Critically analyze the transmission mechanisms that provide the link between monetary policy and Gross Domestic Product (GDP)

Critically analyze the transmission mechanisms that provide the link between monetary policy and Gross Domestic Product (GDP)

Financial globalization in recent years has affected the monetary transmission mechanism, either by changing the overall impact of policy or by altering the transmission channels.The liberalization of capital accounts alongside technological advances and the emergence of increasingly sophisticated financial products have posed new macroeconomic challenges for central banks in industrial and emerging market economies. As a result understanding the transmission mechanism of monetary policy has become one of the pressing issues for policymakers and researchers in recent years. The monetary transmission mechanism refers to the process through which changes in monetary policy instruments affect the rest of the economy and, in particular, output and inflation.Monetary policy is transmitted through various channels that affect different variables and markets in different speeds and magnitude. Key financial variables such as interest rates,asset prices, credit, exchange rates and monetary aggregates define the six transmission channels-the Interest Rate Channel,the Bank Lending Channel,the Balance Sheet Channel,the Equity Price Channel,the Exchange Rate Channel and the Expectations Channel.These channels are interdependent and interrelated as the effects of monetary policy actions could flow through various paths and influence the inflation and Gross Domestic Product in various ways.

Empirical evidence has shown that the interest rate channel is the most important transmission channel in industrial countries with developed financial markets. An increase in the short-term nominal interest rates will lead to higher real interest rates given the assumption of sticky prices. Higher real interest rates will affect both investment and spending and lower current spending. However, the increase in real interest rates will lead to an increase in savings. The profits of the firms will decrease making investments less attractive. As a result from this mechanisms the decrease in investment and consumption will lead to a contraction in output thus pulling prices down .As wages/goods prices adjust overtime ,real Gross Domestic Product will return to its potential level and so will the real interest rate( Schmidt-Hebbel, 2002). For the United Kingdom, a temporary increase of interest rates by 100 basis points lowers output by around 0.2-0.35 per cent and inflation by 20-40 basis points after about a year (Bank of England, 1999).This channel depends deeply on the pass-through effect of monetary changes on consumption. There could be asymmetric effects on the wealth-consumption channel .This means the central bank should take into account the fact that increasing the interest rate will not reign in consumption growth to the desired level which makes it very important to rethink monetary policy measures. The Interest Rate Pass-through suggests that the interest rates of banks are reacting slow to monetary policies and also there is no uniform pattern in the pass-through between loans and deposits. Many economists have questioned the effectiveness of the Real Interest Rate Channel. Bernanke and Gertler (1995) claimed that only short-term interest rates are influenced by monetary policy innovations, while these are long-term rates that to a large extent affect durable assets purchase, therefore, monetary policy transmission through the interest channel proves to be ineffective.(Bernanke and Gertler ,1995).On the other hand, Smets and Wouters (2002) concluded that in countries of the euro area the interest rate channel proved to be effective in transmitting monetary impulses on consumption and investment demand and, consequently, on real output(Smets and Wouters ,2002).Even though there is no clear proof whether this is the best transmission mechanism channel it is still the most used one.

Another channel through which monetary policy can affect Gross Domestic Product is the Exchange Rate Channel. When the central bank increases the money supply ,short-term nominal interest rates fall so short-term real interest rates decreases as well. As a result the financial assets of the country become less attractive resulting in a decrease in the exchange rate(depreciation). However, domestic goods become cheaper since the currency has depreciated so there are more exports and Net Exports increase, pushing the GDP up. This could be a very useful tool for small open economies with flexible exchange rate. However, such currencies can be attacked by speculators aiming to benefit from currency fluctuations. If a country adopts a fixed exchange rate regime , its interest rate should equal the world interest rate so the government will not be able to set the level anymore. There could be some problems associated with using the Exchange Rate Channel such as time-inconsistency. From New-Keynesian models ,when cost-push shocks occur , the exchange rate channel gives rise to excessive output stabilization and insufficient inertia in monetary policy under a discretionary policy(Mishkin).There have been many papers which tried to evaluate the effectiveness of this channel such as the Barran ,Coudert and Mojon (1996).Their paper indicated that the exchange rate channel does not significantly strengthen the impact of a monetary policy shock.

There are two Equity Price Channels – the Tobin’s Q and wealth effects.Q is equal to Market Value of Capital/Replacement Cost of Capital so when Q is high firms will invest more. An expansionary monetary policy can lead to a higher Q because people have more money to spend so they buy stocks or because market interest rates are falling thus leaving people with less alternatives. The wealth effect results from an expansionary monetary policy which increases households wealth or because it increases the value of companies giving them the opportunity to borrow and spend more. A famous example of the wealth effect is the 1996-1999 Dot-com boom. The most important wealth effect comes from the real estate market. Lower interest rates makes borrowing more attractive , allowing people to buy their own houses. However , this leads to an increase in the price of houses which may create a real-estate bubble. Such an effect lead to the 2007 economic crises which proves that this channel is particularly dangerous and can have future consequences. Clearly, such developments are a challenge to central bankers, who carry the heavy responsibility of identifying the bubble ex-ante and subsequently, mitigating the deleterious repercussions arising from its bust.

