The Monetary Policy Transmission Mechanism
It is worth remembering that when the Bank of England is making an interest rate decision, there will be lots of other events and policy decisions being made elsewhere in the economy, for example changes in fiscal policy by the government, or perhaps a change in world oil prices or the exchange rate. In macroeconomics the ceteris paribus assumption (all other factors held equal) rarely applies!
- There are several ways in which changes in interest rates influence aggregate demand, output and prices. These are collectively known as the transmission mechanism of monetary policy
- One of the channels that the Monetary Policy Committee in the UK can use to influence aggregate demand, and inflation, is via the lending and borrowing rates charged in the financial markets.
- When the Bank's own base interest rate goes up, then commercial banks and building societies will typically increase how much they charge on loans and the interest that they offer on savings.
- This tends to discourage businesses from taking out loans to finance investment and encourages the consumer to save rather than spend — and so depresses aggregate demand
- Conversely, when the base rate falls, banks cut the market rates offered on loans and savings and the effect ought to be a stimulus to demand and output.
A key influence played by interest rate changes is the effect on confidence – in particular household's confidence about their own personal financial circumstances.
