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In this article we will discuss about the monetary transmission mechanism in the classical, Keynesian, monetarist and neo-Keynesian theories.
Monetary Transmission Mechanism in the Classical Theory:
In the classical monetary transmission mechanism, a change in the money supply does not affect the real variables like output, employment and income. Money is neutral in its effects on the economy. This analysis is based on a direct and mechanical relationship between money and prices.
If the quantity of money is raised, the price level will also rise in the same proportion, and vice versa. Such a relationship is based on the Quantity Theory Equation MV=PT or M/P = VT where, M is the total quantity of money, P is the price level of commodities traded, V is the velocity of circulation of M, and T is the volume of transactions of goods.
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The equation shows that the supply of real cash balances (M/P) must equal the demand for real cash balances (VT). Thus money plays a causal role in the classical theory which means that changes in the money supply cause changes in the absolute price level, and in normal income. To explain it, the classicists specified two channels through which monetary changes are transmitted to the real sector of the economy.
They are the direct mechanism and the indirect mechanism which are discussed below:
The Direct Mechanism:
The direct mechanism is based on the long run equilibrium of the demand for and supply of money. Suppose the money supply is increased. This leads to increase in the supply of actual money balances (MJP) of the public which now exceed the demand for them. Now the actual money holdings are more than those desired by the people relative to their expenditure and wealth.
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They have a tendency to spend their excess money holdings by buying consumer durable goods, and financial assets. These, in turn, increase the demand for goods and services. As a result, the price level rises which reduces the supply of real cash balances (M/P) until the actual money balances are equal to those people desire to hold. In this way, the equilibrium is restored in the money market.
The direct mechanism is explained in terms of Fig. 1 where the price level is taken on the horizontal axis and the total output (or income) on the vertical axis. MV is the money supply curve which is a rectangular hyperbola. This is because the equation MV=PT holds on all points of this curve.
Given the output level OQ, there would be only one price level OP consistent with the quantity of money as shown by point M on the MV curve. When people spend their excess money balances on goods and assets, the MV curve will shift to M, V. As a result, the price level would rise from OP to OP1, given the same level of output OQ. This rise in price level is exactly proportional to the rise in the quantity of money, i.e. PP1=MM1.
Indirect Mechanism:
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The indirect mechanism operates through the money rate of interest and involves the commercial banking system. Suppose the central bank makes open market purchases of government securities which increase the reserves of commercial banks. With excess reserves, the banks lend more which lowers the money rate of interest. This is illustrated in Fig. 2 where the curves D and S represent the demand and supply of loanable funds respectively.
The equilibrium interest OR is determined at point E where the two curves intersect each other. With increase in the reserves of banks, the supply of loanable funds increases which shifts the S curve to the right to S,. Now the banks lend LL1more of funds and the interest rate falls to OR1.
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The reduction in the market rate relative to the real rate creates a disparity between the actual and desired stock of real capital. This encourages businessmen to invest more in new capital assets. This, in turn, raises the aggregate demand for money which is financed by new money creation. This expands MV to M, V, as shown in Fig. 1. Given the full employment level OQ in the economy, the increase in the money supply raises the price level proportionately so that MM1= PP1
Its Criticisms:
The classical monetary transmission mechanism shows that money is neutral in equilibrium and it does not affect real aggregate demand, output, employment and income. But it is non-neutral in the transition period when it affects the real magnitudes. But in the long run only nominal magnitudes are affected when the money supply changes and money is neutral.
Patinkin’ has criticised the classical transmission mechanism for its failure to analyse the stability of equilibrium in both the goods and money markets through the operation of the real balance effect. This has resulted in the classical dichotomy between the real sector and monetary sector. The relative price level is determined by the demand and supply of goods in the real sector m which all real magnitudes like income and employment are determined at the full employment level.
The absolute price level and nominal magnitudes are determined by the monetary sector. This dichotomy implies that the relative price level has no effect on the monetary sector of the economy and absolute price level has no effect on the real magnitudes of the economy. The above explained dichotomy of the real and monetary sectors leads to an inconsistency in the classical transmission mechanism.
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Patinkin integrates the value theory (real sector) and the monetary theory through the real balance effect. For this, Patinkin introduces the stock of real balances (M/P) held by community as an influence on their demand for goods. Thus the demand for a commodity depends upon real balance as well as relative prices. Now if the price level rises, this will reduce the real balances (purchasing power) with the people who will spend less than before.
This implies a fall in the demand for goods and the consequent fall in the price level. Contrariwise, a fall in the price level increases the real balances thereby increasing the demand for goods and the price level. In Patinkin’s words – “This is the crucial point. The dynamic grouping of the absolute price level towards its equilibrium value will—through the real balance effect—react on the commodity markets and hence on relative prices.” Thus absolute prices play a crucial role not only in the money market but also in the real sector of the economy.
