Unit 5 Macroeconomic policy: Inflation and unemployment

5.13 Transmission of monetary policy decisions to inflation: Domestic channels

Monetary policy relies on:

  • the central bank being able to control interest rates
  • changes in policy interest rates influencing market interest rates, which affect aggregate demand and, in turn, inflation.

How is monetary policy transmitted to the economy in practice? We will show that there are several channels, in addition to business investment and housing, including mechanisms acting through asset prices, and also the exchange rate.

The Bank of England publishes a diagram like Figure 5.18 to explain to the general public how it views the transmission of monetary policy from its policy interest rate decision to aggregate demand and inflation in ‘normal’ situations—that is, when the interest rate is its policy instrument. Other inflation targeting central banks publish similar diagrams.

This flowchart delineates the transmission mechanism of the central bank’s policy interest rate through the economy, culminating in inflation. The process begins with the policy interest rate shaping market interest rates, asset prices, economic expectations and confidence, and the exchange rate. These initial adjustments then simultaneously affect domestic aggregate demand and net exports. The resulting shifts in these components alter the overall aggregate demand. This chain of economic reactions instigates inflationary pressure domestically. In conjunction, changes in the exchange rate adjust import prices. Collectively, these developments result in inflation.
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https://www.core-econ.org/macroeconomics/05-macroeconomic-policy-13-transmission-of-policy-decisions.html#figure-5-18

Figure 5.18 Policy interest rate and monetary policy transmission mechanisms.

In this section, we examine the components of the diagram that relate to the domestic economy; the exchange rate channel is covered in the following section.

Market interest rates

In Unit 6 (page 000), we explain how the central bank can exercise this control.

When the central bank sets the policy rate, it effectively also controls the rate on all risk-free borrowing over relatively short periods—typically up to around three months.

For a wider range of market interest rates, the impact of changes in the policy rate is more indirect and, as Figure 5.19 illustrates for the United States, market interest rates may respond in a relatively limited way to policy rate changes; they will also respond to other factors.

The line chart displays the trends of the nominal policy rate and market interest rates in the United States spanning from 1970 to 2025. The horizontal axis depicts the years from 1970 to 2025, and the vertical axis that ranges from 0% to 20% captures the interest rate in percentages. The graph plots three distinct lines: the 30-year fixed-rate mortgage average, the corporate borrowing rate, and the policy rate. Overall, all lines show a sharp increase starting in the early 1970s, peaking near 20% in the early 1980s, followed by a consistent decrease until the early 2020s when a slight uptick occurs. Throughout the timeline, the mortgage and corporate rates move closely together, reflecting parallel trends in rising and falling rates. In contrast, the policy rate is more erratic, demonstrating pronounced fluctuations and divergences from the other rates, particularly after its peak in the early 1980s. Notable gaps between the policy rate and the other rates emerge in the early 1990s, early 2000s, and from 2008 to the early 2020s. These increasing gaps between the policy rate and market rates suggest that market interest rates do not always align closely with changes in the policy rate.
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https://www.core-econ.org/macroeconomics/05-macroeconomic-policy-13-transmission-of-policy-decisions.html#figure-5-19

Figure 5.19 The nominal policy rate and market interest rates in the United States.

Federal funds effective rates. FRED Economic Data.

To understand these relationships in the data, we need to think about the nature of the markets for lending and borrowing.

bond
A financial asset where the government (or a company) borrows for a set period of time and promises to make regular fixed payments to the lender (and to return the money when the period is at an end).

As explained in more detail in Unit 6 (page 000), commercial banks are profit-maximizing firms. They will usually respond to changes in the policy rate by adjusting the rates at which they lend to households (both consumer lending and rates on mortgages for house purchase) and firms. These rates will typically be above the policy interest rate: this feature is clearly visible in the chart. Just as for other price-setting firms, the extent of competition among banks will affect the size of the markup or spread of the lending rate above the policy rate. But we shall learn in Unit 6 that these rates will also be influenced—sometimes quite strongly—by the extent to which there is a risk of default (that is, of bank loans not being repaid), as well as the length of time over which funds are being lent. Both these effects are shown in the movements of the 30-year mortgage rate in Figure 5.19.

