Over the last few years, a consensus has emerged among economists and central banks that the main objective of monetary policy should be to secure and maintain price stability. With this in mind, the adoption by the Central Bank of a monetary policy strategy whose main feature is to anticipate any future inflationary pressures began to gain importance. The preventive nature of monetary policy is justifiedMA1 not only by the lower social cost associated with a prospective policy that anticipates future events but, above all, its own limitations in controlling inflation. Within this new strategy, a key aspect is the knowledge of the transmission mechanism of monetary policy, that is, the study of the various effects produced by monetary policy in the economy. Although most economists agree on the qualitative effects of monetary policy (e.g. an increase in the interest rate depresses economic activity in the short term and reduces inflation) on the economy, disagreements remain about the magnitude of these effects and, mainly, the channels through which these effects spread in the economy.
It is worth nothing that despite the identification of the channels through which monetary policy spreads through the economy, and the intensity of each, the transmission mechanism varies according to the characteristics of each economy. For example, the exchange rate, recognised as an important channel of transmission of monetary policy, loses relevance in economies whose exchange rates are fixed. Likewise, in those economies with poorly developed financial systems, the credit channel is of little importance.
The main transmission channels of monetary policy are the interest rate, exchange rate, asset price, credit, and expectations. By affecting these variables, monetary policy decisions influence the levels of savingsMA2 , investment, and spending of individuals and firms, which in tum affect aggregate demand and ultimately, the rate of inflation. Before beginning to describe how each of these channels works, it is important to emphasize that monetary policy produces real effects only in the short and medium terms, that is, in the long term, the currency is neutral. The only long-term effect is on the price level of the economy. It should be noted that other factors also influence the price level of the economy in the short term, such as in agricultural shock or a tax increase. AsMA3 mentioned above, the simple expectation of changes in the interest rate is already capable of producing effects in the economy, for example, other interest rates may begin to adjust before the central bank officially changes the interest rate. Therefore, for the sake of analytical clarity, it will be assumed that changes in the interest rate are not anticipated by the market.
The transmission channel through interest rates is the best-known channel of monetary policy, being the most used in textbooks. As the interest rate of the very short-term interest rate increases, which is the interest rate that the central bank controls, the increase spreads throughout the entire term structure of the interest rate, especially for the shorter term rates, where they are verified effects. Considering the prices are rigid in the short term, central bank action also raises real interest rates. In turn, the real interest rate is the relevant rate for investment decisions. Thus, by raising the cost of capital, the rise in the real interest rate decreases investment, either in fixed capital or in inventories. In turn, falling investment reduces aggregate demand. In addition, the literature on the monetary policy transmission mechanism clearly shows that consumer decisions regarding the purchase of durable goods can also be seen as investment decisions. Therefore, the rise in the real interest rate also decreases the consumption of durable goods.