The Transmission mechanism tells us;
- *How changes in Interest Rates affect the level of economic activity.
- All different types of interest rates change and vary on their own.
- Thus, there is a Effect Lag after changes in cash rate targets.
- All different types of interest rates change and vary on their own.
The Transmission Channels
As Illustrated below, these changes in the Interest Rate flow through to Aggregate Demand due to the way they influence;
-
Consumption & Investment Through;
-
Net Exports Through;
These then go on to influence Real GDP, Employment, and Inflation.
Don't draw the Transmission Mechanism Diagram
The Transmission Mechanism’s Channels;
- Explain how a change in the Cash Rate bring about changes in Aggregate Demand, and thus;
- Output, Employment, and Prices
- Are how Monetary Policy does what it says in the description;
FYI
Ceteris Paribus, a reduction in the Cash Rate would also see;
- a reduction in other interest rates;
- Increase in Aggregate Demand over time
- As a result of;
- Reduction in incentive to save
- Increasing Household & Business Cash Flows
- Increasing Prices of Alternative Asset Classes
- (such as shares
- Downwards pressure on the Exchange Rate
- Increasing International Competiveness
Cash Flow of households and firms.
Households can either be
- Net Savers;
- Advantaged; They benefit from higher interest payments
- Net Borrowers;
- Disadvantaged; They will have to make larger interest payments
Generally Firms are Net Borrowers, meaning that they are disadvantaged by higher Interest Rates. As rates increase, there is less free cash to;
- Pay expenses
- Expand Production
- Employ more labour;
The ownership of financial assets such as shares, and property seem less attractive since the relative returns of those assets decline.
Asset Prices / Declining Growth of Asset Prices leads to;
Contractionary Monetary Policy is the example used here that would decline asset prices.
- Decline in “On-paper” wealth of households who have property holdings and/or share portfolios.
- Leading to perception of falling wealth
- Leading to decreases in Household Spending.
- Which could lead to a Reduction in the Equity households offer when getting a loan.
Exchange Rate
Changes in the Interest Rate are reflected almost immediatly reflected in the Exchange Rate due to;
- The Interest Rate Differential
- Where foreigners invest money into countries with a higher iInterest Rate.
- The Mobilility of financial capital
- e.g. A foreign bank can invest in australia without shipping anything, it can occur straight-away
If Australian Interest rates are above that of other countries, the I.R Differential kicks in, leading to a;
- An Increase in the Exchange Rate
- Increases in Capital Inflow
- Increase in Demand for the country
Overall, Increases in the Exchange rate put Downwards Pressure on Aggregate Demand as;
- Appreciation (Increase in the E.R) leads to a decrease in International Competiveness.
- Decreasing net exports
- Imports become cheaper for Australian households
- Decreasing Net Exports
- Import-competing firms in Australia have to compete with cheaper imports.
Figure 13.6 - Contractionary Monetary Policy.excalidraw
Tighter monetary policy;
- reduces upwards pressure on prices,
- Reduces Aggregate Demand
- and Thus, Output & Employment
The Cash Rate
- The Cash Rate is the Interest Rate on unsecured overnight loans between banks
- Near Risk-free
- All other types of Interest Rates are higher than the cash rate in order to compensate lenders.
- A Time premium that compensates the bank for lending over longer periods.
- e.g. a 25 year house mortgage.
- #ask_davis what does this mean, the RBA giving them a better rate for borrowing longer?
- Changes in the cash rate usually flow through to other rates as Financial Instituitions (not sure what ones, just ADIs? others?#ask_davis ) adjust the risk / reward profiles of their portfolio.
How Changes in Interest Rates flow to the economy at large
Changes in the Cash Rate usually flow through to other Interests rates as Financial Instituitions adjust the risk/reward profiles of their portfolio
Imprompto diagram during econs class
Expansionary Monetary Policy
- Inflation is below the Traget range ( < 3%)
- The economy is not growing fast enough (Econ. Growth, (> 3.5% - 4%)
- Unemployment is below the natural rate ( < 4%)
All other interest rates are lower than the cash rate; This is to compensate lenders for the risk they have to take on.
A Change in the Interest flows through to Aggregate Demand through the following influences;
- Incentives for decisions to save, borrow or invest;
- Cash Flow of households and firms
- Asset prices and perceived wealth
- The [[Exchange Rate