Transmission Mechanism and its Lag and Uncertainty.

Essay by pureairUniversity, Bachelor'sA+, April 2003

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The Central Bank (RBA) carries out monetary policy with the aim of protecting the value of Australia money by keeping inflation low and stable. Monetary policy is implemented mainly through changes in the cash rate, which influence other interest rates and affect the level of spending and economic activity in the country. Nevertheless, changes to the cash rate do not immediately affect the economy in a manner that is readily predictable. The transmission mechanism of monetary policy has long and variable lags because the economy takes time to adjust to changes in monetary conditions (for example, businesses and consumers do not normally change their spending plans immediately upon an interest rate change. Businesses must reevaluate, make new decisions and order reductions or expansions in production and expenditures).

Monetary policy typically has a short policy lag (the time it takes to create and implement policy) and a long expenditure lag (the time it takes businesses and consumers to adjust to the new interest rates).

The total lag time is usually 9-12 months to work their way through the economy and have a significant effect on inflation. Thus, when the Federal Reserve changes interest rates now, their decisions will affect economic conditions in approximately a year from the time of the change.

A simple process of monetary mechanism takes place in the following stages:

* Changes in interest rates lead to changes in spending and sales;

* Changes in spending and sales lead to changes in production (and employment); and

* Changes in production lead to changes in prices and, thus, to changes in inflation.

Each of these stages lags behind the previous one, and the length of the lags can vary. Because the effect of monetary policy actions on prices can have a long lag, RBA must recognize, as early as...