What is the mechanism by which monetary policy affects nominal and real variables? Given the recent debates over monetary policy, it is clear that not only is there no consensus on the issue, but there is actually widespread divergence among economists. However, the issue of the monetary transmission mechanism is central to understand how, if at all, monetary policy can be effective in achieving its intended goals.
The mainstream, New Keynesian view suggests that monetary policy works through its effect on the real interest rate. In normal times, the central bank adjusts the nominal interest rate. Since prices are sticky, this has a corresponding effect on the real interest rate. Since the real interest is negatively correlated with consumption and investment, this has real effects in the short run. In the long run, inflation expectations adjust and the effect of policy is purely nominal.
According to this view of the monetary transmission mechanism, monetary policy becomes impotent (or at least more difficult) at the zero lower bound on the nominal interest rate. When the interest rate is at zero, the only way that policy can be effective in this context is by influencing inflation expectations because an increase in short-run inflation expectations (holding the nominal interest rate constant) can also reduce the real interest rate.
This is the logic that underscores many calls for targeting the price level or the level of nominal GDP. The appeal of such policies, according to this view, is that they raise short-run inflation expectations while keeping long-run expectations anchored. Thus, one can generate short-run real effects without sacrificing long-run objectives of price stability.
This raises two main questions. First, how can monetary policy achieve this goal? Second, what evidence do we have to suggest that this type of policy would be successful?
According to the New Keynesian view, the ability of monetary policy to affect inflation expectations is captured in the central bank’s credibility. If the central bank announces a price level or nominal GDP target, the policy is only effective in the NK case if the public believes that the central bank is committed to that target. According to some, all this requires is an announcement by the central bank. If the central bank lacks credibility, the only way to convince the public to expect higher short run inflation is to engage in a policy consistent with the price level or nominal GDP target. However, in the absence of credibility, it is unclear how this happens in the NK model. In other words, in the NK model the nominal interest rate is stuck at zero and therefore the only way that monetary policy can have any effect is through influencing inflation expectations. If the central bank lacks credibility, it cannot raise such expectations. Also, given the monetary transmission mechanism in the NK model, monetary policy is not even capable of convincing the public that it is serious about its target because there is no action that it can take to achieve its goal. This thereby reinforces the public’s view about the credibility of the central bank. This is a liquidity trap.
But what if the NK model of the monetary transmission mechanism is wrong? Suppose that we have another view of the monetary transmission mechanism. Under what conditions can monetary policy be effective and what role would inflation expectations play? My previous post was an attempt to motivate this discussion. In that post I referenced a working paper of mine that examines the role of open market operations in influencing the price level and nominal spending. In that paper, monetary policy is transmitted through the aggregate stock of liquid assets (i.e. assets used in transactions). Thus, the ability of monetary policy to affect the price level or nominal spending is dependent upon whether open market operations have an effect on the aggregate supply of liquidity. In other words, if money and bonds are perfect substitutes, then open market operations are ineffective. If, however, money and bonds have differing degrees of liquidity, then open market operations are always effective (i.e. the effects are not dependent on inflation expectations and the zero lower bound is irrelevant). Thus, determining whether monetary policy can be effective has nothing to do with expectations or the nominal interest rate, but only whether money and bonds are perfect substitutes. In addition, regardless of whether money and bonds are perfect substitutes, it is possible for open market operations to be effective if the central bank buys other, less liquid assets.
Clearly, the view put forth in my working paper differs from the monetary transmission mechanism in the NK model. This brings us to the second question above as well as a follow-up question. What evidence do we have to suggest that adopting a price level or nominal GDP level target would be successful? How can we understand this evidence in light of the NK model and the view put forth in my working paper?
The most frequently cited example is that of FDR raising the price of gold in 1933. To understand the effects of this change, it is useful to revisit my post, “Commodity Money: A Primer.” The workings of the gold standard can be described as follows (taken from that post):
Suppose that resources can be used to produce consumer goods and gold. For a given amount of resources, Rfixed, we can write a production possibilities frontier:
Rfixed = R(C, G)
Where C is consumer goods and G is gold. The marginal productivities can be of producing consumer goods and gold are, respectively, Rc > 0 and Rg > 0.
