From Short to Medium Run (IS-LM-PC)

Monetary Policy Transmission Channels

coreExam · medium

Monetary policy affects the economy through five channels: (1) interest-rate (↓i → ↑I, ↑C), (2) asset-price (↓i → ↑Q → ↑wealth → ↑C), (3) exchange-rate (↓i → depreciation → ↑NX), (4) credit / bank-lending (↓i → ↓x → ↑loans), (5) expectations (forward guidance, ↑πe). Each channel has different lags and magnitudes.

Derivation

Step 1 / 7

1Press Space or click Reveal next
(hidden)
2Press Space or click Reveal next
(hidden)
3Press Space or click Reveal next
(hidden)
4Press Space or click Reveal next
(hidden)
5Press Space or click Reveal next
(hidden)
6Press Space or click Reveal next
(hidden)
7Press Space or click Reveal next
(hidden)

Five Channels

| # | Channel | Mechanism | Direct effect | |---|---------|-----------|---------------| | 1 | Interest rate | $\downarrow r$ → user cost, Euler | $\uparrow I, \uparrow C$ | | 2 | Asset price | $\downarrow r$ → $\uparrow Q$ | $\uparrow C$ via wealth | | 3 | Exchange rate | $\downarrow i$ → UIP → $\downarrow E$ | $\uparrow NX$ | | 4 | Credit | $\downarrow i$ → $\downarrow x$ | $\uparrow I$ | | 5 | Expectations | Forward guidance | $\uparrow A$ via $r^{e'}$ |

Lag Structure

Monetary policy acts with long and variable lags. Rate cuts affect output with a peak ~6–8 quarters out; inflation peaks ~12–16 quarters out. This is why CBs need to act pre-emptively.

Amplification at the ZLB

When the policy rate is pinned at 0:

Channel 1 (rate) is disabled
Channel 4 (credit) works via QE compressing $x$
Channel 5 (expectations) works via forward guidance

Open-Economy Amplification

The exchange-rate channel is crucial in small open economies. A rate cut under floating FX:

Depreciates $E$ via UIP
Raises NX via Marshall–Lerner
Adds to the output response

Under fixed FX, this channel is disabled — hence the impossible trinity.

Worked Example

The CB cuts iᵀ by 1 pp. Decompose the Y effect through each channel.

(1) Interest rate: r falls 1 pp → I responds via user cost; C responds via Euler.
(2) Asset-price: Gordon growth Q = D/(k−g); k falls → Q rises ~20%. Wealth effect MPC ~3% → ΔC ~0.6% of wealth.
(3) Exchange rate: E depreciates ~1% (UIP); NX rises via Marshall–Lerner.
(4) Credit: x narrows, I rises further.
(5) Expectations: if cut signals future easing, r^e' falls too → extra investment.

Combined ΔY is substantially larger than the pure interest-rate channel suggests. Empirical estimates (US): a 1 pp cut raises Y by ~0.5–1.5% peak, with peak in 6–8 quarters.

Common Mistakes

—Focusing only on the interest-rate channel — misses asset-price, exchange-rate, and credit amplifiers.
—Assuming channels work equally at all times — the credit channel collapses in crises; the ZLB disables channel 1 but not 4–5.
—Ignoring the lag structure — monetary policy is a slow-acting tool.
—Treating channels as additive — in practice they interact and amplify each other.

Exam Cues

→Five channels: interest, asset-price, exchange-rate, credit, expectations.
→Open economy: exchange-rate channel amplifies monetary transmission.
→ZLB: interest channel disabled. Must rely on credit (QE → ↓x) and expectations (forward guidance).
→Lag structure: Y peaks ~6–8 quarters; π peaks ~12–16 quarters.