The Impact of Changes in Interest Rates (HSC SSCE Economics): Revision Notes

The Impact of Changes in Interest Rates

Understanding the transmission mechanism

When the Reserve Bank of Australia (RBA) changes monetary policy, the effects don't happen instantly or directly. Instead, policy changes flow through the economy via what economists call the transmission mechanism. This is the process through which changes in monetary policy (such as interest rate adjustments) pass through the economy to ultimately affect key economic objectives like inflation, economic growth, and employment.

The transmission mechanism works through several different channels, each affecting the economy in distinct but related ways. Understanding these channels helps explain why monetary policy is such a powerful tool for managing the economy.

The four channels of monetary policy transmission

Interest rate channel

The interest rate channel is perhaps the most direct way monetary policy affects the economy. When the RBA implements expansionary monetary policy (loosening policy), it puts downward pressure on interest rates throughout the economy. This makes borrowing cheaper for both consumers and businesses.

For consumers, lower interest rates reduce the cost of borrowing for major purchases such as housing and consumer durables (items like cars, furniture, and appliances). When borrowing becomes cheaper, more consumers are willing and able to take out loans to make these purchases, increasing consumption spending in the economy.

For businesses, lower interest rates have two important effects. First, they make it cheaper to borrow money for investment in capital equipment, factory upgrades, and business expansion. Second, they reduce the opportunity cost of investing funds in the business. This opportunity cost concept is important: business owners must decide whether to invest their money in financial assets (like bonds or term deposits) where they can earn interest, or invest it in their own business. When interest rates fall, the returns from financial assets decrease, making it relatively more attractive to invest in the business itself.

The combined effect of increased consumer borrowing and business investment leads to rising consumption and investment demand. This raises the overall level of economic activity in the economy.

Cash flow channel

The cash flow channel affects people and businesses that already have existing loans. When interest rates fall, the cost of servicing these existing loans becomes cheaper. This means borrowers have to pay less each month towards their mortgages, business loans, or other debt obligations.

This channel is particularly important because it has an immediate impact on household and business budgets. When loan repayments decrease, existing borrowers suddenly have more disposable income available. Rather than seeing this extra money disappear into loan repayments, they can use it for additional spending on goods and services.

Exchange rate channel

The exchange rate channel works through international financial markets and currency movements. When the RBA lowers interest rates, it makes Australian financial assets less attractive to international investors. This is because investors can earn higher returns by holding assets in countries with higher interest rates.

As international investors move their money out of Australian assets (or new investors choose not to invest in Australia), demand for Australian dollars falls. This leads to a depreciation of the Australian dollar – that is, the AUD falls in value relative to other currencies.

A depreciated Australian dollar has important effects on international trade:

• Exports become more competitive: Australian goods and services become cheaper for overseas buyers, potentially increasing export sales
• Imports become more expensive: Foreign goods cost more in AUD terms, making them less competitive against locally produced goods

Both effects tend to increase demand for Australian-produced goods and services. Stronger export sales and reduced import competition stimulate aggregate demand. However, more expensive imports can also contribute to inflation, as import prices rise and domestic producers face less competitive pressure.

Wealth channel

The wealth channel operates through changes in asset prices. When interest rates fall, prices tend to rise for a range of assets, including residential property and shares in public companies. There are several reasons for this:

• Lower interest rates make borrowing to buy assets cheaper
• Lower returns on bank deposits and bonds make other assets relatively more attractive
• Lower interest rates mean future income from assets is worth more today (this is a discounting effect)

When asset prices rise, asset holders (such as homeowners and shareholders) experience an increase in their wealth. For example, if house prices rise by 10%, homeowners feel wealthier, even if they haven't sold their property.

This increased wealth tends to make people feel more confident and willing to spend. Homeowners might renovate their properties, upgrade their cars, or increase their general consumption. This is known as the wealth effect, and it can significantly boost consumption and investment spending in the economy.

Impact on aggregate demand and the economy

All four channels described above work in the same direction when monetary policy is loosened: they all tend to increase aggregate demand (total spending in the economy). The combined effect of these channels is:

• Increased consumption spending (from cheaper borrowing, better cash flow, and higher wealth)
• Increased investment spending (from cheaper borrowing and lower opportunity costs)
• Increased net exports (from currency depreciation)

When aggregate demand increases, this typically generates higher economic activity and employment, particularly if the economy was previously operating below full capacity (for example, during a recession). However, if the economy was already close to full employment, the increase in aggregate demand could lead to demand-pull inflation and upward pressure on wages, rather than increased output.

Tightening vs loosening monetary policy

The effects of monetary policy changes can be summarised as follows:

Tightening of monetary policy (contractionary policy):

• Puts upward pressure on interest rates
• Dampens consumer and investment spending through all four channels
• Results in lower economic activity
• Leads to lower inflation
• May result in higher unemployment (as reduced demand leads to lower employment)

Loosening of monetary policy (expansionary policy):

• Puts downward pressure on interest rates
• Boosts consumer and investment spending through all four channels
• Results in higher economic activity
• Leads to falling unemployment (as increased demand creates jobs)
• Often causes increased inflationary pressures (particularly if the economy is near full employment)

The debate over the exchange rate channel

Recent research has sparked important debate about which transmission channel is most effective in controlling inflation. A research paper published in 2022 by economists Isaac Gross and Andrew Leigh (who is also an Assistant Minister in the Federal Government) argued that the exchange rate channel may actually be the most powerful mechanism through which monetary policy affects inflation in Australia.

Their argument works as follows:

1. When Australian interest rates increase relative to interest rates in other countries, holding cash in AUD-denominated assets becomes more attractive
2. This causes the Australian dollar to appreciate
3. An appreciated dollar affects inflation through multiple pathways:
   • Some prices fall directly (particularly prices for imported goods)
   • Input costs fall for businesses that use imported materials
   • Increased competition from cheaper imports puts downward pressure on domestic prices
   • Aggregate demand falls because Australian exports become more expensive and less competitive

Time lags and policy challenges

One of the most important characteristics of monetary policy is that it works with significant time lags. While the RBA can implement a change in monetary policy almost immediately (it doesn't require legislation or parliamentary approval), it takes considerably longer for that change to work through all the transmission channels and bring about the desired impact on economic growth, inflation, and unemployment.

Research and experience suggest that monetary policy typically has a time lag of around 12 to 24 months before the full impact of interest rate changes is felt in the economy. This is because:

• Consumers and businesses take time to adjust their spending decisions
• Existing loans and contracts may have fixed terms that delay the impact
• Asset prices and exchange rates adjust gradually
• The effects compound over time as spending changes flow through the economy

This time lag poses significant challenges for policymakers. Economic circumstances can change substantially during the 12-24 month lag period, potentially making current monetary policy settings inappropriate for current conditions.

Because of these time lags, the RBA doesn't focus on current economic conditions when setting monetary policy. Instead, it focuses on what economic conditions are likely to be in 12 to 24 months' time. This forward-looking approach requires the RBA to forecast future economic conditions with reasonable accuracy.