The variable transmission mechanism Central banks have effectively treated the transmission mechanism as uncertain but fixed (or at best only mildly variable) when it is in fact highly variable and procyclical.
The transmission mechanism is a function of, among other factors, (i) regulation, which changes over time; (ii) financial innovation, which often evolves to circumvent regulation; and (iii) confidence, which is influenced by monetary policy in ways not commonly acknowledged. 4 Consider three states of the world. In the normal state, financial agents balance macroeconomic and idiosyncratic risks in their investing, lending, and financing decisions.