Transmission Mechanism of the Monetary Policy

 EXECUTIVE SUMMARY

 The transmission mechanism is a chain of events by which monetary policy decisions affect the ultimate goals. The mechanism is most commonly understood in terms of channels through which impulses are transmitted. Most significant of them are the saving and investment, cash flow, balance sheet, money and credit and wealth effect channels. Two major schools of monetary economics have different views on the transmission mechanism. Keynesians believe in the indirect link between money supply and aggregate demand through the interest rates whereas monetarists think money supply and aggregate demand are linked directly.

 The nature of the transmission mechanism has changed due to the shift in the monetary policy framework. Central banks worldwide abandoned monetary targeting and adopted inflation targeting using manipulations in the short-term interest rates. The mechanism on which the monetary policy is based has also been transformed to a large degree by the financial deregulation, which contributed to the tremendous growth in the financial sector and development of new financial instruments. The growth in use of hedging instruments and fixed interest loans; the implications of handling the government surpluses or deficits, the announcement effect and other issues have become significant factors affecting the processes and outcomes of the monetary policy.

 INDEX

 Introduction

1.0 Channels of Transmission Mechanism

1.1 Saving and investment

1.2 Cash Flow

1.3 Balance Sheet

1.4 Money and Credit

1.5 Wealth Effects

2.0 Major Views on Transmission Mechanism

2.1 Keynesian Model

2.2 Monetarist Model

3.0 Changes in Monetary Policy

4.0 Transmission Mechanism Pre- and Post-Deregulation

4.1 Exchange Rate

4.2 Money and Credit Channel

5.0 Factors Reducing the Effectiveness of the Monetary Policy

Conclusion

Bibliography  

Appendix

INTRODUCTION

This paper aims to discuss the issue of the transmission mechanism. The transmission mechanism is a chain of events by which monetary policy decisions affect the ultimate policy goals. The paper will focus on the channels of this mechanism and present two major views on the matter. It will then look at how the financial deregulation together with the shift in the monetary policy affected the transmission mechanism. Finally the essay will consider the impact on the monetary policy mechanics of some factors, which evolved in the deregulated environment.

1.0   CHANNELS OF TRANSMISSION MECHANISM

The mechanism is most commonly understood in terms of channels through which the policy impulse is transmitted.

1.1 Saving And Investment

Economists consider this channel as one of the principal avenues through which the monetary policy is transmitted. Contractionary policy i.e. a rise in interest rates will make borrowings to finance the expenditure more expensive. This stimulates incentives to save and reduces incentives to spend. Households, faced with higher mortgage rates will likely to postpone buying a house.  The empirical data from the RBA proves this proposition. At times when interest rates shot up the number of the housing start-ups fell[1]. Drop in demand for housing decreases demand for various household goods and building materials, which creates a contractionary effect on the economy.

Rising interest rates will also affect the business sector.  As costs of finance rise, investment expenditures by the corporate sector will decrease.  Greater interest rates will be reflected in the evaluation of business projects. NPV’s and IRR’s will be lower due to higher discount rate – hence fewer projects will be approved. Weakened investment activity will decrease the aggregate output and reduce inflation.

1.2 Cash Flow

Movements in interest rates will have an impact on cash flow of both the household and business sectors. Higher interest rates will increase interest payments, which households pay on home loans and other borrowings. This will slash their disposable income after interest payments. Consequently, consumption and general economic activity will decelerate.

 Similar effect is observed in the business sector. Australian firms spend on interest payments about 25% of the operating profits. A rise in interest expenses would limit company expenditure on investment. For example, in the late 1980s higher interest rates and the rise in corporate debt lifted commercial interest payments to 40% of profits [2]. Deteriorating cash flows forced businesses to cut investment, which precipitated the recession in the followed years.

1.3 Balance Sheet

Expansionary monetary policy increases companies’ capitalisation through the boom in the stockmarket. This increases their net worth and thus improves their balance sheets. Greater net worth lifts the value of collateral, which lenders hold for loans. The adverse selection effect and the issue of moral hazard of lending to companies will weaken, i.e. the quality of the pool of borrowers will improve (Rogers & Neal, 1994).

