The Cost Channel of The Cost Channel of Monetary TransmissionMonetary Transmission

Barth and RameyBarth and Ramey

IntroductionIntroduction Notice the stylized facts about the effects of a Notice the stylized facts about the effects of a

contractionary monetary policy action:contractionary monetary policy action:a)a) Output falls after a lag of about four months. Output falls after a lag of about four months. b)b) Short-term interest rates have largely transitory effects.Short-term interest rates have largely transitory effects.c)c) The price level is unresponsive for almost two years. The price level is unresponsive for almost two years.

Traditional models try to explain these facts by assuming Traditional models try to explain these facts by assuming sticky wages or prices. However, it is difficult to explainsticky wages or prices. However, it is difficult to explainwhy a decline in aggregate demand does not lead firms towhy a decline in aggregate demand does not lead firms tolower prices. lower prices.

An alternative explanation is to allow monetary shocks toAn alternative explanation is to allow monetary shocks tohave both supply-side and demand-side effects.have both supply-side and demand-side effects.

The authors argue that:The authors argue that:

1.1. If after a tightening in monetary policy If after a tightening in monetary policy output and prices decline simultaneously, output and prices decline simultaneously, then it should be the case that there was a then it should be the case that there was a demand-side response to the policy. demand-side response to the policy.

2.2. If output declines and prices increase, then If output declines and prices increase, then the market response comes from the the market response comes from the supply-side. supply-side.

3.3. If output declines and prices do not change, If output declines and prices do not change, then there was a simultaneous reaction on then there was a simultaneous reaction on the supply and the demand side of the the supply and the demand side of the market. market.

Theoretical FrameworkTheoretical Framework

Firms Firms

Maximize profits given byMaximize profits given by

WhereWhere PPitit = price of output = price of output

QQitit = production = production

RRitit = supply side effect of monetary policy = supply side effect of monetary policy

C(QC(Qitit) = convex cost function) = convex cost function

itititititit QCWRQP

Firms face an inverse demand function Firms face an inverse demand function given by:given by:

Where QWhere Qitit = production = production

DDitit = demand effect of monetary = demand effect of monetary policypolicy

Wages are allowed to be endogenously Wages are allowed to be endogenously determined:determined:

The authors solve the model to show theThe authors solve the model to show the

relationship between output and prices. relationship between output and prices.

Equilibrium ResultsEquilibrium Results

A negative demand shock (i.e. a A negative demand shock (i.e. a decline in Dit) leads to lower decline in Dit) leads to lower equilibrium output Qit and lower equilibrium output Qit and lower equilibrium prices relative to wages, equilibrium prices relative to wages, Pit/Wit.Pit/Wit.

A negative supply shock (i.e. a rise in A negative supply shock (i.e. a rise in Rit) leads to lower equilibrium output Rit) leads to lower equilibrium output Qit but higher equilibrium Pit/Wit.Qit but higher equilibrium Pit/Wit.

Empirical FrameworkEmpirical Framework

Estimate a series of VAR’s considering theEstimate a series of VAR’s considering the

system:system:

Where IPWhere IPtt= industrial production (proxy for output)= industrial production (proxy for output)

PPtt = personal consumption expenditure = personal consumption expenditure

deflatordeflator PCOMPCOMtt= producer price index = producer price index

NB2TOTNB2TOTtt= difference in total reserves= difference in total reserves

FFRFFRtt= Federal funds rate= Federal funds rate

QQitit= industrial production in industry i= industrial production in industry i

PWPWitit= ratio of price to wages in industry i= ratio of price to wages in industry i

SDSDtt= constants and seasonal dummies= constants and seasonal dummies

HPHPtt= Hoover and Perez dummy= Hoover and Perez dummy

The VAR’s are estimated for total manufacturing, The VAR’s are estimated for total manufacturing, durable manufacturing, and non-durable durable manufacturing, and non-durable manufacturing, 18 two-digit industries and two three-manufacturing, 18 two-digit industries and two three-digit industries. digit industries.

The authors consider three sample periods. The authors consider three sample periods.

a) From February 1959 to December 1996.a) From February 1959 to December 1996.

b) From February 1959 to September 1979 (pre-b) From February 1959 to September 1979 (pre-Volcker period).Volcker period).

c) From January 1983 to December 1996 c) From January 1983 to December 1996 (Modern(Modern

Era)Era)

ResultsResults

The results of the estimations for the full sample The results of the estimations for the full sample are illustrated with impulse-response functions. are illustrated with impulse-response functions.

They find that in 13 of the 21 industries They find that in 13 of the 21 industries considered, output falls and prices rise in response considered, output falls and prices rise in response to a positive shock to the Federal funds rate to a positive shock to the Federal funds rate (evidence of a supply-side response). (evidence of a supply-side response).

Industries such as Lumber Products, Primary Industries such as Lumber Products, Primary Metals, Fabricated Metals, Other Durables, and Metals, Fabricated Metals, Other Durables, and Food, and Rubber exhibit a strong demand-side Food, and Rubber exhibit a strong demand-side effect. effect.

The authors present the impulse-response function The authors present the impulse-response function results for the sub-sample labeled “Pre-Volcker”. results for the sub-sample labeled “Pre-Volcker”. Although they do not present the “Modern Era” Although they do not present the “Modern Era” results, they discuss their findings. results, they discuss their findings.

They mention that the “Pre-Volcker” period shows They mention that the “Pre-Volcker” period shows very strong cost channel effects, whereas the very strong cost channel effects, whereas the “Modern Era” shows little evidence of cost channel “Modern Era” shows little evidence of cost channel effects. effects.

Why? Institutional changesWhy? Institutional changes Financial innovation and deregulation. Financial innovation and deregulation. During the earlier period contractionary During the earlier period contractionary

monetary policy was accompanied by credit monetary policy was accompanied by credit actions.actions.

Alternative Explanations of price and output Alternative Explanations of price and output responses. responses.

a)a) The increase in the price/wage ratio may be due The increase in the price/wage ratio may be due to falling wages, rather than to price increases. to falling wages, rather than to price increases.

b)b) Do not consider the Fed’s forecasts of future Do not consider the Fed’s forecasts of future inflation. inflation.

c)c) Counter-cyclical markups. Counter-cyclical markups.

d)d) Increasing returns to scale.Increasing returns to scale.

ConclusionsConclusions

The document presents empirical evidence of a The document presents empirical evidence of a supply-side effect of monetary policy. supply-side effect of monetary policy.

In key manufacturing industries, prices increase In key manufacturing industries, prices increase and output decreases following an unanticipated and output decreases following an unanticipated monetary contraction. monetary contraction.

There is evidence of strong demand-side effects There is evidence of strong demand-side effects

of monetary policy in some industries.of monetary policy in some industries.