economics of money & banking

7/30/2019 Economics of Money & Banking

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The Monetary Transmission Mechanism

Monetary transmission mechanism is the process through which monetary policy decisions are

transmitted into changes in real GDP and inflation. This model has focused on financial market

prices- short-term interest rates, bond yields, and exchange rates. To make clear the consequenceof a change in monetary policy on real GDP and inflation using a financial market prices

framework, it is usually essential to spotlight on at least three types of prices: exchange rates,

long-term interest rates and short-term interest rates.

Effect of short term interest/exchange rate changes:

An increase in the nominal interest rate will lead to an increase in the real interest rate if the

rationally expected inflation rate does not increase by the same amount. With slow adjustment of

wages and goods prices, an increase in the nominal exchange rate usually brings about an

increase in the real exchange rate in the short run. Over the long run, still, the real exchange rate

will meet to its equilibrium value as prices and nominal exchange rates adjust.

To comprehend how this monetary transmission mechanism works, first we assume that a

monetary policy action is taken that changes the short-term interest rate. In any case, given the

inflexibilities existed in the economy, these changes in nominal exchange rates and interest rates

in turn affect real exchange rates and real interest rates. The changes in real rates then have a

short-run effect on real net exports, real consumption and real investment and thereby on real

GDP. After the short run, wages and goods prices start to adjust, and as they do, real GDP

returns to normal. In the long run the real interest rate and real exchange rate return to their

original levels. Thus, the relation is from short-term interest rates, to exchange rates and long-term interest rates, and finally to real GDP and inflation.

Impact of exchange rate:

Exchange rate fluctuation has a significant impact on output growth and price inflation, which

control demand and supply channels. According to Guittian and Dornbusch, A depreciation (or

devaluation) of the domestic currency may stimulate economic activity through the initial

increase in the price of foreign goods relative to home goods. By increasing the international

competitiveness of domestic industries, exchange rate depreciation diverts spending from foreign

goods to domestic goods. Whereas, according to modern theory, currency depreciation resulted

from trade deficit reduces real national income and thereby reduces aggregate demand. To

summarize, currency depreciation increases net exports and increases the cost of production.

Similarly, currency appreciation decreases net exports and the cost of production. The combined

effects of demand and supply channels determine the net results of exchange rate fluctuations on

real output and price


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Bank network and monetary policy transmission:

The bank-lending channel is one of the important channels among various channels of

transmitting monetary policy. This channel operates through the central bank, tightens monetary

policy and also limits the supply of reservable deposits to banks. For testing the bank-lending

channel, it is necessary to identify the loan supply effects of monetary policy. If asymmetricinformation problems become more severe then banks will find it harder to maintain their loan

portfolio in the face of a drop in reservable deposits, and they will have to cut down their loan

supply by relatively large amounts. Small banks suffer more from asymmetric information

problems and find it difficult to raise uninsured funds in times of monetary tightening than large

banks do.

It also has been argued that size in itself might not be a good proxy for testing the bank-lending

channel if bank networks exist. In case of a monetary contraction large banks can access the

international interbank market to dampen the liquidity drain whereas small banks within

networks can access short-term funds held with their head institutions. In conclusion we can say

that when testing for the bank-lending channel, bank network criterion should also be

considered.

The Output Composition Puzzle: A Difference in the

Monetary Transmission Mechanism in the Euro Area and

United States

Now we want to place comparison of certain key macroeconomic features of the transmission

mechanisms of monetary policy between the United States and the euro area. We go to in aparticular direction in steps. Researchers use a small set of VAR models for the two areas. They

find that, the main macroeconomic facts are similar. Specifically, after a monetary shock, real

GDP displays a humped-shaped profile, returning to baseline, whereas the price level diverges

gradually but permanently from the initial value. Thus, the consensus on the way monetary

policy operates in the U.S. has held up through the long business cycle expansion of the 1990s.

Moreover, the consensus view seems to well describe the euro area facts too. Nevertheless, prior

work has paid relatively little attention to the underlying adjustments that accompany the change

in output. In this respect the two areas differ. In particular, after a change in monetary policy the

role of household consumption in driving output changes is greater, and that of investment

smaller, in the U.S. relative to the euro area. This difference is present in VAR estimates and

those of large-scale structural econometric models. We call this the "output composition puzzle."

To explore and explain the puzzle we first make a tentative assessment of whether the puzzle is

more likely due to divergent behavior of consumers or firms. It appears to us that the consumers

are responsible for the differences. Unfortunately we do not have a exact explanation for why

this is the case. It appears that disposable income may be less responsive to monetary changes in

the euro area than in the U.S. We were motivated to make this comparison by the hypothesis that


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social safety net in Europe might cushion the effects of monetary policy on consumption more

there. It appears that movements in consumption relative to disposable income are larger in the

U.S. too. Explaining this finding and sharpening the tests of the conjecture about the importance

of the social safety net are an obvious next step.

A Monetary Model of Inflation for Bangladesh (1974-1985):

Any disequilibrium in the real money-market doesnt adjust rapidly but adjust slowly itself

through changes in the price level. The major determinants of inflation in Bangladesh are-

Changes in the prices of traded goods in the international market, real permanent income,

and real money stock. The overall analysis in relative to the determinants of the inflation:The

coefficient of real permanent income and the terms of trade between traded and non-traded

goods have a negative sign implying that estimated coefficient shows that an increase in real

permanent income and relative prices of traded goods reduce the rate of inflation. The

coefficient of money stock has a positive sign implying that when actual real money supply atthe beginning of a period exceeds the desired real money balances demanded at the end of the

period, then individuals increase their private expenditure by disposing actual money balances.

