The monetary transmission mechanism is the process where general economic conditions and asset prices are affected as a result of decisions of the monetary policy. It occurs through interest rates channels that influence costs of borrowings, levels of investments, and the aggregate demand. The transmission mechanism is characterized by long time lags. This, therefore, makes it hard to forecast the exact effect of monetary policy actions on the economy and price levels of goods and services.
Traditional Interest Rate Channels
Monetary policy influences investments, housings, consumer spending, and aggregate demand. An ease in monetary policy results in a fall in the interest rates. Also, this lowers the cost of borrowing that leads to a high investment spending which results in the rise of aggregate demand.
The credit view concept argues that the financial friction in the credit markets forms causes changes in the aggregate demand. Therefore, these channels run through the effects of the balance sheet of firms and households and also affect bank lending. This includes:
Balance Sheet Channel
Monetary policy influences stock prices, resulting in changes in lending activity and investment, moral hazards, and adverse selections.
Household Liquidity Effects
As monetary policy affects stock prices, it causes changes in financial distress probability and also affects financial wealth. As a result, this affects consumer spending and residential housing.
Bank Lending Channel
Bank deposits are affected by the monetary policy. Changes in the number of bank loans and investments in residential housing are some of the effects of this process.
Other Asset Price Effects on Monetary Transmission
These other asset price effects have various channels which also allow the monetary policy to affect the aggregate demand. This includes:
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
The real interest rates and exchange rates lead to changes in the net exports.
Which of the following is least likely to be included in the monetary transmission mechanism?
A. Changing the official interest rate of the Central Bank
B. Enacting a transfer payment program
C. Setting an inflation rate target
The correct answer is B.
Transfer payments involve fiscal policy and not monetary policy. However, changing the official interest rate of the central bank is the first thing in the monetary transmission mechanism. Also, setting an inflation rate target is part of the monetary transmission mechanism that comes towards the end.
Reading 18 LOS 18i:
describe the monetary transmission mechanism