Monetary Policy Functions and Transmission Mechanisms: An Overview

Abstract

Monetary policy comprises the rules and actions adopted by the central bank to achieve its objectives � In most countries the primary goal of monetary policy is price stability � However, the mandate of many central banks also encompasses other objectives, including attainment of full employment, domestic financial stability, and normal operation of foreign payments � The priority of price stability over other policy goals tends to be politically accepted in most countries, if not actually enshrined in the laws governing the central bank� Changes in monetary policy are triggered by domestic and external shocks that can imperil the attainment of policy objectives� Central banks implement policy changes by resetting their policy instrument, usually a short-term interest rate or a monetary or bank credit aggregate � These instruments affect the economy through various mechanisms of transmission to the ultimate policy goals� Hence a useful way to understand monetary policy is to focus separately on central bank policy actions and the transmission mechanisms through which those actions work their effect � The central bank’s policy rule or reaction function embodies its response to deviations in macroeconomic variables in order to achieve its ultimate policy objectives � Beyond the simple description of these policy rules, it is important to assess their efficiency (in the sense of achieving the desired combination of goals, subject to the structure of the We are grateful to Francisco Gallego for his valuable contribution to the preparation of this overview