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2  Interest and exchange rate channels[2]

A central bank derives the power to influence wholesale money market interest rates from the fact that it is the monopoly supplier of high-powered money (also known as outside money or the monetary base). Although the institutional details differ from country to country, the operating procedure of central banks is generally similar. Central banks choose the price at which they lend high-powered money to the inter-bank market. The quantitative effect of a change in the official central bank lending rate on other interest rates, and on financial market conditions more generally, depends on the extent to which a policy change is anticipated, how the change affects expectations of future policy, interest rates and inflation, and the degree of nominal price rigidities.

Real (inflation expectations adjusted) interest rates reflect the opportunity cost of current expenditure relative to expenditure in some future period, since earning a return in the interim enables greater consumption or investment at a later date. Changes in real interest rates alter the incentives to consume and invest in the present versus consuming and investing in future.

Movements in short-term interest rates affect longer-term interest rates, at which financial institutions typically lend to and borrow from businesses and consumers, as illustrated by the expectations hypothesis of the term structure of interest rates. The expectations hypothesis states that, for any choice of holding period, the expected return is the same for any combination of bonds of different maturities. For example, the rate of return from holding a one-year note should be the same as holding two successive six-month notes.[3]

Real interest rates more closely reflect the costs and benefits of deferring expenditure than nominal interest rates as they account for the loss of purchasing power due to inflation. The link between nominal rates, set by the central bank and financial intermediaries, and real interest rates is through the Fisher equation. The Fisher equation decomposes the observed nominal interest rate into an expected inflation component and an expected real rate and can be written as


where all values are in discrete time, denotes the nominal rate of return on lending (or the cost of borrowing) from time to time , is the ex ante real lending (borrowing) rate from time to time and refers to the expected rate at time of inflation between time and .[4]

An increase in short-term nominal interest rates will lead to higher short-term ex ante real rates if inflation expectations do not adjust upwards by the full increase in short-term interest rates and will result in higher short-term ex post real rates if there is price stickiness.[5] Inflation inertia and price stickiness can arise from slow adjustment of expectations, the existence of explicit or implicit contracts that are not indexed to the rate of inflation, menu costs of adjusting prices, real rigidities, and price and wage staggering.

Higher real rates directly reduce the profitability of investment projects because of higher financing costs, and indirectly because of the prospect of a slowdown in consumption. A rise in interest rates tends to encourage households to reduce current consumption because the return on saving and the cost of borrowing to finance consumption both increase. Monetary policy may have an additional effect on current consumption by lowering the disposable income of households who are borrowers. A portion of households’ spending is on servicing debt interest. Increases (decreases) in interest rates will raise (lower) the amount of debt servicing required and lower (increase) disposable income. The opposite holds true for households who are savers and the overall net effect on consumption will depend on how much the change in consumption of borrowers is offset by that of savers.[6]

In an open economy, monetary policy also affects output and inflation through the influence that interest rates have on the exchange rate. Interest parity arguments imply that movements in domestic interest rates will induce movements in the exchange rate. Uncovered interest parity, for example, states that the expected return on a bond denominated in a foreign currency should be the same as the expected return from holding an otherwise identical domestic currency bond. A differential between domestic and foreign interest rates reflects expected movements in the exchange rate. A change in monetary policy that leads to movements in the differential between domestic and foreign interest rates therefore implies (assuming uncovered interest rate parity) that either the exchange rate or the expected exchange rate or both must change.

Exchange rate movements have a direct impact on the cost of imports and domestic inflation.[7] Exchange rate movements also have an indirect impact on inflation through their impact on the demand and supply of tradeable and non-tradeable goods and services. An appreciation of the exchange rate, for example, will lower the rate of growth of the domestic price level, which is a weighted average of tradeables and non-tradeables prices. This is because an appreciation of the exchange rate decreases the domestic price of tradeables (if tradeables prices are determined in foreign currency units by world markets). A decrease in the price of tradeables relative to non-tradeables increases the domestic demand for tradeables (and lowers the domestic supply of tradeable goods and services).[8] Moreover, an appreciation of the exchange rate (or decline in the relative price of tradeables to non-tradeables) reduces the domestic demand for non-tradeables and increases the domestic supply of non-tradeables, causing excess supply of non-tradeables and a reduction in the price of non-tradeables.

