Chapter 23 Monetary Policy

Topics: Inflation, Monetary policy, Milton Friedman Pages: 5 (946 words) Published: March 16, 2014
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 was actually contractionary during the Great Depression Many different interest rates
During deflation, low nominal interest rates do not necessarily indicate expansionary policy Weak link between nominal interest rates and investment spending does not rule out a strong link between real interest rates and investment spending Interest-rate effects are only one of many channels

III. Early Monetarist Evidence on the Importance of
Money
Milton Friedman – published a series of Studies based on reduced-form evidence that promoted the case for a strong effect of money on Economic Activity. 3 Categories of Monetarist Evidence
Timing Evidence
Money growth causes business cycle fluctuations but its effect on the business cycle operates with “long and variable lags” Post hoc, ergo propter hoc – If one event occurs after another, the second must have been the caused Exogenous event

Reduced form nature leads to possibility of reverse causation “One person’s lead is another person’s lag.”
Statistical Evidence
Autonomous expenditure variable equal
to investment spending plus government spending
For Keynesian model AE should be highly correlated with aggregate spending but money supply should not For Monetarist money supply should be highly correlated with aggregate spending but AE should not Neither model has turned out be more accurate than the other Historical Evidence

If the decline in the growth rate of the money supply is soon followed by a decline in output in these episodes, much stronger evidence is presented that money growth is the driving force behind the business cycle A Monetary History documents several instances in which the change in the money supply is an exogenous event and the change in the business cycle soon followed. IV. TRANSMISSION MECHANISMS OF MONETARY

POLICY

Traditional Interest Rate Channel- where an expansionary monetary policy leads to fall in real interest rate, which in turns lowers the cost of capital, causing a rise in...
Continue Reading

Please join StudyMode to read the full document

You May Also Find These Documents Helpful

  • Monetary Policy Essay
  • Monetary Policy Research Paper
  • monetary policy Research Paper
  • Monetary Policy Essay
  • The Federal Reserve and Monetary Policy Essay
  • Monetary Policy Essay
  • Monetary Policy Essay
  • monetary policy Essay

Become a StudyMode Member

Sign Up - It's Free