Keynesian and monetarist views of the monetary policy transmission mechanism?

Question

Keynesian and monetarist views of the monetary policy transmission mechanism?

Answer 1

According to the traditional Keynesian interest rate channel, a policy‐induced

increase in the short‐term nominal interest rate leads first to an increase in longer‐term

nominal interest rates, as investors act to arbitrage away differences in risk‐adjusted

expected returns on debt instruments of various maturities, as described by the

expectations hypothesis of the term structure. When nominal prices are slow to adjust,

these movements in nominal interest rates translate into movements in real interest rates

as well. Firms, finding that their real cost of borrowing over all horizons has increased,

cut back on their investment expenditures. Likewise, households facing higher real

borrowing costs scale back on their purchases of homes, automobiles, and other durable

goods. Aggregate output and employment fall. This interest rate channel lies at the

heart of the traditional Keynesian textbook IS‐LM model, due originally to Hicks (1937), and it also appears in the more recent New Keynesian models described below.

In open economies, additional real effects of a policy‐induced increase in the shortterm interest rate come about through the exchange rate channel. When the domestic

nominal interest rate rises above its foreign counterpart, equilibrium in the foreign exchange market requires that the domestic currency gradually depreciate at a rate that,

again, serves to equate the risk‐adjusted returns on various debt instruments, in this case debt instruments denominated in each of the two currencies—this is the condition of

uncovered interest parity.

The monetarist transmission mechanism:is  direct effect

  Ã¢Â€Â¢ When people have an excess of money, they ry to get rid of it by spending it or investing

In contrast, Keneysian transimission mechanism is indirect. disequilibrium in the money market,

perhaps induced by an open market operation, causes an adjustment of interest rates which in turn

affects the level of aggregate demand (particularly planned investment spending). For Milton Friedman, the greatest proponent of monetarist view, disequilibrium in the money market can spill directly into the goods market, as well

as spilling into the bond market. The monetarist transmission mechanism is therefore broader than

the Keynesian transmission mechanism. For instance consider the impact of an expansionary open

market operation. Initially this creates an excess supply of money balances matched by excess

demands for bonds and goods. If firms satisfy the demand for goods this results in an excess

demand for inventory, and firms also have excess money balances as a result of increased sales.

Ultimately nominal income and interest rates must adjust until agents are content to willingly hold

the enlarged stock of money. This outcome is similar to that predicted by the IS/LM model, but the adjustment process involves a broader transmission mechanism under which the IS and LM shedules display systematic co-movement.