Introduction

We consider a small, open economy inhabited by an optimising corporate sector and a large number of optimising individuals who each period must formulate, amongst other things, dynamic programmes for investment and consumption following stochastic shifts in total factor productivity. We then ask three questions: What would the marginal productivity of capital, or real interest rate, look like over the course of the cycle in such an economy? How closely does the observed real interest rate in a small, open economy (the United Kingdom) resemble this hypothetical rate? And can we describe ‘inflation and output determination as depending on the relation between a ‘natural rate of interest’ determined primarily by real factors and the central bank's rule for interest rates’ (Woodford, 2000a, p. 2)?

We are accustomed to the supply side of an economy, as measured by the long-run average rate of productivity growth, being the most natural explanation for long-run real outcomes in growth and welfare (Griliches, 1996). But, as economists have recognised that the productivity cycle might be closely related to the propagation or impulses of the business cycle, the cyclical behaviour of productivity has increasingly attracted their attention (Cooley, 1995). Beginning with the seminal papers of Long and Plosser (1983) and Kydland and Prescott (1982), an important strand of macroeconomic research has attempted to construct small, theoretically coherent models based on optimising agents that capture key cyclical patterns in the actual data.

Introduction

This paper addresses the question of whether ‘credit’ contains information additional to that available in ‘money’. There has been a long tradition of modelling monetary conditions in the economy by focusing on the demand for money (i.e. banks' liabilities), but monetary policy is implemented via changes in short-term interest rates. Changes to interest rates influence the demand for loans, and it is through the loan market that aggregate spending is affected, at least to some degree. This issue has been addressed in theoretical terms in the ‘credit channel’ literature (see Bernanke and Gertler, 1995), and two variations on the credit channel story have been identified: a balance sheet channel and a bank lending channel. The first links the determinants of lending to observable characteristics of the financial health of the borrowing firms; the second suggests that some influences on lending flows originate within the banking system.

Banks typically have an ongoing relationship with the households and corporations to which they lend, and they use information about a company's financial position obtained through this banking relationship to determine the loan facility they will offer. Factors that are easily monitored, such as cash flow, financial wealth, previous loan payments history and outstanding debt, will affect the ability of a company to obtain loans, as will the value of collateral that a firm is able to offer.

Introduction

This paper investigates whether the effects of monetary policy on economic activity in the euro area depend on the state of the economy. At least two strands of the literature predict that monetary policy is more effective in a recession than during a boom.

The first class of theories is based on credit market imperfections. In these models, asymmetric information between borrowers and lenders gives rise to agency costs. These agency costs are reflected in an external finance premium, which typically depends on the net worth of the borrower. A borrower with higher net worth is able to post more collateral and can thereby reduce its cost of external financing.

As emphasised by Bernanke and Gertler (1989), the dependence of the external finance premium on the net worth of borrowers creates a ‘financial accelerator’ propagation mechanism. For example, when an economy is hit by a recession, the net worth of firms will typically fall. This decline leads to an increase in the cost of external financing, which in turn may aggravate the effects of the initial shock. During an expansion, firms can largely finance themselves with retained earnings. Moreover, because their balance sheets are strong, the external finance premium is likely to be relatively low. As a result, monetary policy changes have only a limited impact on this premium.

Introduction

A considerable empirical literature has emerged on the estimation of policy reaction functions and the identification of the underlying preferences of monetary authorities (see Groeneveld, Koedijk and Kool, 1996; Muscatelli and Tirelli, 1996; Clarida and Gertler, 1997; Clarida, Galí and Gertner, 1998; Favero and Rovelli, 1999; and Muscatelli, Tirelli and Trecroci, 1999). Some of these contributions examine whether recent changes in institutional structure, such as the shift to inflation targeting, have had an impact on the conduct of monetary policy. The evidence is mixed. For instance, Muscatelli, Tirelli and Trecroci (1999) show that there is only slight evidence that the introduction of inflation targeting affected forward-looking policy reaction functions in the United Kingdom, New Zealand, Sweden and Canada. In contrast they find some evidence of policy instability in Japan and the United States in the 1980s and 1990s, even in the absence of institutional change.

Of course one would also expect significant shifts in monetary policy that bring about a reduction in inflation expectations to affect the transmission mechanism of monetary policy. The standard New Keynesian model of aggregate demand and supply, which has been used extensively for policy analysis (see Svensson, 1997; Rudebusch and Svensson, 1999; McCallum and Nelson, 1999a,b; and Rudebusch, 2000), suggests that forward-looking expectations are important on both the demand and the supply side.

The main question I wish to focus on in this chapter is: ‘How should we think about the monetary transmission mechanism in a live policy-making environment?’ I shall concentrate upon practical problems. There are essentially two sub-questions here. The first is ‘How should we define monetary policy?’ The second is ‘How should we model the economy?’ I shall offer a personal perspective on these two sub-questions, but one that is closely related to the Bank of England's current thinking about monetary policy transmission issues, represented by the book Economic Models at the Bank of England (1999b).

