Ecs 3701 Chapter 25 N 26

THE TRANSMISSION MECHANISM OF MONETARY POLICY

Kock and Brink (2011) defined monetary policy transmission mechanism as the different ways in which the economy is affected by monetary policy. The channels through which changes in monetary policy instruments can generate the desired policy are called the transmission mechanism. It also describes how policy-induced changes in the nominal money stock or the short-term nominal interest rate impact on real variables such as aggregate output and employment.

According to Mishkin (1995) highlighted that the broad categories or main channels of monetary policy transmission mechanism are: the traditional interest rate channel, other asset price channels (exchange rate channel) and the credit channels (balance sheet channel and bank lending channel).

Source: Mishkin (1995)

THE INTEREST RATE CHANNEL

The Keynesian traditional interest rate channel shows that a policy-induced increase in the short-term nominal interest rate leads to an increase in longer-term nominal interest rates. This is so because investors act to arbitrage away differences in risk-adjusted expected returns on debt instruments of various maturities as described by the expectations hypothesis of the term structure (Ireland, 2005). This also influences the relative price of domestic goods in comparison with foreign goods, particularly in terms of long-term interest rates and the exchange rate. As a result, changes in short-term interest rates are transmitted to the real cost of capital. The optimal capital output ratio is changed in the process, and the required return from investment projects, as well as the rate of business investment. When this happens, firms finding that their real cost of borrowing over all horizons has increased, react by cutting back on their investment expenditures. Similarly, households react by reducing their purchases of homes, automobiles, and other durable goods. Thus, the traditional interest rate channels can be summarized...