Learning Objectives

26.1 List and summa- Preview

S
rize the transmission ince 1980, the U.S. economy has been on a roller coaster, with output, unemploy-
mechanisms through ment, and inflation undergoing drastic fluctuations. At the start of the 1980s,
which monetary policy inflation was running at double-digit levels, and the recession of 1980 was fol-
can affect the real lowed by one of the shortest economic expansions on record. After a year, the economy
economy. plunged into the 1981–1982 recession, with the unemployment rate climbing to over
26.2 Summarize and 10%, and only then did the inflation rate begin to come down to below the 5% level.
apply the four lessons The 1981–1982 recession was followed by a long economic expansion that reduced the
outlined in this chapter unemployment rate to below 6% during the 1987–1990 period. With Iraq’s invasion of
for the conduct of mon- Kuwait and a rise in oil prices in the second half of 1990, the economy again plunged
etary policy. into recession. Subsequent growth in the economy was sluggish at first but eventually
sped up, and the unemployment rate fell to below 5% in the late 1990s. In March
2001, after a 10-year expansion, the longest in U.S. history, the economy slipped into a
recession, with the unemployment rate climbing to around 6%. By 2007, an economic
recovery had brought the unemployment rate below 5%, but with the onset of the
global financial crisis, the economy entered a recession in December 2007, with the
unemployment rate rising to 10%. Only in July 2009 did the economy start to recover,
making the recession of 2007–2009 the longest recession since World War II. After a
more than ten-year expansion, the coronavirus pandemic led to another recession that
started in February 2020, with the unemployment rate rising to 14.7% in April. In light
of large fluctuations in aggregate output (reflected in the unemployment rate) and infla-
tion, and the economic instability that accompanies them, policymakers face the fol-
lowing dilemma: What policy or policies, if any, should be implemented to reduce
fluctuations in output and inflation in the future?
To answer this question, monetary policymakers must be able to accurately assess
the timing and effect of their policies on the economy. To make this assessment, they
need to understand the mechanisms through which monetary policy affects the econ-
omy. In this chapter, we examine the transmission mechanisms of monetary policy
and evaluate the empirical evidence on these mechanisms to better understand the
role that monetary policy plays in the economy. We will see that these monetary trans-
mission mechanisms emphasize the link between the financial system (which we stud-
ied in the first three parts of this book) and monetary theory, the subject of this part of
the book.

661
662 PART 6 Monetary Theory

26.1 TRANSMISSION MECHANISMS OF MONETARY POLICY

LO 26.1 List and summarize the transmission mechanisms through which monetary
policy can affect the real economy.

In this section, we examine the ways in which monetary policy affects aggregate
demand and the economy, which are referred to as transmission mechanisms of
monetary policy. We start with interest-rate channels because they are the key mon-
etary transmission mechanism of the AD/AS model developed in Chapters 21, 22, and
23 and applied to monetary policy in Chapters 24 and 25.1

Traditional Interest-Rate Channels

The traditional view of the monetary transmission mechanism can be characterized by
the following schematic, which shows the effect of an easing of monetary policy accom-
plished by lowering the real interest rate:

rT 1 I c 1 Yad c (1)
This schematic shows that an easing of monetary policy leads to a fall in real interest
rates 1rT 2, which in turn lowers the real cost of borrowing, causing a rise in invest-
ment spending 1I c 2, thereby leading to an increase in aggregate demand 1Yad c 2.
Although Keynes originally emphasized this channel as operating through busi-
nesses’ decisions about investment spending, the search for new monetary transmis-
sion mechanisms led economists to recognize that consumers’ decisions about housing
and consumer durable expenditure (spending by consumers on durable items such
as automobiles and refrigerators) also are investment decisions. Thus the interest-rate
channel of monetary transmission outlined in Equation 1 applies equally to consumer
spending, and in this case I represents investments in residential housing and con-
sumer durable expenditure.
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. How is
it that a change in the short-term nominal interest rate induced by a central bank results
in a corresponding change in the real interest rate on both short- and long-term bonds?
We have already seen that the answer lies in the phenomenon of sticky prices—the fact
that the aggregate price level adjusts slowly over time, so expansionary monetary pol-
icy, which lowers the short-term nominal interest rate, also lowers the short-term real
interest rate. The expectations hypothesis of the term structure described in Chapter 6,
which states that the long-term interest rate is an average of expected future short-term
interest rates, suggests that a lower real short-term interest rate, as long as it is expected
to persist, leads to a fall in the real long-term interest rate. These lower real interest
rates then lead to increases in business fixed investment, residential housing invest-
ment, inventory investment, and consumer durable expenditure, all of which produce
the rise in aggregate demand.
The fact that the real interest rate rather than the nominal rate affects spending
suggests an important mechanism through which monetary policy can stimulate the
An appendix to this chapter found in MyLab Economics examines the empirical evidence on the importance of
1

money to economic fluctuations.