Similar factors affect the interest rates at which companies can borrow. In Unit 6 (page 000) we shall also learn that in many economies—especially in the United States and the UK—larger companies borrow large amounts by selling bonds rather than via loans from a bank. These are typically promises to repay the lender over quite long periods, from 5 to 30 years. The longer-term borrowing rates on such loans will usually respond to changes in the policy rate, but, as Figure 5.19 shows, often this response will be quite muted, since those buying the bonds will also take into account what the policy rate is expected to be, often multiple years in the future.

The fact that mortgage lending in the United States is typically over long periods of up to 30 years helps to explain why the mortgage rates and the corporate borrowing rates often show very similar patterns in Figure 5.19.

Exercise 5.10 The disconnect between the policy rate and lending rates

collateral
An asset that a borrower pledges to a lender as a security for a loan. If the borrower is not able to make the loan payments as promised, the lender becomes the owner of the asset.
  1. During the global financial crisis of 2008 and the following years, Figure 5.19 shows that the policy rate in the US fell very sharply to close to zero, while mortgage rates and corporate borrowing rates were initially unchanged. In the light of the discussion above, what do you think explains this pattern? (Hint: think about the extent to which the two types of borrowers have collateral.)
  2. In many countries, mortgage lending contracts have interest rates that are fixed for much shorter periods than in the United States, or may simply be ‘floating rates’ that can be changed at short notice by the lender. How would you expect this to affect the relationship between mortgage rates and the policy rate? Find some data to test whether your expectations were correct.
  3. The chart below shows that the rate on credit card debt is always significantly higher than the policy rate, and relatively unresponsive to changes in the policy rate. What features does such borrowing have in common with mortgage lending and lending to corporations, and what features are distinct?
The line chart depicts the relationship between lending rates and the policy rate in the US from 1995 to 2025. The horizontal axis displays the years from 1995 to 2025, and the vertical axis shows interest rates in percentages, ranging from 0% to 24%. The policy rate line initially shows a plateau at 6% in the late 1990s, then drops to 1% by late 2004, and climbs back to around 6% in 2007. It then dramatically decreases to near 0%, remaining there until 2016, when it gradually rises to 2% by late 2019. Between early 2020 and 2023, it falls back to zero before soaring to around 5% afterwards. The line for commercial bank interest rates on credit card plans is positioned above the policy rate line but mostly follows a similar trend, rising and falling at similar times. It starts at 16% in 1995, then plateaus, and decreases during the early 2010s. Notably, during the 2008 financial crisis, even as the policy rate drops to nearly zero, the lending rate stays around 12%, showing no clear downward trend. A similar pattern occurs during the pandemic, where the policy rate drops to zero, but the lending rate remains steady at 15%.
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Figure for Question 3 The disconnect between the policy rate and lending rates.

Commercial Bank interest rates on credit cards. FRED Economic Data.

The impact on domestic aggregate demand

The Bank of England diagram in Figure 5.18 highlights two channels from a change in the policy rate to aggregate demand. One of them operates via the exchange rate and net exports, and is explained in the next section. Here, we focus just on the linkages with the domestic components of aggregate demand: the impact on investment and consumer spending.

We would not in general expect government consumption spending (G) to be sensitive to the interest rate.

Investment

As the present value model shows, firms’ investment decisions depend on interest rates and expected future profits. If a rise in the policy rate causes the real interest rate to rise, then ceteris paribus, firms will reduce their investment spending.

In practice, however, it is found that business investment is not very sensitive to the real interest rate. The explanations relate to the fact that when the interest rate changes, other factors do not remain constant. In other words, the ceteris paribus assumption does not hold. For example, if the policy rate is being cut because the economy is in a recession, we might well expect—on theoretical grounds—that risk premiums might simultaneously be rising: investment projects are judged to be more risky. This would offset the effect of the fall in the interest rate and leave the discount rate relatively unchanged, thereby limiting the effect of the policy decision on investment. In a recession, it is also possible that the expected rate of profit on new investment projects would fall, again hindering a strong response of investment to a fall in the policy rate.

On the other hand, there is good evidence that changes in real interest rates have a substantial effect on investment in housing, which is part of fixed capital formation. However, different systems of housing finance in different countries affect the interest-sensitivity of investment in housing.

The other component of investment, government investment—such as on infrastructure—is typically much less responsive to real interest rates.

