The transmission mechanism of monetary policy

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The transmission mechanism of monetary policy
The Monetary Policy Committee (MPC) sets the short-term interest rate at which the Bank of England deals with the money markets. Decisions about that official interest rate affect economic activity and inflation through several channels, which are known collectively as the ‘transmission mechanism’ of monetary policy.

The transmission mechanism of monetary policy
Links in the chain
Monetary policy works largely via its influence on aggregate demand in the economy. It has little direct effect on the trend path of supply capacity. Rather, in the long run, monetary policy determines the nominal or money values of goods and services—that is, the general price level. An equivalent way of making the same point is to say that in the long run, monetary policy in essence determines the value of money—movements in the general price level indicate how but these can be important..Monetary Policy Committee much the purchasing power of money has changed over time. Inflation, in this sense, is a monetary phenomenon.

The transmission mechanism of monetary policy
However, monetary policy changes do have an effect on real activity in the short to medium term. And though monetary policy is the dominant determinant of the price level in the long run, there are many other potential influences on price-level movements at shorter horizons. There are several links in the chain of causation running from monetary policy changes to their ultimate effects on the economy.

From a change in the official rate to other financial and asset markets
The transmission mechanism of monetary policy
A central bank derives the power to determine a specific interest rate in the wholesale money markets from the fact that it is the monopoly supplier of ‘high-powered’ money, which is also known as ‘base money’. (1) The operating procedure of the Bank of England is similar to that of many other central banks, though institutional details differ slightly from country to country. The key point is that the Bank chooses the price at which it will lend high-powered money to private sector institutions. In the United Kingdom, the Bank lends predominantly through gilt sale and repurchase agreements (repo) at the two-week maturity.

The transmission mechanism of monetary policy
This repo rate is the ‘official rate’ mentioned above. The box opposite outlines how the Bank implements an official rate decision in the money markets. The quantitative effect of a change in the official rate on other interest rates, and on financial markets in general, will depend on the extent to which the policy change was anticipated and how the change affects expectations of future policy. We assume here for simplicity that changes in the official rate are not expected to be reversed quickly, and that no further future changes are anticipated as a result of the change. This is a reasonable assumption for purposes of illustration, but it should be borne in mind that some of the effects described may occur when market expectations about policy change, rather than when the official rate itself changes.

Short-term interest rates
The transmission mechanism of monetary policy
A change in the official rate is immediately transmitted to other short-term sterling wholesale money-market rates, both to money-market instruments of different maturity (such as rates on repo contracts of maturities other than two weeks) and to other short-term rates, such as interbank deposits. But these rates may not always move by the exact amount of the official rate change. Soon after the official rate change (typically the same day), banks adjust their standard lending rates (base rates), usually by the exact amount of the policy change.

This quickly affects the interest rates that banks charge their customers for variable-rate loans, including overdrafts. Rates on standard variable-rate mortgages may also be changed, though this is not automatic and may be delayed. Rates offered to savers also change, in order to preserve the margin between deposit and loan rates. This margin can vary over time, according to, for example, changing competitive conditions in the markets involved, but it does not normally change in response to policy changes alone.

Long-term interest rates
The transmission mechanism of monetary policy
Though a change in the official rate unambiguously moves other short-term rates in the same direction (even if some are slow to adjust), the impact on longer-term interest rates can go either way. This is because long-term interest rates are influenced by an average of current and expected future short-term rates, so the outcome depends upon the direction and extent of the impact of the official rate change on expectations of the future path of interest rates. A rise in the official rate could, for example, generate an expectation of lower future interest rates, in which case long rates might fall in response to an official rate rise. The actual effect on long rates of an official rate change will partly depend on the impact of the policy change on inflation expectations. The role of inflation expectations is discussed more fully below.

Asset prices

Changes in the official rate also affect the market value of securities, such as bonds and equities. The price of bonds is inversely related to the long-term interest rate, so a rise in long-term interest rates lowers bond prices, and vice versa for a fall in long rates. If other things are equal (especially inflation expectations), higher interest rates also lower other securities prices, such as equities. This is because expected future returns are discounted by a larger factor, so the present value of any given future income stream falls. Other things may not be equal—for example, policy changes may have indirect effects on expectations or confidence—but these are considered separately below. The effect on prices of physical assets, such as housing, is discussed later.

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