How does Monetary Policy affect the Economy?


Whenever the Central Bank changes the interest rate for REPO operations (also known as the benchmark intervention rate)  it sets into motion a series of forces which, with a certain lag, affect market interest rates, the exchange rate, and inflation expectations, which in turn influence:

 

  • The cost of credit
  • Agents’ decisions on spending, production, and use. 
  • Prices of assets
  • Inflation. 

 

The process by which monetary policy decisions affect the different economic variables is known as the transmission mechanism, which should ultimately lead to certain output and inflation results. The monetary authorities monitor the operation of this mechanism in order for it to act with the desired direction and effectiveness, and remain vigilant to make the necessary changes, so as to reach the proposed targets.

 

A general example of how the transmission mechanism operates is the following: 

 

Whenever projected inflation is below the target range:
 
 
Whenever projected inflation is above the target range:


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