Monetary policy

How does monetary policy work?

The process through which monetary policy decisions affect the economy in general, and price levels in particular, is known as the monetary policy transmission mechanism and is a long cause-and-effect chain linking monetary policy decisions with price levels.

The central bank's important role is due to the fact that it is the sole issuer of banknotes and the only supplier of bank reserves.

The mechanism starts with the central bank distributing liquidity and steering short-term interest rates. The chain would schematically continue as follows:

  • Change in official interest rates

    The central bank changes the official interest rates

  • It affects bank and market interest rates

    Given that the banking system demands money issued by the central bank to meet the public demand for currency in circulation, to clear interbank balances and to meet the requirements for minimum reserves that have to be deposited with central banks, the change in official interest rates obviously influences bank rates.

    It indirectly affects market rates as the banking system passes them on to their customers, changing both the remuneration on deposits and credit costs.

  • It has an impact on expectations

    The change in official interest rates also influences expectations concerning future monetary policy, affecting longer-term interest rates- and inflation.

  • It affects the price of financial assets

    Changes in monetary policy and in expectations concerning its future evolution affect financial assets (e.g..shares, government debt, private debt,…)prices and performances.

    These changes in the price of financial assets in turn affect saving, spending and investment decisions of households and firms and, eventually, the demand for goods and services.

  • It influences economic agents' saving and investment decisions

    Changes in interest rates influence the saving and investment decisions of consumers and businesses. Hence, low interest rates favour consumption on the one hand because since the return on savings decreases and investment on the other, becauses the return on the investment is bound to be higher than the cost of the investment.

  • It affects credit supply

    Credit costs and availability are two important factors influencing business investment, household consumer spending and, in turn, the general conditions of demand. In consequence, changes in the availability of credit and its costs resulting from changes in monetary policy can be an important means of transmission.

  • It affects exchange rates

    Changes in interest rates can affect the exchange rate through international capital flows, causing the currency to appreciate or depreciate.

    The extent of the impact will depend on how open the economy is to international trade since exchange rate developments have an effect via their impact on the price of imported goods and the competitiveness of domestically produced goods which can feed through to the price of end goods and external demand.

  • It affects wage and price- setting

    If monetary policy meets its primary objective of price stability, inflation expectations will remain low and wage and price-setting will follow suit.

    Neither should it be forgotten that changes in demand can produce tension in the labour and intermediate goods markets, and this in turn can affect wage and price-setting.

As a result of the aforementioned chain, monetary policy action usually takes a considerable time to affect price developments.

The magnitude and intensity of several effects may vary depending on the state of the economy which makes the exact impact difficult to estimate.

Moreover, economic developments are continuously influenced by shocks from a large variety of sources, such as changes in oil or other commodity prices, developments in the world economy or in fiscal policies which may influence price behaviour.

Central banks, therefore, often use some simple rules to guide or cross-check their action. One such rule is based on the fact that inflation is always a monetary phenomenon in the medium to long term. This means that excessive monetary growth generates inflation as it produces an increase in the demand for goods and in turn in the price, while also influencing future price expectations. Similarly, insufficient monetary growth can cause deflation.

The monitoring of monetary aggregates is therefore justified because it offers useful information for monetary policy and, through its development, it serves to assess whether inflationary trends exist.