Paper for a conference sponsored by the Federal Reserve Bank of New York entitled Financial Innovation and Monetary TransmissionMonetary policy ; Consumption (Economics) ; Wealth

Stephen P. Zeldes

English

Research Papers in Economics

F R B N YE c o n o m i cP o l i c yR e v i e w/M a y2 0 0 2 1 3 5
ne important way that monetary policy can influence
aggregate demand is by changing consumer spending.
This could occur through a variety of possible channels.
ChangesinFederalReservepolicycouldalterrealinterestrates,
credit availability, expected future earnings, or the value of
financial securities suchas stocks and bonds, each of which
could inturn alter current consumer spending. Intheir paper,
Sydney Ludvigson, Charles Steindel, and Martin Lettau
examine empirically the last of these channels. That is, they
examine the narrow but important issue of to what extent
monetary policyaffects consumer spending by altering the
aggregate value of wealth.
Their methodology is to estimate a small structural vector
autoregression (VAR) that includes consumption (of
nondurables and services), labor income, wealth, the federal
funds rate, the inflation rate, and, in some specifications, the
commodity price index. They calculate two impulse response
functions.Thefirst(A) measuresthe responseofconsumption
to a monetary surprise (a shock to the federal funds rate). The
second (B) is calculated in the same way as A, except that the
consumption-wealth channel is shut down by setting the
coefficients of the contemporaneous and lagged response of
consumption to wealth equal to zero. The difference between
A and B is interpreted as “a measure of the contribution of the
consumption-wealth channelin the transmissionof monetary
policy.” The authors thereby provide a quantitative answer to
the question, if consumption did not respond to changes in
wealth,howmuchsmallerwouldtheeffectsofmonetarypolicy
shocks on consumption be?
Their main results are as follows. There is a significant
response of consumption to a shock in the federal funds rate
(A), but the difference (A-B) is economically small and
statistically insignificant. The authors conclude that the
contributionoftheconsumption-wealthchanneltotheoverall
transmission mechanism is small.
Inwhatfollows,Iwillfirstcommentonthepaperitself,then
discuss implications for the broader question of whether the
wealth effect is important (independent of monetary policy),
and then suggest some avenues for future research.
Comments on the Ludvigson-
Steindel-Lettau Test
This paper represents an important contribution to two
literatures: the transmission mechanism for monetary policy,
and the wealth effect on consumption.The paper is based on a
clever idea, it is wellimplemented and clearly written, and it
should becited in thefuture byothers inthese literatures.
Ihavea few commentsandquestionsabouttheirapproach.
First, do we believe the identifying assumptions? A key
identifying assumption is that changes in the stock market do
notcause acontemporaneous change in the federal funds rate,
Stephen P. Zeldes
The views expressed are those of the author and do not necessarily reflect the
position of the Federal Reserve Bank of New York or the Federal Reserve
System.
Commentary
Stephen P. Zeldes is the Benjamin Rosen Professor of Economics and Finance
at Columbia University’s Graduate School of Business and a research associate
at the National Bureau of Economic Research.
O136 Commentary
once other variables are accounted for. This assumption is at
best controversial—a number of researchers have argued that
Federal Reserve policy does and/or should respond to changes
in thevalue ofthe stock market,particularly largechanges.For
example, following the October 1987 stock market crash, the
Fed cut the federal funds rate without waiting for signs of
economic weakening, perhaps to avoid the possibility of a
financial crisis. Moreover, stock prices might contain useful
information about future inflation or real activity above and
beyondtheinformationcaptured byvariables intheVAR.It is
somewhat troubling that identification rests on this
assumption.
Second, is the counterfactual being proposed a meaningful
one, that is, is it feasible that consumers would not respond to
changes in financial wealth, but would respond to changes in
interest rates or changes in current or expected future labor
income? In particular, consider a standard discounted cash
flow model of stock prices. A change in the federal funds rate
could influence stock prices either because it influenced
interest rates and therefore the rate at which stock prices are
discounted (that is, the denominator in the discounted cash
flow equation), or becauseit influenced expected future
corporate earnings (that is, the numerator in the discounted
cash flow equation). It is somewhat perplexing that the
authors’ counterfactual allows for some effects of interest rate
changes and expected future income changes, but not for
others.
Third, should the paper be examining the total change in
wealth, or only thepart ofthe changes in wealth dueto capital
gains or losses? The authors examine the former, but I suspect
it should be the latter. Consider an unexpected increase in the
federal funds rate. The price of assets will fall, leading to an
immediate drop in wealth. However, if this leads to a drop in
consumption, and thus a rise in saving, the added
accumulation will cause wealth to be higher in the future.
Examining total wealth, rather than the capital gain or loss
component of wealth, includes both of these effects and could
therefore potentially bias the estimates.
