Introduction
Monetary policy refers to those policy measures targeted at achieving desired economic outcomes through money market operations. Authorities in charge of money market control use different policy instruments to control the money supply in order to achieve suitable market prices as well as stability in the national economy. The key instruments at disposal for those authorities include open market operations, minimum reserve ratio as well as bank rate. However, the policy instruments application does not have a direct impact on market prices and demand but follows a transition mechanism from the authorities’ actions to the desired economic results. In that respect, this discussion seeks to explain what the Monetary Policy Transition Mechanism is and how its efficiency can be measured. To achieve the objective, the discussion defines the process and then explains the suitable measures including the use of the national economy equation.
Discussion
- Monetary Policy Transition Mechanism
Monetary Policy Transition Mechanism is a process through which monetary policy actions affects an economy particularly the market price. The process is marked by time lags and uncertainty as it involves an interaction and change of various economic variables including interest rates, demand and market prices. (Barron & Lynch, 1999) The process mainly involves three stages including
Stage 1: Effects on Interest Rates
Stage 2: Effects on Consumer Patterns
Stage 3: Effects on Demand and Prices
The three stage operation can be easily demonstrated by the chart shown below.
Source: (Gali, 2008)
With the policy mechanism’s flow shown in the chart above, the transition follows specific process that involves a continued effect on several economic variables as below.
- Policy Changes on the Official Interest Rates
The process begins with The Central Bank Policy actions that seek to influence official interest rate which acts as a basis for money market interest rate. The Central Bank adjusts official interest rate since it is the market regulator responsible for changing the rate in order to influence market operations towards desired monetary results. When there is a need to reduce money supply in the market, the bank increases official interest rate while a need to increase money supply is addressed through a reduction of the rate. (Barron & Lynch, 1999)
- Official Interest Rate Affects Market Interest Rates
A change in official interest rate as set by The Central Bank has a direct effect on the rates that banks offers on deposits as well as their loans’ rates. (Gali, 2008)
- Interest Change Affects Market Expectations
The effect on market interest rate has influence on investors and money market agents’ expectations on the future of interest rates. This affects short term and long-term rates as the long-term expectations are based on investors’ perception of trends that rates would take. Expectations are also based on The Central Bank’s credibility with a more credible bank being able to enhance price stability as investors and market agents do not have to adjust prices in fear of inflation or unfavorable future changes in interest rate. (Barron & Lynch, 1999)
- Interest Rate and Expectations Change Affects Asset prices
Monetary policy actions have effects on investors’ perception as well as on other variables including exchange rate that affects assets prices like securities and stocks. This may result from its direct effect on availability of funds or through the exchange rate effect on funds’ flow and demand for such assets. (European Central Bank, 2013)
- Interest Rate, Expectations and Asset Prices Change Affects Investments and Savings Decisions
As interest rate change affects funds’ availability and asset prices, there is an impact on consumption and investment patterns. For instance, an increase in interest rate increases the cost of borrowing hence a reduction on investments and consumption that is based on borrowing. However, the associated increase in asset prices provides more wealth for assets’ holding households hence their increased ability to borrow for more investments and consumption. The effect of interest rate change on market expectations as well as asset prices then causes changes in investments and consumption patterns. (Barron & Lynch, 1999)
- Rate Change Affects Credit Supply
Interest rate change also effects amount of funds that banks lend out given the change in default risk. For instance, an increase in interest rate results in an increase in risks that are associated with banks’ loans hence an incentive for banks to cut on the amounts they lend out. Consequently, loans’ demand reduces resulting in a reduction in consumption and investments while interest rate decrease has an inverse effect of increasing loans’ amount hence increasing consumption and investments. (European Central Bank, 2013)
- Overall Effect on Demand and Market Prices
This is the final stage of the policy’s effect where the price change objective is achieved. Change in consumption and investments have an effect on market demand hence the impact on an economy’s aggregate demand. Consequently, the demand effects prices and wages as markets adjust to address the change in demand depending on whether it is an increase or decrease. Decrease in interest rate also increases availability of funds hence investment and consumption which in-turn increase inflationary pressure and wages. In summary, an increase in interest rate reduces demand resulting in a decrease in prices and wages. (Barron & Lynch, 1999)
- Transition Mechanism’s Efficiency Evaluation
Monetary policy has effect on several economic variables beginning with effect on the money market rates to the final effect on prices, wages and inflation. It is thus suitable to establish the effectiveness and efficiency of the policies’ effect on the variables and the economy in general. (European Central Bank, 2013) In that consideration, measuring the mechanism’s efficiency require measures that can quantify such effects hence the significance of the national income equation that equates aggregate demand and the national income catering for both supply and demand sides of an economy.
