Chapter 23 Monetary Policy
Chapter 23: Transmission Mechanisms of Monetary Policy: The Evidence
I. Framework for Evaluating Empirical Evidence Two Basic Types of Empirical Evidence
Structural Model - Examines whether one variable affects another by using data to build a model that explains the channels through which the variable affects the other. M i I Y
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)
Reduced-Form
Examines whether one variable has an effect on another by looking directly at the relationship between the two
Analyzes the effect of changes in money supply on aggregate output (spending) to see if there is a high correlation
Does not describe the specific path M ? Y
Structural Model Advantages and Disadvantages
1. Possible to gather more evidence more confidence on the direction of causation between M and Y
2. More accurate predictions
3. Understand how institutional changes affect the links
Reduced-Form Advantages and Disadvantages 1. No restrictions imposed on the way monetary policy affects the economy 2. Correlation does not necessarily imply causation
Reverse causation
Outside driving factor
II. Early Keynesian Evidence on the Importance of Money
Monetary policy does not matter at all
Three pieces of structural model evidence
Low interest rates during the Great Depression indicated expansionary monetary policy but had no effect on the economy.
Empirical studies found no linkage between movement in nominal interest rates and investment spending.
Surveys of business people confirmed that investment in physical capital was not based on market interest rates.
Objections to Early Keynesian Evidence
Friedman and Schwartz publish a monetary history of the U.S. showing that monetary policy
I. Framework for Evaluating Empirical Evidence Two Basic Types of Empirical Evidence
Structural Model - Examines whether one variable affects another by using data to build a model that explains the channels through which the variable affects the other. M i I Y
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)
Reduced-Form
Examines whether one variable has an effect on another by looking directly at the relationship between the two
Analyzes the effect of changes in money supply on aggregate output (spending) to see if there is a high correlation
Does not describe the specific path M ? Y
Structural Model Advantages and Disadvantages
1. Possible to gather more evidence more confidence on the direction of causation between M and Y
2. More accurate predictions
3. Understand how institutional changes affect the links
Reduced-Form Advantages and Disadvantages 1. No restrictions imposed on the way monetary policy affects the economy 2. Correlation does not necessarily imply causation
Reverse causation
Outside driving factor
II. Early Keynesian Evidence on the Importance of Money
Monetary policy does not matter at all
Three pieces of structural model evidence
Low interest rates during the Great Depression indicated expansionary monetary policy but had no effect on the economy.
Empirical studies found no linkage between movement in nominal interest rates and investment spending.
Surveys of business people confirmed that investment in physical capital was not based on market interest rates.
Objections to Early Keynesian Evidence
Friedman and Schwartz publish a monetary history of the U.S. showing that monetary policy