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The transmission mechanism of monetary policy involves channels through which monetary policy decisions affect the economy in general and the price level in particular. As the transmission mechanism is characterised by long, variable and uncertain time lags, it is difficult to predict the precise effect of monetary policy actions on the price level and economy. The chart below provides a schematic illustration of the main transmission channels of monetary policy decisions.

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  • Monetary policy can also guide economic agents' expectations of future inflation and thus influence price developments. A central bank with a high degree of credibility can firmly anchor expectations of price stability. In this case, economic agents do not have to increase their prices for fear of higher inflation or reduce them for fear of deflation.
  • Expectations of future official interest-rate changes affect medium and long-term interest rates, as longer-term interest rates depend in part on market expectations about the future course of short-term rates.
  • A change in the official interest rates affects directly money-market interest rates and, indirectly, lending and deposit rates, which are set by banks to their customers.
  • Impact on banks and money-market interest rate
  • Changes in official interest rates have various impacts.
  • The central bank provides funds to the banking system and charges interest. Given its monopoly power over the issuing of money, the central bank can fully determine this interest rate.

Change in official interest rates

Impact on banks and money-market interest rates
A change in the official interest rates affects directly money-market interest rates and, indirectly, lending and deposit rates, which are set by banks to their customers.

Impact on expectations
Expectations of future official interest-rate changes affect medium and long-term interest rates, as longer-term interest rates depend in part on market expectations about the future course of short-term rates.

Monetary policy can also guide economic agents' expectations of future inflation and thus influence price developments. A central bank with a high degree of credibility can firmly anchor expectations of price stability. In this case, economic agents do not have to increase their prices for fear of higher inflation or reduce them for fear of deflation.

Impact on asset prices
The impact on financing conditions in the economy and on market expectations triggered by monetary policy actions may lead to adjustments in asset prices (e.g. stock market prices) and the exchange rate. Changes in the exchange rate can affect inflation directly, insofar as imported goods are directly used in consumption, but they may also work through other channels.

Impact on saving and investment decisions
Changes in interest rates affect the saving and investment decisions of households and firms. For example, everything else being equal, higher interest rates make it less attractive to take loans for financing consumption or investment. In addition, consumption and investment are also affected by movements in asset prices via wealth effects and effects on the value of collateral. For example, as real estate prices rise, households become wealthier and may choose to increase their consumption. Conversely, equity prices fall, households may reduce consumption.

Asset prices can also have an impact on aggregate demand - for instance, via the value of collateral that allows borrowers to get more loans and/or to reduce the risk premia demanded by lenders/banks.

Impact on the supply of credit
Changes in consumption and investment will change the level of domestic demand for goods and services relative to domestic supply. When demand exceeds supply, upward price pressure is likely to occur. In addition, changes in aggregate demand may translate into tighter or looser conditions in labour and intermediate product markets. This in turn can affect price and wage-setting in these markets.

Impact on the supply of bank loans
Changes in policy rates can affect banks' marginal cost for obtaining external finance differently, depending on the level of a bank's own resources and capitalisation. This channel is particularly relevant in a financial crisis, when capital is scarcer and banks find it more difficult to raise capital.

Higher interest rates also increase the risk that borrowers are no longer able to service their loans and banks may offer fewer loans to households and companies. This may, in turn, decrease the consumption of households and the investments of companies.

In addition to the traditional bank lending channel, which focuses on the quantity of supplied loans, a risk-taking channel exists, which means that banks' incentive to bear risk related to the provision of loans may decrease. This channel usually operates in two ways:
1) first, low interest rates boost asset and collateral values. This, in conjunction with the belief that the increase in asset values is sustainable, leads both borrowers and banks to accept higher risks;
2) low interest rates make riskier assets more attractive, as agents search for higher yields. In the case of banks, these two effects usually translate into a loosening of credit standards, which can lead to an excessive increase in loan supply.