Asset prices and consumer expenditure

asset prices
Asset prices is a general term used to refer to the prices of both financial assets (like shares or bonds) and real assets (such as housing, land, gold, or works of art). See also: asset.

We know from the previous section that changes in interest rates also affect asset prices. These include not only financial assets, but also house prices: buying a house is a form of investment—you incur the cost immediately, and expect to receive benefits in the future. When market interest rates go down, asset prices will typically go up. This in turn can be expected to feed through to aggregate demand, particularly by households (c0 in the consumption equation), because those households that own the assets will feel wealthier.

In a similar way, interest rates will affect spending by households on consumer durables, and also residential investment—a substantial component of which is made up of improvements to existing houses. Here, we would expect there to be both a direct channel from interest rates, via the cost of borrowing, and an indirect channel via asset prices, particularly house prices.

Expectations and confidence

We have stressed the importance of profit expectations and confidence for the investment decisions of firms. When setting the policy rate, the central bank tries to build confidence through consistent policymaking and good communication with the public. If it lowers the policy rate in the context of a negative shock to aggregate demand, for example, and explains its reasoning, this can lead firms to expect higher demand, which will lead to higher investment. Similarly, if it increases the confidence of households that they will not lose their jobs, then they may feel more comfortable in sustaining their regular spending. The confidence channel can help shift the economy from the low-investment equilibrium illustrated in the coordination game in Figure E3.3 to a high-investment equilibrium.

Real versus nominal interest rates

As we stressed in Section 5.2, economic theory would predict that it is the real interest rate that affects spending. But when the central bank sets the policy rate, it sets it in nominal terms. So by setting a particular nominal rate, it is aiming for a specific real interest rate—and it therefore needs to take into account the effect of expected inflation, using the Fisher equation, on the range of market interest rates affected by its policy change.

Read, for example, ‘Nominal Interest Rate Effects on Real Consumer Expenditure’ by James A. Wilcox for the empirical evidence.

Interestingly, there is evidence that changes in real and nominal interest rates can affect spending. While standard economic reasoning would suggest only real interest rates should matter, changes in nominal interest rates can significantly affect household disposable income, especially via mortgage interest payments. If, as discussed in Unit 3, households are subject to credit constraints, a rise in nominal interest rates can reduce consumer spending, even when real interest rates do not change. Empirical evidence suggests that this channel for interest rate changes can sometimes be quite powerful.

And last (but not least): The impact on inflation

As we have stressed, the central bank’s primary remit is to control inflation. Therefore, there is a further crucial link in the transmission mechanism of monetary policy: the link between demand and inflation. The central bank will be relying on the operation of the Phillips curve that links the level of output and demand to the inflation rate. This linkage has been very powerful at times (as illustrated in Figure 5.13); but it is also far from straightforward, in particular given the role of inflation expectations.

The next section shows that, to the extent that changes in monetary policy affect the exchange rate, this will not only considerably strengthen the impact on aggregate demand (via net exports) but also, crucially, will have a direct impact on inflation—as highlighted in the Bank of England’s diagram.

To follow the transmission of monetary policy from the policy rate to inflation, work through Figure 5.20.

This flowchart delineates the transmission mechanism of the central bank’s policy interest rate through the economy, culminating in inflation. The process begins with the policy interest rate shaping market interest rates, asset prices, economic expectations and confidence, and the exchange rate. These initial adjustments then simultaneously affect domestic aggregate demand, denoted as C+I, and net exports, denoted as X−M. The resulting shifts in these components alter the overall aggregate demand, denoted as AD. This chain of economic reactions instigates inflationary pressure domestically. In conjunction, changes in the exchange rate adjust import prices. Collectively, these developments result in inflation.
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https://www.core-econ.org/macroeconomics/05-macroeconomic-policy-13-transmission-of-policy-decisions.html#figure-5-20

Figure 5.20 The transmission of monetary policy from the policy rate to inflation.

