Chapter Five

Central Banking and Monetary Policy

5.1. Functions, Structure and Independence of Central Banks
Central banks today are the most important feature of the financial systems of most countries of
the world. Some of functions of Central Banks are identical to the functions of regular,
commercial banks. Other functions are unique to the central bank. On certain functions it has an
absolute legal monopoly. Central Banks are the nation's principal monetary authority. It is the
entity responsible for overseeing the monetary system for a nation. Central banks have a wide
range of responsibilities - from overseeing monetary policy to implementing specific goals such
as currency stability, low inflation and full employment. Central banks also generally issue
currency, function as the bank of the government, regulate the credit system, oversee commercial
banks, manage exchange reserves and act as a lender of last resort.
i. Functions of a central bank are;
 Issue banknotes
 Serve as a Government's banker
 Serve as a bankers' of bank or "Lender of Last Resort"
 manages the country's foreign exchange and gold reserves and the Government's
stock register;
 Regulate and supervise of the banking industry
 Setting the official interest rate - used to manage both inflation and the country'
exchange rate - and ensuring that this rate takes effect via a variety of policy
mechanisms

ii. Central Bank Independence

The central bank is responsible to make the economy stable. But the policy makers and
politicians push the economy to run faster and further than its capacity limits allow; and the
temptation that governments have to incur budget deficits and fund these by borrowings from the
central bank. This leads to higher inflation and instability of the economy. Thus, the central bank
should be independent of the government. This independence makes the central bank to have
strong commitment to price stability, and the freedom to pursue it.

1|P a g e
Central banks with multiple goals have more independence, because they have extra dimensions
on which they must make decisions. Some would say that this gives the central bank more scope
for making mistakes and for downgrading the priority of price stability. But this need not be the
outcome. An independent central bank has no inherent reason to misuse the short-term trade-off,
provided the bank has a clear bank by legal independence. Central bank independence is
controversial. It requires the delegation of powerful authority to a group of unelected officials. In
a democracy, this strangeness naturally raises questions of legitimacy. It also raises fears of the
concentration of power in the hands of a select few. An independent central bank is a device to
overcome the problem of time consistency: the concern that policymakers will break a promise in
the future on a policy promise made today. Keeping inflation low and stable requires a credible
policy commitment to price stability that, be highly unpopular. When inflation rises, the central
bank must promptly raise interest rates. And, should deflation threaten and the policy rate hit the
zero bound, the central bank must respond by using its balance sheet flexibility. In this way, an
independent central bank improves economic performance: it can achieve a lower and more
stable inflation rate without sacrificing long-run economic growth.

For a central bank to serve as the lender of last resort, as leading central banks did in the recent
crisis, it must have some degree of independence. In particular, it must delay disclosure about the
recipients of its funds: otherwise, banks worried about being seen as fragile will not borrow,
perpetuating the financial system’s liquidity shortfall and the fear. At the same time, the central
bank must not lend to insolvent banks; otherwise, the stigma associated with borrowing will
discourage solvent, but illiquid banks, from seeking funds. Recent experience shows that all
these actions can trigger popular discontent. For legislatures, maintaining such unpopular
commitments is difficult when the benefits only arise over a horizon longer than an electoral
cycle. Not only that, but Congress has a difficult time resisting the temptation to raid the central
bank’s capital to meet shortfalls. Consequently, there is an unavoidable conflict between the
goals of democratic legitimacy and policy effectiveness. A legislature is legitimate by virtue of
its election, but it is not an effective place for making monetary or financial stability policy
decisions
While an independent central bank can make these decisions effectively, and can make credible
commitments, it requires a legal framework that establishes its authority. So, the designers of an
independent central bank must focus on how to make it politically legitimate without

2|P a g e
undermining its ability to make credible policy commitments. Before getting to the details, we
should be clear that one precondition for delegating monetary policy to an independent
institution is that policymakers’ actions do not have first-order distributional effects, transferring
income or wealth between groups in society. Granted, every central bank action affects relative
prices, so there will always be winners and losers. For example, interest rate changes transfer
wealth between borrowers and lenders. But it is widely believed that the primary impact of
interest rate changes is on macroeconomic quantities such as output, employment and the
aggregate price level, and that this impact is not principally a result of distributional shifts.