 CHAPTER 26 Transmission Mechanisms of Monetary Policy 663

economy, even if nominal interest rates hit a floor of zero (the effective lower bound)
during a deflationary episode. With nominal interest rates at a floor of zero, a com-
mitment to future expansionary monetary policy can raise expected inflation 1pe 2,
thereby lowering the real interest rate 1r = i - pe 2 even when the nominal interest
rate is fixed at zero and stimulating spending through the interest-rate channel:

pe c 1 rT 1 I c 1 Yad c (2)
This mechanism thus indicates that monetary policy can still be effective even when
nominal interest rates have already been driven down to zero by the monetary author-
ities. Indeed, this mechanism explains why the Federal Reserve resorted in Decem-
ber 2008 to the nonconventional monetary policy of committing to keep the federal
funds rate at zero for an extended period of time. By so doing, the Fed was trying to
keep inflation expectations from falling in order to make sure that real interest rates
remained low, so as to stimulate the economy. In addition, the commitment to keep
interest rates low for an extended period of time would help lower long-term interest
rates, which would also induce greater spending.
Some economists, such as John Taylor of Stanford University, take the position
that strong empirical evidence exists for substantial interest-rate effects on consumer
and investment spending through the real cost of borrowing, making the interest-rate
monetary transmission mechanism a strong one. His position is highly controversial,
and many researchers, including Ben Bernanke, former chair of the Fed, and Mark
Gertler of New York University, believe that the empirical evidence does not support
strong interest-rate effects that operate through the real cost of borrowing.2 Indeed,
these researchers see the empirical failure of traditional interest-rate monetary trans-
mission mechanisms as having provided the stimulus for the search for other transmis-
sion mechanisms of monetary policy.
These other transmission mechanisms fall into two basic categories: those operat-
ing through asset prices other than interest rates and those operating through asym-
metric information effects on credit markets (the credit view). These mechanisms are
summarized in the schematic diagram in Figure 1.

Other Asset Price Channels

One drawback of the aggregate demand analysis in previous chapters is that it focuses
on only one asset price, the interest rate, rather than on many asset prices. In addition
to bond prices, two other asset prices receive substantial attention as channels for mon-
etary policy effects: foreign exchange rates and the prices of equities (stocks).

Exchange Rate Effects on Net Exports With the growing internationalization

of economies throughout the world and the advent of flexible exchange rates, more
attention has been paid to how monetary policy affects exchange rates, which in turn
affect net exports and aggregate demand.
The foreign exchange rate channel also involves interest-rate effects because, as we
saw in Chapter 18, when domestic real interest rates fall, domestic dollar assets become
less attractive relative to assets denominated in foreign currencies. As a result, the
value of dollar assets relative to other currency assets falls, and the dollar depreciates
2
See John Taylor, “The Monetary Transmission Mechanism: An Empirical Framework,” Journal of Economic Per-
spectives 9 (Fall 1995): 11–26, and Ben Bernanke and Mark Gertler, “Inside the Black Box: The Credit Channel of
Monetary Policy Transmission,” Journal of Economic Perspectives 9 (Fall 1995): 27–48.
 664

Mini-lecture
MONETARY POLICY

FIGURE 1
PART 6

OTHER ASSET PRICE EFFECTS CREDIT VIEW

TRADITIONAL EXCHANGE TOBIN'S q WEALTH BANK BALANCE CASH FLOW UNANTICIPATED HOUSEHOLD
INTEREST- RATE THEORY EFFECTS LENDING SHEET CHANNEL PRICE LEVEL LIQUIDITY
RATE EFFECTS ON CHANNEL CHANNEL CHANNEL EFFECTS

Mechanisms
EFFECTS NET EXPORTS

MECHANISMS
TRANSMISSION
Monetary Monetary Monetary Monetary Monetary Monetary Monetary Monetary Monetary
policy policy policy policy policy policy policy policy policy
Monetary Theory

Real Real Stock prices Stock prices Bank deposits Stock prices Nominal Unanticipated Stock prices
interest rates interest rates interest rates price level

Tobin’s q Financial Bank loans Financial

Exchange wealth Cash flow wealth
rate
Moral hazard, Moral hazard,
adverse Moral hazard, adverse
selection adverse selection
selection

AFFECT SPENDING
HOW POLICY CHANGES
Lending activity Lending activity
Lending activity
Probability
of financial
distress

INVESTMENT INVESTMENT INVESTMENT INVESTMENT INVESTMENT INVESTMENT

RESIDENTIAL RESIDENTIAL RESIDENTIAL
HOUSING HOUSING HOUSING
CONSUMER CONSUMPTION CONSUMER
DURABLE DURABLE
EXPENDITURE EXPENDITURE

SPENDING (GDP)
COMPONENTS OF
NET EXPORTS

The Link Between Monetary Policy and Aggregate Demand: Monetary Transmission

This figure shows the different channels through which monetary policy affects aggregate demand.
AGGREGATE DEMAND
 CHAPTER 26 Transmission Mechanisms of Monetary Policy 665

(denoted by ET ). The lower value of the domestic currency makes domestic goods
cheaper than foreign goods, thereby causing a rise in net exports 1NX c 2 and hence in
aggregate demand 1Yad c 2. The schematic for the monetary transmission mechanism
that operates through the exchange rate is

rT 1 ET 1 NX c 1 Yad c (3)

