How does monetary policy work?

The process through which monetary policy decisions affect the overall economy and price levels in particular is called the monetary policy transmission mechanism. This mechanism comprises a chain of effects whereby monetary policy decisions are ultimately transmitted to price levels.

The central bank plays a pivotal role in this process, since it is the sole issuer of banknotes and bank reserves, which are the two components of the monetary base.

The stages in the monetary policy transmission mechanism are as follows:

  1. Change in policy interest rates: the central bank adjusts its policy interest rates. In the euro area, the European Central Bank (ECB) holds monetary policy meetings every six weeks, where it decides whether to change or maintain its policy interest rates and whether to implement other monetary policy instruments.
  2. Effect on market rates: changes in policy interest rates, which are short-term rates, have a direct impact on short-term money market interest rates, e.g. interbank market interest rates. However, they are also passed through to medium and long-term market rates through their impact on investors’ expectations regarding the future course of monetary policy. This effect has been amplified in recent years following the adoption of forward guidance on interest rates, i.e. the indications provided by the central bank on the future path of interest rates.
  3. Transmission to the interest rates on financing obtained by economic agents: market rates (short, medium and long-term) ultimately feed through, via various channels, to the interest rates at which governments, firms and households finance themselves. One direct channel is the effect on governments and corporate issuers, which mainly raise financing on capital markets through bond issuance. Thus, changes in debt security yields at different maturities, i.e. in the yield curve, directly impact these agents’ financing costs.
  4. Effect on bank lending: another channel, one that affects households and firms without access to capital markets, is the cost of bank lending. For instance, changes in short-term interbank rates, such as the 12-month EURIBOR, are directly passed through to the variable-rate mortgages linked to them. Likewise, medium and long-term market rates are typically used as a reference for pricing fixed-rate loans. Lastly, market rates are also ultimately passed through to the remuneration of bank deposits.
  5. Influence on economic agents’ saving and investment decisions: changes in financing costs have a bearing on business investment, household spending decisions and government budgetary policy. For instance, low interest rates foster household spending (because it is cheaper to finance and the expected returns on savings are lower) and business investment (since the returns tend to be higher than the associated financing costs). This means stronger demand among these agents for the goods and services in the economy. Together with the production costs in each sector (wages, intermediate goods, etc.), this affects how companies price each of these goods and services and, therefore, inflation.

This sequence describes the main transmission mechanism from monetary policy decisions to inflation. However, there are other transmission channels that run in parallel. For instance:

  • Effect on financial asset prices: monetary policy decisions, along with expectations regarding the future path of monetary policy, affect the price of financial assets (e.g. stock market prices). Such changes in the financial wealth of households and firms also influence their spending and investment decisions and, ultimately, demand for goods and services.
  • Effect on exchange rates: policy interest rates also have a bearing on exchange rates through international capital flows. Thus, the ECB’s interest rate decisions can cause the euro to appreciate or depreciate (see How does monetary policy relate to exchange rates?). How this channel affects inflation will depend on the economy’s openness to international trade, since exchange rates influence both the price of imported goods and the price competitiveness of domestic goods, which can affect the prices of final goods and external demand.