My point of departure will be the monetary policy instrument, which is typically a short-term interest rate. In light of the close links between monetary policy and financial markets, I will then explain the benefits of central bank transparency. My comments will end with a note of caution concerning the information value of financial market prices in a world of increasingly market oriented and transparent central banks. 1. How does monetary policy affect financial markets? Monetary policy is aimed at preserving price stability. In some countries, central banks operate under mandates that refer to additional objectives such as full employment, maximum sustainable growth, stable interest rates or stable exchange rates. To meet their objectives, central banks intervene in financial markets. It is through the financial markets that monetary policy affects the real economy. In other words, financial markets are the connecting link in the transmission mechanism between monetary policy and the real economy. I will focus on the first part of the transmission mechanism only, i.e. the transmission from the monetary policy instrument to financial markets. Monetary policy affects financial markets through various channels. However, the transmission process from monetary policy to financial markets and finally to the real economy has a single source: the monetary policy instrument. Typically, the monetary policy instrument is a financial market price which is directly set or closely controlled by the central bank. For most central banks with floating exchange rates today, the monetary policy instrument is a short-term interest rate.

To be more precise, it is the yield curve of both the home and the foreign country, and thus the monetary policies of both the home and the foreign country which affect the exchange rate between two currencies. In practice, exchange rate movements often deviate significantly from what interest rate differentials would suggest. In light of the practical uncertainties about the effects of monetary policy on exchange rates, the exchange rate transmission channel for monetary policy is also not easily exploitable. Other assets Apart from bonds and exchange rates, monetary policy also affects the stock market. The relationship between monetary policy and stock prices is complex, because stocks are influenced by monetary policy through several channels. First, if stocks are priced using the dividend discount model, then monetary policy affects stock prices via the interest rate which is used to discount future dividends. Interest rates may also affect the value of domestic assets of a company, and the exchange rate affects the value of its foreign assets and foreign profits. In addition, monetary policy influences the financing cost of a company as well as the availability of loans. Moreover, the medium-term effects of monetary policy on the real economy can influence a firm's profits. Monetary policy can also affect commodity prices. Expansionary or restrictive monetary policy supports or weakens real activity in the medium run and can thus influence the demand and the price for commodities. Obviously, this dynamic can only occur in economies large enough to impact the global demand for commodities.