In a previous article, I introduced the concept of long-term neutrality of money, which the ECB defines as a general principle according to which “a change in the quantity of money in the economy will be reflected in a change in the general level of prices. But it will not induce permanent changes in real variables such as real output or unemployment.”
Put differently, monetary policy can influence the price level, but it cannot affect long-term economic growth, i.e., make an economy more productive. Economic growth depends on other factors such as technological advances, population growth or a legal framework that protects private property and encourages competition.
However, central banks can help stabilize an economy that is temporarily producing below or above its potential GDP. For instance, the burst of the housing bubble in the US triggered a recession that pushed unemployment up and reduced output. This means that the economy was operating below full capacity: there were idle resources that weren’t being used to produce goods and services.
In these cases, monetary policymakers can make use of the tools we examined in parts two and three of this primer to affect the economy and boost aggregate demand. The ways in which central banks’ policies influence the real economy are called transmission mechanisms of monetary policy. Let’s take a look at the most relevant ones.
If the ECB aims to stimulate aggregate investment to close the output gap (the difference between current output and potential output), it can expand the money supply, thereby pushing down real interest rates (i.e., adjusted for inflation). This encourages firms to increase their borrowing (credit is cheaper than before) and undertake new investment projects, which in turn lowers unemployment and increases aggregate demand. Traditionally, this process was done via the interbank lending market However, in the last years, the ECB has started to purchase corporate bonds in secondary markets to reduce borrowing costs for those firms that raise capital in the financial markets.
ECB’s policies can also impact other asset prices such as exchange rates or equities. For instance, expansionary monetary policies usually result in the depreciation of a country’s currency. When the ECB suggested in late 2014 that it was considering using unconventional monetary policy tools, the EUR/USD started to fall dramatically. A depreciated currency tends to boost exports (it’s cheaper for other countries to buy goods produced in one’s country), bringing about economic growth and lowering the unemployment rate.
Monetary policy also affects equity prices. The market value of a company tends to coincide with the present value of its expected cash flows. Lower interest rates imply a lower discount factor, which means higher stock prices. This in turn leads companies to invest more since issuing new stock is cheaper in relation to the market value of shares. This is the famous Tobin’s q, a transmission mechanism first described by Nobel-awarded economist James Tobin.
Another transmission mechanism is the so-called bank lending channel. Expansionary monetary policies increase bank reserves, which, all else equal, should lead to more loans to businesses and thus, more investment. This mechanism tends to have a greater impact on small firms as they are more dependent on bank financing than large firms.
Finally, two more mechanisms should be mentioned: the balance sheet channel and the cash flow channel. The balance sheet transmission mechanism works as follows. Monetary authorities ease monetary policy, which often results in higher equity prices as we saw above. This in turn increases the net worth of firms (i.e., the solvency position of businesses improves) and collateral for potential loans goes up. Banks are thus more willing to lend knowing that the capital buffer of firms has increased.
The cash flow channel works in a similar way, but through the cash flow statement of firms. Lower interest rates resulting from expansionary monetary policy improve the cash position of firms since interest payments go down. This means that firms will be in a better financial position to pay back their loans, incentivizing banks to increase their lending to the private sector as probability of default is lower.
As shown, monetary policy can influence the real economy in several ways. This provides monetary authorities with a wide range of mechanisms through which to cope with economic and financial crisis. In the next article, I will analyze the balance sheet of the ECB and how it has grown over the last years.
 Central banks can also prevent the economy from overheating, i.e., producing above its capacity. When this happens, inflationary pressures push monetary authorities to undertake contractive monetary policies.
 This isn’t always the case. For instance, when firms are highly leveraged, cheaper credit doesn’t necessarily lead to an increase in demand for loans.
 As I pointed out a footnote in part two, banks don’t lend their own reserves. Instead, they use them to settle their debts with other financial institutions. Yet a higher level of reserves allows banks to expand their lending provided that there exists demand for new credit.