What is it?
The transmission mechanism is the process by which changes in cash rates influence a change in aggregate demand and hence, economic activity.
What is the Process?
A change in cash rates represents a change in market interest rates.
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A Rise in Cash Rates
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A rise in cash rates typically represents a full or proportional rise in the market interest rates of financial products. The rise in market interest rates, in theory, results in lower aggregate demand as it results in:
Savings effect - a rise in interest rates means an increase in savings rates, encouraging households to save rather than consume.
Exchange rate effect - a rise in market interest rates attracts foreign investment as the returns on investment are greater. An increase in foreign investment represents an increased demand for the currency, appreciating the dollar. This reduces the international competitiveness of exports and increases the competitiveness of imports, reducing net exports.
Cash flow effect - Increase in market interest rates means that households and businesses have to meet higher interest repayments, hence reducing cash flow available for consumption and investment.
Asset price effect - Increase in interest rates reduces the accessibility to credit to purchase assets such as property. Reduced demand will reduce property prices, decreasing households perception of wealth and hence, lowering consumption.
Opportunity cost of credit - Increasing market interest rates increases the opportunity cost of credit. Households and businesses may be discouraged to consume or investing due to the higher cost of credit. A higher cost of credit also results in increased investment risk. As a result of higher cash results, in theory, aggregate demand decreases as consumption, investment and net exports all fall.
A Fall in Cash Rates
A fall in cash rates typically represents a full or proportional cut in market interest rates of financial products. The fall in market interest rates, in theory, results in higher aggregate demand as it results in:
Savings effect - a fall in interest rates discourages household saving due to lower returns, encouraging consumption.
Exchange rate effect - lower returns on foreign investment result in a fall in demand for the currency, depreciating the currency. This increases the international competitiveness of exports and reduces the competitiveness of imports.
Cash flow effect - lower interest repayments increase cash flow available for businesses and households, increasing investment and consumption.
Asset price effect - increased accessibility of credit increases demand assets such as property, increasing households perception of wealth and hence, increasing consumption.
Opportunity cost of credit - Lower interest rates lowers the opportunity cost for using credit for consumption or investment. Lower interest rates also mean businesses have reduced investment risk. A fall in cash rates, in theory, increases aggregate demand as it increases consumption, investment and net exports.