THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 671

CHAPTER 25

Transmission Mechanisms of Monetary Policy

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economy. We then go on to examine the transmission mechanisms of monetary
policy and evaluate the empirical evidence on them to better understand the role
that monetary policy plays in the economy. We will see that these monetary transmission mechanisms emphasize the link between the financial system (which we
studied in the first three parts of this book) and monetary theory, the subject of
this part.

FRAM EWORK FO R E VALUAT I NG EM P IRI CAL E VI DE N CE
To develop a framework for understanding how to evaluate empirical evidence,
we need to recognize that there are two basic types of empirical evidence in
economics and other scientific disciplines. Structural model evidence examines whether one variable affects another by using data to build a model that
explains the channels through which this variable affects the other; reducedform evidence examines whether one variable has an effect on another simply
by looking directly at the relationship between the two variables.
Suppose that you were interested in whether drinking coffee leads to heart disease. Structural model evidence would involve developing a model that analyzed
data on how coffee is metabolized by the human body, how it affects the operation of the heart, and how its effects on the heart lead to heart attacks. Reducedform evidence would involve looking directly at whether coffee drinkers tend to
experience heart attacks more frequently than non coffee drinkers.
How you look at evidence whether you focus on structural model evidence
or reduced-form evidence can lead to different conclusions. This is particularly
true for the debate on the importance of monetary policy to economic fluctuations.

Structural
Model
Evidence

The components analysis of aggregate demand discussed in Chapter 24 is specific
about the channels through which the money supply affects economic activity

(called the transmission mechanisms of monetary policy). This approach
typically examines the effect of changes in the money supply on economic activity by building a structural model, a description of how the economy operates
using a collection of equations that describe the behaviour of firms and consumers in many sectors of the economy. These equations then show the channels
through which monetary and fiscal policy affect aggregate output and spending.
A structural model might have behavioural equations that describe the workings
of monetary policy with the following schematic diagram:

M

i

I

Y

The model describes the transmission mechanism of monetary policy as follows: the change in the money supply M affects interest rates i, which in turn affect
investment spending I, which in turn affects aggregate output or aggregate spending Y. Structural model evidence on the relationship between M and Y looks at
empirical evidence on the specific channels of monetary influence, such as the link
between interest rates and investment spending.

Reduced-Form
Evidence

The quantity theory approach to aggregate demand does not describe specific
ways in which the money supply affects aggregate spending. Instead, it suggests
that the effect of money on economic activity should be examined by looking at