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Journal of Econom ic Perspectives Volume 9 Number 4 Fall 1995Pages 310

Symposium on the MonetaryTransmission Mechanism

Frederic S Mishkin

Both economists and politicians have been heard to advocate in recent yearsthat the stabilization of output and inflation be left to monetary policy.Fiscal policy has lost its luster since its heyday in the 1960s, partly because

of concern over persistently large budget deficits, partly because of doubts that thepolitical system can make tax and spending decisions in a timely way to achievedesirable stabilization outcomes. Meanwhile, monetary policy has been ever moreat the center of macroeconomic policymaking.To understand some of the ways that monetary policy can affect the economy,begin with an arbitrary starting point in the late 1970s, when an overly loose mon-etary policy is commonly thought to have contributed to the burst of double-digitinflation in 1979 and 1980. Tight monetary policy engineered by the Federal Re-serve un der the leadership of chairman Paul Volcker broke the back of that infla-tion, bu t also dragged th e economy in to a deep recession. High real interest ratesin the mid-1980s are often linked to the large run-up in the exchange rate value ofthe dollar and the resulting temporary decline in competitiveness of Americanindustry. Lower interest rates then helped extend the economic upswing of the1980s, and also bring down the dollar exchange rate. But when it seemed thatinflation might be accelerating again in the late 1980s, the Fed tightened oncemore. After the recession of 199091, lower interest rates helped the economyrecover. More recently, since early 1994, the Federal Reserve System has raised

Frederic S. Mishkin is Executive Vice President and Director ofResearchat theFederalReserveBank of New York New York New York. He is on leave as the A. Barton HepburnProfessorof conomicsa nd Finance GraduateSchoolof Business Columbia U niversity NewYork New York. He is also aResearch Associate National Bureau of conomic ResearchCambridge Massachusetts.

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4 Journal of Economic Perspectives

interest rates to preempt a bout of increased inflation arising from an overheatedeconomy.Monetary policy is a powerful tool, but one that sometimes has unexpected orunwanted consequences. To be successful in conducting monetary policy, the mon-etary autho rities must have an accurate assessment of the tim ing and effect of the irpolicies on the economy, thus requiring an understanding of the mechanismsthrough which monetary policy affects the economy. These transmission mecha-nisms include interest rate effects, exchange rate effects, other asset price effectsand the so-called credit channel. This symposium contains papers that should helpacqua int the reader with the explosion of research on how m onetary policy is trans-mitted that has taken place in these last few years. This introduction will providean overview of the main types of monetary transmission mechanisms found in theliterature and provide a perspective on how the papers in the symposium relate tothe overall literature and to each other.

The Interest Rate ChannelThe transmission of monetary policy through interest rate mechanisms hasbeen a standard feature in the economics literature for over 50 years. It is the keymonetary transmission mechanism in the basic Keynesian textbook model, whichhas been a mainstay of teaching in macroeconomics. The traditional Keynesianview of how a monetary tightening is transmitted to the real economy can be char-acterized by a schematic diagram,

M i I Y ,where M indicates a contractionary monetary policy leading to a rise in real in-terest rates (i ), which in turn raises the cost of capital, thereby causing a declinein investment spending (I ), thereby leading to a decline in aggregate dem andand a fall in outp ut (Y ).Although Keynes originally emphasized this channe l as ope rating th rou gh busi-nesses' decisions about investment spending, later research recognized that con-sumers' decisions about housing and consumer durable expenditure also are in-vestment decisions. Thus the interest rate channel of monetary transmission out-lined in the schematic above applies equally to consumer spending in which Irepresents residential housing and consumer durable exp enditure . Jo hn Taylor'spaper in this symposium argues that the interest rate channel of monetary trans-mission is a key component of how monetary policy effects are transmitted to theeconomy. In his model, contractionary monetary policy raises the short-term nom-inal interest rate. Th en, throug h a combination of sticky prices and rational expec-tations, the real long-term interes t rate rises as well, at least for a time . These high erreal interest rates lead to a decline in business fixed investment, residential h ousing

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Frederic S. Mishkin 5

investment, consumer durable expenditure and inventory investment, which pro-duces the decline in aggregate output.Taylor takes the position that there are stron g interest rate effects on consumerand investment spending and, hence, a strong interest rate channel of monetarytransmission. His position is controversial, as can be seen in the paper in this sym-posium by Ben Bernanke and Mark Gertler. They state that empirical studies havehad great difficulty in identifying quantitatively important effects of interest ratesthrough the cost of capital. Indeed , they see the lack of support for a strong intere strate channel as having provided the stimulus for the search for other transmissionmechanisms of monetary policy, especially the credit channel discussed in theirpaper.

