How does monetary policy affect the economy?
Research in this area includes work by Silvana Tenreyro
We know that monetary policy has an important effect on the behaviour of the economy (e.g. income, employment, investment). Most theories of how exactly this happens rely on "nominal rigidity" in wages and (or) prices. In other words monetary policy affects the economy because firms and workers respond to increases in liquidity by increasing production instead of increasing wages and prices. Empirical evidence assessing the importance of wage rigidity in the transmission mechanism of monetary policy is, however, very scarce.
Work by Silvana Tenreyro attempts to partially fill this empirical void by providing a study that exploits differences in the effective degree of nominal wage rigidity within and across countries. She starts by observing that the synchronization of wage setting decisions varies significantly across advanced economies. In Japan, the most well-known example of synchronization of wage setting decisions, the majority of firms set wages during the first and second quarters of the calendar year - in what is known as "Shunto," (or spring offensive) - and wages remain in place until the following year. In the United States, a large fraction of firms set wages once a year, typically at the end of the calendar year. In contrast, wage bargaining renegotiations in Germany take place throughout the year, and contracts tend to last one to three years. Theories of the transmission of monetary impulses to other economic variables based on wage rigidity would hence predict that, other things equal, monetary policy changes (i.e. cuts in interest rates) in Japan should have a larger effect when the policy innovation takes place in the second half of the year, i.e. after the Shunto has occurred and wages are relatively rigid. In the United States, the effect should be larger when the shock occurs in the first half of the year, as wages tend to be reset at the end of the calendar year. However, in Germany, where there appears to be little bunching in wage setting decisions within the year, the effect should not vary with the quarter in which the shock takes place.
Silvana's study finds strong support for these predictions find support in the data. More precisely, it assesses
whether the response of the economy to monetary policy shocks differs according to the time of year in which the policy innovation takes place and whether this difference can be reconciled with the observed variation in the timing of wage setting decisions. The countries considered are France, Germany, Japan, the United Kingdom, and the United States.
For both Japan and the United States, there are, indeed, important differences in the response of the economy to monetary policy shocks that depend on the timing of the policy innovation. These differences, in turn, can be related to the differing degree of wage rigidity across the calendar year. Specifically, a monetary policy innovation in Japan that occurs during the first or second quarter -- i.e. during the Shunto period in which wages are being reset -- has a relatively small effect on output, whereas an innovation in the third quarter -- i.e. immediately after the Shunto -- has a remarkably large effect. The pattern is reversed in the United States: A monetary policy innovation in the first half of the calendar year has a significantly larger effect on output, whereas an innovation in the second half has a relatively small effect. Again, this pattern conforms well with the degree of wage rigidity in the United States, which is high in the first half of the year and low in the second half. In sharp contrast, in Germany, France, and the United Kingdom, where there is a more uniform degree of wage rigidity within the year as well as a longer duration of contracts, the quarter in which a monetary policy shock takes place appears to be less relevant. Overall, our findings complement and reinforce the view that wage rigidities play an important role in the transmission of monetary policy.To read more about Silvana Tenreyro's work on the monetary transmission mechanism see:
- "Wage Setting Patterns and Monetary Policy: International Evidence" [Full document in Adobe PDF ] (Giovanni Olivei and Silvana Tenreyro), CEP Discussion Paper 0872, June 2008