This is the process through decisions pertaining to monetary policy affect the economy in general, and the price revels that prevail. The mechanism is characterized by variable, long and uncertain time lags. This makes it to predict the effect of monetary policy actions on price level and the economy with precision. To be successful in conducting monetary policy, the relevant authorities must have an accurate assessment of the timing and the effect that their policies have on the economy. This requires an understanding of the mechanisms through which monetary policy affects the economy.

The monetary transmission mechanism describes how policy induced changes in the nominal money stock or short-term nominal interest rate impact on real variables such as aggregate employment and output. Specific channels of monetary transmission operate through the effects that monetary policy has on equity, interest rates, real estate prices, exchange rates, bank lending, and firm balance sheets.

In the short run, prices may respond to many different shocks, some originating in the domestic economy and some in the foreign sector. Both types of shocks hold the potential of affecting aggregate demand and supply. However, in the medium to long run, monetary policy plays the major role in maintaining price stability. The central bank can influence the dynamics of aggregate demand and inflation by using various instruments which will work their effects on the economy through many different channels.

Monetary policy impulses coming from the central bank are usually transmitted through the banking or financial system. The relationship between commercial banks and monetary authority occurs in the general context of financial markets. On most occasions, the central bank can control short term interest rates relatively efficiently because it has the ability to manage the liquidity in the market. Although monetary policy impulses are passed quite fast through the financial system, to the real economy these impulses are transmitted rather imperfectly. This involves a long time lag, which depends on the structural characteristics of the national economy.

While the central bank can control short term interest rates, the real economy is mainly affected by medium and long term deposit and lending rates charged by commercial banks to their customers. The level of these medium and long-term rates depends on the interest rate set by the monetary authority. There are also a number of other determinants that include economic growth prospects, inflation expectations, among others. They are of utmost importance for consumption, investment or saving decisions. Generally, lower interest rates promote investments and consumption but discourage savings. Higher interest rates on the other hand stimulate savings while restraining consumption and investments in the short run. As a result, aggregate demand in the economy is affected. Furthermore, the amount of external demand for domestic products can exert a significant contribution to domestic economic activity. In the short run, aggregate supply has only a limited ability to adjust to the new level of demand. On the other hand, in the long run aggregate supply does adjust, but gradually and with almost no influence from the monetary policy. Long-run aggregate supply is driven by fundamental factors such as the labor force, productive capacities, or the technological progress and as a result it can change only slowly in time. Therefore, in the short-to-medium run, monetary policy can influence only the difference (output or GDP gap) between the actual level of economic activity and the one that is sustainable over the long run.

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