Introduction: the transmission mechanism and monetary policy

The transmission mechanism of monetary policy explains how monetary policy works – which variables respond to interest rate changes, when, why, how, how much and how predictably. This broadens to the issue of what monetary policy can do and what it should do to offset the effects of disturbances on inflation. This volume sets out how the transmission mechanism is analysed for the purpose of informing monetary policy. The chapters that follow tackle different aspects of how a central bank can build a good working understanding of the transmission mechanism of monetary policy. In this introduction, we summarise how this understanding relates to the forecast apparatus and models employed, along with practical difficulties to be overcome. We highlight two key aspects of the monetary transmission mechanism – the monetary sector and the exchange rate – and conclude by summarising the key elements of current good practice. How does the central bank analyse the transmission mechanism? A central bank's interest in the transmission mechanism of monetary policy arises from the fact that it takes time for monetary policy to exert its maximum impact on inflation. A central bank has to know how to position its interest rate now to keep inflation in the future close to its target, while avoiding any excessive destabilisation of output. It also has to form some view about what might happen to inflation and output over this intervening period (see Blinder, 1998; Budd, 1998).