The transmission mechanism
The transmission mechanism (also referred to as the transmission channels) refers to the way a change in interest rates affects economic activity. There are five generally recognised ways in which a change in interest rates will impact on economic activity. The transmission occurs via the effects on:
1. The cost of credit
2. Cash flows
3. Availability of money and credit
4. Asset values/prices
5. Exchange rate
The cost of credit channel
This is also referred to as the Savings and Investment channel. If we assume that interest rates increase, the cost of credit channel works by making it more costly to borrow money (and more attractive to save). This higher cost of credit should reduce the willingness of households to borrow money for the purchase of goods and services. In particular, it reduces the demand for consumer durables, and overall, it is likely to reduce Consumption in the economy. Similarly, businesses are likely to reduce or delay Investment as higher borrowing costs make any investment spending less viable. The reduction in Consumption and Investment then works to reduce Aggregate Demand and Economic Growth.
The cash flow channel
The cash flow channel impacts on the spending power of those economic agents with existing levels of debt. In particular, householders with mortgages will immediately suffer a fall in their cash flow (or discretionary income) as more of their disposable income is required to repay the interest component of their mortgage. The business sector will also experience a drop in cash flow as they spend more to service their debt. These factors will result in a fall in Consumption and Investment, further reducing Aggregate Demand.
The availability of money and credit channel
The availability of money and credit in the economy is likely to fall in times of higher interest rates because it makes it less likely that some households or businesses will meet the lending criteria established by financial institutions because the risk of default increases. In short, financial institutions are more likely to reduce the number of loan approvals when interest rates rise.
Asset values or asset prices channel
Higher interest rates are likely to induce a fall in asset values or asset prices. This is because the demand for property, shares and other investment assets should decrease when the costs of borrowing rise. This reduces wealth, Consumption, AD and economic activity. For example, to the extent that relatively high interest rates cause less demand for housing and lower house prices, it is fair to expect a slowdown in the rate of spending by some property owners who experience a decline in the value of (perhaps) their biggest asset. This phenomenon played out since 2010-11, as the relatively high interest rates contributed to a slowing property market, resulting in a higher household savings ratio and lower spending.
The exchange rate channel
The exchange rate will generally be positively correlated to interest rates, such that a rise in interest rates is expected to cause an appreciation of the exchange rate. This is because higher domestic interest rates attract foreign funds (capital inflow) in search of higher rates of return. As the foreign funds enter Australia, they are exchanged into Australian dollars, exerting upward pressure on the value of AUD. The higher exchange rate then reduces the international competitiveness of Australia's tradables sector, reducing net exports (X-M) and decreasing Aggregate Demand and inflationary pressure. In addition, a higher exchange rate makes imports relatively cheaper and reduces the prices of imported consumer and producer goods. This further reduces inflationary pressure in the economy.