Thursday, 9 January 2014

Monetary Transmission Mechanism

 - what are the links between the interest rate and inflation?

Very basic economics! (RS)

The transmission mechanism of monetary policy is the process by which interest rate changes affect inflation. The transmission mechanism is basically a 3 stage process.

The transmission mechanism - linked to larger version
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The first stage is that a change in the official interest rate set by the MPC will affect other interest rates. Banks, building societies and other financial institutions have to react to any official rate change by changing their own savings and loan rates. The change will also affect the prices of many assets; shares, houses, gilt-edged security prices and so on. The exchange rate may change as demand and supply of sterling adapt to the new level of interest rates. Finally there may also be an effect on the expectations of both firms and individuals. They may become more or perhaps less confident about the future path of the economy.

The second stage is that all these changes in markets will affect the spending patterns of consumers and firms. In other words there will be an effect on aggregate demand. Higher interest rates are likely to reduce the level of aggregate demand, as consumers are affected by the increase in rates and may look to cut back spending. There will also be international effects as the level of imports and exports change in response to possible changes in the exchange rate.

The third stage is the impact of the aggregate demand change on GDP and inflation. This will tend to depend on the relative levels of aggregate demand and supply. If there is enough capacity in the economy then an increase in AD may not be inflationary. However, if the economy is already at bursting point producing as much as it can, then any further AD increase may be inflationary.

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