How do changes in interest rates transmit into the economy?

The monetary policy transmission mechanism is the process by which changes in the settings of monetary policy instruments lead to the desired changes in inflation. The first stage in the transmission mechanism is therefore a change in the settings of monetary policy instruments. This engenders a change in the behaviour of the intermediary markets which the monetary policy instruments directly influence. The change in behaviour on these markets in turn leads - via changes in various other intermediary markets - to changes on the target markets where the central bank wants to influence inflation.

The transmission mechanism acts through several channels in parallel. The traditionally quoted example is the interest rate channel, which operates in the following way. An increase/decrease in a monetary policy interest rate (specifically the repo rate in the Czech Republic) leads first to an increase/decrease in interest rates on the interbank market. This in turn causes banks to raise/lower their rates on credits and deposits. The result is a contraction/expansion of investment activity and aggregate demand and ultimately a weakening/strengthening of inflationary pressures.

Back to list