In a democracy, we typically assign policies that are purposely and predominantly distributional
to elected officials. Tax policies are not only about paying for public goods, but also about
discouraging certain activities and subsidizes others. Turning to some specifics, there are two
key elements of an effective design of an independent central bank: (1) a legislative mandate that
defines and limits the central bank’s goals and powers; (2) procedures that ensure transparency
and political accountability.

In a democratic society, even independent central banks do not set their own goals. In practice,
what they often do is interpret their legislative mandates in ways that help ensure their
accountability. For example, all central banks have price stability as a key goal of monetary
policy given to them by elected officials. Today, central banks in countries accounting for two
thirds of global GDP announce numerical inflation objectives based on specific price indices.
These are a device to operationalize the goal of price stability and allow the success or failure of
central bank policies to be easily observed. Independent central banks do have delegated
authority to achieve their legally mandated goals. That is, they have “instrument independence,”
which enables them to set policy using specified financial instruments. But even this power must
be limited so that a central bank does not take over functions that are chiefly fiscal. Among other
things, that means restricting the assets the central bank can buy and sell, as well as forbidding
the central bank from acquiring assets directly from the Treasury. The second key element of
good central bank design is a transparent framework that permits effective accountability. If the
central bank’s goals and operational principles are well-defined, then the legislature and the
public can hold it responsible for its actions.

3|P a g e
Transparency also makes central bank policy more effective. Because pre-informed monetary
policies reduces systematic risk in the economy, letting households and businesses make
decisions without overly worrying about temporary disturbances in aggregate prices. However,
too much transparency can undermine the function of a central bank. For instance, the
publication of meeting transcripts (even with a lag) diminishes the give-and-take of ideas needed
for a policy committee to make the best choices.

5.2. Tools of Monetary Policy

Monetary policy instruments may be divided in to direct and indirect control mechanisms.
1. Direct controls
Direct controls are typically directives given by the central bank to control the quantity or price
(interest rate) of money deposited with commercial banks and credit provided by them. Ceilings
on the growth of bank lending or deposits are examples of quantity controls. Maximum bank
lending or deposit rates are examples of interest rate controls.

2. Indirect instruments
An important reason for financial liberalization is to develop a system which promotes an
efficient allocation of savings and credit in the economy. In the monetary area, financial
liberalization involves a movement away from direct monetary controls towards indirect ones.
The latter operate by the central bank controlling the price or volume of the supply of its own
liabilities - reserve money - which in turn may affect interest rates more widely and the quantity
of money and credit in the whole banking system. Indirect instruments used in monetary
operations are often divided in to three:
i. Open Market Operations (OMO)
To enable open market operations, a central bank must hold foreign exchange reserves
(usually in the form of government bonds) and official gold reserves. It will often have some
influence over any official or mandated exchange rates: Some exchange rates are managed,
some are market based (free float) and many are somewhere in between "managed float" or
"dirty float".

Through open market operations, a central bank influences the money supply in an economy
directly. Each time it buys securities, exchanging money for the security, it raises the money

4|P a g e
supply. Conversely, selling of securities lowers the money supply. Buying of securities thus
amounts to printing new money while lowering supply of the specific security. The main
open market operations are:
3) Temporary lending of money for collateral securities ("Reverse Operations").
These operations are carried out on a regular basis, where fixed maturity loans
are auctioned off.
4) Buying or selling securities ("Direct Operations") on ad-hoc basis.
5) Foreign exchange operations such as forex swaps.
ii. Reserve Requirements
Changes in reserve requirements affect the money supply by causing the money supply
multiplier to change. A rise in reserve requirements reduces the amount of deposits that can
be supported by a given level of the monetary base and will lead to a contraction of the
money supply. Conversely, a decline in reserve requirements leads to an expansion of the
money supply because more multiple deposit creation can take place.

iii. Discount Policy

Discount policy, which primarily involves changes in the discount rate, affects the money by
affecting the volume of discount loans and the monetary base. A rise in discount loans adds
to the monetary base and expands the money supply; a fall in discount loans reduces the
monetary base and shrinks the money supply.

