The Transmission of Monetary Policy | Explainer | Education
![logo rba social x.png](/wp-content/uploads/2024/07/logo-rba-social-600x315.png)
![Graph representing the cash rate flow](/wp-content/uploads/2024/07/the-transmission-of-monetary-policy-01.png)
The transmission of monetary policy describes how
changes made by the Reserve Bank to its monetary
policy settings flow through to economic activity
and inflation. This process is complex and there is a
large degree of uncertainty about the timing and
size of the impact on the economy. In simple terms,
the transmission can be summarised in two stages.
- Changes to monetary policy affect interest
rates in the economy. - Changes to interest rates affect economic
activity and inflation.
This explainer outlines these two stages and
highlights some of the main channels through which
monetary policy affects the Australian economy.
First Stage
Monetary policy in Australia is determined
by the Reserve Bank Board. The primary and
conventional tool for monetary policy is the
target for the cash rate, but other tools have
included forward guidance, price and quantity
targets for the purchase of government bonds,
and the provision of low-cost fixed term funding
to financial institutions.
The first stage of transmission is about how
changes to settings for these tools influence
interest rates in the economy. The cash rate is the
market interest rate for overnight loans between
financial institutions, and it has a strong influence
over other interest rates, such as deposit and
lending rates for households and businesses. The
Reserve Bank’s other monetary policy tools work
primarily by affecting longer-term interest rates in
the economy.
While monetary policy acts as a benchmark for
interest rates in the economy, it is not the only
determinant. Other factors, such as conditions in
financial markets, changes in competition, and
the risk associated with different types of loans,
can also impact interest rates. As a result, the
spread (or difference) between the cash rate and
other interest rates varies over time.
Second Stage
The second stage of transmission is about how
changes to monetary policy influence economic
activity and inflation. To highlight this, we can
use a simple example of how lower interest rates
for households and businesses affect aggregate
demand and inflation. (Higher interest rates have
the opposite effect on demand and inflation).
Aggregate Demand
Lower interest rates increases aggregate demand
by stimulating spending. But it can take a
while for the supply of goods and services to
respond because more workers, equipment
and infrastructure may be required to produce
them. Because of this, aggregate demand is
initially greater than aggregate supply, putting
upward pressure on prices. As businesses increase
their prices more rapidly in response to higher
demand, this leads to higher inflation.
There is a lag between changes to monetary
policy and its effect on economic activity and
inflation because households and businesses take
time to adjust their behaviour. Some estimates
suggest that it takes between one and two years
for monetary policy to have its maximum effect.
However, there is a large degree of uncertainty
about these estimates because the structure of
the economy changes over time, and economic
conditions vary. Because of this, the overall effects
of monetary policy and the length of time it takes
to affect the economy can vary.
Inflation Expectations
Inflation expectations also matter for the
transmission of monetary policy. For example, if
workers expect inflation to increase, they might
ask for larger wage increases to keep up with the
changes in inflation. Higher wage growth would
then contribute to higher inflation.
By having an inflation target, the central bank can
anchor inflation expectations. This should increase
the confidence of households and businesses in
making decisions about saving and investment
because uncertainty about the economy is
reduced.
Channels of Monetary
Policy Transmission
Saving and Investment Channel
Monetary policy influences economic activity
by changing the incentives for saving and
investment. This channel typically affects
consumption, housing investment and business
investment.
- Lower interest rates on bank deposits reduce
the incentives households have to save their
money. Instead, there is an increased incentive
for households to spend their money on
goods and services. -
Lower interest rates for loans can encourage
households to borrow more as they face lower
repayments. Because of this, lower lending
rates support higher demand for assets, such
as housing. -
Lower lending rates can increase investment
spending by businesses (on capital goods like
new equipment or buildings). This is because
the cost of borrowing is lower, and because of
increased demand for the goods and services
they supply. This means that returns on these
projects are now more likely to be higher than
the cost of borrowing, helping to justify going
ahead with the projects. This will have a more
direct effect on businesses that borrow to fund
their projects with debt rather than those that
use the business owners’ funds.
Cash-flow Channel
Monetary policy influences interest rates,
which affects the decisions of households and
businesses by changing the amount of cash they
have available to spend on goods and services.
This is an important channel for those that are
liquidity constrained (for example, those who
have already borrowed up to the maximum that
banks will provide).
-
A reduction in lending rates reduces interest
repayments on debt, increasing the amount of
cash available for households and businesses
to spend on goods and services. For example,
a reduction in interest rates lowers repayments
for households with variable-rate mortgages,
leaving them with more disposable income. -
At the same time, a reduction in interest
rates reduces the amount of income that
households and businesses get from deposits,
and some may choose to restrict their
spending. -
These two effects work in opposite
directions, but a reduction in interest rates
can be expected to increase spending in the
Australian economy through this channel (with
the first effect larger than the second).
Asset Prices and Wealth Channel
Asset prices and people’s wealth influence how
much they can borrow and how much they
spend in the economy. The asset prices and
wealth channel typically affects consumption and
investment.
- Lower interest rates support asset prices (such
as housing and equities) by encouraging
demand for assets. One reason for this is
because the present discounted value of
future income is higher when interest rates are
lower. - Higher asset prices also increases the equity
(collateral) of an asset that is available for banks
to lend against. This can make it easier for
households and businesses to borrow. - An increase in asset prices increases people’s
wealth. This can lead to higher consumption
and housing investment as households
generally spend some share of any increase in
their wealth.
Exchange Rate Channel
The exchange rate can have an important
influence on economic activity and inflation
in a small open economy such as Australia. It
is typically more important for sectors that are
export oriented or exposed to competition from
imported goods and services.
- If the Reserve Bank lowers the cash rate target it
means that interest rates in Australia have
fallen compared with interest rates in the rest
of the world (all else being equal). - Lower interest rates reduce the returns
investors earn from assets in Australia (relative
to other countries). Lower returns reduce
demand for assets in Australia (as well as
for Australian dollars) with investors shifting
their funds to foreign assets (and currencies)
instead. - A reduction in interest rates (compared with
the rest of the world) typically results in a lower
exchange rate, making foreign goods and
services more expensive compared with those
produced in Australia. This leads to an increase
in exports and domestic activity. A lower
exchange rate also adds to inflation because
imports become more expensive in Australian
dollars. (To learn more about how exchange rate
movements can affect prices and influence inflation
outcomes, see Explainer: Causes of Inflation.)
Read More