Besides removing the classical dichotomy and integrating the monetary and value theory through the real balance effect, Patinkin also validates the quantity theory conclusion. According to Patinkin, the real balance implies that people do not suffer from ‘money illusion’. They are interested only in the real value of their cash holdings.
In other words, they hold money for ‘what it will buy’. This means that a doubling of the quantity of money will lead to a doubling of the price level, but relative prices and the real balances will remain constant and the equilibrium of the economy will not be changed.
Monetary Transmission Mechanism in the Keynesian Theory:
The transmission mechanism in the Keynesian theory is indirect via the interest rate. It is based on the existence of unemployment equilibrium in the economy and on the assumption of short run. In the Keynesian analysis, there are three motives for holding money: precautionary, transactions and speculative.
The demand for money for speculative motive is determined by the interest rate, while the demand for precautionary and transactions motives is determined primarily by the level of income. Given the level of national income, the demand for money is a decreasing function of the rate of interest.
The higher the interest rate, the lower the demand for money and vice versa. This negative relationship between the interest rate and the demand for money provides a link between changes in the money supply and the aggregate variables of the economy.
The Keynesians further believe that money and financial assets (bonds) are good substitutes. They are highly liquid and yield interest. So even small changes in interest rates lead to substitution between money and financial assets. A fall in the interest rate will mean a rise in the price of bonds (or securities) which will induce people to sell bonds and hold more money for speculative purposes.
Given these main elements of the Keynesian theory, its transmission mechanism is explained below:
In the Keynesian transmission mechanism, changes in the money supply affect aggregate expenditure, output, employment and income indirectly through changes in the interest rate. Suppose the Central bank increases the money supply by open market purchase of government bonds, it lowers the interest rate which, in turn, increases investment and expenditure, thereby raising the national income.
The mechanism by which changes in the money supply are transmitted into the income level is the asset effect. With income level unchanged, when the money supply is increased, it causes people to spend their excess holdings of money on bonds.
This means an increase in the demand for bonds and a rise in their prices. A rise in the prices of bonds brings down the money interest rate. This, in turn, increases the speculative demand for money. People prefer to keep money in cash rather than lend it at a low interest rate. This, is called the liquidity effect. This is the first stage in the Keynesian transmission mechanism.
In the next stage, the fall in the interest rate and an increase in the speculative demand for money stimulates investment. Businessmen prefer to invest in capital goods rather than hold money in cash for speculative purposes.
In the final stage of the transmission mechanism, the increase in investment raises the level of income through the multiplier process. The increased income generates additional savings equal to the increase in investment and equilibrium will prevail in the commodity market. On the other hand, the rise in real income or output brings diminishing returns to labour, thereby raising per unit labour cost and the price level.
The Keynesian transmission mechanism consisting of three stages is called the cost of capital channel and is summarised thus: Money →Interest Rate → Investment → Income, where with increase in the money supply, interest rate falls and investment and income rise.
The rise in price level raises nominal income that leads to an increase in the transactions and precautionary demand for money, thereby bringing a “feedback effect” on the economy. The increase in transactions and precautionary balances, in turn, reduces the speculative balances. The latter raise the interest rate, and bring a fail in investment and income, and lead to a further feedback effect. Friedman calls the feedback effect the income effect.
The Keynesian transmission mechanism is explained in Fig. 3. Given OI1 level of investment in Panel (B) of the figure, income is OY, at which savings OS, equal investment OI1in Panel (A). Panel (C) shows that the interest rate OR, is determined by the equality of money demanded M1, and money supplied Ms at point E1.
It is this rate of interest rate which calls forth the level of investment OI1 with which we started. Now the rise in the money supply to Ms1 brings a fall in the interest rate to OR1, a rise in investment to Ol2 and a rise in income to OY2. Thus equilibrium is restored in the circular flow. The feedback process is not shown in the figure to keep the analysis simple. This is how the effects of an increase in the money supply are transmitted to the real variables of the economy under the Keynesian transmission mechanism.
Its Weaknesses:
The transmission mechanism explained above is neither smooth nor reliable because the velocity of money is not assumed as stable in the Keynesian theory. For example, when the money supply is increased by the monetary authority, this increases liquidity with the public. People may want to hold it rather than spend it. In such a situation, when the money supply increases, the interest rate falls. But the demand for money is insensitive to the change in interest rate.
The investment and income remain unaffected. The velocity of circulation of money falls. This is the Keynesian liquidity trap at a very low interest rate, people prefer to keep money in cash even with an increase in the money supply rather than invest it.
As a result, the money supply does not affect national income. Fig. 4 and 5 depict these cases. Fig. 4 shows that with a liquidity trap when the money supply increases from Ms to Ms1 at the interest rate OR, the EE, portion of the LP curve is perfectly elastic.