The equation is presented as Y = C + I + G + X – M. (Gali, 2008)
Where C represents consumption, I for investments, G for government spending, X for exports and M for imports; all which can be represented by individual equation’s below.
C = Co + C1 Yd: Co- Autonomous Consumption, C1- Marginal Propensity to Consume.
I = I0 + I1 R: Io- Autonomous Investments, I1- Marginal Propensity to Invest.
T = T0 + T1 Y: To- Autonomous Tax, T1-Tax proportion dependent on Income.
M = M0 + M1E: Mo- Autonomous Imports, M1- Marginal Propensity to Import.
Yd = Y – T: Disposable income.
G = G0: Government spending.
X = X0: Exports.
With the equations above, the effect of the change in interest rate on market demand can be evaluated by measuring the proportions by which investments and consumption changes. Change in interest rate results in changes in investments by I1 proportion, in-turn change in consumption resulting from investments’ change causes a change in aggregate demand. (Gali, 2008) Then, change in demand results in price change as demonstrated by the graph below.
Source: (Baron & Lynch, 1999)
Where:
A – Aggregate demand
AE - Aggregate expenditure
P – Price level
Y- National income / Output level
LAS – Long run aggregate supply curve
SAS – Shirt run aggregate supply curve
AD – Aggregate demand curve
Using the national income model as shown by the graph above, equilibrium is achieved at a point where aggregate demand equal aggregate supply; Y = AE. Monetary policy impacts on interest rate which in-turn affects investments and consumption comprising of the aggregate demand AD. A rise in interest rate then results in a fall in aggregate demand as represented by a shift in expenditure from AD1 to AD2 which is associated with a reduction in aggregate expenditure from AE1 to AE2. With that, an economy experiences a fall in price level from P1 to P2 hence a reduction in inflation. Thus, the aggregate expenditure and income model is suitable for evaluating the mechanism’s efficiency in achieving desired results of stable prices and wages. (Barron & Lynch, 1999)
On the other hand the mechanism’s efficiency can be evaluated by observing changes in its variables that include interest rate, expectations, exchange rate, asset prices, wages and credit availability. (Gali, 2008)
Conclusion
The discussion has clearly defined the Monetary Policy Transition Mechanism as a process through which monetary policy actions by The Central Bank’s influences several economic variables to achieve desired economic results. The process have been identified as having three key stages including effects on the market rates and expectations, effects on consumption and savings patterns as well as effect on prices and inflation. The process and the nature of its effects on economic variables has also been shown as depending on nature of the policy implemented through the three key monetary policy instruments including open market operations, minimum reserve ratio and bank rates. All the three instruments targets changing market interest rate through interest rate control or through money supply that in-turn influences market interest rate. Finally, the discussion has clearly demonstrated the national income equation as a good measure of evaluating the Transition Mechanism’s efficiency. This is in consideration that the equation contains all the economic variables that the policy targets hence an ability to identify its influence by observing values by which the variables change.
References
Barron J. & Lynch G. (1999). Economics. London: Richard D. Irwin Inc.
European Central Bank. (2013). Transmission Mechanism of Monetary Policy. Retrieved
Gali, J. (2008). Monetary Policy, Inflation and Business Cycle: An Introduction to the New
Keynesian Framework. Princeton, N. J.: Princeton University Press.