Tobin’s q Theory Nobel Prize winner James Tobin developed a theory, referred to
as Tobin’s q theory, that explains how monetary policy can affect the economy through
its effects on the valuation of equities (stock). Tobin 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. Companies then can issue stock and get
a high price for it relative to the cost of the facilities and equipment they are buying.
Investment spending will rise because firms can buy a lot of new investment goods
with only a small issue of stock.
Conversely, 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. If companies want to
acquire capital when q is low, they can buy another firm cheaply and acquire old capi-
tal instead. Investment spending, the purchase of new investment goods, will then be
very low. Tobin’s q theory gives a good explanation for the extremely low rate of invest-
ment spending during the Great Depression. In that period, stock prices collapsed, and
by 1933, stocks were worth only one-tenth of their value in late 1929; q fell to unprec-
edentedly low levels.
The crux of this discussion is that a link exists between Tobin’s q and investment
spending. But how might monetary policy affect stock prices? Quite simply, lower real
interest rates on bonds mean that the expected return on this alternative to stocks falls.
This makes stocks more attractive relative to bonds, and so demand for them increases,
which raises their price.3 By combining this result with the fact that higher stock prices
1Ps 2 will lead to a higher q and thus higher investment spending I, we can write the fol-
lowing transmission mechanism of monetary policy:

rT 1 Ps c 1 q c 1 I c 1 Yad c (4)

Wealth Effects In their search for new monetary transmission mechanisms,

researchers also looked at how consumers’ balance sheets might affect their spending
decisions. Franco Modigliani was the first to take this tack, using his famous life cycle
hypothesis of consumption. Consumption is spending by consumers on nondurable
goods and services.4 It differs from consumer expenditure in that it does not include
spending on consumer durables. The basic premise of Modigliani’s theory is that con-
sumers smooth out their consumption over time. Therefore, consumption spending is
determined by the lifetime resources of consumers, not just today’s income.

3
An alternative way of looking at this transmission mechanism is to use the model discussed in Chapter 7 in which
a decrease in the real interest rate lowers the required return on investments in stocks and so increases stock
prices. Then the lower yield on stocks reduces the cost of financing investment spending through the issuance
of equity. This way of looking at the link between stock prices and investment spending is formally equivalent to
Tobin’s q theory.
4
Consumption also includes another small component, the services that a consumer receives from the ownership
of housing and consumer durables.
666 PART 6 Monetary Theory

An important component of consumers’ lifetime resources is their financial wealth,

a major part of which is common stocks. When stock prices rise, the value of financial
wealth increases, thereby increasing the lifetime resources of consumers, which means
that consumption should rise. Considering that, as we have seen, monetary easing can
lead to a rise in stock prices, we now have another monetary transmission mechanism:

rT 1 Ps c 1 wealth c 1 consumption c 1 Yad c (5)

Modigliani’s research found this relationship to be an extremely powerful mechanism
that adds substantially to the potency of monetary policy.
The wealth and Tobin’s q channels allow for a general definition of equity, so they
can also be applied to the housing market, where housing is equity. An increase in
home prices, which raises their prices relative to replacement cost, leads to a rise in
Tobin’s q for housing, thereby stimulating its production. Similarly, housing prices are
extremely important components of wealth, so rises in these prices increase wealth,
thereby increasing consumption. Monetary expansion, which raises housing prices
through the Tobin’s q and wealth mechanisms described here, thus leads to a rise in
aggregate demand.

Credit View
Dissatisfaction with the conventional story that interest-rate effects explain the impact
of monetary policy on spending on durable assets has led to a new explanation that
is based on the concept of asymmetric information, a problem that leads to financial
frictions in financial markets (see Chapter 8). This explanation, referred to as the credit
view, 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
and those that operate through effects on firms’ and households’ balance sheets.

Bank Lending Channel The concept of the bank lending channel is based on the
analysis in Chapter 8, which demonstrated that banks play a special role in the finan-
cial system because they are especially well suited to solving asymmetric information
problems in credit markets. Because of banks’ special role, certain borrowers will not
have access to the credit markets unless they borrow from banks. As long as there is
no perfect substitutability of retail bank deposits with other sources of funds, the bank
lending channel of monetary transmission operates as follows: Expansionary monetary
policy, which increases bank reserves and bank deposits, raises the quantity of bank
loans available. Because many borrowers are dependent on bank loans to finance their
activities, this increase in loans causes investment (and possibly consumer) spending to
rise. Schematically, the monetary policy effect is written as follows:

bank reserves c 1 bank deposits c 1 bank loans c 1 I c 1 Yad c (6)

An important implication of the credit view is that monetary policy will have a greater
effect on expenditure by smaller firms, which are more dependent on bank loans, than
it will on large firms, which can get funds directly through the stock and bond markets
(and not only through banks).
Although this mechanism has been confirmed by researchers, doubts about the
influence of the bank lending channel have been raised in the literature, and there
are reasons to suspect that the bank lending channel in the United States may not be
as powerful as it once was. The first reason this channel is less powerful than it once
 CHAPTER 26 Transmission Mechanisms of Monetary Policy 667

was is that current U.S. regulations no longer impose restrictions on banks that hin-
der their ability to raise funds (see Chapter 11). Prior to the mid-1980s, certificates
of deposit (CDs) were subjected to reserve requirements and Regulation Q deposit
rate ceilings, which made it hard for banks to replace deposits that flowed out of
the banking system during a monetary contraction. With these regulatory restrictions
abolished, banks can more easily respond to a decline in bank reserves and a loss of
retail deposits by issuing CDs at market interest rates that do not have to be backed up
by required reserves. Second, the worldwide decline of the traditional bank lending
business (also discussed in Chapter 11) has rendered the bank lending channel less
potent. Nonetheless, many economists believe that the bank lending channel played
an important role in the slow recovery of the United States from the 2007–2009 reces-
sion. However, this channel is likely to be even less potent in recent years because
banks are now paid interest on their excess reserves and so have less incentive to lend
them out.

