This is how monetary policy works
On his Twitter account, Julio Santaella, former president of the National Institute of Statistics and Geography (Inegi), explained the impact that monetary policy has on inflation.
Monetary policy has five transmission channels: interest rate, credit, prices of other assets, exchange rate and expectations.
The different channels through which monetary policy operates operate simultaneously and complement each other, the document specifies. Effects of monetary policy on the economy of Banxico.
In recent days I have read various commentators on the way in which the monetary policy of the @Banxico affects the economy. Most ignore the multiple transmission channels of monetary policy.
Brief ? clarifying.
1/n– Julio A. Santaella (@SantaellaJulio)
May 16, 2022
Interest rate
When inflation is high, central banks begin to raise their interest rates, “raising the cost of capital and discouraging aggregate spending (especially current investment and consumption),” Santaella explains on Twitter.
By increasing the cost of capital to finance projects, investment is discouraged. In addition, the opportunity cost of consumption increases, so it tends to decrease. Both elements affect aggregate demand and eventually inflation, the document reads. Effects of monetary policy on the economy of Banxico.
Credit
A higher reference interest rate, Julio Santaella explained, causes not only a decrease in the demand for credit, but also in supply.
A higher interest rate implies a greater risk of portfolio recovery, which is why financial intermediaries choose to ration it.
“The decrease in consumption and investment translates in turn into a decrease in aggregate demand and consequently in lower inflation,” says Banxico.
Exchange rate
A higher interest rate can cause differentials to increase with respect to other countries, in the case of Mexico with the United States, “which tends to reduce the prices of commercial goods, discourages exports and stimulates imports,” says the former president of the INEGI.
The appreciation of the exchange rate translates into lower costs for companies, something that favorably affects inflation.
Price of other assets
Stocks tend to lose value with higher interest rates, which causes a decrease in the wealth of the holders of this type of asset, Santaella points out.
On the contrary, explains Banxico, high rates and interest make investing in bonds more attractive.
The lower price of shares means that companies have a better ability to access financing sources, which makes it difficult to carry out new investment projects. This leads to “a better aggregate demand and a decrease in inflation,” reads the Banxico document.
Expectations
Expectations about future inflation -which also influence the formation of prices and wages- “is extremely important in an Inflation Targeting regime such as the one in force in Mexico,” reads Julio Santaella’s Twitter thread.
Expectations are not only involved in the price determination process, they also have effects on interest rates, and these on aggregate demand and supply. “To illustrate the role that inflation expectations have in the economy, it is important to highlight that the forecasts of future costs and income of companies are very important in determining the prices and production levels of the goods and services they offer,” he details. The document Effects of monetary policy on the economy.