Fourth, this paper follows the standard approach in the
literature by examining the effects of deviations from the
monetary policy rule,thatis,the effectsofpolicy “mistakes.”Is
this the appropriate variation in policy to examine? It is not
o b v i o u st h a ti ti s .A ni m p o r t a n t( b u td i f f i c u l t )a l t e r n a t i v e
w o u l db et oe x a m i n et h ee f f e c t so ft h eF e d ’ ss y s t e m a t i c
response (through the policyrule) to exogenous shocks to the
economy. Barring this, it would be useful to learn more about
what caused these “mistakes”—they may well be due to
informationflowing totheFederalReservethatis notcaptured
by the VAR, rather than to purely random noise in policy.
The Broader Question
of the Wealth Effect
In addition to helping us understand the transmission
mechanismformonetarypolicy,thispaperhasthepotentialto
s h e dl i g h to nt h eb r o a d e rq u e s t i o no ft h ei m p o r t a n c eo ft h e
wealth effect, that is, how much do changes in stock market
wealth affect consumption? There is a large literature on this
question, using both microeconomic and macroeconomic
data, but the results have been mixed. One reason thatitis not
easy to identify the size of wealth effects is that stock prices are
endogenous. It is difficult to find exogenous shocks that move
the stock market but do not have a direct effect on
consumption. It is also difficult to separate out the reverse
causalityfrom consumptionto stock prices. Onepromising
approachhasbeentousemicrodata to examinethedifference
between the consumption response of stockholders and
nonstockholders (see, for example, Dynan and Maki [2001]).
Onlyhalf of U.S. households own anystock, directly or
indirectly (Ameriks and Zeldes 2001), and even among this
group, stock market wealth is highly concentrated, implying
thatany wealth effect mustoccur through a relatively small set
of households.
The approach by Ludvigson, Steindel, and Lettau could in
principle help solve the identification problem inherent in
macro data and therefore help get cleanestimates ofthewealth
effects. Their approach is similar (but not identical) to
regressingthechangeinconsumptiononthe changein wealth,
and using the innovation in the federal funds rate as an
instrument. There are two well-known requirements ofa good
instrument: it must be correlated with the independent
variables and uncorrelated with the error term. Since the
federal funds rate is assumed to not respond contempor-
aneously to shocks to wealth, and consumption is assumed to
not respond contemporaneously to changes inthe federal
funds rate, the second requirement is (byassumption)
satisfied. Unfortunately, the authors find that wealth does not
respondvery much to federal fundsrate shocks,andthatthose
changes that do occur tend to be temporary. Because the
federal funds rate shock is not highly correlatedwith wealth, it
is therefore not a very good instrument. Put another way, the
reason the channel examined in the paper that leads from the
federal funds rate to wealth to consumption isweak is because
the first link is weak. Therefore, the paper unfortunatelycan
shed little light on the importance of the second link.F RBN YE c ono mi cPo lic yRev i ew/May2 002 1 3 7
Future Research
I have a few suggestions for future research by the authors or
others. First, we need to think harder about the plausibility of
the identifying assumption that changes in stock prices do not
directlyinfluencemonetarypolicy.Second,itwouldbehelpful
to write down an economic model that could explain the
findingin the paper thatapositive federal fundsrateshock has
only temporary effects on the stock market, causing wealth to
fall and then rise back to the starting point within two years.
Using daily data to look at the effects of federal funds rate
changes and also economic news announcements on stock
prices might help improve our understanding of this issue. In
regardto the broader question of the wealth effect, more work
is needed on the theory of household portfolio and
consumption choices with transaction costs and inertia.
Further empirical work examining consumer spending by
householdswith differentassetpositionsmay helpsortoutthe
magnitude of the wealth effect, and help predict howa
continued rise in the fraction of households owning stock
would alter the magnitude of the wealth effect.References
138 Commentary
Ameriks, John, and Stephen P. Zeldes. 2001. “How Do Household
Portfolio Shares Vary with Age?” Unpublished paper, Columbia
University Graduate School of Business, December.
Dynan, Karen E., and Dean M. Maki. 2001. “DoesStockMarket
Wealth Matter for Consumption?” Board of Governors of the
Federal Reserve System Finance and Economics Discussion Series
no. 2001-23, May.
The views expressed are those of the author and do not necessarily reflect theposition of the Federal Reserve Bank of New York
or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty, express or implied, as to the
accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of any information contained in
documents produced andprovided by the Federal Reserve Bank of New York in any form or manner whatsoever.

DoesStockMarket Wealth Matter for Consumption?” Board of Governors of the Federal Reserve System Finance and Economics Discussion Series no.

How Do Household Portfolio Shares Vary with Age?” Unpublished paper,

Monetary policy transmission through the consumption-wealth channel : commentary

http://www.newyorkfed.org/research/epr/02v08n1/0205zeld.pdf

Monetary policy transmission through the consumption-wealth channel : commentary

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