 Overall lending to firms will become more attractive to banks. This will stimulate more lending for investment purposes. Therefore, the net worth will bolster the investment spending which will add to the growth in aggregate demand (Mishkin, 1998). 

Researchers believe this is a very important channel of the transmission mechanism. It was empirically observed that the spending decisions of a significant group of borrowers are influenced by conditions of their balance sheet  [3] .

1.4 Money and Credit

 The previous channels relate to the rate of interest. This channel is concerned with the availability of finance. Monetary impulses can be relayed through market-induced fluctuations in the level of credit supply. Generally, in periods of a tighter monetary policy it is more difficult for borrowers to get loans.

 Banks are constantly monitoring their credit standards, which reflect their assessment of default risks by potential borrowers. If interest rates are high and therefore a greater probability of default exists, lenders will tighten their credit standards, which will reduce the quantity of finance available (Edey, 1998). This will in turn slow the company’s investment activity and suppress the economic growth and inflation.

 1.5 Wealth Effect

 Franco Modigliani developed a theory of life cycle consumption, which related the monetary transmission mechanism to consumers’ spending on non-durable goods and services. He argued that over time consumers smooth out their consumption because they plan it taking into account not just the current income but their total lifetime resources  [4].

 In the developed countries where a large number of people own shares, financial wealth (of which shares is a main component) accounts for an important portion of the consumers’ lifetime resources. Normally, the expansionary monetary policy is quickly transmitted to the stockmarket. (Whenever central banks lower the cash rate, share prices tend to go up). Rising share prices increase the financial wealth and thus expand consumers’ lifetime resources, which in turn stimulate consumption spending and add to the aggregate demand [5].

2.0 MAJOR VIEWS ON THE TRANSMISSION MECHANISM

 The transmission mechanism of the monetary policy was viewed differently by the two dominant schools of monetary economics: the Keynesians and the monetarists.

 2.1 Keynesian Model

 In the Keynesian view there is an indirect link between the level of money supply and the aggregate demand through the interest rates.

 The transmission mechanism works as follows. The shift of money supply from M to M¹ causes interest rates to decrease from r to r¹. This causes initial temporary excess in aggregate money balances held by the public. Consequently, the demand for bonds and other non-cash assets increases. Their prices go up and – since interest rates are inversely correlated with bond prices – this causes a drop in the rates of interest (Rousseas, 1992).

 Falling interest rates cause an increase in planned investment. The rise in investment in turn boosts the aggregate demand, which causes a rundown of stocks and growth in production. This through the Keynes’ multiplier effect increases the national income. Lower interest rates also stimulate consumption expenditure (people borrow more to buy houses, cars etc)  [6].

 2.2 Monetarist Model

 Unlike Keynesians, Monetarists believed in the direct link between the money supply and the aggregate demand. Expansionary monetary policy will directly stimulate the aggregate demand for final goods and services not just through planned investment (via the interest rates) as in the Keynesian analysis.

 The assumption is that if businesses and households will have more money than they would otherwise needed, they will spend the excess by consuming more of the non-cash assets (bonds, shares, goods and services). The spill over of the excess money supply into excess demand for these assets will increase their prices. Higher prices will feed into reduced borrowing costs and intensify consumption of goods and services as well as spending on investment  [7].

3.0 CHANGES IN MONETARY POLICIES

Transmission mechanism, on which the monetary authorities rely today, is different to what was in previous decades. It is due to the major transformation in the whole framework of the monetary policy.

In the past decades central banks used the money supply as the target of the monetary policy. Based on the monetarist ideas the policy revolved around the assumption that price stability could be achieved by fixing the growth of money base at a level approximately corresponding to the growth in aggregate demand.

 However, in the real world targeting money base was problematic. Empirical evidence shows that the policy of monetary targeting largely failed in many countries. For example in Australia only in 1977/78 the money growth was within the target when it was cut to 8% from 22% in 1975/76. However, in all years between 1978/79 and 1982/83 the levels of monetary growth were above the targets. The slowest rate of money growth in that period was 11.3% [8].

