Academic journal article Business Economics

The Response of Small Business Owners to Changes in Monetary Policy

Academic journal article Business Economics

The Response of Small Business Owners to Changes in Monetary Policy

Article excerpt

The small business sector of the economy accounts for h0alf of private gross domestic product and well over half of private sector employment. Little is known about how these firms and the banks that serve them are affected by changes in monetary policy. Using data from the monthly surveys of the members of the National Federation of Independent Business, the impact of unexpected (between meeting) Federal Reserve announcements on owner expectations and hiring and spending plans are examined. Using interviews filled out during the month, "before" and "after" groups are analyzed to assess the impact of Federal Reserve announcements on firm behavior. Narrowing the analysis period to just days before and after Federal Reserve announcements permits the assessment of owner responses uncontaminated by other events. Changes in owner expectations and spending and hiring plans are shown to be translated into subsequent changes in actual spending and hiring that are often the opposite of what is suggested by conventional economic theory. Firms that do not use debt respond in the same way as those regularly active in credit markets. The results provide additional insight and richness to our understanding of the transmission channels through which monetary policy impacts the real economy.

Business Economics (2009) 44, 23-37.

doi:10.1057/be.2008.6

Keywords: monetary policy, monetary policy transmission, small business, Federal Reserve announcements

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The transmission channels through which changes in monetary policy affect private sector spending and hiring are incompletely understood, especially in the small business sector. Most research to date has been based on analysis of time series aggregate data on investment spending (including housing). However, the small business sector, which is responsible for most of the job growth and innovation in the U.S. economy and half of private sector gross domestic product (GDP), is quite different from the population of larger firms that has been the traditional focus of investments studies and monetary policy. (1)

This study documents how small firms react to unexpected changes in monetary policy. (2) Monthly survey data obtained from the National Federation of Independent Business (NFIB) illustrate how owner expectations are affected by these changes, with corresponding adjustments to spending and hiring plans, and ultimately changes in actual spending and hiring. These expectation and plan variables have been shown to be significantly related to spending and hiring at the macro level with a short lag [Dunkelberg, Scott, and Dennis 2003]. Thus, the results can provide some new micro level insight into how quickly changes in monetary policy work through the small business sector--and ultimately the aggregate real economy--and the direction of the effects of policy changes.

1. The Monetary Policy Transmission Mechanism

There are several schools of thought regarding the channels through which monetary policy exercises its influence on real economic activity. Recently popular is the asset price view [Taylor 1995]. This view focuses on the impact of changes in interest rates on the spending decisions of businesses and households through changes in asset values and exchange rates. The higher the market rate of interest, the fewer the number of investment opportunities whose rate of return exceeds the cost of capital and, consequently, the lower the level of investment spending. Also, rising interest rates change the price of current consumption and reduce financial market wealth, adversely affecting current consumption. Except for new housing (treated as part of gross private domestic investment), little empirical evidence is available to support the notion that interest rate changes have a strong direct effect on consumer spending. However, it appears that changes in asset values that are viewed as permanent do have a modest effect on consumer spending. …

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