Transmission Mechanism of Monetary Policy

1. The Transmission Mechanism
of Monetary Policy – Part I
Group 22
Session 14

2. Session Outline
1. Introduction to Transmission Mechanism of Monetary Policy
2. The impact of a change in official interest rates on other
interest rates
3. The impact of interest rate changes on consumption as a
policy instrument
4. The impact of interest rate changes on investment as a policy
instrument

3. Introduction to Transmission Mechanism of
Monetary Policy
01
02
03
04
Definition of
Transmission
Mechanism of
Monetary Policy
Monetary
Policy
Summary Transmission
Channels
Amandi Weerasinghe
CPM 16767

4. Transmission Mechanism of Monetary Policy
The series of links between the monetary policy change and the changes in
output, employment and inflation are known as the transmission mechanism
of monetary policy.
Bain, K. and Howells, P. (n.d.). Monetary Economics: Policy and its Theoretical Basis.
Simply,
The monetary transmission mechanism is the process by which asset prices and
general economic conditions are affected as a result of monetary policy decisions.
Such decisions are intended to influence the aggregate demand, interest rates, and
amounts of money and credit in order to affect overall economic performance.

5. Money Market Investment Real Economy
Interest
Rate(r)
Interest
Rate(r)
Quantity
of Money
Investment
Price
Level
Real
Output(Y)
I
Ms1
Md
ADA
AS
Ms2
A
B
A
B
ADB
•More Employment
•Increase in Price Levels
•Higher Y
rA
rB
rA
rB
IdA IdB
p
p1
yA yB0 0 0

6. Monetary Policy
Monetary policy is the process by which a Central Bank manages the supply
and the cost of money in an economy mainly with a view to achieve the
macroeconomic objective of price stability.
Central Bank of Sri Lanka(CBSL)
• Central Bank of Sri Lanka is responsible for conducting monetary policy in Sri
Lanka, which mainly involves setting the policy interest rates and managing the
liquidity in the economy.
• The monetary operations of the Central Bank influences interest rates in the
economy, affecting the behavior of borrowers and lenders, economic activity and
ultimately the rate of inflation.
• Therefore, the Central Bank uses monetary policy to control inflation and keep it
within a desired path.

7. Monetary Policy Cont’d
• Monetary Policy change may take one of the 3 forms ;
1. a change in the short term rate of interest at which the central bank is willing
to lend to the banking sector in order to relieve any shortages of liquidity
within the monetary system (interest rate control)
2. a change in the monetary base in the expectation that this will alter the money
supply, or its rate of growth (monetary base control)
3. changes in the regulations that apply to banks in an attempt to influence the
rate of growth of their lending (direct controls)

8. Time Lags of Monetary Policy
The length of time ;
1. it takes for the authorities to observe changes in the economy and to decide on a
change in the official short-term rate of interest (policy decision lag)
2. it takes for the change in the official rate to feed through to other interest rates in
the economy (institutional lag)
3. required for interest rate changes to affect the disposable income of households
(income lag)
4. required for changes in short-term and long-term interest rates to affect the
expenditure of households and firms (expenditure lag)
5. needed for changes in expenditure to be reflected in changes in the rate of
inflation, output, and employment (real response lag)

9. Transmission Channels
• The monetary policy measures are transmitted into the real economy through
several channels.
1. Market Interest Rate Channel
2. Asset Prices Channel
3. Expectation/Confidence Channel
4. Exchange Rate Channel

10. Market Interest Rate Channel
• Official Bank rate or the repo rate affects market rates.
• By market rates, it means the rates of interest you’ll get if you go in to any
commercial bank.
• These market rates are affected by many policy instruments like reserve
rate, repurchase agreements and treasury bills.
For example,
If Sampath Bank has a shortage of cash they could go to any other banks or directly to the Central
Bank if necessary and borrow from them. Assume, if the Sampath Bank wants to borrow from the
Central Bank. Then the Central Bank will offer a loan under 0.05% interest rate from the Sampath
Bank’s existing reserves or issuing treasury bills or else by repurchase agreements