 As a consequence of the failure to control the money growth, the central banks worldwide have abandoned monetary targeting. In the 1990s the monetary authorities in many countries adopted inflation targeting. The main instrument of this policy is manipulation of the short-term interest rates (e.g. the federal funds rate in the US or the overnight cash rate in Australia). Monetary management thus shifted from the money supply to the interest rates [9].

 In Australia, the RBA adopted the inflation target of 2 – 3% (average over time). To achieve this the Bank manipulates the cash rate, which is announced as the target of its activities in the market. If prices grow (or expected to) substantially the Bank raises the cash rate. To achieve higher interest rates it generates the overall deficit of the financial system [10].

 The RBA changes the banking liquidity by injecting or withdrawing funds from the system. It does it through open market operations by selling or buying securities until demand and supply of funds in the cash market balance at the targeted cash rate  [11].

Overall, fixing interest rates proved to bring more stability to the financial system [12]. Central banks around the world were quite successful in achieving the inflation targets. According to the RBA (1998) the five-year average inflation from 1993 to 1998 in Australia was 2.2%, i.e. within the desired range. In all G7 countries except Italy average inflation over the five years was below 3%  (see appendix 1).

4.0 TRANSMISSION MECHANISM PRE- AND POST-DEREGULATION

Since the financial deregulation the transmission mechanism and the monetary policy as a whole have undergone a number of changes.

4.1 Exchange Rate

Exchange rate is an important determinant of the transmission mechanism. The mechanism works differently under floating and fixed regimes. Since 1983 Australian monetary system operates under the floating rate, prior to that fixed exchange rate was used.

 Under the floating exchange rate, the expansionary monetary policy conducted by the Reserve Bank will decrease interest rates from r¹ to r² moving the LM curve rightwards to LM¹. The economy will shift from A to A¹, a point where both the capital and current accounts of the balance of payments will tend to move into deficit. This will result in the loss of foreign exchange reserves [13] .

	r                                      r¹ r²
			A    A¹  A²                         Y

 Under fixed regime the loss of foreign reserves will lower the supply of domestic money and pull the LM¹ schedule back to the initial position. Under floating exchange rates the monetary expansion will cause currency depreciation. This will make imports more expensive. Dearer imports will make domestically produced goods cheaper relatively to imports. As a result, the depreciation in exchange rate will strengthen the demand for the domestic goods and make exports more competitive internationally. This will improve the current account and will have an overall expansionary effect on the aggregate demand and boost the economic activity. The IS curve, therefore, will shift to the right to IS¹. The equilibrium income will move to A².

 Thus the impact of the monetary policy under the flexible exchange rate will be larger than when exchange rates are fixed.

  4.2 Money and Credit Channel

 The deregulation caused some channels of the transmission mechanism to wane in significance whereas others became more important. For instance, prior to the deregulation the money and credit channel was one of the key elements in the transmission mechanism. However, since the deregulation this channel became less important.

 Before the deregulation interest rates charged by banks were subject to the government control. Credit rationing was an important tool of the monetary policy. Tightening of the monetary policy would limit the supply of funds to banks so they would have to cut lending. A prospective borrower may not obtain a bank loan even the rates of interest remained unchanged. Many such borrowers would then go to the non-banking financial institutions to get a loan at a higher rate of interest (Edey, 1998).

 Since the abolition of the regulation on credit rationing and controls on interest rates charged by the banks the money and credit channel ceased to be an essential component of the monetary framework.  A research on the monetary mechanics in continental Europe using the data from banks found no evidence of a significant response of bank loans to the monetary tightening. It also concluded that in France, which has the most “Anglo-Saxon” model of the examined countries, the credit channel is apparently non-existent [14].

 5.0 FACTORS REDUCING THE EFFECTIVENESS OF MONETARY POLICY

 The deregulated environment has changed the way the monetary policy is formulated and transmitted to the economy. Such phenomena as the widespread use of hedging instruments and fixed interest loans, the handling of government surpluses or deficits, the announcement effect and other issues have gained an important role in the conduit of the monetary policy. They alter the channels by which the mechanism operates and may reduce the effectiveness of the monetary policy.