What do we mean, therefore, by monetary policy? This should be a phrase about which central bankers should be clear. Monetary policy in the UK context is what we can do to interest rates. Yet we know that monetary policy also concerns money. Inflation is a monetary phenomenon. Economists applying for positions at the Bank of England are often asked during their interview, ‘Is inflation possible in a barter economy?’ A correct answer to this question is closely correlated with our selection decision !

If inflation is a monetary phenomenon, what role is there for money? The policy process for setting interest rates is informed by the use of many models that appear to have little explicit role for money. Perhaps we should state that inflation is always and everywhere a monetary policy phenomenon. If we have an inflation target, it is tempting to say that inflation is an inflation target phenomenon.

The transmission mechanism of monetary policy explains how monetary policy works – which variables respond to interest rate changes, when, why, how, how much and how predictably. This broadens to the issue of what monetary policy can do and what it should do to offset the effects of disturbances on inflation.

This volume sets out how the transmission mechanism is analysed for the purpose of informing monetary policy. The chapters that follow tackle different aspects of how a central bank can build a good working understanding of the transmission mechanism of monetary policy. In this introduction, we summarise how this understanding relates to the forecast apparatus and models employed, along with practical difficulties to be overcome. We highlight two key aspects of the monetary transmission mechanism – the monetary sector and the exchange rate – and conclude by summarising the key elements of current good practice.

How does the central bank analyse the transmission mechanism?

A central bank's interest in the transmission mechanism of monetary policy arises from the fact that it takes time for monetary policy to exert its maximum impact on inflation. A central bank has to know how to position its interest rate now to keep inflation in the future close to its target, while avoiding any excessive destabilisation of output. It also has to form some view about what might happen to inflation and output over this intervening period (see Blinder, 1998; Budd, 1998).

Introduction

Formal models are an essential input to the policy-making process. Most central banks, like other organisations, have a suite of different models designed for different purposes and to answer different questions. The papers in Den Butter and Morgan (2000) examine the use of empirical models in policy-making. Constructing these models involves blending economic theory, local knowledge and econometric methods. A longstanding issue of dispute has been the right way to blend these three ingredients, with different approaches giving each a different weight. In most countries a large amount of ‘tender loving care’ will have been bestowed on the individual equations of the policy model in order to obtain sensible results and to get the model to work. Typically this involves adding a range of country-specific variables, which makes it difficult to compare results across models and means that what should be the same equation applied to different countries can look very different. This variability can prompt the suspicion that the results are the product of data mining and may not be robust. Such criticism has been directed at models such as Project Link that combine highly heterogeneous country models. When standard specifications are estimated for a large number of different countries, they tend to produce a high degree of parameter heterogeneity. This is illustrated by Pesaran, Shin and R.P. Smith (1999), who estimate an error correction consumption function for OECD countries, and Baltagi and Griffin (1997), who estimate a gasoline demand function for OECD countries.

Introduction

The exchange rate is a key transmission channel for monetary policy in conventional macro models that assume flexible exchange rates. Particularly since the work of Dornbusch (1976), the link between exchange rates and monetary policy in such models has been increasingly embodied in the uncovered interest parity (UIP) condition. Under UIP, the expected change in the exchange rate equals the interest rate differential between domestic and foreign assets. This establishes a simple and transparent link between monetary policy actions – as reflected in interest rate movements – and the exchange rate.

Although attractive from a theoretical viewpoint, there are two issues that need to be addressed in implementing the conventional framework. The first is the awkward fact that the existence of UIP has been resoundingly rejected in empirical studies, as documented in a vast literature. At face value, the empirical failure of UIP calls into question the specification of the exchange rate transmission channel in conventional models. Is there a way of explaining this empirical failure that can rescue the conventional means of specification?

The second issue involves interpreting the role of the exchange rate as a monetary transmission channel, even if UIP holds. UIP specifies only the relationship between the expected future change in the exchange rate and the current interest differential between domestic and foreign assets. Holding the expected future value of the exchange rate constant, a rise in the domestic interest rate, under UIP, would lead to an appreciation of the domestic currency.

Introduction

The United Kingdom's monetary policy and inflation history over the past 45 years provides a rich source of information about the effects of monetary actions. It is a reflection of the wealth of this experience that several of the key catchphrases used in macroeconomic policy analysis were originally coined to describe regularities in UK policy-making or UK data: ‘stop–go’, ‘the Phillips curve’ and ‘stagflation’ are prominent examples.

Monetary policy in the United Kingdom has undergone several regime changes over this period: from a fixed exchange rate with foreign exchange controls until 1972; to free-floating with no domestic nominal anchor until 1976, followed by a loose system of monetary targeting until the mid-1980s; then a renewed emphasis on exchange rate management (so-called ‘shadowing’ of the Deutsche Mark), which culminated in a fixed exchange rate regime – membership of the Exchange Rate Mechanism (ERM) – from 1990 to 1992. Since 1992, of course, the UK monetary policy regime has been one of inflation targeting – with interest rate decisions made by the Treasury up to May 1997, and by the Monetary Policy Committee of the Bank of England thereafter.

