Monetary policy has a rather complex transfer mechanism. The effectiveness of the policy as a whole depends on the quality of the work of all its links.
There are 4 links of the transmission mechanism of monetary policy:
changes in the value of the real money supply as a result of the Central Bank’s policy; changes in the interest rate in the money market; the reaction of total expenditures (especially investment costs) to the dynamics of the interest rate; changes in the volume of output in response to changes in aggregate demand (aggregate expenditures).
Between the change in the supply of money and the reaction of the aggregate supply there are two more intermediate stages, the passage through which significantly affects the final result.
The change in the market interest rate (2) occurs by changing the structure of the asset portfolio of economic agents after, as a result of, say, the expansionary monetary policy of the Central Bank, they have more money in their hands than they need. The consequence, as you know, will be the purchase of other types of assets, the cheapening of the loan, that is, as a result, a decrease in the interest rate (see Fig. 7.3a).
However, the reaction of the money market depends on the nature of the demand for money, i.e. on the steepness of the LD curve. If the demand for money is sufficiently sensitive to changes in the interest rate, then the result of an increase in the money supply will be a slight change in the interest rate. Conversely , if the demand for money reacts poorly to the interest rate (steep LD curve), then an increase in the supply of money will lead to a significant drop in the interest rate (Figures 7.3b, 7.3b).
The next step is to adjust aggregate demand (total expenditure) due to changes in the interest rate. It is generally believed that investment expenditures react more than others to the dynamics of the interest rate (although we can also talk about the reaction of consumption, the costs of local government, but they are less significant). If we assume that there has been a significant change in the interest rate in the money market, then the question of the sensitivity of investment demand (or aggregate demand as a whole) to the dynamics of the interest rate will arise. All other things being equal, the magnitude of the multiplicative expansion of total income will depend on this.
We also note the need to take into account the degree of reaction of aggregate supply to changes in aggregate demand, which is associated with the slope of the AS curve.
Obviously, violations in any link of the transmission mechanism can lead to a decrease or even the absence of any results of monetary policy. For example, minor changes in the interest rate in the money market or the lack of response of the components of aggregate demand to the dynamics of the interest rate break the relationship between fluctuations in the money supply and the volume of output. These disturbances in the work of the transmission mechanism of monetary policy are especially pronounced in countries with economies in transition, when, for example, the investment activity of economic agents is associated not so much with the interest rate in the money market as with the general economic situation and investors’ expectations.
In addition to the quality of the transmission mechanism, there are other difficulties in the implementation of monetary policy. The Central Bank’s maintenance of one of the target parameters, say, the interest rate, requires a change in the other in the event of fluctuations in the money market, which does not always favorably affect the economy as a whole. Thus, the Central Bank can keep the interest rate at a certain level to stabilize investments, and consequently, their impact through the multiplier on the volume of output as a whole. But, if for some reason the economy begins to rise and GNP grows, then this increases the transactional demand for money (real GNP is one of the parameters of the demand for money: ). With an unchanged supply of money, the interest rate will grow, which means that in order to keep it at the same level, the Central Bank must increase the supply of money. This, in turn, will create additional incentives for the growth of GNP and can also provoke inflation.
In the event of a downturn and a reduction in demand for money, the Central Bank should reduce the supply of money to prevent a reduction in the interest rate. But this will lead to a drop in aggregate demand and will only exacerbate the downturn in the economy.
Possible side effects in monetary policy should also be taken into account. For example, if the central bank deems it necessary to increase the money supply, it can expand the monetary base by buying bonds in the securities market. But simultaneously with the growth of the money supply, the interest rate will begin to decrease. This may affect the value of the coefficients cr and rr. The population can transfer part of the funds from deposits to cash and the ratio will increase, banks may increase their excess reserves, which will increase the ratio .
Monetary policy has a significant external lag (the time from making a decision to its result), because its impact on the size of GNP is largely related through fluctuations in the interest rate to changes in investment activity in the economy, which is a rather long process. This also complicates its implementation, because delaying the result can even worsen the situation. For example, a countercyclical expansion of the money supply (and a reduction in the interest rate) to prevent a recession can give a result when the economy is already on the rise and causes undesirable inflationary processes.
The effectiveness of monetary policy in modern conditions is largely determined by the degree of confidence in the policy of the Central Bank, as well as the degree of independence of the Central Bank from the executive branch. The latter is difficult to accurately assess and is determined both on the basis of some formal criteria (frequency of turnover of the Central Bank’s management, the boundaries of the bank’s participation in lending to the public sector, solving the problems of the budget deficit and other official characteristics of the bank fixed in the charter) and informal moments indicating the actual independence of the Central Bank.
In developing countries, as well as countries with economies in transition, the pattern is often seen: the greater the independence (both formal and informal) of the Central Bank, the lower the inflation rate and the budget deficit.
Monetary policy is closely linked to fiscal and foreign economic policy. If the Central Bank aims to maintain a fixed exchange rate, then an independent internal monetary policy is practically impossible, since an increase or decrease in foreign exchange reserves (the purchase or sale of foreign currency by the Central Bank in the foreign exchange market) in order to maintain the exchange rate automatically leads to a change in the money supply in the economy (for example, when buying a currency, the supply of money in the economy increases). The only exception is the situation when the Central Bank sterilizes the inflow or pool of foreign exchange reserves, neutralizing fluctuations in the money supply that have occurred as a result of foreign exchange transactions, by changing the volume of domestic credit with the help of known monetary policy instruments.
Certain difficulties are associated with the issue of coherence, coordination of fiscal and monetary policies. If the government stimulates the economy with a significant expansion of public spending, the result will be largely related to the nature of monetary policy (the behavior of the Central Bank). Financing additional spending by debt, that is, through the issuance of bonds, will put pressure on the financial market, tie up part of the money supply and cause an increase in the interest rate, which can lead to a reduction in private investment (the “crowding out effect”) and undermine the initial incentives to expand economic activity. If the Central Bank simultaneously pursues a policy of maintaining the interest rate, it will be forced to expand the supply of money, provoking inflation.
A similar problem arises when deciding on the financing of the state budget deficit. As you know, the deficit can be covered by money emission (monetization of the deficit) or by selling government bonds to the private sector (debt financing). The latter method is considered non-inflationary, not associated with an additional supply of money, if bonds are bought by the population, firms, private banks. In this case, there is only a change in the form of private sector savings – they are transferred into securities. If the Central Bank joins the purchase of bonds, then, as has already been shown, the amount of reserves of the banking system, and, accordingly, the monetary base, increases, and the multiplicative process of expanding the supply of money in the economy begins.
An effective stable monetary policy (which usually means a low sustainable growth rate of the money supply) in most cases cannot coexist with a fiscal policy that allows for a significant budget deficit. This is because in the face of prolonged, much less growing, deficits and limited debt financing opportunities, it can be difficult for the government to resist pressuring the central bank to increase the money supply to finance the deficit.