Th e Exchange Rate C hannelWith the growing internationalization of the U.S. economy and the advent offlexible exchange rates, more attention has been paid to monetary policy trans-mission operating through exchange rate effects on net exports. Indeed, this trans-mission mechanism is now a standard feature in the leading textbooks in macro-econom ics and m oney and bank ing. This channel also involves interes t rate effects,

because when domestic real interest rates rise, domestic dollar deposits becomemore attractive relative to deposits denominated in foreign currencies, leading toa rise in the value of dollar deposits relative to other currency deposits, that is, anappreciation of the dollar (denoted by E ). The h igher value of the domesticcurrency makes domestic goods more expensive than foreign goods, thereby caus-ing a fall in net exports (NX ) and hence in aggregate outp ut. The schematic forthe monetary transmission m echanism operating th roug h the exchange rate is thus:M i E NX Y .

Both the Taylor paper and the paper in this symposium by Maurice Obstfeld andKenneth Rogoff emphasize the importance of the exchange rate channel of mon-etary transmission. Both papers emphasize that a framework for the conduct ofmonetary policy must be inherend y interna tional in scope.

Other Asset Price EffectsAs emphasized by Allan Meltzer in his paper for the symposium, a key mone-tarist objection to the Keynesian paradigm for analyzing monetary policy effects onthe economy is that it focuses on only one relative asset price, the interest rate, orin the case of Taylor's model, two interest rates and the exchange rate. Instead,monetarists hold that it is vital to look at how m onetary policy affects the universeof relative asset prices and real wealth. Monetarists are often loath to commit

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6 Journal of Economic Perspectives

themselves to specific t ransmission mech anism s, beca use they see these me cha nism sas changing during different business cycles. However, two channels are often em-phasized in monetarist stories about the monetary t ransmission mechanism: theseinvolve Tobin 's qtheory of investm ent and wea lth effects on con sum ption .

T o b i n ' s qtheory provides a m ech anism thr ou gh wh ich mon etary policy affectsthe economy through i ts effects on the valuat ion of equit ies. Tobin (1969) definesqas the m ark et value of fi rms divided by the re pla ce m en t cost of capi tal . If qis high,the market price of f i rms is high relat ive to the replacement cost of capi tal , andnew plant and equipment capital is cheap relat ive to the market value of businessfirms. Companies can then issue equity and get a high price for i t relat ive to thecost of the p lant and equipment they are buying. Thus investment spending wi l lrise because firms can buy a lot of new investment goods with only a small issue ofequi ty . On the o ther hand, when qis low, f irms will not purc has e new investm entgoods because the market value of firms is low relative to the cost of capital. Ifcom panies want to acqui re capi tal when q is low, they can buy a no the r f irm cheaplyand acquire old capital instead. Investment spending wil l be low.

The crux of this discussion is that a l ink exists between Tobin 's q and invest-m en t spend ing. But how mig ht mon etary policy affect equity prices? In a mon etariststory, when the money supply falls, the public finds it has less money than it wantsan d so t r ies to acquire i t by decre asing i ts spe ndin g. On e place th e public can spe ndless is in the stock market , decreasing the demand for equit ies and consequentlylowering their prices. A m ore Keynesian story com es to a similar conc lusion beca usei t sees the r ise in intere st rates com ing from contra ct ionary m one tary policy ma kingbonds more at t ract ive relat ive to equit ies, thereby causing the price of equit ies tofall. Co m bin ing these views with th e fact tha t lower equity price s (Pe ) will lea d toa lower q(q ) , an d thus to lower investment spen ding (I ), leads to the followingtransmission mechanism of monetary policy:

M P e q I Y .An al ternat ive channel for monetary t ransmission through equity prices occursthrough wealth effects on consumption. This channel has been strongly advocated

by Fra nco M odigl iani an d his MIT-Penn-SSRC (MPS) m ode l , a version of which iscurrendy in use at the Board of Governors of the Federal Reserve System. InM odig liani 's life-cycle m od el ex pla ine d very clearly in M odigliani (1971) consu mp t ion spend ing is dete rm ined by the l ife time resources of consumers , whichare m ad e up of hu m an capital , real capi tal and financial w ealth. A major com po-ne nt of financial we alth is co m m on stocks. W he n stock prices fall, the value offinancial wealth decreases, thus decreasing the l i fet ime resources of consumers,and consumption should fal l . Since we have already seen that contract ionary mon-etary policy can lead to a decline in stock prices (Pe ) , we then have anoth ermonetary t ransmiss ion mechanism:

M P e weal th c onsum pt ion Y .

