Glamor Economics

Chapter 101

Chapter 14 Section 2 How Monetary Policy Works - The Monetary Transmission Mechanism

Knowing about monetary policy, the next question is: How does monetary policy work?From this we need to understand the concept of monetary policy transmission mechanism.

The famous economist Wixell is the founder of the Swedish school. The monetary economic theory he put forward in the early 20th century, also known as the cumulative process theory, combined currency with the real economy for the first time, which had a great impact on the development of economics. Impact.

First of all, Wicksell divides interest rates into two types: one is money interest rate, that is, the market interest rate existing in the real financial market; The interest rate thus roughly corresponds to the expected rate of return on newly formed capital".Wicksell believes that if the two interest rates are consistent, the investment of the entire economy is equal to savings, and the currency is neutral and does not affect the economy.Because when the two interest rates are equal, it is the ideal equilibrium state of the currency, and this equilibrium state of the currency guarantees the equilibrium of the economic state.But in real life, these two rates of interest often diverge, either because the money rate changes without changing the natural rate, or because the natural rate changes without the money rate changing accordingly.

He himself believes that the latter case is more common.The improvement of production technology and the increase in the demand for physical capital will make the natural rate of interest rise, while the money rate of interest will remain unchanged and fail to follow the rise, thus causing a divergence between the two.If the market interest rate is lower than the natural interest rate, it will lead to an increase in investment, and the increase in investment will increase the prices of raw materials, land, and labor, thereby increasing the monetary income of raw material producers, land owners, and employees.Because the market interest rate is low, this part of the income is diverted to consumption instead of savings. As a result, the demand for consumer goods increases, thereby increasing the price of consumer goods.After the price of consumer goods rises, the price of capital goods also rises. In this way, a cycle of "low market interest rate→increase in investment→increase in money income→increase in price of consumer goods→increase in price of capital goods→increase in investment→increase in market interest rate"is formed.This cycle continues until the market rate of interest equals the natural rate of interest.Conversely, if the market interest rate is higher than the natural interest rate, it will lead to changes in the market interest rate and the natural interest rate until the two interest rates are finally equal.This is the famous Wicksell's cumulative process theory.

This is the earliest theory of monetary policy transmission mechanism.The monetary policy transmission mechanism is the transmission path and mechanism through which the central bank uses monetary policy tools to influence intermediary indicators, and then finally achieves the established policy goals.

There are generally three basic links in the transmission path of monetary policy, and the sequence is: [-]. From the central bank to commercial banks and other financial institutions and financial markets.The monetary policy tool operation of the central bank first affects the reserves, financing costs, credit capabilities and behaviors of commercial banks and other financial institutions, as well as the status of money supply and demand in the financial market.Second, various economic actors ranging from commercial banks and other financial institutions and financial markets to enterprises, residents and other non-financial sectors.Commercial banks and other financial institutions adjust their behavior according to the central bank's policy operations, thereby affecting the consumption, savings, investment and other economic activities of various economic actors.Third, from non-financial sector economic actors to social economic variables, including total expenditure, total output, prices, employment, etc.

In addition, the financial market also plays an extremely important role in the entire currency transmission process.First, the central bank mainly implements monetary policy tools through the market, and commercial banks and other financial institutions learn about the central bank’s monetary policy regulation intentions through the market; The adjustment of capital supply further affects investment and consumption behavior; finally, changes in social economic variables affect the behavior of the central bank and financial institutions through market feedback information.

On the basis of Wicksell's cumulative process theory, the Keynesian school concluded that the transmission mechanism of monetary policy is: the increase and decrease of money supply affect the interest rate, the change of interest rate affects investment through the marginal benefit of capital, and the increase and decrease of investment affect the aggregate The main link in this transmission mechanism is the interest rate.

Different from the Keynesian school, the monetary school believes that the interest rate does not play an important role in the monetary transmission mechanism. They believe that changes in the money supply directly affect expenditure, and then expenditure affects investment, and finally affects total income.Monetarists believe that in the short run, changes in the money supply will bring about changes in output, but in the long run it will only affect the price level.

[links to related words]

Interest rate liberalization means that the interest rate level of financial institutions operating and financing in the money market is determined by market supply and demand, which includes the marketization of interest rate determination, interest rate transmission, interest rate structure and interest rate management.In fact, the decision-making power of the interest rate is handed over to financial institutions, and the financial institutions themselves adjust the interest rate level based on their capital status and judgments on financial market trends, and finally form a central bank benchmark interest rate based on the money market interest rate as an intermediary. Market supply and demand determine the market interest rate system and interest rate formation mechanism of financial structure deposit and loan interest rates.

(End of this chapter)