A Guy Called Ben And The Monetary Transmission Mechanism

A key problem in discussing monetary policy is how to understand the monetary transmission mechanism. In this blog post, I’ll try to explain how I see it.

Combining old monetarist insights with rational expectations

The historical debate between ‘old-school’ Keynesians and monetarists in the late 1960s and 1970s basically centred around the Investment Saving-Liquidity Preference Money Supply (IS-LM) model.

The debate was both empirical and theoretical. On the one hand, Keynesians and monetarists placed differing emphases on the interest-rate elasticity of money and investments, respectively.

This turned the whole discussion into an argument about the slope of the IS and LM curves. Milton Friedman, in many of his writings, seemed to accept the validity of the IS-LM framework.

This is something that always frustrated me about Friedman’s work on the transmission mechanism, and other monetarists also criticized him for it. Karl Brunner and Allan Meltzer were especially critical of “Friedman’s monetary framework” and his “compromises” with the Keynesians on the IS-LM model.

Brunner and Meltzer suggested an alternative to the IS-LM model. In my view, their work provides many important insights into the monetary transmission mechanism, though it is often unduly complicated given the relatively simple and straightforward basic argument.

At the core of the Brunner-Meltzer critique is the insight that the IS-LM model only works for two kinds of assets – money and bonds. Once other assets such as equities and real estate are included, the model breaks down and yields drastically different results from the standard IS-LM analysis. It is especially notable that the ‘liquidity trap’ argument cannot be sustained when more than two assets are included in the model. Obviously, this observation is central to Market Monetarist arguments against the liquidity trap’s existence.

It logically follows that monetary policy does not work solely through the bond market (in effect, the money market). In fact, we could easily imagine a theoretical world in which interest rates do not exist and monetary policy would still work perfectly well.

Expressed in terms of an IS-LM model, we could have two sorts of assets: money and equities. In such a world, an increase in the money supply would push up equity prices. This would reduce the funding costs of companies and increase investments. At the same time, household wealth would increase (for those with savings in an equity portfolio), encouraging private consumption. In this world, monetary policy functions smoothly and there is no problem with a “zero lower bound” on interest rates.

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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