The transmission mechanism of monetary policy Stages in the

Document Sample
The transmission mechanism of monetary policy Stages in the Powered By Docstoc
					          The transmission mechanism                                  Stages in the transmission of monetary
               of monetary policy                                                      policy

• How does monetary policy affect the economy?
  continued…
                                                                    • 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.
     shocks?
   – 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
                                                                          Channels:
      • 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
                                                                    also
     borrow.
                                                                     → affects consumers’ purchasing power
                                                                    and
                                                                     → ↑ value of assets held abroad (in domestic
                                                                          currency)




 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
                                                              occurs.
                                                                  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
      improvements
                                                                     – 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
                                                                                       prices
             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
  Why?
                                                                      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.

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