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In recent decades, the switch from
targeting a monetary aggregate to an inflation framework has become more
prevalent, with most Central Banks opting for this strategy.

The current practice in the UK seeks to
target inflation directly, with the Bank of England’s Monetary Policy Committee
(MPC) aiming to hit 2%. The variation of price, quantity of money and credits
are all altered by the Central Bank in an attempt to trigger demand shocks. The
monetary transmission mechanism looks into how these monetary policy decisions
affect the economy, through price level and interest rates. However, this does
vary in detail between different economies across the due to differences in
institutional structures. Throughout this essay, I will provide an insight into
the four channels of influence, which are key in determining output and prices
ceteris paribus. As well as this, I look at how the transmission mechanism can
be broken and come to a conclusion as to which solution I deem as having the
upmost of relevance in addressing the transmission mechanism of monetary

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In this instance, there is a conflict of
interest between economists over the implementation of monetary policy. The old
transmission mechanism which provided us with an exogenous view of the model stated
that 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 of
UK monetary policy, under which the Bank of England targeted the rate of growth
of the money stock”. Keynesian economists claimed that the excess supply of
money would cause a reduction in interest rates, thus, increasing the demand
for 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 the
value of money relatively stable in terms of the number of goods and services
it can buy”. Through the use of the four channels, monetary policy has been
given more room for manoeuvre, allowing for adjustments when necessary, and
considering the economic climate that we are currently in, it is a valuable
asset to possess.


To begin, the central bank pumps funds into
the banking system through the means of interest rates. Mcleay, Radia and
Thomas (2014, p.21) disputes that, “Central banks do not typically choose a
quantity of reserves to bring about the desired short-term interest rate.

Rather, they focus on prices – setting interest rates”. In addition to central
banks adjusting interest rates to influence lending and borrowing, commercial
banks can also create broad money directly with monetary policy. As well as
this, existing borrowers will also be affected due to the fact that they have
to 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 lower
bound”. The second channel involves asset prices. The rate of return on all
assets is impacted when there is a change in the level of interest. A rise in
the interest rates inevitably lowers the price of bonds because they have an
inverse relationship. As mentioned above, there is a clear connection between
inflation expectations and long-term interest rates, but, a change in the level
of interest can also have an effect on other expectations. Rising interest
rates may deceive households and firms into thinking the economy is
over-performing. This, therefore, contributes to the uncertainty and
transparency of the economy, or policymakers in this case, and although,
monetary policymakers have direct control over the interest rate, misleading
assumptions will inevitably slow down the economy. The final channel that
provides a link between the official rate of interest and inflation is the
exchange rate. When interest rates rise, the value of the country’s exchange
rate should appreciate, providing that all other factors remain constant. This,
in turn, allows for cheaper imports and the level of exports plummets. When the
price of imports falls, it suggests that the demand for domestic goods and
services decreases, and as the price level is high, external demand is also
negatively impacted.


There are certain circumstances when the
monetary transmission mechanism breaks down. One of the main issues arises when
an economy enters a deflationary period, having accumulated large amounts of
debt. Liquidation would, therefore, arise due to a confidence shock within
markets and pessimism within the economy. Due to the large overhang of debt, a
recession may follow which, inevitably would trigger a raid deflationary
process as said by Fisher. Devrim (2017) claims that “This starts a process of
deleveraging, which feeds into the deflationary spiral, as asset prices
collapse.” In this instance, households and firms are discouraged from
borrowing as they attempt to reduce their excessive debt levels. This was
particularly common when the bankruptcy of the Lehman Brothers occurred. When
Central Banks alter interest rates in correlation with the economy, banks do
not tend to change theirs. For example, during a period of recession, banks may
not respond to a change in Interest rates set by the Central Bank. This is
because Banks access the ability of borrowers as the level of risk attached to
lending rises. The decision not to change the level of interest is therefore
significant, 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 of
lending to borrowers who turn out to be unable to repay their loans”. Central
banks, therefore, try to convince the banks not to hold onto excess reserves.

The Volker inflation method, which indicates that “Mr. Volcker orchestrated a
series of interest rate increases that took the federal funds target from
around 10% to near 20%” according to Washington, M.C.K. (2012). This put a halt
to all spending and inflation collapsed thereafter. A painful recession
followed and unemployment rose to almost 11%. The banking system capitulated
and the effects of this implementation persisted for years to come. If the
central bank reduced the rate to zero, the economy remains static. When this
occurs households and firms begin to de-leverage, thus, pay back loans. This
replicates the first quarter of 2009 in the United Kingdom when consumers
panicked, and the economy ‘froze’, as it depicted symptoms of the Great


It is now apparent that a conventional
interest rate policy is not a solution to a broken monetary transmission
mechanism. On one hand, it can be argued that Quantitive Easing (QE) is a
policy that when implemented, is useful enough to rebuild the mechanism. QE is
often a form of unconventional monetary policy that is imposed when interest
rates 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, with
the notable implementations occurring in the wake of the 2008 financial crisis
and 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 banks
do this by creating money to purchase assets, usually in the form of government
bonds. This, in turn, creates a fall in the level of interest due to the
overall amount of usable funds in the financial system increasing. However, an
implication arises, whereby the economy may overheat and inflationary pressures
are imminent. A recent article published by the Financial Times expressed that
the European Central Bank opted for imposing QE and it had a limited impact on
the prospect of the Eurozone. Smaghi, B.L (2016) discusses that “But currency
depreciation is temporary and dependent on the reactions by other central
banks. You can win a battle, but winning the currency war is a different
story.” Central Banks are therefore faced with a trade-off, leading to the
other, arguably, more significant factors of the QE mechanism impaired. As the
exchange rate is a key channel in the transmission of monetary policy as mentioned
above, it cannot be ignored by Central Banks. Japan, a country where deflation
and recession have haunted the country for decades, is notably, known for its
failure in implementing QE. It has since been perceived, however, that QE is
discredited and has not been ceased to work. Apart from QE, there are other
solutions to the monetary transmission mechanism. Firstly, the need for banks
to be overly responsive, shouldn’t be discussed and the concept of “waiting it
out” should be considered according to the European Central Bank, which could
lead to an automatic change in inflation, to a lower, more stable rate. As well
as this, the regulation of liquidity capital markets could be deemed as a
solution, the excess liquidity created by the deficit that is created by the
government can be controlled. Lastly, from the United Kingdom’s perspective,
The Bank of England could regulate control liquidity in capital markets around
the globe. The Bank would inevitably control British corporations, should they
merge, thus leading to stability within markets.


To conclude, Central Banks going through
the current mechanism know that they are faced with challenges as they impose
certain implementations like QE in an attempt to achieve a stable inflation
rate. The crash in 2008 which gave the United Kingdom a taste of what a period
of depression is like, proved to be a vital indicator for monetary policymakers
in their attempt at addressing macroeconomic objectives. In terms of solutions
to the monetary mechanism breaking down, it is still unclear as to which policy
is sustainable as there are various implications. For me personally, I would
enforce Quantitive Easing as my desired solution for the monetary transmission
mechanism. It may seem as if it has been unsuccessful in past, taking Japan for
example, but, there are signs of hope if Central Banks implement it
efficiently. In the United Kingdom, it has been a catalyst for recovery since
the crash in 2008 having increased consumer confidence. Having said that, the
decision to go with QE as my desired method of correcting the monetary
transmission mechanism allows us to distinguish between Central Banks and
Governments, thus avoiding political disagreements.

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