A key problem in discussing monetary policy is how to understand the monetary transmission mechanism. In this blog post, I’ll try to explain how I see it.

Combining old monetarist insights with rational expectations

The historical debate between ‘old-school’ Keynesians and monetarists in the late 1960s and 1970s basically centred around the Investment Saving-Liquidity Preference Money Supply (IS-LM) model.

The debate was both empirical and theoretical. On the one hand, Keynesians and monetarists placed differing emphases on the interest-rate elasticity of money and investments, respectively.

This turned the whole discussion into an argument about the slope of the IS and LM curves. Milton Friedman, in many of his writings, seemed to accept the validity of the IS-LM framework.

This is something that always frustrated me about Friedman’s work on the transmission mechanism, and other monetarists also criticized him for it. Karl Brunner and Allan Meltzer were especially critical of “Friedman’s monetary framework” and his “compromises” with the Keynesians on the IS-LM model.

Brunner and Meltzer suggested an alternative to the IS-LM model. In my view, their work provides many important insights into the monetary transmission mechanism, though it is often unduly complicated given the relatively simple and straightforward basic argument.

At the core of the Brunner-Meltzer critique is the insight that the IS-LM model only works for two kinds of assets – money and bonds. Once other assets such as equities and real estate are included, the model breaks down and yields drastically different results from the standard IS-LM analysis. It is especially notable that the ‘liquidity trap’ argument cannot be sustained when more than two assets are included in the model. Obviously, this observation is central to Market Monetarist arguments against the liquidity trap’s existence.

It logically follows that monetary policy does not work solely through the bond market (in effect, the money market). In fact, we could easily imagine a theoretical world in which interest rates do not exist and monetary policy would still work perfectly well.

Expressed in terms of an IS-LM model, we could have two sorts of assets: money and equities. In such a world, an increase in the money supply would push up equity prices. This would reduce the funding costs of companies and increase investments. At the same time, household wealth would increase (for those with savings in an equity portfolio), encouraging private consumption. In this world, monetary policy functions smoothly and there is no problem with a “zero lower bound” on interest rates.

Throw in the real estate and foreign exchange markets, and you have even more ways for monetary policy to influence the economy. This yields the following dictum expressing the Market Monetarist perspective: ‘Monetary policy works through many channels.’

Keynesians: obsessed with interest rates

Fast forward to the debate today. New Keynesians have mostly accepted that there are ways out of the liquidity trap – as shown by the work of Lars E. O. Svensson, for example. However, when reading contemporary research, one cannot help being struck by the fact that New Keynesians are just as obsessed with interest rates as the key transmission channel for monetary policy as the old Keynesians were.

What has changed is that the New Keynesians believe we can get around the liquidity trap by manipulating expectations. Old Keynesians assumed that economic agents had a backward-looking or static outlook, while New Keynesians assume they are rational and forward-looking.

Even so, New Keynesians still see interest rates at the core of monetary policymaking. This perception is as questionable now as it was 30 years ago. While it is praiseworthy that the New Keynesians acknowledge agents are forward-looking, their continued narrow focus on interest rates is problematic.

According to the New Keynesian model, monetary policy works by increasing inflation expectations, which push down real interest rates and spur private consumption and investment. Market Monetarists like myself regard this as one of many channels through which monetary policy operates, but by no means the most important one.

Rules at the centre

Market Monetarist stresses the importance of policy rules and how they impact agents’ expectations and the monetary transmission mechanism. We are more focused on the forward-looking nature of monetary policy than the ‘old’ monetarists were. In that regard, we resemble the New Keynesians.

Precisely because of our acceptance of rational expectations, Market Monetarists are obsessed with nominal GDP level targeting. When discussing the monetary policy transmission mechanism, the key question for us is whether we are in a world with credible policy rules or not. Each alternative is discussed below.

From zero credibility to NGDP targeting

Let’s assume that the economy is in ‘bad equilibrium’. Money velocity has collapsed, putting downward pressure on inflation and economic growth, and therefore on NGDP. Enter a new central bank governor with the following announcement:

‘Starting today, we will ensure that a “good equilibrium” is re-established. To do so, we will “print” however much money is needed to make up for the observed decline in money velocity. We will not stop expanding the money base until market participants again believe nominal GDP has returned to its old trend path. Thereafter, we will conduct monetary policy so as to keep NGDP on a 5% growth path.’

Let’s also assume that this new central bank governor is credible, and that market participants believe him. Call him Ben Volcker.

By his rousing opening statement, the credible Ben Volcker has likely set in motion the following process:

1) Consumers who have been hoarding cash because they were expecting no or very slow growth in nominal income will immediately reduce their cash holdings and increase private consumption.

2) Companies will start investing – they have no reason to hoard cash with the economy poised for faster growth.

3) Banks will realise that there is no reason to continue aggressive deleveraging and will anticipate better returns from lending to companies and households. They will certainly no longer be eager to pile up reserves at the central bank. Lending growth will accelerate as the ‘money multiplier’ increases sharply.

4) Investors in the stock market know that equity prices track nominal GDP in the long run, so the promise of a sharp increase in NGDP will make stocks much more attractive. Furthermore, with a 5% growth path rule for NGDP, investors will expect earnings and dividend flows from companies to be much less volatile. This reduces the ‘risk premium’ on equities and gives share prices a further boost. With equity valuations higher, companies will invest more and consumers will consume more.

5) The promise of looser monetary policy also means that the supply of money will outstrip growth in demand. The result will be a sharp selloff in the country’s currency. This will improve competitiveness and spur export growth.

Note that these are five policy transmission channels and I have not yet mentioned interest rates. This is no accident. Under this scenario, interest rates would increase along with bond yields, as market participants start to price in higher inflation in the transition period from ‘bad’ to ‘good’ equilibrium.

This illustrates the pointlessness of the New Keynesian interest rate fetish. We’ve just named five more powerful channels for the transmission of monetary policy, and that does not exhaust the list.

Monetary transmission mechanism with a credible NGDP level target

Ben Volcker’s announcement has now brought the economy back to ‘good equilibrium’. In the process, he may have needed initially to increase the money base to convince economic agents that he meant business.

However, once the credibility of the new NGDP level target rule has been established, Ben Volcker just needs to look serious and credible. Expectations and the market will take care of the rest.

Imagine the following situation: A positive shock increases the velocity of money; with money supply fixed, this pushes NGDP above its target path. What happens?

1) Consumers realise that Ben Volcker will tighten monetary policy and slow NGDP growth. Anticipating lower income growth, consumers tighten their belts and private consumption slows.

2) Investors also see NGDP growth slowing, so they scale back investments.

3) Banks following suit, cutting back lending and increasing reserves.

4) Stock prices start to drop as expectations for earnings growth are scaled back (NGDP and earnings growth are strongly correlated). This slows private consumption and investment growth.

5) Expecting tighter monetary conditions, players in the foreign exchange market bid up the currency. This weakens the country’s competitiveness and slows export growth.

6) Interest rates and bond yields drop on expectations that monetary policy will tighten.

All this happens without Ben Volcker doing a thing to the money base. He just sits around repeating his mantra: ‘The central bank will control the money base so that economic agents expect NGDP to grow along the 5% path we have already announced’.

By now, Ben has become so predictable he might as well be replaced by a computer.