Monetary Transmission Mechanism: How Monetary Policy Influences Inflation
The process through which monetary policy decisions by the central bank affects changes in the prices of goods and services is called the monetary transmission mechanism. There are three main channels through which monetary policy actions can affect inflation:
- The credit channel impacts inflation through aggregate demand and the output gap. A change in the policy rate will affect real monetary conditions based on market interest rates and changes in the exchange rate. The overall effect on real monetary conditions will influence aggregate demand and hence inflation;
- The exchange rate channel works through the direct effect of changes in the nominal exchange rate on the prices of imported goods and services; and
- Inflation expectations depends on the Bank’s ability to shape the public’s view of future prices through improved communication strategies and reducing the level of uncertainty in the economy. If the public believes that in the future prices will increase, they will increase the demand for certain goods and services now thus raising the cost for those goods/services thus resulting in inflation.