Monetary policy and Transmission mechanism

The “transmission mechanism” of monetary policy is decisions about that official interest rate affect economic activity and inflation through several channels.

There are several classical rules which are taken into account under running monetary policy:

Taylor rule is a monetary-policy rule that stipulates how much the central bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions. In particular, the rule stipulates that for each one-percent increase in inflation, the central bank should raise the nominal interest rate by more than one percentage point. This aspect of the rule is often called the Taylor principle.

Friedman's k-percent rule advocates a constant yearly expansion of the monetary base.

The Friedman rule is a monetary policy rule proposed by Milton Friedman, who advocated setting the nominal interest rate at zero. According to the logic of the Friedman rule, the opportunity cost of holding money faced by private agents should equal the social cost of creating additional fiat money. It is assumed that the marginal cost of creating additional money is zero (or approximated by zero). Therefore, nominal rates of interest should be zero. In practice, this means that the central bank should seek a rate of deflation equal to the real interest rate on government bonds and other safe assets, to make the nominal interest rate zero.

Monetary policy is referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy rapidly, and a contractionary policy decreases the total money supply, or increases it slowly. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates to combat inflation.

Effects of MP on an economy are different but one of them is the most noticable:

A liquidity trap is a situation described in Keynesian economics in which injections of cash into an economy by a central bank fail to lower interest rates and hence to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.

The old Keynesian literature emphasized that increasing money supply has no effect in a liquidity trap so that monetary policy is ineffective. The modern literature, in contrast, emphasizes that, even if increasing the current money supply has no effect, monetary policy is far from ineffective at zero interest rates. What is important, however, is not the current money supply but managing expectations about the future money supply in states of the world in which interest rates are positive.

Date: 2015-02-28; view: 1386