For the period as a whole, the swings of inflation and economic growth have also been drastic. Inflation was continually in double digits from 1974 to 1977, and returned there in the early 1980s and early 1990s.

The Bank of Japan (BOJ) has gone through a unique experience in the past few years. When I joined the Bank's newly formed policy board in April 1998, the overnight call market rate, the key policy instrument of the BOJ, was already below 0.5%. The economy was in the midst of the most serious recession in the postwar period, although it took us a little while to realise this. We guided the call rate down to virtually zero in the first quarter of 1999 and followed up by promising to keep it there until deflationary concerns had been dispelled. Finally, in August 2000, we brought the rate up to 25 basis points after having kept the zero rate for one and a half years.

In this short paper, I would like to discuss some of the key aspects of the evolution of our thinking on monetary policy over the period 1998–2000. In so doing, I would like to focus specifically on the characteristics of the 1997–98 Japanese recession, the transmission process of monetary policy in the neighbourhood of a zero rate and the background thinking behind the rate hike in August 2000.

The nature of the 1997–98 recession

It is appropriate to begin with a brief discussion of the nature of the recession that started in 1997(Q4), which is what the BOJ was trying to respond to in 1998–2000.

Introduction

Forecasting the nominal exchange rate path is one of the most challenging aspects of an inflation-targeting framework. According to Bank of Brazil estimates, the pass-through from nominal exchange rate movements to inflation is around 10% in each quarter. Therefore, an accurate forecast of the nominal value of the currency is very important for the efficiency of an inflation-targeting regime. If the evaluation of the future exchange rate path can be made more precise, it may reduce the variance in output and inflation.

Uncovered interest parity (UIP), which relates the expected nominal depreciation to the nominal interest rate differential, has been a popular model for exchange rate forecasting. But UIP has been questioned as an adequate tool to forecast future exchange rates because many empirical tests have found a negative correlation between exchange rate changes and the interest differential, in contradiction to what is predicted by UIP. This situation has led us to consider what can be gained and lost with other models for forecasting the exchange rate.

A simple alternative is to assume that the exchange rate follows a random walk and is not cointegrated with any exogenous variable for which we have data. The expected future exchange rate therefore should be equal to the current value. This first approach, although simple and transparent, does not preclude the risk of occasional large forecast errors in the exchange rate and hence inflation.

I have now developed a framework of ‘liberal democracy’, and I have delineated the possible relations between economic development and liberal democracy. I have also explored the existing arguments pro and anti the democracy–development link and, first, unearthed elements of ‘security’, ‘stability’ and ‘openness and information’ in the purported positive democracy–development link, and, second, shown that the counter-arguments are often associated with an inadequate concept of the state and an incomplete explanation of the Asian success. I am now ready to use all these conceptual tools to reconstruct an explanation of the Asian experience.

In this chapter, I will show how Asian NICs have arrived at their economic success through a different institutional base that embodies a unique mix of ‘economic’, ‘civil’ and ‘political’ liberties, which produced in turn elements of ‘security’, ‘stability’ and ‘openness and information’ in a way that is distinctive. This explanation will, first, highlight the importance of a more ‘inclusionary’ institutionalism; second, discuss how these institutions have incorporated some elements of ‘liberal democracy’, such as a distinctive mixture of ‘economic’, ‘civil’ and ‘political’ liberties; and third, explain how these are connected to the variables we found in the ‘democracy-is-good-for-development’ arguments discussed in section 5.2: ‘security’, ‘stability’ and ‘openness and information’. We thereby arrive at a new conception of state strength in section 6.4, while section 6.5 provides a summary. This explanation of the Asian experience will allow us to understand the democracy–development link in a new way.

How to construct an explanation of the democracy–development connection with the Asian cases? How does this particular sub-set of cases compare with other sub-set(s) of cases? And which of the sub-issues raised in Part I can be tested by the Asian cases and which not? In choosing to tackle the democracy–development question with some theoretical rethinking and then applying and illustrating the advantages of my rethinking by taking a small sub-set of cases within the universe of democracy–development cases, I need to explain and justify my methodology. This chapter tackles this in three steps: first, it takes stock of the body of literature that analyses the democracy–development link using macro, cross-national, quantitative studies, and outlines the inadequacies involved in this line of enquiry; second, it explains how there is the need to expound the qualifications and limitations involved in constructing the type of explanations I intend to undertake; and therefore, third, it lays out how, in taking the particular cases I take, one can only examine a sub-set of the issues raised in the broader conceptual analysis in Part I of this study, how only some of the general arguments introduced in Chapter 1 can be properly tested while others have to be left aside.

Macro vs micro

First, one should not ignore that there have been many statistical studies attempting to prove either that economic development is promoted by democracy or that it is hindered by democracy and promoted by ‘authoritarianism’.