The transmission mechanism of monetary policy Stages in the

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					          The transmission mechanism                                  Stages in the transmission of monetary
               of monetary policy                                                      policy

• How does monetary policy affect the economy?
                                                                    • Stage 1: MPC announces change in official interest rate.
• UK compared to EMU countries:
  - Speed of pass through;                                          • Stage 2: Changes feed through to components of
   - Channels.                                                        demand.
• Implications?                                                     • Stage 3: Changes in demand feed through to changes in
   – Could monetary policy be a source of asymmetric                  output, Y, and inflation, π.
   – What are the distributional implications of
     monetary policy action?
• Endogeneity in the transmission mechanism?
    HM Treasury Euro Study on the Monetary Transmission Mechanism

             Stages in the transmission                                          Stages in the transmission

• Stage 1:                                                          • Stage 2:

   – MPC announces change in official interest rate                    – Changes feed through to components of demand
   – Impacts on                                                           • Y = C + I + G + (X-M)

      • Market rates
      • Asset prices                                                      • Interest rate channel
      • Expectations                                                      • Credit channel
      • Exchange rate                                                     • Exchange rate channel
             Stages in the transmission                             Interest rate channel

• Stage 3:                                            • Affects incentives to borrow and save;

   – Changes in demand feed through to changes in     • Impact on disposable income;
     output, Y, and inflation, π.                     • Bigger effect on consumption if credit constrained.
   – Impact on Y depends on wage and price rigidity         Mankiw “Macroeconomics” Ch 16
   – Impact on π depends on output gap (Y-Y*)
                                                      • Impact on Investment.
         Mankiw “Macroeconomics” Ch 13
                                                      • Interest rate change also affects asset prices…

      Interest rate channel through to                      Interest rate channel through to
                 asset prices                                   asset prices (continued)

   ↓ r → borrowing more affordable                    ↓ r → ↑ equity prices
   so ↑ D(housing);                                      Why?

   S(housing) fixed in SR                                Equity prices reflect the pdv of expected
                                                         future income stream from equity holding,
   so excess D → ↑ P(houses)                             ↓ r → discount at lower rate, increasing pdv

   → wealth effect on C for owner occupiers.             Also, ↓ r → ↑ attractiveness of equity
                                                                   → ↑ D and ↑ P (equity)
                    Credit channel                                         Exchange Rate channel

                                                              ↓r   → capital outflow
• Monetary policy action →                                         → ↓ D(£) → depreciation

   • affects ability of banking sector to supply credit             → increases prices of foreign produced
                                                                        goods relative to domestic produced
                                                                         goods → ↑ (X-M)
   • affects collateral values so impacts on ability to
                                                                     → affects consumers’ purchasing power
                                                                     → ↑ value of assets held abroad (in domestic

 Qualifications to Exchange Rate channel                       Qualifications to Exchange Rate channel

• ↓r       → capital outflow…
                                                              ↓ r →capital outflow→↓ D(£) → depreciation→↑rel.P of M
BUT will the capital outflow be generated?
• Expectations of relative real returns matter                But even when the exchange rate does move,
     • UIP condition: currencies should move to               to what extent will relative prices reflect the change?
      equalise risk-adjusted rates of return on assets
      across countries                                          When £ depreciates against the euro, does Dijon
       •    –how much/how long will ↓ r last?                   mustard increase in price at Sainsbury’s?

• expected impact of ↓ r on economic growth?                  The impact on demand (X-M) won’t follow unless the
       - could result in a shift into UK equities → ↑ D(£).   pass-through from the exchange rate to relative prices
                                                                  UK relatively more sensitive to housing
     Strong £ - exerts pressure on firms…
                                                                           market developments
 Consider an appreciation:                                        • Housing market matters, activity is relatively more
 • Exporters may hold prices of their goods constant in the         sensitive to mortgage rates
   foreign currency - pricing to market                              – reflects relatively high mortgage debt
 • incomplete pass-through                                           – high owner occupation rates
 • Why? customer attachments, expectations…                          – popularity of buy-to-let mortgages
                                                                     – pervasiveness of variable rate mortgages
 • Implication
                                                                     ⇒ ∆r has strong effects on cash flow
    – squeeze profit margins
    – pressure to improve productivity, reduce costs,
      increase competitiveness… supply side                          – low house price elasticity of supply
                                                                     – relatively strong response of house prices
    – or…?
                                                                     – affects housing wealth, and consumption thro’ MEW

          Mortgage Equity Withdrawal:                                Mortgage Equity Withdrawal:
          How does it work in practice?                         How does it work in practice? (continued)
                                                              Following year…
Stylised example:                                             • house prices remain flat… no equity to extract
• Household income £40K p.a.                                  • interest rates unchanged.
• House valued at £200K
• Mortgage debt £100K, mortgage interest rate = 6%            • With no new home equity to extract, spending
                                                                drops to £40K.
Mortgage interest rate falls to 5%
                                                                 continued rapid gains in house prices and continued falls in
    •    Able to borrow £20K more without any increase
                                                                 interest rates would be required to sustain the recent pace
        in debt servicing costs;
                                                                 of mortgage equity withdrawal in the US and the UK
    •   Total spending power = £40K + £20K = £60K.
                                                              Rising interest rates   impact on debt servicing
                                                                                      impact on housing demand and house
             UK and equity holdings                                 Endogeneity of transmission mechanism?

                                                                    • more stable macroeconomic environment
• Widespread but mainly in the form of life assurance
  and pension fund holdings.                                          lenders may be willing to offer fixed rate mortgages at
                                                                      better rates ~ less risk that inflation will erode returns.
• evidence so far suggests that consumption hasn’t
  reacted very strongly to movements in equity prices               • furture euro entry? – impact on exchange rate channel,
                                                                      also interest rates would be set to target weighted
                                                                      average of eurozone inflation rates rather than UK
  – not easy to access funds                                          inflation.
  – funds tend to be earmarked for retirement
                                                                    • cross border competition in savings and credit markets
  - may change as information disclosure improves
                                                                      within Euro area.
  - may differ between pensions schemes with defined
    benefits as opposed to defined contributions.                   • increase in private pension provision in Euro area.

 Summary: What we have now covered

• How does monetary policy impact on the economy?
   – Stages in the transmission mechanism
   – Channels

• Some key features in comparison of UK to Europe
   – Housing market (mortgage lending)
   – Asset prices (equity holdings)

• Endogeneity of the transmission mechanism.

   HM Treasury Euro Study on Monetary Transmission Mechanism, see
   reading list on module web page.