Monetary Policy

The transmission mechanism of monetary policy

The transmission mechanism is the process through which monetary policy decisions affect the economy in general, and the price level in particular. 

In theory, given its monopoly power to issue money, a central bank can fully determine the interest rate at which it provides funds to the banking system. This, in turn, influences bank lending and deposit rates, as well as other variables, such as exchange rates and asset prices. Monetary policy decisions also affect expectations about inflation in the future. Interest rates, asset prices, the exchange rate and expectations all have a bearing on saving and investment decisions, on the supply of credit, and on aggregate demand. In turn, when aggregate demand exceeds aggregate supply, this generates upward pressure on prices and vice-versa.

In practice, the transmission mechanism is a complex web of economic interactions. Consequently, it is difficult to quantify the precise effects of monetary policy decisions on the economy and the price level. 

Given the lags in the transmission process, monetary policy changes made today will only affect the price level after months, or even years. This means that monetary policy must be forward-looking. Central banks need to determine what policy stance is needed at present to maintain price stability in the future. 

Furthermore, given the complexity of the transmission process, there is always a large element of uncertainty surrounding the timing and size of adjustment triggered by changes in the monetary policy stance. In this regard, a medium-term orientation to monetary policy is desirable to avoid excessive and unnecessary volatility in the real economy.