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Interest rate cuts, for example, lower the cost of borrowing, which results in higher
investment activity and the purchase of consumer durables. The expectation that economic
activity will strengthen may also prompt banks to ease lending policy, which in turn enables
businesses and households to boost spending. In a low interest-rate environment, shares
become a more attractive buy, raising households financial assets. This may also contribute
to higher consumer spending, and makes companies investment projects more
attractive. Lower interest rates also tend to cause currencies to depreciate: Demand for
domestic goods rises when imported goods become more expensive. All of these factors
raise output and employment as well as investment and consumer spending. However, this
stepped-up demand may cause prices and wages to rise if goods and labour markets are
fully utilized.
The process through which monetary policy decisions impact on an economy in general and
the price level in particular is known as the monetary policy transmission mechanism. The
individual links through which monetary policy impulses proceed are known as transmission
channels. The main channels of monetary policy transmission are set out in a simplified,
schematic form in the chart.
2.
Tobins q theory provides a mechanism through which monetary policy affects the
economy. It works via its effects on the valuation of equity prices. You should recall that
Tobin defined q as the market value of firms divided by the replacement cost of capital.
q=
marketvalueofcapital
replament cos tofcapital
When q is high, it tell us that the market values of firms is high relative to the replacement
cost of capital; and therefore, new plant and equipment capital is cheap in comparison with
the market value of business firms. This suggests that when firms issue equity the price they
get is higher than the cost of the plant and equipment they buy. Thus, buy issuing a small
equity, firms can raise huge amount of funds to buy new plant and equipment; investment
increases as a result. On the other hand, when q is low the value of firms is low relative to
the replacement cost of capital. Under this situation, if firms want to buy new investment it
is cheaper for them to buy another firm cheaply and acquire the old plant and equipment of
the purchased firm. The implication of this is low Investment when q is low.
2
Central to this discussion is that there is a strong link between Tobins q and investment
expenditure. The logic of this is easily understood. For instance, when there is a fall in
money supply, the public finds that it has less money than it wants to hold. When this
happens, the public endeavours to acquire more money by spending less. One place the
public can spend less in the capital market by buying fewer stocks in the market. The
reduced demand for stocks consequently lowers their prices. Of course, this argument can
be juxtaposed against the Keynesian conclusion which goes as follows: that a tight monetary
policy that raises interest rates makes the demand for bonds more attractive in relation to
equities. The prices of stocks fall as a consequence. The following schematic diagram arises
from the Tobin q theory of monetary transmission mechanism of monetary policy.
M Pe q I Y
Where M is money supply, Pe stands for equity prices, q represents Tobins q, I denotes
investment and Y indicates aggregate output.
Equity prices affect wealth which, in turn, affects consumption. This channel draws on the
life-cycle /permanent income hypothesis of consumption. This says that consumption is
determined by the life time resources of the consumers. The life time resources comprises:
(i) human capital; (ii) real capital; and (ii) financial wealth. Common stocks are a major
component of financial wealth. It follows that when the prices of stocks fall, the value of the
financial wealth declines. This decreases the lifetime resources of the consumers and
consumption falls consequently. Also, if a tight monetary policy leads to a fall in land and
property values, households wealth falls, consumption and, therefore, output fall. The
Tobin q theory discussed earlier is also applicable to structures and residential housing. The
schematic representation of this:
M Pe Wealth Consumption Y
Central Bank Independence (CBI) refers to a situation where the central bankers are
insulated from short-term political considerations and are allowed to take a long-term view
of the economy.
The hypothesis that CBI leads to lower inflation is built on:
a. the temper of the times
i. the experience of central banks has become favorable for CBI
ii. the 20th century history of monetary policy under dependent central
banks have been a sobering experience
iii. which is supported by the modern consensus on the Phillips curve,
according to which
1. there is a short run trade-off
2. but no long run trade-off
3. Which leads to a consensus on the goals for monetary policy,
i.e. the pursuit of long run price stability without disrupting
output in the short run.
4. This consensus on goals for monetary policy is crucial for the
CBI case as Goodhart observed:
a. there does not seem to be room for disagreement
on final goals if we are going to talk about independent
central banks (Goodhart)
5. But this consensus is also associated with the shift in politics
since the 70s, which may be temporary
iv. The comparative experience of Central Banks was also important:
1. Bundesbank and SNB (Swiss National Bank) were notably
successful and significantly independent
2. Without impairing economic growth
3. Further, the Bundesbank combined its independence with the
use of explicit targets to communicate
a. Which maintained accountability
4. This pattern has been widely copied, i.e.:
4
most
operationally
independent,
i.e.
instrument
and
instrument
independence
iii. Apart
form
independence
this
distinction
(mentioned
between
above)
goal
the
empirical
literature
might often