The transmission mechanism of monetary policy: Analysing the financial market pass-through

Abstract

This paper uses a structural vector autoregressive approach to identify the e?ects of monetary policy innovations on di?erent sub-markets of the Icelandic financial system. This forms the first stage of the interest rate channel of the monetary transmission mechanism, with the second stage explaining the propagation of monetary policy from the financial markets to the real economy. The results indicate that an innovation to monetary policy has a significant within-the-month e?ect on the money market rate. The innovation is then propagated through the money market to the bond market and from there to the bank loan rate market, with the e?ect peaking one to four months after the initial monetary policy shock and lasting for about eight to nine months. The results suggest that the bond rate is the most important determinant of the marginal cost of loan funding. This could be explained by mark-up pricing of loans over deposits with some type of adjustment costs explaining the sluggish response of the bank loan rate to shocks in the marginal cost of loan funding.

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