Thursday, December 24, 2009

Mishkin and Monetary Policy.

According to the International Economic Law and Policy Blog, if Santa were party to the WTO he would be charged with "dumping, not to mention violating IP rules, destroying the environment, using genetically modified reindeer and abusing his labor."

So, I just finished reading an NBER paper titled, "The Channels of Monetary Transmission: Lessons for Monetary Policy" by Frederic S. Mishkin (author of my ECON 321 - Money and Banking textbook!) I found it on Akila's homepage and thought it would be fun to read.  It was written in 1996, but seems relevant to today's economy, no

Before I talk about the paper, I thought it would be good to review IS-LM curves!  Also, throughout this blog post remember that Y = C+I+G+NX.  (output = consumption + investment + government spending + net exports)

[picture from the Economist]

LM stands for liquidity-money.  And if there's one thing I learned from Professor Johnson, it is that IS-LM curves are NOT supply and demand curves.  They're equilibrium loci!  IS is the equilibrium locus of points at which the market for goods and services is cleared in the short run.  Example: at r1 and Y1, the market for goods and services is cleared.

LM is an equilibrium locus of points for which money supply equals money demand.  Example: at r3 and Y3, the money demanded in an economy equals the money supplied in that economy. 

Okay, Mishkin's paper!
Mishkin starts out by explaining the principle of traditional expansionary monetary policy:

Money supply [M] increases leading to a decrease in real interest rates [r].  This stimulates investment spending [I] and leads to an increase in aggregate demand [AD] and output [Y].
M increases --> r decreases --> I increases --> Y increases.

If you're looking at IS-LM curves, the LM curve is shifting to the right.  Because in order for demand to match the increased supply of money, interest rates must be lower for any given level of output/income [Y].

So what happens when money supply increases SO much such that nominal interest rates reach zero? (hrm...sound familiar?!) 
Spending is actually affected by real interests rates rather than nominal interest rates.  So, during times of expansionary monetary policy, expected price level [P^e] and expected inflation levels [π^e] rise.  Given the Fisher equation, r = i − π, we can say that this increased expected inflation will lower the r and stimulate I leading to an increase in AD and Y.
M increases --> P^e increases --> π^e increases --> r decreases --> I increases --> Y increases.

Mishkin says that "this mechanism is a key element in monetarist discussions of why the U.S. was not stuck in a liquidity trap during the Great Depression and why expansionary monetary policy could have prevented the sharp decline in output during this period."

Mishkin points out that interest rate channels are not the only way through which monetary policy can promote growth.  There is also the exchange rate channel, equity price channels and credit channels.

Exchange Rate Channel
When money supply increases, real interest rates fall.  This means that the return on dollar denominated deposits will be relatively less than that on foreign exchange denominated deposits.  Thus, demand for the dollar will fall and the exchange rate (E) will reflect depreciation.  Depreciation isn't always a bad thing though.  If the value of the dollar falls, American goods become relatively cheaper than foreign goods.  This boosts net exports (NX) which boosts output (Y).
M increases --> r decreases --> E decreases --> NX increases --> Y increases.

Equity Price Channels
1) Tobin's q theory of investment:  "q" --> the market value of firms divided by the replacement cost of capital.  The higher q is, the cheaper it is (relatively) for firms to buy new plant and equipment capital.  Fixed investment rises as q rises.
Since higher equity prices (P^e) will lead to higher q, we can say that:
M increases --> higher P^e --> higher q --> I increases --> Y increases.

2) Wealth effects:  Remember Y = C+I+G+NX?  Well, one of the determinants of C is the value of one's financial wealth.  When stock prices rise, C is likely to rise as well.
M increases --> P^e increases --> wealth increases --> C increases --> Y increases.

1 & 2 apply to housing and land prices channels as well since housing and land also determine one's wealth.

Credit Channels:
"There are two basic channels of monetary transmission that arise as a result of information problems in credit markets:"
1) The bank lending channel:  Expansionary monetary policy increases bank reserves and bank deposits thus allowing them to make more loans available to firms.
M increases --> bank deposits increase --> bank loans increase --> I increases --> Y increases.

Clearly, this does not always happen.  The Economist recently wrote about the difficulties that small firms face during recession.  Small firms rely on banks for about 90% of their financing needs while larger firms rely on banks for only about 30% of their financing needs.

2) Balance sheet channels: 
When firms have lower net worth, there tend to be more adverse selection and moral hazard problems in lending to these firms.  Businesses with lower net worth don't have as much collateral to put down for their loans (banks are more likely to suffer losses).  Owners of such businesses also have lower equity stake in their firms and are willing to take greater risks with investment projects, etc.  (moral hazard)
Thus, when M increases and P^e (net worth of firms) increases --> adverse selection/moral hazard decrease --> lending increases --> I increases --> Y increases.

Increased M and decreased nominal interest rates (i) also raises cash flow of firms which improves their balance sheets.
M increases --> i decreases --> cash flow increases --> adverse selection/moral hazard decrease --> lending increases --> I and Y increase.

An unanticipated rise in price level also improves balances sheets by raising the real value of firms' assets.  Since burden of debt is dictated by nominal interest rates, an unexpected rise in price level lowers burden of debt.  (Lenders don't like inflation, debtors like inflation)
Therefore, an unexpected rise in price level raises real net worth of firms, lowering adverse selection and moral hazard problems and stimulating I and Y as mentioned above.
M increases --> unanticipated P increases --> adverse selection/moral hazard decrease --> lending increases --> I and Y increase. 

Household balance sheet effects:
This one's pretty straightforward...if households expect themselves to be in financial distress in the near future, they don't want to invest in illiquid consumer durable or housing assets.  
However, if they expect the value of their financial assets to rise, they will be willing to buy a new house or car, etc.
M increases --> P^e increases --> financial assets increase --> likelihood of financial distress decreases --> consumer durable and housing expenditure increase --> Y increases.

Okay, so this blogpost is pretty monstrous.  I'll just bullet point a few important things from the rest of Mishkin's paper:
  • Monetary policy affects Y through other asset prices besides interest rates.
  • Near zero short-term interest rates do not necessarily mean that monetary policy is easy if economy is undergoing deflation.  (ex: short-term interest rates during Great Depression were near zero, but monetary policy was contractionary)
  • If short-term interest rates are near zero but stock Ps are low, land prices are low and value of domestic currency is high, then monetary policy is very tight and not easy.
  • "Avoiding unanticipated fluctuations in the price level is an important objective of monetary policy, thus providing a rationale for price stability as the primary long-run goal for monetary policy." 

So, basically, when I started writing this blog post, I just wrote out the things that are bolded and in green so I wouldn't forget what I had read in Mishkin's paper.  It turned out to be a pretty incoherent blogpost, so I started adding more and more details...

If you're still reading, pat yourself on the back.

Happy Christmas Eve!

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