The term structure and cost channel effect of monetary policy

Sims (1992) first recognized a puzzling protracted rise in the price level following a contractionary monetary policy shock. Two groups of studies have addressed this "price puzzle". The first group suggests that the price anomaly can be resolved by adding future inflation information to the policy rule, because they believe that this undesirable result comes from the omission of important information available to the monetary authority. The second group regards this price response as normal because of the cost channel effect of monetary policy.; Since the effectiveness of monetary policy depends critically on the correct identification of the policy transmission mechanism, the recognition of the existence of the cost channel is important for the policy makers. This paper provides evidence of the cost channel effect through a structural VAR analysis. Based on empirical evidence, I construct a dynamic stochastic general equilibrium model, which addresses the cost channel effect.; My model focuses on two related features by which monetary policy affects real variables. (1) The model derives the term structure of interest rates, which states that the monetary policy action changes the market's expectations on the current and future short rate path that, in turn, determine the long rates. Despite the closer relationship of macro variables to long rates than to short rates, the monetary authority adopts the short rate as a policy instrument based on the belief of the existence of a channel through which the short rate policy is transmitted to long rates. Moreover, many studies fail to take into account the direct impact of long rates on the economy. In contrast, (2) my model highlights the role of long rates. I find that time lags in the capital formation and long-term financing contracts by firms enhance the cost channel effect, and generate the variables' staggered responses. The monetary policy action changes the short and long rates through the term structure of interest rates. Also the firms' borrowing pattern for both labor costs with short-term contracts and investment projects with long-term contracts link the nominal short- and long-term interest rates directly to firms' marginal costs.; This paper incorporates a simple cash in advance feature, sticky prices and wages, and habit formation. My model indicates that the price stickiness makes a limited contribution to generate persistent responses, but the sticky wage amplifies the inertial behavior of variables and ensures that the real wage responds in the direction that the cost channel effect of monetary policy predicts. Contrary to the studies by Fuhrer (2000) and Amato and Laubach (2004), in which they showed that habit formation helps to explain the gradual response of macro variables such as output and inflation to monetary policy shocks, habit formation in this paper only smoothes the response of consumption across time.