11. Asset Prices Channel
• Equity and bond prices respond to new information about term structure of
discount rates, real growth prospects, and inflation prospects.
• House and other property prices adjust (maybe slowly) to new borrowing
costs.
As interest rates go up probably the number of mortgage approvals would fall and so the demand for
housing would probably settle down a little bit and so asset prices would also start to fall.
Interest Rate
No of
mortgage
approvals
Demand for
housing
Asset Prices

12. Expectation/Confidence Channel
Policy actions and policy announcements have effects on expectations of future growth in
real activity and inflation.
• According to the rational expectations theory, if people expect inflation to rise they just
turn spending behavior accordingly. Also if there’s a forward guidance, confidence to the
markets and people’s expectations of what’s going on in the markets are also given
confidence and assurance.
• As a consequence of that they are less likely to either stop spending if the interest rate is
falling or they are less likely to not to spend if they say the interest rate is rising.
• So it follows that the size of the likely fall in aggregate demand depends crucially on:
1. whether the present increase in interest rates had been expected
2. whether the present increase leads to expectations of further increases in future or
quick reversals of policy
3. expectations regarding future inflation rates

13. Exchange Rate Channel
When the interest rates are falling the exchange rate moves in the same direction
as the industry so the price of exports.
If the interest rates fall the exchange rate depreciates and the price of exports fall so the demand for exports
should go up. And of course the flip side of that is, the price of imports will rise and the demand for imports
should fall. Ultimately that should help the overall trade balance to move potentially from a deficit more into
a surplus.
Interest
Rate
Exchange
Rate
Price of
Exports
Demand
for
Exports
Price of
Imports
Demand
for
Imports
Trade
Balance

15. Summary
We can conclude from this session that:
• monetary policy influences aggregate demand in a variety of ways;
• the relationship between interest rate changes and changes in aggregate demand
might be quite powerful;
• the relationship between interest rates and aggregate demand is inverse-increases in
interest rates reduce aggregate expenditure; reductions in interest rates cause
aggregate expenditure to increase
• nonetheless, the relationship between interest rates and aggregate demand is
complex
• interest rate changes affect the distribution of income as well as the level of
aggregate demand.

16. Questions
1. Does the recent inflation environment in many countries result from
successful inflation targeting and understanding of the Monetary
Transmission Mechanism?
2. To what extent does inflation control depend on credibility rather than
actual policy decisions?

17. References
bain_y_howells_monetary_economics_policy_and_its_ theoretical_basis
Monetary theory MC VAISH 15th edition.
Hajela, T.(n.d.). Monetary Economics
Monetary Policy Strategy by Frederic Mishkin

18. The Impact of a change in Official
Interest Rates on other Interest Rates
01
02
03
04
The Impact of a change
in Official Interest
Rates on Reserves
The Impact of a
change in Official
Interest Rates on
Repurchase
agreements
The Impact of a
change in Official
Interest Rates on
Treasury bills
Limitations of
Bank Rate Policy
used by Central
Bank
D.T.Roshani
CPM 16761

19. The impact of a change in official interest rates
on other interest rates
• Official interest rate is the rate that Central Bank charge for overnight
loans.
• The central bank changes its official dealing rate, normally it affects
other short term market rates.
• Most of the monetary authorities used repo rate but Sri Lankan
Central Bank use Bank Rate for provides credit to commercial bank.

20. Reserves
• Banks must be able to guarantee the convertibility into cash of
customer deposits. For this purpose they hold reserves at the
central bank.
• If there are any short of fund in daily bank settlement process ,
they need more fund to resolve situation.
• If the interbank lending and borrowing cannot resolve the shortage
and the central bank is the in the position to exploit its monopoly
position in the supply of reserves.

21. • The central bank can select either the price or quantity of reserves which it
supplies. There are two contrasting possibilities.

