Monetary Policy Impact on Companies, GDP, and Inflation
Companies
Companies are also influenced by the effects of a change in the policy rate on the interest rates in the market. The magnitude of impact depends on the nature of the business, company size, and sources of funding. An increase in the interest rate policy, and its impact on market rates, will have a direct effect on all companies that use bank financing or similar for working capital and investments. Many companies experience a close relationship between liquidity and investment decisions. These companies prefer to finance first with internal funds (retained earnings), then bank loans, and ultimately by issuing bonds and stocks.
Second-Round Effects: Changes in Spending Decisions Affect GDP and Inflation
The reaction of companies and individuals to an increase in the policy rate is a reduction in their levels of spending. A company that was not directly touched by the changes in interest rates, asset prices, or the exchange rate induced by a change in the policy rate may be affected by changes in consumer spending or demand for inputs of others.
The Lags with Which Monetary Policy Operates
The effects of a policy rate change will take some time to fully manifest in the economy. A change in monetary policy affects interest rates quickly from the very short term, the exchange rate, and prices of financial assets, but the impact on some longer-term rates can be much slower.
Empirical evidence indicates that on average, it takes 3 to 5 quarters in Chile for the response to a change in monetary policy to achieve most of the effect on demand and output. It takes 4 to 6 quarters more for these changes in activity to generate maximum impact on the rate of inflation.
GDP and Inflation
In the long run, GDP growth is a result of supply factors, such as technical progress, capital accumulation, and the size and quality of the workforce. When the GDP is at its potential, production levels are such that they do not exert inflationary pressures in commodity markets.
The difference between actual GDP and potential GDP is what is called the output gap. When there is a positive gap, it is because a very high aggregate demand has brought the product above its sustainable level, and companies are working beyond capacity.
This additional demand for labor and the better job prospects will bring pressure on wages and inflation. Perhaps some companies take advantage of periods of high demand to increase their profit margins and raise prices in proportion to increases in higher unit costs.
The maintenance of GDP at its potential level is, in the absence of external shocks, enough to keep inflation at its target level when this coincides with the rate expected by economic agents. The absence of an output gap is consistent with any constant expected inflation rate. So, if it is possible to keep the product at its potential level, this would theoretically be consistent with a high and stable inflation rate as with a lower and stable one.
Expectations of Inflation and Real Wages
Inflation expectations are important because they affect wage and price setting and thus fuel inflation in subsequent periods. Wage increases exceeding the rate of growth in labor productivity reflect the combined effect of a positive expected inflation rate and a component resulting from the pressure of demand in labor markets.
Imported Inflation
There is also a more direct effect of changes in the exchange rate on domestic inflation. This situation arises because these variations in the exchange rate affect domestic prices of imported goods, which are determining factors in the costs of many companies and retail prices of many goods and services. Peso depreciation leads to a higher domestic price of imported goods, while an assessment may diminish it.
The strength of domestic demand for the imported product is also relevant, since it is this that fuels the margin of the importer and the other participants in the distribution chain.