Monetary Transmission Mechanism

The monetary transmission mechanism is the process where general economic conditions and asset prices are affected due to the monetary policy decisions. It occurs through interest rate channels that influence the costs of borrowing, the levels of investment, and aggregate demand. The transmission mechanism is characterized by long-time lags. Therefore, this makes it hard to forecast the exact effect of monetary policy actions on the economy and price levels.

How Monetary Policy Decisions Impact Economic Growth and Asset Prices

Traditional Interest Rate Channels

Monetary policy influences investments, housing, consumer spending, and aggregate demand. Relaxation of the monetary policy results in a fall in the interest rates. This lowers the cost of borrowing, which leads to higher investment spending. The end result is the rise in aggregate demand.

Balance Sheet Channel

The balance sheet channel states that changes in interest rates affect the borrowers’ balance sheets and income statements. A dovish monetary policy might lead to higher stock prices, higher asset prices, and, therefore, increased investments.

Household Liquidity Effects

Increased wealth from rising asset prices leads to increased spending by households.

Bank Lending Channel

Increased deposits from consumers lead to more commercial bank reserves. These banks can then redeploy this capital in the form of business loans. These businesses will, in turn, invest in positive net present value projects, which should lead to higher asset prices.

Other Asset Price Effects on Monetary Transmission

Wealth Effects

Effects on stock prices caused by monetary policy consequently influence financial wealth and consumer spending on non-durable goods and services.

Exchange Rate Effects on Net Exports

Since currency exchange rates are a function of the difference in interest rates among countries, real interest rate changes lead to changes in net exports.

Question

Which of the following actions is the least likely to be included in the monetary transmission mechanism?

A. Increasing the central bank official interest rate

B. Enacting a transfer payment program

C. Setting the inflation rate target

Solution

The correct answer is B.

Transfer payments involve fiscal policy and not monetary policy.

Option A, increasing (or decreasing) the central bank official interest rate, is the first thing in the monetary transmission mechanism.

Option C, setting the inflation rate target, is part of the monetary transmission mechanism that comes towards the end of the process.

Reading 16 LOS 16i:

describe the monetary transmission mechanism