Monetary Transmission.
Preview
Monetary transmission mechanism is the channel through which a countrys monetary policy has an impact on the economic variables of that country which include output and employment. Comprehension of this mechanism has been very essential topic of research in macro economics and is central to the analysis of the economic policy. There are various explanations of the monetary transmission policy to the real economy and they try to capture the total effects. These channels include the Cost of Capital Channel (traditional view), the Credit Channel (which has traditionally been broken down into Bank Lending Channel and Balance Sheet Channel) and the financial accelerator. Cost of capital channel can be explained in the following way. Companies fund their operations using three ways. These ways include stocks and equities, debt methods and the reinvestment of money earned through previous trading. This means that the weight of capital for a company is weighted upon the sub total of equity and debt while the reinvested capital is charged as the cost of equity because if that money us not reinvested, it is normally returned to the company investors who are the share holders. The cost of debt is also termed as the cost of borrowing money.
In this traditional channel, when the central bank reserves reduce, the demand for deposits by the commercial bank reduces and it the prices get prickly a short term decrease in the monetary holdings in the real economy always leads to real interest rates that are higher than the normal ones and this translates into a contracted interest positive elements of aggregate expenditure. The credit channel approach of transmission postulates that fictions in information in the credit market always worsens during tight money periods and there is a resulting increase in the external finance premium which is seen as the cost variation between internal and external funds. This enhances the effects of the policy on the economic situation of a country and can be seen in the response in the GDP. In this policy of monetary transmission, a change in the interest rates affects the levels of inflation. This mechanism generally describes how changes that are induced by policies in the nominal short term interests can have a major impact on several variables such as employment and the output aggregate. There are particular channels of monetary transmission that work on the premises that monetary policy has effects on interest rates, rates of exchange, prices of the real estates, equities, bank lending and the balance sheets of firms. The transmission mechanism has three stages.
Stages of monetary transmission
Monetary transmission channels occur in different stages. The first stage is where a change in the rates of interest that are set by the MPS influence changes on all the other rates. This is where banks and all the other institutions react to an official change in the rates by changing their rates that govern savings and loans. This change will always affect the prices of very many other things like the households assets, security prices, shares and equities, energy and equities. The expectations of individuals and companies will also change to accommodate that change in the interest rates. The confidence about the future financial path begins to wane. The second stage is where the spending patterns of the consumers are affected thus affecting the demand of goods and services.
When the interest rates are high, the level of aggregate demand for goods is usually low because the consumers in the wake of the increased rates and the accompanying effects cut back on their spending meaning that their purchasing power is very low. The effects will also be felt internationally as the volumes of exports and imports are also affected. The third stage is the impact of the monetary transmission mechanism on inflation and the gross domestic product of the nation. These are largely dependent on the total levels of supply and demand underpinned by the fluctuations in the interest rates. However, if there is an AD increase, and enough economic capacity, then the increase in the rates may not cause a noticeable inflation.
Impacts Economic Downturn
In 2008 there was an economic crisis that had a very huge impact on the monetary transmission mechanisms and the energy sector was one of the hardest hit by the economic downturn that started toward the end of 2007. In 2008 petroleum prices went up to unprecedented levels, something that pushed up the interest rates all over the world and had a huge impact on prices of very many commodities around the world since petroleum products are hugely involved to fuel the transport industry that relays different consumer goods through the different levels. The petroleum crisis had an interweaving relationship with the global economic downturn because the shortage of petroleum led to the rapid increase in prices of the petroleum products while the global economic down turn affected the spending power of most consumers meaning that in the long run, the consumption of petroleum products went down because of the low purchasing power.
Impact on oil and Auto Industry
One of the industries that were worst hit by this monetary transmission crisis in the petroleum industry is automotive making industry especially in the US. There was substantial increase in the cost of the fuels that drive automobiles because of the combination of the energy crisis and the economic downtown. Automakers that deal in vehicle that do not have low fuel economy were the hardest hit by the this instance of monetary transmission because the demand for the sports utility vehicles that guzzle fuels and trucks went down visibly This is because of the reduced spending power occasioned by the high interest rates that had been pushed up by the effects of the energy crisis and the economic downturn. The sales for the giant automakers in America, GM Ford and the Chrysler started sliding and they did not have alternative fuel-efficient autos to provide to the customers who were highly watching their pockets. This scenario had a double impact on petroleum companies because to start with, there is a problem with the availability of fuel meaning that they will have to spend more to get the usual amount of fuel, and secondly, even if the fuel is there, the rate of consumption was very low because of the spending habits of most people who were economically conscious because of the credit crunch. Some of the petroleum companies were forced to reduce their operations in various countries.
For example, Caltex pulled out of various African countries including Kenya while Shell sold half of their stations in a number of countries to the emerging oil Libya. It is during this energy crisis coupled with the economic downturn in 2008 that prompted the shell CEO to create a global scenario that he called the scramble and Blue prints that focused on the state of the oil industry and the energy sector in the next five years onwards, forecasting a global crisis should the world opt to follow the scramble option that will see the countries scramble for the available petroleum resources, thus depleting them without having made an alternative form of energy to replace the dwindling oil resources.
