Channels – Why Does Monetary Policy Work?
Monetary policy works because the impact of changing interest rates is very broad. We can talk of the “channels” of monetary policy – the paths that a change in interest rates will follow to impact upon the Australian economy.
- Savings and Investment Channel – Put simply, when interest rates increase it costs more to borrow money. This means that the effective cost of certain things (most notably a home) will be more expensive. Higher interest rates will also mean that the return on savings is higher. As such, people are encouraged to save (ie delay expenditure) so that they can gain a higher return. These two things work together to reduce the level of consumption and investment in the Australian economy.
- Cash Flow Channel – There is also a direct impact of increasing interest rates on the cash flow of businesses and individuals with existing loans. When interest rates increase, the discretionary funds available to these people will be lower. As such, any change in the cash rate will have flow on effects for the cash flow of people and businesses in the economy, and this in turn will affect their ability and willingness to spend.
- Money and Credit Channel – Whilst the first two channels consider the cost of borrowing, here we are looking at the availability of borrowing. In brief, when interest rates increase it is more difficult to obtain funds for borrowing, and therefore new borrowers are less likely to arise. With fewer new loans in the market, the increases in consumption and investment expenditure may not be able to be maintained, and as such aggregate demand will either fall, or increase at a slower rate.
- Asset Prices Channel – A change in interest rates will have flow on effects for the value of certain assets within the economy. Any asset considered an “investment” (such as shares) and also property will be affected by changing interest rates. For example, if interest rates fall then demand for these assets will increase. With an increase in demand, the value of these assets will also increase. With a stronger asset base, many people will be more inclined to spend the funds that they have available, and as such aggregate demand will increase. (The true impact of this channel is uncertain, however an understanding of this process can be very beneficial if you want to be an investor!)
- The Exchange Rate Channel – Changing interest rates can have a strong impact on the value of the Australian dollar in the foreign exchange market. When interest rates increase investors around the world will want to invest in Australian securities to benefit from these increased returns. To make these investments, they will need to change their money into Australian dollars, increasing demand for our currency. This may lead to an appreciation of the Australian dollar, and in turn this may reduce demand for our exports. Once again, this could lead to a decrease in aggregate demand.
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