Analysis and News

Transmission Mechanisms of Monetary Policy

BY ARMCORE VPI's Analyst: Chaitram Mohamed

Price stability is the predominant objective of most central banks around the world. However, other important objectives include low unemployment and a sustained level of growth in the economy. To achieve their goals, central banks employ monetary policy tools such as interest rates, quantitative easing/tightening and reserve requirements.

A contractionary monetary policy is used by central banks to decrease the level of money supply in the economy. It is used to control high levels of inflation.

Monetary transmission mechanism is a process in which policy-induced changes in the short-term nominal interest rate impact real variables such as aggregate output and employment,  (Ireland,  2005). According to Mishkin (1995), there are four main channels of monetary transmission mechanism.

The Interest Rate Channel

This channel is the key monetary transmission mechanism in the basic Keynesian IS-LM textbook model. Though Keynes recognised that the channel operates through business decisions about investment spending, later research found that consumer decisions about housing and other durable consumer goods are also important investment decisions. According to the model, a contractionary monetary policy that causes an increase in real interest rates will raise the cost of capital. This leads to a decline in investment spending and a decrease in aggregate demand and output.

The Exchange Rate Channel

The monetary transmission operating through exchange rate effects on net exports has been a concern for central banks of export-oriented economies. The exchange rate channel is as follows: M↓→ i↑→ E↓→ NX↓→ Y↓. With contractionary monetary policy, the rise in domestic real interest rates translates into an appreciation of the domestic currency, as domestic currency deposits become more attractive relative to foreign currency deposits. As such, the higher value of the domestic currency results in domestic goods becoming relatively expensive than foreign goods, resulting in a decline in net exports and thereby a reduction in aggregate output. The effectiveness of the exchange rate channel depends on the exchange rate regime, the extent of exchange rate pass-through and the degree of openness to capital flows, (Mishra, 2012).

Other Asset Price Effects

There are two basic channels involving asset prices: Tobin’s (1969) q theory of investment and Ando and Modigliani’s (1963) life-cycle theory of consumption.

Monetary policy can affect the economy through its effects on the valuation of equities. Tobin’s q is defined as the market value of firms divided by the replacement cost of capital. If q is greater than 1, new plant and equipment are cheap relative to the market value of business firms. Corporations can then issue equities and get a higher price for them relative to the cost of the plant and equipment they are investing in. As a result, investment spending will rise. On the other hand, investment spending will be low when q is low. With contractionary monetary policy in place, higher interest rates make bonds more attractive relative to equities, thereby causing the price of equities to fall. Lower equity prices causes q to be low and thus leads to a reduction in investment spending.

Ando and Modigliani’s life-cycle model assumes that consumption spending is determined by the lifetime resources of consumers. A contractionary monetary policy causes stock prices to reduce, resulting in a decrease in the value of financial wealth. This decreases the lifetime resources of consumers, leading to a fall in consumption, output and employment. The monetary transmission mechanism for this effect is as follows: M↓→ Ps↓→ Wealth↓→ C↓→ Y↓

Credit Channel

The bank lending channel arises since banks are producers of information and they can solve asymmetric information issues in credit markets. The implementation of a contractionary monetary policy decreases excess reserves, forcing banks to reduce their deposits. This decreases the bank loans available to bank-dependent firms, resulting in a decrease in investment spending. The monetary policy effect through the bank lending channel is as follows: M↓→ bank deposits↓→ bank loans ↓→ I↓→ Y↓.

Recent Research

Ramlogan (2004) assessed the monetary transmission mechanism of Jamaica, Trinidad and Tobago, Barbados and Guyana using a vector auto-regression model for the period 1970Q1: 2000Q2. The recursive VAR model estimated the responses of reserves, bank deposits, bank loans, effective exchange rates, consumer price index and output to the monetary policy variable- the reserve requirement. The findings revealed that the credit and exchange rate channels are more important than the money channel in transmitting impulses from the financial sector to the real sector. This was expected since the money market is underdeveloped in most Caribbean countries. Nevertheless, the results can assist policymakers in their design and implementation of monetary policy to achieve positive economic growth.

The bank lending channel is the dominant channel of monetary transmission mechanism in low-income countries, (Mishra, 2012). Low-income countries are characterised by the absence of well-functioning markets for fixed-income securities, imperfect links with private international capital markets and heavy central bank intervention in foreign exchange markets. This leaves little or no scope for the functioning of interest rate channel, exchange rate channel and the asset channel. Since these other channels are weak coupled with the fact that banks are the most dominant financial intermediaries in low-income countries, the bank lending channel is the most important channel of monetary policy transmission.


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