In recent decades, the switch fromtargeting a monetary aggregate to an inflation framework has become moreprevalent, with most Central Banks opting for this strategy. The current practice in the UK seeks totarget inflation directly, with the Bank of England’s Monetary Policy Committee(MPC) aiming to hit 2%. The variation of price, quantity of money and creditsare all altered by the Central Bank in an attempt to trigger demand shocks. Themonetary transmission mechanism looks into how these monetary policy decisionsaffect the economy, through price level and interest rates.
However, this doesvary in detail between different economies across the due to differences ininstitutional structures. Throughout this essay, I will provide an insight intothe four channels of influence, which are key in determining output and pricesceteris paribus. As well as this, I look at how the transmission mechanism canbe broken and come to a conclusion as to which solution I deem as having theupmost of relevance in addressing the transmission mechanism of monetarypolicy. In this instance, there is a conflict ofinterest between economists over the implementation of monetary policy.
The oldtransmission mechanism which provided us with an exogenous view of the model statedthat the change in money supply was directly initiated by the Central Bank.According to Dastgir (2009, p.49), “During the 1980’s, this was the thrust ofUK monetary policy, under which the Bank of England targeted the rate of growthof the money stock”. Keynesian economists claimed that the excess supply ofmoney would cause a reduction in interest rates, thus, increasing the demandfor money in the economy. Mcleay, Radia and Thomas (2014, p.10) claims that,”The inflation target means that the Bank is committed to aiming to keep thevalue of money relatively stable in terms of the number of goods and servicesit can buy”. Through the use of the four channels, monetary policy has beengiven more room for manoeuvre, allowing for adjustments when necessary, andconsidering the economic climate that we are currently in, it is a valuableasset to possess.
To begin, the central bank pumps funds intothe banking system through the means of interest rates. Mcleay, Radia andThomas (2014, p.21) disputes that, “Central banks do not typically choose aquantity of reserves to bring about the desired short-term interest rate.Rather, they focus on prices – setting interest rates”. In addition to centralbanks adjusting interest rates to influence lending and borrowing, commercialbanks can also create broad money directly with monetary policy. As well asthis, existing borrowers will also be affected due to the fact that they haveto pay more to lenders.
This allows the economy to meet the inflation target,as a reaction to the financial crises, Mcleay, Radia and Thomas (2014, p.21)state that, “The MPC cut Bank Rate to 0.5% – the so-called effective lowerbound”. The second channel involves asset prices.
The rate of return on allassets is impacted when there is a change in the level of interest. A rise inthe interest rates inevitably lowers the price of bonds because they have aninverse relationship. As mentioned above, there is a clear connection betweeninflation expectations and long-term interest rates, but, a change in the levelof interest can also have an effect on other expectations. Rising interestrates may deceive households and firms into thinking the economy isover-performing. This, therefore, contributes to the uncertainty andtransparency of the economy, or policymakers in this case, and although,monetary policymakers have direct control over the interest rate, misleadingassumptions will inevitably slow down the economy.
The final channel thatprovides a link between the official rate of interest and inflation is theexchange rate. When interest rates rise, the value of the country’s exchangerate should appreciate, providing that all other factors remain constant. This,in turn, allows for cheaper imports and the level of exports plummets. When theprice of imports falls, it suggests that the demand for domestic goods andservices decreases, and as the price level is high, external demand is alsonegatively impacted. There are certain circumstances when themonetary transmission mechanism breaks down. One of the main issues arises whenan economy enters a deflationary period, having accumulated large amounts ofdebt.
Liquidation would, therefore, arise due to a confidence shock withinmarkets and pessimism within the economy. Due to the large overhang of debt, arecession may follow which, inevitably would trigger a raid deflationaryprocess as said by Fisher. Devrim (2017) claims that “This starts a process ofdeleveraging, which feeds into the deflationary spiral, as asset pricescollapse.
” In this instance, households and firms are discouraged fromborrowing as they attempt to reduce their excessive debt levels. This wasparticularly common when the bankruptcy of the Lehman Brothers occurred. WhenCentral Banks alter interest rates in correlation with the economy, banks donot tend to change theirs. For example, during a period of recession, banks maynot respond to a change in Interest rates set by the Central Bank. This isbecause Banks access the ability of borrowers as the level of risk attached tolending rises. The decision not to change the level of interest is thereforesignificant, as they need some sort of leverage against the borrower. Mcleay,Radia and Thomas (2014, p.
