Chapter 10 : Financial Markets and Monetary Policy ( Monetary Theory and Policy , 3 rd ed . )

Central banks in the major industrialized economies implement policy by intervening in the money market to achieve a target level for a short-term interest rate.1 Why central banks use a short-term interest rate as a policy instrument, and how they achieve the targeted value they set for this rate are topics to be discussed in chapter 11. The focus in this chapter is on the role of …nancial markets and the linkages between the interest rate a¤ected directly by monetary policy and the broad range of market interest rates and credit conditions that a¤ect investment and consumption spending. After considering issues of price level determinacy and liquidity traps in section 2, the term structure of interest rates and the relationship between short-term and long-term interest rates are discussed in section 3. Recent work has linked the term structure models commonly used in the …nance literature to the types of macro models commonly used to investigate monetary policy issues. These models are the topic of section 4. If, however, credit markets are imperfect, interest rates (i.e., prices) may not be su¢ cient to capture the impact of monetary policy on the economy. Instead, there may be credit e¤ects that arise when frictions are present in …nancial markets. Section 5 will examine these frictions and their implications for macroeconomic equilibrium and the impact of monetary policy. Section 6 concludes by providing a brief review of the evidence on whether credit matters.