The transmission mechanism

inSight

03 Jun 2004

The transmission mechanism

The nature and effectiveness of the transmission mechanism for monetary policy varies according to the size, structure and openness of the economy in question.

In discussions about monetary policy we often come across references to the transmission mechanism. This is broadly speaking the way in which changes in the monetary policy instrument, where these can be contemplated, bring about the macroeconomic effects that they are designed to produce. Thus, if the objective of monetary policy is to dampen or pre-empt inflation and the instrument selected is interest rate, the transmission mechanism describes how higher interest rates are supposed to curb increases in the general price level. Where the monetary policy instrument is market-based, for example interest rate, or the price of money, rather than an administrative instrument, as in the case of credit control, the transmission mechanism involves the operation of market forces. Increases in interest rates raise the cost of borrowing for firms and depress corporate investment; they also raise the return on savings and therefore reduce consumption (although this effect may be partially or fully offset by the increased income for savings). Furthermore, they reduce the value of assets, which impacts negatively on wealth and therefore consumption. Lower asset prices also reduce the value of collateral and therefore restrict banks' willingness to lend at the going rate. In economies with floating exchange rates and open capital accounts, higher interest rates tend to cause the exchange rate to appreciate, which shifts spending from domestic to foreign goods and services. On balance, these effects slow economic growth and reduce inflation pressures. This is, by and large, how the transmission mechanism works, where monetary management is practised.

But the real life situation, as always, is a little more complicated than that. There are economies that are less market-oriented than others, where the behaviour of borrowers may be less sensitive to the price of money and where bottom-line considerations may not be of prime importance in business decisions. Likewise the behaviour of lenders, which may be affected, relatively speaking, more by government policies to support the development of particular sectors of the economy than by credit risk, cost of funding or profitability considerations. There is also the possibility of the borrowing and lending rates of the banks being less sensitive to changes in the key policy rates. For these and other reasons, the transmission mechanism, from an interest rate hike to the slowing of inflation or of an intermediate target such as the money supply, may be less efficient than would otherwise be the case. This may be so to such an extent that interest rate as a monetary policy instrument may not be an effective one. And if the pain of higher interest rate, and therefore possible objections to its use, readily gets into the monetary policy decision-making process, reluctance in the use of interest rate may not be too surprising.

There is obviously a need to appreciate the dynamics of the transmission mechanism in order to gain a better understanding of, and possibly to predict, monetary policy in any jurisdiction. The conduct of monetary policy in developed market economies does have a high degree of similarity, but significant differences in their transmission mechanism still exist that justify different emphasis in the use of different monetary policy instruments. The size of the economy, its openness and its degree of external orientation are all relevant factors, justifying for example the use of varying degrees of flexibility in the exchange rate. And it is not difficult to envisage a situation where higher interest rates to curb inflation could lead to large capital inflow and the associated monetary consequences that defeat the original purpose of the monetary policy change, or to exchange rate overshooting that puts financial stability at risk. One further reason why raising interest rates may not be desirable is that when interest rates rise, prudent and risk-averse firms and consumers may be more hesitant to apply for loans than less prudent firms and consumers. This tends systematically to worsen banks' loan portfolios.

Furthermore, there are circumstances in which, taking everything into consideration, administrative instruments may, in the absence or before the establishment of structures that encompass efficient, market based transmission mechanisms, prove to be more effective and less risky in the conduct of monetary policy than the use of market instruments. But, clearly, the use of administrative instruments, involving executive decisions by government, for example, about who can borrow and how much, undermine the efficiency in the allocation of scarce financial resources and the extent to which financial intermediation through the banking system would benefit economic growth and development. There is therefore a balance to be struck, and I do not believe there is an institution better able to strike that balance than the central bank concerned. There is no case for simplistically imposing the practices of others, through political means or otherwise.

In the situation of the Mainland, where markets and institutions are being built in an impressive transition to a market economy, there is increasing but realistic emphasis in the use of market instruments, to the extent that the transmission mechanism can be relied upon to deliver. But, again realistically in the meantime, the use of administrative instruments, including the use of persuasion or directives from the executive authorities, cannot be excluded.

 

Joseph Yam

3 June 2004

 

Click here for previous articles in this column.

 

 

Document in Word format

Latest inSight
Last revision date : 03 June 2004