5.3. Conduct of Monetary Policy

5.3.1. Goals of Monetary Policy
The main goals central banks need to achieve include; high employment, economic growth,
price stability, interest-rate stability, stability of financial markets, and stability in foreign
exchange markets.
a. High Employment
Promoting high employment that is consistent with a stable price level is the main
macroeconomic objective of Countries. High employment is a worthy goal for two main
reasons: (1) the alternative situation, high unemployment, causes much human misery, with
families suffering financial distress, loss of personal self-respect, and increase in crime
(though this last conclusion is highly controversial) and (2) when unemployment is high, the

5|P a g e
economy has not only idle workers but also idle resource (closed factories and unused
equipment), resulting in a loss of output (lower GDP). Although zero unemployment is
desired, actually countries expected to face natural type of unemployment and mostly work
to reduce cyclical unemployment.

b. Economic Growth
The goal of steady economic growth is closely related to the high-employment goal because
businesses are more likely to invest in capital equipment to increase Productivity and economic
growth when unemployment is low. Conversely, if unemployment is high and factories are idle,
it does not pay for a firm to invest in additional plants and equipment. Although the two goals
are closely related, policies can be specifically aimed at promoting economic growth by directly
encouraging firms to invest or by encouraging people to save, which provides more funds for
firms to invest. In fact, this is the stated purpose of so-called supply side economics policies,
which are intended to spur economic growth by providing tax incentives for businesses to invest
in facilities and equipment and for taxpayers to save more.

c. Price Stability
Price stability is desirable because a rising price level (inflation) creates uncertainty in the
economy, and that may hamper economic growth. For example, the information conveyed
by the prices of goods and services is harder to interpret when the overall level of prices is
changing, which complicates decision making for consumers, businesses, and government.
Not only do public opinion surveys indicate that the public is very hostile to inflation, but
also a growing body of evidence suggests that inflation leads to lower economic growth!
Inflation also makes it hard to plan for the future decision.

d. Interest-Rate Stability
Interest-rate stability is desirable because fluctuations in interest rates can create uncertainty in
the economy and make it harder to plan for the future. Fluctuations in interest rate that affect
consumers' willingness to buy goods and services and make it more difficult for consumers to
decide. A central bank may also want to reduce upward movements in interest rates. Upward
movements in interest rates generate hostility toward central banks like the NBE and lead to
demands that their power be shortened.

6|P a g e
 e. Stability of Financial Markets
Financial crises can interfere with the ability of financial markets to channel funds to people with
productive investment opportunities, thereby leading to a sharp contraction in economic activity.
The promotion of a more stable financial system in which financial crises are avoided is thus an
important goal for a central bank. The stability of financial markets is also fostered by interest-
rate stability because fluctuations in interest rates create great uncertainty for financial
institutions. An increase in interest rates produces large capital losses on long-term bonds and
mortgages; losses that can cause the failure of the financial institutions holding them. In recent
years, more pronounced interest-rate fluctuations have been a particularly severe problem for
savings and loan associations and mutual savings banks.

f. Stability in Foreign Exchange Market

With the increasing importance of international trade to a country's economy, the value of its
currency relative to other currencies has become a major consideration for the Central Banks.
For instance the change of value of Ethiopian birr makes Ethiopian industries less or more
competitive in the world market. Stabilizing extreme movements in the value of the Ethiopian
birr in foreign exchange markets is thus viewed as a worthy goal of monetary policy. In other
countries, which are even more dependent on foreign trade, stability in foreign exchange
markets takes on even greater importance.