Market interest rates: This flowchart delineates the transmission mechanism of the central bank’s policy interest rate through the economy, culminating in inflation. Initially, the central bank’s policy interest rate influences market interest rates. Subsequently, these adjusted market rates impact domestic aggregate demand. Alterations in domestic aggregate demand, in turn, exert pressure on the overall aggregate demand. This sequence of events generates domestic inflationary pressures, ultimately resulting in inflation.
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https://www.core-econ.org/macroeconomics/05-macroeconomic-policy-13-transmission-of-policy-decisions.html#figure-5-20a

Market interest rates

The central bank’s policy interest rate affects the market interest rate (used for mortgages, personal loans, and so on) and aggregate demand. This alters the bargaining gap and therefore inflation.

Elements of the business cycle model: This flowchart delineates the transmission mechanism of the central bank’s policy interest rate through the economy, culminating in inflation. Initially, the central bank’s policy interest rate influences market interest rates. Subsequently, these adjusted market rates impact consumption, denoted as C, and investment, denoted as I, which in turn cause changes in the overall aggregate demand, denoted as AD. This sequence of events generates bargaining gaps, ultimately resulting in inflation.
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https://www.core-econ.org/macroeconomics/05-macroeconomic-policy-13-transmission-of-policy-decisions.html#figure-5-20b

Elements of the business cycle model

This diagram shows the elements of the business cycle model in the transmission mechanism.

Asset prices and expectations: This flowchart delineates the transmission mechanism of the central bank’s policy interest rate through the economy, culminating in inflation. Initially, the central bank’s policy interest rate influences market interest rates, asset prices and expectations and confidence simultaneously. Subsequently, these changes impact domestic aggregate demand. Alterations in domestic aggregate demand, in turn, exert pressure on the overall aggregate demand. This sequence of events generates domestic inflationary pressure, ultimately resulting in inflation.
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https://www.core-econ.org/macroeconomics/05-macroeconomic-policy-13-transmission-of-policy-decisions.html#figure-5-20c

Asset prices and expectations

A higher policy rate reduces asset prices and business and consumer confidence, depressing domestic aggregate demand.

Exchange rate and net exports: This flowchart delineates the transmission mechanism of the central bank’s policy interest rate through the economy, culminating in inflation. Initially, the central bank’s policy interest rate influences market interest rates, asset prices, expectations and confidence, and exchange rate simultaneously. Subsequently, these changes impact both the domestic aggregate demand and net exports, which in turn lead the overall aggregate demand to change. This sequence of events generates domestic inflationary pressure, ultimately resulting in inflation.
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https://www.core-econ.org/macroeconomics/05-macroeconomic-policy-13-transmission-of-policy-decisions.html#figure-5-20d

Exchange rate and net exports

A higher policy rate causes an exchange rate appreciation, which reduces exports and raises imports, depressing aggregate demand. We explain this mechanism in more detail in Section 5.14.

Import prices: This flowchart delineates the transmission mechanism of the central bank’s policy interest rate through the economy, culminating in inflation. The process begins with the policy interest rate shaping market interest rates, asset prices, economic expectations and confidence, and the exchange rate. These initial adjustments then simultaneously affect domestic aggregate demand and net exports. The resulting shifts in these components alter the overall aggregate demand. This chain of economic reactions instigates inflationary pressure domestically. In conjunction, changes in the exchange rate adjust import prices. Collectively, these developments result in inflation.
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https://www.core-econ.org/macroeconomics/05-macroeconomic-policy-13-transmission-of-policy-decisions.html#figure-5-20e

Import prices

An appreciated exchange rate reduces import prices, which lowers inflation directly; it raises real wages, which lowers inflation indirectly by reducing the bargaining gap.

The transmission mechanisms: This flowchart delineates the transmission mechanism of the central bank’s policy interest rate through the economy, culminating in inflation. The process begins with the policy interest rate shaping market interest rates, asset prices, economic expectations and confidence, and the exchange rate. These initial adjustments then simultaneously affect domestic aggregate demand, denoted as C+I, and net exports, denoted as X−M. The resulting shifts in these components alter the overall aggregate demand, denoted as AD. This chain of economic reactions instigates inflationary pressure domestically. In conjunction, changes in the exchange rate adjust import prices. Collectively, these developments result in inflation.
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https://www.core-econ.org/macroeconomics/05-macroeconomic-policy-13-transmission-of-policy-decisions.html#figure-5-20f

The transmission mechanisms

This diagram shows the transmission mechanism through the lens of the WS–PS, multiplier, and Phillips curve models.