Central banks can choose effective monetary policy instruments and achieve their targets as long as they can accurately assess the impacts of existing policies on the economy. Therefore, it is very important to identify the effects of monetary policy implementations on prices and the real sector. Accordingly, effective functioning of the monetary policy mechanism plays a critical role in the success of the monetary policy.
Monetary Transmission Mechanism
The effect of central banks’ decisions regarding monetary policy instruments on economic activity and inflation materializes via the monetary transmission mechanism.
Central banks use short-term interest rates as a monetary policy instrument, and their interest rate decisions affect the economy to a large extent. This effect emerges through the channels of expectations, interest, asset prices, and exchange rate. This process affects aggregate demand, and consequently the economic activity and inflation.