econ 4325 monetary policy lecture 10: monetary ...holm monetary policy, lecture 10 16 / 32...
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ECON 4325Monetary Policy
Lecture 10: Monetary Transmission Mechanisms
Martin Blomhoff Holm
... we summarize their views of what is required in a new core model.These can be grouped under four headings:
(i) incorporating financial frictions rather than assuming that financialintermediation is costless;
(ii) relaxing the requirement of rational expectations;
(iii) introducing heterogeneous agents; and
(iv) underpinning the modelāand each of these three newadditionsāwith more appropriate microfoundations.
Vines and Wills (2018)The rebuilding macroeconomic theory project
Holm Monetary Policy, Lecture 10 1 / 32
Outline
Lecture based on Boivin-Kiley-Mishikin (2011)
1. Overview of the transmission mechanisms in the three-equation NKM.
2. Additional non-household transmission mechanims:I Investment channelsI Exchange rate channelsI Financial channels:
bank lending, bank capital, deposits, and balance sheet
3. Additional household-based transmission mechanisms:I Balance sheet channelI Cash-flow effectsI Indirect income effects (Kaplan-Moll-Violante)
Holm Monetary Policy, Lecture 10 2 / 32
Part I: The transmission mechanisms in ourthree-equation framework.
Holm Monetary Policy, Lecture 10 3 / 32
Overview
I All transmission goes through households.
I Two direct household channels:I Intertemporal substitutionI Wealth effects.
I And the indirect channel through wages.
Holm Monetary Policy, Lecture 10 4 / 32
Intertemporal Substitution
Mechanism:
1. it ā2. rt ā3. Consumption today is cheaper relative to tomorrow
4. ct ā
(Euler-equation effect)
Holm Monetary Policy, Lecture 10 5 / 32
Wealth Effects
Mechanism:
1. it ā2. rt ā3. Revaluation of future discounted flows. Households become wealthier
(if positive wealth).
4. ct ā
Note: there is no financial wealth in equilibrium in the standard model.Only effect through revaluation of human capital.
Holm Monetary Policy, Lecture 10 6 / 32
Indirect Income Effect
Mechanism:
I ct ā due to other channels
I wt ā since firms need to increase production
I ct ā
Accelerator mechanism(no independent effect of MP, but strengthens already existing channels)
Holm Monetary Policy, Lecture 10 7 / 32
Part II: Additional non-household transmissionmechanisms.
Holm Monetary Policy, Lecture 10 8 / 32
Overview
I Firms: investment channel.
I Open-economy: exchange rate channels.
I Intermediation/financial sector:I Bank lending channelI Bank capital channelI Balance sheet channel
Holm Monetary Policy, Lecture 10 9 / 32
Investment Channel
Mechanism:
1. it ā2. rt ā3. User cost of capital ā4. Investment ā5. GDP ā
NB! This channel was missing in action during the last recession. Why?
I Uncertainty
If uncertainty is high, user cost of capital has a negligible effect oninvestment. Two reasons: firms donāt want to invest (demand), banksdonāt want to provide loans (supply).
Holm Monetary Policy, Lecture 10 10 / 32
Exchange Rate Channel
Uncovered interest rate parity:
1 + rt = Et
{St+1
St
}(1 + rāt )ut
where
I St is the real exchange rate (St = ĪµPā
P ā is a real depreciation of NOK)
I rt is the real interest rate at home
I rāt is the foreign real interest rate
I ut is a risk premium.
Holm Monetary Policy, Lecture 10 11 / 32
Exchange Rate Channel
Mechanism
1. it ā2. rt ā3. St ā (real depreciation)
4. Two effects: exporters more competitive, export volumes increase;prices of imported goods more expensive, prices increase
5. yt ā and Ļt ā
However: many reasons why it doesnāt work quite so much (UIP doesnāthold empirically, variation in risk premium, pricing to market...).
