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The New Palgrave Dictionary of Economics Online

monetary transmission mechanism

Peter N. Ireland

From The New Palgrave Dictionary of Economics, Second Edition, 2008

Edited by Steven N. Durlauf and Lawrence E. Blume

Abstract

The monetary transmission mechanism describes how policy-induced changes in the nominal money stock or the

short-term nominal interest rate impact on real variables such as aggregate output and employment. Specific

channels of monetary transmission operate through the effects that monetary policy has on interest rates, exchange

rates, equity and real estate prices, bank lending, and firm balance sheets. Recent research on the transmission

mechanism seeks to understand how these channels work in the context of dynamic, stochastic, general

equilibrium models.

Keywords

asset price channels of monetary transmission; balance sheet channel of monetary transmission; balance sheet

credit channel; bank lending credit channel; bank reserves; bonds; central banks; currency; exchange rate channel

of monetary transmission; inflation targeting; interest rate channel of monetary transmission; interest rates; IS–LM

model; Keynesianism; life-cycle theory of consumption; liquidity trap; loanable funds theory; monetarism;

monetary base; monetary policy; monetary transmission mechanism; New Keynesian economics; New Keynesian

Phillips curve; open market operations; Phillips curve; rational expectations models; real business cycles; Taylor

rule

Article

The monetary transmission mechanism describes how policy-induced changes in the nominal money stock or the

short-term nominal interest rate impact on real variables such as aggregate output and employment.

Key assumptions

Central bank liabilities include both components of the monetary base: currency and bank reserves. Hence, the

central bank controls the monetary base. Indeed, monetary policy actions typically begin when the central bank

changes the monetary base through an open market operation, purchasing other securities – most frequently,

government bonds – to increase the monetary base or selling securities to decrease the monetary base.

If these policy-induced movements in the monetary base are to have any impact beyond their immediate effects on

the central bank's balance sheet, other agents must lack the ability to offset them exactly by changing the quantity

or composition of their own liabilities. Thus, any theory or model of the monetary transmission mechanism must

assume that there exist no privately issued securities that substitute perfectly for the components of the monetary

base. This assumption holds if, for instance, legal restrictions prevent private agents from issuing liabilities having

one or more characteristics of currency and bank reserves.

Both currency and bank reserves are nominally denominated, their quantities measured in terms of the economy's

unit of account. Hence, if policy-induced movements in the nominal monetary base are to have real effects,

nominal prices must not be able to respond immediately to those movements in a way that leaves the real value of

the monetary base unchanged. Thus, any theory or model of the monetary transmission mechanism must also

assume that some friction in the economy works to prevent nominal prices from adjusting immediately and

proportionally to at least some changes in the monetary base.

The monetary base and the short-term nominal interest rate

If, as in the US economy today, neither component of the monetary base pays interest or if, more generally, the

components of the monetary base pay interest at a rate that is below the market rate on other highly liquid assets

such as short-term government bonds, then private agents’ demand for real base money M/P can be described as a

decreasing function of the short-term nominal interest rate i: M/P

=

L(i). This function L summarizes how, as the

nominal interest rate rises, other highly liquid assets become more attractive as short-term stores of value,

providing stronger incentives for households and firms to economize on their holdings of currency and banks to

economize on their holdings of reserves. Thus, when the price level P cannot adjust fully in the short run, the

central bank's monopolistic control over the nominal quantity of base money M also allows it to influence the

short-term nominal interest rate i, with a policy-induced increase in M leading to whatever decline in i is necessary

to make private agents willing to hold the additional volume of real base money and, conversely, a policy-induced

decrease in M leading to a rise in i. In the simplest model where changes in M represent the only source of

uncertainty, the deterministic relationship that links M and i implies that monetary policy actions can be described

equivalently in terms of their effects on either the monetary base or the short-term nominal interest rate.

Poole's (1970)

analysis shows, however, that the economy's response to random shocks of other kinds can depend importantly on

whether the central bank operates by setting the nominal quantity of base money and then allowing the market to

determine the short-term nominal interest rate or by setting the short-term nominal interest rate and then supplying

whatever quantity of nominal base money is demanded at that interest rate. More specifically, Poole's analysis

reveals that central bank policy insulates output and prices from the effects of large and unpredictable

disturbances to the money demand relationship by setting a target for i rather than M. Perhaps reflecting the

widespread belief that money demand shocks are large and unpredictable, most central banks around the world

today – including the Federal Reserve in the United States – choose to conduct monetary policy with reference to

a target for the short-term nominal interest rate as opposed to any measure of the money supply. Hence, in

practice, monetary policy actions are almost always described in terms of their impact on a short-term nominal

interest rate – such as the federal funds rate in the United States – even though, strictly speaking, those actions still

begin with open market operations that change the monetary base.

The channels of monetary transmission

Mishkin (1995)

usefully describes the various channels through which monetary policy actions, as summarized by changes in

either the nominal money stock or the short-term nominal interest rate, impact on 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

differences in risk-adjusted expected returns on debt instruments of various maturities as described by the

expectations 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 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. This interest rate channel lies at the heart of the traditional Keynesian

textbook IS–LM model, due originally to Hicks (1937), and also appears in the more recent New Keynesian

models described below.

In open economies, additional real effects of a policy-induced increase in the short-term interest rate come about

through the exchange rate channel. When the domestic nominal interest rate rises above its foreign counterpart,

equilibrium in the foreign exchange market requires that the domestic currency gradually depreciate at a rate that,

again, serves to equate the risk-adjusted returns on various debt instruments, in this case debt instruments