Monetary Transmission Mechanism

The process through which changes in monetary policy instruments affect an economy and, in particular, inflation and output

Author: Manu Lakshmanan
Manu Lakshmanan
Manu Lakshmanan
Management Consulting | Strategy & Operations

Prior to accepting a position as the Director of Operations Strategy at DJO Global, Manu was a management consultant with McKinsey & Company in Houston. He served clients, including presenting directly to C-level executives, in digital, strategy, M&A, and operations projects.

Manu holds a PHD in Biomedical Engineering from Duke University and a BA in Physics from Cornell University.

Reviewed By: Sid Arora
Sid Arora
Sid Arora
Investment Banking | Hedge Fund | Private Equity

Currently an investment analyst focused on the TMT sector at 1818 Partners (a New York Based Hedge Fund), Sid previously worked in private equity at BV Investment Partners and BBH Capital Partners and prior to that in investment banking at UBS.

Sid holds a BS from The Tepper School of Business at Carnegie Mellon.

Last Updated:December 31, 2023

What Is Monetary Transmission Mechanism?

The Monetary Transmission Mechanism is the process through which changes in monetary policy instruments (such as short-term policy interest rates or monetary aggregates) affect an economy and, in particular, inflation and output.

Impulses of a monetary policy transmit through various channels, affecting different variables and markets at various speeds and intensities.

For a monetary policy to be effective, it is essential to have a broad understanding of these channels and the associated lags.

Thus it is difficult to accurately predict the effect of monetary policy actions on the economy and price level.

Monetary policies affect output and prices by influencing key financial variables such as monetary aggregates, interest rates, exchange rates, asset prices, and credit.

At the same time, changes in the structure of an economy tend to alter the effects of a given monetary policy measure. This requires a central bank to reinterpret monetary transmission channels continuously.

Key Takeaways

  • The Monetary Transmission Mechanism is the process by which changes in monetary policy instruments impact an economy, influencing variables like inflation and output through various channels and at different speeds.
  • Predicting the effects of monetary policy on the economy is challenging due to the complex and interconnected nature of the transmission channels. A comprehensive understanding of these channels and associated lags is crucial for effective policy implementation.
  • Monetary policy is a set of measures employed by a central bank to control the money supply and interest rates, aiming to stimulate long-term economic growth. It involves influencing key macroeconomic factors such as inflation, GDP growth, and unemployment.
  • Monetary policies impact output and prices by influencing financial variables like monetary aggregates, interest rates, exchange rates, asset prices, and credit. Changes in the economic structure can modify the effectiveness of these channels, necessitating continuous adaptation by central banks.

What is Monetary policy?

Monetary policy is a collection of measures that a country's central bank can use to encourage long-term economic growth by controlling the amount of money accessible to the country's banks, consumers, and enterprises.

Put another way, it is the central bank's macroeconomic policy. It entails controlling the money supply and interest rate. By doing so, the central bank could effectively impact key macroeconomic factors such as inflation, GDP growth, unemployment rate, etc.

The country's central bank often decides a country's monetary policy. This is often compared with fiscal policy, which the country's government implements. While both policies are inherently different, they are generally designed to achieve long-term growth for the country. 

Although the Treasury Department can produce money, the Federal Reserve significantly affects the amount of money available in the economy, mostly through open market operations (OMO).

Although there is no hard and fast rule, treasury bills and agency mortgage-backed securities are generally the Fed's favored securities to carry out OMO.

When monetary policy is eased, financial securities are purchased, and when it is tightened, financial securities are sold. Therefore, the country's current economic environment and objective depend on whether the central bank decides to ease or tighten monetary policy.

The idea is to keep the economy moving at a steady pace that is neither too fast nor too slow. As a result, the central bank may raise interest rates to discourage expenditure or lower rates to encourage greater borrowing and spending.

Monetary Transmission Mechanism and Interest Rates

As a part of monetary policy, central banks also often alter the interest paid to their deposits with commercial banks. This is called the Bank Rate.

Commercial banks typically alter their interest rates for borrowing and saving when the Bank Rate changes. However, the Bank Rate is not the sole factor influencing interest rates for borrowing and saving.

Interest rates may vary for different reasons and are not always proportional to the changes in the bank rate. For example, banks must earn less on savings than lending to meet their expenses.

However, it is conventional to ensure that the savings rate is at least 0% because it may discourage consumers from depositing.

This indicates how much of a reduction in saving and borrowing rates banks pass down when the Bank Rate approaches 0%. Less of a rise in borrowing and saving rates will also likely occur if Bank Rate moves away from its current near-zero percent.

All financial institutions adjust the rates they charge their clients when the institutions raise or drop their rates, from large enterprises borrowing for significant projects to house buyers seeking mortgages.

Those house buyers are all rate-sensitive consumers. As a result, they are more inclined to borrow when interest rates are low and delay borrowing when they are high.

The monetary policy regulates the amount of money in circulation in a given economy and the routes through which new money is provided.

A central bank can impact macroeconomic parameters such as inflation, consumption, economic growth, and general liquidity by controlling the money supply.

A central bank can purchase or sell government bonds, control foreign exchange (forex) prices, vary the number of cash banks must keep as reserves, and change the interest rate.

Economists, analysts, and investors anticipate monetary policy decisions and even the minutes of meetings. This news will have a long-term influence on the economy, individual industrial sectors, and marketplaces.

Understanding Monetary Transmission Mechanism in detail

Let us understand how Monetary Transmission Mechanism works:

1. Change in official interest rates

A central bank provides funds to the banking system and charges interest. A central bank can fully determine this interest rate, given its monopoly over money issues in an economy.

