Monetary Transmission Mechanism
The monetary transmission mechanism refers to a process of complex, and sometime subtle, changes in the economy that come about as a result of manipulating the money-supply as part of a short-term stabilization policy i.e. a policy to smooth out the boom-bust business cycle.
Right away it is important to know that this sort of short-term macroeconomic management fits in with the Keynesian school of thought, but Monetarist economists also favor this sort of economic management - they just have a slightly different target to Keynesians in that they emphasize monetary policy to control inflation rather than income/output (and, by association, unemployment).
For illustration purposes, the IS-LM Model is once again useful for highlighting the main headline variables that are affected by monetary policy.
To gain a better understanding of this model, I highly recommend clicking the link above, because it really gets to the heart of short-term demand-management techniques.
Just for recap purposes, each LM curve represents a fixed real money-supply, and therefore a fixed level of purchasing power.
If the government increases the nominal money-supply, a rightward shift of the LM curve occurs, and income/output will increase whilst the interest rate will fall.
For simplicity we keep the price level fixed (i.e. we assume that the economy is operating on the horizontal section of the aggregate supply curve).
On this page, I'll explain in greater depth the whole range of changes in both the financial asset market and the goods market following a money-supply boost. I do this to help better understand the process, i.e. the monetary transmission mechanism, that induces changes in interest rates and income/output.
The Keynesian Monetary Transmission Mechanism in Four Stages
The basic Keynesian transmission mechanism of monetary policy is a very straightforward four step process, as summarized in the picture below. The first step involves the central bank increasing the nominal money supply, and whilst this step also needs some explanation, it is not the focus of this page, and will be discussed separately on my page about:
Step 4 in the monetary transmission mechanism is simply the results stage of process and since we are holding prices constant there's nothing too controversial about the end results. That leaves us with steps 2 and 3, and it is these steps that are of particular interest.
The Four Stages of the Monetary Transmission Mechanism
Term Structure of Interest Rates
By increasing the monetary base, the central bank buys up short-term securities in the financial system, typically these are Treasury bills and some commercial bills. To do this, the holders of those securities must be enticed to sell, and so the central bank offers a higher price than the current market clearing rate for those securities.
I did say that we are holding prices constant, but that is with regard to the general level of prices in the goods/services market i.e. inflation, but the financial assets market is treated independently of the goods/services market.
As the price of these short-term securities rises, the whole structure of securities of all terms to maturity are adjusted in order to re-balance the expected returns from these assets for their associated risk levels given the higher price of short term securities.
Since these assets have a fixed nominal return, any increase in their selling price translates as a reduction in the assets' implied interest rate, and so the whole term structure of interest rates is reduced by the central bank paying a higher price for short-term securities.
Again, just to reiterate, we are holding the general price level in the goods market constant - so the interest rate changes here are 'real interest rate' changes, not merely nominal changes.