Use the transmission mechanism to explain how raising the bank rate would affect the economy.
The transmission mechanism is a tool used by the MPC to control output and inflation
through the central bank’s decision making around interest rates which have ripple effects
through financial markets and to businesses and households
Firstly the central bank lowers the money supply which raises the bank rate
This raises interest rates
Changes in interest rates affect spending in various sectors
o Interest rate channel
When bank rate increases, broader market interest rates follow which
encourages saving and less spending on interest sensitive items like
consumer durables, housing and physical capital
Higher interest rates increase the cost of capital, hindering investment and
consumption and decreasing aggregate demand
o Asset prices channels
Increase in bank rate can reduce equity and house prices which reduces
demand for houses in the economy
There will be a negative wealth effect for people currently owning houses
and their spending will fall as their wealth decreases
People with mortgages will see a rise in their interest payments and their
spending will decrease
o Exchange rate channel
When domestic interest rates increase relative to foreign interest rates an
inflow of capital can ensue causing the exchange rate to appreciate
A stronger domestic currency makes foreign goods cheaper relative to
domestic goods encouraging more imports and less production of domestic
goods as a result of less demand for domestic goods
Attracts foreign investors to save in the UK which increases the demand for
the British pound
Lowers cost push inflation
o Bank lending channel
When the bank rate rises banks funding costs increase
This increase causes a decrease in bank lending which decreases
consumption and investment
Increases saving, lowers aggregate demand, lowers demand pull inflation
o Balance sheet channel
Higher interest rates can worsen household and business financial health by
increasing loan delinquencies and reduces cash flows
This limits access to credit and ability to invest and spend
These spending patterns influence overall output and inflation in the economy
o Leads to lower aggregate demand and less investment
o Leads to lower business and consumer confidence which indicates that future
growth will be lower
o Lowers both demand pull and cost push inflation
o Can cause decrease in growth through a reduction in output
How could the monetary policy committee use monetary policy to prevent a period of deflation?
QE
o When nominal interest rates are lowered to 0 and economic growth is stalled
o Used to increase money supply and spur economic activity
o Central bank purchases government bonds and other assets
The transmission mechanism is a tool used by the MPC to control output and inflation
through the central bank’s decision making around interest rates which have ripple effects
through financial markets and to businesses and households
Firstly the central bank lowers the money supply which raises the bank rate
This raises interest rates
Changes in interest rates affect spending in various sectors
o Interest rate channel
When bank rate increases, broader market interest rates follow which
encourages saving and less spending on interest sensitive items like
consumer durables, housing and physical capital
Higher interest rates increase the cost of capital, hindering investment and
consumption and decreasing aggregate demand
o Asset prices channels
Increase in bank rate can reduce equity and house prices which reduces
demand for houses in the economy
There will be a negative wealth effect for people currently owning houses
and their spending will fall as their wealth decreases
People with mortgages will see a rise in their interest payments and their
spending will decrease
o Exchange rate channel
When domestic interest rates increase relative to foreign interest rates an
inflow of capital can ensue causing the exchange rate to appreciate
A stronger domestic currency makes foreign goods cheaper relative to
domestic goods encouraging more imports and less production of domestic
goods as a result of less demand for domestic goods
Attracts foreign investors to save in the UK which increases the demand for
the British pound
Lowers cost push inflation
o Bank lending channel
When the bank rate rises banks funding costs increase
This increase causes a decrease in bank lending which decreases
consumption and investment
Increases saving, lowers aggregate demand, lowers demand pull inflation
o Balance sheet channel
Higher interest rates can worsen household and business financial health by
increasing loan delinquencies and reduces cash flows
This limits access to credit and ability to invest and spend
These spending patterns influence overall output and inflation in the economy
o Leads to lower aggregate demand and less investment
o Leads to lower business and consumer confidence which indicates that future
growth will be lower
o Lowers both demand pull and cost push inflation
o Can cause decrease in growth through a reduction in output
How could the monetary policy committee use monetary policy to prevent a period of deflation?
QE
o When nominal interest rates are lowered to 0 and economic growth is stalled
o Used to increase money supply and spur economic activity
o Central bank purchases government bonds and other assets
