Question

Discuss the channels of Monetary Policy transmission.

Answer 1

In a financial system monetary policy measures are transmitted into the real economy through several channels. There are four basic channels of monetary policy transmission

1 interest rate channel

​​​​​​The interest rate channel is based on the assumption that the increase in the supply of money by the expensive monetary policy which cause real interest rate on the money market to fall. This development creates condition for changes and medium term interest rate on loans which an effect on the level of investment as well as aggregate expenditure in the economy

Transmission mechanism interest rate channel it is important to differentiate between real and nominal interest rates new loans are affected by marginal costs which determine the ratio of savings to consumption the marginal cost of new loans unchanged by nominal rise in interest rates.The improved cash flows of these entities as a potential impact on the level of aggregate demand.

The volume of aggregate expenditure on GDP is affected by the real interest rates, can be used to formulate monetary policy aimed at the support of economic activity

countries with high inflation rates do not function interest rate channels of this type

2 The exchange rate channels

The foreign trade continuing internationalisation increased attention is being paid to effect of monetary impulses on net export vis exchange rate the channel presence a mutual relationship between exchange rates and interest rates since a fall in domestic interest rates lead to an outflow of foreign capital and depreciation in the exchange rate.Economies with the high level of external debate perceive any appreciation in the exchange rate of the local currency as an improvement in the balance sheets of companies which may increase the level of domestic demand. Price and balance sheet may affect each other. Depreciation in the exchange rate by relaxation of monetary policy, rise in the price of imported goods and an increase in the price of domestic products without increasing the level of aggregate demand

3 channel determining the price of asset in the economy

Interest interest rate fluctuation induced by monetary policy, affects the level of other asset as well in the economy. We said that expansive monetary policy increases the price of share and investment expenditure. However, there is an alternative channel available for the transmission mechanism where price fluctuations affects the level of wealth and consumption, and not that of investment. Main component financial wealth is bound up in shares. If if then the level of share prices begins to rise the level of financial wealth will also increase together with the financial resources of consumer and the level of consumption.

4 The credit channel

In the formation of monetary policy the volume of credits plays significant role, due to its close relation tour create expenditure. In the case of monetary policy tightening banks reacts not only by increasing their lending rates but by reducing the total volume of new loans as well. This situation will effect Mili small businesses those who have not the other source of finance.

Monetary policy main effect the balance sheets of companies in a variety of ways. Expansive monetary policy let's to a rise share prices which increases the net wealth of companies as well as investment expenditure and aggregate demand because in reduces the moral hazard problems at the same time expansive monetary policy leads to a rise in share prices which increases the net wealth of companies as well as investment expenditure and aggregate demand because it reduces the moral hazard problem. At the same time expansive monetary policy may lead to to fall in interest rate levels which increases the cash flow companies and reduces the moral hazard problems.