EMU: some unanswered questions



capital are extremely important in the monetary transmission mechanism (Taylor, 1995). This
is called the interest rate channel. In Taylor’s model, contractionary monetary policy raises
the short-term nominal interest rate and then, through a combination of sticky prices and
rational expectations, the real long-term interest rate rises as well, at least for a time. These
higher real interest rates lead to a decline in business fixed investment, residential housing
investment, consumer durable expenditure and inventory investment, which produces the
desired decline in aggregate output. This mechanism is based, then, on the well-known IS-LM
keynesian model. Following this view, the main features of the transmission of the monetary
policy are related to the extent that the central bank interest rate is being used in the economy
and to the other factors such as the “life” of financial contracts (if the interest rate is fixed for
a long period of time, the effect of monetary policy will be lower).

Another factor through which changes in monetary policy instruments influence non-financial
activity operates through the exchange rate (Menon, 1995). The interpretation of the exchange
rate channel is related with the impact on non-financial activity of monetary policy decisions
through movements in the balance of payments. Under flexible exchange rates, a change in
the domestic instrument variable ceteris paribus elicits movements in the exchange rate. This
channel also involves interest rates effects, because when domestic real interest rates rise,
domestic national currency deposits become more attractive relative to deposits denominated
in foreign currencies leading to a rise in the value of national currency deposits relative to
other currency, which causes a appreciation of the national currency. The higher value of the
domestic currency makes domestic goods more expensive than foreign goods, thereby causing
a fall in net exports and hence in aggregate output (altering the relative prices of national and
foreign goods).

As Meltzer (1995) emphasises, a key objection to the keynesian paradigm for analysing
monetary policy effects on the economy (present in the two previously presented “channels”),
is that it only focuses on one relative asset prices, the interest rate (and the exchange rate but
in relation to it). The description of the Japanese experience during the 80s and 90s in Meltzer
(1995) shows how monetary policy can have a relevant impact on non-financial activity
through its effect on land and property values. This channel, known as asset prices channel,
relative prices channel or stock market channels, assumes that monetary policy has influence
on the prices (and composition) of agent’s assets portfolios through changes in the
opportunity cost and, as a result, when agents try to bring into balance their portfolios (having



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