5.3.2. Central Bank Strategy: Use of Targets

The central bank's problem is that it wishes to achieve certain goals, but it does not directly
influence the goals. It has a set of tools to employ that can affect the goals indirectly after a
period of time (typically more than a year). All central banks consequently pursue a different
strategy for conducting monetary policy by aiming at variable that lie between its tools and the
achievement of its goals. The strategy is as follows: the central bank chooses a set of variables to
aim for, called intermediate targets, such as the monetary supply or interest rates (short- term or
long-term), which have direct effect on the goals of the central bank. However, even these
intermediate targets are not directly affected by the central bank's policy tools. Therefore, it
chooses another set of variables to aim for, called operating targets, or alternatively called
instruments, such as reserve aggregates or interest rates, which are more responsive to its policy
tools. The central bank pursues this strategy because it is easier to hit a goal by aiming at target
7|P a g e
than by aiming at the goal directly. Specifically, by using intermediate and operating targets, it
can more quickly judge whether its policies are on the right track, rather than waiting until it sees
the final outcome of its policies on goals.
One way of thinking about this strategy is that the central bank is using its operating and
intermediate targets to direct monetary policy toward 'the achievement of its goals. After the
initial setting of the policy tools, an operating target such as the monetary base, which the
central bank can control fairly directly, is used to reset the tools so that monetary policy is
channeled toward achieving the intermediate target of a certain rate of money supply growth.
Midcourse corrections in the policy tools can be made again when the central bank sees what is
happening to its intermediate target, thus directing monetary policy so that it will achieve its
goals of high employment and price stability.
Interest Rate,i

i”
i* Md"

i’ Md *
Md'

M* Quantity of Money, M
Targeting on the Money Supply Targeting on the money supply at M*, will lead to fluctuations
in the interest rate between i' and i" because of fluctuations in the money demand curve between
Md' and Md".

A. Choosing the Targets

There are two different types of target variables: interest rates and aggregates (monetary
aggregates and reserve aggregates), If the central bank target 4% GDP growth and 3% lower
interest rate . Can the central bank choose to pursue both of these targets at the same time? The
answer is no. Why a central bank must choose one or the other can be shown using the
application of the supply and demand analysis of the money market. Targeting the interest rate at
i* will lead to fluctuations of the money supply between M' and M" because of fluctuations in
the money demand curve between Md' and Md", If the demand curve falls to Md, the interest rate
will begin to fall below i*, and the price of bonds will rise. With an interest rate target the central

8|P a g e
bank will prevent the interest rate from falling by selling bonds to drive their price back down
and the interest rate back up to its former level. The central bank will make policies until the
equilibrium is achieved.

B. Criteria for Choosing Intermediate Targets

The rationale behind a central bank's strategy of using targets suggests three' criteria for choosing
an intermediate target: It must be measurable, it must be controllable by the central bank, and it
must have a predictable effect on the goal.

Measurability: quick and accurate measurement of an intermediate-target variable is necessary

because the intermediate target will be useful only if it signals when policy is off track more
rapidly than the goal, focusing on interest rates and monetary aggregates as intermediate targets
rather than on a goal like GDP can provide clearer signals about the status of the central bank's
policy, At first glance, interest rates seem to be more measurable than monetary aggregates and
hence more useful as intermediate targets. The interest rate that is quickly and accurately
measured, the nominal interest rate, is typically a poor measure of the real cost of borrowing,
which indicates with more certainty what will happen to GDP, This real cost of borrowing is
more accurately measured by the real interest rate- the interest rate adjusted for expected
inflation (ir = i-∏e). Unfortunately, the real interest rate is extremely hard to measure because
we have no direct way to measure expected inflation. Since both interest rate and monetary
aggregates have measurability problems, it is not clear whether one should be preferred to the
other as an intermediate target.

Controllability: a central bank must be able to exercise effective control over a variable if it is
to function as a useful target. If the central bank cannot control an intermediate target, knowing
that it is off track does little good because the central bank has no way of getting the target back
on track. Some economists have suggested that nominal GDP should be used as an intermediate
target, but since the central bank has little direct control over nominal GDP, it will not provide
much guidance on how the Fed should set its policy tools. A central bank does, however, have a
good deal of control over the monetary aggregates and interest rates.

Our discussion of the money supply process and the central bank's policy tools indicates that a
central bank does have the ability to exercise a powerful effect on the money supply, although its

9|P a g e
control is not perfect. We have also seen that open market operations can be used to set interest
rates by directly affecting the price of bonds. Because a central bank can set interest rates
directly whereas it cannot completely control the money supply, it might appear that interest
rates dominate the monetary aggregates on the controllability criterion. However, a central bank
cannot set real interest rates because it does not have control over expectations of inflation. So
again, a clear-cut case cannot be made that interest rates are preferable to monetary aggregates as
an intermediate target or vice versa.

