ANALYTICS OF MONETARY POLICY

 Analytics of Monetary Policy

• As we are aware, just as fiscal policy, monetary policy is intended to influence macro- economic variables such as the aggregate demand, quantity of money and credit , interest rates etc , so as to influence overall economic performance.
•  The process or channels through which the change of monetary aggregates affects the level of product and prices is known as ‘monetary transmission mechanism’. It describes how policy-induced changes in the nominal money stock or in the short- term nominal interest rates impact real variables such as aggregate output and employment. 
• Although we know that monetary policy does influence output and inflation, we are not certain about how exactly it does so because the effects of such policy are visible often after a time lag which is not completely predictable.

There are mainly four different mechanisms through which monetary policy influences the price level and the national income. These are:

(a) the interest rate channel,

(b) the exchange rate channel,

(c) the quantum channel (e.g., relating to money supply and credit), and

(d) the asset price channel i.e. via equity and real estate prices.

We shall have a brief discussion on each of the above transmission mechanisms. According to the traditional Keynesian interest rate channel, a contractionary monetary policy‐induced increase in interest rates increases the cost of capital and the real cost of borrowing for firms with the result that they cut back on their investment expenditures.

•  Similarly, households facing higher real borrowing costs, cut back on their purchases of homes, automobiles, and all types of durable goods. A decline in aggregate demand results in a fall in aggregate output and employment. 
• Conversely, an expansionary monetary policy induced decrease in interest rates will have the opposite effect through decreases in cost of capital for firms and cost of borrowing for households.
• In open economies, additional real effects of a policy‐induced change in the short‐ term interest rate come about through the exchange rate channel. Typically, the exchange rate channel works through expenditure switching between domestic and foreign goods.
•  Appreciation of the domestic currency makes domestically produced goods more expensive compared to foreign‐produced goods. This causes net exports to fall; correspondingly domestic output and employment also fall.
• Two distinct credit channels- the bank lending channel and the balance sheet channel- also allow the effects of monetary policy actions to spread through the real economy. Credit channel operates by altering access of firms and households to bank credit. Most businsses and people mostly depend on bank for borrowing money.
•  “An open market operation” that leads first to a contraction in the supply of bank reserves and then to a contraction in bank credit requires banks to cut back on their lending. This, in turn makes the firms that are especially dependent on banks loans to cut back on their investment spending. Thus, there is decline in the aggregate output and employment following a monetary contraction.
• Now we shall look into how the balance sheet channel works. Logically, as a firm’s cost of credit rises, the strength of its balance sheet deteriorates. A direct effect of monetary policy on the firm’s balance sheet comes through an increase in interest rates leading to an increase in the payments that the firm must make to repay its floating rate debts. An indirect effect occurs when the same increase in interest rates works to reduce the capitalized value of the firm’s long‐lived assets. 
•  Hence, a policy‐induced increase in the short‐term interest rate not only acts immediately to depress spending through the traditional interest rate channel, it also acts, possibly with a time-lag, to raise each firm’s cost of capital through the balance sheet channel. These together aggravate the decline in output and employment.The standard asset price channel suggests that asset prices respond to monetary policy changes and consequently affect output, employment and inflation.
•  A policy‐ induced increase in the short‐term nominal interest rates makes debt instruments more attractive than equities in the eyes of investors leading to a fall in equity prices. If stock prices fall after a monetary tightening, it leads to reduction in household financial wealth, leading to fall in consumption, output, and employment.

The manner in which these different channels function in a given economy depends on:
(i) the stage of development of the economy, and

(ii) the underlying financial structure of the economya