Monetary Policy Transmission Mechanism PDF

  This is the process through which monetary policy decisions affect the economy in general and the price level in particular  Transmission Mechanisms of Monetary Policy Monetary policy decisions affect two broad welfare indicators, output and inflation through the...

  This is the process through which monetary policy decisions affect the economy in general and the price level in particular  Transmission Mechanisms of Monetary Policy Monetary policy decisions affect two broad welfare indicators, output and inflation through the monetary transmission process that conventionally operates through five channels.  These channels are the interest rate channel, the exchange rate channel, the credit channel, the asset price channel, and the expectations channel This is the process through which monetary policy decisions affect the economy in general and the price level in particular. The transmission mechanism is characterised by long, variable and uncertain time lags. Aggregate  Formula demand the  AD=C+I+G+(X-M) total  AD = aggregate demand demand for C = consumption goods and I = investment services G = government spending within a X = total exports particular M = total imports market. Interest Rate Channel Mechanism: When the BSP changes its policy interest rates, it directly influences short-term market interest rates, which in turn affects long-term interest rates, such as those for loans and bonds. Impact: Higher interest rates make borrowing more expensive, reducing consumption and investment, which can lower inflation. Conversely, lower interest rates make borrowing cheaper, stimulating consumption and investment. Exchange Rate Channel Mechanism: Policy rate adjustments can influence the exchange rate of the Philippine peso. For example, a higher interest rate might attract foreign investment, leading to a stronger peso. Impact: A stronger peso can make imports cheaper and exports more expensive, influencing the trade balance and inflation. Conversely, a weaker peso can boost exports but increase import costs and inflation. Credit Channel Mechanism: Changes in policy rates influence the cost of borrowing and the availability of credit from banks. Tighter monetary policy may reduce bank lending and increase the cost of credit. Impact: If credit becomes more expensive or less available, it can lead to reduced consumer spending and business investment, slowing down economic activity. Easier credit conditions can stimulate spending and investment. Asset Price Channel Mechanism: Changes in interest rates can affect asset prices such as stocks and real estate. Lower interest rates can drive up asset prices, while higher rates can depress them. Impact: Higher asset prices can increase wealth and spending (wealth effect), while lower asset prices might reduce spending. Expectations Channel Mechanism: BSP’s policy decisions also influence expectations about future economic conditions. If people expect stable inflation and growth, they may spend and invest more confidently. Impact: Well-anchored inflation expectations can make monetary policy more effective, as consumers and businesses make decisions based on their expectations of future economic conditions. Economic indicators are determinants or financial data that indicate the direction of movement of an economy, thereby helping investors decide whether it is the right time to invest or better to wait. Inflation Rate What it Measures: The rate at which the general level of prices for goods and services is rising. Significance: Inflation is a primary concern for the BSP, as its main mandate is price stability. The BSP sets an inflation target to guide its monetary policy. Gross Domestic Product (GDP) What it Measures: The total value of goods and services produced in the Philippines over a specific period. Significance: GDP growth indicates the overall health of the economy. The BSP considers GDP when setting policy to support sustainable economic growth. Unemployment Rate What it Measures: The percentage of the labor force that is unemployed and actively seeking work. Significance: A high unemployment rate may prompt the BSP to adopt more accommodative monetary policy to stimulate economic activity. Balance of Payments (BOP) What it Measures: The difference between the country’s total exports and imports of goods, services, and capital. Significance: A surplus in the BOP strengthens the peso, while a deficit weakens it. The BSP monitors this to ensure external stability. Consumer Confidence Index What it Measures: The degree of optimism that consumers feel about the overall state of the economy and their personal financial situation. Significance: Higher consumer confidence typically leads to increased spending and investm Fiscal Deficit What it Measures: The difference between the government’s total expenditures and its revenues. Significance: A large fiscal deficit can lead to higher interest rates and inflation, influencing the BSP’s policy decisions.