Again, when the money supply increases from Ms to Ms1, it is held by the people and not spent. As a result, the LP curve is horizontal and the IS curve intersects it at point E in Fig. 5. There is no change in equilibrium income OY and interest rate OR. Keynes himself accepts the weakness of his transmission mechanism when he explains the liquidity trap.
The transmission mechanism also does not operate smoothly by the expectations of money holders over future interest rates. These are highly volatile. The demand for money curve shifts with changes in expectations. This is illustrated in Fig. 6 which extends the explanation of Panel (c) of Fig. 3.
The increase in the money supply to Ms1 brings a fall in the interest rate from OR, to OR2, given the demand for money Md1. But a rise in future expectations shifts the MD curve to the right to MD1 due to increase in the speculative demand for money. This raises the interest rate to OR3 with increase in the money supply to Ms1.
Another factor which inhibits the smooth operation of the Keynesian transmission mechanism is the interest rate elasticity of investment. The less elastic is the investment curve, the less is the increase in investment as a result of a fall in the interest rate, and vice versa. This is illustrated in Fig. 7 where the 7D, curve in Panel (A) is less elastic. When the interest rate falls from OR, to OR2 investment increases by I1 I2 which is less than increase in investment I3I4 when the investment curve ID2 is elastic in Panel (B).
Monetary Transmission Mechanism in the Monetarist Theory:
The monetarists hold that the transmission mechanism by which changes in the money supply cause changes in aggregate demand (or expenditure), prices, interest rates and other economic variables is essentially a portfolio adjustment process. The economy is composed of individuals, households and firms who hold their wealth in the form of portfolios of assets.
These assets are both financial and non-financial which include money, securities, durable and semi-durable goods, and services etc. Any change in the money supply causes disequilibrium between the public’s actual and desired real cash balances of assets in their portfolios.
Suppose the money supply is increased, this increases the cash balances with the public. People will reduce their excess cash balances by spending on a wide range of financial and non-financial assets like shares, bonds, goods and services, etc.
The portfolio holders are always shifting their holdings of wealth among different assets in order to obtain satisfactory relative rates of return on their entire portfolios of financial and non-financial assets. If they find that the returns in the securities market are relatively higher than returns in the real estate market, they will shift some of their portfolio holdings of land and buildings into shares and bonds. Thus the relative prices of assets are always changing in response to shifts in the spending patterns of the people caused by changes in the money supply.
According to Friedman, the next step in the transmission process is the attempt of holders of money to restore or retain a desired balance in their portfolios after an unexpected increase in the money supply. The increase in the money supply will affect interest rates in three different ways.
First, there is the liquidity effect which causes a very short run reduction in interest rates. As a result, the portfolio holders will sell securities and their holdings of money will increase which means rise in liquid money with them.
Second, they will spend their excess money balances on financial and non-financial assets. This increase in aggregate expenditure on assets and goods and services will tend to raise output, employment and income. This is the output effect. This will lead to a rise in prices because of the rise in output and demand for money resulting from the liquidity effect. Finally, there is the price expectations effect which occurs due to the expectations of lenders that inflation will continue. They will demand higher interest rates as a premium on the expected inflation rate.
Thus the short-run liquidity effect brings a reduction in interest rates and both the output and price expectation effects increase the interest rates. Their combined effect will be an increase in interest rates. These will, in turn, discourage investment and reduce output and employment. Thus the channel of monetarists’ mechanism is: Money →Prices →Interest Rates.
This is illustrated in Fig. 8 where the initial equilibrium is at point E, where the money demand curve MD intersects the money supply curve Ms and both determine OR interest rate. With increase in the money supply, the Ms curve shifts to Ms1. If the money demand remains constant, the interest rate would fall from OR to OR1 .The increased demand for financial and non-financial assets leads to an increase in output and prices so that the demand for money increases at every interest rate. As a result, the MD curve shifts upwards to MD, and the interest rate increases to OR2
Brunner and Metzler do not agree with the above monetarist transmission mechanism and characterise it as “essentially Keynesian”. According to them, the true mechanism is based on relative price adjustments of all types of assets including capital goods. The increase in the money supply by reducing the rate of interest on financial assets switches the demand to consumption and capital goods.
This increases the size of the optimal capital stock which will bring adjustments in the actual capital stock until equilibrium is restored in the economy. All these effects will ultimately lead to an increase in output and prices. As a result, the market rate of interest rises which discourages investment, thereby reducing output and employment.
Modern monetarists also argue that a change in the money supply influences the real variables such as output and employment in the short run, while the nominal variables such as nominal national income, interest rates and prices are influenced in the long run by the monetarist transmission mechanism.
