Transmission Mechanisms

Question 1

What are Transmission Mechanisms?
(Definition)

Answer 1

When banks change the interest rates that they are charging their customers, (households and businesses with a loan) the effects of this change flow through the economy in 4 unique ways. We call these transmission channels or mechanisms.

Question 2

What are the 4 Transmission Mechanisms and which parts of AD do they affect?
(Name of the 4 channels)

Answer 2

1. Savings and Investment (C and I)
2. Cash Flow / incomes (C and I)
3. Wealth and Asset Prices (C and I)
4. Exchange Rates (X and M)

Question 3

How does the “Savings and Investment” Transmission Channel Work?

Answer 3

• If interest rates increase, the reward for saving increases, and the cost of borrowing increases.
• This impacts the decision of consumers to save vs to borrow and spend/invest. (For those who don’t have a loan yet)
• Affects both households and businesses
• Decrease in C and I –> Decrease in AD

Question 4

How does the “Cash-flow” Transmission Channel Work?

Answer 4

• It affects households and businesses that have existing debt
• Most households have variable interest rates
• Increase in interest repayments on existing variable loans
• Causing a decrease in discretionary income for households and thus a decrease in cash flow for businesses
• Decrease in C and I –> Decrease in AD

Question 5

How does the “Exchange Rate” Transmission Channel Work?

Answer 5

• A change in interest rates in Australia would cause a change in the relative interest rate (compared to other countries)
• Thus, investors are more likely to invest their money into Australia (if it has a higher relative interest rate)
• Thus the demand for AUD will increase on the foreign exchange market, (also change the suppply) and therefore effect X and M.
• Higher relative interest rates –> X↓ and M↑ –> Decrease in AD

Question 6

How does the “Asset Prices / Wealth effect” Transmission Channel Work?

Answer 6

• Strong evidence shows that as interest rates increase, the price of assets like shares, bonds and property decrease.
• The ‘wealth effect’ describes the feeling households have knowing the price/value of their assets has changed.
• Lower ‘wealth effect’ means households are less likely to spend due to feeling less wealthy
• Decrease in C and I –> Decrease in AD