This article examines critically the dominant theory of the monetary transmission mechanisms. It shows that monetary policy has abandoned the money supply as the instrument for inflationary control in favor of the interest rate. Formed in the market of bank reserves, the basic interest rate represents the opportunity cost of capital, which makes it a variable that affects the value of real and financial assets, impacting the supply of money and credit and, through the "wealth effects" and the availability of credit, the demand for consumption goods, housing and inventories fluctuations, which is the most important variable to explain economic downturns. It shows that the main effects of aggregate demand variations are felt through changes in real output and not in prices. Considering the success of cambial anchoring in curbing high inflation/hyperinflation and the failure of aggregate-demand-based stabilization programs, it concludes that perhaps the main channel through which changes in the interest rate affects the price level is the exchange rate, though the money supply still has a secondary role.
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Length: 57 pages Date of creation: Oct 2007 Date of revision: Handle: RePEc:cdp:texdis:td321
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Find related papers by JEL classification: E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
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