Predictable Effect on Goals: The most important characteristic a variable must have to be
useful as an intermediate target is that it must have a predictable impact on a goal. If a central
bank can accurately and quickly measure the price of tea in China and can completely control its
price, what good will it does? The central bank cannot use the price of tea in China to affect
unemployment or the price level in its country. Because the ability to affect goals is so critical to
the usefulness of an intermediate-target variable, the linkage of the money supply and interest
rates with the goals-output, employment, and the price level-is a matter of much debate.
C. Criteria for Choosing Operating Targets
The choice of an operating target can be based on the same criteria used to evaluate intermediate
targets. An operating target that has a more predictable impact on the most desirable intermediate
target is preferred. If the desired intermediate target is an interest rate, the preferred operating
target will be an interest-rate variable like the federal funds rate because interest rates are closely
tied to each other. However, if the desired intermediate target is a monetary aggregate, our
money supply model.
5.4. Transmission Mechanism of Monetary Policy
Policymakers should have a good understanding of how monetary policies transmit from a
monetary tool into the goal. In order for monetary policies to have the desired effects on the
economy policymakers should have an accurate assessment of the effects and timing of their
policies. This is what the monetary transmission mechanism describes. There are several
different channels through which a monetary policy can pass through the economy. The modern
financial system identified four Monetary Policy Transmission channels in which the monetary
policy influences the real sector. These are;
 The Interest Rate Channel, through the direct interest rate effects; which affect not only
the cost of credit but also the cash flows of debtors and creditors

10 | P a g e
  The Asset Price Channel through the impact of monetary policy on domestic asset
prices; such as bond, stock market and real estate prices
 The Exchange Rate Channel
 The Credit Channel; which includes the Bank Lending Channel & the Balance Sheet
Channel
i. The Interest Rate Channel
Direct interest rate effects: cost of credit
The interest rate channel is a mechanism of monetary policy, whereby a policy-induced change in the short-term
nominal interest rate by the central bank affects the price level, and subsequently output and employment. While
the central bank controls short term nominal interest rates, the overall economy is primarily
affected by the long-term real interest rates charged by commercial banks to their customers. The
interest rate channel focuses on how changes in the central bank’s policy rate affect various
commercial interest rates including forex. The interest rate channel posits that an increase in the
short-term nominal interest rate leads first to an increase in longer-term nominal interest rates.
This is described by the expectation hypothesis of the term structure. In turn, this affects the real
interest rate and the cost of capital, because prices are assumed to be sticky in the short-run. So
an important aspect of this mechanism is the emphasis on the real, rather than the nominal,
interest rate, which affects consumer and business decisions. Accordingly, a decline in the long-
term real interest rate reduces both the cost of borrowing, and the money paid on interest-bearing
deposits, therefore encouraging household spending on durable goods as well as investments by
corporations. This rise in investments and durable goods purchases boosts the level of aggregate
demand and employment. This transmission mechanism is characterized by the following
diagram of monetary expansion: M↑ ⇒ ir↓ ⇒ I↑ ⇒ Y↑

M↑ represents an expansionary monetary policy which leads to a decrease in the real interest rate
(ir↓), which in turn lowers the cost of capital. This causes a rise in investment spending and
consumer durable expenditure I↑, thereby leading to a rise in aggregate demand and an increase
in output Y↑.

Changes in interest rate policy leads to changes in bank loan for borrowers which may affect
investment decisions, and in deposit rates may affect the choice between consuming now and
later. The long-term interest rates most relevant to investment or to purchases of durable goods.
The present value of durable goods is inversely related to the real interest rate. A lower rate of
11 | P a g e
interest increases the present value of such goods and thus increases demand. In this framework,
interest-rate-sensitive spending is affected by changes in the marginal cost of borrowing.
Changes in interest rates also lead to changes in average rates on outstanding contracts, and these
changes increase over time as old contracts come up for renegotiation. Similarly, marginal
adjustments in deposit rates will over time change the average deposit rate. These changes in
average interest rates will affect the income and cash flow of borrowers.

ii. Asset prices channel

Asset price channel is the monetary transmission channel that is responsible for the distribution
of the effects induced by monetary policy decisions made by the central bank of a country that
affect the price of assets. These effects on the prices of assets will in turn affect the economy.

