Discuss the transmission mechanism and lags in Monetary Policy framework.

 Transmission Mechanism of Monetary Policy: It is argued by the economists that monetary policy is more effective in controlling inflation and stabilizing output because Fiscal policy has lost its significance due to concern over persistently large budget deficits, and political system cannot make tax and spending decisions in a timely way to achieve desirable stabilization outcomes.

The effectiveness of monetary policy essentially depends on the institutional framework available for transmitting impulses released by the central bank. The inter-relationship between money, output and prices lies at the core of monetary theory. Transmission channels are neither static nor uniform over time. These channels need to undergo changes possibly making the earlier channels relatively less effective compared to the new ones. It includes the various channels through which the policy operates like quantum channel, credit rate channel such as interest rate channel, exchange rate channel and asset prices channel.

Transmission Mechanism is the process through which monetary policy decisions affect the economy in general and the price level in particular. The transmission mechanism is characterized by long, variable and uncertain time lags. Thus it is difficult to predict the precise effect of monetary policy actions on the economy and price level. Time lags that occur between the onset of an economic problem and the full impact of the policy intended to correct the problem. Policy lags come in two broad categories-inside lag (getting the policy activated) and outside lag (the subsequent impact of the policy). The three specific inside lags are recognition lag, decision lag, and implementation lag. The one specific outside lag is termed impact lag. Policy lags can reduce the effectiveness of business-cycle stabilization policies and can even destabilize the economy. Policy lags, especially inside lags, are often different for monetary policy than for fiscal policy.

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