What is mean by monetary policy transmission mechanism?

How monetary policy of the RBI influences the economy and living of the people? It is through the well-known theoretical and practical phenomenon called monetary policy transmission or monetary policy transmission mechanism. Actually, monetary policy transmission is the way in which a monetary policy signal from the RBI works through the financial market (especially through the banking system) to influence general economic activities like consumption and investment.

What is monetary transmission?

Monetary transmission refers to the process by which a central bank’s monetary policy signals (like repo rate) are passed on, through financial system to influence the businesses and households.

There are many monetary policy signals by the RBI; the most powerful one is the repo rate. When repo rate is changed, it brings changes in the overall interest rate in the economy as well. As a result of a decrease in repo rate, the interest rate on loans by banks also changes and this encourages consumption and investment activities of businesses and households. In an economy, both consumption and investment are often financed by borrowings from banks. As the repo rate brings changes in market interest rate, the repo rate channel is often referred as interest rate channel of monetary transmission.

Repo rate↓ → Interest rate ↓→Consumption, Investment↑ →Output↑→ Growth↑

Interest rate is the main channel of monetary policy transmission. Similarly, there is credit channel, asset price channel, confidence channel etc.

An interesting development in recent times is that often central banks gives certain communications in the form of guidelines which are aimed to create certain effects in the financial market.

Monetary policy transmission mechanism in India

In the Indian scenario, the momentary policy transmission is heavily depending upon the repo rate. The repo rate is the anchor rate in determining the interest rate in the economy (of the banking system). Now, how far a change in repo rate can bring a corresponding change in interest rate by banks depends upon the financial conditions of the banking system as well. In this respect, the banking system holds the center stage in India’s monetary policy transmission.