Chapter 23
Modern Monetary Policy
and the Challenges
Facing Central Bankers
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
Modern Monetary Policy:
The Big Questions
1. What are the various channels of
monetary policy transmission?
2. What are the factors that make
modern monetary policy so difficult?
23-2
Japan and the U.S.
What made the Japanese and U.S.
experiences of the last 20 years so
different?
23-3
Japan: Growth and Interest Rates
23-4
U.S.: Growth and Interest Rates
23-5
Modern Monetary Policy:
Roadmap
• Monetary Policy Transmission
Mechanism
• Challenges Facing Modern Monetary
Policymakers
23-6
The Monetary Policy Transmission
Mechanism: Traditional Channels
Interest Rates and Exchange Rates
the traditional channels of monetary policy
transmission aren’t very powerful
23-7
The Monetary Policy Transmission
Mechanism: Credit Channels
Bank Lending and Balance Sheet Channels
• By altering the supply of funds to the banking
system, policymakers can affect banks' ability and
willingness to lend
• an open market purchase has a direct impact on the
supply of loans, increasing their availability to those
who depend on banks for financing
• as interest rates fall, the supply of loans increases
23-8
The Monetary Policy Transmission
Mechanism: Asset Price Channels
Investment and Wealth
• a fall in the interest rate
– pushes stock prices up
– drives the mortgage rate down leading to higher demand for
residential housing, driving up the prices of existing homes
• Higher asset prices mean increased wealth and
higher consumption
23-9
The Monetary Policy
Transmission Mechanism
23-10
• If neighborhoods with high crime rates
have more police, does that mean
police cause crime?
• Finding correlations is straightforward
• Establishing causal relationships is
difficult
23-11
• Why did Japan’s economy fail to
respond to interest rates near zero?
• One possibility is that the stock market
collapse lowered borrower net worth
• In addition, with borrowers unable to
repay, banks had virtually no capital
and could not make additional loans.
23-12
23-13
The Challenges Modern Monetary
Policymakers Face: Estimating Potential
During the late 1990s,
people failed to
recognize potential
output was growing
more rapidly than it had
earlier. As a result,
forecasts of GDP were
consistently too low.
23-14
• Computing real returns means
subtracting inflation from nominal
returns
• In order to evaluation nominal interest
rates, wage increase and the like, you
need to know the level of inflation
23-15
In the 1970s
inflation rose in
two big bursts
23-16
One possible
explanation
is that Fed
policymakers
failed to
realize that
growth had
slowed.
23-17
The Challenges Modern Monetary
Policymakers Face: Deflation
Deflation & Zero Nominal Interest Rate Bound:
– Nominal interest rates can't fall below zero
– This places a restriction on what monetary
policymakers can do
– The most effective way to expand the monetary
base when the overnight interest rate has fallen to
zero is to shift to targeting longer-term rates.
23-18
The Challenges Modern Monetary
Policymakers Face: Booms and Busts
Booms & Busts in Equity & Property Prices
Bubbles that inflate and then burst are
particularly damaging, because the wealth
effects they create cause consumption to
explode and then contract just as rapidly.
23-19
The Nasdaq Bubble
23-20
The Challenges Modern Monetary
Policymakers Face
Evolving Financial Structure
changes in financial structure will change
the impact of monetary policy.
23-21
Chapter 23
End of Chapter
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008