2. It affects banks and money-market interest rates.

The change in the official interest rates directly affects money-market interest rates and, indirectly, lending and deposit rates, which banks set for their customers.

3. Affects expectations

Expectations of future official interest-rate changes affect medium-term and long-term interest rates. In particular, longer-term interest rates depend partly on market expectations about the future course of short-term rates.

Monetary policy can also guide expectations of economic agents of future inflation and thus influence price developments.

A central bank firmly anchors the expectations of price stability. In this case, the economic agents do not have to increase/decrease their prices, fearing higher inflation or deflation.

4. Affects asset prices

The impact on financing conditions in an economy and on market expectations triggered by monetary policy actions may lead to an adjustment in the exchange rate and asset prices (e.g., stock market prices). 

Changes in the exchange rate can directly affect inflation, as imported goods are directly used for consumption but may also work through other channels.

5. It affects saving and investment decisions

Interest rates affect households’ and firms’ saving and investment decisions. For example, assuming everything else is equal, higher interest rates make it less attractive to take out loans for investment or financing consumption.

In addition, investment and consumption are also affected by movements in asset prices via wealth effects and effects on the value of the collateral.

For example, share-owning households become wealthier as equity prices rise and may choose to increase their consumption. Conversely, households may reduce consumption when equity prices fall.

Asset prices can also impact aggregate demand via the collateral’s value, allowing borrowers to get more loans and reducing the risk premium demanded by banks or lenders.

6. It affects the supply of credit.

For example, higher interest rates increase the risk of default (borrowers cannot repay their loans). Banks may cut the funds they lend to households and firms, which may reduce the investment and consumption of firms and households.

7. It leads to changes in aggregate demand and prices.

A change in consumption and investment changes the domestic demand for goods and services relative to the domestic supply. When the demand exceeds supply, upward price pressure will likely occur. 

In addition, a change in aggregate demand may translate into looser or tighter conditions in labor and intermediate product markets. This, in return, can affect price and wage-setting in the respective market.

8. It affects the bank loan supply

Changes in policy rates can affect a bank’s marginal cost for obtaining external finance differently, depending on the bank’s resources or bank capital level. 

This channel is particularly relevant in dire times, such as a financial crisis when capital is scarcer, and banks find it more challenging to raise capital. 

In addition to the traditional bank lending channel that focuses on the number of loans supplied, a risk-taking channel might exist when banks’ incentive to bear risk related to the provision of loans is affected. 

This risk-taking channel is thought to operate mainly via two mechanisms. 

First, low-interest rates boost asset and collateral values. In conjunction with the belief that an increase in asset values is sustainable, this leads both borrowers and banks to accept higher risks. 

Second, low-interest rates make riskier assets alluring as agents search for high yields.
In the particular case of banks, these two effects translate into a softening of credit standards, which can increase loan supply.

Most Dominant channels of Monetary Policy Transmission: Central bank views

Most Dominant channels of Monetary Policy Transmission: Central bank views
Latin America  
Argentina Interest rates, nominal exchange rate innovations (under an environment of low inflation), and money growth
Chile Direct interest rate, exchange rate, credit, and expectations channel
Colombia Expectations, cost-push, aggregate demand, and exchange rate channel
Mexico Nominal interest rate
Asia  
India Money growth, interest rate, and credit channel
Malaysia Credit, interest rate, asset price channel, and exchange rate
Hong Kong SAR Direct cost of capital effect
China Mainly credit channel
Philippines Base money, exchange rate channel, and interest rate
Singapore Exchange rate channel
Thailand Interest rate, asset price channel, exchange rate
Central Europe  
The Czech Republic Interest rate and exchange rate channel
Hungary Exchange rate channel
Poland Interest rate and exchange rate channel 

Monetary Transmission Mechanism Recent developments

Recent theoretical work on monetary transmission mechanisms seeks to understand how the traditional Keynesian interest rate channel operates within the context of dynamic, stochastic, general equilibrium models.

This recent work builds on early attempts by Fischer (1977) and Phelps and Taylor (1977) to combine the key assumption of nominal price or wage rigidity with the assumption that all agents have rational expectations to overturn the policy ineffectiveness result.

The key behavioral equations of the New Keynesian model are derived in this latest work from more elementary descriptions of the goals and constraints faced by optimizing households and companies, building on those earlier works.

More specifically, the basic New Keynesian model consists of three equations involving three variables: output yt, inflation πt, and the short‐term nominal interest rate it.

The first equation, which Kerr & King (1996) and McCallum & Nelson (1999) dub the expectational IS curve, links output today to its expected future value and to the ex-ante real interest rate, computed in the usual way by subtracting the expected rate of inflation from the nominal interest rate:

yt = Etyt +1 − σ (it− Etπt+1)

Where σ is strictly positive.

This equation corresponds to a log‐linearized version of the Euler equation linking an optimizing household’s intertemporal marginal rate of substitution to the inflation-adjusted return on bonds, that is, to the real interest rate.

The second equation, the New Keynesian Phillips curve, takes the following form:

πt = βEtπt + 1 + γyt

The best behavior of monopolistic competitive companies that either face explicit costs of nominal price adjustment or set their nominal prices in a randomly staggered manner is described by this condition, which corresponds to a log-linearized variant of the first-order condition.

The third and final equation is an interest rate rule for monetary policy proposed by Taylor (1993). 

it = απt + ψyt, 

According to this formula, the central bank systematically adjusts the short‐term nominal interest in response to movements in inflation and output.

Researched and authored by Rohan Kumar Singh | LinkedIn

Reviewed & Edited by Ankit Sinha | LinkedIn

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