By Thomas, Julia K.
Business Review (Federal Reserve Bank of Philadelphia)
Each meeting of the FOMC is met with widespread interest by everyone from financial market participants on Wall Street, to real estate agents, to the cashier at your local grocery store. People perceive changes in the FOMC's target for the federal funds rate--the interest rate at which banks borrow and lend to each other, usually overnight, through the federal funds market--as relevant and important in their everyday lives. Business people view changes in this interest rate as an important determinant influencing everything from car and home sales to consumer spending over the Christmas holiday season. Whenever business conditions are widely perceived to be weak, most people welcome cuts in the federal funds rate.
Despite these observations, however, the means through which changes in an interest rate affect business activity is, in fact, far from obvious. Over the past few decades, economists have devoted ever-growing effort to developing formal economic models to help us understand precisely how changes in interest rates brought about by monetary policy actions affect the production and provision of goods and services throughout the economy. While there are several different types of models describing how monetary policy actions drive short-run changes in total employment and GDP, a growing consensus has emerged. Most often, when an economic model is used as an additional tool with which to analyze the consequences of alternative monetary policy actions, it is drawn from a class of models known as New Keynesian (or sticky price) models.
New Keynesian models have broad appeal because they provide a relatively simple explanation for how changes in the stock of money can affect business activity and because they are, in some respects, quite consistent with what economists known about how actual changes in the money stock affect the economy. Unfortunately, though, versions of these models capable of generating realistic effects of changes in the money stock for production and employment are, at their most basic level, inconsistent with what we know about how interest rates move with policy-induced changes in the stock of money.
This article argues that, by extending the New Keynesian model to reintroduce an abandoned liquidity role of money found in earlier models, we can resolve some of the remaining divorce between our economic theory and the patterns we observe in the workings of actual economies. (1) What is this role of money? It is the idea, from classical economics, that money serves a special purpose in allowing transactions to take place between buyers and sellers, since it is the only financial asset universally accepted as a means of payment. Other assets, such as stocks and bonds, are typically not accepted as a means of payment and cannot be directly used to buy goods and services. Thus, in contrast to money, these nonmonetary assets are relatively illiquid.
When we introduce the classic liquidity role of money into the New Keynesian model, and we acknowledge the fact that it is costly to convert nonmonetary assets into monetary ones (and vice versa), we arrive at a richer model that is consistent with our knowledge of how interest rates are affected by changes in the stock of money. At the same time, the mechanics of the New Keynesian model become more complicated with this improvement, because the level of an individual's monetary assets takes on an independent role in his or her spending decisions. Exploring the effects of changes in monetary policy in this richer environment, we find that the overall magnitude of these effects and the rate at which they spread throughout the economy can depend importantly on how much money is typically held and how rapidly it changes hands, on average. In short, our extended theoretical model offers new insights about how the effects of monetary policy are transmitted throughout the economy.
WHAT HAPPENS FOLLOWING A CHANGE IN MONETARY POLICY? …