Banks play a special role in the economy not only by issuing liabilities but also by providing loans to small and medium-sized companies. Small enterprises which are unable to offer shares on the stock market can fund investment through such loans. An expansionary monetary policy will result in more deposits and reserves in the bank so more money could be loaned. As a result small firms could borrow and invest more pushing the level of GDP up. However , there are some problems with this channel. First of all there are informational asymmetries between lenders and borrowers. Lenders should carefully evaluate the investment they are making which can be hard and costly and borrowers could have trouble finding a lender who is willing to invest in their project. Before the Global Financial Crisis in 2007 banks were lending a lot of money even to high risk clients in order to maximize profits. However, these risky loans became one of the main reasons the economic crisis occurred. That’s why policy changes in the regulatory environment served to ensure that banks are operated in a safe and sound manner. These, however, could have indirectly contributed to the cautious lending stance of banks in granting new or additional credit, thereby affecting the Bank Lending Channel.

The balance of sheet is a broader credit channel where financial market imperfections also play a key role. If there is an expansionary policy , the increase in the in interest rates will result in an increase in the payments the firm has to made in order to service its loan. Also this increase will reduce the capitalized value of the firm’s long-lived assets. As a result there is a decrease in consumption from the direct effect and increased cost of capital through the Balance Sheet Channel which leads to a decrease in Gross Domestic Product.The main problems with this channel are moral hazard and adverse selection in financial markets(Mishkin).There is always a risk that borrowers will not be able to pay their loans. The bank has to evaluate whether it is worth lending to a low net-worth firm having in mind that the company can fail. Also if they do lend money , the increased loan will push the firm to engage in more risky investments which will increase the likelihood of failure. Whether risk avoidance results in underinvestment or overinvestment ,however, depends on assumptions about technology and the nature of uncertainty and cannot be derived from the incentive problem as such. It is therefore quite possible that the Balance Sheet Channel works to decelerate rather than to accelerate financial shocks Through this channel there could also be an effect on the balance sheets of households. If there is a decrease in credit card, student loan, or mortgage interest rates , consumer will be able to spend more money on consumption and housing.

The impact of the Expectations Channel is the most uncertain of all channels because it depends on the public’s interpretation of the monetary policy. Changes in the monetary policy stance affect the expectations of the people about inflation , Gross Domestic Product , employment. The public could interpret a decrease in the policy rate as a signal that the economy is going to expand so they consume and invest more thus increasing GDP. However, they could think that the economy is weaker than expected , decreasing their consumption and investment and driving GDP down. Usually governments publicly announce their intentions in order to keep the people informed. However, there might be an incentive to cheat if there are gains from cheating. Even thought there might be some short-run gains, in the future the public will not believe the government so blindly. As a result the people will ignore the announcements of the government , making the Expectations Channel unusable for the government.

The central bank does not control Gross Domestic Product directly because it is determined by the supply and demand of many goods and services. As a result there is an extreme need for the monetary authority to identify the effects that its actions have on the general economy and, particularly, on the GDP. The study of the channels by which these effects take place is known as the monetary policy transmission mechanism. The different channels through which the effects of monetary policy are transmitted to the economy are complementary because they operate simultaneously. Each channel has its criticism regarding the extend to which it affects GDP so a government should focus on multiple channels in order to achieve its goal.

Bibliography:

MISHKIN, Frederic S., 2010. The economics of money, banking, and financial markets. Pearson.

HANDA, Jagdish., 2000. Monetary economics. Routledge. Bank of England < http://www.bankofengland.co.uk/statistics/Pages/default.aspx> 5.12.2012

Schmidt-Hebbel,Klaus , Macroeconomic policies and performance in Latin America ,
Central Bank of Chile, Agustinas, Santiago 1180, Chile

Bernanke,Ben S. ; Gertler,Mark 1995
Inside the Black Box:The credit channel of monetary policy transmission
< http://www.calstatela.edu/faculty/rcastil/ECON_435/Bernanke.pdf>

Smets,Frank;Wouters,Raf , August 2002
An estimated stochastics dynamic general equilibrium mode of the euro area

Fernando Barran & Virginie Coudert & Benoit Mojon, 1996
The transmission of Monetary Policy in the European Countries
Working Papers 1996-03, CEPII research center

Bibliography: MISHKIN, Frederic S., 2010. The economics of money, banking, and financial markets. Pearson. HANDA, Jagdish., 2000 Fernando Barran & Virginie Coudert & Benoit Mojon, 1996 The transmission of Monetary Policy in the European Countries