Transmission mechanism of monetary policy


Following is the transmission mechanism by which monetary policy influence the economy. The central bank is responsible for providing the funds to different banking systems of the country and in return they charge interest. Central bank is solely in charge for determining the interest rates because it has monopolistic power on the issuance of money.

Influences on the rate of interest of money market and banks:

When the changes occur in the official rate of interest, it directly affects the interest rate of the money market. It also indirectly affects the deposit and lending rates that a bank sets for its respective customers.

Expectations are affected:

When changes happen in the future of different official rate of interest, it ultimately affects the medium term and long term rate of interest. This is because long term rates of interest greatly depend on the expectations of the market which is about short term rates of future courses. Monetary policy no doubt can guide the expectations of the financial agents about future inflation rates which in turn affects the prices. Central bank has sound credibility so it caters the expectations related to price consistency. When this is the case, the economic agents are not forced to boost up the prices cause of the fear of price hike or they neither have to decrease the prices with fright of deflation.

Prices of the assets are affected:

The actions resultant from the monetary policies may guide a way to the settlement of prices of the assets for example rate of exchange and prices of stock market. The modifications in the rate of exchange can directly affect the inflation because all the imported products are used by the consumption. But this is a fact that they also function through some other channels too to influence the inflation rate.

Investment and saving verdicts have influences:

The decisions of different firms and households regarding saving and other investment policies are affected by the changes in the rate of interest. When the rate of interest is higher then the attraction to take loans for investment purpose or financial consumption decreases vehemently. The prices of the assets can also influence the demand through the collateral value which permits the borrowers to take out more and more loans.

Credit supply is affected:

When the interest rate is high increases the possibility that the borrowers won’t be able to pay the loans back. When the risk factor increases, the banks start cutting back the loans to the firms and small households which in turn reduces the level of investment and consumption ratio by the firms and household.

Modification in collective prices and demand level:

The demand levels related to the domestic services and goods are affected by the modification in the investments and consumption levels. The upward pressure on the price is very much expected to happen when demands gets higher than the supply. When the changes happen in the aggregate demand levels, then it may lead to some lenient or tighter conditions of market products and labor. This ultimately affects the wages and prices in the concerned market.


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