Balance Sheet Channel Even though the bank lending channel may be declin-
ing in importance, it is by no means clear that this is the case for the other credit
channel, the balance sheet channel. Like the bank lending channel, the balance sheet
channel arises from the presence of financial frictions in credit markets. In Chapter 8,
we saw that the lower the net worth of business firms, the more severe the adverse
selection and moral hazard problems in lending to these firms become. Lower net
worth means that lenders in effect have less collateral for their loans, so their potential
losses from adverse selection are higher. A decline in firms’ net worth, which raises
the adverse selection problem, thus leads to decreased lending to finance investment
spending. The lower net worth of businesses also increases the moral hazard problem
because it means that owners have a lower equity stake in their firms, giving them
more incentive to engage in risky investment projects. When borrowers take on more
risky investment projects, it is more likely that lenders will not be paid back, and so a
decrease in businesses’ net worth leads to a reduction in lending and hence in invest-
ment spending.
Monetary policy can affect firms’ balance sheets in several ways. Easing of mon-
etary policy, which causes a rise in stock prices 1Ps c 2 along the lines described ear-
lier, raises the net worth of firms and so leads to higher investment spending 1I c 2
and higher aggregate demand 1Yad c 2 because of the decrease in adverse selection and
moral hazard problems. This leads to the following schematic for this particular bal-
ance sheet channel of monetary transmission:

rT 1 Ps c 1 firms’ net worth c 1 adverse selectionT ,

(7)
moral hazardT 1 lending c 1 I c 1 Yad c

Cash Flow Channel Another balance sheet channel operates by affecting cash
flow, the difference between firms’ cash receipts and cash expenditures. An easing of
monetary policy, which lowers nominal interest rates, also causes an improvement in
firms’ balance sheets because it raises cash flow. The increase in cash flow increases
the liquidity of the firm (or household) and thus makes it easier for lenders to know
whether the firm (or household) will be able to pay its bills. The result is that adverse
selection and moral hazard problems become less severe, leading to an increase in lend-
ing and economic activity. The following schematic describes this alternative balance
sheet channel:
668 PART 6 Monetary Theory

i T 1 firms’ cash flow c 1 adverse selectionT ,

(8)
moral hazardT 1 lending c 1 I c 1 Yad c
An important feature of this transmission mechanism is that nominal interest rates affect
firms’ cash flow. Thus this interest-rate mechanism differs from the traditional interest-
rate mechanism discussed earlier in which the real interest rate affects investment.
Furthermore, the short-term interest rate plays a special role in this transmission mech-
anism because interest payments on short-term (rather than long-term) debt typically
have the greatest impact on the cash flow of households and firms.
A related transmission mechanism involving adverse selection is the credit-rationing
phenomenon. Through this mechanism, expansionary monetary policy that lowers
interest rates can stimulate aggregate demand. As discussed in Chapter 9, credit ration-
ing occurs when borrowers are denied loans even though they are willing to pay a
higher interest rate. The loans are denied because individuals and firms with the riski-
est investment projects are exactly the ones who are willing to pay the highest interest
rates because, if the high-risk investment succeeds, they will be the primary benefi-
ciaries. Thus higher interest rates increase the adverse selection problem, and lower
interest rates reduce it. When expansionary monetary policy lowers interest rates, risk-
prone borrowers make up a smaller fraction of those demanding loans, and so lenders
are more willing to lend, raising both investment and aggregate demand, along the lines
of parts of the schematic given in Equation 8.

Unanticipated Price Level Channel A third balance sheet channel operates

through monetary policy effects on the general price level. Because in industrialized
countries debt payments are contractually fixed in nominal terms, an unanticipated
rise in the price level lowers the value of firms’ liabilities in real terms (decreases the
burden of the debt) but should not lower the real value of the firms’ assets. An easing of
monetary policy, which raises inflation and hence leads to an unanticipated rise in the
price level 1P c 2, therefore raises real net worth, which lowers adverse selection and
moral hazard problems, thereby leading to a rise in investment spending and aggregate
demand, as in the following schematic:

rT 1 p c 1 unanticipated P c 1 firms’ real net worth c

(9)
1 adverse selectionT , moral hazardT 1 lending c 1 I c 1 Yad c
The view that unanticipated movements in the price level affect aggregate demand
has a long tradition in economics: It is the key feature in the debt-deflation view of the
Great Depression, outlined in Chapter 12.

Household Liquidity Effects Although most literature on the credit channel

focuses on spending by businesses, the credit view should apply equally well to con-
sumer spending, particularly spending on consumer durables and housing. Declines in
bank lending induced by a monetary contraction should cause corresponding declines
in durable and housing purchases by consumers who do not have access to other
sources of credit. Similarly, increases in interest rates should cause deteriorations in
household balance sheets, because consumers’ cash flow is adversely affected.
The balance sheet channel also operates through liquidity effects on consumer
durable and housing expenditures. These effects were found to be important factors
during the Great Depression (see the FYI box “Consumers’ Balance Sheets and the Great
Depression”). In the liquidity effects view, balance sheet effects work through their
 CHAPTER 26 Transmission Mechanisms of Monetary Policy 669