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Symposium on the Mon etary Transmission Mech anism 7

Meltzer's contribution to this symposium emphasizes that asset price effectsextend beyond those operating through interest rates, exchange rates and equityprices. For example, in his description of the Japane se experience in the 1980s and1990s, monetary policy has an important impact on the economy through its effecton land and property values. The two channels in the schematics in this sectionprovide sup por t for this view. A monetary contrac tion can lead to a decline in landand property values, which causes households' wealth to decline, thereby causinga decline in consum ption and aggregate o utput. This is described by the schematicabove in which Pealso represen ts land and property values. Tobin's qtheory alsoapplies equally to structures and residential housing so that the schematic outliningth eq-theory m echanism applies. A monetary con traction that leads to a decline inland and property values lowers their market value relative to replacement cost,with the resulting fall in their qleading to a decline in spending on structures andhousing.

Credit ChannelAs pointed out in the paper by Bernanke and Gertler in the symposium, dis-satisfaction w ith the conventional stories about how interes t rate effects explain theimpac t of monetary policy on e xpe nditu re on long-lived assets has led to a new viewof the monetary transmission mechanism that emphasizes how asymmetric infor-mation and costly enforcement of contracts creates agency problems in financialmarkets. Two basic channels of monetary transmission arise as a result of agencyproblems in credit markets: the bank lending channel and the balance-sheetchannel.Th e b ank lend ing ch anne l is based on the view tha t banks play a special rolein the financial system because they are especially well suited to deal with certaintypes of borrow ers, especially small firms w here the prob lem s of asymm etric infor-mation can be especially pronounced. After all, large firms can directly access the

credit markets through stock and bon d m arkets without going throu gh banks. Thus,contractionary monetary policy that decreases bank reserves and bank deposits willhave an impact through its effect on these borrowers. Schematically, the monetarypolicy effect isM bank deposits bank loans I Y .

Doubts about the importance of the bank lending channel have been raised in theliteraturefor example, after all the financial innovation of the last couple of de-cades, banks play a less important role in credit markets now than in the 1950s,1960s or 1970s (Edwards and Mishkin, 1995). This criticism and others are raisedin the symposium papers by Meltzer and by Bernank e a nd Gertler.The balance-sheet channel operates through the net worth of business firmsand as emphasized by Bernanke and Gertler, there is no reason to think that it has

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becom e less importan t in r ecent years. Lower ne t worth m eans that lenders in effecthave less collateral for their loans, and so losses from adverse selection are higher.A decline in net worth, which raises the adverse selection problem, thus leads todecreased lending to finance investment spending. Lower net worth of businessfirms also increases the moral hazard problem because it means tha t owners havea lower equity stake in their firms, giving them more incentive to engage in riskyinvestment pro jects. Since taking on riskier investment projects m akes it more likelythat lenders will not be paid back, a decrease in business firms' net worth leads toa decrease in lending and hence in investment spending.Monetary policy can affect firm s' balance sheets in several ways. Contractionarymonetary policy (M ), which causes a decline in equity prices (Pe ) along linesdescribed earlier, lowers the net worth of firms and so leads to lower investmentspending (I ) and aggregate demand (Y ), because of the increase in adverseselection and moral hazard problems. This leads to the following schematic for thebalance-sheet channel of monetary transmission:1

M P e adverse selection & moral hazard lending I Y .The balance-sheet channel provides a further rationale for asset price effects em-phasized in monetarist thinking.

