Transmission Mechanism Of Monetary Policy

This is the process through which monetary policy decisions affect the economy in general and the price level in particular. The transmission mechanism is characterised by long, variable and uncertain time lags. Thus it is difficult to predict the precise effect of monetary policy actions on the economy and price level.

This is the process through which monetary policy decisions affect the economy in general and the price level in particular. The transmission mechanism is characterised by long, variable and uncertain time lags. Thus it is difficult to predict the precise effect of monetary policy actions on the economy and price level.

The chart below provides a schematic illustration of the main transmission channels of monetary policy decisions.




Change in official interest rates

The central bank provides funds to the banking system and charges interest. Given its monopoly power over the issuing of money, the central bank can fully determine this interest rate.


Affects banks and money-market interest rates


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


Affects expectations


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


Monetary policy can also guide economic agents’ expectations of future inflation and thus influence price developments. A central bank with a high degree of credibility firmly anchors expectations of price stability. In this case, economic agents do not have to increase their prices for fear of higher inflation or reduce them for fear of deflation. 


Affects asset prices


The impact on financing conditions in the economy and on market expectations triggered by monetary policy actions may lead to adjustments in asset prices (e.g. stock market prices) and the exchange rate. Changes in the exchange rate can affect inflation directly, insofar as imported goods are directly used in consumption, but they may also work through other channels.  


Affects saving and investment decisions


Changes in interest rates affect saving and investment decisions of households and firms. For example, everything else being equal, higher interest rates make it less attractive to take out loans for financing consumption or investment.

In addition, consumption and investment are also affected by movements in asset prices via wealth effects and effects on the value of collateral. For example, as equity prices rise, share-owning households become wealthier and may choose to increase their consumption. Conversely, when equity prices fall, households may reduce consumption.

Asset prices can also have impact on aggregate demand via the value of collateral that allows borrowers to get more loans and/or to reduce the risk premia demanded by lenders/banks. 


Affects the supply of credit


For example, higher interest rates increase the risk of borrowers being unable to pay back their loans. Banks may cut back on the amount of funds they lend to households and firms. This may also reduce the consumption and investment by households and firms respectively. 


Leads to changes in aggregate demand and prices

Changes in consumption and investment will change the level of domestic demand for goods and services relative to domestic supply. When demand exceeds supply, upward price pressure is likely to occur. In addition, changes in aggregate demand may translate into tighter or looser conditions in labour and intermediate product markets. This in turn can affect price and wage-setting in the respective market. 


Empirical evidence on the monetary policy transmission in the euro area 


Understanding the transmission mechanism is crucial for monetary policy. It is, therefore, not surprising that a number of studies – produced by both academics and Eurosystem staff – have tried to shed more light on the complex interactions underlying it. While still subject to considerable uncertainty (among other things related to the use of largely pre-1999 data), the main results of the studies on this issue seem to confirm that a number of widely accepted and well-established facts are also valid for the euro area.


Empirical estimates of the effects of changes in the short-term interest rate on real activity and prices

Several econometric models of the euro area have been used to estimate the effects of changes in the short-term interest rate on output and prices. As an illustration, the table below shows the results of the effects of changes in short-term interest rates based on three different models of the euro area, which reflect different economic structures and/or econometric methodologies. The table shows the responses of the levels of GDP and prices to a transitory 1 percentage point increase in the policy interest rate controlled by the central bank, which is then maintained at the higher level for two years. The main features of the responses of GDP and prices are qualitatively consistent across all three models. An increase in short-term interest rates results in a temporary decrease in output, which peaks about two years after the initial monetary policy impulse and reverts back to the baseline level thereafter. At the same time, prices adjust gradually to a permanently lower level. Broadly similar patterns are seen in a larger class of empirical models than those reported in the table below and they are consistent with the results for other countries and with the most consensual theoretical models of the transmission mechanism.

In short, they show that monetary policy is neutral in the long run. Its effect on output is temporary while its effect on prices is permanent. However, the magnitude and the timing of these responses are quite different across models, reflecting the uncertainty about the precise features of the transmission mechanism. For instance, the peak output responses in the three models shown in the table below range between -0.38% and -0.71% and, two years after the initial interest rate shock, the price response lies in a range between -0.10% and -0.30%. Altogether, these estimates confirm the existence of long and uncertain lags in the mechanism by which monetary policy affects the price level.



Evidence on the channels of monetary policy transmission in the euro area


Regarding the responses of individual components of GDP to interest rate changes, some studies stress the importance of the impact of monetary policy on investment compared with its impact on consumption and other components of aggregate demand. Business investment is mainly influenced by changes in the user cost of capital (a variable that is closely linked to interest rates). It is also sensitive, albeit to a more limited extent, to liquidity or cash-flow constraints (i.e. the ability of firms to issue debt on financial markets or to borrow from banks). Available empirical studies also suggest that exchange rate effects can be quite important in the euro area. Hence, the response of consumer prices to a change in the official central bank interest rates will also depend on the effects of this change on the exchange rate. For example, the larger the appreciation of the euro triggered by a change in interest rates, the faster and larger the decline in inflation will be. However, the central bank can take for granted neither the size nor the direction of the exchange rate response to the interest rate because this response depends on other factors, e.g. foreign monetary policy developments, that are not controlled by the central bank.


 "The European Central Bank." . . The European Central Bank. 1.31.08