impact on consumers’ desire to spend rather than on lenders’ desire to lend. Because
of asymmetric information regarding their quality, consumer durables and housing are
very illiquid assets. If, as a result of a severe income shock, consumers needed to sell
their consumer durables or housing immediately to raise money, they would expect to
suffer a big financial loss because they would not be able to get the full value of these
assets in a distress sale. (This is just a manifestation of the lemons problem described in
Chapter 8.) In contrast, if consumers held financial assets (such as money in the bank,
stocks, or bonds), they could sell them quickly and easily for their full market value
and raise the cash. Hence, if consumers expect that they are likely to find themselves in
financial distress, they will prefer to hold fewer illiquid consumer durable and housing
assets and a greater amount of liquid financial assets.
A consumer’s balance sheet should be an important influence on his or her esti-
mate of the likelihood of future suffering from financial distress. Specifically, when
consumers have a large amount of financial assets relative to their debts, their estimate
of the probability of financial distress is low, and they are more willing to purchase
consumer durables or housing. When stock prices rise, the value of financial assets
increases as well; consumer durable expenditure will also rise because consumers have
a more secure financial position and therefore a lower estimate of the likelihood of
future financial distress. This leads to another transmission mechanism for monetary
policy, one that operates through the link between money and stock prices:

rT 1 Ps c 1 value of households’ financial assets c

1 likelihood of financial distressT (10)
1 consumer durable and housing expenditure c 1 Yad c

The illiquidity of consumer durable and housing assets provides another reason
why a monetary easing, which lowers interest rates and thereby increases cash flow to
consumers, leads to a rise in spending on consumer durables and housing. An increase
in consumer cash flow decreases the likelihood of financial distress, which increases the
desire of consumers to hold durable goods and housing, thus increasing spending on
these items and hence increasing aggregate demand. The only difference between this
view of cash flow effects and that outlined in Equation 8 is that in this view, it is not

FYI Consumers’ Balance Sheets and the Great Depression

The years between 1929 and 1933 witnessed the the value of financial assets relative to the amount
worst deterioration in consumers’ balance sheets ever of debt declined sharply, increasing the likelihood
seen in the United States. The stock market crash in of financial distress. Not surprisingly, spending on
1929, which caused an economic slump that lasted consumer durables and housing fell precipitously:
until 1933, reduced the value of consumers’ wealth From 1929 to 1933, consumer durable expenditure
by $1,020 billion (in 2009 dollars), and as expected, declined by over 50%, while expenditure on housing
consumption dropped sharply (by $199 billion). declined by 80%.*
Because of the decline in the price level during that *For further discussion of the effect of consumers’ balance sheets on spending
during the Great Depression, see Frederic S. Mishkin, “The Household Bal-
period, the level of real debt that consumers owed ance Sheet and the Great Depression,” Journal of Economic History 38 (1978):
also increased sharply (by over 20%). Consequently, 918–937.
670 PART 6 Monetary Theory

the willingness of lenders to lend to consumers that causes expenditure to rise, but the
willingness of consumers to spend.

Why Are Credit Channels Likely to Be Important?

There are three reasons to believe that credit channels are important monetary trans-
mission mechanisms. First, a large body of evidence on the behavior of individual firms
supports the view that financial frictions of the type crucial to the operation of credit
channels do affect firms’ employment and spending decisions. Second, evidence shows
that small firms (which are more likely to be credit-constrained) are hurt more by tight
monetary policy than large firms, which are unlikely to be credit-constrained. Third,
and maybe most compelling, the asymmetric information view of financial frictions,
which is at the core of credit channel analysis, is a theoretical construct that has proved
useful in explaining many other important economic phenomena, such as why many
of our financial institutions exist, why our financial system has the structure that it has,
and why financial crises are so damaging to the economy (topics discussed in Chapters 8
and 12). The best support for a theory is its demonstrated usefulness in a wide range
of applications. By this standard, the asymmetric information theory, which supports
the existence of credit channels as an important monetary transmission mechanism, has
much to recommend it.

A P P L I C AT I O N The Great Recession

With the advent of the financial crisis in the summer of 2007, the Fed began a
very aggressive easing of monetary policy. The Fed dropped the target federal funds
rate from 514 % to 0% over a 15-month period from September 2007 to December
2008. At first, it appeared that the Fed’s actions would keep the growth slowdown
mild and prevent a recession. However, the economy proved to be weaker than
the Fed or private forecasters expected, with the most severe recession of the post–
World War II period up until that time beginning in December 2007. Why did the
economy become so weak despite this unusually rapid reduction in the Fed’s policy
instrument?
The financial meltdown led to negative effects on the economy from many of the
channels we have outlined above. The rising level of subprime mortgage defaults,
which led to a decline in the value of mortgage-backed securities and CDOs, led
to large losses on the balance sheets of financial institutions. With weaker balance
sheets, these financial institutions began to deleverage and cut back on their lend-
ing. With no one else available to collect information and make loans, adverse selec-
tion and moral hazard problems, and hence financial frictions, increased in credit
markets, leading to a slowdown of the economy. Credit spreads also went through
the roof with the increase in uncertainty caused by the failure of so many financial
markets. The declines in the stock market and housing prices also weakened the
economy because they lowered household wealth. The decrease in household wealth
led to a drop in Tobin’s q, which led to restrained consumer spending and weaker
investment spending.
With all these channels operating, it is no surprise that despite the Fed’s aggressive
lowering of the federal funds rate, the economy still took a big hit. ◆
 CHAPTER 26 Transmission Mechanisms of Monetary Policy 671

26.2 LESSONS FOR MONETARY POLICY

LO 26.2 Summarize and apply the four lessons outlined in this chapter for the conduct
of monetary policy.

