THE TRANSMISSION

MECHANISM OF MONETARY
POLICY
 Introduction
• The Monetary Policy Committee (MPC) sets the
short-term interest rate at which the Central
Bank deals with the money markets.

• Decisions about that official interest rate affect

economic activity and inflation through several
channels, which are known collectively as the
‘transmission mechanism’ of monetary policy.
The key links in that mechanism are
illustrated in the figure below.
 I-Links In The Chain
• Monetary policy works largely via its influence
on aggregate demand in the economy.
• It has little direct effect on the trend path of
supply capacity.
 SR vs. LR
• In the long run the nominal or money values of
goods and services—that is, the general price level.
• Alternatively, monetary policy in essence
determines the value of money—movements in the
general price level indicate how much the
purchasing power of money has changed over time.
• Inflation, in this sense, is a monetary phenomenon.
• However, monetary policy changes do have an
effect on real activity in the short to medium
term.
 A. From A Change In The Official
Rate To Other Financial And
Asset Markets
• Central Bank is the Monopoly supplier of
wholesale money (also called Base Money) and
thus determines a specific interest rate.
 ST Interest Rates
• A change in the official rate by CB is
immediately transmitted to the other short-term
rates.
• Soon after the official rate changes (typically the
same day), banks adjust their standard lending
rates (base rates), usually by the exact amount of
the policy change.
 LT Interest rates
• Though a change in the official rate unambiguously
moves other short-term rates in the same direction
(even if some are slow to adjust), the impact on
longer-term interest rates an go either way.
• As long-term interest rates are influenced by an
average of current and expected future short-term
rates
• For instance, a rise in the official rate could, for
example, generate an expectation of lower future
interest rates, in which case long rates might fall in
response to an official rate rise.
 Asset Prices
• Changes in the official rate also affect the market
value of securities, such as bonds and equities.
• The price of bonds is inversely related to the long-
term interest rate, so a rise in long-term interest
rates lowers bond prices, and vice versa for a fall in
long rates.
• Other things equal (especially inflation
expectations), higher interest rates also lower other
securities prices, such as equities.”
 The Exchange Rate
• Policy-induced changes in interest rates can also affect the
exchange rate.
• Other things being equal, an unexpected rise in the
official rate will probably lead to an immediate
appreciation of the domestic currency in foreign
exchange markets, and vice versa for a similar rate fall.
• The exchange rate appreciation follows from the fact that
higher domestic interest rates, relative to interest rates on
equivalent foreign-currency assets, make domestic assets
more attractive to international investors.
 Expectations And Confidence
• Official rate changes can influence expectations about the future
course of real activity in the economy, and the confidence with which
those expectations are held.
• Such changes in perception will affect participants in financial markets
for example, changes in expected future labour income,
unemployment, sales and profits.
• The direction in which such effects work is hard to predict though.
• For instance a rise n the official rate may be interpreted as
a. The CB believes economy is growing faster than before and therefore
this perception may boost confidence and future growth eventually
b. An attempt by CB to slow down growth to hit a lower inflation target
so lower inflation is expected in the future.
 B. From Financial Markets To
Spending Behavior
• How the spending decisions of individuals and
firms respond to the changes in interest rates,
asset prices and the exchange rate
• The immediate effects of a monetary policy
change.
Assumption: unchanged fiscal policy stance by
the government in response to the change in
monetary policy.
 Individuals
1. Consumption: Face new rates of interest on their savings and debts-
disposable incomes of savers and borrowers alter, as does the
incentive to save rather than consume now.
2. Assets: The value of individuals’ financial wealth changes as a result
of changes in asset prices eg price of housing
3. Exchange rates: Any exchange rate adjustment changes the relative
prices of goods and services priced in domestic and foreign
currency-a shift of spending away from home-produced towards
foreign-produced goods and services
4. Expectations and Confidence: Such effects vary with the
circumstances of the time, but where a policy change is expected to
stimulate economic activity, this is likely to increase confidence and
expectations of future employment and earnings growth, leading to
higher spending. The reverse will follow a policy change expected to
slow the growth of activity.
 Firms
• Firms combine capital, labour and purchased
inputs in some production process in order to
make and sell goods or services for profit.
• Firms are affected by the changes in market
interest rates, asset prices and the exchange rate
that may follow a monetary policy change.
• The importance of the impact will vary
depending on the nature of the business, the
size of the firm and its sources of finance.
 Firms (Contd.)
1. Savings & Debt: An increase in the official interest rate will have a direct
effect on all firms that rely on bank borrowing or on loans of any kind
2. Cash-rich firms will receive a higher income from funds deposited with
banks or placed in the money markets, thus improving their cash flow.
3. Asset Prices: fall in asset prices can make it harder for them to borrow,
since low asset prices reduce the net worth of the firm. This is sometimes
called a ‘financial accelerator’ effect.
4. Exchange Rate: An appreciation of sterling in the foreign exchange
market would then worsen the competitive position of domestic firm for
some time, generating lower profit margins or lower sales, or both.
5. Expectations and Confidence: A fall (rise) in the expected future path of
demand will tend to lead to a fall (rise) in spending on capital projects.
6. Bank loans to firms (especially small firms) are often secured on assets-fall
in asset prices can make it harder for them to borrow-‘financial
accelerator’ effect
II-The impact of a policy change on
GDP and inflation: orders of
magnitude
• Positive output gap:
– high level of aggregate demand takes actual output to a level above its
sustainable level,
– firms work above their normal-capacity levels.
– unit costs will rise, as firms are work above their most efficient output
level.
– firms may also feel the need to attract more employees
• This extra demand for labour and improved employment prospects
will be associated with upward pressure on money wage growth and
price inflation.
• So booms in the economy that take the level of output significantly
above its potential level are usually followed by a pick-up of inflation,
and recessions that take the level of output below its potential are
generally associated with a reduction in inflationary pressure.
 Time Lags
• Any change in the official rate takes time to have its full impact on the
economy.
• It may be several months before higher official rates affect the retail
interest rates.
• It may be even longer before changes in their mortgage payments (or
income from savings) lead to changes in their spending in the shops.
• Changes in consumer spending (not fully anticipated by firms) affect
retailers’ inventories, and this then leads to changes in orders from
distributors. Changes in distributors’ orders then affect producers’
inventories, and when these become unusually large or small,
production changes follow, which in turn lead to employment and
earnings changes. These then feed into further consumer spending
changes. All this takes time.
Chart 1: Effect on real GDP, relative to base, of 100
basis point increase in the official rate maintained for
one year
Chart 2: Effect on inflation rate, relative to base, of
100 basis point increase in the official rate
maintained for one year
 IS/PC/MR Model
• Derivation of the Taylor’s rule
– Optimal interest rate
• An interest rate that minimizes the loss function
subject to the Phillips curve.
 IS/PC/MR Model
• We develop a graphical 3-equation New
Keynesian model for macroeconomic analysis to
replace the traditional IS-LM-AS model.
• The new graphical IS-PC-MR model is a simple
version of the one commonly used in central
banks and captures the forward-looking thinking
engaged in by the policy maker.
 Policy Maker Preferences
SRPC
Inflation D

