ECON 4325 Monetary Policy Lecture 10: Monetary ...Holm Monetary Policy, Lecture 10 16 / 32 Banks/intermediation channels The Balance Sheet Channel Mechanism: 1.Expansionary monetary

ECON 4325Monetary Policy

Lecture 10: Monetary Transmission Mechanisms

Martin Blomhoff Holm

... we summarize their views of what is required in a new core model.These can be grouped under four headings:

(i) incorporating financial frictions rather than assuming that financialintermediation is costless;

(ii) relaxing the requirement of rational expectations;

(iii) introducing heterogeneous agents; and

(iv) underpinning the model—and each of these three newadditions—with more appropriate microfoundations.

Vines and Wills (2018)The rebuilding macroeconomic theory project

Holm Monetary Policy, Lecture 10 1 / 32

Outline

Lecture based on Boivin-Kiley-Mishikin (2011)

1. Overview of the transmission mechanisms in the three-equation NKM.

2. Additional non-household transmission mechanims:I Investment channelsI Exchange rate channelsI Financial channels:

bank lending, bank capital, deposits, and balance sheet

3. Additional household-based transmission mechanisms:I Balance sheet channelI Cash-flow effectsI Indirect income effects (Kaplan-Moll-Violante)


Part I: The transmission mechanisms in ourthree-equation framework.


Overview

I All transmission goes through households.

I Two direct household channels:I Intertemporal substitutionI Wealth effects.

I And the indirect channel through wages.


Intertemporal Substitution

Mechanism:

1. it ↓2. rt ↓3. Consumption today is cheaper relative to tomorrow

4. ct ↑

(Euler-equation effect)


Wealth Effects

Mechanism:

1. it ↓2. rt ↓3. Revaluation of future discounted flows. Households become wealthier

(if positive wealth).

4. ct ↑

Note: there is no financial wealth in equilibrium in the standard model.Only effect through revaluation of human capital.


Indirect Income Effect

Mechanism:

I ct ↑ due to other channels

I wt ↑ since firms need to increase production

I ct ↑

Accelerator mechanism(no independent effect of MP, but strengthens already existing channels)


Part II: Additional non-household transmissionmechanisms.


Overview

I Firms: investment channel.

I Open-economy: exchange rate channels.

I Intermediation/financial sector:I Bank lending channelI Bank capital channelI Balance sheet channel


Investment Channel

Mechanism:

1. it ↓2. rt ↓3. User cost of capital ↓4. Investment ↑5. GDP ↑

NB! This channel was missing in action during the last recession. Why?

I Uncertainty

If uncertainty is high, user cost of capital has a negligible effect oninvestment. Two reasons: firms don’t want to invest (demand), banksdon’t want to provide loans (supply).


Exchange Rate Channel

Uncovered interest rate parity:

1 + rt = Et

{St+1

St

}(1 + r∗t )ut

where

I St is the real exchange rate (St = εP∗

P ↑ is a real depreciation of NOK)

I rt is the real interest rate at home

I r∗t is the foreign real interest rate

I ut is a risk premium.


Exchange Rate Channel

Mechanism

1. it ↓2. rt ↓3. St ↑ (real depreciation)

4. Two effects: exporters more competitive, export volumes increase;prices of imported goods more expensive, prices increase

5. yt ↑ and πt ↑

However: many reasons why it doesn’t work quite so much (UIP doesn’thold empirically, variation in risk premium, pricing to market...).


Simplified Balance SheetsCentral Bank

Liabilities Assets

Reserves Bonds

Banks

Liabilities Assets

Deposits ReservesBonds

Equity Loans

Households/Firms

Liabilities Assets

Loans Deposits

Equity Bonds

Government

Liabilities Assets

Bonds Deposits

Equity


Open Market Operations

Open Market Operations (conventional)

1. CB increases reserves by buying bonds with CB money.

2. This money is instantly transferred to the deposit account of theseller and ends up as reserves at the seller’s bank or is sold to a bankand ends up as reserves directly.

⇒ expansive open market operations increases reserves and deposits.

Quantitative Easing: An expansion of the central bank’s balance sheetCredit Easing: ... with a focus on which assets they purchase.


Banks/intermediation channels

The Bank Lending Channel

Mechanism:

1. r ↓, cost of financing loans goes down + expansionary open marketoperations increase bank reserves and deposits.

2. This in turn increases the level of bank loans a bank can make(supply effect).

3. Previously constrained firms get loans and GDP increases.

Note: this is one of the primary mechanisms through which QE issupposed to work.Note 2: Independent mechanism.



The Bank Capital Channel

Mechanism:

1. Expansionary monetary policy results in higher asset prices and/orhigher interest margins.

2. Banks gain on their loan portfolio.

3. Bank equity increases.

4. Banks expand lending (supply effect).

5. Previously constrained firms get loans and GDP increases.

Note: another mechanism through which QE is supposed to work.Note 2: accelerator mechanism.



The Balance Sheet Channel

Mechanism:

1. Expansionary monetary policy results in higher asset prices and highernet worth of firms.

2. Firms can therefore pose more collateral and borrow more.

3. More lending (demand effect) to previously constrained firms.

4. GDP increases.

Note: this is the typical financial accelerator mechanism used in large scaleDSGE models (Kiyotaki-Moore, 1997; Bernanke-Gertler-Gilchrist, 1999).


