand,
a larger output gap and finally higher inflation
Moreover
The exchange rate channel: import prices

i
e
Pm
An exchange rate (e) depreciation also raises import prices (Pm),

which are important determinants of firms costs and the retail
price of many goods and services: this directly affects the price
level and (temporarily) inflation
An appreciation should reduce inflation (with a longer lag if prices
are sticky on the downside)
The exchange rate channel: net wealth

i
e
NW
y
An exchange rate depreciation increases the relative value of

foreign-denominated assets and liabilities and therefore net
wealth (NW), affecting demand
The sign of the effect depends on the make-up of balance sheets
Other asset price effects

Changes in interest rates have a direct effect on the valuation of
financial assets and their expected returns
For example, lower interest rates increase the present value of
future income flows (or the cost of finance for assets) and
therefore asset prices
This may have no direct impact on inflation if asset prices are
excluded from the CPI basket...
...but it may raise (total) wealth which will affect demand
Other asset price effects: investment (Tobins q)

The investment channel (Tobins q):
i
Pe
q
I
y
Consider two ways of increasing the size of a firm:

buy another firm (and acquire old capital); or
invest in new capital
The ratio of the market value of a firm to the replacement cost of

its assets is known as Tobins q
Tobin (1969) argued that a firm should invest in new buildings
and equipment if the stock market will value the project at more
than its cost (that is, if the project's q is greater than 1)
Increased equity prices (Pe) mean that new investment projects
have become relatively cheaper to finance and therefore more
attractive
Other asset price effects: consumption

Other asset price effects: consumption
i
Pe
TW
C
y
The permanent income hypothesis postulates that consumers

spending is related to (total) wealth
Increased wealth (as a result of higher equity prices, Pe, say) if
it is perceived to be permanent leads to a (much smaller)
increase in (desired) consumption
Other asset price effects: housing wealth

Other asset price effects: housing wealth
i
Ph
TW?
C
y
Increased house prices (Ph) are often associated with increased

private consumption in the UK/US
Why?
housing wealth represent greater wealth for some (but for the
economy as a whole?);
housing wealth increases available collateral and therefore reduces
credit constraints; and
people may be more likely to change house or spend on
improvements/consumer durables (in a process called mortgage
equity withdrawal)
How do interest rates affect expectations?

An increase in short-term interest rates has an ambiguous effect
on longer-term interest rates
Expectations are all about how monetary policy changes are
interpreted as an indicator of future short rates
Interest-rate changes affect consumer confidence, cause firms to
revise spending plans and affect asset values in financial
markets (risk premia)
Credit market frictions

Financial markets do not always work perfectly
We generally assume that the effects of monetary policy work
through interest rates and that firms and individuals can borrow
freely at the quoted interest rate
In practice, most individuals and many firms can borrow only
from banks
and banks often turn down potential borrowers, despite their
willingness to pay the posted interest rate
Why does that happen and how does it affect our view of how
monetary policy works?
A new view: the role of banks in financial markets

Asymmetric information and costly enforcement of financial
contracts create principal-agent problems in financial markets
Banks play a special role in the financial system because they
are well suited to deal with certain types of borrowers, especially
small firms and private individuals, where the problems of
asymmetric information can be especially pronounced
The role of banks and the credit channel

The credit channel holds that monetary policy has additional
effects because interest-rate decisions by the central bank affect
the cost and availability of credit by more than would be implied
by the associated movement in risk-free interest rates
Two forms of the credit channel

Two basic channels of monetary transmission arise in the credit
channel as a result of principal-agent problems in credit markets:
the bank lending channel, also know as the narrow credit channel;
and
the balance sheet channel, also known as the broad credit
channel
The balance sheet or broad credit channel (1)

Asset values play an important role in the broad credit or
balance sheet channel developed by Bernanke and Gertler
(1989)
In the broad credit channel, asset prices are especially important
in that they determine the value of the collateral that firms and
individuals will have to present when obtaining a loan
The balance sheet or broad credit channel (2)

