Is the Transmission Mechanism worth calculating?

Discussion in 'Economics' started by morganist, Feb 22, 2011.

  1. morganist

    morganist Guest

    Is the Transmission Mechanism worth calculating?

    The Transmission Mechanism, according to the Bank of England,

    “The Monetary Policy Committee (MPC) sets the short-term
    interest rate at which the Bank of England deals with the
    money markets. Decisions about that official interest rate
    affect economic activity and inflation through several
    channels, which are known collectively as the ‘transmission
    mechanism’ of monetary policy.” (link)

    However I would like to go a bit further and isolate a specific function or view of the Transmission Mechanism, which I believe is completely futile. The effect of an interest rate alteration is monitored and predicted for two years. The concept that a small alteration in the short term interest rate can have a huge effect on the long term economy is in my opinion impossible to predict accurately. Further than that there are so many other factors that impact the economy especially on an international level, such as oil prices and foreign currency alterations, that the effect of an interest rate alteration is unlikely to have a significant impact on the level of demand up to two years after it was enacted. Any impact that it does have is likely to be counteracted or dwarfed by these other factors.

    I also have my reservations about the calculation of the Transmission Mechanism in general. The functions and predictions of the impact of the actions the Transmission Mechanism creates are supposed to relate to the rate of inflation, partly through controlling aggregate demand and partly through predicting future inflation. This leads to the issue that bothers me the most, inflation is not calculated by weighing aggregate demand against aggregate supply but through the relative increase or decrease in a basket of goods over a period of time. Although it is likely that an alteration in money supply could lead to an increase or decrease in the prices for the basket of goods it does not guarantee it. Remember it is also only a measure of monetary effects of the economy, which could lead to an inflationary or deflationary gap and although this is the current popular view of the creation of inflation it does not support the concept of the original inflation calculation through the increase in the price of a basket of goods. There is another aspect relating to supply of goods which impacts on prices so the calculation of money supply alone cannot in my opinion provide a fully accurate prediction of future prices.

    Perhaps I am Keynesian leaning in this view but I think I have a justifiable point. The international aspect of supply from foreign trade partners will have an impact on the future price of goods as much if not more than the domestic monetary targets. I do not think it would be possible to go to each country we trade with and calculate future supply prices and even I did I would not advise it. I personally believe that inflation should be dealt with when it occurs and that the actions used should be direct and short term. The measurement of the impact of that action should not be estimated to predict what the rate of inflation will be in two years time, it should be purely to impact the current prices of the basket of goods.
  2. Ed Breen

    Ed Breen

    Good to see a post from you. Best I can tell, inflation is always caused by private credit expansion. Money supply increase and interest rate modulation do not of themselves cause credit, I agree that they have 'transmission' problems.
  3. morganist

    morganist Guest

    I have had a whole re-think on monetary theory, it is based on monetary states. I think you will like it. The importance isn't the availability of credit but the state it exists in.
  4. Ed Breen

    Ed Breen

    I can hardly wait to understand what you are talking about! I never meant to suggest that the supply of credit was the main driver of credit expansion. I think the demand for credit is the main driver. So, tell me what state is the credit in?
  5. morganist

    morganist Guest

    Your missing my point in the exact way all economists do. The emphasis is monetary states as in whether the money can be used in the economy and how effectively. For example the availability of credit whether demand or supply created works in two ways. The first is the increased speed of transactions that lent money creates because people only borrow money to spend it. This means there is a greater demand for goods when the money is lent to people rather than being held by the investor. The second way it works is the reserve when banks hold reserves that money is not used to buy goods so does not create demand the greater or smaller the reserve the greater or lesser the demand.

    I call the first of these two monetary states flux, the speed at which transactions can occur. The second is stasis and is the time the money is not available to spend. The whole point is the mechanism used to control these monetary states is irrelevant the transition from one monetary state to the other is the factor that impacts demand and inflationary or deflationary pressure. In my opinion all of the observations of monetary theory are observations of effect rather than cause. They have missed a whole level.
  6. Ed Breen

    Ed Breen

    So, you are parsing out the concept of 'velocity'. What is new about that? You are making up new words but its the same thing. I don't know how to seperate symptoms from causes when the only thing you can really see is the capital flow...sure it flows for reasons that are not measured by the flow...but its the flow that makes the difference.

