Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 6 Monetary Transmission Mechanism

Issues In Monetary Transmission - Empirical Evidence

Recent research on monetary transmission confirms that monetary policy actions affect output in the short-run. While output is quicker to respond to monetary policy, prices display inertial behaviour and remain largely unaffected for almost one year or even more. Movements in real output are not only substantial but also long-lived (though not permanent) with the effects remaining up to three years. The recent vector auto-regression (VAR) literature confirms these results. Output, consumption and investment display a hump-shaped response, and for the US economy, the peak effect is found to occur about 1.5 years after a monetary policy shock. Inflation also displays a hump-shaped response, with the peak response after about two years. Interest rate returns to its pre-shock level within one year. According to estimates for the US economy made by Romer and Romer (2003), a shock of 100 basis points to the interest rate starts to reduce industrial production after five months and the peak decline of 4.8 per cent occurs after 22 months. The impact then weakens gradually, reaching (-) 1.2 per cent after 48 months. As regards prices, there is little effect for the first 18 months and the prices start falling in the subsequent period. The prices decline by around 2 per cent after 30 months and by 6 per cent after 48 months.

For the United Kingdom, a temporary increase (increased for one year and then reversed) of interest rates by 100 basis points lowers output by around 0.2-0.35 per cent after about a year and reduces inflation by around 20-40 basis points a year or so after (Bank of England, 1999). The results for the Euro area broadly conform to this pattern. The peak effect of output occurs after one year while inflation hardly moves during the first year. The delayed response of prices relative to that of output suggests that studying the transmission of policy to spending and output is a logical step, even if the aim of monetary policy is defined primarily or exclusively in prices. Although the persistence of inflation has declined per se in the US and the UK, the lags in the impact of systematic monetary policy actions on inflation still persist despite numerous changes in monetary policy arrangements and advances in information processing as well as financial market sophistication.

Notwithstanding the broad similarities in the transmission process across countries, there are a few differences as well. In the Euro area and Japan, real output changes are brought about largely by the response of investment whereas in the US, output variations are mainly brought about by consumption. The differential response of investment and consumption - the "output composition puzzle" -suggests that it is important to understand not only the dynamics of the overall output but also to have a reasonable grasp of the various constituents of GDP. Accordingly, the key monitoring indicators may differ for each central bank. Thus, given the above results, consumer behaviour needs to be watched more carefully in the US and accordingly, changes in the mortgage markets may be more important than studying changes in the tax treatment of depreciation. In contrast, it appears that, in the Euro area, disposable income is relatively less responsive to monetary changes which might reflect wider social safety nets in the Euro area. Thus, the particular institutional structure in each economy affects the transmission process differently.

A comparative analysis of the alternative channels for the Euro area, as a whole, suggests that the exchange rate channel is the dominant channel of transmission in the first two years, both in terms of its impact on output and on prices; from the third year onwards, the user cost of capital channel is dominant in terms of impact on output. The 'credit channel' is found to operate significantly in Germany and Italy but is irrelevant in some other Euro area countries. Thus, the role of the banks is found to be smaller than expected. On the other hand, evidence for Japan indicates a strong role for the 'credit channel' since borrowers have been unable to substitute bank borrowing with alternative sources and consequently, business investment is especially sensitive to monetary shocks. In contrast to the above studies with their focus on aggregate output, Dedola and Lippi (2000) undertook an industry-wise analysis of monetary policy effects and found that the impact of monetary policy is stronger in industries that -

1. produce durable goods

2. have greater requirements for working capital and

3. a smaller borrowing capacity.

These results can be viewed as supportive of the credit channel. Cost-channel is found to be operative only for the period till the 1970s (pre-Vocker period). The weak evidence in the subsequent period can be attributed to financial innovations and deregulation.

On the relative roles of money and interest rates, the Japanese evidence shows that a money shock is found to have a large impact on economic activity even when the interest rate is included in the VAR. This suggests that the interest rate channel does not fully account for the transmission mechanism in Japan.

Recent research has also focused on the role of alternative forms of wealth - housing wealth and equity wealth - in transmission. For Canada, consumer spending is found to respond very little to changes in equity wealth but is more sensitive to housing wealth. The average marginal propensity to consume from wealth (5.7 cents per dollar) is found to be more than 10 times that from equity wealth (less than 0.5 cents per dollar). The weaker response to equity wealth arises from the fact that changes in equity prices tend to be more temporary coupled with the fact that only a small segment of households holds equities in their portfolios. Similar results are found by Case, Quigley and Shiller (2001) for a panel of 14 countries and a panel of US States. This suggests that property prices play a greater role in the transmission process vis-à-vis equity prices. In this context, the recent household borrowing behaviour has raised concerns to policymakers. Household borrowing has grown considerably in many countries over the past two decades, reflecting easing of liquidity constraints as well as lower borrowing rates. The large build-up of household wealth in housing suggests that the household sector consumption, and hence overall domestic demand, will be more sensitive to shocks to interest rates and household incomes in the future.

There is some evidence of temporal changes in the transmission process: between 1970-85 and 1985-95, in the case of the US, the interest rate elasticity of investment indicates a decline while the consumption elasticity shows an increase. No general pattern of change in these interest rate elasticities is, however, observed for the G-7 group of countries as a whole. Moreover, the response of output to monetary policy signals might be asymmetric, with a tight monetary policy being more effective than an easy monetary policy. For the US, the short-run response of output to increases in the Fed Funds rate is estimated to be more than twice the response to decreases in the Fed Funds rate .

As regards the transmission mechanism in emerging market economies, available empirical evidence suggests a broadly similar pattern as prevailing in key advanced economies. For instance, evidence for Chile indicates that, on average, it takes three to five quarters for a change in monetary policy to reach its main impact on demand and production and an additional four to six quarters are necessary for these changes in activity to have the maximum impact on inflation (Central Bank of Chile, 2000). For South Africa, a change in the repo rate takes around five quarters to have its maximum impact on output and around 6-8 quarters for maximum impact on inflation. At the same time, some subtle differences have also been brought out by empirical evidence. In view of the relatively underdeveloped financial markets as well as the prevalence of liquidity constraints, lags of monetary policy transmission may be shorter. For the Czech Republic, the peak effect on inflation occurs within 18 months of variation in policy interest rate which is shorter than that in major advanced economies. Quicker exchange rate pass-through coupled with a more centralised system of wage bargaining can explain the relatively fast response of prices. For a sample of East Asian economies, Fung (2002) finds that prices decline immediately in response to interest rate hikes. The relatively quick response of prices is attributed to lesser rigidity in the labour markets in these East Asian countries which imparts a greater flexibility to prices.

In brief, the above cross-country evidence suggests that monetary policy actions affect output with a lag of almost one year while it takes nearly two years for monetary policy to have significant impact on inflation. The latter finding explains as to why inflation targeting central banks typically operate with a two-year framework for monetary policy. It must, however, be stressed that these lags are average lags and are surrounded by a great deal of uncertainty. In view of the ongoing structural changes in the real sector as well as financial innovations, the precise lags may differ in each business cycle.