MONETARY POLICY: HOW FINANCIAL MARKETS INFLUENCE ITS EFFECTIVENESS

Monetary policy is less effective in economies where transactions costs in financial markets are low – that is, where financial market participants find it easier to rebalance their portfolios in reaction to monetary policy changes and hence weaken their impact. That is the conclusion of new research by Professors William Lastrapes and Douglas McMillin, published in the October 2004 Economic Journal.

Monetary policy – the control of overall liquidity in the economy by central banks – is the focus of a great deal of attention in the press, and financial markets often respond quickly to eagerly awaited policy decisions. Monetary policy actions are widely perceived as having important effects on production and unemployment, at least in the near term.

Conventional wisdom suggests that these effects operate through interest rates, and thereby spending on interest-sensitive items such as housing, automobiles, industrial equipment and factories. There is a great deal of evidence that central bank actions that increase liquidity reduce interest rates in the short run – this is what economists call the ‘liquidity effect’ of expansionary monetary policy – and hence stimulate spending and total demand for production in the economy.

What is not yet well understood is why there is a liquidity effect. We know that over time, changes in the supply of money affect the level of prices only, but not real economic activity like the production of goods and services. Short-run market rigidities, such as price or wage stickiness, or transactions costs in financial markets must therefore be a part of any explanation of the liquidity effect.

Which of these rigidities is the ultimate source of the liquidity effect, however, remains an open question. Yet understanding the cause of the effect of monetary policy on interest rates and economic activity is necessary to formulate good monetary policy.

Whatever the factors that cause the liquidity effect may be, magnitudes of these factors are likely to vary across countries. Consequently, it is natural to turn to a cross-country comparison to sort out the relative importance of these factors.

This study is the first to document and compare systematically the liquidity effect across a substantial number of countries, and to exploit differences in the magnitude of rigidities and institutional characteristics of financial markets in explaining the size of the liquidity effect.

The researchers establish that the size of the liquidity effect for a given monetary policy action does indeed vary substantially across countries. For example, on average, Belgian interest rates fall by 186 basis points, while US rates fall 31 basis points, in the face of comparable policy-induced changes in liquidity in each country.

The research also finds a striking ability of differences in financial market variables to explain this cross-country variation. For example, the results imply that a hypothetical country with a bank asset-to-GDP ratio of 88% (one standard deviation higher than the average country’s ratio of 65%) will have a liquidity effect 39 basis points smaller than the average country.

There are similar results for other measures of the role of financial intermediaries in reducing financial market transactions costs. Yet measures of price and wage rigidity have little explanatory power.

Lastrapes and McMillin interpret these results as suggesting that monetary policy is less effective in economies where financial market participants find it easier to rebalance their portfolios in reaction to monetary policy changes – that is, where financial market transactions costs are low.

The message for policy-makers is that they should rely on models in which financial market factors, rather than price or wage rigidities, are the primary force generating the liquidity effect.

ENDS

Note for Editors: ‘Cross-country Variation in the Liquidity Effect: The Role of Financial Markets’ by William Lastrapes and Douglas McMillin is published in the October 2004 issue of the Economic Journal.

Lastrapes is at the University of Georgia; McMillin is South Central Bell Professor in the Department of Economics at Louisiana State University, Baton Rouge, LA 70803-6306, and co-editor of the Journal of Macroeconomics.

For Further Information: contact Bill Lastrapes on +1-706-542-3569 (email: last@terry.uga.edu); website: http://www.terry.uga.edu/~last/personal/); Doug McMillin on +1-225-578-3798 (email: eodoug@lsu.edu; website: http://www.bus.lsu.edu/economics/faculty/dmcmillin/personal); or RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or 07768-661095 (email: romesh@compuserve.com).