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The process through which changes in the monetary policy stance affect the aggregate demand and inflation is termed as the transmission mechanism of monetary policy. The transmission mechanism generally involves uncertain time lags and it is, therefore, difficult to predict the precise effect of monetary policy changes on inflation. Broadly, the monetary policy transmission works through five channels; i.e. interest rate channel; balance sheet channel; exchange rate channel; assets price channel; and expectations channel.
Changes in the policy rate impact the cost of borrowing and return on savings for households and businesses. This in turn influences the decisions of economic agents to consume, save or invest, which ultimately influences output and inflation. For instance, an increase in the policy rate will push the cost of borrowing up, while also increasing the return on savings, thereby leading to moderation in demand and bringing inflation down
Balance sheet channel works through the borrowers’ net worth and the cost of funding for banks. Specifically, changes in the monetary policy rate affect the availability of loanable funds with the financial institutions and financial position of other economic agents by altering their cash flows and net wealth. These changes in wealth and interest income have an effect on micro and aggregate expenditure, output, and prices in an economy. For example, if the central bank decides to raise the policy rate, it will reduce borrowers’ net worth and increase the cost of funding for commercial banks. As a result, banks will reduce the supply of loans and choose to ration risker borrowers. In this way, a tight monetary policy decreases the aggregate demand and thus prices of goods and services in the economy.
Changes in the policy rate also lead to changes in foreign capital flows, leading to changes in the exchange rate. For instance, an increase in the domestic interest rates make the local currency financial assets, such as rupee denominated bonds, rupee deposits, etc, relatively more attractive than foreign currency denominated assets. It results into an increase the relative demand of local currency compared to foreign currency and may lead to either an appreciation of local currency or lower depreciation pressure on local currency. The relative increase in the value of domestic currency makes domestic goods more expensive than foreign goods, thereby causing a fall in the net exports and thus in aggregate demand. In addition, changes in interest rate may have a direct effect in inflation by influencing the prices of imported goods and services.
The asset prices channel reflects how changes in interest rates alter the value of assets like stocks and property. An increase in policy rate increases the rate of return on bank deposits making them more attractive compared to other real and financial assets. This leads to a reduction in the prices of these assets that in turn affect the wealth of its holders. This negative wealth effect results in overall reduction of demand for goods and services and the level of inflation in the economy
deals with the expectations of general public and investors mainly about the future interest rates and inflation in the economy. As the longer-term interest rates depend in part on market expectations about the future course of short-term rates, the expectations of future official interest-rate changes affect the long-term interest rates and hence the aggregate demand in the economy. Similarly, monetary policy may influence market expectations about the future inflation; which generally play an important role in wage and price setting behavior of economic agent and determining actual inflation in an economy. For instance, a credible central bank with a history of success in curtailing inflationary pressure announces that inflation is high and may need tightening in the future. The announcement may be enough to trigger the market sentiments and may lead their stakeholders to adjust their expectation that inflation will come down in the near term.
It is important to note that monetary policy does not impact the economy instantly. While short-term rates like overnight repo rate, may adjust immediately, the full effects on inflation often take 1-2 years to materialize as households, businesses and banks gradually adapt to the changes in interest rates.
