Monetary Policy Transmission Mechanism
A change in monetary policy affects aggregate demand through different channels.
Monetary policy rate in Georgia is transmitted to the economy through the following main channels:
Interest Rate Channel. NBG’s interest rate decisions directly impact short-term interest rates of the banking sector. Eventually, change in short term interest rates are transmitted to longer-term interest rates and, finally to interest rates on bank loans. Higher loan interest rates reduce demand for loans, which leads companies to reduce investments and consumers - spending. Other things equal, this process helps to curb aggregate demand and thus reduce the price level. Given the high dollarization of the economy though, this channel’s impact on the real economy is limited as it affects lari loans only. By changing the monetary policy rate, the NBG will not be able to influence foreign currency interest rates.
Exchange Rate Channel. Other things equal, an increase in policy rate widens the yields differential between assets denominated in local and foreign currencies. As a result, money market instruments for lari become more attractive and demand for lari assets goes up. The increase in demand for local currency assets appreciates the lari. Changes in the exchange rate then directly and indirectly impact inflation. Appreciation of the exchange rate reduces the price of imported goods and vice versa. Simultaneously, the appreciation of the lari encourages demand for imports, as the relative price of imported goods decreases compared to locally produced goods. Also, with the appreciation of lari, exports of goods of Georgia become more expensive and therefore foreign demand will decrease. Thus, the aggregate demand weakens, and that pushes prices further down.
Credit channel. A change in monetary policy by the NBG influences the economy through changes in the credit supply as well. The policy rate hike is initially transmitted to the money market, pushing short-term interest rates upwards and subsequently reflecting in long-term interest rates. Increased interest rates limit the availability of credit, reduce the number of high-quality credit projects, which leads banks to tighten their lending standards and reduce loans to the economy. Reduced lending diminishes aggregate demand and eventually inflation, too. Lower policy rate has the opposite effect: Higher lending stimulates investments, which is reflected in higher levels of aggregate demand and prices.
Expectations channel. Economic entities make decisions based on expectations, and thus, inflation expectations may have a strong impact on their behavior and, consequently, on inflation. For example, households decide how much to spend or save at present based on their potential future consumption. Companies determine the amount of investment based on production capacity expectations. These decisions will ultimately determine the aggregate demand today and, in this way, affect inflation.