In literature, most studies analyze monetary policy with focus on demand-side transmission mechanisms. The interest rate channel and the extended exchange rate channel provides standard explanation of how domestic and foreign shocks affects the macroeconomy, whereas the credit channel stresses their impact as bank-dependent sectors are present because of financial frictions. These demand-side channels state that, at least in the short run, monetary policy leads to the change in output which moves in the same direction as the price level but in the opposite direction to the interest rate and the exchange rate. Recent studies, such as Barth and Ramey (2002), Ravenna and Walsh (2006) and Chowdhury et al. (2006), argue that there may exist supply-side transmission mechanisms dubbed as the cost channel. Their works, however, discuss the issue in a closed economy only. This paper attempts to deepen both theoretically and empirically the cost channel with analysis that incorporates both financial frictions and foreign shocks and derive implications for optimal monetary policy.
The rationale for the cost channel originates from Blinder (1987), Christiano and Eichenbaum (1992), and Christiano et al. (1997), who point out a liquidity effect of the bank lending rate on working capital of firms, usually borrowing from financial intermediaries to pay for wages before selling their products. The change in the interest rate driven by a monetary shock therefore affects directly marginal cost for firms. Through the firm’s pricing behavior, the price level adjusts in the opposite direction to the level of output, which contrasts with traditional interest rate and credit channels.
Barth and Ramey (2002) indicate that the cost channel is an extension rather than a refutation to demand-side channels. It also serves to elucidate at least three stylized facts about monetary policy. The first concerns the price puzzle that observes a fall in the price level following a rise in money supply. The second involves, as mentioned by Bernanke and Gertler (1995), an amplified and persistent effect of monetary policy on output. The third relates to the real effect the policy creates. With clarification by the cost channel, the three facts that seemingly oppose to conventional wisdom appear explicable and proven to be interconnected. Contrary to other types of demand-side shocks, a monetary shock is able to change, because of an additional impact on working capital for firms, both aggregate demand and aggregate supply. On one hand, the shift in the latter generates a real effect analogous to that caused by supply-side shocks such as technological progress; on the other hand, the simultaneous movement in demand and supply leads to amplifying output growth but possibly attenuating inflation because of their offsetting effect on the price level.
Ravenna and Walsh (2006) advance the cost channel literature by estimating with the US data a forward looking New Keynesian Phillips curve and find that inflation is directly affected by the nominal interest rate that represents a type of marginal cost for firms, suggesting the very presence of the cost channel. They also demonstrate that the cost channel alters implications for optimal monetary policy, under which stabilization in the output gap will be accompanied with fluctuations in inflation. Chowdhury et al. (2006) take into account financial market frictions that lead to a spread between the market interest rate and the bank lending rate and estimate with G7 data a hybrid New Keynesian Phillips curve. Their empirical findings substantiate the cost channel and the resulting interest rate pass-through on inflation, too.
This paper essentially refines the model of Ravenna and Walsh (2006), embedded with financial frictions specified by Chowdhury et al. (2006) and elements that characterize a small country influenced by foreign shocks as modeled by Tuesta (2004) and Woodford (2003). Our extension serves to contribute new evidence on the cost channel having been explored mainly in a closed economy setting. Our modeling, supported with Taiwan’s dataset analyzed by the generalized method of moments (GMM), demonstrates a stronger pass-through effect on inflation via the cost channel than the demand-side channels. The magnitude of this effect appears even more pronounced as the combined role played by financial frictions and foreign shocks is taken into account. The issue on optimal monetary policy is also examined to appreciate whether the output-inflation tradeoff for the central bank equally applies and evaluate its significance for both discretionary and commitment policies.
The remainder of the paper is structured as follows. Section 2 presents our expanded small economy incorporating with financial frictions and foreign shocks in the cost channel. Section 3 describes the data for empirical analysis as regards the existence and magnitude of the cost channel effect on inflation. Section 4 discusses implications for optimal monetary policy under the cost channel by theory and calibration. Section 5 draws the conclusion.
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Cost Channel and Optimal Monetary Policy: Financial Frictions and Foreign Shocks
