Question

Question 6 (Note this question is from the Week 11 Tutorial) There are four (4) main transmission channels that can be used as monetary policy to target the official interest rate. Identify each of the four (4) transmission channels and explain, within the context of monetary policy, the impact each channel has on economic activity. (11 marks. Word limit Maximum 500 words)

Answer 1

Four main transmission channels that can be used as monetary policy to target the official interest rates are - Interest rate channel, exchange rate channel, asset price & wealth channel and Bank funding and lending (Credit) channel.

Interest rate channel: A policy-induced change in the policy interest rate(s) directly affects money-market interest rates and, indirectly, lending and deposit rates, which banks set for their customers. An increase in the short-term nominal interest rate can be expected to persist and should therefore – according to the expectations hypothesis of the term structure– lead to an increase in longer-term nominal interest rates. When nominal prices are slow to adjust, these movements in nominal interest rates also translate into movements in real interest rates. Firms, finding that their real cost of borrowing over all horizons has increased, cut back on their investment expenditures or hiring decisions. Likewise, households facing higher real borrowing costs scale back on their purchases of homes, automobiles and other durable goods. This affects supply and demand conditions in the goods and labour markets resulting in a downward impact on inflation.

Exchange rate channel: In open economies, when the domestic nominal interest rate rises above its foreign counterpart, the domestic currency will tend to appreciate towards foreign exchange rates, due to its increased attractiveness as an investment currency. When prices are slow to adjust, this makes domestically produced goods more expensive than foreign produced goods. Net exports fall, as do domestic output and employment, while inflation decreases.

Asset price and wealth channels: A monetary policy induced increase in the nominal interest rates may, from an investor’s point of view, raise the attractiveness of new debt instruments compared to equities and existing debt. Following such monetary tightening, the equilibrium across securities markets may be re-established partly through a fall in asset prices. This in turn induces smaller investment expenditures by the affected firms. In addition, changes in asset prices can have an impact on aggregate demand via changes in the value of collateral, affecting the amount that borrowers can borrow. For example, as asset prices rise, household financial wealth increases, share-owning households and house owners become wealthier and may choose to increase their consumption.

Bank funding and lending channel: Monetary policy may affect the supply of loanable funds available to banks and thereby the amount of loans banks can create. Banks play a special role in the economy not only by issuing liabilities – bank deposits – which contribute to the broad monetary aggregates, but also by holding/creating assets – bank loans – for which few close substitutes exist. A tighter supply of bank loans or tighter credit conditions would again weigh on spending and investment. Central bank liquidity support in the event of a bank funding crisis can therefore be crucial in order to sustain loan origination to the private sector. This channel is also closely linked to (i) the money channel in terms of the availability of money and deposits as a funding source and (ii) the balance sheet channel for valuation effects on loan activity.