The Transmission Mechanism Of Monetary Policy
The interest rate channel
In economic literature, for more than 50 years the transmission of monetary policy via interest rate mechanisms have been a normal characteristic. In the fundamental Keynesian textbook model, it is the main financial transmission process, which was a cornerstone of macroeconomics education. A schematically diagram can characterize the traditional Keynesian perspective of how the currency distortion is passed on to the true economy,
M↑ ⇒ ir↓ ⇒ I↑ ⇒ Y↑,
Where M ARE is an expansionary currency policy, leading to a reduction of the actual interest rate (i), which reduces capital costs. This creates an increased investment and sustainable consumption expenditure I as a result of which aggregate demand is increasing and as a result production Y as a result. While Keynes initially stressed that the channel was operated through investments choices made by companies, later study acknowledged that consumer choices about housing and sustainable consumers ' expenditure are also choices about investment. The interest rate channel for the currency transfer described in the above schema, therefore, covers consumer expenditure equally with residential accommodation and long term expenditure for the customer. In this Symposium John Taylor's paper claims that the currency transmission interest rate channel is the main element of how financial policies are passed on to the economy. The short-term nominal interest rate is raised in its model by contractionary monetary policy. Then the true long-term interest rate increases, at least for some moment, with a mixture of sticky rates and rational expectations. These higher real interest rates lead to a decrease in fixed company investments and housing. The decrease in aggregate production generates investment, consumer sustainable spending, and stock investments. Taylor takes the view that consumer and investment expenditure is strongly affected by an interest rate channel and therefore a significant channel of currency transmission. He's a contentious stance, as Ben Bernanke and Mark Gertler can see in this article at this symposium. They show that the quantitative impacts of interest rates on costs of capital are very difficult to identify in empirical research. (Frederic, 1995).
2. The exchange rate channel
The exchange rate is measuring a country`s currency value against other country`s value. In the same way, the exchange rate is a monetary policy by the central bank to have control over the money market and the prices. The exchange rate plays an important role in the determination of interest rates in the short –term and long term. Governmental intervention in controlling the prices and having a fixed exchange rate helps in better indication for the inflation. When the government is having the fixed exchange rate, so the output level will increase. Resulting from an increase in consumption, investment, net exports, and less government spending. Exchange rate directly affects the consumption according to Engel (1998) for example, if the country`s currency having a strong economic position. Therefore the value of other currencies will be relatively low.
M↓ ⇒ ir↑ ⇒ E↑⇒ NX↓ ⇒ Y↑,
This means that the purchasing power or the market basket of an individual will not cost that much. The more the prices are getting controlled is the more the consumption. Investment as well, from investors perspective they paying a low amount of money while they are importing goods and paying by the domestic currency, positively affecting the net exports. The production wheel is stirred so fast; increasing the production and the number of units of goods and services produced increased. The central bank is trying to survive stability as mentioned above that when the central bank controls the exchange rate, therefor the consumption, investment, and imports increased. Causing the demand for money to increase, affecting the interest rates and may lead to higher rates of inflation. Or the central bank is obliged to supply more money. However, this driving the country towards the instability of the economy, and the currency may be under-risk of being devalued against other currencies. Moreover, the central bank should trade in foreign stocks markets to keeps its value in line with pegged nation`s currency. (Frederic, 2001).
3. Credit channel
As a result of agency problems, the bank depends on two transmission mechanism: the bank lending channel and the balance-sheets channel. Because the lending channel is particularly suited to dealing with certain kinds of borrowers, tiny companies where asymmetric information issues can be particularly prominent, banks have a unique role to play in the financial system. After all, big companies can directly access credit markets without passing through the banks via stock and bond markets. This would have an impact on these borrowers as a result of the contractionary monetary policy which reduces bank reserves and deposits. The monetary policy impact is schematically,
M↓ ⇒ bank deposits ↓ ⇒ bank loans ↓⇒ I↓ ⇒ Y↓,
The significance of the bank lending channel has been raised in the literature, such as banks ' position in credit markets now less significant than in the 1950s, 1960s, or 1970s since financial innovation of the last couple of centuries (Edwards and Mishkin in 1995). The symposium documents of Meltzer and Bernanke and Gertler highlight this critique and others. The balance channel works through the net worth of enterprises and there is no reason to believe that it has gone down in the last years, as emphasized by Bernanke and Gertler. Lower net value implies that lenders have less collateral on their lending, thus greater losses resulting from negative selection. A net decrease that increases the adverse selection problem, therefore, leads to lower lending for investment expenditure finance. Lower corporate net worth will also increase the moral hazard issue since owners have reduced equity participation in their enterprises and are more encouraged to participate in risky investment projects. Since it is more likely that loans will not be reimbursed for more risky investment projects, a decline of corporate net worth leads to a reduction in lending and therefore investment costs. A further justification of asset pricing impacts highlighted in monetarist thinking is the balance sheet channel. (Charles, 2003).
Another cause of a deterioration in the balance sheet of an enterprise's financial policies, as they lower interest rates is the reduction in cash flows. This leads to the following scheme for the balancing channel:
M↓⇒ I↑ ⇒ cash flow adverse selection ↑ & moral hazard ↑⇒ lending ↓⇒ I↓ ⇒ Y↓.