Holm Monetary Policy, Lecture 10 12 / 32
Simplified Balance SheetsCentral Bank
Liabilities Assets
Reserves Bonds
Banks
Liabilities Assets
Deposits ReservesBonds
Equity Loans
Households/Firms
Liabilities Assets
Loans Deposits
Equity Bonds
Government
Liabilities Assets
Bonds Deposits
Equity
Holm Monetary Policy, Lecture 10 13 / 32
Open Market Operations
Open Market Operations (conventional)
1. CB increases reserves by buying bonds with CB money.
2. This money is instantly transferred to the deposit account of theseller and ends up as reserves at the sellerās bank or is sold to a bankand ends up as reserves directly.
ā expansive open market operations increases reserves and deposits.
Quantitative Easing: An expansion of the central bankās balance sheetCredit Easing: ... with a focus on which assets they purchase.
Holm Monetary Policy, Lecture 10 14 / 32
Banks/intermediation channels
The Bank Lending Channel
Mechanism:
1. r ā, cost of financing loans goes down + expansionary open marketoperations increase bank reserves and deposits.
2. This in turn increases the level of bank loans a bank can make(supply effect).
3. Previously constrained firms get loans and GDP increases.
Note: this is one of the primary mechanisms through which QE issupposed to work.Note 2: Independent mechanism.
Holm Monetary Policy, Lecture 10 15 / 32
Banks/intermediation channels
The Bank Capital Channel
Mechanism:
1. Expansionary monetary policy results in higher asset prices and/orhigher interest margins.
2. Banks gain on their loan portfolio.
3. Bank equity increases.
4. Banks expand lending (supply effect).
5. Previously constrained firms get loans and GDP increases.
Note: another mechanism through which QE is supposed to work.Note 2: accelerator mechanism.
Holm Monetary Policy, Lecture 10 16 / 32
Banks/intermediation channels
The Balance Sheet Channel
Mechanism:
1. Expansionary monetary policy results in higher asset prices and highernet worth of firms.
2. Firms can therefore pose more collateral and borrow more.
3. More lending (demand effect) to previously constrained firms.
4. GDP increases.
Note: this is the typical financial accelerator mechanism used in large scaleDSGE models (Kiyotaki-Moore, 1997; Bernanke-Gertler-Gilchrist, 1999).
Holm Monetary Policy, Lecture 10 17 / 32
Part III: Additional household-based transmissionmechanisms.
Holm Monetary Policy, Lecture 10 18 / 32
Overview
I Modern macroeconomics: incomplete markets models increasinglyprevalent.
I What does this mean?
I Households face uninsurable risk(e.g. unemployment, income risk, returns risk...)
I ... and constraints(e.g. liquidity constraints, loan-to-value constraint, loan-to-incomeconstraint ...)
I Implications (things actually matter in the model)
I Short-run fluctuations affect householdsI Balance sheet effects on householdsI Fiscal policy matters (weaker Ricardian Equivalence)
Holm Monetary Policy, Lecture 10 19 / 32
The Household Problem
maxct ,ht ,nt
E0
āāt=0
Ī²tu(ct , ht , nt) (1)
subject to
Ptct + Ph,tht + bt ā¤ Ph,thtā1 + (1 + it)btā1 + Wtztnt + dt (2)
zt ā¼ f (ztā1) (3)
bt ā„ B(Wtztnt ,Ph,tht) (4)
ht ā„ 0 (5)
+ something that keeps h fixed most of the time (6)
I h is volume of housingI Ph,t is nominal price of housingI z is idiosyncratic productivity
