The goal of monetary policy is to induce changes in aggregate expenditures, which result in changes in aggregate production (gross domestic product), the price level, inflation, employment, and unemployment. The route between monetary policy and aggregate expenditures works through a variety of channels. The six key channels are: interest rates, exchange rates, wealth, equities, bank lending, and balance sheet.
These six channels generally reinforce each other, all moving aggregate expenditures in the same direction. All six channels increase aggregate expenditures with expansionary monetary policy. And all six channels work to decrease aggregate expenditures with contractionary monetary policy. Four of the six channels (interest rates, equities, bank lending, and balance sheet) primarily work through investment expenditures. One channel (exchange rates) works through net exports. And two channels (interest rates and wealth) work through consumption expenditures.
While monetary policy takes different routes to aggregate expenditures, once there, the consequences to the economy are the same. As these aggregate expenditures change, so too does the aggregate production of gross domestic product. More expenditures mean more production and fewer expenditures mean less production. Changes in aggregate production, then led to changes in other key macroeconomic variables, including employment, unemployment, the price level, and inflation. An increase in aggregate production generally reduces unemployment, but induces greater inflation. A decrease in aggregate production then works in the opposite way, increasing unemployment, but limiting inflation.
Interest RatesThe most noted and perhaps most important monetary policy channel works through interest rates. This channel has guided monetary policy since the early days of Keynesian economics. It continues to play a critical role in modern policy as indicated by the fact that the Federal Reserve System (Fed) targets interest rates.
The interest rates channel works like this: Monetary policy, specifically open market operations, affect bank reserves, which then affect interest rates. If the Fed buys through the open market operations, then banks have more reserves that they are willing to lend at lower interest rates. If the Fed sells through the open market operations, then banks have fewer reserves that they are willing to lend at higher interest rates.
Changes in interest rates then induce changes in investment expenditures on capital goods by the business sector and consumption expenditures on durable goods by the household sector. Lower interest rates induce greater investment and consumption expenditures and higher interest rates induce less. Consumption and investment expenditures are two of the four aggregate expenditures on gross domestic product. Changes in aggregate expenditures then work their magic to either stimulate or restrain the overall macroeconomy.
Exchange RatesA second monetary policy channel that has become increasingly important with the integration of the global economy works through exchange rates. An exchange rate is the price of nation's currency in terms of the currency of another nation. For example, the exchange rate between U.S. dollars and Japanese yen might be something like 100 yen per dollar. One dollar can buy 100 yen or 100 yen can buy one dollar.
This monetary policy channel works like this: Once again monetary policy affects bank reserves and interest rates. Interest rates then affect the flow of capital investment among nations. A lower interest rate induces domestic investment to seek relatively higher interest rates in other countries. A higher interest rate attracts capital investment from other countries.
The flow of capital investment induces changes in exchange rates. If capital investment flows out of a country, then demand for the nation's currency decreases, which then decreases the exchange rate (moving in the same direction as interest rates). If capital investment flows into a country, then demand for the nation's currency increases, which then increases the exchange rate (also moving in the same direction as interest rates).
Exchange rates then affect the flow of exports and imports into and out of a country. If the exchange rates for a country decrease, meaning the domestic currency is less expensive relative to other currencies, then exports rise and imports fall, resulting in an increase in net exports. If the exchange rates for a country increase, meaning the domestic currency is more expensive relative to other currencies, then exports decline and imports rise, resulting in a decrease in net exports.
As net exports change, so too do aggregate expenditures, gross domestic product, and other macroeconomic variables. A stimulation of the economy through lower interest rates is reinforced by lower exchange rates. Alternatively, restraint on the economy caused by higher interest rates is also reinforced by higher exchange rates.
WealthA third monetary policy channel works through the value of financial assets, that is, the financial wealth of the country. This is the one of two that works through financial wealth. Wealth comes in two basic varieties--financial and physical. Financial wealth includes the ownership of corporate stocks, corporate bonds, U.S. Treasury securities, money, and other legal claims. Physical wealth includes business capital goods, consumer durable goods, and other tangible products used to satisfy wants and needs. This channel focuses on the relation between financial wealth and the physical wealth of consumer goods.
