The monetary transmission mechanism is the process by which

asset prices In finance, valuation is the process of determining the present value (PV) of an asset. In a business context, it is often the hypothetical price that a third party would pay for a given asset. Valuations can be done on assets (for example, inve ...

and general economic conditions are affected as a result of

monetary policy Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money supply, often a ...

decisions. Such decisions are intended to influence the

aggregate demand In macroeconomics, aggregate demand (AD) or domestic final demand (DFD) is the total demand for final goods and services in an economy at a given time. It is often called effective demand, though at other times this term is distinguished. This is ...

interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...

s, and amounts of money and credit in order to affect overall economic performance. The traditional monetary transmission mechanism occurs through interest rate channels, which affect interest rates, costs of borrowing, levels of

physical investment In macroeconomics, investment "consists of the additions to the nation's capital stock of buildings, equipment, software, and inventories during a year" or, alternatively, investment spending — "spending on productive physical capital such as mach ...

, and aggregate demand. Additionally, aggregate demand can be affected through friction in the

credit market The bond market (also debt market or credit market) is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the secondary market. This is usually in the form of bonds, bu ...

s, known as the credit view. In short, the monetary transmission mechanism can be defined as the link between monetary policy and aggregate demand.

Traditional interest rate channels

An interest rate channel may be categorized as traditional, which means monetary policy affects

real Real may refer to: Currencies * Brazilian real (R$) * Central American Republic real * Mexican real * Portuguese real * Spanish real * Spanish colonial real Music Albums * ''Real'' (L'Arc-en-Ciel album) (2000) * ''Real'' (Bright album) (2010) ...

(rather than nominal) interest rates, which influence investment, spending on new housing,

consumer spending Consumer spending is the total money spent on final goods and services by individuals and households. There are two components of consumer spending: induced consumption (which is affected by the level of income) and autonomous consumption (which ...

, and

. An easing of monetary policy in the traditional view leads to a decrease in real interest rates, which lowers the cost of borrowing resulting in greater investment spending, which results in an overall increase in aggregate demand.

Credit view

Apart from the traditional channel which focuses on effects as a result of changes to the interest rate, additional methods exist to allow monetary policy to achieve the desired economic results and changes in aggregate demand, but through different channels categorized as the credit view. The credit view argues that financial friction in the credit markets creates additional channels that lead to changes in aggregate demand. These channels operate through effects on bank lending, as well as the effects on the balance sheet of a given firm or household. * Bank lending channel Monetary policy affects

bank deposit A deposit account is a bank account maintained by a financial institution in which a customer can deposit and withdraw money. Deposit accounts can be savings accounts, current accounts or any of several other types of accounts explained below. ...

s, leading to changes in the amount of

bank loan In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations, etc. The recipient (i.e., the borrower) incurs a debt and is usually liable to pay interest on that de ...

s and investment in residential housing. * Balance sheet channel Monetary policy affects stock prices, leading to

moral hazard In economics, a moral hazard is a situation where an economic actor has an incentive to increase its exposure to risk because it does not bear the full costs of that risk. For example, when a corporation is insured, it may take on higher risk ...

and

adverse selection In economics, insurance, and risk management, adverse selection is a market situation where buyers and sellers have different information. The result is that participants with key information might participate selectively in trades at the expe ...

, which leads to changes in lending activity and investment * Cash flow channel Monetary policy leads to changes in

nominal interest rate In finance and economics, the nominal interest rate or nominal rate of interest is the rate of interest stated on a loan or investment, without any adjustments or fees. Examples of adjustments or fees # An adjustment for inflation(in contrast with ...

s, which affects cash flow, leading to moral hazard, adverse selection, and changes in lending activity and investment * Unanticipated price level channel Monetary policy can lead to unanticipated

price level The general price level is a hypothetical measure of overall prices for some set of goods and services (the consumer basket), in an economy or monetary union during a given interval (generally one day), normalized relative to some base set. ...

changes, resulting in moral hazard, adverse selection, and changes in lending activity and investment * Household liquidity effects Monetary policy affects stock prices, leading to changes in financial wealth and the probability of financial distress, which affects residential housing and consumer spending

Other asset price effects

Finally, other asset price effects have separate channels which allow monetary policy to affect aggregate demand: * Exchange rate effects on net exports Monetary policy affects real interest rates and the

exchange rate In finance, an exchange rate is the rate at which one currency will be exchanged for another currency. Currencies are most commonly national currencies, but may be sub-national as in the case of Hong Kong or supra-national as in the case of ...

, leading to changes in

net exports The balance of trade, commercial balance, or net exports (sometimes symbolized as NX), is the difference between the monetary value of a nation's exports and imports over a certain time period. Sometimes a distinction is made between a balance ...

* Tobin's ''q'' theory Monetary policy affects stock prices, leading to changes in

Tobin's q Tobin's q (or the q ratio, and Kaldor's v), is the ratio between a Asset, physical asset's market value and its replacement value. It was first introduced by Nicholas Kaldor in 1966 in his paper: ''Marginal Productivity and the Macro-Economic Theo ...

(the market value of firms divided by the replacement cost of capital) and investment * Wealth effects Monetary policy affects stock prices, which affects financial wealth and consumption (consumer spending on nondurable goods and services)

Traditional interest rate channels

Credit view

Other asset price effects

References

Further reading