Indirect effects of interest rates via other asset prices

Policy-induced interest rate changes also affect the level of asset prices, principally those of
bonds, equities and real estate. Another means by which asset price changes triggered by
monetary policy actions can affect aggregate demand is described by the so-called Tobin’s q.
Tobin’s q is defined as the total market value of firms divided by the replacement cost of capital.
This means that if q > 1, the market price of the firm is higher than the replacement cost of
capital and new plant equipment is cheap compared to the market value of firms. Under these
circumstances, firms can issue stocks and get a high price for it, relatively to what it costs to buy
the facilities and equipment that they need. As a result, investment spending will rise and firms
buy this new equipment with only a small issue of stocks.

Expansionary monetary policy (a lower interest rate) makes stocks relatively more attractive than
bonds. More demand for stocks will generally tend to drive up their prices. In terms of Tobin’s q
it means that q goes up, since the nominator increases. As was explained above, this raises the
level of investment spending of firms, thereby leading to an increase in aggregate demand and a
rise in output. This process can be described by the following schematic: ↑ M → ↑ stock price →
↑ q → ↑ I → ↑ Y.

Alternatively, the effects of expansionary monetary policy can also be described as higher stock
prices (again leading to more funds) lower the costs of capital (financing with stocks instead of
bonds makes investment cheaper), and will rise both demand and aggregate output. In other
12 | P a g e
words: ↑ M → ↑ stock price → ↓ c → ↑ I → ↑ Y. It can be argued by the same logic that the
opposite holds for contractionary monetary policy.

Firm balance sheet effects

Similarly, expansionary monetary policy causes stock prices to rise. When the stock price of a
company increases, also the net worth of a company increases. This holds because the market
capitalization of a company is equal to the total value of its outstanding stocks, which in turn
provides a proxy for the company’s net worth. Lending to companies with a lower net worth is
more risky because these companies generally have less collateral and so the changes of potential
losses are higher. This increases the risk of moral hazard and adverse selection problems for
firms with a lower net worth. Therefore, a decline in net worth increases moral hazard and
adverse selection problems and may lead to less lending to finance investment spending.
This mechanism is called the firm balance-sheet effects because it works through the effect on
stock prices on the firm’s balance sheet. Expansionary policy raises the stock prices of the firm,
which increases the net worth of the company. This decreased problems of moral hazard and
adverse selection which means that funds to finance investments can rise. This again leads to a
higher output of the economy. ↑ M → ↑ stock price → ↑ NW → ↑ L → ↑ I → ↑ Y.
Stock price channel
Fluctuations in the stock market have important impacts on the economy and influenced by
Central Bank monetary policies. Transmission mechanisms involving the stock market have their
results on the economy in three different ways. Firstly through their effects on investment in the
stock market, for which stock prices is a determining factor. Secondly, changes in stock prices
also have effects on a firm’s balance sheet. Lastly, stock prices affect a households’ wealth and
liquidity by being directly related to the amount of financial wealth that a household holds.
Stock market effects on investment
A very well-known theory that describes how fluctuating stock prices affect the aggregate
economy is Tobin's q theory. Tobin’s q is defined as the total market value of firms divided by
the replacement cost of capital. This means that if q > 1, the market price of the firm is higher
than the replacement cost of capital and new plant equipment is cheap compared to the market
value of firms. Under these circumstances, firms can issue stocks and get a high price for it,
relatively to what it costs to buy the facilities and equipment that they need. As a result,

13 | P a g e
investment spending will rise and firms buy this new equipment with only a small issue of
stocks.

Household liquidity and wealth effects

Durable products and housing are very illiquid assets because of asymmetric information. The
higher the amount of financial assets, such as stocks, relative to a household’s debt (in other
words, the higher the amount of liquid assets), the lower the risk for financial distress.
Consumers will then be less reluctant to purchase durable products and spend on residential and
housing assets. This will again have a positive on aggregate demand and the output of the
economy. ↑ M → ↑ stock price → ↑ financial assets → ↓ financial distress → ↑ Cdurables, ↑ H → ↑
Y, where Cdurables is the consumption of durable goods and H is the spending on housing and
residential assets.