What useful lessons regarding the appropriate conduct of monetary policy can we draw
from the analysis in this chapter? Four basic lessons can be learned.
1. It is dangerous to consistently associate an easing or tightening of monetary pol-
icy with a fall or rise in short-term nominal interest rates. Because most central
banks use short-term nominal interest rates—typically, the interbank rate—as the
key operating instrument in their monetary policies, the danger exists that central
banks and the public will focus too much on short-term nominal interest rates as
an indicator of the stance of monetary policy. Indeed, it is quite common to see
statements that always associate monetary tightenings with a rise in the interbank
rate and monetary easings with a decline in the interbank rate. We do not make
this mistake in this book because we have been careful to associate monetary easing
or tightening with changes in real and not nominal interest rates.
2. Other asset prices besides those on short-term debt instruments contain important
information about the stance of monetary policy because they are important ele-
ments in various monetary policy transmission mechanisms. As we have seen in this
chapter, economists have come a long way in understanding that other asset prices
besides interest rates have major effects on aggregate demand. As we saw in Figure 1,
asset prices such as stock prices, foreign exchange rates, and housing prices play
an important role in monetary transmission mechanisms. Furthermore, additional
channels, such as those that operate through the exchange rate, Tobin’s q, and wealth
effects, provide additional evidence that other asset prices play an important role in
monetary transmission mechanisms. Although economists strongly disagree among
themselves about which channels of monetary transmission are the most important—
not surprising, given that economists, particularly those in academia, always enjoy a
good debate—they do concur that asset prices other than those on short-term debt
instruments play an important role in the effects of monetary policy on the economy.
The view that asset prices other than short-term interest rates matter has
important implications for monetary policy. When we try to assess the stance of
policy, it is critical that we look at other asset prices in addition to short-term inter-
est rates. For example, if short-term interest rates are low or even zero and yet stock
prices are low, housing prices are low, and the value of the domestic currency is
high, monetary policy is clearly tight, not easy.
3. Monetary policy can be effective in reviving a weak economy even if short-term
interest rates are already near zero. We have recently entered a world in which
inflation is not always the norm. Japan, for example, recently experienced a period
of deflation during which the price level was actually falling. In the United States,
the federal funds rate hit a floor of zero from the end of 2008 until the end of
2015 and then again in March 2020. One common view is that when a central bank
has driven down short-term nominal interest rates to nearly zero, monetary policy
can do nothing more to stimulate the economy. The transmission mechanisms of
monetary policy described here indicate that this view is false. As indicated in our
discussion of the factors that affect the monetary base in Chapter 15, expansionary
monetary policy aimed at increasing liquidity in the economy can be conducted
through open market purchases, which do not have to be solely in short-term
672 PART 6 Monetary Theory

government securities. For example, purchases of private securities, as the Federal

Reserve made in 2009 and in 2020, can reduce financial frictions by lowering credit
spreads and stimulating investment spending. In addition, a commitment to future
expansionary monetary policy helps revive the economy by raising inflation expec-
tations and by reflating other asset prices, which then stimulate aggregate demand
through the channels outlined here. The nonconventional monetary policies we dis-
cussed in Chapter 16 are policies of this type. Nonconventional monetary policies
can be a potent force in reviving economies that are undergoing deflation and that
have short-term interest rates near zero. Indeed, as we saw in Chapter 12, aggres-
sive nonconventional monetary policy during the recent financial crisis helped pre-
vent the Great Recession from turning into a Great Depression and also helped the
economy avoid a deflationary episode like the one that occurred during the Great
Depression era. Aggressive nonconventional monetary policy has again been imple-
mented to boost the economy in the aftermath of the coronavirus pandemic.
4. Avoiding unanticipated fluctuations in the price level is an important objective of
monetary policy, thus providing a rationale for price stability as the primary long-
run goal of monetary policy. As we saw in Chapter 17, central banks in recent years
have been placing greater emphasis on price stability as the primary long-run goal of
monetary policy. Several rationales for this goal have been proposed, including the
undesirable effects of uncertainty about the future price level on business decisions
and hence on productivity, distortions associated with the interaction of nominal
contracts and the tax system with inflation, and increased social conflict stemming
from inflation. Our discussion of monetary transmission mechanisms provides an
additional reason why price stability is so important. As we have seen, unanticipated
movements in the inflation rate can cause unanticipated fluctuations in output, an
undesirable outcome. Particularly important in this regard is the knowledge that, as
we saw in Chapter 12, price deflation can be an important factor leading to a pro-
longed financial crisis, as occurred during the Great Depression. An understanding
of the monetary transmission mechanisms thus makes it clear that the goal of price
stability is desirable because it reduces uncertainty about the future price level. The
price stability goal implies that a negative inflation rate is at least as undesirable as
too high an inflation rate. Indeed, because of the threat of financial crises, central
banks must work very hard to prevent price deflation.