19) imply that, “This is the risk to the bank oflending to borrowers who turn out to be unable to repay their loans”. Centralbanks, therefore, try to convince the banks not to hold onto excess reserves.The Volker inflation method, which indicates that “Mr.
Volcker orchestrated aseries of interest rate increases that took the federal funds target fromaround 10% to near 20%” according to Washington, M.C.K.
(2012). This put a haltto all spending and inflation collapsed thereafter. A painful recessionfollowed and unemployment rose to almost 11%.
The banking system capitulatedand the effects of this implementation persisted for years to come. If thecentral bank reduced the rate to zero, the economy remains static. When thisoccurs households and firms begin to de-leverage, thus, pay back loans.
Thisreplicates the first quarter of 2009 in the United Kingdom when consumerspanicked, and the economy ‘froze’, as it depicted symptoms of the GreatDepression. It is now apparent that a conventionalinterest rate policy is not a solution to a broken monetary transmissionmechanism. On one hand, it can be argued that Quantitive Easing (QE) is apolicy that when implemented, is useful enough to rebuild the mechanism. QE isoften a form of unconventional monetary policy that is imposed when interestrates are low in an attempt to boost spending and achieve the inflation target.In the United Kingdom, QE has been attempted, and various times in fact, withthe notable implementations occurring in the wake of the 2008 financial crisisand most recently in 2016. The BBC (2016) argues that “The UK created £375bn($550bn) of new money in its QE programme between 2009 and 2012.
” Central banksdo this by creating money to purchase assets, usually in the form of governmentbonds. This, in turn, creates a fall in the level of interest due to theoverall amount of usable funds in the financial system increasing. However, animplication arises, whereby the economy may overheat and inflationary pressuresare imminent. A recent article published by the Financial Times expressed thatthe European Central Bank opted for imposing QE and it had a limited impact onthe prospect of the Eurozone.
Smaghi, B.L (2016) discusses that “But currencydepreciation is temporary and dependent on the reactions by other centralbanks. You can win a battle, but winning the currency war is a differentstory.
” Central Banks are therefore faced with a trade-off, leading to theother, arguably, more significant factors of the QE mechanism impaired. As theexchange rate is a key channel in the transmission of monetary policy as mentionedabove, it cannot be ignored by Central Banks. Japan, a country where deflationand recession have haunted the country for decades, is notably, known for itsfailure in implementing QE. It has since been perceived, however, that QE isdiscredited and has not been ceased to work. Apart from QE, there are othersolutions to the monetary transmission mechanism. Firstly, the need for banksto be overly responsive, shouldn’t be discussed and the concept of “waiting itout” should be considered according to the European Central Bank, which couldlead to an automatic change in inflation, to a lower, more stable rate. As wellas this, the regulation of liquidity capital markets could be deemed as asolution, the excess liquidity created by the deficit that is created by thegovernment can be controlled. Lastly, from the United Kingdom’s perspective,The Bank of England could regulate control liquidity in capital markets aroundthe globe.
The Bank would inevitably control British corporations, should theymerge, thus leading to stability within markets. To conclude, Central Banks going throughthe current mechanism know that they are faced with challenges as they imposecertain implementations like QE in an attempt to achieve a stable inflationrate. The crash in 2008 which gave the United Kingdom a taste of what a periodof depression is like, proved to be a vital indicator for monetary policymakersin their attempt at addressing macroeconomic objectives. In terms of solutionsto the monetary mechanism breaking down, it is still unclear as to which policyis sustainable as there are various implications. For me personally, I wouldenforce Quantitive Easing as my desired solution for the monetary transmissionmechanism.
It may seem as if it has been unsuccessful in past, taking Japan forexample, but, there are signs of hope if Central Banks implement itefficiently. In the United Kingdom, it has been a catalyst for recovery sincethe crash in 2008 having increased consumer confidence. Having said that, thedecision to go with QE as my desired method of correcting the monetarytransmission mechanism allows us to distinguish between Central Banks andGovernments, thus avoiding political disagreements.