The transmission of monetary policy describes howchanges made by the Reserve Bank to its monetarypolicy settings flow through to economic activityand inflation. This process is complex and there is alarge degree of uncertainty about the timing andsize of the impact on the economy. In simple terms,the transmission can be summarised in two stages.
- Changes to monetary policy affect interestrates in the economy.
- Changes to interest rates affect economicactivity and inflation.
This explainer outlines these two stages andhighlights some of the main channels through whichmonetary policy affects the Australian economy.
First Stage
Monetary policy in Australia is determinedby the Reserve Bank Board. The primary andconventional tool for monetary policy is thetarget for the cash rate, but other tools haveincluded forward guidance, price and quantitytargets for the purchase of government bonds,and the provision of low-cost fixed term fundingto financial institutions.
The first stage of transmission is about howchanges to settings for these tools influenceinterest rates in the economy. The cash rate is themarket interest rate for overnight loans betweenfinancial institutions, and it has a strong influenceover other interest rates, such as deposit andlending rates for households and businesses. TheReserve Bank's other monetary policy tools workprimarily by affecting longer-term interest rates inthe economy.
While monetary policy acts as a benchmark forinterest rates in the economy, it is not the onlydeterminant. Other factors, such as conditions infinancial markets, changes in competition, andthe risk associated with different types of loans,can also impact interest rates. As a result, thespread (or difference) between the cash rate andother interest rates varies over time.
Second Stage
The second stage of transmission is about howchanges to monetary policy influence economicactivity and inflation. To highlight this, we canuse a simple example of how lower interest ratesfor households and businesses affect aggregatedemand and inflation. (Higher interest rates havethe opposite effect on demand and inflation).
Aggregate Demand
Lower interest rates increases aggregate demandby stimulating spending. But it can take awhile for the supply of goods and services torespond because more workers, equipmentand infrastructure may be required to producethem. Because of this, aggregate demand isinitially greater than aggregate supply, puttingupward pressure on prices. As businesses increasetheir prices more rapidly in response to higherdemand, this leads to higher inflation.
There is a lag between changes to monetarypolicy and its effect on economic activity andinflation because households and businesses taketime to adjust their behaviour. Some estimatessuggest that it takes between one and two yearsfor monetary policy to have its maximum effect.
However, there is a large degree of uncertaintyabout these estimates because the structure ofthe economy changes over time, and economicconditions vary. Because of this, the overall effectsof monetary policy and the length of time it takesto affect the economy can vary.
Inflation Expectations
Inflation expectations also matter for thetransmission of monetary policy. For example, ifworkers expect inflation to increase, they mightask for larger wage increases to keep up with thechanges in inflation. Higher wage growth wouldthen contribute to higher inflation.
By having an inflation target, the central bank cananchor inflation expectations. This should increasethe confidence of households and businesses inmaking decisions about saving and investmentbecause uncertainty about the economy isreduced.
Channels of MonetaryPolicy Transmission
Saving and Investment Channel
Monetary policy influences economic activityby changing the incentives for saving andinvestment. This channel typically affectsconsumption, housing investment and businessinvestment.
- Lower interest rates on bank deposits reducethe incentives households have to save theirmoney. Instead, there is an increased incentivefor households to spend their money ongoods and services.
- Lower interest rates for loans can encouragehouseholds to borrow more as they face lowerrepayments. Because of this, lower lendingrates support higher demand for assets, suchas housing.
- Lower lending rates can increase investmentspending by businesses (on capital goods likenew equipment or buildings). This is becausethe cost of borrowing is lower, and because ofincreased demand for the goods and servicesthey supply. This means that returns on theseprojects are now more likely to be higher thanthe cost of borrowing, helping to justify goingahead with the projects. This will have a moredirect effect on businesses that borrow to fundtheir projects with debt rather than those thatuse the business owners' funds.
Cash-flow Channel
Monetary policy influences interest rates,which affects the decisions of households andbusinesses by changing the amount of cash theyhave available to spend on goods and services.This is an important channel for those that areliquidity constrained (for example, those whohave already borrowed up to the maximum thatbanks will provide).
- A reduction in lending rates reduces interestrepayments on debt, increasing the amount ofcash available for households and businessesto spend on goods and services. For example,a reduction in interest rates lowers repaymentsfor households with variable-rate mortgages,leaving them with more disposable income.
- At the same time, a reduction in interestrates reduces the amount of income thathouseholds and businesses get from deposits,and some may choose to restrict theirspending.
- These two effects work in oppositedirections, but a reduction in interest ratescan be expected to increase spending in theAustralian economy through this channel (withthe first effect larger than the second).
Asset Prices and Wealth Channel
Asset prices and people's wealth influence howmuch they can borrow and how much theyspend in the economy. The asset prices andwealth channel typically affects consumption andinvestment.
- Lower interest rates support asset prices (suchas housing and equities) by encouragingdemand for assets. One reason for this isbecause the present discounted value offuture income is higher when interest rates arelower.
- Higher asset prices also increases the equity(collateral) of an asset that is available for banksto lend against. This can make it easier forhouseholds and businesses to borrow.
- An increase in asset prices increases people'swealth. This can lead to higher consumptionand housing investment as householdsgenerally spend some share of any increase intheir wealth.
Exchange Rate Channel
The exchange rate can have an importantinfluence on economic activity and inflationin a small open economy such as Australia. Itis typically more important for sectors that areexport oriented or exposed to competition fromimported goods and services.
- If the Reserve Bank lowers the cash rate target itmeans that interest rates in Australia havefallen compared with interest rates in the restof the world (all else being equal).
- Lower interest rates reduce the returnsinvestors earn from assets in Australia (relativeto other countries). Lower returns reducedemand for assets in Australia (as well asfor Australian dollars) with investors shiftingtheir funds to foreign assets (and currencies)instead.
- A reduction in interest rates (compared withthe rest of the world) typically results in a lowerexchange rate, making foreign goods andservices more expensive compared with thoseproduced in Australia. This leads to an increasein exports and domestic activity. A lowerexchange rate also adds to inflation becauseimports become more expensive in Australiandollars. (To learn more about how exchange ratemovements can affect prices and influence inflationoutcomes, see Explainer: Causes of Inflation.)
