Interest rate transmission of monetary policy

Abstract

Monetary policies around the globe have gained a lot more prominence of late. Whether the Great Recession of 2008, the sovereign debt crises of 2013 in Europe or the latest COVID induced slowdown across the world, monetary policies have genuinely done some heavy lifting in close conjunction with fiscal support from the respective governments. This has prompted renewed interest in understanding the mechanism by which monetary policies work. The mechanism by which central bank actions, whether through policy rate changes or asset purchase or expectation guidance, affect the real economy is called the transmission mechanism of monetary policy. It is important to note that monetary policies affect real economic variables in multiple ways – many transmission mechanisms. Some of the commonly cited tools include the interest rate channel, asset price channel, credit channel, balance sheet channel, exchange rate channel, and expectations channel. For a central bank to attain its objectives of price stability, optimum employment levels and financial market stability, understanding the country's transmission mechanisms is important. Therefore, it is necessary that central bank be able to identify the dominant channels of transmission in its country of operation and then frame policies accordingly to attain its objectives most efficiently. While, as mentioned before, there are multiple mechanisms at play, this report focuses mainly on the interest rate channel. The report is organized as follows. We briefly explain the different mechanisms and assess the literature review on the same. We then focus on the interest rate mechanism in India and see the methodology adopted to study its effect. The report then identifies some issues that hamper efficient transmission from policy rates to the real economy and then shed light on the importance of efficient transmission from a business – government – society (BGS) perspective, followed by policy recommendations and conclusions.