The monetary transmission mechanism is the channels through which the monetary target works and it describes the mechanisms through which the monetary policy actions of the central bank impact on the ultimate objective of inflation and output. Miskhin (1995) usefully describes the various channels through which monetary policy action as summarized by changes in either the nominal money stock or the short term nominal interest rate, impact real variables such as aggregate output and employment. According to the traditional Keynesian interest rate channel, a policy induced increase in the short term nominal interest rate, leads first to an increase in longer- term nominal interest rates, as investors act to arbitrage away the differences in risk-adjusted expected returns on debt hypothesis of the term structure. When nominal prices are slow to adjust, these movements in nominal interest rates translate into movements in real interest rates as well. Firms, finding that their real cost of borrowing over all the horizons has increased, cut back on their investment expenditures. Likewise, households facing higher real borrowing costs scale back on their purchases of homes, automobiles and other durable goods, aggregate output and employment fall. According to Frederic S. Miskhin, there are three main types of monetary transmission mechanism models; 1. Interest Rate Channels
2. Other Asset Price Channels (including Exchange Rates, Equity Prices, Real Estate) 3. Credit Channels (including the Bank Lending Channel and the Balance Sheet Channel)
THE EXCHANGE RATE CHANNEL
Another channel through which monetary policy can affect GDP, and one that is sometimes modeled in the IS-LM model, is through the impact on exchange rates. The basic idea is as follows: when the central bank increases the money supply, it lowers short-term nominal interest rates and thus lowers short-term real interest rates as well. Lower short-term real interest rates imply that dollar denominated assets are less attractive than foreign assets leading to a decrease in demand for dollars. The subsequent depreciation of the dollar makes domestic goods cheaper than foreign goods and leads to an increase in Net Exports, and therefore in GDP as well. We can summarize the relationship (where rw denotes interest rates in the rest of the world) as M ! i ! r ! (r − rw) ! Nominal Exchange Rates (e)! NX. For small open economies with flexible exchange rates, this can be a particularly important channel of transmission. The reason why some small open economies choose to adopt fixed exchange rates can also be understood from this equation: when the exchange rate is not allowed to change then domestic interest rates must be equal to world interest rates, thus the monetary policymaker is rendered toothless.
THE EQUITY PRICE CHANNEL
Mishkin emphasizes two equity price channels: Tobin’s Q and wealth effects. Tobin’s Q is a widely used theory of investment, which states that Q = Market Value of Capital Replacement Cost of Capital
When Q is high, firms will invest more either because adding capital is cheap or because the value of installed capital is high. Conversely when Q is low they will invest less. Expansionary monetary policy can lead to a higher Q - either because market interest rates are falling leaving people with less attractive alternatives or because they have more money to spend, therefore they buy more stocks. Higher stock prices (a higher market value) lead to a higher Q and more investment. The wealth effects aspect of the equity price channel rose to prominence during the great stock boom, and subsequent great stock collapse of 1999-2000. The increase in the price of stocks that follows a monetary expansion raises household wealth and leads individuals to spend more money. It could also be the case that higher demand for stocks increases the value of companies and enables companies to borrow and spend...