Structural Model

Examines whether one variable affects

another by using data to build a model that
explains the channels through which the
variable affects the other
Transmission mechanism
The change in the money supply affects interest
rates
Interest rates affect investment spending
Investment spending is a component of
aggregate spending (output)
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

24-1

Reduced-Form
Examines whether one variable has an effect
on another by looking directly at the
relationship between the two
Analyzes the effect of changes in money
supply on aggregate output (spending) to
see if there is a high correlation
Does not describe the specific path

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

24-2

Structural Model Advantages

and Disadvantages
Advantages
Opportunity to gather more evidence gives more
confidence on the direction of causation
More accurate predictions
Understand how institutional changes affect the
links

Disadvantage
Only as good as the model it is based on

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

24-3

Historical Evidence
If the decline in the growth rate of the
money supply is soon followed by a decline
in output in these episodes, much stronger
evidence is presented that money growth is
the driving force behind the business cycle
A Monetary History documents several
instances in which the change in the money
supply is an exogenous event and the
change in the business cycle soon followed

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

24-4

FIGURE 3 The Link Between Monetary Policy

and GDP: Monetary Transmission Mechanisms

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

24-5

Asset Price Effects

Traditional interest rate effects
Expansionary monetary policy

ir I Y

Emphasis on real interest rate: Expansionary monetary

policy

P e e ir I Y

Exchange rate effects on net

ir E NX Y
exports
Expansionary monetary policy

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

24-6

Asset Price Effects (contd)

Tobins q theory
Expansionary monetary policy

Ps q I Y

Wealth effects
Expansionary monetary policy

Ps wealth

consumption Y
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

24-7

Credit View
Bank lending channel
Expansionary monetary policy bank deposits bank loans
IY

Balance sheet channel

Expansionary monetary policy Ps net worth
adverse selection , moral hazard lending
IY

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

24-8

Credit View (contd)

Cash flow channel
Expansionary monetary policy i cash flow adverse selection ,
moral hazard lending I Y

Unanticipated price level channel

Expansionary monetary policy unanticipated P real net worth
adverse selection , moral hazard lending I Y

Household liquidity effects

Expansionary monetary policy Ps value of financial assets
likelihood of financial distress consumer durable and housing
expenditure Y
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

24-9