A P P L I C AT I O N Applying the Monetary Policy Lessons to

Japan’s Two Lost Decades
Until 1990, it looked as if Japan might overtake the United States in per capita income.
From the early 1990s until 2012, during the years that have become known as the “two
lost decades,” the Japanese economy stagnated, with deflation and low growth. As a result,
Japanese living standards fell further and further behind those of the United States. Many
economists take the view that Japanese monetary policy is in part to blame for the poor
performance of the Japanese economy during this period. Could Japanese monetary policy
have performed better if Japan had applied the four lessons outlined in the previous section?
The first lesson suggests that it is dangerous to think that declines in interest rates
always mean that monetary policy has been easing. In the mid-1990s, when short-term
interest rates began to decline, falling to nearly zero in the late 1990s and early 2000s,
the monetary authorities in Japan took the view that monetary policy was sufficiently
 CHAPTER 26 Transmission Mechanisms of Monetary Policy 673

expansionary. Now it is widely recognized that this view was incorrect, because the
falling and eventually negative inflation rates in Japan meant that real interest rates
were actually quite high and that monetary policy was tight, not easy. If the monetary
authorities in Japan had followed the advice of the first lesson, they might have pursued
a more expansionary monetary policy, which would have helped boost the economy.
The second lesson suggests that monetary policymakers should pay attention to other
asset prices, in addition to those on short-term debt instruments, in assessing the stance of
monetary policy. At the same time that interest rates were falling in Japan, stock and real
estate prices were collapsing, thus providing another indication that Japanese monetary
policy was not easy. Knowledge of the second lesson might have led Japanese monetary
policymakers to recognize sooner that they needed a more expansionary monetary policy.
The third lesson indicates that monetary policy can still be effective even if short-
term interest rates are near zero. Officials at the Bank of Japan frequently claimed that
they were helpless to stimulate the economy because short-term interest rates had fallen
to nearly zero. By recognizing that monetary policy can be effective even when interest
rates are near zero, as suggested by the third lesson, the Japanese monetary authori-
ties could have taken monetary policy actions that would have stimulated aggregate
demand by raising other asset prices and inflationary expectations.
The fourth lesson indicates that unanticipated fluctuations in the price level should
be avoided. If the Japanese monetary authorities had adhered to this lesson, they might
have recognized that allowing deflation to occur could be very damaging to the econ-
omy and that such deflation was inconsistent with the goal of price stability.
These four lessons of monetary policy were finally taken to heart by the Bank of
Japan. As we discussed in Chapter 24, monetary policy in Japan has undergone a dra-
matic shift since 2013, to a highly expansionary, nonconventional monetary policy
with a higher inflation target. Since then the Japanese economy has improved, with
the unemployment rate falling. However, although the inflation rate has risen, it still
remains stubbornly low, well below the Bank of Japan’s 2% inflation target. ◆

SUMMARY
1. The transmission mechanisms of monetary policy rise in short-term nominal interest rates; (2) other asset
include traditional interest-rate channels that operate prices besides those on short-term debt instruments
through the real cost of borrowing and affect investment; contain important information about the stance of mon-
other asset price channels such as exchange rate effects, etary policy because they are important elements in the
Tobin’s q theory, and wealth effects; and the credit view monetary policy transmission mechanisms; (3) mon-
channels—the bank lending channel, the balance sheet etary policy can be effective in reviving a weak economy
channel, the cash flow channel, the unanticipated price even if short-term interest rates are already near zero;
level channel, and household liquidity effects. and (4) avoiding unanticipated fluctuations in the price
2. Four lessons for monetary policy can be drawn from level is an important objective of monetary policy, thus
this chapter: (1) It is dangerous to consistently associ- providing a rationale for price stability as the primary
ate monetary policy easing or tightening with a fall or long-run goal of monetary policy.

KEY TERMS
consumer durable expenditure, p. 662 consumption, p. 665 transmission mechanisms of monetary
credit view, p. 663 policy, p. 662
674 PART 6 Monetary Theory

