How Does Monetary Policy Impact the Economy?

Because of the impact monetary policy has on financing conditions in the economy (not just the costs, but also the availability of credit or banks’ willingness to assume specific risks) but also because of its influence on expectations about economic activity and inflation, monetary policy can affect the prices of goods, asset prices, exchange rates as well as consumption and investment.

Interest rate cuts, for example, lower the cost of borrowing, which results in higher investment activitiy and the purchase of consumer durables.  The expectation that economic activity will strengthen may also prompt banks to ease lending policy, which in turn enables businesses and households to boost spending.  In a low interest-rate environment, shares become a more attractive buy, raising households’ financial assets. This may also contribute to higher consumer spending, and makes companies’ investment projects more attractive.  Lower interest rates also tend to cause currencies to depreciate:  Demand for domestic goods rises when imported goods become more expensive.  All of these factors raise output and employment as well as investment and consumer spending.  However, this stepped-up demand may cause prices and wages to rise if goods and labor markets are fully utilized.

The process through which monetary policy decisions impact on an economy in general and the price level in particular is known as the monetary policy transmission mechanism.  The individual links through which monetary policy impulses proceed are known as transmission channels. The main channels of monetary policy transmission are set out in a simplified, schematic form in the chart.

Every monetary policy impulse (e.g. an interest rate change by the central bank, change in the monetary base resulting from changes in the minimum reserve rate) has a lagged impact on the economy.  Moreover, it is uncertain how exactly monetary policy impulses are transmitted to the price level or how real variables develop in the short and medium term. 

The difficulty of the analysis is to adjust the effects of the individual channels for external factors.  The effect of such external factors – e.g. supply and demand shocks, technical progress or structural change – may be superimposed on the effect of central bank measures, and it is difficult to isolate monetary policy effects on various variables for analytical purposes.  Moreover, the time lag in the reaction of the real sector to monetary measures renders the analysis more difficult. Hence, monetary policy must be forward looking.

The individual transmission channels are described in detail below: 

Interest rate channel: An expansion of the money supply by the central bank feeds through to a reduction of short-term market rates through this channel.  As a result, the real interest rate and capital costs decline, raising investment.  Additionally, consumers save less and opt for current consumption over future consumption. This, in turn, causes demand to strengthen. However, this stepped-up demand may cause prices and wages to rise if goods and labor markets are fully utilized.

Credit channel: The credit channel in effect breaks down into two different channels: 

1. Bank lending channel:  Central banks’ monetary policy decisions influence commercial banks’ refinancing costs; banks are inclined to pass the changes on to their customers.  If financing costs diminish, investment and consumer spending rise, contributing to an acceleration of growth and inflation.  However, following an increase in interest rates, the risk that some borrowers cannot pay back their loans in due course may increase so much that banks will not grant loans to these borrowers.  As a result, borrowers would be forced to cut back on planned expenditure. 
2. Balance sheet channel:  Monetary policy may have a direct impact on corporate policy, because companies may borrow to improve return on equity as long as the return on debt – in effect the lending rate – is lower than the return on assets. Hence, the return on assets is a weighted arithmetic mean of the return on equity and the lending rate, which are respectively weighted by the share of equity and debt in total assets.  Consequently, lower interest rates improve the return on equity.  For this reason, nonprofitable enterprises may show a positive return on equity. However, this may reinforce the influence of interest rates on investment behavior, which is referred to as the financial accelerator effect.  

Exchange rate channel: Expansionary monetary policy affects exchange rates because deposits denominated in domestic currency become less attractive than deposits denominated in foreign currencies when interest rates are cut.  As a consequence, the value of deposits denominated in domestic currency declines relative to that of foreign currency-denominated deposits and the currency depreciates.  This depreciation makes domestic goods cheaper than imported goods, causing demand for domestic goods to expand and aggregate output to augment.  This channel does not operate if a country has a fixed exchange rate; conversely, the more open an economy is, the stronger this channel is.  Exchange rate fluctuations may also influence aggregate demand by affecting the balance sheets of banks and companies whose balance sheets include a large share of foreign currency-denominated debt.  Interest rate reductions that entail a depreciation of the national currency raise the debt of domestic banks and companies which have foreign currency-denominated debt contracts.  Since assets are typically denominated in domestic currency and therefore do not increase in value, net worth declines automatically.  If balance sheets deteriorate, the risk that some borrowers cannot pay back their loans in due course may increase so much that banks will not grant loans to these borrowers.  As a result, borrowers would be forced to cut back on planned expenditures. 

Wealth channel: Monetary policy impulses are also transmitted through the price of assets such as stocks and real estate.  Fluctuations in the stock or real estate markets that are influenced by monetary policy impulses have important impacts on the aggregate economy.  The expansionary monetary policy effects of lower interest rates make bonds less attractive than stocks and result in increased demand for stocks, which bids up stock prices.  Conversely, interest rate reductions make it cheaper to finance housing, causing real estate prices to go up. There are three different types of transmission mechanisms involving asset prices: 

1. Investment effects:  Tobin’s q theory explains an important mechanism through which movements in stock prices can affect the economy.  Tobin’s q is defined as the market value of firms divided by the replacement cost of capital.  If q is high, the market price of firms is high relative to the replacement cost of capital, and new plant and equipment capital is cheap relative to the market value of firms.  Companies can then issue stock and get a high price for it relative to the cost of the facilities and equipment they have bought.  Investment spending will rise because firms can now buy a relatively large amount of new investment goods with only a small issue of stock.  An interest rate cut entailing a rise in stock prices will therefore reduce companies’ capital costs and consequently boost investment spending. 
2. Wealth effects:  Modigliani’s life cycle model states that consumption is determined by the lifetime resources of consumers.  These life cycle resources consist primarily of financial assets, mostly stock, and real estate.  Interest rate cuts entail a rise in stock and real estate prices and accordingly boost household wealth.  At the same time, consumers’ life cycle resources expand, in turn lifting consumer spending and aggregate demand. 
3. Balance sheet effects: A rise in stock and real estate prices improves corporate and household balance sheets alike.  Higher net worth translates into higher collateral for lending to companies and households.  This in turn increases lending, investment spending and hence higher aggregate spending.  

For further information please refer to

• The Transmission of Monetary Policy in Canada, Bank of Canada (Bank of Canada)

• Key Reading on Monetary Policy, Bank of England (Bank of England)

• Eurosystem Monetary Transmission Network (MTN), ECB