In Reality, Monetary Policy Is More Complicated Than the Traditional View

Houses under construction are seen in a Seattle neighborhood, on August 2, 2014.

Much of the nuance of how monetary policy works comes from relatively recent economic research. This column builds on the traditional monetary transmission mechanisms discussed in part one of this series but adds some realism and detail to better reflect the evolution of the modern U.S. economy. How banks and financial markets actually work is another important piece of recent economic work, and you can skip ahead to part three in this series if the suspense is killing you.

Business investment based more on debt than share prices

Lower interest rates raise demand for investments, which causes stock prices, along with other asset prices, to rise. Higher stock prices mean that public companies can raise a set amount of money by selling much fewer shares of the company.

Economists have pointed out that this is why companies sell stock when markets go up. Other economists have pointed out that this pretty much never happens in real life, which is a fairly compelling point.

In fact, even when prices are high, most public companies are buying their stocks rather than selling them. Modern publicly traded companies make investments with profits from current sales or by borrowing in debt markets. This has led economists to look more closely at other effects of monetary policy since large companies’ capital costs are not driven by appreciating share prices. With debt driving most investments, it is even more important to understand how monetary policy affects banks and other sources of debt-based financing—the main focus of part three of this series.

Inequality lessens wealth effects on consumption

A drop in interest rates makes assets, and the households that own them, worth more. When many people spend even a little bit of this windfall, monetary policy affects the consumption portion of economic growth.

However, when wealth is concentrated in the hands of a fraction of wealthy households, this logic can break down. Around 76 percent of wealth is held by the top 10 percent of households, and even within this group, wealth is concentrated heavily toward the top. Aside from the obvious fairness concerns, this skewed wealth distribution means that most people experience little to no wealth effect from lower interest rates. Moreover, the households that do see an increase in their net worth are already quite well off, so their consumption is less likely to respond to a windfall.

On top of this skewed distribution, virtually all wealth held by American families with moderate incomes is in the form of housing equity or retirement savings. Even when these assets appreciate, it is difficult for households to spend these gains. Thus, it is reasonable to question if the wealth effect on consumption has changed, especially if the housing crash has permanently changed how Americans think of their housing wealth.

The United States is not the only player manipulating international trade balances

As discussed in part three of this series, the value of the dollar falls when the Federal Reserve cuts interest rates, allowing the United States to sell more exports and Americans to buy more domestically made products.

However, this tactic only works if the United States is the only one trying it. The recovery from the Great Recession shows many countries trying the same policy at the same time, so that nobody’s currency has become much cheaper than anyone else’s; the result is less growth than one would expect given the cuts in interest rates.

Conclusion

The world was never as simple as textbook economics, but new research is bringing the understanding of how monetary policy works closer to real life. The economy is also changing, altering the ways monetary policy works, even in the more traditional sense. But perhaps nowhere is there more need for nuance than in understanding how the banking system is responsible for transmitting Fed policy through the economy, which is discussed in part three.

Michael Madowitz is an Economist at the Center for American Progress.