Monetary Policy Transmission Mechanisms

Monetary economics centers its interest on the prices behavior, interest rates, monetary aggregates and output. After long discussions it has been agreed that economic performance can be influenced by monetary policy changes. Nowadays, “most economists would agree, at least in the short-run, monetary policy can significantly influence the course of real economy” .

Therefore, the debate has changed its point of view, trying to answer the question of what is the mechanism which makes these effects take place and its effectiveness.

Introduction

Fiscal and monetary policies are among the most important economic tools in a way to stabilize the aggregate output.

Monetary policy is often considered more powerful since changes in fiscal policies may have delays or time bottlenecks in its implementation (e. g. variations in taxes or public budget).

As Mishkin says “Fiscal policy has lost its luster since its heyday in the 1960s” but he also states that “monetary policy is a powerful tool, but one that sometimes has unexpected or unwanted consequences” .

Or as Bernanke and Gertler state “empirical analysis of the effects of monetary policy has treated the monetary transmission mechanism itself as a ? black box? ” . Thus, it is important to understand the mechanism which generates the changes, which is known as the Monetary Transmission Mechanism (MTM).

The Monetary Transmission Mechanism providing a clear and short definition of what is the MTM, Ireland affirms that “The monetary transmission mechanism 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”.

In a plain way to set up a definition, the MTM is the channel through which changes in monetary policy are translated into real effects. Several discussions have taken place on how the different types of MTMs affect the real variables.

Under a general view, the most important models are based on the following scheme: through open market operations, the changes in reserves performed lead to changes in Fed funds rate and monetary base, thus affecting market interest rates and, therefore asset prices levels, real rates and exchange rates; as a result the aggregate demand is affected. Hence, the transmission channels generally analyzed are the interest rate channel, the exchange rate channel, the credit channel and other assets prices channel. These are the main links into the MTM which will be analyzed in the next section.