The European Monetary Mechanism

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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 change the interest rates to money markets and then to deposits and credit rates in normal commercial banks. These changes have an impact on the level of consumption, investments and savings. As explained in many economic textbooks, if the money quantity injected in the national economy (M) grows, then the interest rate (i) would decrease, stimulating the consumption (C) investments (I) due to lower opportunity costs, and subsequently stimulating national output or income (Y). When decreasing the policy rate, the public tend to reallocate their savings towards non-interest bearing assets such as real estate and equity. This is operated through the asset price channel. The higher the demand for these kinds of assets, the higher the prices will be. This results in more wealth and an increasing consumption. In addition, the higher the prices of the effects the higher the valuation of the company, attracting more investors in the future. Shortly said, an expansion of domestic demand would lead to higher economic growth. The exchange rate channel reports that when policy rate decreases, the foreign investments are having a bigger ROI than the domestic ones, causing a capital outflow. As capital moves to foreign countries, consequently the national currency depreciates benefiting the net trade balance (exports increase) so that following the equation of national income (Y = G + C + I + NX) it would create more wealth and more employment. The credit channel operates through changes in debt obligations. When interest rate decline, the companies owe less money to their creditors (financial instutions like banks) reinforcing their balance sheet. Finally the expectations channel concerns the expectations of the public towards inflation, employment, future income and profits/losses and the credibility of the Central Bank. The impact of monetary policy, due to the impossibility to quantize the expectations, through this channel is the most uncertain of all. When Mario Draghi,...
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