26 Oct 2016  Vol. 16, No. 38
Effectiveness of Monetary Policy on Heterogeneous Economic Agents
Seok Ki Kim
Summary: Recently, research on effectiveness of monetary policy in consideration of heterogeneous economic agents has been receiving growing attention.
Auclert(2016) argued that an expansionary monetary
policy could be less effective for borrowers of longterm, fixed-rate loans as they do not benefit from a
lower interest rate and cannot increase spending as
much. Wong(2016) showed that when an interest rate
falls, relatively older people tend to avoid refinancing
of their loans due to additional fees, and thus, a monetary policy might have weaker effect as the share of
elderly population grows. Meanwhile, in Korea, the
government has set target rates for fixed-rate mortgage loans to promote financial market stability, while
the elderly population is growing rapidly. Under this
circumstance, the effectiveness of monetary policy may
be undermined with time. To address this, some of the
conceivable ideas would be to lower early termination
fee for mortgage loans or reduce the period that allows
such fees, so that households' repayment burden can
be mitigated and the monetary policy can be effective.
Lastly, to avoid banks' additional cost burden from early termination of mortgage loans, it might be considered to reflect the fees in the fixed-rate mortgage
loans, rather than charging early termination fees.
Typically, analysis of monetary policy is based on a
model that assumes one representative agent within a
given economy. For instance, that representative
agent's income, production or consumption level would
be examined when a policy rate is adjusted. However,
recently, there is a growing awareness that a monetary
policy can affect different economic agents in varying
ways depending on their characteristics. Also, evolving
computing technologies enable more sophisticated
analysis, and accordingly, academic interests have been
heightened on how heterogeneous economic agents
respond to monetary policies, and how a particular
monetary policy affects the economy as a whole. The
research outcomes have provided a new perspective on
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the counter-cyclical role of monetary policy.
In this article, we examine the latest trends of research
on how monetary policy affects heterogeneous economic agents, and draw policy implications from the
findings.
Conventional research on effectiveness of monetary
policy: based on representative agent
Most of the earlier studies on counter-cyclical effect of
monetary policy have been based on models that assume one representative agent in an economy, notably
New Keynesian models. A typical New Keynesian model
assumes that lowering interest rate leads to an increase
in the representative agent's present consumption, due
to inter-temporal substitution effects. If a monetary
authority lower interest rate, the representative agent
has a weaker incentive to defer current spending, increase savings instead to increase future spending.
Thus, economic agents cut down on savings, increase
current consumption, and the subsequent increase in
effective demands lead to increased outputs. Since inter-temporal substitution effects apply to individual
economic agents' present and future consumptions,
the effects can be commonly observed even for economic agents with heterogeneous characteristics.
New research on effectiveness of monetary policy:
based on heterogeneous agents
However, in reality, economic agents are in widely
different situations, in terms of age, family structure,
income, assets, and so forth. Such heterogeneity affects
economic agents' spending and savings behaviors. Suppose a person responds sensitively to an interest rate,
and adjusts the level of consumption accordingly. In
this case, he/she would be significantly affected by
changes in monetary policy, and vice versa. That is, an
expansionary monetary policy (or lowering interest
rate) boosts consumption, but the extent of increase
would depend on economic agents' different characteristics. Also, the effectiveness of monetary policy could
change as the demographic composition of the population changes.
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26 Oct 2016  Vol. 16, No. 38
Auclert(2016)1) conducted research on redistribution
effect of monetary policy. According to the study, an
expansionary monetary policy affects the economy
through mainly three redistribution channels: real
wage, inflation, and real interest rate. First, a lower interest rate reduces a company's interest expenses, and
the subsequent increase in profits and wages affects
economic agents' behaviors (real wage channel). Second, a lower interest rate stimulates inflation, which
benefits debtors and hurts creditors (inflation channel).
Lastly, the real interest rate channel is related to duration of assets and liabilities, more specifically, the 'gap
in the period of fixed interest rates for assets and liabilities.' If someone has assets of fixed interest rate whose
duration is shorter than that of liabilities, he/she would
probably lose assets when interest rate falls. It is because while liabilities' high interest rate is fixed, assets'
interest rate would be soon lowered. Conversely, if
someone has assets of fixed interest rate whose duration is longer than that of liabilities, he/she would benefit from a lower interest rate due to lower funding
costs.
Auclert used data from Italy and the US, and demonstrated that the third redistribution channel of real interest rate can play an as crucial role as inter-temporal
substitution effects. Then, the effect of the three redistribution channels on the economic cycle was analyzed
by linking economic agents' losses and benefits and
their marginal propensity to consume. If economic
agents that benefit from a lower interest rate have
greater marginal propensity to consume those that do
not, the consumption would be significantly boosted.
