Lesson 3 of 8 · All lessons in this module
- What central banks do and what they aim for
- The three tools: open market operations, policy rate, reserve requirements
- How a rate change reaches growth, inflation and the currencyVideo lesson
- Effective central banks and inflation targeting
- Exchange rate targeting and policy in developing economies
- Expansionary or contractionary? The neutral rate and the source of shocks
- Limits of monetary policy: weak transmission, deflation and quantitative easingVideo lesson
- How monetary and fiscal policy interact
Lesson 3 of 8 · 13 min
How a rate change reaches growth, inflation and the currency
A change in the policy rate spreads through four linked channels (market interest rates, asset prices, expectations and the exchange rate) to total demand and import prices, and so to inflation.
In short
- The monetary transmission mechanism is the path from the policy rate to inflation.
- Four interconnected channels: short-term market rates (bank and interbank rates), asset prices, expectations of economic agents and the exchange rate.
- A rate rise lowers domestic demand (dearer credit, lower wealth, gloomier expectations) and net external demand (a stronger currency makes exports dearer).
- Weaker total demand cuts domestic inflationary pressure; a stronger currency also lowers import prices. Together they reduce inflation.
- Central bankers act as if money is not neutral in the short run: policy can move real growth temporarily, even if not in the long run.
- The official rate most directly affects market rates, asset prices, inflation expectations and the exchange rate; import prices and domestic inflation are reached only indirectly.
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