 The use of hedging with interest rate forward contract by bondholders (e.g. banks) in some instances can diminish the effect of the monetary policy. Banks or other bondholders may anticipate the future rise of interest rates. Higher interest rates will mean lower bond prices, which may result in losses for bondholders if they sell the bonds. Such bondholders may protect themselves from the exposure to interest rate hike by hedging with an interest-rate forward contract. The contract will lock in the bond’s future price and eliminate the risk of price swings due to changing interest rates. Such hedging contracts will reduce the effectiveness of the monetary actions because bonds’ yields and prices will be effectively semi-fixed and will not fully respond to the impulse from the central bank.

Similarly, the use of fixed interest rates too diminishes the effect of monetary policy. Banks often enter into fixed-interest arrangements with their customers, for instance home-loans.  This means that regardless of movements in the official interest rates, borrowers will have to pay the same amount of interest on their loans. Change in the monetary policy stance will not significantly affect their cash flows and thereby may undermine the effectiveness of the monetary policy.

Fiscal stance (budget deficits or surpluses) will also affect the implementation of the monetary policy. It is especially valid after the deregulation since central banks worldwide became independent from governments. For example, the central bank’s objective of maintaining interest rates low at some point will be hard to achieve if the government runs a budget deficit. To cover the imbalance the government will most likely to issue treasury bonds. Supply of bonds will grow which will feed into bonds’ lower prices and higher interest rates. To contain rise in interest rates and support the bonds’ prices the central bank will buy bonds. This will increase the monetary base through creation of high-powered money. Thus a consistent deficit will cause a continuous growth in bonds supply, which will suppress their prices and make interest rates to go up. As a result, the money base will expand rapidly, which in turn will fuel the inflation [15].

The effect of announcement by the monetary authorities may also affect the conduit of the monetary policy. The market participants closely monitor the announcements by central bankers as well scrutinise every bit of the statistics released by the authorities in order to outguess their decisions. Analysts try to interpret the announcements to find out what is the ‘bias’ (or policy intentions) of the authorities. By understanding the bias market players try to diminish the impact of the policy by say, hedging against interest rate movements. Thus the impact of announcement effect may interfere with the process of transmitting the policy.

Fulfilment of the monetary policy objectives can also be difficult due to the psychological effect that the announcement may create. For example, if Alan Greenspan announces a substantial rise in the interest rates (say, to prick the share price bubble) this can spark negative moods in the business sector and throughout the community.  As many more people own shares and rely on the stockmarket as a significant source of income and wealth the implications of that might be far reaching. A panic in the stockmarket may trigger a deep fall in share prices, which can lead to a severe recession in the US and consequently around the world. Thus a simple tightening of the policy may provoke a full-blown crisis [16].

Another factor, which complicates the conduct of the monetary policy, is the increased globalisation of financial markets. For instance, in early 1990s US low interest rates forced capital outflows from the US and into Asia. Recently, the process has been reversed as capital turned from the depressed Asian economies and went to the US, causing appreciation of the US dollar at a time when import prices were reduced due to excess capacity in Asia. Those factors suppressed US inflation and helped the Fed to keep interest rates low, which in turn gave another boost to the stockmarket [17] .

 Finally, the transmission mechanism is affected by the shrinking size of the banking sector relative to the size of capital markets. The policy is increasingly transmitted not via the bank lending but through changes in asset prices e.g. bonds, equities and exchange rates [18]

 CONCLUSION

 The 1990s saw a major shift in the way the monetary system is managed. The dissatisfaction with the monetary targeting prompted central bankers to abandon the attempts to control the money supply and switch to the inflation targeting by controlling the short-term interest rates. As the policies changed the transmission mechanism transformed too.

 It can be concluded that the mechanism, which policy makers rely on today was also shaped to a great extent by the deregulation of the financial system. In the deregulated environment the financial sector has expanded quite rapidly. A large number of new financial instruments and practices – e.g. currency trading or hedging contracts – alter the channels by which the transmission mechanism operates and thereby are capable to reduce the effectiveness of monetary policy.

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