Inflationary adjustment effects influence the time taken to offset the impact of transmission

mechanism in case of short term interest rate change.

The Monetary Transmission Mechanism in Bangladesh:

Bank Lending and Exchange Rate Channels

The country approved the FSRP in the early 1990s. An assessment of the empirical evidence hasbeen instituted through the unconfined vector auto regressions (VARs) approach using quarterly

data for the period of July-September 1979 to April- June 2005. The results of the empirical

analysis suggest weak existence of both bank lending and exchange rate channels in the

Bangladesh economy for the full-sample period as well as in the sub-sample period (January-

March 1990 to April-June 2005). The excess liquidity position in the banking system as well as a

significant share of net government borrowing in reserve money in most years partly counteract

the efficacy of monetary policy actions. Therefore, the observation regarding the existence of

bank lending channel is non-existent in Bangladesh. In Exchange Rate Channel (1990:1-2005:2)

the reserve money has a momentous explanatory power of forecasting the movements in nominal

exchange rate. The movement in aggregate output, on the other hand has a significant

explanatory power of forecasting the future pathway of prices as well as nominal exchange rate.

The response of prices to imports is negative and significant in the 1st quarter and exports

respond positively to nominal exchange rate only in the 2nd quarter.

So, we can conclude that, in Bangladeshs economy there is a weak existence of both bank

lending and exchange rate channels for the full-sample period (i.e., July- September 1979 to


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April-June 2005) as well as in the sub-sample period (i.e., January- March 1990 to April- June

2005).

Monetary policy and money programming in Bangladesh:

Whether monetary policy has any impact on the economy has been debated over the last several

decades. The new classical economists firmly deny any role of monetary policy, even in the shortrun. The rational expectations and perfect flexibility of wages and prices result the

ineffectiveness of monetary policy. Objectives of monetary policy vary from country to country

depending on the mandates of the central banks, but they typically include one or more of the

following: (1) price stability, (2) high employment, (3) economic growth and welfare, and (4)

external balance. In last several decades many central banks were expected to pursue all these

objectives, although not equally, but it is now recognized that the central banks may not be a

suitable body to directly pursue some of these objectives, such as economic growth, and that

some of the objectives may actually be in a trade-off relation to one another.

Monetary authorities deploy their instruments to attain the proximate or intermediate targets in

the hope of achieving the ultimate goals. This presupposes a link between the instruments and

the ultimate goals which operates through several channels that transmit the policy impulse to the

wider economy. In a financially developed market economy the immediate effect of a monetary

policy action, such as an open market purchase of securities, is felt in the short term money

market where the lending rate declines. A broad range of interest rates also decline with varying

lags in response to the reduction in the short term rate. The reduction in the interest rates

stimulates aggregate demand. There are several mechanisms through which the reduced interest

rates raise the aggregate demand. These are described succinctly in the following.

Saving and Investment: A reduction in the interest rate affects household saving through both

substitution and income effects. The substitution effect tends to reduce saving while the income

effect raises it. The final outcome is, therefore, ambiguous. If the substitution effect is stronger

than the income effect, saving will fall and consequently consumer spending will rise. The cost

of investment falls with a reduction in the interest rate such that more investment projects

become profitable. The cost of mortgage on housing investment also declines. Thus, both firms

and households are likely to undertake more investment given other conditions. The spurt in

investment spending raises income and leads to secondary increases in spending through the

multiplier effect. The opposite happens if the income effect is stronger than the substitution

effect.Asset Prices: A reduction in the interest rate is likely to raise the market prices of such assets as

property investments and financial instruments. The net wealth of the asset holders increases.

Such an increase in wealth raises spending through the wealth effect. As people feel more

wealthy, they have less necessity to save as suggested by the life cycle hypothesis. Consequently,

they may spend more. Firms may be encouraged to invest more as their net worth rise.


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Exchange Rates: A reduction in the domestic interest rate due to an easy monetary policy

encourages a net outflow of capital. In an economy with substantial cross border mobility of

capital, this puts pressure on the balance of payments such that the domestic currency

depreciates. Domestic prices of importable rise while the international prices of exportable fall.

The heightened competitiveness of the domestic goods raises domestic production, reduces

imports and increases exports thus improving the current account balance to offset the reduction

in the capital account. To conclude, it should be emphasized that the transmission mechanism of

monetary policy is seldom as clear cut or predictable as outlined above. Monetary policy works

with a substantial lag. While the foregoing discussion suggests how the policy is transmitted to

the wider economy, it is quite possible that the operation of the other factors may blunt or even

reverse the impact of the policy.

REFERENCES:1) John B. Taylor,The Monetary Transmission Mechanism: An Empirical

Framework,The Journal of Economic Perspectives, Vol. 9, No. 4 (Autumn,1995), pp. 11-26

2) Michael Ehrmann and Andreas Worms, Bank Networks and MonetaryPolicy Transmission, Journal of the European Economic Association, Vol. 2,No. 6 (Dec., 2004), pp. 1148-1171

3) Shamim Ahmed and Md Ezazul Islam,The Monetary TransmissionMechanism in Bangladesh: Bank Lending and Exchange Rate Channels, TheBangladesh Development Studies, Vol. 30, No. 3/4 (September-December

2004), pp.31- 87

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