This monetary policy channel works like this: Monetary policy has a direct impact on financial wealth. An increase in the money supply causes an increase in financial wealth and a decrease in the money supply reduces financial wealth. Any changes in wealth are likely to induce consumers to reevaluate their asset portfolios, that is, the relative mix of financial and physical assets.
In particular, consumers are bound to convert a portion of any increase in financial wealth into physical wealth. That is, people spend extra money on consumption goods, which is seen as an increase in consumption expenditures. Alternatively, a decrease in financial wealth induces consumers to convert a portion of physical wealth into financial wealth, meaning people have less money to spend and consumption expenditures decrease. Once again any change in consumption expenditures led to changes in aggregate expenditures, gross domestic product, and other macroeconomic variables.
EquitiesA fourth monetary policy channel also works through value of financial assets, but in this case through value of corporate stock (that is, equities) and investment expenditures.
This monetary policy channel works like this: Once again, monetary policy has a direct impact on the quantity of money available and thus financial wealth. Changes in the money portion of financial wealth is likely to induce changes in the mix of financial assets. That is, people are bound to use extra money to buy additional corporate stocks, or if less money is available, they are inclined to sell off (cash) in a few corporate stocks. The flow of money into or out of the stock market then affects the overall value of stocks, that is, equity prices.
The change in stock prices subsequently induces changes in investment expenditures. If stock prices change relative to the price of capital goods, then the business sector is inclined to adjust the mix of financial stock and physical capital, moving toward the lower priced option. That is, if stock prices rise, then the business sector purchases more physical capital. If stock prices fall, then the business sector purchases less physical capital.
The result, of course, is a change in investment expenditures, with corresponding changes in aggregate expenditures, gross domestic product, and the rest of the macroeconomy.
Bank LendingInvestment expenditures are also affected by the fifth monetary policy channel, however, in this case the route works through the willingness of banks to make loans to the business sector. This is one of two related channels that work through the credit or financial markets of the economy. This particular channel reflects the basic money creation process triggered by monetary policy.
It works like this: Monetary policy, especially open market operations, changes the amount of reserves held by the banking system. Expansionary monetary policy increases bank reserves and contractionary monetary policy decreases bank reserves.
The change in bank reserves is then translated into a change in the willingness of banks to make loans. More reserves mean more loans and fewer reserves mean fewer loans. The money creation process occurs when the change in lending is facilitated through checkable deposits. The monetary policy channel results as the loans are extended to the business sector for investment expenditures on capital goods.
More lending means greater investment expenditures and less lending means fewer investment expenditures. Like other channels affecting investment expenditures, the sequence of change continues through aggregate expenditures, gross domestic production, and the rest of the macroeconomy.
Balance SheetThis sixth monetary policy channel also works on investment expenditures through credit or financial markets. This channel, though, is reflects the impact monetary policy has on the balance sheets of business firms. It works on the presumption that the credit or borrowing that business firms are able to obtain and use to finance capital investment depends on the net worth reported on their balance sheets. That is, a sizeable net worth is more likely to receive loan approval than a smaller (or negative) net worth.
This monetary policy channel takes this particular route: As monetary policy induces a changes in financial wealth, especially corporate stock prices, the value of the assets reported on balance sheets also changes. An increase in financial wealth and stock prices is reflected by an increase in the value of balance sheet assets and a decrease shows a decrease in balance sheet asset value.
The resulting change in asset value results in a change in net worth. Greater asset value means more net worth and lower asset value means less net worth. The change in net worth subsequently affects the ability of business firms to obtain loans to finance capital investment expenditures. More net worth makes it easier to acquire loans and less net worth makes it more difficult.
Once again, this channel works its way up to investment expenditures, aggregate expenditures, gross domestic product and the rest of the economy.
All For OneThese six channels of monetary policy are neither independent nor mutually exclusive, nor are they equally important. Some channels tend to generate a bigger impact on the macroeconomy. And that impact changes over time under different circumstances. However, the channels do inevitably work together. Monetary policy causes changes in interest rates, exchange rates, and the value of financial assets, which then affect consumption expenditures, investment expenditures, and net exports, all of which then cause changes in the aggregate production and other macroeconomic variables.
MONETARY POLICY CHANNELS, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2022. [Accessed: May 22, 2022].