World financialsystems have changed and now monetary transmission mechanisms have otherdistributional effects that are not addressed within the traditional moneyview. Firstly, I shall explain the distributional aspects of the traditionalmoney view ...

University Degree Business and Administrative studies

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World financial systems have changed and now monetary transmission mechanisms have other distributional effects that are not addressed within the traditional money view. Firstly, I shall explain the distributional aspects of the traditional money view and then that of the credit channel, exchange rate channel and other asset price effects. The traditional money view is an interest rate based channel, featured by the standard Keynesian IS-LM framework with exogenous money supply ( basic assumptions that characterize the interest rate channel are:

sticky-price adjustment to money supply shocks,
direct control of the monetary authority on nominal money supply by adjusting reserves, and
presence of two assets such as money and bonds where loans are perfect subtitutes for bonds.

The IS-LM view of money stresses that changes in the policy are important only insofar as they affect aggregate outcomes. Investment flactuations are of importance since policies only affected the required rate of return on new investment projects. Hence a monetary policy tightening (Mcauses the interest rate to rise. The rise in interest rates cause investment spending to fall (I. This is a leftward movement along the the investment schedule from I0 to I1. Consequently, the aggregate demand and output fall (Y). Fig.1.(a), (b) and (c) explain the transmision. Under this framework, investment includes residential housing and consumer durable expenditure and business investment as well. The schematic of the distributional effects is:

The transmission mechanism under this view works through the liability side of the bank balance sheets. Three conditions are necessary for the money channel to work. First, banks can not perfectly shield transaction balances from changes in reserves. Second, there is no close substitute for money in the conduct of transactions in the economy. Thirdly, it makes no difference which type of assets banks hold. Fig.2 shows the transmission through the major channels.

The traditional view however has inefficiencies. Firstly, in the IS-LM analysis, the bond market is assumed to be in equilibrium. Banks have a primary role of providing capital for businesses but the model totally ignores the banks involvement in the economy. Furthermore, in a modern economy firms have different sources of finance (41MY lecture notes). Second, there is no strong evidence that business investment in particular is interest sensitive. The model also fails to explain why short-term interest rates affect spending durables such as housing which presumably depend on the long-term rate. Fourth, empirical evidence has shown significant output changes following a change in the interest rate, simultaneously the cost of capital measures appear insignificant in explaining individual expenditure components. Lastly there is a response lag in the economy following an interest rate change. Bernanke and Gertler (1995) state that the effect of a monetary policy shock on interest rate is transitory, while some components of GDP do not change until after the interest rate returns to its trend. The traditional view does not address why real variables continue to adjust after most of the rise in short-term interest rates have been reversed.

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The credit channel however, is an enhancement mechanism and emphasizes how asymmetric information and costly enforcement of contracts creates agency problems in the financial markets (Bernanke and Gertler (1995)). It describes how an external financial premium (set by banks), which is a wedge between the cost of funds raised externally (by issuing equity or debt) and the opportunity cost of funds raised internally (retained earnings), has an important role in economic activities. The size of an external finance premium reflects imperfections in credit markets that drive a wedge between the expected return received by lenders and the costs faced by potential borrowers. Monetary policy, which alters interest rate, tends to affect the external finance premium in the same direction. Thus, the direct effects of the monetary policy on interest rate are amplified by changes in the external financial premium. This complimentary movement in the external finance premium may help explain the strength, timing, and composition of the monetary policy effects better than a reference to interest rates alone ().

The influence of monetary shocks on the real economic activity has two dimensions in the credit view. First, a monetary shock can influence the financial position or the net worth of a borrower firm. A higher net worth of a firm’s balance sheet makes external financing from the loan market cheaper and stimulates investment. As the transmission mechanisms of the monetary shocks to the real economy operate through the borrowers’ balance sheets, this transmission mechanism is called the bank balance sheet channel. Second, a monetary shock can influence the banks loan supply to the bank-dependent firms (http://www.erc.metu.edu.tr/menu/series02/0203.pdf). A change in the availability of loans influences investment decisions by borrower firms by reducing the external sources of finance. This is the bank lending channel.

The balance sheet channel is based on the fact that a firm’s investment decision is based on the firm’s financial position which is affected by underlying monetary shocks. That is, the greater the borrower’s net worth, the lower external financial premium should be. Monetary policy tightening directly weakens borrowers' balance sheets in at least two ways. First, rising interest rates (idirectly increase interest expense repayments, reducing net cash flows (CF) and weakening the borrower's financial position. Second, rising interest rates are also typically associated with declining stock prices (Ps, which reduce the value of the borrower’s collateral. Indirectly, monetary policy tightening affects net cash flows and collateral values from deterioration in consumers’ expenditure. The firm’s revenues will decline while its various fixed or quasi-fixed costs do not adjust in the short run. The financing gap, therefore, erodes the firm’s net worth (NW) and credit worthiness over time.

Lower net worth means that lenders in effect have less collateral for their loans, and so losses from adverse selection are higher. Decline in net worth raises the adverse selection problem, thus leading to a decrease in lending (L to finance investment spending. Gertler and Gilchrist (1993, 1994) found this monetary policy tightening to affect smaller firms more because they had limited access to short-term credit markets. Lower net worth of firms also increases the moral hazard problem because firms’ equity stakes are low, so there is a high incentive for firms to engage in risky investment projects. Since taking on risky projects reduces the likelihood of loan repayments, decrease in net worth leads to a decrease in lending and thus investment and output. The schematic for this mechanism is:

MPs

Mi.

The bank lending channel specifically affects small to medium sized firms who have few or no alternative sources of finance other than bank loans. Any frictions in the asset-liability management of banks due to monetary shocks would be transmitted to real economic activity through the bank dependent producers in the economy. Monetary policy tightening leads to reduction in the volume of deposits and short run sell-off of banks’ security holdings, with little effect on loans. Overtime banks respond by terminating old loans and refusing to make new one. Since small and medium sized firms are dependent on bank loans for credit, reduction in the loan supply can depress the economy (Bernanke & Blinder 1992).

However 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 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;

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:

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:

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:

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:

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.

Bibliography

41MY lecture notes

Bernanke and Gertler (1995)

Gertler and Gilchrist (1993, 1994)

Bernanke & Blinder 1992

Kashyap, Stein & Wilcox (1993)

Romer and Romer (1990)

Kashyap and Stein (1993, 1994)

Cecchetti (1995)

Taylor (1995)

Obstfeld & Rogoff (1995)

F.S Mishkin (1995, 2001)