Similarly, it can be argued that when expansionary policy rises the stock prices, it automatically
also rises the value of the financial wealth of a household and consumption will increase. This
effect of stock prices is explained by Modigliani’s model of life-cycle consumption theory. This
theory states that an important component of consumer’s lifetime resources are stocks and that
stocks therefore are an important determinant for consumption. ↑ M → ↑ stock price → ↑ W → ↑
C → ↑ Y, where W is the financial wealth of a household.

Real estate price channel

Another important asset besides stocks that should therefore also be considered as an important
transmission channel is real estate. Real estate prices can affect the output of an economy via
three different routes: effects on housing expenditures, household wealth and bank balance
sheets.

Direct effects on housing expenditure

A monetary expansion policy that goes with a decrease of the interest rate, lowers the costs of
financing houses (debt financing becomes cheaper). With equal house prices, houses become
relatively more expensive and the construction of new houses (H) becomes more attractive. As a
result, housing expenditures (such as the construction of new houses) will increase and so
aggregate demand will rise. ↑ M → ↑ Phouses → ↑ H → ↑ Y.

14 | P a g e
Household wealth effects
As we saw in Modigliani’s lifecycle consumption theory before, houses are also a very important
component of a households’ financial wealth. The amount of financial wealth of a household
directly affects the amount of spending. Therefore, an expansionary monetary policy that
increases the housing prices also increases a household’s financial wealth. This will have a
positive effects on consumption and spending behavior. Therefore: ↑ M → ↑ Phouses → ↑ W → ↑
C → ↑ Y.

iii. Exchange rate channel

There are two main channels through which monetary policies that affect the exchange rate
operate in the economy: first, and most important, through their effects on exports, and secondly
through their effects on companies’ balance sheets.
Exchange rate effects on exports
Mainly in export-oriented economies, the effect of monetary policy transmission operating
through exchange rate effects has been a major concern of their central banks. Expansionary
monetary policy will cause the interest rate in a country to fall and deposits that are denominated
in that domestic currency becomes less attractive than their foreign equivalents. As a result, the
value of domestic deposits will fall compared to foreign deposits, which leads to a depreciation
of the domestic currency. Since the value of the domestic currency is falling compared to foreign
currencies, it now takes more of the domestic currency to buy a same amount in the foreign
currency, and thus a depreciation of a currency is denoted be ↑e. As a result of this depreciation
(domestic products become cheaper), net exports will rise and consequently so will aggregate
spending. ↑ M → ↑ e → ↑ NX → ↑ Y

Exchange rate effects on balance sheets

When countries have debt denominated in foreign currencies, the burden of their financial debt
will rise when an expansionary monetary policy is implemented. The same reason in as in the
previous section applies. The domestic currency will depreciate against the foreign currency and
this will increase the amount of foreign currency needed to pay the debt and the debt burden
increases. However, assets that are debt-financed are generally denoted in the domestic currency,
and thus their value does not increase with expansionary policy, but rather decreases the net

15 | P a g e
worth (compared to foreign currency). This again increases the problems of moral hazard and
adverse selection and therefore will drive the amount of funds available through lending down.
As a result, investment spending and accordingly aggregate spending will decrease. ↑ M → ↑ e
→ ↓ NW → ↓ I → ↓ Y. Note that both effects of the exchange rate are opposite.

iv. The Credit Channel

The central bank's monetary policy changes affect the amount of credit that banks issue to firms
and consumers for purchases, which in turn affects the real economy. The monetary policy
adjustments affects the short-term interest rate and then changes in the external finance premium.
The external finance premium is the difference in the cost of capital internally available to firms
versus firms' cost of raising capital externally via equity and debt markets. External financing is
more expensive than internal financing and the external finance premium will exist so long as
external financing is not fully collateralized. Fully collateralized financing implies that even
under the worst-case scenario the expected payoff of the project is at least sufficient to guarantee
full loan repayment. This means firm who borrows for the project has enough internal funds
relative to the size of the project that the lenders assume no risk. Contractionary monetary policy
is thought to increase the size of the external finance premium, and subsequently, through the
credit channel, reduce credit availability in the economy.

