Monetary transmission mechanism

The monetary transmission mechanism is the process by which asset prices and general economic conditions are affected as a result of monetary policy decisions. Such decisions are intended to influence the aggregate demand, interest rates, and amounts of money and credit to affect overall economic performance. The traditional monetary transmission mechanism occurs through interest rate channels, which affect interest rates, costs of borrowing, levels of physical investment, and aggregate demand. Additionally, frictions in the credit markets, known as the credit view, can affect aggregate demand. In short, the monetary transmission mechanism can be defined as the link between monetary policy and aggregate demand.

Traditional interest rate channels

An interest rate channel may be categorized as traditional, which means monetary policy affects real (rather than nominal) interest rates, which influence investment, spending on new housing, consumer spending, and aggregate demand. An easing of monetary policy in the traditional view leads to a decrease in real interest rates, which lowers the cost of borrowing, resulting in greater investment spending, involving an overall increase in aggregate demand.^[1]

Credit view

In addition to the traditional interest rate channel, which focuses on the effects of interest rate changes, there are other methods through which monetary policy can influence economic outcomes and aggregate demand. These alternative channels are classified under the credit view,^[2] which argues that financial frictions in the credit markets create additional channels that lead to changes in aggregate demand. These channels operate through effects on bank lending, as well as the effects on the balance sheet of a given firm or household.^[2]

Bank lending channel

Monetary policy affects bank deposits, leading to changes in the amount of bank loans and investment in residential housing.^[2]

Balance sheet channel

Monetary policy affects stock prices, leading to moral hazard and adverse selection, which leads to changes in lending activity and investment^[2]

Cash flow channel

Monetary policy leads to changes in nominal interest rates, which affects cash flow, leading to moral hazard, adverse selection, and changes in lending activity and investment^[2]

Unanticipated price level channel

Monetary policy can lead to unanticipated price level changes, resulting in moral hazard, adverse selection, and changes in lending activity and investment^[2]

Household liquidity effects

Monetary policy affects stock prices, leading to changes in financial wealth and the probability of financial distress, which affects residential housing and consumer spending^[3]

Other asset price effects

Finally, other asset price effects have separate channels allowing monetary policy to influence aggregate demand:

Exchange rate effects on net exports

Monetary policy affects real interest rates and the exchange rate, leading to changes in net exports^[4]

Tobin's q theory

Monetary policy affects stock prices, leading to changes in Tobin's q (the market value of firms divided by the replacement cost of capital) and investment^[2]

Wealth effects

Monetary policy affects stock prices, which affects financial wealth and consumption (consumer spending on nondurable goods and services)^[5]

Uncertainty channel

Stock prices respond more aggressively and asymmetrically to monetary policy under high uncertainty. The time-varying link between monetary policy and stock prices depends on uncertainty.^[6]

References

^ Ireland, P.N. (2008). "Monetary Transmission Mechanism". In Blume, Lawrence; Durlauf, Steven (eds.). The New Palgrave Dictionary of Economics. London: Palgrave Macmillan. pp. 1–7. doi:10.1057/978-1-349-95121-5_2339-1. ISBN 978-1-349-95121-5.
^ ^a ^b ^c ^d ^e ^f ^g Mishkin, Frederic (2012). The Economics of Money, Banking, and Financial Markets. Prentice Hall. ISBN 9781408200728.
^ Christiano, Lawrence J.; Eichenbaum, Martin (1992). "Liquidity Effects and the Monetary Transmission Mechanism". American Economic Review. 82 (2): 346–353. JSTOR 2117426.
^ Boivin, Jean; Kiley, Michael T.; Mishkin, Frederic S. (2010). "Chapter 8: How Has the Monetary Transmission Mechanism Evolved Over Time?". In Friedman, Benjamin M.; Woodford, Michael (eds.). Handbook of Monetary Economics. Vol. 3 (1 ed.). Elsevier. pp. 369–422. doi:10.1016/B978-0-444-53238-1.00008-9. ISBN 978-0-444-53470-5.
^ Kuttner, Kenneth N.; Mosser, Patricia C. (2002). "The monetary transmission mechanism: some answers and further questions". Economic Policy Review. 8. Federal Reserve Bank of New York: 15–26.
^ Benchimol, Jonathan; Saadon, Yossi; Segev, Nimrod (2023). "Stock market reactions to monetary policy surprises under uncertainty". International Review of Financial Analysis. 89: 102783. doi:10.1016/j.irfa.2023.102783.