QUESTIONS
1. During 2012, as the ECB moved to avert and credit 10. From February to March 2020, the FTSE 100 declined
squeeze and bank failures, the financial departments of by more than 15%, while real interest rates were low
many European car manufacturers borrowed billions of or falling. What does this scenario suggest should have
euros to avail of cheap, three-year loans. In turn, the car happened to investment?
manufacturers lent the money to customers to buy cars. 11. Nobel Prize winner Franco Modigliani found that the
Do you think this is a normal and intended mechanism most important transmission mechanisms of monetary
of ECB’s monetary policy? policy involve consumer expenditure. Describe how at
2. “Considering that consumption accounts for nearly least two of these mechanisms work.
56% of total GDP, this means that the interest rate, 12. In the late 1990s, the stock market was rising rapidly,
wealth, and household liquidity channels are the the economy was growing, and the Federal Reserve
most important monetary policy channels in India” kept interest rates relatively low. Comment on how this
Is this statement true, false, or uncertain? Explain your policy stance would affect the economy as it relates to
answer. the Tobin q transmission mechanisms.
3. How can the interest rate channel still function when 13. During and after the global financial crisis, the Fed
short-term nominal interest rates are at the effective reduced the fed funds rate to nearly zero. At the same
lower bound? time, the stock market fell dramatically and housing
4. Lars Svensson, a former Princeton professor and deputy market values declined sharply. Comment on the
governor of the Swedish central bank, proclaimed that effectiveness of monetary policy during this period with
when an economy is at risk of falling into deflation, regard to the wealth channel.
central bankers should be “responsibly irresponsible” 14. From 2008 to 2009, the ECB continued to lower
with monetary expansion policies. What does interest rates. At the same time, the stock market fell
this mean, and how does it relate to the monetary dramatically, and housing market values declined
transmission mechanisms? sharply. Comment on the effectiveness of monetary
5. Describe an advantage and a disadvantage of the fact policy during this period with regard to the wealth
that monetary policy has so many different channels channel.
through which it can operate. 15. Why does the credit view imply that monetary policy has
6. Suppose that Argentina fixes its exchange rate. Does a greater effect on small businesses than on large firms?
this mean that the exchange rate channel of monetary 16. Do you think the banking channel is more important in
policy does not exist? Explain your answer. a developing country with no active financial markets
7. During the 2007–2009 recession, the value of common or a developed country with a very active financial
stocks in real terms fell by more than 50%. How might market?
this decline in the stock market have affected aggregate 17. If adverse selection and moral hazard increase, how
demand and thus contributed to the severity of the does this affect the ability of monetary policy to address
recession? Be specific about the mechanisms through economic downturns?
which the stock market decline affected the economy.
18. How does the Great Depression demonstrate the
8. “The costs of financing investment are related only to unanticipated price level channel?
interest rates; therefore, the only way that monetary
19. How are the wealth effect and the household liquidity
policy can affect investment spending is through its
effect similar? How are they different?
effects on interest rates.” Is this statement true, false, or
uncertain? Explain your answer. 20. After the coronavirus pandemic hit the economy,
mortgage rates reached record-low levels in 2020.
9. The Melbourne Institute and Westpac Bank Consumer
Sentiment Index for Australia jumped 4.1% in a. What effect should this have had on the economy
December 2020, while the stock market increased according to the household liquidity effect channel?
by more than 20%. Explain how this relates to the b. As unemployment soared and the global economy
monetary transmission mechanisms. went into full recession, a lot of banks became
 CHAPTER 26 Transmission Mechanisms of Monetary Policy 675

reluctant to lend. How does this information alter and the stance of monetary policy would remain
your answer in part (a)? accommodative. Explain this seeming contradiction.
21. “If the fed funds rate is at zero, the Fed can no longer 23. In a local newspaper, Rasa reads that stock prices in
implement effective accommodative policy.” Is this Lithuania are falling and unemployment is high and
statement true, false, or uncertain? Explain. consumption is slowing. Would she classify monetary
22. In 2019, Riksbank, Sweden’s central bank raised its policy as tight or easy?
benchmark repo rate from - 0.25% to 0%, after five 24. How does the experience of Japan during the “two lost
years of holding the rate in negative territory. The decades” lend support to the four lessons for monetary
central bank said in a statement that it expected the policy outlined in this chapter?
repo rate would remain unchanged through 2021,

APPLIED PROBLEMS
25. Suppose the economy is in recession and the monetary easing when the transmission mechanisms are function-
policymakers lower interest rates in an effort to stabilize ing normally and when the transmission mechanisms
the economy. Use an aggregate supply and demand are weak, such as during a deep downturn or when sig-
diagram to demonstrate the effects of a monetary nificant financial frictions are present.

DATA ANALYSIS PROBLEMS

The Problems update with real-time data in MyLab Economics 2. Real-time Data Analysis As defined in Exercise 1, a
and are available for practice or instructor assignment. “rate cycle” is a period of monetary policy during which the
1. Real-time Data Analysis A “rate cycle” is a period of federal funds rate moves from its low point toward its high
monetary policy during which the federal funds rate moves point, or vice versa, in response to business cycle condi-
from its low point toward its high point, or vice versa, in tions. Go to the St. Louis Federal Reserve FRED database,
response to business cycle conditions. Go to the St. Louis and find data on the federal funds rate (FEDFUNDS), bank
Federal Reserve FRED database, and find data on the reserves (TOTRESNS), bank deposits (TCDSL), commer-
federal funds rate (FEDFUNDS), real business fixed invest- cial and industrial loans (BUSLOANS), real estate loans
ment (PNFIC1), real residential investment (PRFIC1), and (REALLN), real business fixed investment (PNFIC96), and
consumer durable expenditures (PCDGCC96). Use the real residential investment (PRFIC1). Use the frequency set-
frequency setting to convert the federal funds rate data to ting to convert the federal funds rate, bank reserves, bank
“quarterly,” and download the data. deposits, commercial and industrial loans, and real estate
a. When did the last rate cycle begin and end? loans data to “quarterly,” and download the data.
(Note: If a rate cycle is currently in progress, a. When did the last rate cycle begin and end?
use the current period as the end.) Is this (Note: If a rate cycle is currently in progress,
rate cycle a contractionary or an expansion- use the current period as the end.) Is this
ary rate cycle? rate cycle a contractionary or an expansion-
b. Calculate the percentage change in busi- ary rate cycle?
ness fixed investment, residential (housing) b. Calculate the percentage change in bank
investment, and consumer durable expen- deposits, bank lending, real business fixed
ditures over this rate cycle. investment, and real residential (housing)
c. Based on your answers to parts (a) and (b), investment over this rate cycle.
how effective was the traditional interest c. Based on your answers to parts (a) and (b),
rate channel of monetary policy over this how effective was the bank lending channel
rate cycle? of monetary policy over this rate cycle?
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