Resource owners earn income:
Y = (Pc/Pg) C + G
Where Y is income and Pc and Pg are the prices of consumer goods and gold, respectively.
Equilibrium necessarily requires that
Rc/Pc = Rg/Pg
Or
Rc/Rg = Pc/Pg
This implies that the price of consumer goods in terms of gold is equal to the marginal opportunity cost (marginal rate of transformation).
Given this equilibrium condition, if the price of gold is exogenously increased, the price level will have to rise. But what is the mechanism by which the price level rises?
According to the New Keynesian view, this is a prime example of level targeting. The government announces a higher price of gold, which requires a higher price level. Short-run expectations of inflation rise. Long-run expectations about price stability are anchored. This is a textbook case of level targeting.
Nonetheless, it is not clear that this expectations channel is actually the correct transmission mechanism. For example, if monetary policy is transmitted through aggregate liquidity, then the increase in the price level results from the corresponding exogenous increase in the monetary base. Along these lines, the traditional Old Monetarist transmission mechanism would suggest that the real effects of the policy are directly the result of the increase in the monetary base because of portfolio/distributional effects on money balances.
Each of these transmission mechanisms provide (somewhat) observationally equivalent results. The precise mechanism through which monetary policy works is important given the different monetary regimes. For example, if monetary policy works through expectations, then the ability of current monetary policy to be successful is to influence inflation expectations. Under the gold standard, all this requires is a change in the price of gold. Under the current policy regime, this requires that central bank has sufficient credibility to convince the public that they are committed to some level target.
If monetary policy works through its effect on aggregate liquidity, under a gold standard the increase in the price of gold results in an increase in the monetary base. Under the current monetary regime, monetary policy must be conducted through open market operations. The ability of the central bank to have an effect on the aggregate stock of liquidity is therefore dependent on the relative liquidity properties of base money and the assets purchased in the open market.
What this tells us is that we cannot completely understand the events of the 1930s without understanding the monetary transmission mechanism. The evidence suggests that monetary policy can be effective (very effective). Nonetheless, the different in monetary regimes are important. Under the gold standard, the change in the price of gold is sufficient to produce an exogenous increase in the monetary base and short-run inflation expectations. Under the current monetary regime, influencing expectations requires credibility on the part of the central bank. In addition, increasing the aggregate stock of liquidity through open market operations depends on the relative liquidity property of money and bonds (and other assets).
In discussing policy and providing policy advice, it is first important to understand the monetary transmission process. Unfortunately, there is little agreement about how monetary policy is transmitted and existing evidence often supports mechanisms that are observationally equivalent, but yet very different processes. Perhaps this is why there are such divergent views on the current stance of monetary policy.
The Everyday Economist 
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Great post. I’ve had many of the same thoughts–left them strewn in comments around the econo-blogosphere.
In my view, ultimately, influencing inflation-expectations is not necessary to hurdle the zero lower bound. Even a central bank with zero credibility could, in principle, catch a sceptical market off-guard. The ‘transmission mechanism’ (such a horrible metaphor) is the ‘portfolio/distributional effects on money balances’.
I remember trying to make this point explicit following Krugman’s tepid endorsement of NGDP targeting. It was a rhetorical move. Krugman merely thought it would approximate his ideal: increasing inflation expectations. NGDP targeting, in this view, is simply an easier sell to the public than higher inflation. Moreover, for Krugman, the potency of such a target depends entirely on the central bank’s credibility. That is, if nobody believes the new NGDP level target, then the Fed would be powerless to prevent such expectations fulfilling themselves.
It seems to me that (most?) market monetarists (who really just seem like Old Monetarists to my anemic knowledge of the matter) harbour a different perspective. I this view, the liquidity trap is, at best, a kind of institutional glitch–a quirk of how central banks choose to conduct business rather than some fundamental law of macroeconomics.
The trouble with this theory is that it does not cover the whole of the macro-economy. Keynes was surely aware of this, but he deliberately chose to fool a lot of us by presenting analysis for only part of it. A more comprehensive model and proper logical and scientific presentation can be seen in my newly published book: “Consequential Macroeconomics–Rationalizing About How Our Social System Works”.