Kenneth N. Kuttner and Patricia C. Mosser
The Monetary Transmission
Mechanism: Some Answers
and Further Questions
Introduction from the discussions was the consensus that a useful area for
future research is to determine more precisely the role of each
W hat are the mechanisms through which Federal Reserve
policy affects the economy? And has financial
innovation in recent years affected the monetary transmission
hypothesis in the evolution of the monetary transmission
mechanism.
Negative findings are often as informative as positive ones,
mechanism, either by changing the overall impact of policy or however, and the conference succeeded in identifying three areas
by altering the channels through which it operates? These where financial innovation has left the monetary transmission
were the questions examined by the conference Financial mechanism largely unchanged. The first of these areas is the
Innovation and Monetary Transmission, sponsored by the reserves market, which has changed profoundly in recent years as
Federal Reserve Bank of New York on April 5 and 6, 2001.1 Our lower reserve requirements, higher vault cash holdings, and
goal in this overview is to summarize the conference papers and innovations such as sweep accounts have dramatically reduced
distill from them some tentative answers to the questions posed the size of aggregate reserve balances. Yet despite these changes,
at the outset. the Fed has retained its ability to influence overnight interest
The overall conclusion drawn from the research presented is rates—and indeed has generally succeeded in keeping the
that monetary policy appears to have less of an impact on real effective federal funds rate closer to its target than in years past.
activity than it once had—but the cause of that change remains Changes in the reserves market therefore may have had a
an open issue. The conference papers explored three significant effect on the day-to-day implementation of policy, but
hypotheses en route to that finding. First, the transmission they have not diminished the Trading Desk’s leverage over short-
mechanism may have changed as a result of the financial term interest rates. Second, there is no evidence to suggest that
innovations that motivated the conference, such as the growth the quantitative importance of the wealth channel has changed
of securitization, shifts between sources of financing for much in recent years. Its contribution to the impact of monetary
residential investment, or changes in the strength of wealth policy has always been modest, and that contribution has, if
effects. Second, a change in the conduct of monetary policy anything, decreased somewhat since 1980. Third, while the
may explain what appears to be a change in the effectiveness of parallel trends of financial consolidation and globalization have
policy. Finally, the fundamental structural changes affecting had a dramatic impact on financial services industries, thus far
the economy’s stability (and by implication, monetary the trends appear to have had no perceptible effect on monetary
transmission) may be nonfinancial in nature. Also emerging transmission.
Kenneth N. Kuttner and Patricia C. Mosser are assistant vice presidents The authors are grateful to the conference participants and to Benjamin
at the Federal Reserve Bank of New York. Friedman for their comments on earlier drafts. The views expressed are those
<> of the authors and do not necessarily reflect the position of the Federal Reserve
<> Bank of New York or the Federal Reserve System.
FRBNY Economic Policy Review / May 2002 15
, A Monetary Transmission Schema curve—whether of the “Old Keynesian” variety, or the forward-
looking equations at the heart of the “New Keynesian” macro
Monetary transmission is a complex and interesting topic models developed by Rotemberg and Woodford (1997) and
because there is not one, but many, channels through which Clarida, Galí, and Gertler (1999), among others. But as Bernanke
monetary policy operates. The exhibit depicts schematically an and Gertler (1995) have pointed out, the macroeconomic
eclectic view of monetary policy transmission, identifying the response to policy-induced interest rate changes is considerably
major channels that have been distinguished in the literature.2 larger than that implied by conventional estimates of the interest
The process begins with the transmission of open market elasticities of consumption and investment. This observation
operations to market interest rates, either through the reserves suggests that mechanisms other than the narrow interest rate
market or through the supply and demand for money more channel may also be at work in the transmission of monetary
broadly. From there, transmission may proceed through any of policy.
several channels. One such alternative path is the wealth channel, built on the
The interest rate channel is the primary mechanism at work in life-cycle model of consumption developed by Ando and
conventional macroeconomic models. The basic idea is Modigliani (1963), in which households’ wealth is a key
straightforward: given some degree of price stickiness, an determinant of consumption spending. The connection to
increase in nominal interest rates, for example, translates into an monetary policy comes via the link between interest rates and
increase in the real rate of interest and the user cost of capital. asset prices: a policy-induced interest rate increase reduces the
These changes in turn lead to a postponement in consumption value of long-lived assets (stocks, bonds, and real estate),
or a reduction in investment spending. This is precisely the shrinking households’ resources and leading to a fall in
mechanism embodied in conventional specifications of the “IS” consumption.
