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Lecture 17

ECON 3430 Lecture 17: CH26 book powerpoint notes

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ECON 3430
Brenda Spotton- Visano

Transmission Mechanisms of Monetary Policy Chapter 26 • Transmission Mechanisms of Monetary Policy • Examines whether one variable affects another by using data to build a model that explains the channels through which the variable affects the other • Transmission mechanism – The change in the money supply affects interest rates – Interest rates affect investment spending – Investment spending is a component of aggregate spending (output) • The Links Between Monetary Policy and Aggregate Demand • Traditional Interest-Rate Channels • An important feature of the interest-rate transmission mechanism is its emphasis on the real (rather than the nominal) interest rate as the rate that affects consumer and business decisions • In addition, it is often the real long-term interest rate (not the real short- term interest rate) that is viewed as having the major impact on spending – Especially purchases of durable items • Exchange Rate Effects on Net Exports • Exchange rates are affected by interest rates – When real rates fall, domestic dollar assets become less attractive, so the dollar depreciates • Lower value of domestic currency makes domestic goods cheaper than foreign goods • Net exports rise, and therefore aggregate demand rises as well • Tobin’s q Theory • Theory that explains how monetary policy can affect the economy through its effects on the valuation of equities (stock) • Defines q as the market value of firms divided by the replacement cost of capital – If q is high, the market price of firms is high relative to the replacement cost of capital, and new plant and equipment capital is cheap relative to the market value of firms – When q is low, firms will not purchase new investment goods because the market value of firms is low relative to the cost of capital • Wealth Effects • Consumption is spending by consumers on nondurable goods and services • An important component of consumers’ lifetime resources is their financial wealth, a major component of which is common stocks • When stock prices rise, the value of financial wealth increases, thereby increasing the lifetime resources of consumers, and consumption should rise • Credit View • Credit View is the new explanation based on the problem of asymmetric information in financial markets that leads to financial frictions • It proposes that two types of monetary transmission channels arise as a result of financial frictions in credit markets: – Those that operate through effects on bank lending – Those that operate through effects on firms’ and households’ balance sheets • Credit View (cont’d) • Bank Lending Channel – Based on the analysis that demonstrates that banks play a special role in the financial system because they are especially well suited to solve asymmetric information problems in credit markets • Balance Sheet Channel – Like the bank lending channel, the balance sheet channel arises from the presence of financial frictions in credit markets • Credit View (cont’d) • Cash Flow Channel – another balance sheet channel operates by affecting cash flow, the difference between cash receipts and cash expenditures • Unanticipated Price Level Channel – another balance sheet channel operates through monetary policy effects on the general price level • FYI Consumers’ Balance Sheets and the Great Depression • The years between 1929 and 1933 witnessed the worst deterioration in consumers’ balance sheets ever seen in the United States • Because of the decline in the price level in that period, the level of real debt consumers owed also increased sharply (by over 20%) • Consequently, the value of financial assets relative to the amount of debt declined sharply, increasing the likelihood of financial distress • Household Liquidity Effects • If, as a result of a bad income shock, consumers needed to sell their consumer durables or housing to raise money, they would expect a big loss because they could not
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