Monetary transmission refers to the
process by which the impact of the monetary policy actions passes on to its
ultimate goal or the real sector of the economy. Changes made in money supply
and policy rates will bring change in aggregate demand such that improvements
would be brought in monetary policy objectives such as employment, price and
output as desired. That is why monetary policy is also called demand management
policy.
Main Transmission Channels
1 1. Interest Rate Channel:
Interest rate channel is the
traditional and most widely used channel in monetary transmission mechanism.
According to this channel, when the monetary policy rates are changed, it
causes changes in the short term interest rates which will ultimately bring changes
in long term interest rates. Such changes affect the demand for credit and the
aggregate demand of the economy. Change in aggregate demand, in turn, will
influence real sectors such as employment, output and price level. The working mechanism of this channel can be shown
in the chart below:
The effectiveness of this channel
depends on the structure of the economy and the level of the development of the
financial markets. If the relationship between interest rate and the demand for
credit is weak, this channel is not effective. In such a case if the central
bank reduces interest rate by adopting expansionary monetary policy, the demand
for credit does not rise as expected as such the impact on aggregate demand is
minimum. Alternative transmission channel should be used in such a case.
2. Asset Price Channel:
In this channel, the policy actions
of the monetary authority brings changes in value of assets (real estate,
security) of households and business firms which in turn change the aggregate
demand of the economy. For instance if expansionary monetary policy is used
resulting in an increase in the prices of equity and real estate, it will raise
the consumption demand of the households and investment demand of the firms. An
increase in aggregate demand will in turn results in an increase in output,
price and employment.
According to this channel, the
impact of monetary policy actions is transmitted through two mediums:
A. Tobin's q :
Tobin's q ratio shows the relationship
between the market value of the company and its book value. A q-ratio greater
than one is indicative of higher market value which gives incentive to
investment. If expansionary monetary policy raises the market value of the
company by reducing interest rate, the investment demand of the economy will
increase thereby pushing the aggregate demand upwards.
B. Wealth Effect
B. Wealth Effect
Wealth effect works through the
changes in the financial and physical assets of the households due to monetary
policy actions. Such changes affect the consumption and investment behaviors of
the households thereby affecting the aggregate demand of the economy. For
instance, if expansionary monetary policy leads to an increase in equity and
real estate prices, it will increase the consumption and investment demand of
the households and raises output, employment and price level by raising the
aggregate demand.
The working mechanism of this
channel can be shown in the chart below:
This channel will be effective when
there is a clear and strong relationship between interest rate and asset prices.
3. Credit Channel
Credit channel is the direct
transmission channel of monetary policy. Under this channel, changes in
monetary policy actions change the credit availability which brings changes in
consumption and investment demand. This channel can be effective in credit
deficient economy where availability of credit is more important rather than
the cost of credit. Such a situation exists in underdeveloped countries where
the allocation of financial resources is generally sub-optimal.
The working mechanism of this
channel can be shown in the chart below:
4. Exchange Rate Channel
Under this channel, change in
monetary policy actions influences the exchange rate of the economy which in
turn influences the export and import demand. For instance, if the central bank
adopts expansionary policy, interest rate decreases which reduces the capital
inflow resulting into a fall in the supply of foreign exchange. Reduction in
foreign exchange creates pressure in BOP as such the domestic currency
depreciates. It encourages export and discourages imports. As a consequent of
this, the aggregate demand of the economy rises.
The working mechanism of this
channel can be shown in the chart below:
- The country should have adopted the flexible exchange rate regime.
- Capital account must be convertible.
- Exports should be sensitive to devaluation i.e. price elasticity of exports should be high.
5. Expectation Channel
The expectations made by economic
agents about economy also influence transmission of monetary policy. Such
expectations will affect consumption and investment decision of the agents and
thus affect aggregate demand. This channel can be effective only if the
financial and economic sectors are well developed.
The working mechanism of this
channel can be shown in the chart below:
- The effectiveness of monetary policy transmission mechanism depends on the economic and financial sector development, institutional and policy framework and monetary policy framework, among others.
- The price based transmission mechanisms are less useful in underdeveloped economies due to the weak relationship between interest rate, exchange rate and investment.
- According to an IMF study, the credit channel of the monetary policy is more effective in UDCs.
- In Nepal the impact of changes in policy rate on interest rate is not much strong and the impact of changes in interest rate on consumption, investment, output and employment is minimal. Investment decision is rather affected by policy regime, internal rate of return, political stability, labor relation and others.
- Since Nepal has adopted pegged exchange rate regime and capital account is only partially convertible, the exchange rate mechanism has limited role to play.
- The asset price channel seems to work to some extent as the monetary policy actions often brings changes in the real estate prices and share prices. However, such increase has meager effect on the real sector of the economy including output and employment. This is due to the underdeveloped capital and real estate sector.
- In Nepal, different empirical studies have emphasized the use of credit channel as an effective channel. They include Khatiwada (2005), Kharel (2012), Budha (2013). This channel works well when access to financial services is low, the market is less competitive, there is lack of capital and the environment is not much supportive for large scale investment.
- For transmission mechanism to effectively operate, independence of monetary policy is must. The situation of pegged exchange rate system with India, convergence of Nepal’s inflation to the Indian inflation, the labor mobility and the long-open border with India raise question on independence of Nepalese monetary policy.
The monetary transmission channels are not substitutes of each other. Rather
they may complement each other while working to attain the final target of the
policy. In Nepalese context, among different channels of monetary policy
transmission, bank lending channel is more effective. Other channels at the
same time complement it to attain the desired targets of the policy.
2 comments:
"In such a case if the central bank reduces money supply by adopting expansionary monetary policy, "
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