In frictionless credit markets, a fall in the value of borrowers
collateral will not affect investment decisions by the bank (due to
the Modigliani-Miller theorem)
but in the presence of information or agency costs, declining
collateral values will increase the premium borrowers must pay
for external finance, which in turn will reduce consumption and
investment
The bank lending or narrow credit channel (1)

The narrow credit or bank lending channel also relies on credit
market frictions, but banks play a more central role (Bernanke
and Blinder (1988))
Banks play a special role in the economy not just by issuing
liabilities bank deposits that contribute to the broad monetary
aggregates, but also by holding assets bank loans with few
close substitutes

Because banks rely on reservable demand deposits as an
important source of funds, contractionary monetary policy which
reduces the aggregate volume of bank reserves will reduce the
availability of bank loans
in consequence, because a significant number of firms and
households rely heavily (or exclusively) on bank financing, a
reduction in loan supply will depress aggregate spending

Theory suggests that two key conditions must be satisfied for the
bank lending channel to operate:
the first essential element is that banks should not be able to fully
shield their loan portfolios from changes in monetary policy;
the presumption is that banks cannot offset completely the decline
in liquid funds due to restrictive monetary policy by resorting to
alternative sources of funding without incurring additional costs; and
as a result, banks reduce their loan supply

Theory suggests that two key conditions must be satisfied for the
bank lending channel to operate:
the second crucial element is that there is a substantial group of
borrowers, firms or consumers that cannot insulate their spending
from the reduction in bank credit; and
this, in turn, can depress real investment and consumption
New developments in emerging-market economies

The traditional intertemporal substitution channel in emerging
markets may have been modified due to recent changes in the
balance-sheet position of the private sector (Mohanty and Turner
(2008)):
changes in household balance sheets implied by the growth in
household credit;
changes in the response of investment to monetary policy changes
as a result of corporate financial disintermediation; and
the impact due to structural changes in (banks) balance sheets
Intertemporal substitution: new developments (1)

The implications of the greatly increased proportion of bank
lending to households include:
a magnification of the intertemporal substitution effects of monetary
policy;
potential wealth effects from monetary policy, particularly through the
housing market; and
cash-flow effects of monetary policy on consumption and residential
investment, in the sense that high interest rates impose a cash-flow
constraint on prospective borrowers

Corporate balance sheets and the monetary transmission
mechanism:
the impact of monetary policy on non-residential investment
depends in part on the balance sheet position of corporates (through
the financial accelerator described in Bernanke et al. (1999))
Potential indicators of trends in corporate balance sheet

vulnerabilities include net worth (the ratio of net assets to
income), the ratio of debts to assets (leverage) and the ratio of
net interest payments to income

Implications of changes in bank balance sheets:
the relaxation of resource constraints on banks reduces non-price
related distortions on credit supply and may reduce the importance
of the bank lending channel
but changes in banks balance sheets may affect their exposure to
market risks and changes in monetary policy could thus aggravate
such exposures
another major source of exposure to monetary policy shocks could
arise from the investment portfolio of banks (which could well have
financial accelerator effects again)
The transmission mechanism and dollarisation (1)

Monetary policy needs to take into consideration banks
exposures to currency mismatches and the risk of a run on dollar
deposits in the banking system
Even with macro-prudential measures to control some of these
risks, exchange rate intervention to smooth currency fluctuations
may have unwanted effects

Tighter monetary policy on its own will tend to accelerate the
short-run impact on inflation and could generate additional
adverse output effects through the exchange rate channel
But when combined with exchange market intervention, the
inflation and output effects of monetary tightening are longerlasting and more effective

Yet, excessive foreign exchange intervention runs the risk that
people do not internalise the risks of denominating their debts in
foreign currencies
This is because resisting exchange-rate appreciation does not
discourage and may even encourage, by preventing the
emergence of two-way risks and leading to one-way bets in local
currency markets an upsurge in speculative net portfolio flows
Banking sector consolidation

