Recent years have seen great changes in monetary policy analysis, as economists in central banks and academia have come together on an analytical approach of the general type discussed by Rotemberg and Woodford (1997), Goodfriend and King (1997), Clarida, Galí, and Gertler (1999), Woodford (2003), and many others. This approach is characterized, as argued by McCallum (2002), by investigations of alternative rules for monetary policy conducted in models that are based on private-agent optimizing behavior but with specifications that include features designed to lend empirical veracity, thereby aspiring to be structural and accordingly usable (in principle) for policy analysis. Despite a widespread belief that this approach is fundamentally sound, and that recent work represents a major improvement over the practice typical 15 or 20 years ago, there are some reasons for unease. Prominent among these are the absence from the standard framework of any significant role for monetary aggregates, financial intermediation, or distinctions among various short-term interest rates that play different roles in the transmission mechanism.
A recent paper by Goodfriend (2005) develops a qualitative framework designed to overcome these particular weaknesses. Specifically, it “… integrates broad money demand, loan production, asset pricing, and arbitrage between banking and asset markets” (2005, p. 277) and illustrates the logical necessity (in principle) for monetary policy to take account of—among other things—the difference between the interbank rate of interest (used as the policy instrument) and other short rates including the government bond rate, the collateralized bank loan rate, the (nominal) net marginal product of capital, and a shadow nominal intertemporal rate—each of which differs from the others. As noted by Hess (2005), however, Goodfriend (2005) provides no evidence or argument concerning the quantitative importance of these features and distinctions. The primary objective of the present paper, accordingly, is to formulate a quantitative version of Goodfriend’s model, develop a plausible calibration, and utilize this model to assess the magnitude and policy relevance of the effects and distinctions just mentioned for steady state interest rates and aggregate variables, and for dynamic monetary policy simulations. Among other things, the paper will investigate the role of the “external finance premium” that is emphasized in the prominent work of Bernanke, Gertler, and Gilchrist (1999). It will do so using a model in which the external finance premium is endogenously determined by no-arbitrage relationships in an environment in which loan production depends upon both collateral and loan-monitoring inputs, with capital serving less efficiently as collateral than bonds, while bank-deposit money is crucial for facilitating transactions. In this setting, the external finance premium may move either pro-cyclically or counter-cyclically in response to shocks, depending upon parameters of the model.
How does the present paper compare with previous efforts to outline and quantify the role of financial intermediation (banking) in monetary policy? Probably the most prominent line of work of this type is that begun by Bernanke and Gertler (1989, 1995) and continued by Bernanke, Gertler, and Gilchrist (1999), but the literature also includes notable contributions by Kiyotaki and Moore (1997), Carlstrom and Fuerst (1997), Kocherlakota (2000), Cooley, Marimon, and Quadrini (2004), and others. It is apparently the case, however, that in all of these studies the models are fundamentally non-monetary—i.e., do not recognize the existence of a demand for money that serves to facilitate transactions.1 This omission could be of first-order importance for the financial accelerator, however, for its mechanism works via increases in the supply of collateral induced by asset price increases. In models with money, however, such increases also increase the demand for collateral as spenders go to the banking system for additional money to facilitate the additional spending induced by the initiating shock. Accordingly, our analysis focuses on the net effect of these offsetting forces.
Our model’s “banking accelerator” transmission effects work in much the same way as the financial accelerator does in existing models. For instance, monetary policy that stimulates employment and output in the presence of sticky prices raises the marginal product of capital, the price of capital, and the value of collateral in the economy, thereby tending to reduce the external finance premium for a given quantity of bank deposits demanded. However, our model includes in addition “banking attenuator” effects, which recognize that monetary stimulus to spending also increases the demand for bank deposits, thereby tending to raise the external finance premium for a given value of collateral-eligible assets in the economy.
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Banking and Interest Rates in Monetary Policy Analysis: A Quantitative Exploration