LRPC
B

A
MR
Output
 The IS/ PC/ MR Model:

• Loss Function:
L=(Yt+1-Y*)2+ (t+1-T)2
–  determines if CB is inflation averse(>1) or not.
• Philips Curve (PC) equation
t+1=t +(Yt+1-Y*)
• IS equation
Yt+1=A-rt
 Policy Maker Preferences
SRPC
Inflation λ=1 D
λ>0

LRPC
B λ=1

A
MR
Output
 Derivation
• Putting PC in L
L=(Yt+1+Y*)2+ (t+1-T)2
L=(Yt+1+Y*)2+(t +(Yt+1-Y*)-T)2
• Differentiating w.r.t output

L/Yt+1= 2(Yt+1-Y*)+ 2(t +(Yt+1-Y*)-T)

Yt+1-Y* +(t+( Yt+1-Y*) -T=0
 MR-AD Equation
Yt+1-Y*= -(t+1-T) -----------(a)

• This is the MR-AD equation. It shows the

equilibrium relationship between inflation and
output.
• IS equation:
Yt+1=A-rt -------------------- (i)
• At stabilizing interest rate rs , Yt=Y*
Y*=A-rs ---------------------- (ii)
• Subtracting eq (ii) from eq (i)
(Yt-1-Y*)= - (rt-rs) ----------------------- (b)
 Derivation
• Rewriting (a)
(Yt+1-Y*)= -(t+ (Yt+1-Y*)-T)
(Yt+1-Y*) + 2(Yt+1-Y*) = -(t-T)
(Yt+1-Y*)=(-/1+2) (t-T) -----------------(c)
• Equating (b) and (c)

- (rt-rs)= (-/1+2) (t-T)

rt= rs+(/ (1+2)) (t-T)
if ===1
rt= rs+0.5(t-T)