Title Chapter 7 Monetary transmission mechanism (1).docx ✅

1 Unit -VII Monetary Transmission Mechanism and Channel Introduction The monetary transmission mechanism describe how policy induce change in the nominal money stock or the short-term nominal interest rate impact economic activity (production, saving, investment etc.) and inflation. It explains various channels through which monetary policy affect, the real variables. Although monetary policy is neutral in the long run and medium term, it can affect economic activity through various channels recent research on the transmission mechanism seek to understand how these channels work in the context of dynamic, stochastic general equilibrium models. Some economists have divided monetary transmission channels into two types i ) neo-classical channel in which financial market are perfect and ii) non neo classical channel in which financial market are assumed to be imperfect. The study of monetary transmission mechanism concludes that monetary policy affects the real variables through interest rates, wealth change, asset prices, and credit etc. channels. Therefore, there are various mechanism by which change in the supply of money are transmitted to the goal variables (price, output and employment) these are; i) Money Supply ⟶ link (a) Portfolio ⟶ (b) Link ⟶ goal variables ii) Money Supply ⟶ Link (a) Wealth ⟶ Link (b) goal variables iii) Money Supply ⟶ Link (a) availability ⟶ Link (b) goal variables of debt iv) Money supply ⟶ Link (a) Expectation ⟶ Link (b) goal variables Therefore, there is casual relationship between the variables of transmission mechanism so that the mechanism can work more effectively. In conclusion, monetary transmission mechanism refers to the general conceptual framework within which the analysis of monetary disturbance may be undertaken, whereas the channel of monetary influence refers to the root through which these monetary disturbances affects the goals variables. Following are the major channels of monetary transmission mechanism; 1) Portfolio transmission mechanism Portfolio is a set of assets and debts of different yields, risks, maturities and other features. Portfolio balance theory consists of the composition of portfolios having different features of assets yields risks, maturities as well as preference of the wealth holder. The interrelationship
2 of the different assets depends on wealth holders’ views of the degree of substitutability and complementary of the assets. As a monetary transmission mechanism, portfolio balance theory gives both preference of wealth holders and characteristics of assets, apart from their yields. Money is one of the best assets among many that may features in the portfolio of wealth holders. Other includes wide range of financial assets such as government bills and bonds, debentures, equities, real assets, and so on. (Real assets means durable and non-durable consumer goods) Each assets provides a yield the nature of wealth depends on the characteristics of assets. Yields on assets will reflect not only money yield but also the speed up assets converted into the money and their capital value of certainty, risk etc. The yield obtain from each assets are subject to diminishing returns. Greater the quantity of assets. The smaller will be the yield from additional unit of assets. The portfolio will be balance when the marginal yields are the same on all assets. The demand for any assets will vary directly with its own yields and inversely with yield on all other assets. Thus, the demand for money as a proportion of total portfolio will rise when the yields on other assets falls and fall when the yield on other assets rises. A change in yields of any one assets will affect the demand to hold other assets. How much the demand for any assets is affected by a change in yield on other, depends on how close they are substitute for each other. Link of portfolio balance and goal variable The portfolio balance transmission mechanism operates through aggregate expenditure. Adjustment to portfolio leads to increase expenditure and through that prices, output and employment. In order to link the portfolio balance and goal variable we can consider following assumptions in simple Keynesian approach; 1) Economy consists of two sectors i.e. household sector and business sector. 2) There are three kinds of assets i.e. money, real assets and government bonds. 3) There is only one financial rate of interest on bonds. 4) The demand for money and real assets are taken into perfectly inelastic in order to yields. If the monetary policy undertaken through open market operation which rise money supply, than bond prices will be goes up and the rate of interest on bond goes down. This reduces opportunity cost of investing on real capital assets, rises the size of optimum capital stock which leads to increase in demand for capital assets and flow of investment expenditure. This channel of monetary influence is called cost of capital channel.
3  M S   Actual money balance >desired money balance  reallocation of assets  increases relative prices, real economic activity and price level. 2) Wealth transmission mechanism There are two channels involving wealth that are important to the monetary transmission mechanism. a) Real balance effect Real balance is defined as M/P where M is money issued by central bank and P is price level. It is a part of net wealth of public. The change in M exerts positive effect to M/P and the change in P exerts inverse effect to M/P. The theory of real balance effect was developed by Prof. Don Patinkin in 1965AD. He attempted to integrate monetary and real sector variables through real balance effect. According to him there is direct wealth effect of money supply on real sector variables. But his theory is applicable only in the short time period. The increase in the stock of money (M s), remaining the price level constant, raises real balance of public (M/P). This will increase aggregate demand of the economy. The excess aggregate demand generates inflationary pressure in the economy. Symbolically it can be expressed as; M s   M/P   C and I   Y     Where, M s = Money Supply M/P = real balance C = Consumption expenditure I = Investment expenditure  = Inflation and Y = aggregate demand The above channel shows that the increase in money supply increases the real balance effect/balance of people. This will directly affect the consumption and investment spending. Then aggregate demand will increase in the economy and finally inflation occurs.
4 b) Wealth effect on consumption This channel has been strongly advocated by Franco Modigliani based on his marginal propensity to save model. In his life cycle model, consumption expenditure is assumed to be an increasing function of the life time resources of consumer. The life time resource of the consumer made up of human capital, real capital and financial wealth. When there is rise in the life time income then consumption demand will increase in the economy. The crux of his discussion is that a link exists among monetary policy stock price, wealth and consumption spending. But how might monetary policy affect stock price. In a monetarist theory, when the money supply rises, the public finds it has more money than it wants and so tries to reduce the holdings of money by increasing their spending. One place, the public can spend more is in the stock market. This will increase the demand for common stocks and consequently will increase the stock prices. Then a channel has been established between monetary policy and real sectors variable through wealth mechanism. When central bank increases the money supply in the economy, price of common stock will also increases. This leads to increase in wealth of publish and consequently consumption expenditure, aggregate demand and inflation. Symbolically the wealth transmission mechanism can be shown as, M S  P common Stock   Wealth   C  Y   M S= Money supply P = Price C = Consumption expenditure Y = Aggregate demand and  = Inflation 3) Credit availability transmission Mechanism Bernanke and Gertler (1995) Proposed credit channels which explains the monetary transmission mechanism as an outcome of credit market imperfections arising from asymmetric information and costly enforcement of contracts in financial markets. The fundamental matter of this channel is that monetary policy can have price and output effect through credit rationing that arises from information asymmetric between financial institutions and the firms and consumers to which they lend (loayza 2002). There are two links in credit availability transmission mechanism and they are;