Answer to Question #239293 in Macroeconomics for Avu

Question

Discuss the different transmission mechanisms.

Answer 1

Solution:

Transmission mechanisms are the channels through which monetary policy decisions affect the behavior of other economic variables or the economy in general, mainly price level and output.

The different transmission mechanisms include the following:

1.). Saving and investment channel – Changes in interest rates affect the saving and investment decisions of companies and households. Higher interest rates make it less attractive to borrow loans for financing investment or consumption and vice versa.

 

2.).  Exchange rate channel – When the interest rate rises, the domestic currency tends to appreciate reducing the price level of tradable products expressed in national currency. Changes in the exchange rate also affect inflation directly by decreasing the prices of imported consumer goods and inputs used in domestic production.

 

3.). Credit channel – An increase in real interest rates tends to increase bank lending rates as well, hence reducing the supply of credit to firms and households, discouraging consumption and investment.

 

4.). Asset prices channel – Asset prices can also have an effect on aggregate demand through the value of the collateral that permits borrowers to get more loans or to reduce the risk premium demanded by banks or lenders.

 

5.). Expectation’s channel – Expectations of future official interest rate changes affect medium and long-term interest rates. Also, the central bank's decisions affect agent's expectations about the economic performance in the future and inflation.