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
Editor's Notes
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