The transmission mechanism from interest rates to aggregate demand

Overview

Higher interest rates affect saving behaviour, investment by firms sensitive to the rate of interest and exchange rate channel of monetary policy.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Set out the chain of events by which a rise in the central bank’s policy rate reduces aggregate demand.

   Model answer

   The policy rate rises, so commercial banks’ funding costs rise and they raise the rates charged on mortgages, loans and overdrafts and the rates paid on savings. Households with variable-rate borrowing have less income left after debt payments and everyone finds saving more attractive, so consumption falls, while firms find that fewer investment projects clear the higher cost of finance, so investment falls. Higher rates also tend to reduce house and share prices, weakening the wealth that supports spending, and to attract capital inflows that push the exchange rate up, making exports dearer and imports cheaper so net exports fall. Together these reduce planned spending at every price level, so aggregate demand shifts left.

2. 2

   A household has a 200,000 pound mortgage. The interest rate on it rises from 2% to 5%. Calculate the change in the annual interest cost and the monthly equivalent, and explain the effect on consumption.

   Model answer

   At 2% the annual interest is 0.02 times 200,000 = 4,000 pounds; at 5% it is 0.05 times 200,000 = 10,000 pounds. The increase is 6,000 pounds a year, which is 6,000 divided by 12 = 500 pounds a month. That sum has to come out of a broadly fixed monthly income, so the household must cut spending elsewhere, and since housing costs are unavoidable the cuts fall on discretionary items such as eating out, holidays and durable goods, reducing consumption and therefore aggregate demand.

3. 3

   How do higher interest rates affect saving behaviour?

   Model answer

   A higher rate raises the reward for postponing consumption, so households have a stronger incentive to put money aside rather than spend it now, and the substitution effect pushes saving up and consumption down. There is a counteracting income effect for those living off interest income, who can now reach a given income from a smaller stock of savings and might therefore save less. In aggregate the substitution effect normally dominates, so higher rates raise the saving ratio and reduce consumption.

4. 4

   Why is investment by firms sensitive to the rate of interest?

   Model answer

   A firm undertakes a project only if the expected return exceeds the cost of the funds used, whether that cost is interest on a loan or the interest forgone on internal funds that could have been deposited instead. When rates rise, the threshold return that a project must clear rises with them, so marginal projects are shelved and planned capital spending falls. The effect is strongest for long-lived, capital-intensive projects, where interest is a large share of lifetime cost, and weakest where the expected return is very high.

5. 5

   How do interest rate changes affect aggregate demand through asset prices and wealth?

   Model answer

   Higher interest rates raise the cost of mortgages and make bonds more attractive relative to shares and property, so house prices and share prices tend to fall. Households whose wealth has fallen feel poorer and less secure and therefore save more and spend less, and they can also borrow less because the collateral behind secured lending is worth less. The reverse happens when rates fall, which is one reason cheap money tends to show up quickly in the housing market.

6. 6

   What role does confidence play in the transmission of monetary policy?

   Model answer

   A rise in interest rates is usually read as a signal that the central bank expects the economy to run hot or that harder times are coming, so households become more cautious about large commitments and firms become more cautious about expansion. This expectations channel can move spending before any actual change in interest payments occurs. It also works in reverse, and it can be perverse: a cut in rates during a crisis may be read as confirmation that conditions are dire, so spending falls despite cheaper credit.

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