Monetary Policy - transmission mechanisms

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What does monetary transmission mechanism?
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Describes channels through which a change in monetary policy influences economic activity.

What kind of channels can we name?
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market interest rates; expectations/confidence; balance sheets; other asset prices –exchange rate, share prices, house prices

What is interest rate channel?
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Primary mechanism at work in traditional Keynesian models and contemporary macroeconomic models

What interest rate channel requires?
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Requires some degree of price stickiness so that decrease in nominal interest rates translates into lower real interest rates across the yield curve

What is exchange rate channel?
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Lower domestic interest rate requires domestic currency to appreciate over time to rule out arbitrage opportunities

What is the main rule in exchange rate channel?
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Expected future appreciation requires an initial depreciation of the currency (e rises, where e is defined as domestic currency units per foreign currency unit).

What is changing with export in exchange rate channel?
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With sticky prices, domestically produced goods become cheaper than foreign-produced goods, resulting in a rise in net exports.

What is q in Tobin's q theory of investment?
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q = market value of firm / replacement cost of capita

How do we interpret q?
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If q is high, firms can buy a lot of new investment goods with only a small issue of equity. Hence investment rises.

In equity price channel what happens with interest rates?
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Lower interest rates raise value of equities because any given expected income stream is discounted at a lower rate which raises its value. This raises q and investment.

What increases higher share prices?
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Higher share prices increase the financial wealth of households, so their lifetime resources are higher

What would predict life-cycle hypothesis?
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The life-cycle hypothesis or permanent income hypothesis would predict that households will spend more.

What improves balance sheet?
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Lower interest rates reduce payments to service debt. They also increase the capitalisedvalue of a firm’s long-lived assets. Both cause balance sheets to improve

When cost of credits fall?
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In presence of financial market imperfections, the cost of credit to firms and households falls when the strength of their balance sheets improve

What does lower interest rates do?
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Lower interest rates also reduce risk that borrowers will be unable to pay back their loans. Banks may increase lending.

How household changes affected by monetary policy?
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change in interest rates affects disposable income as well as incentive to save/consume now; Second, financial wealth changes; Third, any exchange rate adjustment changes the relative prices of goods and services priced in domestic and foreign currency; Higher interest rates generally imply lower consumption

How firms changes affected by monetary policy?
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First, higher interest rates worsen financial position of firms dependent on short-term borrowing; Second, by altering required rates of return, higher interest rates encourage postponement of investment; Third, policy changes may change firms’ expectations about future course of economy, and confidence with which those expectations are held; Higher interest rates generally imply lower investment and employment

Anticipation vs monetary policy?
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Also possible that effects will be dampened if economic agents expect a monetary policy response. Policy actions will differ in their qualitative effects depending on whether these actions are anticipated or unanticipated


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