    I think you are prejudiced by putting aggregate demand measured as GDP as your central seem to think that you have to do something with money supply and its relation to credit supply to create an effect in aggregatge demand GDP. Excess reserves build up in the banking system when the money supply is increased more than the private demand for credit. You can't create private demand for credit through money supply increase alone. Credit demand is a function of fiscal conditions and expectations about the future.
  7. morganist

    morganist Guest

    First of all the concept of flux is only one monetary state. So I have only acknowledged one state and not others. Secondly the concept of velocity is the speed of flux not flux itself. Flux means the money is used in transactions. The concept I would use to explain velocity is the efficiency of liquidity. But there is the other end of it too. This has not been explained before and relates to stasis, the non included money in society. There is another form too, void. These will all be explained. You are right the concepts have been explained to a degree but not sufficiently. Remember the effect of the money that is not in use in society is as important as the money in use.

    In any event I disagree that credit demand is the leading factor in credit expansion. In the UK especially it is the other way round. People cannot get enough credit no matter what the price. In fact the level of debt is so high that people were lent to that would not be lent to previously. I believe this was the case in America too, with the subprime. I think the demand for credit with the reliable creditors is the control of the creditors but the credit of unreliable subprime creditors is led by the supply. People took the money without considering whether they could pay it back as soon as it was offered to them. Partly this was from desperation and the prospect they could have things previously unavailable, regardless of the reason when the offer of credit was made to the subprime it was taken. This leads me to the conclusion the supply of credit controls the creditors in the majority of the market.

    One further thing I would point out too is the whole concept of credit is flawed in my opinion. The calculations that are used to determine return are based on the principal investment at the time of original agreement. For example in the original agreement £100 is lent the return is a percentage of the principal which has to be paid over ten years. So each year you will have to pay back £10 plus the interest, which is inflexible. Unfortunately the amount of debt generated over many years means the repayments build up and the amount which has to paid back is based on the principal investment when the economies output could have been higher. Therefore if there is a reduction in output the ability to pay the loan instalments no longer exists. This has become strangulated in the current environment because so much has been lent out and because the output is likely to fall which means there is less money to pay back loans, which were based on previous output levels.

    This inflexibility requires perpetual growth to enable existing loan repayments and is unsustainable. In my opinion the only way around this is to alter the investment calculations so that they are flexible. This means the end of credit.
  8. Ed Breen

    Ed Breen

    I don't know why you want to make up a new economic vocabulary instead of using the existing one. That is not the best way to get people to understand you...especially when you teas with words and new 'states' that will be revealed in the future. I do think its fun that you have introduced the idea of the 'flux capacitor' to your new fantasy economics...I suppose you will lead us back to the future.

    If everyone in the U.K. is lining up for debt as you say, even if they are not qualified, then I would suggest that you admit to a high demand for debt. If supply drove private sector debt formation then there would never be an excess reserves problem, even and especially, when the money supply icreases. Does the U.K. have an excess resereve problem?

    What do you think the velocity index published by the St. Louis Fed is measuring with regards to you flux and flam?
  9. morganist

    morganist Guest

    Yes flux is partly described by velocity but the other states are not. This is where the real issue lies and the forms of flux itself.

    I don't want to do into this in great detail until I have finished the paper.

    In relation to the demand supply credit concept. I think it is really irrelevant as I think credit is failing. In addition to that I think it changes.

    In the past people were demand credit driven. Now the economy has changed they are supply credit driven.

    Also the reason for the reserve excess is the fear of the banks to cover future bank runs. This is something they control so it is supply led. I can almost guarantee you if the banks were prepared to lend the money again it would be taken in both the UK and the US. The only reason there is a supply excess is because 1.) The governments require it to prevent a future bank run 2.) The banks know they will need the money to cover withdrawal because they know they have bad credit because they lent it to people who could not realistically pay it back.

    These are both supply controlled factors. At the moment supply of credit is the constraint to lending not the demand.
  10. Ed Breen

    Ed Breen

    It is ridiculous to talk about credit supply and demand without establishing a quality metric. The demand for credit that is properly underwritten by current standards set by the government and the banks is soft. To say that there is demand for bad credit or credit that cannot be underwritten properly and so would need to marked down the day it was written is not a proper way to think about supply and demand for credit. The main regulator of credit quality is the regulatory and business standard for collateral value and leverage ratios. In the U.S. now where the mortgage market under $770,000 is completely sociallized (90% plus of all loans are made by FNMA & FDMC which are owned by U.S. Gov.) the value of the collateral has declined more than 30% from 2007...The government continues to subsidize the leverage ratio at 90% LTV. However, on loans over the $770,000 threshold there is only a private market for such this market the collateral values are down about 40% and the leverage ratio that most banks will lend is only 60-65% of that lower value. This change in current value and allowed underwriting leverage reflects a changed view about the future that redifines present credit quality.
    #10     Feb 25, 2011