22. Reserves Cont’d
• When banks can borrow funds from the Reserves of Central Bank at a less
expensive rate, they are able to pass the savings to banking customers
through lower interest rates charged on personal, auto or mortgage loans.
This creates an economic environment that encourages consumer borrowing
and ultimately leads to an increase in consumer spending while rates are low.
• Although a reduction in the discount rate positively affects interest rates for
consumers wishing to borrow from banks, consumers experience a reduction
to interest rates on savings vehicles as well. This may discourage long-term
savings in safe investment options such as certificates of deposit (CDs)
or money market savings accounts.

23. Repurchase Agreements
• It is a form of short term borrowing , mainly in government securities. Under that a
bank will agree to buy securities from dealer and resell them a short time later at
a specified price.
• Banks and other financial institutions are holding excess cash quite often employ
these instruments.
• Central Bank and other banks enter into repurchase agreements.
• By buying these securities, the central bank helps to boosts the supply of money in
the economy, as a result of that encouraging spending and reducing the cost of
borrowings. And also rate of interest rate will decrease.

24. Treasury Bills
• Treasury bills represent the greatest liquidity and the lowest risk of
principal. Treasury bills are issued by governments through their central
banks to resolve temporarily insufficient budget.
• When the sells T-bills, it is increasing the supply of debt in the market.
An increase in supply without a corresponding increase in demand would
cause the price of any commodity to drop. If the price of a Treasury
security drops, the interest rate correspondingly will rise.

25. Limitations of Bank Rate Policy used by
Central Bank
(1) Existence of an Organized and Developed Money Market:
• Efficacy of the bank rate in controlling credit requires a close correspondence
between the bank rate and the structure of interest rates in the money market,
so that changes in the bank rate will be followed by changes in the market
rates. This presupposes the existence of a highly organized money market.
• Unfortunately, most underdeveloped countries do not have an organized money
market. The wide range and multiplicity of money rates in such an organized
money market will make the success of the bank rate policy doubtful. The
absence of any conventional relationship between the central bank and other
segments of the money market will further add to the ineffectiveness of the
bank rate policy.

26. (2) Existence of Well-developed Bill Market.
(3) Banks Need for Rediscounting.
The need for commercial banks to approach the central bank for
rediscounting facilities is an important factor in determining the
successful working of the bank rate policy. But commercial banks will
have no need to approach the central bank when they have ample liquid
resources at their disposal, i.e., when they have enough excess resources.
Limitations of Bank Rate Policy used by
Central Bank Cont’d

27. Summary
• The Impact of a change in Official Interest Rates on
 Reserves
 Repurchase agreements
 Treasury bills
• Limitations of Bank Rate Policy used by Central Bank

28. Questions
( 1)How transparent should the central bank be? Explain.
( 2)Why might market interest rates not change instantly and exactly in
line with changes in official rates?
(3) Why is the demand for reserves by commercial banks highly
interest inelastic?

29. References
• bain_y_howells_monetary_economics_policy_and_its_
theoretical_basis
• Monetary theory MC VAISH 15th edition.
• Hajela, T.(n.d.). Monetary Economics Monetary Policy Strategy
• Monetary Policy Strategy by Frederic Mishkin

30. The impact of interest rate changes on
consumption
01
02
03
04
Summary
Definition of
Consumption
Economic
effects of having
a higher Interest
Rate
Monetary Policy is
likely to influence
Consumption
through several
channels
S.C.H Jayasinghe
CPM 15876

31. Consumption
`Consumption is the use of goods and services by households
-investopedia.com

32. Monetary Policy is likely to influence
Consumption through several channels
An increase in interest rate,
 Makes saving from current income more attractive
 Increases repayments on existing floating-rate debt and thus lowers
disposable income
 Increases the cost of borrowing and thus increases the cost of goods and
services obtained on credit
 Lowers the price of financial assets and hence influences estimates of
private sector wealth
Lowers house prices or, at least, slows the rate at which they are increasing
and this, too, influences estimates of household wealth and lowers the value
of the collateral against which households seek to borrow

33. Economic effects of having a higher Interest Rate

34. Makes saving from current income more
attractive
Increased incentive to
save rather than spend.
Higher interest rates
make it more attractive
to save in a deposit
account because of the
interest gained.

