Articles on the Economy-Transmission Mechanism of Monetary Policy

Unraveling the Interplay of Inflation, Exchange Rates, and Interest Rates

Monetary policy plays a pivotal role in shaping the economic landscape of a country. Central banks worldwide utilize various tools to influence the economy, and understanding the transmission mechanisms is crucial for policymakers, investors, and the general public. In this article, we delve into the intricacies of how monetary policy impacts key economic indicators, specifically focusing on inflation, exchange rates, and interest rates.

Transmission Mechanisms of Monetary Policy:

  1. Interest Rates:
    Central banks primarily use interest rates as a tool to implement monetary policy. By adjusting policy interest rates, such as the federal funds rate in the United States or the European Central Bank’s main refinancing rate, central banks can influence borrowing costs for businesses and consumers.

    • Direct Impact on Spending: Lowering interest rates encourages borrowing and spending, stimulating economic activity. Conversely, raising interest rates has the opposite effect, cooling off an overheated economy and preventing inflation from rising too rapidly.
    • Investment and Consumption: When interest rates are low, businesses are more likely to invest in projects, and consumers are more inclined to borrow for major purchases like homes and cars.
  2. Inflation:

    • Demand-Pull Inflation: Changes in interest rates affect aggregate demand. Lower rates stimulate spending, increasing demand for goods and services, which, if supply cannot keep up, can lead to inflation.
    • Cost-Push Inflation: By influencing borrowing costs and investment, interest rates indirectly affect production costs. Higher costs for businesses may be passed on to consumers in the form of higher prices.
  3. Exchange Rates:

    • Interest Rate Differentials: Central banks set interest rates that, in turn, affect exchange rates. Higher interest rates attract foreign capital seeking better returns, leading to an appreciation of the domestic currency. Conversely, lower interest rates may lead to depreciation.
    • Inflation Differentials: Central banks also consider inflation differentials when setting interest rates. A country with lower inflation than its trading partners might experience an appreciation of its currency.
    • Impact on Trade Balance: Exchange rate movements influence a country’s trade balance. A weaker domestic currency makes exports more competitive, potentially improving the trade balance. However, it may also lead to higher import costs and contribute to inflation.

Interplay of Inflation, Exchange Rates, and Interest Rates:

  1. Interest Rates and Inflation:

  • Trade-Off: Central banks often face a trade-off between controlling inflation and supporting economic growth. Tightening monetary policy by raising interest rates can help curb inflation but may also slow down economic activity.
  • Inflation Targeting: Many central banks adopt inflation targeting as a framework. The goal is to maintain a stable inflation rate, typically around a target level, while allowing for some flexibility to support economic growth.
  1. Interest Rates and Exchange Rates:

  • Carry Trade: Differences in interest rates between countries can lead to carry trades, where investors borrow in a low-interest-rate currency to invest in a higher-yielding one. This can influence exchange rates.
  • Capital Flows: Changes in interest rates can trigger capital flows, affecting the supply and demand for currencies in the foreign exchange market. This, in turn, influences exchange rates.
  1. Inflation and Exchange Rates:

  • Purchasing Power Parity (PPP): PPP suggests that over the long term, exchange rates should move towards the rate that equalizes the prices of identical baskets of goods and services in any two countries. Deviations from PPP may indicate inflation differentials.
  • Inflation Expectations: Expectations of future inflation influence currency values. If a country has consistently low and stable inflation, its currency may be perceived as more attractive, leading to appreciation.

Transmission Mechanisms of Monetary Policy

Any country’s central bank provides funds to the banking system and charges interest. Given its monopoly on money creation, the central bank has complete control over the interest rate. The State Bank of Pakistan provides funds to the banking system by charging a three-day reverse repo rate (also known as the policy rate or discount rate), which is the rate at which banks in Pakistan borrow from the SBP on an overnight basis. This rate was recently revised and increased from 9.5 percent to 10.0 percent in order to control inflation in the medium term.

According to the SBP policy document, inflation expectations are around the medium-term targets of 9.5 percent for 2013 and 8 percent for FY14, as envisaged in the government’s Medium Term Budgetary Framework (MTBF). Year-on-year CPI inflation was 10.8 percent in March 2012, and given current economic conditions, it is expected to remain in the double digits during FY13. In this article, we will look at how other variables change as policy rates change.

Changes in official interest rates have an immediate impact on money-market interest rates and, indirectly, lending and deposit rates set by banks for their customers. Several studies revealed that lending rates on new loans are more sensitive to changes in money market rates than lending rates on outstanding loans. A 100-basis-point change in KIBOR of different tenors results in a 91- to 96-basis-point change in the lending rate on new loans. In terms of time, the full impact takes two to three months. In comparison to lending rates, the pass-through of changes in money market rates to deposit rates is not only slow but also incomplete. Due to the 100-basis point change in money market rates, the response of returns on new deposits is limited to only 60 basis points. Furthermore, it takes two to six months to see this impact.

The empirical results demonstrate the validity of the Phillips curve in Pakistan (A.W. Philips demonstrated evidence of a negative relationship between changes in nominal wages for British data and pioneered the idea of a trade-off between inflation and unemployment). The structure of the reduced-form Phillips curve reveals that expected inflation is significant for all periods. Current unemployment exceeds lag unemployment, implying that unemployment has been increasing at an increasing rate, causing a significant change in current inflation.

According to one study, the employment elasticity in Pakistan is 0.5 percent, and labor force growth is 3.5 percent, implying that we need at least a 7 percent increase in GDP to absorb this much labor force.


Understanding the transmission mechanisms of monetary policy is crucial for comprehending the dynamics of an economy. The interplay of inflation, exchange rates, and interest rates forms a complex web that central banks navigate to achieve their dual mandate of price stability and sustainable economic growth. As global economic conditions evolve, the effectiveness of these transmission mechanisms continues to be a subject of academic and policy debate.

Transmission of monetary policy

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