TAILIEUCHUNG - The transmission mechanism of monetary policy

step example, follows: A municipal issuer and counterparty agree to a $100 mil lion “plain vanilla” swap starting in January 2006 that calls for a 3-year maturity with the municipal issuer paying the Swap Rate (fixed rate) to the counterparty and the counter- party paying 6-month LIBOR (floating rate) to the issuer. Using the above formula, the Swap Rate can be calculated by using the 6-month LIBOR “futures” rate to estimate the present value of the floating component payments. Pay ments are assumed to be made on a semi-annual basis (., 180-day periods) | The transmission mechanism of monetary policy The Monetary Policy Committee Bank of England This report has been prepared by Bank of England staff under the guidance of the Monetary Policy Committee in response to suggestions by the Treasury Committee of the House of Commons and the House of Lords Select Committee on the Monetary Policy Committee of the Bank of England. The Monetary Policy Committee Eddie George Governor Mervyn King Deputy Governor responsible for monetary stability David Clementi Deputy Governor responsible for financial stability Alan Budd Willem Buiter Charles Goodhart DeAnne Julius Ian Plenderleith John Vickers This report is also available on the Bank s web site The transmission mechanism of monetary policy Introduction and summary The Monetary Policy Committee MPC sets the short-term interest rate at which the Bank of England deals with the money markets. Decisions about that official interest rate affect economic activity and inflation through several channels which are known collectively as the transmission mechanism of monetary policy. The purpose of this paper is to describe the MPC s view of the transmission mechanism. The key links in that mechanism are illustrated in the figure below. First official interest rate decisions affect market interest rates such as mortgage rates and bank deposit rates to varying degrees. At the same time policy actions and announcements affect expectations about the future course of the economy and the confidence with which these expectations are held as well as affecting asset prices and the exchange rate. Second these changes in turn affect the spending saving and investment behaviour of individuals and firms in the economy. For example other things being equal higher interest rates tend to encourage saving rather than spending and a higher value of sterling in foreign exchange markets which makes foreign goods less expensive relative to goods produced at home. So changes in the .

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