Its Criticisms:
The post-Keynesians have criticised the monetarist transmission mechanism on several counts:
1. The monetarists have not clearly specified the channels of monetary influence in a structural way. They have done little to specify exactly how and through what channels money influences nominal income, price level and output. How a million dollar increase in the money supply will have the same effects on nominal
national income when there are changes in technology and in consumer and investor psychology? The transmission mechanism fails to clarify these doubts.
2. The post-Keynesians do not agree with the monetarist proposition that the money supply basically determines the national income. The money supply and national income can also move in a reverse manner because changes in national income lead to changes in the money supply.
3. The monetarist transmission mechanism is weak in that it fails to determine as to what proportion of an increase in the money supply affects the price level and what proportion the output level.
Monetary Transmission Mechanism in the Neo-Keynesian Theory:
The Keynesian analysis considered only two types of assets: speculative cash balances and bonds. Their allocation depended on the rate of interest which, in turn, led to changes in the real sectors of the economy with a change in the money supply.
The neo-Keynesians discuss the monetary transmission mechanism through the portfolio adjustment process. When the supply of money changes, it sets in motion wealth effect, substitution effects, and availability effects, These channels of monetary mechanism are discussed as under.
Wealth Effect:
In the Keynesian analysis, no direct wealth effect is involved when the central bank engages in open market purchases of bonds or securities. It simply involves the transfer of money for bonds. But in the neo- Keynesian analysis, changes in the money supply affect the economy through wealth effect channels.
The increase in the money supply through open market purchase of securities by the central bank increases consumer wealth which, in turn, leads to a rise in consumer spending.
The increased money supply lowers the interest rate and produces a wealth effect. As a result, the expected value of real capital assets increases and the asset holders feel wealthier. They buy more of all assets in their portfolios and thus increase their demand for capital non-durable goods which ultimately lead to increase in output, employment and income in the economy.
Substitution Effects:
The neo-Keynesians widened considerably the portfolio of assets to include not only government securities but also industrial bonds, equities, savings, mortgages, etc. Given this type of portfolio, suppose the Central bank engages in open market purchases of securities. This will increase the prices of securities, thereby reducing the yield on them. In other words, the holders of securities sell them to the central bank because they get high prices for them.
They now hold more money than they desire. As a result, they try to readjust the structure of their portfolios so as to reduce their money holdings. Suppose they substitute bonds for their excess money balances. The increase in the demand for bonds results in an increase in their market price, thereby reducing their current yield, as interest rate falls. Consequently, the demand for other assets such as equities, consumer durables, etc. increases.
When people having surplus money balances purchase-equities (shares), their prices rise. As a result, the value of capital of such firms rises above the supply price of such new capital. Such firms are, therefore, induced to increase their demand for more capital equipment, thereby raising output in the capital goods industries.
This will, in turn, spread to the rest of the economy via the multiplier effect Thus the “neo-Keynesians contend that financial assets are the closest substitutes for money, and that, consequently, increases in the supply of money will have their effect eventually on the level of economic activity by bringing about increase in the output of capital goods industries.”
Credit Availability Effects:
The credit availability effects relate to the transmission mechanism following effects of changes in the interest rate on banks and financial institutions. Banks and other financial institutions which advance loans to private borrowers generally charge a standard interest rate and resort to non-price credit rationing depending on the status, credit worthiness and wealth of borrowers.
The non-price rationing of credit is also due to the absence of a market clearing interest rate. Non-price credit rationing leads to “lock-in” effect. Both these are called credit availability effects.
Suppose the central bank increases the money supply by purchasing government securities. This increases the money supply with the banks. Consequently, the reserves of banks increase and there is increase in bank credit. This leads to a fall in interest rates.
The banks will reduce credit rationing and make more credit available to their customers. At the same time, they will not “lock-in” securities in their portfolios because the prices of securities rise in the market with a fall in interest rates. They will, therefore, prefer to sell them to have more capital gain.
Thus they use these additional funds for advancing more loans. If, however, the interest rate charged on bank loans is very low in relation to the interest rate earned by the banks on other assets in their portfolios, the banks may continue with credit rationing.
If there is free competition among financial and non- financial lending institutions, credit rationing will be a temporary phenomenon. Further, if the funds are being advanced by non-bank financial institutions such as a building society, the banks may continue credit rationing due to the absence of market clearing interest rate. Interest rates may also be slow to adjust or they may continue to be administered by the non-bank financial institutions. In all such cases, banks may resort to credit rationing.
Conclusion:
When the wealth effect, substitution effects and credit availability effects operate through an increase in the money supply, their initial impacts lead to additional income which, in turn, will expand the demand for consumer non-durable and durable goods and services and ultimately to increase in output and employment. The opposite will happen when the money supply is decreased.
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