Monetary Policy Transmission
Open market operations
Reserves
Fed funds rate Monetary base
Money supply
Loan supply Market interest rates
Asset price levels Real rates πe Exchange rate
Wealth
channel
Interest
rate
Collateral channel Relative asset prices
Exchange
rate
Broad channel
Narrow credit
credit channel Monetarist
channel channel
Aggregate demand
16 The Monetary Transmission Mechanism
The Monetary Transmission
Mechanism: Some Answers
and Further Questions
Introduction from the discussions was the consensus that a useful area for
future research is to determine more precisely the role of each
W hat are the mechanisms through which Federal Reserve
policy affects the economy? And has financial
innovation in recent years affected the monetary transmission
hypothesis in the evolution of the monetary transmission
mechanism.
Negative findings are often as informative as positive ones,
mechanism, either by changing the overall impact of policy or however, and the conference succeeded in identifying three areas
by altering the channels through which it operates? These where financial innovation has left the monetary transmission
were the questions examined by the conference Financial mechanism largely unchanged. The first of these areas is the
Innovation and Monetary Transmission, sponsored by the reserves market, which has changed profoundly in recent years as
Federal Reserve Bank of New York on April 5 and 6, 2001.1 Our lower reserve requirements, higher vault cash holdings, and
goal in this overview is to summarize the conference papers and innovations such as sweep accounts have dramatically reduced
distill from them some tentative answers to the questions posed the size of aggregate reserve balances. Yet despite these changes,
at the outset. the Fed has retained its ability to influence overnight interest
The overall conclusion drawn from the research presented is rates—and indeed has generally succeeded in keeping the
that monetary policy appears to have less of an impact on real effective federal funds rate closer to its target than in years past.
activity than it once had—but the cause of that change remains Changes in the reserves market therefore may have had a
an open issue. The conference papers explored three significant effect on the day-to-day implementation of policy, but
hypotheses en route to that finding. First, the transmission they have not diminished the Trading Desk’s leverage over short-
mechanism may have changed as a result of the financial term interest rates. Second, there is no evidence to suggest that
innovations that motivated the conference, such as the growth the quantitative importance of the wealth channel has changed
of securitization, shifts between sources of financing for much in recent years. Its contribution to the impact of monetary
residential investment, or changes in the strength of wealth policy has always been modest, and that contribution has, if
effects. Second, a change in the conduct of monetary policy anything, decreased somewhat since 1980. Third, while the
may explain what appears to be a change in the effectiveness of parallel trends of financial consolidation and globalization have
policy. Finally, the fundamental structural changes affecting had a dramatic impact on financial services industries, thus far
the economy’s stability (and by implication, monetary the trends appear to have had no perceptible effect on monetary
transmission) may be nonfinancial in nature. Also emerging transmission.
Kenneth N. Kuttner and Patricia C. Mosser are assistant vice presidents The authors are grateful to the conference participants and to Benjamin
at the Federal Reserve Bank of New York. Friedman for their comments on earlier drafts. The views expressed are those
<> of the authors and do not necessarily reflect the position of the Federal Reserve
<> Bank of New York or the Federal Reserve System.
FRBNY Economic Policy Review / May 2002 15
, A Monetary Transmission Schema curve—whether of the “Old Keynesian” variety, or the forward-
looking equations at the heart of the “New Keynesian” macro
Monetary transmission is a complex and interesting topic models developed by Rotemberg and Woodford (1997) and
because there is not one, but many, channels through which Clarida, Galí, and Gertler (1999), among others. But as Bernanke
monetary policy operates. The exhibit depicts schematically an and Gertler (1995) have pointed out, the macroeconomic
eclectic view of monetary policy transmission, identifying the response to policy-induced interest rate changes is considerably
major channels that have been distinguished in the literature.2 larger than that implied by conventional estimates of the interest
The process begins with the transmission of open market elasticities of consumption and investment. This observation
operations to market interest rates, either through the reserves suggests that mechanisms other than the narrow interest rate
market or through the supply and demand for money more channel may also be at work in the transmission of monetary
broadly. From there, transmission may proceed through any of policy.
several channels. One such alternative path is the wealth channel, built on the
The interest rate channel is the primary mechanism at work in life-cycle model of consumption developed by Ando and
conventional macroeconomic models. The basic idea is Modigliani (1963), in which households’ wealth is a key
straightforward: given some degree of price stickiness, an determinant of consumption spending. The connection to
increase in nominal interest rates, for example, translates into an monetary policy comes via the link between interest rates and
increase in the real rate of interest and the user cost of capital. asset prices: a policy-induced interest rate increase reduces the
These changes in turn lead to a postponement in consumption value of long-lived assets (stocks, bonds, and real estate),
or a reduction in investment spending. This is precisely the shrinking households’ resources and leading to a fall in
mechanism embodied in conventional specifications of the “IS” consumption.
Monetary Policy Transmission
Open market operations
Reserves
Fed funds rate Monetary base
Money supply
Loan supply Market interest rates
Asset price levels Real rates πe Exchange rate
Wealth
channel
Interest
rate
Collateral channel Relative asset prices
Exchange
rate
Broad channel
Narrow credit
credit channel Monetarist
channel channel
Aggregate demand
16 The Monetary Transmission Mechanism
