The monetary transmission mechanism has historically evolved along two lines. Firstly the classical dichotomy case and quantity theory of money whereby increases in Ms where converted to increases in price level and through the Pigou Real balance and Keynes effect later on in neoclassical synthesis also to effects of falling national income. However, this view is largely abandoned now because of the limited empirical evidence and the instability of money velocity.
Keynes outlined another transmission mechanism with his ISLM system.
r r Md Ms
This is sometimes called the interest rate channel. When MS is changed the interest rate changes. This will lead to a shift in LM curve, moving along the IS curve, because firms will invest less with higher interest causing lower income and vice versa, we will reach to a new equilibrium with GDP changed. Keynes originally emphasised business decision, that were susceptible to animal spirits, also he said investment is interest inelastic. Thus the link is not that strong. However, recent studies show that consumers also care about interest rate when buying durables, thus some writers argue that interest rate channel is the strongest.
In an open economy Ms changes also affect the GDP through exchange rate channel. High interest will lead to currency inflow of hot money and thus to appreciation of domestic currency. This will make exports more expensive, and increases imports. Balance of payments moves into deficit and because this has to be absorbed domestically (higher taxes or lower investment), national income is reduced by a multiple.
Other assets prices also channel Ms changes according to Tobin q theory and wealth effects on consumption. q = (stock-market value of firm)/assets. High q means firms can issue equity easily and buy extra assets and thus invest. However, when Ms is reduced, public spends less on stock-markets, thus equity prices and q falls and firms are reluctant to invest, they rather buy up existing firms. Keynesians also argue that interest rate rise makes bonds more attractive, thus people will switch to them instead of equity. This is very marked in firms investment decisions – they will not invest when they can obtain more money by putting profits to the bond market.
Modigliani developed wealth effects theory. It assumes that people want to smooth out their consumption over their lifetime. Thus they consume in proportion to their expected lifetime wealth, saving when income is above it. Contraction in Ms leads to fall in asset prices (assuming assets are bonds) and thus will reduce the wealth of individuals. That will lead them to consume less, leading to contraction in GDP.
There is also a credit channel that operates through bank lending. Tight monetary policy will reduce banks’ assets either directly or indirectly, by limiting credit creation when tighter reserve requirements are imposed. This will lead to reduction in loans, thus in investment, and through a multiplier in GDP. However, financial innovations have reduced the importance of this channel, because banks are not the only lenders anymore and state is not likely to change credit requirement. Balance Sheet transmission is also a form of credit channel. Tight monetary policy reduces the net worth of companies, making them less attractive to banks and reducing their opportunities for credit. Lower net worth will also induce firm managers to engage in risky activities, because their equity level is low and they want to get it back to previous levels. Higher interest could also reduce cash flow of firms and thus lead again to adverse selection by banks and moral hazard by choices of owners. Thus less is invested and GDP again aversely affected.
Credit channel will affect the consumers as well. They will want to spend less on illiquid assets when their financial situation worsens and thus invest less in consumer durables. This is exactly what happened in the great depression, where every spare penny was saved, so that it could be used in rough times.
Monetary policy is used widely nowadays, because it is really easy to implement, sufficiently complicated to keep the trade unions happy and surprisingly powerful. As it is directly related to money it is ideal when one needs to adjust nominal variables like nominal interest rate, exchange rate or inflation. However, one should be careful not to finance the real economy with monetary expansion as this will lead to spiralling inflation and unfair inflation tax on savers. Fiscal policy should be used for that.
Again historically monetary policy has been used to target different measures. In Bretton Woods it kept the pegged exchange rate, then it Ms was used directly as a target believing in stable velocity. Now inflation target of around 2.5% annually is used. It is best because it is the actual monetary target and it is relevant to people and a thing that should be kept stable. Of course governments still engage in open market operations to stabilise the exchange rate and economic growth and unemployment are used as measures complementing the inflation rate. What is new to the system is complete openness and the acceptability of shocks, both demand and supply side. Before government used to stick to its targets, now it tries to accept the unexpected shocks and will not start pursuing restrictive policies. At least in theory as no major shock is yet occurred. Government will also publish its meetings to gain credibility. As the firms can already hedge against exchange rate fluctuations, openness is the best government can do to make it possible for the firms to account for the inflation changes as well, making the environment more predictable and thus encouraging investment.
There is however a problem in empirical analysis to determine the lags of how much it takes for the monetary policy to work. Rational expectations assume immediate adjustment, however, in real life the effects of increased interest rates will be felt by about a year. This will make monetary policy good for fine-tuning economy when the models can predict the path of the economy for more than one year ahead. British government has got it right for the past 5 years and this has showed up as a low unemployment, inflation and stable growth. However, costs of getting it wrong can be very large, including recession and high inflation.