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transmission mechanismthe process whereby a particular policy instrument (e.g INTEREST RATE) ‘works’ its way through the economic system to affect a designated policy target (e.g. the rate of INFLATION). The linkages between an instrument and target can be lengthy and complicated. By way of illustration, Fig. 189 depicts a simplified version of the Bank of England model (the full model has some 150 linkages!) that the Bank's MONETARY POLICY COMMITTEE (MPC) uses to track the impact of interest rate changes on the government's inflation target (currently an annualized inflation rate of no more than 2%). The process begins when the MPC ‘announces’, for example, an increase in the ‘official’ rate of interest with the objective of reducing inflationary pressures in the economy. To enforce this rate rise in the money markets, the Bank must move to reduce the money supply (see MONETARY POLICY COMMITTEE for further details).
These monetary changes can be expected to impact on the ‘real’ economy in various ways. Monetarists posit that the reduction in the money supply will directly reduce the CONSUMPTION component of AGGREGATE DEMAND and that this will be reinforced by higher interest rates causing a fall in the demand for CREDIT (bank loans and mortgages) to finance consumption and house and other asset purchases. Keynesians also emphasize the impact of an increase in the cost of capital, as interest rates rise, in reducing the amount of INVESTMENT expenditure undertaken by businesses. (For further discussion see MONEY SUPPLY/SPENDING LINKAGES.) The combination of these factors can be expected to dampen down spending in the economy and thus reduce any tendency for demand to outstrip the supply potential of the economy (see DEMAND-PULL INFLATION).
Moreover, a determined effort by the authorities to keep the inflation rate low will impact on EXPECTATIONS, that is, consumers, wage bargainers and businesses will come to ‘expect’ low inflation and adapt their economic behaviour accordingly, thus preventing any tendency for an INFLATIONARY-SPIRAL to develop. (See ADAPTIVE-EXPECTATIONS, EXPECTATIONS-ADJUSTED/AUGMENTED PHILLIPS CURVE.)
Furthermore, monetarists posit that under a FLOATING EXCHANGE-RATE system, a reduction in the money supply will reduce the amount of pounds offered in exchange for foreign currencies, thus causing the exchange rate to appreciate. This has the effect of reducing import prices, again exerting downward pressure on the general price level.
However, there are various problems involved in the transmission mechanism:
- various ‘side-effects’ may occur that adversely affect other policy targets. For example, higher interest rates, by reducing investment, may harm long-term ECONOMIC GROWTH potential, while an appreciation of the exchange rate will increase export prices and harm domestic industries dependent on export demand as well as adversely affecting the BALANCE OF PAYMENTS;
- because of‘leads and lags’ in the introduction and implementation and the length of time it takes for the effects of a particular instrument change to work its way through the economy, various ‘distortions’ may occur that undermine the effectiveness of the policy initiative. For further discussion see DEMAND MANAGEMENT. See QUANTITY THEORY OF MONEY.