However they are motivated, we can use our general model to think about a Tobin- esque world in which the supply of assets matters for their price and return. As with our discussion of money in section 4.1, such a world implies that the demand curve for assets A and B are less than perfectly elastic, and therefore βA and βB are both greater than zero.
Let us reconsider our earlier thought experiment; an open market operation exchanging asset A for newly created money. The …rst point of note is that the existence of supply e¤ects does not preclude the transmission mechanisms we have previously outlined. The expansion in the money supply works in exactly the same way as detailed above; itfalls to clear the money market and this lowers
both iA
t and iBt through the term structure. However, we now get an additional
e¤ect on iA
t caused by the reduction in the quantity of A available to the public.
Whatever the underlying friction, the change in supply leads to a movement in the price and yield of A which cannot be fully arbitraged away.
This direct supply e¤ect may also be accompanied by a more broadly "local" supply e¤ect if asset B is an imperfect substitute for asset A, in other words if δ > 0. Intuitively δ is the extent to which B operates as a successful substitute for A. Imagine the two assets are very close substitutes and supply matters for determining price. In this case the relevant variable is the joint supply of both A and B, as they are interchangeable, so δ ≃ 1. As δ → 0 the less of an e¤ective substitute B is for A and the less the supply of B matters in determining the price of A, and vice versa. Therefore, if 0 < δ < 1, as exchanging asset A for money increases the price of asset A, at least some investors will be induced to
switch out of holding A and in to holding asset B. This increase in demand for asset B will push up on its price and down on its yield, lowering iB
t by an amount
in excess of the pure expectations hypothesis. This transmission mechanism has become known as the portfolio rebalancing channel.
The values of βA, βB and δ are therefore integral to the transmission and
e¢cacy of asset purchases as a monetary policy tool. To see why, let us again imagine our A for money open market operation, but assuming demand for asset A is almost entirely inelastic. As βAtends to in…nity, δ tends to zero. This would mean that our open market operation would have an increasingly large impact on iA but the transmission to iB would diminish to nothing. In other words,
there would be a large direct e¤ect, but no portfolio rebalancing. All that the open market operation is achieving is to disconnect asset A from the yield curve. Contrast this with the case where demand for assets is perfectly elastic and so βA and βBtend to zero, but δ tends to one. Now the assets are perfect substitutes, so
a change in the supply of one is equivalent to the change in the supply of the other, but the perfectly elastic demand means that a change in supply of either has no impact on iA or iB. This can be seen in …gure 5 which applies the same shock to
the supply of money under di¤erent parameterisations of these parameters. When βA = 0 and δ = 1 then the movement of all variables is the same as the initial shock presented in …gure 4. However, as the demand curve for asset A becomes less elastic, the impact of the operation on iAincreases. Interestingly, the impact
on i reduces, as the heightened sensitivity of other assets to the operation takes some of the burden of stabilising the economy and so relaxes the amount of work required by the policy rate. The impact on iB is determined by the interaction
of βB and δ. A higher degree of pass-through from increased substitutability can be o¤set by a more elastic demand curve.
This has implications for the design of policy. In a world where βA was large but δ low, asset purchases would represent a useful tool for manipulating a targeted market, or market segment. Such a scenario is likely to occur when
world between these two extremes in which there is less than perfect arbitrage, but assets are still to some degree substitutable. Moving along the spectrum between the two poles will alter how asset purchases work and transmit through the economy.
So, what is likely to determine the values of these parameters? The stronger the frictions that limit arbitrage opportunities, be they credit constraints, risk aversion of arbitrageurs or valuing assets for characteristics beyond their pecuniary return are at their largest the greater we would expect βA to be. This suggests that asset purchases may be especially e¤ective at manipulating rates in times of …nancial turmoil, as this is exactly when frictions are at their strongest and markets become most segmented. This is not to discount the importance of this supply channel in more normal times, as it is highly probable that frictions exist to one extent or another even when markets are functioning relative well. In fact, D’Amico et al (2012) …nd signi…cant supply e¤ects in a pre-crisis sample for the US economy.
It is also important to note that βA and δ are unlikely to be independent of one another. The less there exists close and viable substitutes for asset A, the more inelastic demand for A will be. Therefore, βAand δ are likely to be inversely correlated. This is a signi…cant statement as it highlights a trade-o¤ at the heart of the debate around supply e¤ects and the use of asset purchases as a policy tool.
5
A demand shock
Figure 6 shows the response of the model to a demand shock under two parameterisations. In the …rst there are no frictions which give rise to supply e¤ects for any asset other than money. In the second βA, βB and δ are set so that there are signi…cant supply e¤ects on assets A and B. As can be seen, the monetary authority has to reduce the policy rate by less to stabilise the economy in the latter case as the reduction in the premium on A moves iA by more. This
is an important result as it means that the correct policy setting, even in normal times must be aware the extent of supply e¤ect. The existence of supply e¤ects does appear to lessen the falls in output and in‡ation, though under this setting the magnitude is not great.