The Bank of Canada Review is published quarterly, usually including good educative materials. I read the autumn review this morning and found one of the articles is particular interesting to improve my understanding of monetary policies set out by the central banks.
The article summarizes channels through which monetary policies affect broader economy. The first channel, which is the traditional way and commonly used, is the interest rates and foreign exchange rate.
The second channel is balance-sheet of the borrowers. An accommodative monetary policy strengthens the balance-sheet of government, firms and individuals as they will spend less on interest payment. Accommodative policies also tend to push up asset prices such as stocks and housing prices so that borrowers have higher values of collaterals and are more able to access loans.
The third channel is bank lending. This channel controls money supply and this is usually achieved via required reserve requirement. Compared with the interest rate channel, the credit supply is relatively soft but more prompt in affecting the real economy with shorter time constant.
The fourth channel, which is adopted most recently, is the risk-taking channel. If we use the concept of PI (proportional and integral) control scheme from control theory, the three other channels are more of proportional in nature, exerting control based on present information and focusing impact on the present economic conditions. The risk-taking channel is similar to integral control, and it focuses on long term effect of the economy. Since last year, the Fed has repeatedly said to keep low interest rate for a prolong period of time. Low interest rate will encourage lenders to seek riskier assets.
The four transmission channels are mutual inclusive. Central banks rely on these channels to exercise controls of the economy. Remember in July this year when EU debt crisis again intensified, ECB president Dr, Draghi declared, “to the extent that the size of these sovereign premia hampers the functioning of the monetary policy transmission channel, they come within our mandate” and he promised that the ECB would take whatever to achieve its goals.