Wong(2016)2) argued that when the interest rate falls,
people show different patterns of increasing consumption by their age. Using US data, Wong confirmed that
younger people increase spending more than older
people when a policy rate is cut. This is mainly because
the consumption was markedly improved among people who refinanced their mortgage loans or newly purchased homes, and a majority of them were relatively
young people.
The study attributed this finding to the structure of US
mortgage market where long-term fixed rate is a default and a certain fee is charged for refinancing. In the
US, many young people take out mortgage loans to buy
a house, at fixed interest rate for 15~30 years. If an interest rate falls, younger people might find it more advantageous to refinance their loans, despite additional
fees, to mitigate repayment burden. Then they can increase consumption with extra disposable income. In
comparison older people have already repaid much of
their loans, and thus might decide to stay with the current loan rather than refinancing. For this reason, older
people are likely to be hardly affected by falling interest
rates. Based on this analysis, it was estimated that a
monetary policy would have increasingly less effect as
the share of elderly population grows.
Both studies observed that, for an expansionary monetary policy (or lower interest rate) to affect the market
behaviors, economic agents should be able to benefit
from reduced interest expenses for their liabilities, so
that they can secure extra disposable income for consumption.
Household debts and demographic composition of Korea
As discussed earlier, effectiveness of monetary policy
could vary widely by individual economic agents' characteristics and demographic composition of the overall
population. In Korea, one of the most notable features
in household finance is a sharply growing household
debt. It first exceeded 1,000 trillion won in Q4 2013,
and hovered over 1,250 trillion won as of Q2 2016.
Meanwhile, nominal GDP has been growing at a slower
pace from 1,429 trillion won in 2013 to 1,559 trillion
won in 2015, raising overall debt burdens of the economy. Regarding effectiveness of monetary policy, it can
be estimated that, as the ratio of household debt rises,
households' interest expenses decrease when the policy rate is lowered, and thus consumption can be stimulated and the monetary policy can be more effective.
1) Auclert, Adrien, "Monetary Policy and the Redistribution Channel," Manuscript, January 2016.
2) Wong, Arlene, "Population Aging and the Aggregate Effects of Monetary Policy," Manuscript, April 2016
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26 Oct 2016  Vol. 16, No. 38
Currently, the government keeps a tight rein over mortgage loans that represent a significant part of household debts, in a bid to maintain financial market stability. Particularly, banks are given a target rate of fixedrate mortgage loans, to absorb shocks in case the interest rate rises. According to government measures for
household debt management announced on August 25,
the target rate of fixed-rate mortgage loan is 40% for
2016 and 42.5% for 2017. Indeed the share of fixedrate mortgage loans has increased steadily. It was a
meager 0.5% at the end of 2010, rose to 14.2% at the
end of 2012, and rose higher to 36.8% as of March this
year. However, if the interest rate falls, households
would not be able to benefit much from the rate cut
due to their 'fixed-rate liabilities', and as a result, the
positive impact on consumption and GDP growth would
be quite limited.
charging early termination fee is banned in principle,
with exceptions for borrowers in the past three years.
Reducing early termination fees or shortening the period that allows such fees is expected to enhance effectiveness of monetary policy.
In considering this, it needs to be noted that early repayment of long-term debts incurs costs (e.g. portfolio
rebalancing) for banks, and reducing early termination
fee can further increase such costs as more borrowers
repay ahead of schedule. Going forward, greater efforts
are needed to seek measures other than charging early
termination fee―for instance, reflecting the feeequivalent cost to the interest rate of fixed-rate mortgage loans―to ensure both financial market stability
and effectiveness of monetary policy.
Aging population is another factor that can alter the
effectiveness of monetary policy. Korea is among the
most rapidly aging countries in the world. According to
Statistics Korea, the share of elderly population (ages
65 and over) rose over 7% in 2000, and projected to
reach 14% by 2017. If the current increasing trend in
fixed-rate mortgage loan continues, many elderly people would be holding fixed-rate mortgage loans in the
future. Then, lowering an interest rate might not be as
effective as it is now as elderly people's repayment burden would not be reduced as much.
Policy implications
Since the effectiveness of monetary policy relies heavily
on economic agent's characteristics and demographic
composition of the overall population, the monetary
authority needs to formulate monetary policy accordingly. The same expansionary policy could have varying
effects depending on economic agents' circumstances.
To ensure effective monetary policy, it is necessary to
examine which factors affect effectiveness of monetary
policy.
For instance, a policy that reduces early termination fee
for mortgage loans might be considered so that borrowers of fixed-rate mortgage loans could benefit more
from lower interest rates. A legislative announcement
for the Framework Act on Financial Consumer Protection was made back in June, and according to the act,
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