Impact on Future of Oil Industry
To make long term strategies, shell has been developing scenarios since the 70s and the latest scenario is the Scramble and Blueprints that illustrates the routes the world will take in the face of the energy crisis that will hit the world as from 2015. The scramble route will be an exciting route with a lot of competition but will grind to a halt with unimaginable consequences. The scramble scenario is a path of less resistance where the nations will make haste while the sun shines meaning that they will run to secure energy resources and there will be losers and winners. However, a time will come when all the fuel energy will be depleted and the race will come to a painful end. This method solves no problem because the supplies will run short leading to high energy prices, political response and volatility. However, the Blueprint option will have a lot of problems at the start and the ride will be bumpy but due to the ingenuity and technical innovation, the excitement will be felt at the end.
Whichever route is taken, the problem cannot be solved without the addition of other energy sources in the world in order to keep up with the increasing demand occasioned by the population upsurge. However, the Blueprints route will be disorderly at the start but less painful toward the end because positive coalitions will emerge to ensure energy security and enhance more innovation. This scenario will work hand in hand with the environmental sustainability path and there will be growth of number of cars that use alternative energy sources like electricity and hydrogen. This is where the shells scramble and blue prints scenario and the automotive industry relate because the path taken will have an impact on the automotive industry.
According to the shell CEO, this will occasion unprecedented monetary transmission mechanism around the world with prohibitive interest rates and very high prices of assets and products. Once again, the industries that will be heavily affected are the motor and petroleum industries. This is because, auto industry relies on petroleum products and with the dwindling resources it means that there will be an extremely low demand for motor vehicles from a global population that will already being reeling from the effects of an unprecedented credit crunch. The main reason for the increased demand of oil that will outstrip the capacity of the world resources to supply it is the revolutionary growth of economies especially China and India, if the world does not invest in alternative forms of energy like the oil sands or nuclear energy. However, the shell CEO says that if the world chooses to follow the blueprint option, such a monetary transmission crisis may be avoided because the blueprints path will ensure that countries invest in alternative forms of energy in the face of dwindling oil resources. This is a path of creativity and auto makers will not suffer from demand problems because they will have prepared for this eventuality by manufacturing vehicles that use alternative forms of energy and the interest rates will have been cushioned by this preparedness unlike the just ended economic crisis that saw the purchasing power of many household being completely depleted.
Inflation
There are energy advocates who are pushing for a consistent policy of energy because the swings in prices have become wild thus affecting inflation and interest rates and this has crippling effects in many industries. For example, due to the credit crunch, the GM motor company almost collapsed and it was not in a good financial position to obtain credit for it to be able to make an acquisition of Chrysler. The fall of sale and tightening consumer credits was another big impact that almost drove the automaker out of market. The other impact of monetary transmission was the effect on credit worthiness of people. The financial crisis made it hard for the average person to get credit from banks to buy vehicles meaning the rate of vehicle consumption went down thus also pushing down the demand for oil products. Most average people buy cars using loans granted by banks and at that time when the interest rates were at an all time high, most people would shy away from such risky monetary commitments. This is especially because of the instability in the job market.
Cyclical Impact
The monetary transmission especially during the 2007 -2008 period also had an impact on the industrial output of very many industries. This is because the credit crunch affected the buying power of consumers meaning that the demand for industrial products went down. Very few companies were operating at maximum capacity while some of the industries had to close down in the wake of the economic downturn that drove levels of inflation to unprecedented heights. All industries use energy meaning that if the companies were not operating at maximum capacity, then the levels of energy that they were utilizing were very low. This means that the demand for energy due to the low industrial production occasioned by the low demand for industrial good and this had a major effects on major oil companies especially the one that concentrate in industrial supplies like Caltex. The situation here was very cyclical and this manifests how deep the impacts of monetary transmission had gone. The cyclical situation starts from the high oil prices that push up the prices of products because oil is used in various stages of business, for example, industrial production and transportation.
The increase in the prices forces the consumers to cut their spending on different industrial goods including automobiles and the increase in interest rates also reduce their chances of getting credit from monetary institutions. Their reduced spending means that the demand for the industrial products goes down and the industries respond by producing lesser goods and in the process of producing lesser goods, they use lesser amount of energy including oil. These industries are now forced to reduce the amount of labour force, who are industrial consumers meaning that their spending power goes down again pushing the demand for industrial products and energy down. With the low demand of energy including oil, the prices of oil go down thus as the levels of inflation also goes down making the situation to go back to a state of normal equilibrium. That is the cyclical impact of monetary transmission mechanism that in this case is triggered by the rise in the fuel prices and is brought to a halt by the reduction of the same prices, but after a series of events and counter events.