The balance of factors of the effect of banking sector
consolidation (mergers and acquisitions or foreign ownership) on
monetary policy transmission is uncertain:
a few large banks may dominate the banking market, which could
reduce and lower the pass-through to the policy rate to bank deposit
and lending rates; or
bank consolidation could increase the effectiveness of the interest
rate channel if it increases efficiency, reduces transaction costs and
speed up information processing
Government intervention
In the past, government intervention in the financial system
affected the monetary transmission process in at least three
ways:
by imposing interest rate controls or other limits on financial market
prices;
by imposing direct limits on bank lending; or
by providing government-financed credit to selected areas
The risk taking channel (1)

The most recent channel to be identified is the risk taking
channel (Bernanke and Kuttner (2005), Borio and Zhu (2008),
Adrian and Shin (2009) and Gambacorta (2009)):
an easy monetary policy (i.e., low interest rates) may give rise to
expected excess return by reducing the riskiness of stocks (for
instance, by improving the balance sheet position of firms) as well as
increasing investors willingness to bear risk (for instance, by
increasing expected future income)
The risk taking channel (2)

In a nutshell, monetary policy may influence banks perceptions
of, and attitudes towards, risk in at least two ways:
through a search for yield process, especially in the case of nominal
return targets; and
by means of the impact of interest rates on valuations, incomes and
cash flows, which in turn can modify how banks measure risk
Summary (1)
Developments in financial markets can affect both banks ability
and willingness to lend and companies ability to raise funds in
the capital markets
which, in turn, will affect the consumption and investment
decisions of households and businesses
Endogenous changes in creditworthiness may increase the
persistence and amplitude of business cycles (the financial
accelerator) and strengthen the influence of monetary policy (the
credit channel)
Summary (2)
These channels complement the traditional interest rate channel
The different channels of the monetary transmission mechanism
are not mutually exclusive
and the economys overall response to monetary policy will
incorporate the impact of a variety of channels
But monetary policy appears to have less of an impact on real
activity than it once had although the causes of that change
remain an open issue
Conclusions
The transmission mechanism is important
We need to know the structure of the economy i.e., what is the
relevant transmission mechanism (in different countries)?
The channels of transmission continue to change as the
economy evolves central banks therefore need to be alert to
the implications of such changes and calibrate their policy
responses to macroeconomic developments
The uncertainty of the impact of any policy change increases the
importance of having a credible and transparent monetary policy
regime
References and further reading (1)

Adrian, T and Shin, H S (2009), Financial intermediaries and
monetary economics, Federal Reserve Bank of New York Staff
Reports No. 398.
http://www.newyorkfed.org/research/staff_reports/sr398.pdf.
Bernanke, B S and Blinder, A S (1988), Credit, money and
aggregate demand, American Economic Review, Vol. 78, No. 2,
pages 435-9.
Bernanke, B S and Gertler, M (1989), Agency costs, net worth and
business fluctuations, American Economic Review, Vol. 79, No.
1, pages 14-31.

Bernanke, B S, Gertler, M and Gilchrist, S (1999), The financial
accelerator in a quantitative business cycle framework, in Taylor,
J B and Woodford, M (eds), Handbook of Macroeconomics, Vol.
1, No. 3, pages 1341-93.
Bernanke, B S and Kuttner, K N (2005), What explains the stock
markets reaction to Federal Reserve policy?, Journal of
Finance, Vol. 60, No. 3, pages 1221-57.
Borio, C and Zhu, H (2008), Capital regulation, risk-taking and
monetary policy: a missing link in the transmission mechanism?,
BIS Working Paper No. 268. http://www.bis.org/publ/work268.pdf.
Gambacorta, L (2009), Monetary policy and the risk taking
channel, BIS Quarterly Review, December, pages 43-53.
http://www.bis.org/publ/qtrpdf/r_qt0912f.pdf.

