The monetary transmission mechanism refers to a process in which the policy rate is transmitted through the economy and ultimately affects the inflation rate. The policy rate or benchmark rate is one of the monetary policy tools to influence the money supply besides reserve requirements and open market operation.
Interest rates as a monetary policy tool
When the central bank wants to avoid hyperinflation, it will adopt a tight monetary policy by raising the policy rate. An increase in the policy rate reduces the rate of growth of the money supply in the economy. It then reduces aggregate demand and weakens economic growth and moderates the inflation rate.
Conversely, to avoid deflation – usually, during weak economic growth or recession – the central bank cuts policy rate. That is known as expansionary monetary policy. Lower interest rate reduces borrowing costs, drive up aggregate demand, and stimulate economic growth. Businesses increase their production, pushing real GDP to grow positively. The inflation rate should gradually increase.
Monetary transmission mechanism channels: Case of lower interest rates
Say, the central bank adopts expansionary policies to stimulate economic growth by lowering policy rates. Interest rate cuts affect the economy of several channels, including lending rate, economic agents’ expectation, asset price, wealth, and exchange rate.
The decrease in loan interest rates
Commercial banks respond to official rate cuts by lowering lending rates. As a result, households and businesses borrow more because they are cheaper.
They use cheaper loans to buy goods and services. As the demand for goods increases, businesses respond to it by increasing their production.
Economic agents are becoming more optimistic
Households and businesses are becoming more confident. They attribute lower interest rates to higher economic growth in the future. They expect household income to be higher and company profits to increase.
This optimism encourages households to increase consumption now. Businesses are also eager to order some capital goods, particularly for light equipment.
Asset prices increase
Asset prices tend to rise. That’s because the present value of estimated future cash flows increases. Investors favor bonds because prices will tend to grow when interest rates fall. Improving the outlook for corporate profits also pushed up share prices. As a result, household wealth increases.
Higher wealth leads to more significant expenditure on goods and services.
The domestic currency depreciates. Lower local interest rates narrow the spread with international interest rates. The situation leads to an outflow of hot money. The outflow devalues the domestic currency.
Depreciation makes domestic goods prices cheaper for foreign buyers. Because goods are more competitive (in terms of relative prices), exports should increase. An increase in exports means higher aggregate demand, spurring domestic producers to increase output.
Overall, stronger aggregate demand will drive up domestic prices. It, together with higher import prices (due to depreciation of the local currency), will put upward pressure on actual inflation.
The increase in aggregate demand also stimulates businesses to increase production. Therefore, the economy is growing, as reflected in an increase in real GDP.