Money, Interest, and the Channels of Monetary Transmission

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How diverse are the channels through which monetary policy actions impact on the economy? Can the overall stance of monetary policy be summarized simply by examining the behavior of the short-term nominal interest rate? Or do changes in the money stock matter as well? These questions--the ones to be addressed in this research project--have implications, not just for the specification of popular macroeconomic models, but also for the way in which US macroeconomic policy may have to be conducted in the not-too-distant future. The starting point for addressing these questions is a benchmark model of the monetary transmission mechanism, variants of which appear throughout the recent literature on monetary policy and its effects on the economy. This benchmark model assumes that the impact of monetary policy on output comes exclusively through the effects that policy has on the short-term nominal interest rate. Changes in the money stock can matter for the behavior of output, but only to the extent that those changes in money affect the interest rate first. The project considers two sets of modifications to this benchmark model, both of which imply that changes in the money stock play a more important, direct role in the transmission mechanism. The first modifications introduce direct effects of money through nonseparabilities in a representative household's utility function. The second--and more extensive--modifications permit money to become a component of private-sector wealth in a way that the benchmark model does not. In this second modified model, a Pigouvian real balance effect arises, allowing monetary policy to influence the economy even after the nominal interest rate hits its zero lower bound. A distinguishing feature of this research project is that each of the models considered will be estimated with formal econometric techniques; statistical hypothesis tests will then be used to discriminate between competing views of the monetary transmission mechanism.