Goldman Sachs (2010), A global look at the credit channel, Global
Economics Weekly 10/44, 8 December.
Ireland, P N (2008), The monetary transmission mechanism in
Blume, L E and Durlauf, S N (eds), The new Palgrave dictionary
of economics, second edition, London, Palgrave Macmillan.
Kuttner, K N and Mosser, P C (2002), The monetary transmission
mechanism: some answers and further questions, Federal
Reserve Bank of New York Economic Policy Review, Vol. 8, No.
1, pages 15-26.
http://www.newyorkfed.org/research/epr/02v08n1/0205kutt.pdf.
Mishkin, F S (1995), Symposium on the monetary transmission
mechanism, Journal of Economic Perspectives, Vol. 9, No. 4,
pages 3-10.

Mohanty, M S and Turner, P (2008), Monetary policy transmissions
in emerging market economies: what is new?, in Transmission
mechanisms for monetary policy in emerging market economies,
BIS Papers No. 35, pages 1-59.
http://www.bis.org/publ/bppdf/bispap35a.pdf.
The Monetary Policy Committee (1999), The transmission
mechanism of monetary policy.
http://www.bankofengland.co.uk/publications/Documents/other/m
onetary/montrans.pdf.
Tobin, J (1969), A general equilibrium approach to monetary
theory, Journal of Money, Credit, and Banking, Vol. 1, No. 1,
pages 15-29.

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The monetary transmission mechanism

Dollarisation, banking sector consolidation and government

Monetary transmission channels, liquidity conditions and determinants of inflation

The monetary transmission mechanism

How powerful is a central bank really?

Paul Krugman, New York Times, 14 December 2001

Monetary transmission channels, liquidity conditions and determinants of inflation

The monetary transmission mechanism

Definition of the monetary transmission mechanism

Monetary transmission channels, liquidity conditions and determinants of inflation

The monetary transmission mechanism

The old view: the interest rate channel

Expanding money (M) reduces interest rates (i), reduces the

Monetary transmission channels, liquidity conditions and determinants of inflation

The monetary transmission mechanism

The interest rate channel and policy responses

Monetary transmission channels, liquidity conditions and determinants of inflation

The monetary transmission mechanism

The monetary transmission mechanism

Source: Kuttner and Mosser (2002).

The monetary transmission mechanism

The exchange rate channel: net exports

Lower interest rates (i) lead to a depreciation of the exchange

Monetary transmission channels, liquidity conditions and determinants of inflation

The monetary transmission mechanism

The exchange rate channel: import prices

An exchange rate (e) depreciation also raises import prices (Pm),

Monetary transmission channels, liquidity conditions and determinants of inflation

The monetary transmission mechanism

The exchange rate channel: net wealth

An exchange rate depreciation increases the relative value of

Monetary transmission channels, liquidity conditions and determinants of inflation

The monetary transmission mechanism

Other asset price effects

Monetary transmission channels, liquidity conditions and determinants of inflation

The monetary transmission mechanism

Other asset price effects: investment (Tobins q)

Consider two ways of increasing the size of a firm:

The ratio of the market value of a firm to the replacement cost of

The monetary transmission mechanism

Other asset price effects: consumption

The permanent income hypothesis postulates that consumers

Monetary transmission channels, liquidity conditions and determinants of inflation

The monetary transmission mechanism

Other asset price effects: housing wealth

Increased house prices (Ph) are often associated with increased

Monetary transmission channels, liquidity conditions and determinants of inflation

The monetary transmission mechanism

How do interest rates affect expectations?

Monetary transmission channels, liquidity conditions and determinants of inflation

The monetary transmission mechanism

Credit market frictions

Monetary transmission channels, liquidity conditions and determinants of inflation

The monetary transmission mechanism

A new view: the role of banks in financial markets

Monetary transmission channels, liquidity conditions and determinants of inflation

The monetary transmission mechanism

The role of banks and the credit channel

Monetary transmission channels, liquidity conditions and determinants of inflation

The monetary transmission mechanism

Two forms of the credit channel

Monetary transmission channels, liquidity conditions and determinants of inflation

The monetary transmission mechanism