© The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin

Chapter 23

Modern Monetary Policy and the Challenges

Facing Central Bankers

23-2

Modern Monetary Policy:The Big Questions

1. What are the various channels of monetary policy transmission?

2. What are the factors that make modern monetary policy so difficult?

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Japan and the U.S.

What made the Japanese and U.S. experiences of the last 20 years so different?

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Japan: Growth and Interest Rates

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U.S.: Growth and Interest Rates

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Modern Monetary Policy:Roadmap

• Monetary Policy Transmission Mechanism

• Challenges Facing Modern Monetary Policymakers

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The Monetary Policy Transmission Mechanism: Traditional Channels

Interest Rates and Exchange Rates

the traditional channels of monetary policy transmission aren’t very powerful

23-8

The Monetary Policy Transmission Mechanism: Credit Channels

Bank Lending and Balance Sheet Channels

• By altering the supply of funds to the banking system, policymakers can affect banks' ability and willingness to lend

• an open market purchase has a direct impact on the supply of loans, increasing their availability to those who depend on banks for financing

• as interest rates fall, the supply of loans increases

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The Monetary Policy Transmission Mechanism: Asset Price Channels

Investment and Wealth

• a fall in the interest rate – pushes stock prices up – drives the mortgage rate down leading to higher demand for

residential housing, driving up the prices of existing homes

• Higher asset prices mean increased wealth and higher consumption

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The Monetary Policy Transmission Mechanism

23-11

• If neighborhoods with high crime rates have more police, does that mean police cause crime?

• Finding correlations is straightforward

• Establishing causal relationships is difficult

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• Why did Japan’s economy fail to respond to interest rates near zero?

• One possibility is that the stock market collapse lowered borrower net worth

• In addition, with borrowers unable to repay, banks had virtually no capital and could not make additional loans.

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The Challenges Modern Monetary Policymakers Face: Estimating Potential

During the late 1990s, people failed to recognize potential output was growing more rapidly than it had earlier. As a result, forecasts of GDP were consistently too low.

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• Computing real returns means subtracting inflation from nominal returns

• In order to evaluation nominal interest rates, wage increase and the like, you need to know the level of inflation

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In the 1970s inflation rose in two big bursts

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One possible explanation is that Fed policymakers failed to realize that growth had slowed.

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The Challenges Modern Monetary Policymakers Face: Deflation

Deflation & Zero Nominal Interest Rate Bound:

– Nominal interest rates can't fall below zero– This places a restriction on what monetary

policymakers can do – The most effective way to expand the monetary

base when the overnight interest rate has fallen to zero is to shift to targeting longer-term rates.

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The Challenges Modern Monetary Policymakers Face: Booms and Busts

Booms & Busts in Equity & Property Prices

Bubbles that inflate and then burst are particularly damaging, because the wealth effects they create cause consumption to explode and then contract just as rapidly.

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The Nasdaq Bubble

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The Challenges Modern Monetary Policymakers Face

Evolving Financial Structure

changes in financial structure will change

the impact of monetary policy.

© The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin

Chapter 23

End of Chapter