The size of the external finance premium that results from these market frictions may be affected
by monetary policy actions. The credit channel or, equivalently, changes in the external finance
premium can occur through two conduits: the balance sheet channel and the bank lending
channel. The balance sheet channel refers to the notion that changes in interest rates affect
borrowers' balance sheets and income statements. The bank lending channel refers to the idea
that changes in monetary policy may affect the supply of loans disbursed by depository
institutions.
Balance sheet channel
The balance sheet channel theorizes that the size of the external finance premium should be
inversely related to the borrower's net worth. For example, the greater the net worth of the
borrower, the more likely may be to use self-financing as a means to fund investment. Higher net
worth agents may have more collateral to put up against the funds they need to borrow, and thus
are closer to being fully collateralized than low net worth agents. As a result, lenders assume less

16 | P a g e
risk when lending to high-net-worth agents, and agency costs are lower. The cost of raising
external funds should therefore be lower for high-net-worth agents. Since the quality of
borrowers' financial positions affect the terms of their credit, changes in financial positions
should result in changes to their investment and spending decisions. This idea is closely related
to the financial accelerator. A basic model of the financial accelerator suggests that a firm's
spending on a variable input cannot exceed the sum of gross cash flows and net discounted value
of assets. This relationship is expressed as a "collateral-in-advance" constraint. An increase in
interest rates will tighten this constraint when it is binding; the firm's ability to purchase inputs
will be reduced. This can occur in two ways: directly, via increasing interest payments on
outstanding debt or floating-rate debt, and decreasing the value of the firm's collateral through
decreased asset-prices typically associated with increased interest rates (reducing the net
discounted value of the firm's assets); and indirectly, by reducing the demand for a firm's
products, which reduces the firm's revenue while its short-run fixed cost do not adjust (lowering
the firm's gross cash flow). The reduction in revenue relative to costs erodes the firm's net worth
and credit-worthiness over time.

The balance sheet channel can also manifest itself via consumer spending on durables and
housing. These types of goods tend to be illiquid in nature. If consumers need to sell off these
assets to cover debts they may have to sell at a steep discount and incur losses. Consumers who
hold more liquid financial assets such as cash, stocks, or bonds can more easily cope with a
negative shock to their income. Consumer balance sheets with large portions of financial assets
may estimate their probability of becoming financially distressed as low and are more willing to
spend on durable goods and housing. Monetary policy changes that decrease the valuation of
financial assets on consumers' balance sheets can result in lower spending on consumer durables
and housing.
Bank lending channel
The bank lending channel theorizes that changes in monetary policy will shift the supply of
intermediated credit, especially credit extended through commercial banks. The bank lending
channel is essentially the balance sheet channel as applied to the operations of lending
institutions. Monetary policy actions may affect the supply of loanable funds available to banks
(i.e. a bank's liabilities), and consequently the total amount of loans they can make (i.e. a bank's
assets). Banks serve to overcome informational problems in credit markets by acting as a

17 | P a g e
screening agent for determining credit-worthiness. Thus many agents are dependent on banks to
access credit markets. If the supply of loanable funds banks possess is affected by monetary
policy changes, then so too should be the borrowers who are dependent on banks' funds for
business operations. Firms reliant on bank credit may either be shut off from credit temporarily
or incur additional search costs to find a different avenue through which to obtain credit. This
will increase the external finance premium, consequently reducing real economic activity.

The bank lending channel presumes that monetary policy changes will drain bank deposits so
long as banks cannot easily replace the short-fall in deposits by issuing other uninsured
liabilities. The abolition of reserve requirements on certificates of deposit in the mid-1980s made
it much easier for banks facing falling retail deposits to issue new liabilities not backed by
reserve requirements. This is not to say that the bank lending channel is no longer relevant. On
the contrary, the fact that banks can raise funds through liabilities that pay market interest rates
exposes banks to an external finance premium as well. Forms of uninsured lending carry some
credit risk relative to insured deposits. The cost of raising uninsured funds will reflect that risk,
and will be more expensive for banks to purchase.

18 | P a g e