35. Increases repayments on existing floating rate debt
and thus lowers disposable Income

36. Increases the cost of borrowing and thus increases
the cost of goods and services obtained on credit
Demand and Supply for Borrowing Money
with Credit Cards

37. Lowers the price of financial assets and hence
influences estimates of private sector wealth
Eg :- Now let's suppose that later that year, interest
rates in general go up. If new bonds costing $1,000 are
paying an 8% coupon ($80 a year in interest), buyers
will be reluctant to pay you face value ($1,000) for
your 7% ABC bond. In order to sell, you'd have to offer
your bond at a lower price – a discount – that would
enable it to generate approximately 8% to the new
owner. In this case, that would mean a price of about
$875.

38. Lowers house prices or, at least, slows the rate at which they are
increasing and this, too, influences estimates of household wealth and
lowers the value of the collateral against which households seek to
borrow

39. Summary : Effect of increase in interest rates

40. Questions
1. What are the various economic effects of having a higher interest
rate?
2. How does the official interest rate influences estimates of private
sector wealth?

41. References
• bain_y_howells_monetary_economics_policy_and_its_
theoretical basis
• Monetary theory MC VAISH 15th edition.
• Hajela, T.(n.d.). Monetary Economics
• Monetary Policy Strategy by Frederic Mishkin

42. The Impact of a change in Official
Interest Rates on Investment
01
02
03
04
Summary
How Monetary
Policy likely to
influence
Investment
through Several
Channels
A.G.Pavithra Udayangani
CPM 16759
Definition of
Investment
How Interest Rate
get affected by
Money Supply and
How Investment
get affected by
Interest rate

43. “An investment is the purchase of goods that are not consumed today
but are used in the future to create wealth.”
-investopedia.com
Investment

44. Money Supply Interest Rate
Money Supply Interest Rate
MD
MS MS1
i0
i1
Quantity Of
Money
Interest
Rate
0
How Interest Rate get affected by Money
Supply

45. InvestmentI
0
Interest
Rate
i0
i1
I0 I1
Interest Rate Investment
Interest Rate Investment
How Investment Expenditure get affected
by Interest Rate

46. An increase in interest rate,
 Raises external borrowing costs for firms that raise funds
through bank loans or from bills or bonds markets;
 Lowers asset prices, reducing the net worth of firms and making
it more difficult for them to borrow;
 Increases the rate at which they discount back expected future
returns from investment, making investment projects less
attractive;
Monetary Policy is likely to influence
Investment through several channels

47.  Increases the costs of holding inventories of goods, which
are often financed by bank loans;
 Increases the difficulty and cost of raising investment funds
through the issue of new capital on the stock market;
 Increases the return from the savings of firms;
 Increase the opportunity cost of financing investment
internally;
Monetary Policy is likely to influence
Investment through several channels Cont’d

48. Summary
 Definition of investment.
 The impact of interest rate on investment.
 Monetary policy is likely to influence investment through several
channels.

49.  bain_y_howells__monetary_economics__policy_and_its_theoretical_
basis
 The_Economics_of_Money,_Banking,_and_the_Financial_Market
 Monetary theory MC VAISH 15th edition
 Monetary Policy Strategy by Frederic Mishkin
References

50.  An decrease in interest rate ;
i. Increase the return from the savings of firms.
ii. Decrease the external borrowing cost for firms.
iii. Discourage the investment.
iv. Lowers asset prices.
 Downward sloping investment curve implies;
i. Negative relationship between money supply and investment.
ii. Positive relationship between investment and interest rate.
iii. Negative relationship between investment and interest rate.
iv. Negative relationship between investment and cost of borrowings.
Questions