In this video we’ll look at the transmission mechanism of monetary policy and see how it
impacts an economy.
The monetary transmission mechanism is the process by which a change in the rate set
by the central bank ultimately leads to changes in aggregate demand, real GDP and the price
level.
The central bank sets an official rate at which commercial banks can borrow from it
and it also influences the overnight lending rate between banks.
If the official rate changes, it may eventually have an impact on real GDP, employment and
inflation.
The official rate works through a series of channels by which it will eventually influence
the price level and real GDP.
We’ll examine at the relationship between the official rate set by the central bank
and market rates, wealth, expectations and the exchange rate.
You should be aware that the official rate is the rate at which commercial banks borrow
directly from the central bank.
If the cost of borrowing from the central bank rises or falls, this will have an impact
on the variables you see here.
Let’s consider each in turn.
We’ll start with market rates.
Market rates are the rates charged by commercial banks to borrowers for a variety of loans,
including personal, business, auto and home loans.
These rates tend to move in the same direction as the official rate.
There is a spread between market rates and the official rate as this is how banks make
their money.
If they are borrowing from the central bank or from other commercial banks, they will
need to pay interest.
Therefore, they make loans out at rates above the rate at which they’ve borrowed funds.
If the central bank increases the official rate, this will likely lead to an increase
in the interest rate charged to borrowers.
This will cause borrowing to decrease as it is now more expensive to borrow and savings
to increase as it is more rewarding to save.
Conversely if lending rates decrease, then borrowing is likely to increase and saving
is likely to decrease.
This will lead to either an increase in consumption and investment or a decrease, which will have
an impact on aggregate demand, real GDP and the price level.
If borrowing increases, aggregate demand and real GDP are likely to rise.
This may have an impact on the price level, but the ultimate change will depend upon the
level of spare capacity of the economy.
The definition of wealth includes all of one’s assets minus all of one’s liabilities.
The two assets we will focus on for the transmission mechanism will include real estate and stocks.
A change in market rates will impact real estate and stock prices.
Higher interest rates increase the cost of borrowing and reduce the demand for house
purchases, and vice versa.
As demand for real estate drops, housing prices will fall and vice versa.
As the value of their assets fall, individuals are less likely to spend, thus reducing aggregate
demand.
Similarly, if market rates drop then demand for real estate will rise, increasing real
estate prices and resulting in an increase in wealth.
This is likely to encourage spending and increase aggregate demand.
Stocks, or shares, are impacted by changes in interest rates as well.
Lower market rates cause investors to seek better returns from other financial assets
such as stocks.
As demand for stocks increases, so does their price.
In general, higher stock prices leave investors feeling wealthier and thus likely to spend
more.
This will likely increase aggregate demand.
Expectations are also influenced by central bank decisions.
If the central bank is reducing interest rates, it is pushing for economic growth and an increase
in real GDP.
This will shape the behaviour of firms and individuals.
However, if the central bank is increasing interest rates, it is likely perceiving inflation
as a threat.
This will also shape the behaviour of firms and individuals as they respond to the actions
of the central bank.
There is also an impact on the exchange rate when interest rates change.
A change in the interest rate paid on deposits will either result in capital inflows or capital
outflows.
If demand increases for the currency, it will likely appreciate.
Similarly, if demand decreases for the currency, it will likely depreciate.
The change in the value of the currency will impact exports and imports, or the net export
component of aggregate demand.
As net exports rise or fall, all else equal, aggregate demand will move in the same direction.
If the currency appreciates or depreciates, this will impact imported resource costs.
If the currency depreciates, imported resources will become more expensive.
However, if the currency appreciates, imported resources will become cheaper.
The impact of this change will affect aggregate supply as the cost of production for firms
will change.
The impact from each of these channels will eventually have a combined effect on real
GDP, aggregate demand, employment and thus the price level.
You should be comfortable explaining how the official rate will impact each of these channels.
Additionally, you should be able to connect changes in the official rate to their intended
impact on real GDP, aggregate demand, employment and inflation.
Another important factor to remember is that there is a time lag of monetary policy of
approximately 12 to 24 months as it takes time for the policy changes to impact the
various channels and thus the economy.
If you are evaluating monetary policy, you should introduce the time lag but be specific
and include details about the transmission mechanism to supplement your discussion.
By now you should be able to explain how the transmission mechanism of monetary policy
works.
If you have any questions, leave them below and let’s try to answer them together.
That’s us done for now and I will see you in the next one!