The Monetary Transmission Mechanism

The Fed targets a short-term nominal interest rate. Changes in this rate lead to changes in long-term real interest rates, which affect spending on investment and durable goods, ultimately leading to a change in real GDP. The monetary transmission mechanism explains how the actions of the Federal Reserve Bank affect aggregate economic variables, and in particular real gross domestic product (real GDP). More specifically, it shows how changes in the Federal Reserve’s target interest rate affect different interest rates in the economy and thus influence spending in the economy. Through open-market operations, the Fed targets a short-term nominal interest rate. Changes in that interest rate in turn affect long-term nominal interest rates. Changes in long-term nominal rates lead to changes in long-term real interest rates. Changes in long-term real interest rates affect investment and durable goods spending. Finally, changes in spending affect real GDP. We will examine every step of this process. This chapter focuses on the effects of Fed actions, but essentially the same analysis applies to the study of monetary policy in other countries. The channels of influence are to a large degree independent of which country we study, although the magnitudes of the policy effects might differ across countries. Monetary policy differs across countries more through the targets set by different central banks than through the transmission mechanism. How Well Can the Fed Meet Its Target? On February 2, 2005, the Federal Open Market Committee (FOMC) decided to increase the target federal funds rate to 2.5 percent. The word target is critical here.

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