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Monetary policy

Kashyap, Stein & Wilcox (1993) state that there are two conditions necessary if the monetary policy is to affect the aggregate demand. First, loans and commercial paper must be imperfect substitutes in the bank assets. This implies that banks can not just reduce the amount of commercial paper to keep the loan supply unchanged. The second condition is that loans and commercial paper must be imperfect substitutes in corporate liabilities. This ensures that firms will not be able to costlessly offset a decline in loan supply by issuing more paper.

Empirical studies suggest that other conditions must be satisfied for the credit channel to fully hold. First, bank loans are important sources of funds for firms such that there is no perfect substitute for this kind of credit, such as certificates of deposit and/ or commercial papers (Kashyap, Stein, and Wilcox (1993), Romer and Romer (1990)). Second, monetary tightening by the central bank must be able to constrain the banks’ ability to lend (Kashyap and Stein (1993, 1994), Cecchetti (1995)). Finally, there must be imperfect price adjustments in order to allow the monetary policy to affect real activity.

The credit view explains the distributional effects of the monetary policy on both lenders

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and borrowers while the traditional money view does not. The credit view implies that the impact of monetary policy on economic activity is also sensitive to the state of firms’ balance sheet and the health of the banking sector. The following schematic diagram shows the effect of a policy tightening; M. Fig. 3 shows and explains how monetary policy shocks affect output using the commodity and credit curve.

Asset prices provide important channels through which monetary policy affects the economy. Namely these are exchange rates, stock market prices and real estate prices. The exchange rate channel operates under its effect on net exports and the effect on firms’ balance sheet (Taylor (1995) and Obstfeld & Rogoff (1995)). Under flexible exchange rate, an expansionary monetary policy lowers the domestic interest rate (i<i*) and makes foreign currency deposits more attractive. This leads to capital outflows and thus supply of domestic currency increases which causes it to depreciate.

The lower value of the domestic currency makes domestic goods more competitive and so exports rise and hence aggregate demand increases (F. S Mishkin 1995). The schematic for the distributional effects is: M Unstable exchange rates also have important distributional effects on aggregate demand by affecting the balance sheets of financial and non-financial firms. This normally occurs when a substantial amount of domestic debt is denominated in foreign currency and this is typical of emerging country markets. As above, a monetary expansion causes the domestic currency to depreciate.

If debt is denominated in foreign currency, the depreciation increases the debt burden of domestic non-financial firms. From the foreign creditors view, the domestic asset prices of firms decline in net worth (NW) when valued in foreign currency. The balance sheets of the firms then deteriorate. Moral hazard problems increase as stated earlier, and so both foreign and domestic creditors become reluctant to finance such firms, thus adversely selecting borrowers (F. S Mishkin 2001). The result is that there is a decrease in investment and hence in economic activity. The transmission mechanism is represented as:

M I shall now consider the distributional effects of the ‘stock market prices’ channel and then the ‘real estate prices’ channel. Tobin (1969) provides the Tobin’s ‘q’ which is the market value of firms divided by the replacement cost of capital. The crux of the Tobin’ q-model is that a link exists between stock prices and investment spending (F. S Mishkin 2001). An expansionary monetary policy lowers returns on bonds relative to stocks and so this increases the demand for stocks and thus raises their price (Ps). This makes q high and so replacement cost of capital is cheap, relative to the value of the firm.

Thus the higher stock price will lead to an increase in investment. The following schematic shows the mechanism: M. Alternatively, the rise in stock prices makes it cheaper for firms to issue new stock for to produce funds for investment because the increase in stock prices lower the cost of capital (c). The increase in investment causes output to rise. This leads to: M. Household liquidity preferences depend on the likelihood of consumers finding themselves in financial distress such that they wish to hold more illiquid assets when their financial distress is low.

Specifically, when consumers have a large amount of financial assets relative to their debts, their probability of financial distress is low. Consumers then purchase more durables and housing (F. S Mishkin 2001). This implies that an increase in stock prices raises the value of financial assets (FA thus consumer durable and housing expenditure increases ((Cdand (H) respectively). The transmission mechanism is as follows: Increases in stock prices raise the value of household wealth (W, increasing consumers’ lifetime resources and thereby consumption (Cand aggregate demand rise (Modigliani’s life cycle model).

The schematic for household wealth effects is: I shall now describe the distribution in the real estate prices. Monetary expansion lowers the interest rate and the cost of financing housing in turn. This increases house prices (Ph. Construction costs thus become low relative to house price and so firms find it cheaper to build more houses housing expenditure (Hand output rise. The schematic for this is: Increases in house prices also raise household wealth and consumption output in turn so this leads to the following distribution:

With banks however, an expansionary monetary policy rises the prices of real estates (Prand thus minimizes bank loan losses. This increase the banks capital (NWb and so they will engage in more lending and thus investment increases as a result which in turn causes output to increase. The transmission is as follows: In conclusion, this essay does not attempt to give a complete analysis of all the distributional consequences of monetary policy but highlights other important distributional effects that are not addressed in the money view.

It considers how each individual channel of monetary policy affects certain individuals and firms with respect to some characteristic. The word limit prohibited me into discussing other channels such as the inflation expectations channel.


www. erc. metu. edu. tr/menu/series02/0203. pdf http://wb-cu. car. chula. ac. th/papers/transmission. htm 41MY lecture notes Bernanke and Gertler (1995) Gertler and Gilchrist (1993, 1994) Bernanke & Blinder 1992

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