Monetary policy transmission mechanism

The transmission mechanism of monetary policy involves the channels through which monetary policy decisions affect the economy in general and the price level in particular. As the transmission mechanism has long time lags, it is difficult to predict the precise effect of monetary policy actions on the price level and the economy.

The figure below illustrates the main transmission channels of monetary policy decisions.

Changes in monetary policy interest rates

The central bank lends money to the banking system and charges interest on it. As the central bank is the monopoly supplier of money, it can decide the interest rate it charges.

Changes in monetary policy interest rates have various impacts

The impact on banks and money-market interest rates

A change in the monetary policy interest rates set by the central bank affects money-market interest rates directly and then indirectly the lending and deposit rates that are set by banks for their customers.

The impact on expectations

Expectations of future changes in monetary policy interest rates affect medium and long-term interest rates, as longer-term interest rates depend in part on market expectations about the future course of short-term rates.

Monetary policy can also guide the expectations of participants in the economy for future inflation and so influence developments in prices. A central bank with a high degree of credibility can firmly anchor expectations of price stability. In this case, prices do not need to be raised for fear of higher inflation or cut for fear of deflation.

The impact on asset prices and exchange rates

The direct impact of monetary policy decisions on financing conditions, the economy and market expectations may lead to adjustments in asset prices such as share prices and real estate values, and in exchange rates. Asset prices can in turn affect aggregate demand, as a higher value for collateral could for instance allow borrowers to take more loans or reduce the risk premiums that the banks demand from them. Changes in the exchange rate can affect inflation directly, through the imported goods in the consumer basket, and indirectly, through the prices of imported raw materials for example.

The impact on saving and investment decisions

Changes in the interest rates affect the saving and investment decisions of companies and households. If other conditions remain the same, higher interest rates make borrowing for consumption or investment less attractive. However they also make it possible to earn more on savings like deposits, and so can indirectly restrain inflation or drive inflation higher if that money is used for consumption. Consumption and investment are also subject to the wealth effect as changes in the value of collateral cause asset prices to change. If real estate prices rise for example, households become wealthier and can increase their consumption. A fall in real estate prices may lead households to reduce their consumption though.

The impact on aggregate demand and the price level

Changes in consumption and investment change the level of domestic demand for goods and services relative to supply. When demand exceeds supply, there is upwards pressure on prices. Changes in aggregate demand, meaning domestic demand plus net exports, may also translate into tighter or looser conditions in labour and intermediate product markets. This can then affect price and wage-setting in those markets.

The impact on the supply of loans

Changes in monetary policy interest rates can affect the marginal cost for banks of accessing external finance in different ways, depending on the capital position and own funds of the bank. This channel is particularly relevant in a financial crisis, when capital is scarcer and banks find it more difficult to raise capital.

Higher interest rates also increase the risk of borrowers no longer being able to repay their loans, and so banks may offer fewer loans to households and companies. This may in turn reduce the consumption of households and the investments of companies. Alongside the traditional bank lending channel, which focuses on the quantity of loans issued, there is a risk-taking channel, which means that the banks may become less willing to bear the risks of lending. This channel usually operates in two ways:

  1. low interest rates boost asset and collateral values, and this, in conjunction with the belief that the increase in asset values is sustainable, leads both borrowers and banks to accept higher risks;
  2. low interest rates make riskier assets more attractive, as agents search for higher yields.

For banks, these two effects usually translate into a loosening of credit standards, which can lead to an excessive increase in loan supply.

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