What is monetary policy transmission mechanism?
The monetary policy transmission mechanism explains the steps involved before a change in monetary policy can have the desired effect. For example, if the government decides to reduce the inflation rate, it will increase the interest rate. However, there are a few variables that will be affected before the inflation rate is eventually reduced.
The monetary policy transmission mechanism shows the variables that will be affected before the impact of a monetary policy tool is felt in the economy. This is why it may take a few months before a policy produces results.
Figure 1: Monetary Policy Transmission Mechanism
The monetary policy transmission mechanism for a rise in interest rate
The monetary authority or central bank may increase the interest rate to curb inflation. The steps involved are explained below.
The bank rate
The bank rate is the rate of interest the central bank charges on loans given to other banks. The bank rate determines the interest rates commercial banks charge their customers- they will not want to charge below the rate they pay to the central bank, i.e. the bank rate.
Other banks’ interest rates
The decision to raise the bank rate will cause a rise in the interest rates demanded by commercial banks for granting credit or loans to their customers.
Effect of interest rate on exchange rate
A rise in the market interest rate encourages foreigners to save money in the country’s banks. The flow of hot money into the country increases the demand for the domestic currency, causing the appreciation of the exchange rate. When the currency appreciates or rises in value, exports become expensive while imports are cheaper. Therefore, exports fall and imports rise. Net exports will decrease, thereby reducing aggregate demand and the inflation rate..
Asset prices
A rise in interest rate leads to a fall in the prices of bonds and shares. When the central bank raises the interest rate, existing bonds become less attractive. A fall in the demand for the existing bonds causes a drop in their values or prices. Therefore, a rise in interest rate leads to a fall in bond prices.
A rise in interest rate makes stocks or shares less attractive than bonds, thereby forcing share prices to decrease.
Therefore, when the interest rate rises, bondholders or shareholders become poorer due to a decline in the prices of bonds and shares. Demand for goods falls, depressing prices and reducing the inflation rate.
Business investment
A rise in interest rate raises the cost of borrowing and reduces borrowing for investment. If investment drops, aggregate demand decreases because investment is one of the components of aggregate demand. A fall in aggregate would reduce demand-pull inflation.
Consumer spending
Consumer spending decreases following an increase in the interest rate. This is because the cost of borrowing by households rises. A decrease in consumption reduces aggregate demand and the inflation rate.
Expectations
The expectation of a fall in the inflation rate due to the policy of the central bank would cause a decrease in consumption and investment spending. Aggregate demand and inflation rate, as a result, fall.