The monetary policy transmission mechanism is a process through which monetary policy affects macroeconomic aggregates such as aggregate demand, production and prices. It works through different channels, impacts different aggregates and markets, at varied speed and intensity. In economic theory, the most important transmission mechanism channels are: the interest rate channel, credit channel, exchange rate channel, expectations channel, balance sheet channel etc. The impact of monetary policy measures on the real sector and inflation takes place simultaneously through different, inter-linked channels. The monetary policy transmission mechanism can be illustrated as follows:
Monetary policy transmission channels are not equally important in all economies. The strength of the impact of the key policy rate on inflation through different channels depends on the specificities of each economy (its size, degree of openness, euroisation, financial market development etc.). It can change in time depending on structural changes in the economy.
The identification of transmission channels helps determine the most effective set of monetary policy instruments and decide when to start with its implementation. In the case of Serbia, the interest rate and exchange rate channels are the most important. The expectations channel also plays an increasingly important role. These three channels play the key role in the NBS medium-term projections model.
The level of the key policy rate of the central bank directly impacts interest rates in the money market and, indirectly, bank interest rates on loans and deposits. A reduction in the key policy rate should influence banks to reduce their rates on loans as their yields on alternative investment in NBS repo operations fall. This should prop up the demand of corporates and households for loans, and lead to a rise in their consumption. Increases in the key policy rate create a different situation. The importance of the interest rate channel depends on the transmission of the key policy rate to lending interest rates of banks and the elasticity of demand for bank loans. While the central bank efficiently controls short-term interest rates in the money market due to the direct influence on market liquidity, the impact on the real sector is usually slower and often incomplete, with the strength of the effect and speed of transmission depending on the structural characteristics of the economy.
In a small and open economy such as Serbia, the exchange rate plays an important role in monetary policy transmission to inflation. Changes in the key policy rate influence the attractiveness of the dinar relative to other currencies, i.e. the exchange rate. For instance, a rise in the key policy rate increases the yield on dinars. This stimulates investors to convert foreign currency into dinars, triggering the appreciation of the domestic currency. In practice, the effects of the key policy rate on the exchange rate are intertwined with many other factors, most notably the risk premium, whose effect may vary significantly depending on factors from the international and domestic environment. The exchange rate has a direct impact on inflation as numerous products in the consumer basket originate from imports, and many products produced in the domestic market contain imported raw materials. When the exchange rate appreciates, imported products become cheaper, which leads to lower inflation, and vice versa. The exchange rate influences inflation not only directly, but also indirectly – by impacting the demand for domestic goods and, thus, inflationary pressures. When the real exchange rate excessively appreciates (domestic goods are relatively more expensive than foreign goods), the demand for domestic goods declines, which has a disinflationary effect, and vice versa.
The channel of inflation expectations is becoming an increasingly important monetary policy transmission channel, particularly in countries with inflation targeting regimes. Namely, inflation expectations of market entities are largely determined by their trust in the central bank and their perception of its capacity to efficiently control inflation. If inflation expectations are anchored around the central bank target, the transmission of shocks on the supply side to other prices is limited, which contributes to higher monetary policy efficiency.
The dynamics of aggregate demand and inflation also depends on other aspects of economic policy (such as fiscal and incomes policies). Given the domestic economy’s increasing integration in global economic flows, it also depends on developments in the international environment, i.e. commodity and financial markets. The task of a responsible monetary policy is to carefully monitor the trends in the international and domestic environment, assess their effects on economic activity and inflation at home, and undertake measures to deliver low and stable inflation in the medium run and contribute to sustainable economic growth.