The transmission mechanism of monetary policy

The Reserve Bank sets a target for the cash rate. A change in that target passes to other interest rates and then to spending through several channels: savings and investment, cash flow, the exchange rate, and asset prices and wealth. Spending then moves growth, employment and inflation.

The instrument	The cash rate target
The channels	Savings and investment, cash flow, exchange rate, asset prices and wealth
Where it lands	Aggregate demand, then the domestic macroeconomic goals
Where it sits	Unit 4, Area of Study 1

One channel at a time

Name the channel, then write each link in order. A lower cash rate target lowers other interest rates, so borrowing costs less and saving earns less; households and firms spend more, and aggregate demand rises.

The stance

The stance compares the cash rate target with the neutral rate: below it is expansionary, above it is contractionary. Describe a stance from the data in the question, never from memory of a real rate.

Strengths and weaknesses

Strengths: the target can change at any meeting, and the decision rests with an independent central bank.
Weaknesses: the effects take time to reach spending, and they fall unevenly on borrowers and savers.

Try 2 questions

Question 1

Changes in the six months after a cut in the cash rate target (invented figures)
Indicator	Change
Value of new housing loans	+6 per cent
Trade-weighted index of the currency	−3 per cent
Share price index	+4 per cent
Average deposit rate	−0.5 percentage points

The table shows changes in a hypothetical economy in the six months after its central bank cut the cash rate target (invented figures). Which change is evidence of the exchange rate channel at work?

Question 2

Which of these is an indirect tax?

Next step

Take the free test The monetary policy lesson

Questions people ask

Do I need real cash rate figures?

The study design asks you to judge policy over the past two years, so use the data your class gives you. Our questions use invented rates and never state a real one.

How many channels should I explain?

Answer the question asked: a part that asks for one channel wants that channel traced step by step, not a list of four.