Monetary policy affects asset prices more generally. For example, monetary policy directly affects the market value of future cash flows through its effect on the discount factor. The relationship between the market price of a unit future cash flow and interest rates is


where is the present value at time of a cash flow that matures at time , denotes the continuously compounding interest rate at annual rates at time and is the number of years to maturity at time . The present value (or market price) of the cash flow is inversely related to the yield, i.e. a rise in lowers the present value of the cash flow and a decline in raises it. This result generalises to all assets (bonds, equities, property, etc.) because the value of all assets can be defined as a combination of expected future cash flows.

Tobin’s q theory provides a mechanism through which monetary policy affects the economy through its effects on the valuation of equities. Tobin (1969) defines q as the market value of firms divided by the replacement cost of capital. The market price of firms will increase with an easing in monetary policy. Tobin’s q rises if this market price of firms increases relative to the replacement cost of capital, i.e. if the cost of new plant and equipment capital declines relative to the market value of firms. Investment spending will rise because firms can purchase new investment goods, which will be valued in the equity market at greater than their purchase cost.[9]

On the other hand, when q is low, firms will not purchase new investment goods because the market value of firms is low relative to the cost of capital. If companies want to acquire capital when q is low, they can buy another firm cheaply and acquire old capital instead. As a result, investment spending will be low.

Consumption spending will also be affected by changes in the market value of equities. This is because equities are typically a component of households’ financial wealth. When equities and stock prices fall, because of a tightening in monetary policy, the value of financial wealth decreases, leading to a decline in household consumption. This is because households’ consumption spending is determined by their lifetime resources, which consist of current and future human capital, real capital and financial wealth. A tightening in monetary policy that leads to a decline in land and property values or structures and residential housing values also causes households’ wealth to decline, while lower interest rates cause an increase in financial wealth.

Interest and exchange rates and asset prices are important channels through which monetary policy affects economic activity and inflation. All, or most of these channels are typically incorporated in macroeconomic models and can operate in conjunction with various degrees of price stickiness. However, in the presence of imperfect information, financial prices are unlikely to be a complete description of the monetary transmission mechanism for the reasons outlined in the introduction. Macroeconomic models that rely solely on the traditional price channels as conduits of monetary policy are likely to omit key channels through which monetary policy can affect activity and inflation. The remainder of this paper examines the role of financial intermediaries and credit in establishing additional channels of monetary policy influence on the real and nominal economy.


  • [2]The channels described in this section reflect those typically incorporated in macroeconomic models of the type listed in footnote 1. Specific references to these and other sources are therefore not noted separately in the discussion that follows.
  • [3]Uncertainty regarding future short-term interest rates coupled with risk aversion may cause the term structure to deviate from the shape implied by the risk-neutral expectations hypothesis. This deviation is captured by a term premium.
  • [4]This formulation of the Fisher equation abstracts from taxes and, as Svensson (1985) notes, the simple Fisher relation does not hold under uncertainty.
  • [5]It is not frequently recognised that an increase in short-term nominal interest rates will, ceteris paribus, have a neutral effect on the real economy only if prices adjust downwards in a stepwise manner, enabling subsequent price inflation to occur over the period relevant to that interest rate.
  • [6]In the case of fixed term interest rates, changes in interest rates will affect consumption if households believe that they eventually will have to face the new interest rate and alter their consumption behaviour in anticipation.
  • [7]See, for example, Adolfson (2002) and Smets and Wouters (2002).
  • [8]The increase in demand for tradeables is reflected in a deterioration in the current account deficit of the balance of payments (matched by a rise in the net foreign demand for domestic assets).
  • [9]Here we are referring to marginal q rather than average q since it is the valuation of the marginal investment project which is relevant (Hayashi, 1982).
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