Monetary transmission mechanism and the financial accelerator

Abstract

To control for different economic situations the government through the central bank institutes various policies that result into alteration of real economic indicators. This paper wished to evaluate the ways through which monetary policy conveys change to actual economic variables – monetary transmission mechanism – and the role of imperfections in the credit market in amplifying economic shocks – financial accelerator theory. The paper discussed these aspects in relation to the energy (oil) industry drawing some examples from the 2007/8 financial crisis. By open market operations that increase effective interest rates hence cost of capital, monetary policy could deter corporations from acquiring credit facilities that ensure success of expansion programs thus having a negative effect on employment. Further banks may deny credit facilities to corporations based on the entity’s balance sheet strength or where the lending is mainly financed by customer deposits monetary policy effects that lead to the need for increased bank reserves could curtail the extent to which the banks can advance credit. Though mainly imperfections in the credit markets lead to elongation and aggravation of economic shocks, such have at times been noted to provide a stabilizing effect. For multinational corporations monetary policy is important since through its exchange rate effect it affects the business between various trading partners where such multinationals operate.

Introduction

To control for different economic situations the government through the institution charged with monetary control can institute various monetary policies. Monetary policies adopted may on the other hand achieve their function through controlling the supply and availability of money and/ or increasing the cost of money. By increasing the bank rate, for instance, institutions such as the central bank aim to control the lending power of other financial institutions due to subsequent increase in the rate at which credit is availed. This then would deter people from borrowing and hence firms from lending thus curtailing spending and keeping inflation in check. Ways through which the monetary policy-generated changes in nominal stock of money convey an effect on the actual variables of the economy such as employment and production what the term “monetary transmission mechanisms” describes (Ireland, 2005, October). Monetary policy adopted could, for instance, have strong ramifications on the credit market especially when the regulator (central bank) controls both aspects of the monetary base – the bank and currency reserves. Actually, the central bank is able to effect changes on the monetary base through such ways as open market operations and purchasing and selling securities – in most cases of which the securities involved are government bonds (Ireland, 2005, October). The purchase of treasury bills by a monetary authority in an open market, for instance, results into an increase in the supply of reserves with the short term decrease in interest rates being converted into the long-term rate thus stimulating private investment. By these actions the bank thus introduces changes to the credit markets. Such distortions to the credit market are the key concerns that the financial accelerator hypothesis tries to explain. The financial accelerator hypothesis explores the effect of alteration of the credit markets on different economic situations. For economic depressions the hypothesis postulates that distortions in credit markets amplify the economic shocks. This then means that adverse effects of depressions that would have otherwise been small and limited become exaggerated and prolonged due to the deficiencies that are introduced into the credit and lending markets. This paper analyses the ‘monetary transmission mechanisms’ and ‘financial accelerator’ aspects in regard to the energy sector. Discussions on how these aspects affect investment in the oil industry will be presented while explaining how the 2007/08 financial crisis was transmitted to the sector. Source of funding for investment activities in respect to country providing the funds and where such are utilized and whether monetary policies adopted in one country also impacts on cross-boarder companies will be evaluated. Go to mechanisms of monetary transmission.

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