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The European Monetary Mechanism

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The European Monetary Mechanism

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  • April 15, 2013
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Monetary Transmission Mechanism
Course : Monetary Economics
Professor : Ing. Jaromir Hurnik, Ph.D.
Student : Nicolas Mancini

The transmission mechanism of monetary policy cannot be better defined than by the ECB itself : « The process through which monetary policy decisions affect the economy in general and the price level in particular ». Decisions concern changes in interest rates, asset prices, aggregate demand, output gap and eventually inflation. The transmission mechanism is marked by uncertain time lags, which means that monetary economists are not able to provide accurate forecasts and analysis about the concrete effect of new monetary policy actions on the economy and price level. Although there is a lot of debate around the real nature of the MTM, the mainstream view can be illustrated as follows :

The impact of monetary policy on inflation incurs in general a 1 up to 2 years lag since the announcement, by the ECB or any Central Bank, of the policy rate decision. Economists usually speak of ‘’long and variable lags’’, that means that central bankers must be patient until having proper results of their interventions but also that they should be aware of some surprises or unexpected setbacks. It is impossible to predict exactly the outcome of such actions because of the complexity of our economy but also because of the behavior of the population. There is this problem with the expectations of the public. The five main channels of the MTM include the interest rate channel, the asset price channel, the exchange rate channel, the credit channel and finally the expectations channel. These channels are the ways the Central Bank affects the economy, and more accurately production and inflation, through adjustments in consumption and investments.

Described in the standard IS-LM model in macroeconomics, the interest rate channel is the primary channel of the transmission mechanism. It describes the process of transmission when Central Bank decides to...