Question

Briefly explain the concept "monetary policy transmission mechanism" and then illustrate how changes in interest rates impact on your business organisation. Substantiate your answer fully.

Answer 1

In very simple words, the "monetary policy transmission mechanism" can be defined as the impact of monetary policy on the economy in terms of GDP growth, price level and asset prices.

To elaborate on the transmission mechanism, an example works best. Assume that the economy is in a recession and the central bank pursues expansionary monetary policy. The objective of expansionary monetary policy is to increase liquidity in the banking system and drive down interest rates. The central bank can use open market operations and buy bonds from the open market to infuse liquidity in the banking system. When liquidity increases, the cost of money (interest rate) trends lower.

The "Transmission" happens as follows -

1. At lower interest rates, consumers are increasingly willing to borrow and this triggers higher consumption spending in the economy. Consumers increase purchase of durable as well as non-durable consumer goods at lower cost of money. Therefore, consumption spending component of GDP trends higher.

2. When consumption spending increases, businesses are encouraged and this translates into higher investment spending. As businesses invest in expansion, economic growth is triggered and new jobs are created. This further fuels consumption spending in the economy.

3. As businesses make higher profits, the stock prices also increase and this translates into higher overall markets. Since stock markets also create wealth, higher markets implies more wealth in the hands of consumers and businesses for consumption and investment spending.

Overall, this chain of event translates into the aggregate demand curve moving to the right, which implies higher real GDP (output) and relatively higher prices. As price level increases, interest rates again trend higher (gradually).

Specific to an individuals own business, lower interest rates implies lower cost of money and hence more leverage can be used for expansion of business activities.