The Mechanism and Transmission of Monetary Policy
The mechanism and transmission of the monetary policy has become and major threat to the economic development and growth. In this regard, the monetary policy transmission can be referred to as the changes and amendments to the cash flow affect the economic growth, economic inflation as well as economic activity (Atkin & La Cava, 2017). A lower cash flow does not only result to depreciation and downfall of economy, but also stimulates the housing investments and expenditures of a household through raising the cash rates of the households as well as their capital and wealth.
The Effects of Monetary Policy Transmission
The monetary policy transmission has effects and impacts cash rate economic inflation and activities. In their article, Atkin and La Cava (2017) claim that enumerating the impacts and effects of the monetary policy is difficult. However, the market of housing seems essential to the monetary policy transmission process within Australia. Atkin and La Cava (2017) focused on the two stages of monetary policy transmission and the channels used for transmissions. The primary purpose of this essay is to summarize the two stages of monetary transmission policy, with their channels, and provide a critical evaluation of the article, specifically examining the strengths and weaknesses of the article.
Summary
The monetary policy transmission can be summarized and simplified into two stages. First, changes to the cash flow results to effects on other rates of interest in the economy. Secondly, changes in this these rates of interests affects the economic inflation as well as the economic activity (Atkin & La Cava, 2017). The two stages of the monetary policy transmission are outlined in the article focusing on the Australian economy. A summary of the two stages outline in the article is provided respectively for each stage of the monetary policy transmission. The stage of monetary policy transmission as outlined by the authors include:
The First Stage of Monetary Policy Transmission
As aforementioned, the first stage of the monetary transmission policy entails how changes and modifications of the cash affects the economic activity as well as inflation. The cash rate plays a vital role of providing a benchmark for the rates of interest, which allows many sources to lend and borrow funds within the financial and banking markets (Atkin & La Cava, 2017). Besides its effects on the economy and funding expenses of financial institutions, the cash flow has severe effects on the deposits and lending rates, which are faced by businesses and households. Furthermore, Atkin and La Cava (2017) identified other factors that results to the depreciation of the interest rates include; risk associated with the loans, competition in the financial market, and changes of conditions in the market. Loans and deposits might either have fixed or variable interest rates. The type of interest determines the speed at which the interest reach the households and businesses.
According to Atkin and La Cava (2017), the loans and deposits with variable interest rate tend to react quickly to the cash flow changes. For instance, the authors discovered that the variable rate loans and deposits account for approximately two-thirds on business loans sector, and about four-fifths in the households’ loans in Australia (Atkin & La Cava, 2017). In this regard, the loans and deposits are affected and influenced quickly. On the contrary, fixed interest rate loans are resistant to changes in the cash flow. The expected trail of the interest rate determines the rate of interest on new fixed loans (Atkin & La Cava, 2017). Consequently, an anticipated modification and change in the cash flow would not be typically passed to the new loans with fixed rate interest. In the first stage of the monetary policy transmission, cash flows anchor other rates of interests.
The Second Stage of Monetary Policy Transmission
In the second stage of monetary transmission, the authors have focused on how changes in interest rates affect factors such as inflation, employment, and economic activity. To achieve this, the article has focused on different channels, ranging from the saving and investment channel, the cash flow channel, the asset prices and wealth channel, to the exchange rate channel.
The saving and investment channel is a key monetary transmission channel in contemporary macroeconomic models. Under this channel, interest rates affect economic activity through a shift in business and household incentives that encourages saving over consuming (Atkin & La Cava, 2017). When interest rates are low, households are encouraged to save and borrow. Reduced interest rates are also associated with increased business borrowing. Under the cash flow channel, businesses and households' spending decisions are influenced by reduced interest rates paid on loans and received on deposits. This influences the amount of disposable income households and businesses are willing to spend. According to Atkin and La Cava (2017), for borrowers, reduced interest rates reflect lower repayments, resulting in increased disposable income and willingness to spend. For lenders, however, low interest rates result in lower income and reduced disposable income.
The article has divided the asset prices and wealth channel into two sub-channels: the wealth channel, the balance sheet channel. The wealth channel assumes that demand for assets can be stimulated through a reduction in interest rates since it will increase the current reduced value of the asset's prospect income flows. The balance sheet channel assumes that reduced interest rates will increase the capacity of households and businesses for borrowing.
According to the article, the exchange rate channel draws from the impacts of interest rates on the exchange rate, which influence both inflation and economic activity in small and open economies such as Australia (Atkin & La Cava, 2017).
Critical Evaluation
The article aimed to establish the implication of changes in the cash rate on inflation and economic activity. Through the transmission of monetary policy, the authors have achieved in demonstrating how changes in cash and interest rate affect economic activity and inflation.
A key strength of the article is its organization. The authors have divided the transmission of monetary policy into two underlying stages: first stage of monetary policy transmission and second stage of monetary policy transmission. The first stage has focused on how shifts in cash rate influence interest rates within an economy. The second stage highlights the implications of changes in interest rates on inflation and economic activity. The second stage of monetary policy transmission is further divided into four main channels: the saving and investment channel, the cash flow channel, the asset prices and wealth channel, and the exchange rate channel.
While the authors have clearly described the assumptions under the aforementioned channels, they fail to comprehensively discuss the Credit Channel. This is an underlying weakness of the article. In addition to the balance sheet and cash flow channel, the credit channel also includes the bank-lending channel. This channel holds that external finance premium monetary policy that shift the supply of bank credit. Under the channel, reduced supply of bank credit results in low economic activities and increased external finance premium.
Conclusion
It is apparent that changes in monetary policy are transmitted through the economy, and have adverse impacts on demand, rate of inflation, and economic activity. The article focused on the impacts of monetary policy on the Australian economy and inflation. The authors conclude that reduced cash rates result in increased household spending. Reduced cash rates are also associated with lower exchange rates, resulting in increased net exports and trade-in inflation.
Reference
Atkin, T. and La Cava, G., 2017. The Transmission of Monetary Policy: How Does It Work? RBA Bulletin, pp.01-08.