Contractionary monetary policy that raises interest rates also causes a deteri-oration in firm's balance sheets because it reduces cash flow. This leads to thefollowing additional schematic for the balance-sheet channel:M i cash flow adverse selection & moral hazard

lending I Y .Although most of the literature on the credit cha nnel focuses on spending by

business firms, Bernanke and Gertler suggest that the credit chan nel shou ld applyequally as well to consum er spending. D eclines in bank lending induced by a mon-etary contraction should cause a decline in durables and housing purchases byconsumers who do not have access to other sources of credit. Similarly, increasesin interest rates cause a deterioration in household balance sheets because theircash flow is adversely affected.1 If the contractionary mo netary policy prod uces an u nantic ipated decline in the pr ice level , there is anaddit ional re inforcem ent of the balance-sheet transmission mechan ism. Because deb t payments are con-tractually fixed in nominal terms, an unanticipated decline in the price level raises the value of firms'liabilities in real terms (that is, it increases the burden of the debt), but does not raise the real value ofthe f irms' assets . Monetary contractio n, which leads to an unan tic ipated dro p in the p r ice level, therefo rereduces real net worth and causes an increase in adverse se lection and moral hazard problems, whichcause a decline in investment spend ing and aggregate outp ut a long th e l ines of the schematic here . Thisis a rationalization of the debt-deflation view of the Great Depression espoused by Irving Fisher (1933).

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Frederic S. Mishkin 9

A nother way of looking at how the balance-sheet chann el may operate throug hconsumers is in the work on liquidity effects on consumer expenditures on durablegoods and housing, which have been found to be an important factor during theGreat Depression (Mishkin, 1978). In the liquidity-effects view, balance-sheet effectswork through their impact on consumers' desire to spend rather than on lenders'desire to lend. In this model, if consumers expect a higher likelihood of findingthemselves in financial distress, they would rather be holding fewer illiquid assetslike consum er durab les or hou sing and mo re liquid financial assets. The underlyingreason is that if consumers needed to sell their consumer durables or housing toraise money, they would expect to suffer large losses, because they could not getthe ir full value in a distress sale.2In contrast, financial assets like money in the bank ,stocks or bonds can more easily be realized at full market value to raise cash.This leads to anoth er transmission m echanism for monetary policy opera tingthrough the link between m oney and equity prices. When falling stock prices re ducethe value of financial assets, consum er e xpend itures on housing or consum er dur-ables will also fall, because consumers have a less secure financial position and ahigher estimate of the likelihood of suffering financial distress. Expressed in sche-matic form,M P e financial assets likelihood of financia l distress

consumer durable and housing expenditure Y .Th e illiquidity of consumer d urables and housing provides anothe r reason whya monetary contraction that raises interest rates and thereby reduces cash flow toconsumers leads to a decline in spending on consumer durables and housing. Adecline in consumer cash flow increases the likelihood of financial distress, whichreduces the desire of consumers to hold durable goods or housing, thus reducingspending o n them and h enc e agg regate outpu t. This view of cash-flow effects differsfrom the view outlined in the earlier schematic in that it is not the unwillingnessof lenders to lend to consumers that causes expenditure to decline, but the un-willingness of consumers to spend.

Concluding RemarksUnderstanding monetary transmission mechanisms is crucial to answering abroad ra nge of policy questions. What is the appropr iate monetary policy in differ-ent business cycle episodes? What should be the appropriate rule for monetary

policy? What is the correct choice of a tradeoff between output variability and2This is just a manifesta t ion of the lem on s proble m descr ibed by Akerlof (1970) , which helped st im-ula te research on the credit channel.

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infl tion variability? Wouldafixed rather thanaflexible exchange rate regimeprodu ebetter inflationandoutput outcomes?Thepapersinthis symposiumdis-usstheresearch that will help answer these questions. All opinions expressed are those of the author and not those of Columbia University theNational Bureau of Economic Research the Federal Reserve Bank of New York or the FederalReserve System. I thank Mark Gertler Allan Meltzer and Timothy Taylor for helpful comments.

eferen esAkerlof George TheMarketfor 'Lemons':

Qualitative Uncertaintyand the Market Mecha-nism, Quarterly Journal ofEconomics, August1970,84:3, 488500.

Edwards Franklin and Frederic S. MishkinThe Decline of Traditional Banking: Implica-

tionsforFinancial Stabilityan dRegulatoryPol-icy,''Federal Reserve Bank ofNew York Economic Pol-icyReview, July 1995,1:2,2745.

Fisher Irving TheDebt-Deflation Theo ryofGreat Depressions, Econometrica,October 1933,1,33757.

Mishkin Frederic S. Th eHouseholdBal-ance Sheeta nd theGreat Depression, JournalofEconomicHistory, December 1978,38:4, 91837.

Modigliani Franco Monetary Policy andConsumption. In Consumer SpendingandMone-tary Policy: The Linkages. Boston: Federal ReserveBankofBoston, 1971,pp.984.

Tobin James A General EquilibriumAp-proach to Monetary Theory, Journal ofMoney Credit andBanking, February 1969,1,1529.

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