Bernanke on Interest Rates, Monetary Aggregates, and How Monetary Policy Impacts the Economy

One of Ben Bernanke's influential papers, written with Alan Blinder (quoted on Bernanke here) "The Federal Funds rate and the Channels of Monetary Policy" appeared in the American Economic Review in September 1992 (JSTOR link). There is a lot in the paper, some of it on the technical side, and I will make no attempt to cover all of the papers points or nuances. But there are interesting tables and figures in the paper that give a sense of the paper's impact and two of these are presented below.

At the time the paper is published, there is a fairly active debate among those studying monetary policy concerning how to correctly measure monetary policy shocks, a debate that continues today. The traditional measures are derived from monetary aggregates such as M1, M2, the monetary base, and reserves, but interest rates such as the T-Bill rate and the federal funds rate, and interest rate spreads such as long-short spreads and the spread between the T-bill rate and the commercial paper rate are beginning to gain favor on both theoretical and empirical grounds. This table helped to push the profession away from aggregates and towards interest rates and interest rate spreads, with this paper pushing towards the federal funds rate in particular. This table asks a simple question using a model known as a vector autoregression or VAR model to ask it. The question is how well each of the monetary aggregate and interest rate variables listed at the top of the table predict macroeconomic variables of interest listed on the left-hand side.

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The table shows that the federal funds rate predicts the variables listed in the table better than the other variables such as M1, M2, the three month T-Bill rate, and the 10 year government bond rate, and it is more robust to the sample period than other variables on the list such as the T-Bill rate which does better prior to 1980 than after. There is one interesting line on the table. Housing starts is the only variable examined that does not appear to respond to changes in the federal funds rate.

Because of this table, and many more additional tables in the paper (which also examine interest rate spreads), and because of other papers like this one, the weight of the evidence began to shift towards the use of interest rates and away from monetary aggregates. I should add that the evidence in the paper is not just empirical, there is also a theoretical argument made for the  use of interest rates rather than monetary aggregates to measure monetary policy shocks.

Another aspect of the paper is an argument that a credit channel for the transmission of monetary shocks exists. Let's start with this graph from the paper:

This graph shows how the unemployment rate and the bank balance sheet variables deposits, securities, and loans move over time in response to change in the federal funds rate. Under the standard transmission mechanism, the tightening of money reduces bank reserves and lowers bank deposits through the familiar multiple deposit contraction process. In addition, as expected, bank assets also fall which is initially reflected by the fall in securities. However, over time, securities begin to recover and bank loans, a different bank asset, begin to fall instead and after 24 months the change is reflected almost entirely in loans rather than securities.

The fall in loans corresponds fairly well to the rise in the unemployment rate. This then, to Bernanke and Blinder, gives credence to the credit view over the money view in explaining how money impacts the economy. Why? Under the money view, it is the change in deposits and the corresponding changes in interest rates from the fall in liquidity that drive the fall in output after a contraction. Under the credit view, it is the reduction in reserves causing loans to dry up that generates the negative impact on the aggregate economy. This paper argues strongly for the existence of a credit channel as an alternative means by which changes in bank reserves brought about by monetary policy can affect variables such as output and employment.