Financial Risk and Boom-Bust Cycles

The monetary transmission is one of the most studied fields of monetary economics from both a theoretical and an empirical perspective. Understanding how monetary impulses are translated into changes in aggregate expenditures is of essential importance for the evaluation of the monetary policy stance. Monetary policy must be conducted with an accurate assessment of the timing and effect of policy changes on prices and quantities on an aggregate level (Mishkin, 1995). The evolution and identification of the multiple channels of monetary transmission at work has changed with the emergence of varying conceptional frameworks which have been applied to analyze monetary policy. For instance, the early debate on the propagation effects between Keynesian and Monetarist models has been dominated with the question on how changes in the money supply affect the yields of a (imperfectly substitutable) set of assets. Whereas in the simpleIS-LM model the relevant distinction was based on money and a “representative” long-term bond, the monetarist approach highlighted the importance of wealth and substitution effects between various domestic and foreign assets, which are affected by changes in the money supply and have induced changes in investment and consumption paths.By the same token, the recognition that the central bank uses the short-term interest rate as the operating instrument for achieving its policy goals may alter the logic of monetary transmission compared to the older view according to which money supply was treated as exogenous and viewed as under the control of the monetary authority. With an interest-rate setting monetary policy, the stock of money adjusts endogenously and arises from the private sector’s money demand and the bank’s willingness to provide loans (Meyer, 2001).