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Inflation Dynamics and the Cost Channel of Monetary Transmission

  • Ibrahim Chowdhury
  • Mathias Hoffmann
  • Andreas Schabert

Evidence from vector autoregressions indicates that the impact of interest rate shocks on macroeconomic aggregates can substantially be affected by the so-called cost channel of monetary transmission. In this paper we apply a structural approach to examine the relevance of the cost channel for inflation dynamics in G7 countries. We augment the so-called hybrid New Keynesian Philips curve by letting firms’ costs for external funds rise with the short-run nominal interest rate. Our estimates reveal that the magnitude of this cost channel strongly varies between countries, including member countries of the EMU, in accordance with differences in their financial systems. Simulations of a New Keynesian model further show that the presence of the cost channel substantially affects the transmission of monetary policy shocks, in particular, the inflation response.

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Paper provided by Business School - Economics, University of Glasgow in its series Working Papers with number 2003_19.

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Date of revision: Oct 2003
Handle: RePEc:gla:glaewp:2003_19
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