Chapter 8: Transmission Mechanisms of Monetary Policy and the Demand for Money
8. Transmission mechanisms of monetary policy and the demand for money INTRODUCTION Monetary policy affects output in the short run but only the price level in the long run. Yet the impact of monetary policy on the economy remains uncertain because of long and variable lags. The emerging consensus is that monetary policy has a comparative advantage in maintaining long-term price stability. Therefore, monetary authorities should use monetary policy for maintaining price stability, rather than attempting to finetune the economy (Cagan, 1992b; Friedman, 1961; 1968a). Transmission mechanisms of monetary policy suggest the plausible channels through which monetary policy actions affect the economy in the short run (Purvis, 1992). As monetary policy is seen as a demand management policy, monetary policy actions are expected to influence aggregate demand directly via its various components. The actions can be indirect depending on instruments being used (Mishkin, 1995; 2007a). As reviewed in Chapter 4, the issue remains whether the monetary authorities should pursue an activist monetary policy to achieve the objective of price stability in the medium and long runs, in conjunction with maintaining steady economic growth and/or stabilising the economy (Fischer, 1990). Identifying the transmission mechanisms of monetary policy is therefore essential for deployment of monetary policy instruments that may influence aggregate demand (and probably aggregate supply), leading to stabilising the price level over the medium term or the business cycle. When central banks undertake monetary policy, they set in motion a series of economic adjustments that work through both the goods and...
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