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. A 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. From a central bank perspective, monetary policy transmission mechanism summarizes all these relevant channels.

Although the theory has suggested a wide range of transmission channels, economic practice has emphasized the following: interest rate channel; credit channel; exchange rate channel; wealth and balance sheet channel; inflation expectations channel.

A simplified description of these transmission channels, adapted to the characteristics of the Romanian economy, lies at the root of the NBR model for medium term analysis and projection (ro. MAPM).

Monetary policy impulses coming from the central bank are usually transmitted through the banking (or financial) system. The relationship between commercial banks (financial intermediaries) and monetary authority occurs in the general context of financial markets (money market, foreign exchange market). Normally, 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 and only with a time lag, depending usually 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 but also on a number of other determinants (inflation expectations, economic growth prospects, etc.) and are of utmost importance for investment, consumption or saving decisions. Generally, lower interest rates promote investments and consumption but discourage savings, while higher interest rates stimulate savings, restraining consumption and investments in the short run. As a result, aggregate demand in the economy is affected. Moreover, 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 productive capacities, the labor force or the technological progress and as a result it can change only slowly over 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 (or potential GDP).

Real GDP gap is a key determinant for price inflation dynamics. For example, a demand for consumption or investment goods in excess to the related supply puts pressure on the cost with the production factors (including labor and, therefore, wages). Faced with such an increase in the production costs, some firms might decide to reduce their profit margins, which is equivalent to leaving the final sale price unchanged. However, in the medium term, if the production costs rise systematically, firms will gradually transfer these costs onto the final price, which will eventually lead to a rise in the price of consumption goods (thus generating inflation). An aggregate demand deficit will exert opposite effects.

Having a relatively efficient control over the short-term interest rates, the central bank can also influence economic agents' incentive to hold domestic currency against holding foreign currency, namely the exchange rate. However, the exchange rate is the outcome of other various influences (e.g. risk aversion of foreign investors, domestic and external macroeconomic disequilibria - interest rates differential -, political factors, etc). Monetary policy has no ability to influence some of these factors, whereas it might have - conditional on the consistency of the macroeconomic policy mix (fiscal policy, structural reforms) - only a limited influence on others.

The exchange rate affects the relative price of domestic goods versus foreign goods. If the exchange rate falls (the domestic currency depreciates), an exporter would profit when he converts back in domestic currency the price charged in foreign currency from selling his goods overseas. On the other hand, if the domestic currency rises (or appreciates) an importer would profit when selling on the domestic market goods purchased abroad. Those goods had a price denominated in foreign currency, but they should be cheaper when valued in domestic currency, because of the increase in (appreciation of) the exchange rate. As a result, through the so-called net exports (or indirect exchange rate) channel, monetary policy impulses which initially have an effect on the exchange rate, could be transmitted, although with a lag, to the real economic activity (as reflected by the output gap).

Real economic activity can also be influenced, through the combined effects of interest rates and exchange rate, via the so-called wealth and balance sheet channel (see Wealth and balance sheet effect). Exchange rate depreciation can lower the incentive to borrow in foreign currency. At the same time, domestic currency depreciation reduces the disposable income that is left after servicing the regular payments on the foreign currency loan. This is because economic agents with revenues denominated in domestic currency would have to pay more following a depreciation of the currency. Domestic currency appreciation will have opposite effects, lowering the costs associated with loans denominated in foreign currency.

One of the simplest and fastest transmission channels of the changes in the exchange rate is through the import price of goods and services (direct exchange rate channel). The price charged for an imported good or service on the domestic market will be the foreign price (the price expressed in foreign currency on the international market) adjusted for the relevant exchange rate. Generally, the domestic price of an imported good or service will not change one-to-one with the exchange rate. This is the result of several possible factors: the setting, by the exporter of the good, of the final selling price in the currency of the buyer (importer) of the good (i.e., local currency pricing). The variable content of non-tradable goods used in the production of tradable goods, the high “menu costs” implied by the adjustment of domestic prices to every change of the exchange rate. As a result, the exchange rate pass-through to the domestic price of an imported good or service will be incomplete.

Inflation expectations are heavily affected by the economic agents' perceptions regarding the central bank commitment towards achieving its primary objectives (see The importance of inflation expectations). Anchoring inflation expectations could become one of the most powerful and efficient channels of monetary policy transmission, provided that it is transparent and its actions are regarded as credible.

Besides the influence of the monetary policy, the dynamics of aggregate demand and prices accommodate strong influences coming from the other components of the macroeconomic policies mix, such as fiscal policy and income policy. Fiscal policy has a direct effect on the economy by affecting the aggregate demand through the fiscal impulse (see Fiscal projections and macroeconomic forecast). An optimal fiscal policy plays the role of stabilizing business cycle fluctuations and, consequently, smoothing the adjustment of real GDP towards its potential level. Setting the fiscal stance in terms of taxes such as VAT or the level of excise duties for different products has a direct impact on prices in the economy. Actually, a balanced income policy should allow for a proper correlation between real wages in the public sector and the private sector, on one hand, and the dynamics of labor productivity, on the other hand.