The aim of this essay is to provide a framework
on the relation between monetary policies and its effects on aggregate demand
and other economic indicators. The process of how changes in monetary policy
affects the economy is also known as the monetary transmission mechanism. The transmission
mechanism can be defined as comprehending the effects of monetary policies
adopted by central banks and how this is passed on to the economy. Generally, the
Central Bank sets IR in order to
influence aggregate demand, money and credit supply, while aiming to achieve a certain
economic level. The study of the monetary transmission mechanism consists on
understanding how each of these decisions will affect asset prices, households,
businesses and other indicators in an economy.
There are many different opinions and views
regarding the transmission mechanism, where some views focus on aspects like
money supply & credit supply, interest rates, exchange rates, asset prices,
commercial banks and etc. Monetary policies are set by the central banks, where
the CB, control the changes in interest rate, which consequently, changes money
supply and vice versa. ,
Whereas the Central Bank can – in theory – control
money supply by changing IR or increasing the minimum reserve requirements for
banks. The Central Bank being the monopolist on issuing money has the power of
fully determining the amount of funds they will provide to the banking system
and the interest they will charge. A larger money supply will lower market
interest rates and a lower money supply tends to increase market interest rates
as with less money to supply, the higher the interest they will charge.
The monetary transmission mechanism shows
how interest rate changes are somehow transmitted and felt on AD levels, through
its effects on the following indicators:
Demand and Consumption – Any change in the Interest
Rates will affect household demand because of its relation to savings,
consequently affecting spending levels. Also, Individuals and firms with
pending debt are also affected by interest rates as their repayments might vary,
causing them to have more/less money available after paying their debts,
changing the amount of money to consume. Changes in AD affect market rates because
if demand increases manufacturers and producers of goods in the economy will
increase their prices in response.
Expectation – Interest Rate changes affects
consumers’ confidence and expectation on the economy performance. People tend
to consume and spend based on their future/expected income. Confidence is
extremely important in order to increase spending and consumption. Thus, the
importance of a central bank with credibility. Example of this importance is
the expected inflation and the prices adjust prior to it.
prices – Firms profitability is correlated to the
interest rates, as when IR falls firms then see an increase in profits (debts
and price of loans fall if IR is low). Also, it affects the supply of bank
loans, as changes in policy rates might affect the cost for banks to fund
themselves and capital. Common on times like financial crisis capital is really
scarce, so loans are low and banks can’t find a way to raise capital.
of credit – When interest rates are higher then so
is the risk of those who borrowed the money to default, consequently banks
might cease lending or cut the amount of loans. Resulting in a shortage of
credit on the economy which will lead to a reduction in consumption and
investments by household.
As much as the transmission mechanism
explain us the correlation between interest rate changes and aggregated demand
levels and that this seems to be a straight forward equation. This mechanism can
sometimes breakdown, which we will see examples of that, varying from financial
crisis, housing sector, and rates charged by banks.
Under normal conditions, the rates charged
by banks and offered on returns for investments depends mainly on two other
factors: rates charged by other banks on inter-banking lending on the overnight
market, which is how they fund loans when new deposits are not enough. And the second
is the CB interbank offered rate or overnight rate, which is related to the official
interest rate and represents the cost they have for borrowing money.
Theoretically, if official rates increase,
so will rates charged by banks, creating a decrease in loans. If official rates
fall, so will rates charged by banks, increasing loans as people will take more
loans because they are cheaper, meaning that more money will be circulating,
consequently boosting the economy, (. However,
this doesn’t always work in practice when the transmission mechanism is broken.
Following the crash of 2008, we saw banks literally not lending any money, afraid
that loans would not be re-payed1.
During the 2008 crisis banks had simply
stopped lending one to the other as they were afraid that their loans would be
defaulted, as many banks became insolvent. As much as loans represent assets to
banks, they have the risk of being defaulted, where they would then ‘lose’ an
asset and become insolvent. Therefore, if they do not expect that that people they
are lending the money to will repay them, the banks simply stop lending and
ignore the official interest rate. It does not matter how cheap getting money
is in this case, if banks decide to lend they will lend charging an amount they
know it will be worth the risk or not lend at all. Making the interest rate
which they lend to each other totally un-meaningful to the supply of loans.
Also, if we analyse existent data we can see
that following the crash the CB set IR to the lowest level on the US history of
0,25%, However prime lending (rate which individual banks lend to their most creditworthy
customers) rate stayed the same 5,25%2.
If the transmission mechanism system was to work perfectly, with a reduce in
interest rates by the CB would result in a reduction of the prime IR charged by
commercial banks, therefore resulting in a larger demand for credit. However,
in practice, it did not work and prime rates stayed high.
Another good example of how the
transmission mechanism can fail is the ECB, back in 2012 when the ECB reduced
the key interest rate to 0,75 %3
– which was the lowest IR on the EU story that time. And at the same time, they
decided to set the interest rate paid to banks that had deposits with the ECB
Theoretically and under normal conditions,
reducing interest rates so aggressively as the ECB did would result in most all
interest rates decreasing. This would happen because commercial banks would be
able to borrow money from the ECB on a very low level of 0,75 and lend it to
the private sector, households and firms. Also, they wouldn’t have any reason
of leaving their deposits with the ECB as the interest rate would be zero, resulting
on banks’ lending more money with lower interest rates. However, interest rates
for household and firms stayed stable and did not change.
Off course, when the transmission mechanism
fails it raises doubts about the efficiency of classical monetary policies,
opening doors to new alternative policies. As we saw the ECB trying to fix the
broken transmission mechanism through a controversial policy: QE. According to reports
from the ECB, they injected up to 1 trillion euros – by buying 50 billion euros/month
worth on government securities in 20164.
The idea of this strategy was to reduce the cost of borrowing by increasing the
overall money supply and creating liquidity. However, the ECB failed to take
into account that such measures as QE are not the answer to fix the
transmission mechanism and it doesn’t do any good to the population, as most of
the money stays dragged in the banking system. The success of measures like QE
is in fact depended on the transmission mechanism to work.
However, it is not because one alternative
policy did not work that the CB should leave behind the fight on fixing the
transmission mechanism. In the past few years, economist came up with ideas and
policies that even being different from what we know on mainstream economics,
can provide a new way of fighting the transmission mechanism. Some economists
suggest more alternative policies as General Basic Income for the population,
which is somehow the same idea of QE, but for the people. QE benefits the banks
while the idea of Basic Income would benefit the people directly, boosting
consumption and resulting on household debt reduction. Also, we have Helicopter
Money, which is basically the idea of giving/paying ‘dividend’s direct to the
However, measures that include giving money
direct to the people have two risks: People spend the money and create hyperinflation,
which will result on government increasing interest raises to contain inflation.
Or people don’t spend the money, increasing government debt without boosting
the economy. The author of this essay, beliefs that alternative measures can definitely
work but represent a certain risk if not well analysed its consequences on the
economy. Policies like negative interest rates, which some countries already adopted,
have proven to be successful, and have the power to fix the transmission
mechanism by obliging the banks to lend as they would be losing money for not
doing so, and people to spend.
To conclude, it is important that we bear
in mind that the monetary transmission mechanism has a significant importance
on the economy and a huge risk when it is broken. After mainstream policies
failed to fix the broken mechanism, it is now time for the CB to start thinking
about implementing alternative policies that benefit the general population and
not the banking system only.