The “Monetary Transmission Mechanism” is the set of operations by which monetary policy decisions affect the aggregate demand, the credit market, interest rates and the economy in general.

This mechanism operates through different transmission channels which are grouped into three main categories, depending on the area they affect the most. These are interest rate channels, credit view, and other asset price channels.

The Traditional Interest-rate Channel

The Traditional Interest-rate Channel, is the channel that characterizes the traditional view of the monetary transmission mechanism, according to which, monetary policy affects real (rather than nominal) interest rates and therefore it can have a great influence over investments, spending on new housing, consumer spending, and aggregate demand.

As mentioned above, in the traditional view an easing of monetary policy leads to a decrease in real interest rates, which, for its part, helps to lower the cost of borrowing.

This easier access to credit, favored by the lower cost of borrowing, usually induces an increase in demand for money by companies, and therefore to new lending from banks.

Overall, this greater amount of money borrowed by firms leads to a boost in investment spending, which usually leads to a general increase in aggregate demand.

An important feature of this transmission mechanism lays in its emphasis on the differences between real and nominal interest rates.

In fact, as said before, only a change in real interest rates can have a substantial impact on the economy, especially in the case of the real long-term interest rate, which is viewed as having a major impact on spending, as opposed to the short-term one.

Another advantage related to the focus on real rather than nominal interest rate is that even if normal rates hit a floor of zero during a deflationary period is still possible to use the real interest rate to stimulate the economy, in fact with nominal interest rates at the zero level, a commitment by the monetary institutions towards future expansionary monetary policy can raise expected inflation, thereby lowering the real interest rate.

This mechanism thus indicates that monetary policy can still be effective even when nominal interest rates have already been driven down to zero by the monetary authorities.

The Credit View

The conventional theory according to which interest rate effects explain the impact of monetary policy on spending on durable assets does not convince everybody, this dissatisfaction has led to a new explanation, the “Credit View”, based on the concept of asymmetric information and on the financial frictions caused in the markets by this asymmetry.

In fact, the credit view proposes that the financial friction in credit markets fosters the rise of two types of monetary transmission channels:

· Bank Lending Channel: This is based on the ability of banks in solving problems related to asymmetric information in credit markets. In fact, banks are considered to be the best suited, in the financial world, to solve problems related to the asymmetry of information, because, for most players, they are usually the only source to have access to credit.

Therefore, relying on this established situation, monetary policy actions may affect the supply of funds available for banks to loan, and banks serve as a screening agent in order to determine the credit-worthiness of possible borrowers.

Hence, in this situation, an expansionary monetary policy that increases the level of loanable funds available to banks may lead to an increase in loans and therefore to an increase in investments and a rise in consumer spending.

Clearly, these measures will have their greatest effects upon the behavior of small firms, which are more dependent on bank loans than larger firms, which may look for funds even on the stock and bond markets.

· Balance Sheet Channel: It arises (like the bank lending channel) from the presence of financial frictions in credit markets. These financial frictions depend on the fact that lending to firms with a low net worth holds more severe problems of adverse selection and moral hazard. Lower net worth means that lenders have less collateral for their loans, so their potential losses from adverse selection are higher.

A decline in firms’ net worth, which raises the adverse selection problem, leads to decreased lending to finance investment spending. Moreover, the lower net worth of businesses also increases the moral hazard problem because it means that owners have a lower equity stake in their firms, giving them more incentive to engage in risky investment projects.

When borrowers do so, it is more likely that lenders will not be paid back, and so a decrease in businesses’ net worth leads to a reduction in lending and hence in investment spending. In this situation, monetary policy can affect firms’ balance sheets in many different ways, in fact, an easing in monetary policy which leads to a rise in stock prices leads to higher investment spending and higher aggregate demand because of the decrease in adverse selection and moral hazard problems.