I B(Wtztnt ,Ph,tht) is theborrowing constraint
Holm Monetary Policy, Lecture 10 20 / 32
Implications
1. Some households endogenously end up as hand-to-mouth (manyunlucky draws of income).
2. Some households are endogenously wealthy hand-to-mouth (e.g. justbought a new house).
Holm Monetary Policy, Lecture 10 21 / 32
Consumption vs. liquid reserves (Norway 2011)
0 10 20 30 40 50 60 70 80 90 100Likvid formue (i 1000 USD)
0
5
10
15
20
25
30
35
40
Ć rli
g ko
nsum
(i 1
000
US
D)
Data, Norge 2011Komplett markedstilnƦrming
Liquid Assets = deposits + cash + stocks + bonds + mutual funds
Holm Monetary Policy, Lecture 10 22 / 32
Andel WHTM i Norge etter alder, 2014
20 30 40 50 60 70 80 900
5
10
15
20
25
30
35
40
45
innskudd<Y/12
innskudd<Y/24
Holm Monetary Policy, Lecture 10 23 / 32
Householdsā Partial Equilibrium Response to an InterestRate Change
0 2 4 6 8 10
Assets
-0.2
-0.1
0
0.1
0.2
0.3
0.4
Ch
an
ge
in
co
nsu
mp
tio
n
Total Effects
Unconstrained
0 2 4 6 8 10
Assets
-0.2
-0.1
0
0.1
0.2
0.3
0.4a = āā,Ļ = 0
All
Substitution
Wealth
0 2 4 6 8 10
Assets
-0.2
-0.1
0
0.1
0.2
0.3
0.4a = 0,Ļ > 0
Holm Monetary Policy, Lecture 10 24 / 32
Householdsā Partial Equilibrium Response to an InterestRate Change
0 2 4 6 8 10
Assets
-0.2
-0.1
0
0.1
0.2
0.3
0.4
Ch
an
ge
in
co
nsu
mp
tio
n
Total Effects
Unconstrained
a = 0,Ļ > 0
0 2 4 6 8 10
Assets
-0.2
-0.1
0
0.1
0.2
0.3
0.4a = āā,Ļ = 0
All
Substitution
Wealth
0 2 4 6 8 10
Assets
-0.2
-0.1
0
0.1
0.2
0.3
0.4a = 0,Ļ > 0
All
Substitution
Wealth
Income risk
Holm Monetary Policy, Lecture 10 25 / 32
Monetary Transmission Mechanisms
Old Transmission Mechanisms
I Weaker intertemporal substitution
I Wealth effects
New Transmission Mechanisms
1. Indirect income effects (Kaplan-Moll-Violante)
2. Balance sheet channel
3. Cash-flow effects
Holm Monetary Policy, Lecture 10 26 / 32
Indirect Income Effects
Complete markets benchmark: households react almost nothing toshort-run changes in wages. Main part of monetary transmission isthrough direct effects.
Incomplete markets: some households are constrained and are verysensitive to short-run changes in wages. Main monetary transmission isthrough indirect effects on wages. (Kaplan-Moll-Violante / Luetticke)
Implication: The indirect effects are crucial for monetary transmission.
Holm Monetary Policy, Lecture 10 27 / 32
Balance Sheet Channel
Mechanism:
1. it ā2. c and h ā3. Ph,t ā4. Borrowing constraint becomes slacker
5. c and h ā
Accelerator mechanism(no independent effect of MP, but strengthens already existing channels)
Holm Monetary Policy, Lecture 10 28 / 32
Cash-flow Effects
Remember: there is a reason why households donāt adjust housing/debtevery period.
I it āI itBtā1 āI Disposable income net of debt amortization ā (if debtor)
I c and h ā
Independent mechanism
Holm Monetary Policy, Lecture 10 29 / 32
Cash-flow Effects in Norway
Source: Norges Bank MPR 1/14Holm Monetary Policy, Lecture 10 30 / 32
Summary
ššš”š” āExpansionaryopen market
operationššš”š” ā
Intertemporal substitutionand cash-flow effects
š¦š¦š”š” ā
Investment and exchange rate channel
š¤š¤š”š” ā
Indirect income effect
ššš”š” āAsset pricing
Wealth effect andbalance sheet channel
Supply of bank lending āBank lending channel
Bank capital channel
Balance sheet channel
ššš”š” āExchange rate channel
Phillips curve
Holm Monetary Policy, Lecture 10 31 / 32
Next week
I Zero Lower Bound
I Quantitative Easing
I Forward Guidance
I And then negative interest rates the week after that.
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