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…
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
⇒ ∆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
– 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)
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
• 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.