· Cash Flow Channel: It is based on the concept that an increase in cash flow (the difference between firms’ cash receipts and cash expenditures), caused by an easing of monetary policy, leads to an increase in firms’ (or households’) liquidity and makes it easier for lenders to know whether the firm (or household) will be able to pay back its liabilities. This results in lower adverse selection and moral hazard, and an increase in lending and economic activity.

· Unanticipated Price Level Channel: Focuses upon monetary policy effects on the general price level. In a situation where debt payments are contractually fixed in nominal terms, a rise in inflation, due for example to an easing of monetary policy, lowers the value of the firm’s liabilities in real terms but should not lower the real value of the firms’ assets. Therefore real net worth rises, leading to a reduction in adverse selection and moral hazard, thus encouraging an increase in investment spending and of aggregate demand.

· Household Liquidity Effects: While studying this phenomenon usually the focus is on businesses’ spending habits, while, however, the credit view should apply equally well to consumer spending, particularly directed toward consumer durables and housing.

In fact, in the liquidity effects view, balance sheet effects work through their impact on consumers’ desire to spend rather than on lenders’ desire to lend, therefore, if consumers expect to suffer financial losses as in the case of a severe income shock, they will prefer to hold fewer illiquid consumer durable and housing assets and a greater amount of liquid financial assets.

The illiquidity of consumer durable and housing assets provides another reason why a monetary easing, which lowers interest rates and thereby increases cash flow to consumers, leads to a rise in spending on consumer durables and housing.

Why are Credit Channels Likely to be important?

First, a large body of evidence on the behavior of individual firms supports the view that financial frictions of the type crucial to the operation of credit channels do affect firms’ employment and spending decisions.

Second, evidence shows that small firms (which are more likely to be credit-constrained) are hurt more by tight monetary policy than large firms, which are unlikely to be credit-constrained.

Third, and maybe most compelling, the asymmetric information view of financial frictions, which is at the core of credit channel analysis, is a theoretical construct that has proved useful in explaining many other important economic phenomena, such as why many of our financial institutions exist, why our financial system has the structure that it has, and why financial crises are so damaging to the economy.

Other Asset Price Channels

Other asset price effects have in fact several separate channels that allow monetary policy to affect aggregate demand in different ways, these are:

· Exchange Rate Effects on Net Exports: This channel has been experiencing a strong increase in importance largely due to the growing internationalization of economies all over the world, and the advent of flexible exchange rates, that heavily affects both net exports and aggregate demand.

The effect of the exchange rate on net exports is mainly based on the fact that when the rate falls, makes domestic assets less attractive relative to other assets denominated in foreign currencies, this causes an unavoidable fall in the value of these domestic assets and a depreciation of the domestic currency.

This new situation of depreciated currency, makes domestic goods more attractive for foreigners, because the price of goods denominated in domestic currency, is lower than that of foreign goods. This leads to a rise in net exports, and hence in aggregate demand.

· Tobin’s q Theory: Is useful to explain how monetary policy can affect the economy through its effects on the valuation of equities (i.e. lower rates on bonds make stocks returns more attractive), q is defined by Tobin as the market value of firms divided by the replacement cost of capital, therefore, if q is high, the market price of firms is high relative to the replacement cost of capital, and new plant and equipment capital is cheap relative to the market value of firms.

Then, companies can issue stock and get a high price for it relative to the cost of the facilities and equipment they are buying. This will lead to a rise in investment spending because firms will be able to buy a lot of new investment goods with only a small issue of stock.

This mechanism helps to explain the existing link between Tobin’s q and investment spending.

· Wealth Effects: It relates to how consumers’ balance sheets affect their spending decisions and to Franco Modigliani’s life cycle hypothesis of consumption, which states that consumption spending is determined by lifetime resources of consumers, not just today’s income.

This channel is effective because, one important component of consumer lifetime resources is composed of common stocks, therefore, if the monetary institutions decide to implement an expansionary monetary policy, the stock prices rise, thus the lifetime resources of consumers grow. This increase in consumers’ wealth should boost consumption.

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