THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 693

CHAPTER 25

Transmission Mechanisms of Monetary Policy

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high. Short-term interest rates that are near zero therefore do not indicate that
monetary policy is easy if the economy is undergoing deflation, as was true
during the contraction phase of the Great Depression. As Milton Friedman and
Anna Schwartz have emphasized, the period of near-zero short-term interest
rates during the contraction phase of the Great Depression was one of highly
contractionary monetary policy rather than the reverse.
2. Other asset prices besides those of short-term debt instruments contain
important information about the stance of monetary policy because
they are important elements in various monetary policy transmission
mechanisms. As we have seen in this chapter, economists have come a long
way in understanding that other asset prices besides interest rates have major
effects on aggregate demand. As we saw in Figure 25-3 (page 653), other asset
prices, such as stock prices, foreign exchange rates, and housing and land
prices, play an important role in monetary transmission mechanisms.
Furthermore, the discussion of such additional channels as those operating
through the exchange rate, Tobin s q, and wealth effects provides additional
reasons why other asset prices play such an important role in the monetary
transmission mechanisms. Although there are strong disagreements among
economists about which channels of monetary transmission are the most
important not surprising, given that economists, particularly those in academia, always like to disagree they do agree that other asset prices play an
important role in the way monetary policy affects the economy.
The view that other asset prices besides short-term interest rates matter has
important implications for monetary policy. When we try to assess the stance
of policy, it is critical that we look at other asset prices in addition to short-term
interest rates. For example, if short-term interest rates are low or even zero and

yet stock prices are low, land prices are low, and the value of the domestic currency is high, monetary policy is clearly tight, not easy.
3. Monetary policy can be highly effective in reviving a weak economy
even if short-term interest rates are already near zero. We have recently
entered a world where inflation is not always the norm. Japan, for example,
recently experienced a period of deflation, when the price level was actually
falling. One common view is that when a central bank has driven down shortterm nominal interest rates to near zero, there is nothing more that monetary
policy can do to stimulate the economy. The transmission mechanisms of monetary policy described here indicate that this view is false. As our discussion of
the factors that affect the monetary base in Chapter 16 indicated, expansionary
monetary policy to increase liquidity in the economy can be conducted with
open market purchases, which do not have to be solely in short-term government securities. For example, purchases of foreign currencies, like purchases
of government bonds, lead to an increase in the monetary base and in the
money supply. This increased liquidity and a commitment to future
expansionary monetary policy helps revive the economy by raising general
price-level expectations and by reflating other asset prices, which then stimulate aggregate demand through the channels outlined here. Therefore, monetary policy can be a potent force for reviving economies that are undergoing
deflation and have short-term interest rates near zero. Indeed, because of the
lags inherent in fiscal policy and the political constraints on its use, expansionary monetary policy is the key policy action required to revive an economy
experiencing deflation.