The transmission mechanism
The process by which monetary policy decisions affect the economy in general and prices, in particular, is called the monetary policy transmission mechanism.
It is a long chain of causes and effects that link monetary policy decisions to price levels.
The important role of the central bank comes from its character as sole issuer of notes and sole provider of bank reserves. The mechanism commences with liquidity distribution and control of short-term interest rates by the central bank.
The chain continues, schematically, along the following lines:
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Variation of the official interest rates.
The ECB Governing Council varies the official rates of interest, specifically the rates corresponding to the major financial operations and to standing facilities. -
This affects bank and market interest rates.
Given that the banking system demands money issued by the central bank to satisfy the demand for money in circulation, netting for interbank balances and meeting the requirements of the minimum reserves to be deposited with the central bank, the initial decision taken concerning the official interest rates affects the bank interest rates.It has an indirect effect on the market rates, as the banking system passes on variations to its clients, modifying both the remuneration on deposits and the costs of loans.
It affects forecasts.
Variation of the official rates also affects forecasts, both as regards the monetary policy's future evolution, which affects the long-term interest rates, and in terms of inflation.It affects the price of financial assets.
Variations in monetary policy or of the expectations regarding future changes in monetary policy affect the prices and returns on financial assets (such as shares, public debt, private debt, etc.).This asset price variation affects, in turn, decisions concerning savings, expenditure and investment in homes and companies and, in the final instance, the demand for goods and services in the economy.
- It conditions the economic agents' decisions on savings and investment.
Changes in interest rates condition consumer and companies' decisions on savings and investments; thus, low interest rates favour both consumption, given the lower expectations for yield on savings, and investment, given that the investment returns can easily be greater than the effective costs of the investment made. - It affects the loan offers.
Loan costs and availability are important factors that determine company investment and decisions regarding consumer expenditure in the home and, therefore, the general situation of demand. Consequently, variation in the availability and costs of loans, resulting from changes in monetary policy, can constitute an important transmission channel. It affects our currency exchange rate.
Variation of the interest rate can affect the exchange rate through the international capital flows, in such a way as to appreciate or depreciate the currency value.The impact depends on the degree of aperture of the economy to international trade, as the exchange rate affects both the prices of imported goods and the competitiveness of domestic goods prices, which can affect end product prices and foreign demand.
In view of the above, it is clear that monetary policy can take some time to affect prices. Furthermore, the magnitude and intensity of the different effects may vary, depending on the state of the economy, thus making it difficult to give a precise estimate of the impact.
The monetary policy transmission mechanism is also affected by different types of disruptions, such as variations in oil prices or other raw materials, which have a short-term effect on inflation; the performance of world economy or tax policy can also affect prices.
Consequently, as central banks must deal with a complex web of economic interactions, they usually use a set of rules to compare the measures taken.
One of these standards is based on the fact that inflation, in the medium and long term, is always a monetary in origin. This means that excessive monetary growth generates inflation, because it produces increased demand on goods, which increases their price and directly affects future expectations concerning prices. Similarly, insufficient monetary growth can generate deflation. Furthermore, monetary growth can reflect the pressures of demand on the economy.
Therefore, monitoring monetary aggregates provides useful information for monetary policy, following its performance to assess whether or not inflationary trends exist.