Part III: Additional household-based transmissionmechanisms.


Overview

I Modern macroeconomics: incomplete markets models increasinglyprevalent.

I What does this mean?

I Households face uninsurable risk(e.g. unemployment, income risk, returns risk...)

I ... and constraints(e.g. liquidity constraints, loan-to-value constraint, loan-to-incomeconstraint ...)

I Implications (things actually matter in the model)

I Short-run fluctuations affect householdsI Balance sheet effects on householdsI Fiscal policy matters (weaker Ricardian Equivalence)


The Household Problem

maxct ,ht ,nt

E0

∞∑t=0

βtu(ct , ht , nt) (1)

subject to

Ptct + Ph,tht + bt ≤ Ph,tht−1 + (1 + it)bt−1 + Wtztnt + dt (2)

zt ∼ f (zt−1) (3)

bt ≥ B(Wtztnt ,Ph,tht) (4)

ht ≥ 0 (5)

+ something that keeps h fixed most of the time (6)

I h is volume of housingI Ph,t is nominal price of housingI z is idiosyncratic productivity

I B(Wtztnt ,Ph,tht) is theborrowing constraint


Implications

1. Some households endogenously end up as hand-to-mouth (manyunlucky draws of income).

2. Some households are endogenously wealthy hand-to-mouth (e.g. justbought a new house).


Consumption vs. liquid reserves (Norway 2011)

0 10 20 30 40 50 60 70 80 90 100Likvid formue (i 1000 USD)

0

5

10

15

20

25

30

35

40

Årli

g ko

nsum

(i 1

000

US

D)

Data, Norge 2011Komplett markedstilnærming

Liquid Assets = deposits + cash + stocks + bonds + mutual funds


Andel WHTM i Norge etter alder, 2014

20 30 40 50 60 70 80 900

5

10

15

20

25

30

35

40

45

innskudd<Y/12

innskudd<Y/24


Households’ Partial Equilibrium Response to an InterestRate Change

0 2 4 6 8 10

Assets

-0.2

-0.1

0

0.1

0.2

0.3

0.4

Ch

an

ge

in

co

nsu

mp

tio

n

Total Effects

Unconstrained

0 2 4 6 8 10

Assets

-0.2

-0.1

0

0.1

0.2

0.3

0.4a = −∞,σ = 0

All

Substitution

Wealth

0 2 4 6 8 10

Assets

-0.2

-0.1

0

0.1

0.2

0.3

0.4a = 0,σ > 0


Households’ Partial Equilibrium Response to an InterestRate Change

0 2 4 6 8 10

Assets

-0.2

-0.1

0

0.1

0.2

0.3

0.4

Ch

an

ge

in

co

nsu

mp

tio

n

Total Effects

Unconstrained

a = 0,σ > 0

0 2 4 6 8 10

Assets

-0.2

-0.1

0

0.1

0.2

0.3

0.4a = −∞,σ = 0

All

Substitution

Wealth

0 2 4 6 8 10

Assets

-0.2

-0.1

0

0.1

0.2

0.3

0.4a = 0,σ > 0

All

Substitution

Wealth

Income risk


Monetary Transmission Mechanisms

Old Transmission Mechanisms

I Weaker intertemporal substitution

I Wealth effects

New Transmission Mechanisms

1. Indirect income effects (Kaplan-Moll-Violante)

2. Balance sheet channel

3. Cash-flow effects


Indirect Income Effects

Complete markets benchmark: households react almost nothing toshort-run changes in wages. Main part of monetary transmission isthrough direct effects.

Incomplete markets: some households are constrained and are verysensitive to short-run changes in wages. Main monetary transmission isthrough indirect effects on wages. (Kaplan-Moll-Violante / Luetticke)

Implication: The indirect effects are crucial for monetary transmission.


Balance Sheet Channel

Mechanism:

1. it ↓2. c and h ↑3. Ph,t ↑4. Borrowing constraint becomes slacker

5. c and h ↑

Accelerator mechanism(no independent effect of MP, but strengthens already existing channels)


Cash-flow Effects

Remember: there is a reason why households don’t adjust housing/debtevery period.

I it ↓I itBt−1 ↓I Disposable income net of debt amortization ↑ (if debtor)

I c and h ↑

Independent mechanism


Cash-flow Effects in Norway

Source: Norges Bank MPR 1/14Holm Monetary Policy, Lecture 10 30 / 32

Summary

𝑖𝑖𝑡𝑡 ↓Expansionaryopen market

operation𝑐𝑐𝑡𝑡 ↑

Intertemporal substitutionand cash-flow effects

𝑦𝑦𝑡𝑡 ↑

Investment and exchange rate channel

𝑤𝑤𝑡𝑡 ↑

Indirect income effect

𝑞𝑞𝑡𝑡 ↑Asset pricing

Wealth effect andbalance sheet channel

Supply of bank lending ↑Bank lending channel

Bank capital channel

Balance sheet channel

𝜋𝜋𝑡𝑡 ↑Exchange rate channel

Phillips curve


Next week

I Zero Lower Bound

I Quantitative Easing

I Forward Guidance

I And then negative interest rates the week after that.


Documents

ECON 4325 Monetary Policy Lecture 10: Monetary ...Holm Monetary Policy, Lecture 10 16 / 32 Banks/intermediation channels The Balance Sheet Channel Mechanism: 1.Expansionary monetary