TRANSMISSION MECHANISMS OF MONETARY POLICY

3. TRANSMISSION MECHANISMS OF MONETARY POLICY (10 channels through which monetary policy affects economic output) 2 Interest Rate Channels 1. Traditional Interest Rate Expansionary monetary policy => falling real interest rates => lower cost of capital => rising investment => rising output 2. Inflation Rate Expansionary monetary policy => rising expected inflation => falling real interest rates => lower cost of capital => rising investment => rising output 3 Asset Price Channels 3. Exchange Rate Expansionary monetary policy => falling real interest rates => U.S deposits become relatively less attractive than foreign deposits => depreciating dollar => increasing net exports => rising output 4. Tobin’s q Expansionary monetary policy => falling interest rates => falling demand for bonds => higher demand for stocks => higher stock prices => lower equity cost of financing investment=> market value of firm > replacement cost of capital => rising investment => rising output 5. Wealth Effect Expansionary monetary policy => falling interest rates => falling demand for bonds => higher demand for stocks => higher stock prices => increasing financial wealth =>increasing consumption => rising output

4. 5 Credit Channels 6. Bank Lending Expansionary monetary policy => increasing bank deposits => rising bank loans => rising business investment and consumer spending => rising output 7. Balance Sheet Expansionary monetary policy => higher stock prices =>higher firm net worth => lower adverse selection and moral hazard => higher business lending => greater investment => rising output adverse selection = potential bad credit risks are the ones who most actively seek out loans moral hazard = the lender runs the risk that the borrower will engage in risky activities that make it less likely that the loan will be paid back 8. Cash Flow Expansionary monetary policy => lower nominal interest rates =>higher cash flows => higher liquidity => improved balance sheet => lower adverse selection and moral hazard => higher business lending => greater investment => rising output 9. Unanticipated Price Level Expansionary monetary policy => unanticipated increase in prices => reduces real value of firm’s liabilities => higher real net worth => lower adverse selection and moral hazard => higher business lending => greater investment => rising output 10. Household Liquidity Expansionary monetary policy => higher stock prices => increasing financial assets => higher net worth => lower likelihood of financial distress => higher consumer durable and housing expenditures => rising output

5. 4% = Recession causing level

7. Deflation leads to: • Households postpone spending • Rising real interest rates • Rising debt burdens Deflation can lead to: Falling goods & services prices Falling home prices Falling stock prices Falling wages Hoarding money => deflation Austerity => stagnation/deflation Deflation => rising purchase power of dollar Deflation => lower wages => rising debt burden

8. Source: FRB: Exchange Rates G.5 (405)

11. Weak fundamentals are restricting sales: Few new jobs, low income growth, high unemployment, low and volatile wealth, limited access to credit, deleveraging and low confidence consistent with a deep recession. Factors supporting consumer spending: Private sector job growth, consumer are fixing their budgets, falling debt payments through debt reduction and refinancing, consumers who have stopped making mortgage payments but not yet defaulted have extra cash.

12. Demand side factors: • Affordability is high • Large pent up demand for homes • Low mortgage interest rates, but tight credit and some households suffer from inpaired credit • Rising investor and consumer confidence • Modest job and income growth Supply-side factors: • Falling inventory of homes (“underwater” households are reticent to list home) • Falling distressed homes available for sale • Lack of new home inventory

13. Deleveraging = 1/3 Charge-off = 2/3 January monthly change = $ 16.2 billion January Y-O-Y growth rate = 5.8% • Surging non-revolving credit (financing for big ticket items) • Rising auto loans due to strong auto sales • Rising government-backed student loans ($500 billion, 1/5 of total consumer credit). • debt => spending => DY/Y • Stagnant revolving credit (credit card) due to relatively high borrowing rates, but credit standards are looser. Supply Side of Credit • Cheaper financing and better access to credit has released pent-up demand. Demand Side of Credit • Better labor market => improving financial positions (ability) => rising consumer confidence (willingness) => credit financed consumption

14. The household debt service ratio is an estimate of the ratio of debt payments to disposable personal income. Debt payments consist of the estimated required payments on outstanding mortgage and consumer debt. The debt service ratio fell to 10.61% in the third quarter of 2012, the lowest level since Q3 of 1994. Falling interest rates and debt levels both caused the decline. Low debt payments are freeing up disposable income for additional consumption or savings. The financial obligations ratio adds automobile lease payments, rental payments on tenant-occupied property, homeowners' insurance, and property tax payments to the debt service ratio. The financial obligation ratio fell to 15.74% in the third quarter of 2012, down from 18.9% in Q3 of 2007.

15. Lessons for Monetary Policy • Dangerous to associate easing or tightening with fall or rise in nominal interest rates. • Other asset prices besides short-term debt have information about stance of monetary policy. • Monetary policy effective in reviving economy even if short-term interest ratesnear zero. 4. Avoiding unanticipated fluctuations in price level important: rationale for price stability objective.